Government Influence on Exchange Rates

Understanding the role that governments play in influencing

exchange rates

Government Activities that Influence Spot Exchange Rates

• The foreign exchange regime that the government adopts. – Independent float, managed float and pegs.– Recall that market forces can result in “forced”

changes in foreign exchange regimes.• UK in 1992; Asian economies during the Asian currency

crisis of 1997, etc.

• Direct and indirect government intervention in foreign exchange markets.

Why do Governments Attempt to Influence Exchange Rates?

• To react to what the government feels is an unwarranted level of the spot rate.– Generally done when the exchange rate “threatens”

domestic economic activity.• Japan’s intervention on September 15, 2010

• To respond to “temporary” disturbances.– Generally done when sudden and unanticipated events

produce extreme moves in exchange rates.• Offsetting safe haven effects.

• To establish and maintain implicit and explicit exchange rate boundaries.– Done within the context of a pegged or managed

exchange rate regime.

Direct and Indirect Intervention• Direct Intervention:– Buying and selling currencies in foreign exchange

markets.• Buying weak (depreciating) currencies and selling strong

(appreciating) currencies.• Indirect Intervention:– Government adjusting domestic interest rate.

• Raising interest rates to support weak (depreciating) currencies and lowering interest rates to offset strong (appreciating) currencies.

– Foreign exchange controls.• Restrictions on the exchange of currency (i.e., the type and

amount of transactions).

Direct Intervention• Through direct intervention in foreign exchange markets,

governments are attempting to offset market forces on spot exchange rates.– If market forces strengthen a currency, a government (central

bank) could respond by selling the strong currency (and buying the weak currency) into the foreign exchange market (thus meeting market demand for the strong currency).• When the government does so, it accumulates international reserves

(i.e., the “weak” currency it is buying).– If market forces weaken a currency, a government (central

bank) could respond by buying the weak currency (and selling the strong currency) on the foreign exchange market (thus reducing the supply of the weak currency).• When the government does so, it uses its international reserves (i.e.,

the “strong” currency it is selling).

Direct Intervention to Support a Weak Currency

Why is the Currency Weakening?• Markets moving out of that

currency into another currency (i.e., into the preferred currency).– Interest rate differentials, safe

haven effects, trade flows, political and economic risk, asset bubbles, expectations of changes in peg, etc.

• Government needs to buy its currency to offset market selling.• Either unilaterally or through

cooperative intervention.

Impact of Intervention• As the government is buying its

weak currency, it is also supplying the currency that the markets are moving into (i.e., the preferred currency).

• In doing so, the government is reducing its international reserves (i.e., the key currency the market is preferring).– Success of this direct intervention

depends on government’s supply of international reserves and extent of international cooperation.

Direct Intervention to Offset a Strong Currency

Why is the Currency Strengthening?• Markets moving into that

currency (i.e., the preferred currency) and away from other currencies.– Interest rate differentials, safe

haven effects, trade flows, political and economic risk, expectations of changes in peg, etc.

• Government needs to sell its currency to offset market demand.• Either unilaterally or through

cooperative intervention.

Impact of Intervention• As the government is selling its

strong currency, it is essentially supplying the currency that the markets are moving into (i.e., the preferred currency).

• In doing so, the government is increasing the supply of its currency in foreign exchange markets and also potentially in its own domestic market. – The potential impact of increasing

the country’s domestic money supply is to accelerate inflationary pressures and inflationary expectations for that economy.

• Success of this direct intervention depends on the extent of international cooperation.

Non-sterilized Versus Sterilized Direct Intervention

Non-sterilized Intervention • Defined as a central bank not

taking any action to offset the increase (or decrease) in the country’s domestic supply resulting from direct intervention to offset a strong (weak) currency.

• Likely to be followed if the central bank is not concerned about inflationary impacts or impacts on economic activity.– For example, Japan today.

Sterilized Intervention• Defined as a central bank using

monetary policy actions to offset the increase (decrease) in the country domestic money supply resulting from direct intervention to offset a strong (weak) currency.– Usually done through central bank

open market operations, specifically selling or buying government securities through domestic financial institutions.• Sales of government securities will

reduce bank reserves and purchases of government securities will increase bank reserves (see slides which follow).

Text Book Exhibit of Non-sterilized Versus Sterilized Intervention

• The illustration below shows an example of the U.S. Central Bank (i.e., the Federal Reserve)intervening to offset a strong US dollar against the Canadian dollar.– The Fed wants to weaken the U.S. dollar and strengthen

the Canadian dollar.

Text Book Exhibit of Non-sterilized Versus Sterilized Intervention

• Intervention can also produce reductions in a country’s domestic money supply (i.e., if the government is buying its currency and selling the preferred currency).– In the illustration below, the Fed has used direct

intervention to strengthen the U.S. dollar and weaken the Canadian dollar (i.e., offset USD selling on FX markets)

Indirect Intervention• Indirect intervention generally involves two possible

actions:– Adjusting domestic interest rates.

• Raising interest rates to support a weak currency – i.e., increasing the interest rate differential in favor of the weak currency country.• September 18, 1992, the Swedish Central Bank raised its marginal lending

rate to 500% to temporarily stem speculative pressures against the krona (SEK). At the time the krona was pegged to a trade-weighted basket of 15 foreign currencies (peg was dropped in December of 1992 and an independent float was adopted).

• Lowering interest rates to offset a strong currency – i.e., decreasing the interest rate differential in favor of the strong currency country.

– Assumption is that by adjusting the interest rate differential, the demand for the currency is affected.

– Problem with interest rate adjustments:• This policy may be inconsistent with domestic economy conditions

and required monetary policy stance for those conditions.– For example, the U.K. in 1992 when part of the Exchange Rate Mechanism

(ERM) – UK needed lower interest rates to stimulate domestic demand, but higher interest rates to maintain exchange rate in ERM.

Raising Interest Rates to Defend a Currency

Interest Rates During the Asian Currency Crisis

Interest Rates in Argentina, 2002 @ 125% in August

Indirect Intervention• A second type of indirect intervention involves the use of foreign

exchange controls.– Defined: Government restrictions on transactions in the foreign

exchange market.• Regulations on convertibility:

– Setting the amount of foreign exchange a resident can purchase and/or setting limits on the amount of foreign exchange a domestic company can hold (from foreign sales) and thus must sell “excess” back to government.– Viet Nam Ordinance On Foreign Exchange Controls (Jan 31, 2010): “Residents must

remit all foreign currency amounts derived from export of goods and services into a foreign currency account opened at an authorized credit institution in Vietnam. If residents wish to retain foreign currency overseas, they must obtain approval from the State Bank of Vietnam.”

• Regulations on market makers:– Central bank (or government agency) is the only bank authorized to conduct foreign

exchange transactions.• Regulation on types of transactions (i.e., capital controls):

– Permitting foreign exchange transactions resulting from commercial transactions, but not from “speculative” transactions (e.g., closing the markets for short term capital flows).– In 1997 (Sep 1), Malaysia, in response to the ringgit currency attack, imposed

capital controls which essentially closed down transactions in short term capital movements out of the ringgit by requiring that any investment transactions involving ringgits had to be held for 12 months in approved banks. Restriction was lifted in December 2000.

Case Study of Malaysia’s Response to the 1997 Currency Crisis

Sequence of Events• During the mid 1990s, Malaysia attracts a

substantial volume of volatile capital (short term and portfolio; i.e., mobile capital) which were driven by the boom in the equity market (an equity bubble occurs).– FDI investment peaks in 1996; but volatile capital

inflows continue to rise.• May 14-15, 1997: Malaysia ringgit comes under

attack. At the time the ringgit is highly managed to the USD (@a rate of 2.5).– Part of a contagion effect in Asia (started in Thailand)– Market concerns about weak corporate governance

and weakness in the financial sector in Malaysia results in outflows of volatile capital.

• July 2, 1997, Malaysia drops its managed float, and the ringgit falls 18%, but the government continues to use direct intervention to support the currency. Malaysia continues to raise interest rates during the crisis.

• September 1, 1997, Malaysia imposes a set of capital controls which shut down the “offshore” market in ringgit and stop “speculative trading.”

• September 2, 1998, Malaysia introduces a peg regime (@3.8).

• Capital controls are lifted from Feb 1999 through Jan 2003.

• July 21, 2005, Malaysia announces abolition of the ringgit peg in favor of a managed float.

Exchange Rate: USD/MYR

Case Study of U.K. Currency Crisis of 1992

Background• Britain joined the European

Exchange Rate Mechanism (ERM) in October 1990.– ERM was designed to promote

exchange rate stability within Europe.

• Under the ERM, European currencies were “pegged” to one another at agreed upon rates.– In October 1990, the British

pound was “locked” into the German Mark at a central rate of about DM2.9/£

– General feeling at the time was that this rate overvalued the pound against the mark.

Germany’s Role in the ERM• While the ERM included many

European countries, Germany was the leading player because of its economic dominance.– Thus, the German mark was also

the dominant currency in this arrangement and German monetary policy set the tone for the rest of the ERM members.

• Thus, German monetary policy had to be followed by the other members in order for the other member states to keep their currencies aligned with the German mark.– This was especially true with

regard to Germany’s interest rate.

Case Study of U.K. Currency Crisis of 1992

Events Leading up to the Speculative Attack• While the markets felt the pound was

“overvalued” when it joined the ERM, a combination of two critical events, one just before and a second just after Britain joined the ERM convinced some in the market that the pound was now ready for speculation.

• These events were:– The fall of the Berlin Wall in Nov 1989– The economic “recession” in the U.K. in 1991-

92.• Fall of the Berlin Wall: As a result, German

decided to raise interest rates in order to attract needed capital for the reunification of East and West Germany.– Other ERM countries need to follow with

higher interest rates.• UK Recession: However, the issue for the

U.K. was having to raise interest rates during their recession.– A recession would be properly addressed by

lower interest rates.– Thus there was both a political and economic

component to the potential decision to raise rates.

– Markets thought the UK would not be willing to raise rates to defend the pound.

The Attack and Response• Pound currency attack begin in September

1992– Short selling of the pound was led by

hedge funds: particularly George Soros.• The British Government’s initial response to

the attack occurred on Wednesday, September 16 – Government raised interest rates twice

from 10% to 12 and then to 15%• Attempt to make U.K. investments more

attractive.• During the attack the Bank of England used

$4 billion in hard currency in defense of the pound. Bank of England bought $4 billion worth of pounds which were being sold short (it did this by selling U.S. dollars and German marks to speculators).– Estimates: 1/3 of its hard currency was

spent.• On Wednesday at 7pm (UK time), the U.K.

government announced they would be leaving the ERM the next day and that interest rates would go back to 10%. (referred to as “Black Wednesday”).– Thursday, September 17, the pound

returned to an independent float.• By late October, the pound had fallen about

13% against the mark and 25% against the U.S.

Sterling Exchange Rate Around the Time of the 1992 Crisis

GBP/DEM GBP/USD