Should a central bank use its currency reserves to support the value of its country’s currency in the foreign exchange market? What can be achieved by such intervention?
Introduction:
In this modern world, nearly every country is completely dependant on international trade. This has far reaching implications for countries that export much of their output. This leads one to reasoning that the foreign exchange reserves and the current account balance are of paramount importance. There will be surpluses or deficits each year. While having a surplus current account is always the ideal, countries are always realistic enough to understand that deficits are bound to exist some time or the other. In the short run, retained reserves and international financing could meet deficits. It must also be remembered that having a balanced current account should not be an end in itself. It should not negate other targets set by the government.
The government has at its disposal, an array of economic tools, which could be used to correct a balance of payments deficit. What must be kept in mind is that these tools are themselves subject to limitations. For example a government could use tariffs and other barriers like quotas as part of its international trade policy. However, these measures are themselves limited by international agencies such as the World Trade Organization (WTO).
A country’s international trade policy could be affected by the economic policies of its trading partners. For example, Ireland could find it very difficult to export to Brazil if Brazil pursued a policy to protect its infant industries. One consideration could also include that countries in the European Community are part of what is called the Exchange Rate Mechanism (ERM), which allows the exchange rate to fluctuate within a very narrow range.
Therefore, it would be very difficult for countries within the European Community to use their exchange rates as part of their foreign exchange policy in dealing with a balance of payments deficit[1]. In short, the factors that will influence the government’s foreign trade policy will be determined by commitments to international agencies, as well as the exchange rate system, government policies, and the state of the domestic economy and the causes of the disequilibrium.
What is of concern at the moment is the type of exchange rate and whether the central bank should intervene in supporting the value of its currency in the foreign exchange market.
There are three types of exchange rate systems. There are as follows:
- Floating Exchange Rate System
- Fixed Exchange Rate System
- Managed Floating Exchange Rate System[2]
Floating Exchange Rate System
A government could use floating exchange rates to support the currency in the international market. In theory, by simply buying or selling its currency, a government could increase or decrease the value of its currency. In a floating exchange rate system, the currency market sets the value of the currency in question. When one refers to the currency market here, it must be remembered that the currency market is itself composed of banks, governments and other financial institutions that have many different objectives[3]. With so many forces coming into play, it may come as no surprise that in some cases, when governments buy and sell currency, their actions might have little or no affect on the value of the currency. However, it must be added that the government is a key player, and what really determines whether the actions of the government results in the appreciation or depreciation of its currency, is determined by the amount of currency which is held by the central bank (Devereux & Engel, 1999, 99-13).
Suppose the Indian government would like to decrease the value of its currency in order to make its exports cheaper in the international market. It would have to sell its own currency and purchase US Dollars. It could only do this if it has adequate reserves in the central bank. On the other hand, if the Indian government sees that the value of its currency is falling too fast, it must buy its own currency and sell US Dollars that it has in its reserves. This would result in the increase of the value of the Indian Rupee. However, this would depend on the amount of US Dollars held in its reserves[4].
This leads one to the following conclusion that with all else equal, higher demand for a particular currency would lead to higher value of the currency. On the other hand, with all else equal, lower demand for a particular currency would result in lower value of the currency. Similarly, with all else equal, higher supply of a particular currency would result in lower value of the currency. On the other hand, with all else equal, lower supply of a particular currency would result in higher value of the currency. Since the early 1970s, many governments have changed over to floating exchange systems. It must be added here that, in reality, very few governments actually have a true floating exchange system (Stanlake & Grant, 2000, 527).
Fixed Exchange Rate System
In some countries there is a system in which the central bank decides the currency rate and is committed to buy or sell the local currency at the agreed value. The underlying reason for having fixed exchange rates is based on the principal that constant exchange rates will help to foster improved trading partnerships and will also reduce uncertainty, and help to make decisions for the future. With this in mind, fixed exchange rates are quite common. One must also realize that although by fixing exchange rates brings about stability, there will always be demand and supply for currencies. This would imply that in the short run exchange rates may be fixed but it is the exchange rates in the long run that are of equal, if not greater importance[5].
When the Fixed Exchange Rate System is considered, the Central Bank must be willing and able to accept at a specified rate both local and foreign currency. Another factor that must also be considered is the fact that the market equilibrium rate may or may not be the same as the government specified rate. The central bank must be in a position to handle the excess demand or supply for which it must have sufficient amounts of local and foreign currency reserves (Mundell, 1963, 475-485).
With regard to local currency, the central bank could print more currency notes and hold sufficient amounts of local currency. This is of course not a problem for the central bank. The real problem is holding sufficient amount of foreign currency reserves, as all transactions in foreign currency must be handled. One way to obviate this is when the central bank uses all its foreign exchange reserves to back the local currency. Reserves could be held in the form of any stable currency like the Dollar, Yen, and Euro[6]. The central bank could only handle this effectively if there were a small difference between the fixed rate and the equilibrium rate[7]. For example, suppose a central bank of India has a Fixed Exchange System and the difference between the fixed exchange rate and the equilibrium rate is quite big. The value of the US Dollar is much greater in the equilibrium rate as compared to the fixed rate[8].
To lessen the difference, the central bank of India will buy Indian Rupees and sell US Dollars. However, it could only cover such a huge difference if it had a huge amount of US Dollars in its foreign exchange reserves. If the Indian government does not have sufficient foreign exchange reserves to do this, then it would have to make the difference between the equilibrium rate and the fixed rate as small as possible. This can be achieved by lowering the value of the Indian Rupee as compared to the dollar by reducing the excess demand for the dollar. This action is called devaluation. The advantage will be to make exports cheaper and imports more expensive. This will help to improve the country’s Balance of Payments (Stanlake & Grant, 2000, 527).
If a country increases the value of its currency, exports will be more expensive and imports cheaper. The type of system in which the government fixes the value of the currency but reserves the right to adjust the value of the currency, is termed as the Adjustable Pegged Exchange Rate System. The most important point to remember is that the central bank must not run out of foreign currency reserves at any cost. If the central bank does not keep adequate reserves, it could result in a financial crisis[9].
The best way to maintain foreign exchange reserves is to have adequate foreign currency in order to convert all local currency to foreign currency, should the need arise. For example, if 1 US Dollar is equal to 60 Indian Rupees, the government will issue 60 times the value of US Dollars that it has in its reserves. This system is termed as a currency board. In this way, foreign exchange reserves will be kept at acceptable levels. Examples of countries using the currency board system are Argentina and Hong Kong. It must be noted that any country, which has a currency board system, should never run out of reserves or it will be left with no other alternative but to devalue its currency (Stanlake & Grant, 2000, 527).
Managed Floating Exchange System
Some countries have a managed floating exchange system. A managed floating exchange system is actually a combination of a fixed exchange system and a floating exchange system. In a managed floating exchange system, the central bank has the center stage in the foreign currency market. Under the managed floating exchange system, the government does not have an explicit value for its currency. However, it does not allow the market to set the value of the currency. It decides before hand what its implicit target for the value of its currency is[10]. If the value of its currency is within the implicit range, it is acceptable to the government. If the value of the currency is out of the implicit range, the government steps in the foreign exchange market by buying and selling its own currency as well as the foreign currency, which it has in the reserves (Stanlake & Grant, 2000, 527).
The government does this in order to bring the value of its currency within its implicit range. For example, suppose that in Japan the government has a managed floating exchange system and the government decides that the value of 1 Dollar is equal to 130 Yen. Under the managed floating exchange system, the government can allow minute fluctuations in the exchange rate, such as from 125 to 135. As long as the exchange rate is within the range of 125 to 135, the government will not step in. If the value of the Japanese Yen is 140, the government of Japan will step in and buy Japanese Yen from its reserves and sell US Dollars in the foreign currency market. If on the other hand, the value of the Japanese Yen is 120, the government of Japan will buy US Dollars from its reserves and sell Japanese Yen from the foreign currency market[11].
Under a managed floating exchange system the central bank holds foreign currency, which is called foreign exchange reserves. It must be mentioned here that the Managed Floating Exchange System will only succeed if the government’s implicit range is near the equilibrium, and it should exist without the central bank interfering. If the central bank makes a habit of interfering, it runs the runs the risk of losing all its foreign currency reserves. If the government loses all its foreign currency reserves, it cannot take part in the foreign currency market. This would result in the country having to revert to a Floating Exchange System (Fischer, 2001, 3-24).
Another example of the Managed Floating Exchange Rate System is that some countries use explicit target values rather than implicit target values. A case in point includes the countries within the European Union. They were part of what was termed ‘The Exchange Rate Mechanism’. The countries in the mechanism were allowed to fluctuate within a band of 2.25 per cent of the value. However, if the exchange rate fluctuated outside the band, the governments were allowed to buy or sell currency from their reserves in order to correct the problem. The Exchange Rate Mechanism was unsustainable, and the United Kingdom, under severe financial pressure, was forced to withdraw from the Exchange Rate Mechanism in 1992 (Stanlake & Grant, 2000, 527).
Conclusion:
In accordance with the above exchange rate systems described, it can be finally asserted that it is necessary for a central bank to intervene and use its currency reserves to support the value of its country’s currency in the foreign exchange market. This is because there needs to be some supervision in order to ensure long-term stability of a country’s currency value with regard to the foreign exchange market. This centralized means of intervention and supervision is important as it has the ability and authority to carefully oversee the currency value, and can take action in order to prevent a currency being devalued. Along with this, by a central bank using its currency reserves to support the value of its country’s currency in the foreign exchange market, it has the authority to make sure that adverse reactions do not take place with regard to its currency value.
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References:
Devereux, M. B. & Engel. C. Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-rate Regime. (University of Washington and NBER) April 1999. Discussion Paper No.: 99-13.
Fischer, S. 2001. Distinguished Lecture on Economics in Government: Exchange Rate Regimes: Is the Bipolar View Correct? Journal of Economic Perspectives, Vol. 15, No. 2 (Spring, 2001). 3-24
Hartmann, P. Currency Competition and Foreign Exchange Markets. The Dollar, the Yen and the Euro. European Central Bank, Frankfurt.
Mundell, R. A. 1963. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. Canadian Journal of Economics and Political Science, Vol. 29, No. 4 (Nov., 1963). 475-485.
Open Economies Review: Springer Netherlands. Volume 11, Number 4. October 2000. Pages: 303 – 321 The Euro as a Monetary Anchor in the CEECs
Portes, R., Rey, H., De Grauwe, P., & Honkapohja, S. 1998. The Emergence of the Euro as an International Currency. Economic Policy, Vol. 13, No. 26, EMU (Apr., 1998), 305-343.
Stanlake, G. F. & Grant, S. J. 2000. Introductory Economics, Longman, pp 527.
Weerapana, Akila. Spring Semester ‘03-’04. Lecture 5: Exchange Rate Systems. http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-05.pdf
Footnotes
[1] Hartmann, P. Currency Competition and Foreign Exchange Markets
The Dollar, the Yen and the Euro. European Central Bank, Frankfurt
[2] Stanlake, G. F. & Grant, S. J. 2000. Introductory Economics, Longman, pp 527.
[3] Portes, R., Rey, H., De Grauwe, P., & Honkapohja, S. 1998. The Emergence of the Euro as an International Currency. Economic Policy, Vol. 13, No. 26, EMU (Apr., 1998), 305-343
[4] Weerapana, Akila. Spring Semester ‘03-’04. Lecture 5: Exchange Rate Systems. http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-05.pdf
[5] ibid
[6] Portes, R., Rey, H., De Grauwe, P., & Honkapohja, S. 1998. The Emergence of the Euro as an International Currency. Economic Policy, Vol. 13, No. 26, EMU (Apr., 1998), 305-343
[7] Hartmann, P. Currency Competition and Foreign Exchange Markets
The Dollar, the Yen and the Euro. European Central Bank, Frankfurt
[8] Weerapana, Akila. Spring Semester ‘03-’04. Lecture 5: Exchange Rate Systems. http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-05.pdf
[9] Open Economies Review: Springer Netherlands. Volume 11, Number 4
October 2000. Pages: 303 – 321 The Euro as a Monetary Anchor in the CEECs
[10] Portes, R., Rey, H., De Grauwe, P., & Honkapohja, S. 1998. The Emergence of the Euro as an International Currency. Economic Policy, Vol. 13, No. 26, EMU (Apr., 1998), 305-343
[11] Weerapana, Akila. Spring Semester ‘03-’04. Lecture 5: Exchange Rate Systems. http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-05.pdf