fx regimes and central bank

fx regimes and central bank - FX Regimes & Central...

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Unformatted text preview: FX Regimes & Central Bank Intervention FBE 436 Prof. Aris Protopapadakis 1 Key Concepts and Skills Floating rate Pure, Dirty Fixed rate One currency; basket of currencies, target zones, snakes & tunnels; Currency board; Dollarization; Common currency Why do central banks intervene? Central bank intervention Principles & Action 4 Why Discuss FX Regimes? The choice of FX regime, or FX policy has major implications for The degree of FX volatility and FX exposure FX forecasting The potential for currency and banking crises The nature of current and future trade and capital movement curbs and restrictions All other economic policies of the government 5 FX Regimes There are two basic categories of FX regimes: 1. Floating FX rates 2. Fixed FX rates Variations within these broad categories span the spectrum of possibilities We need a little detour to talk about the basics of central bank intervention 6 Central Bank Balance Sheet (cnt.) Central Bank Assets Liabilities DA H = Domestic Bank Reserves + Currency FA Equity held by private members where: DA: domestic assets –government bonds, possibly private assets (now the dominant asset!!) Gold: small amounts (not the stuff in Fort Knox) FA: foreign assets –other government bonds, possibly foreign private assets high powered money (the base for M1 & M2) H: 7 Central Bank Balance Sheet (exa.) Central Bank Assets Liabilities DA 800 H? FA 100 where: DA FA H is domestic assets is foreign assets is high powered money 8 The Fed Balance Sheet 10 Open Market Operations The Central bank creates money, say M1: It purchases assets in the market (generally gov. bonds) It pays for them with checks redeemable only for cash, made out to its name • only banks can hold these checks The banks redeem most of these checks for cash the Central bank prints the needed cash • If you do this you go to jail The rest become domestic bank reserves 11 Open Market Operations (cnt.) These bank reserves + currency through the money multiplier process become M1 MS M1 = m1 * H; similarly, M2 = m2 * H Purchasing gov. bonds increases H and M1 DA increases Selling gov bonds decreases H and M1 DA decreases 12 Central Bank Intervention But the Central bank could also do the same thing by purchasing and selling its foreign assets, THAT is FX intervention 13 Central Bank Intervention (cnt) IF the central bank buys foreign assets, and allows H to change, we call it unsterilized intervention • Not usually done the central bank buys foreign assets, and does not allow H to change, we call it sterilized intervention • Generally what is done 17 Central Bank Intervention (cnt) IF the central bank wishes to appreciate its currency, it should buy it • This means selling foreign assets from its portfolio • Generally this is to stem currency depreciation Many developing countries the central bank wishes to depreciate its currency, it should sell it • This means buying foreign assets for its portfolio • Generally this is to prevent currency appreciation China, Japan 18 Example 1 The € is too weak => ECB purchases € & sells its $ T-Bonds => ΔFA < 0 19 Example 2 The ¥ is too strong => BoJ buys $ T-Bonds for ¥ => ΔFA > 0 20 How Does CB Affect FX? When a central banks buys or sells currency: If the Fed buys $s, it has to sell foreign currency • The foreign currency holdings of a CB are the country’s international reserves or FX reserves international FX Adds to the supply of fc (currency sold) Adds to the demand of $s (currency bought) 21 Floating FX Rates The central bank doesn’t intervene in the FX market! There is no change in the central banks foreign reserves: FA = 0 The FX rate adjusts until the private demand & supply of $s (or fc) are equal • This is like the rest of the US financial markets • For a pure float both central banks must not intervene • The U.S. comes the closest to not intervening 22 Floating FX Rates (cnt.) The 2 countries’ FX rate is determined by their monetary policies –Mx in relation to GDP– the relation between their national savings and investment, and investors’ expectations about future policies Governments and businessmen may not like the outcome 23 Floating FX Rates (concl.) In practice, floating countries U.S., Japan, EU, the U.K. and others occasionally intervene in the FX market No announcement of targets Not even a notional target • From 1980 thru 1998, the US intervened in 372 out of 4,537 possible days (8%), while the Bundesbank intervened in 811 days (18%). There was some intervention in 974 days (21%) 24 Fixed FX Rates The central bank supplies or withdraws enough $ assets (by adjusting FA) so that private demand and supply for $s are equal at _ S t S , the fixed FX rate Generally the CB will announce a range and it will buy or sell its currency when the FX rate moves outside that range The chart illustrates the differences between fixed and floating regimes 25 FX Demand & Supply FX Demand & Supply for $ 2.60 2.40 2.20 Demand0 Supp ly0 FX fc/$ 2.00 Demand1 1.80 1.60 1.40 $ Demand falls, $ Depreciates 1.20 1.00 70 75 80 85 90 95 100 Quantity 26 Fixed FX Rates The standard fixed rate regime has a fatal flaw To support its depreciating currency the central bank –CB– needs foreign reserves • assumes sterilized intervention Unlike domestic reserves, the CB cannot “create” foreign reserves CBs that need to support their currency over long periods (happens often) will run out of reserves • and cannot borrow more of them 27 Fixed FX Rates (cnt.) When foreign reserves get low, there is often a speculative attack • It happens at the earliest moment when the market suspects that the government may be unable to meet unable its foreign debt obligations The CB either runs out of foreign reserves or gives up supporting its currency 28 Fixed FX Rates (concl.) The currency may depreciate a lot or may collapse • This may cause a banking crisis or even a recession 10–13 years is as long as such regimes have lasted Countries have adopted intermediate policies to prevent these crises 29 Advantages of Fixed FX Rates FX rates are stable, at least in the short term Real FX rates change relatively slowly and predictably (by the difference in inflation) • RFX are very volatile with floating rate If managed intelligently it can approximate PPP No unexpected and frequent price “shocks” from FX rates 30 Disadvantages of Fixed FX Rates It is an unstable system; it always explodes and fails Economic policy is constrained to be consistent with the chosen FX rate Particularly true of monetary policy It creates incentives for trade and for capital movement restrictions It requires holding of large foreign reserves The BOP becomes a key economic indicator Over most of its life, it reduces short-term uncertainty and increases long-term uncertainty 31 Advantages & Disadvantages of Floating FX Rates No FX crises! Market determines the “fair” price of the currency FX rate is unstable in the short term Real FX rate can change very quickly RFX can stay “out of balance” for a looong time Requires careful risk management on the part of firms 32 Mini Summary CBs sell foreign assets (and buy domestic assets) to support a depreciating currency Choice between fixed and flexible FX rates Fixed Flexible Short term stability Long-term crisis Capital and goods flow controls Short-term volatility Long-term stability Generally minimal controls 33 Variations on Fixed FX Rates Simple peg Credibility issues • What constitutes adequate reserves? One currency v.s. a basket of currencies A single currency peg means that when that currency appreciates yours does too • Argentina, Asian crisis Target zones, tunnels and snakes 34 Variations on Fixed FX Rates (cnt.) Currency Board No monetary policy authority to the central bank Fixed rules govern the creation of domestic reserves • H is 100% backed by foreign reserves (in principle) • Real bills doctrine (for macro experts) It means monetary policy is conducted to keep FX rates fixed • Hong Kong, Argentina (!), Lithuania, Estonia (€) 35 Variations on Fixed FX Rates (cnt.) Currency Board (continued) In principle you can never run out of reserves • Therefore, in theory no possibility for a crisis It should eliminate policy credibility, BUT you can opt out! • The possibility of a crisis exists • Hong Kong during the Asian crisis, Argentina In some ways it is the worst of both worlds • Interest rates can become very high 36 Variations on Fixed FX Rates (cnt.) Dollarization Adopt the $ (or some other major currency) as the national currency • Ecuador, Panama, El Salvador, • Argentina wanted to, Can you do it without the Fed’s agreement? • Mexico Costs of opting out much higher than for a currency board • Government may default on domestic obligations • Who is the lender-of-last-resort? 37 Variations on Fixed FX Rates (cnt.) Common Currency • Totally fixed within • Floating outside (at least the € does) • Costs of opting out very high for the EU Loss of autonomous monetary policy Any one government can go bankrupt A single central bank for the currency area Only 2 cases of monetary union without political union 38 Intervention Intervention is a fact of life in the FX markets It probably affects FX rates It may signal future economic policy It may help with forecasting 39 Why Do Central Banks Intervene? The FX rate is a very important price Here are some arguments listed by increasing sophistication The market is inefficient Insufficient or too much speculation Central bank has an informational advantage Traders have incomplete information 40 Takeaways -1 Floating rates produce very volatile RFX and persistent deviations from PPP Fixed rates result in FX and possibly banking crises There is a spectrum of options within “fixed” and “floating” FX regimes Currency boards don’t solve the policy credibility problem completely Dollarization comes closer but has other serious drawbacks 41 Takeaways -2 Unsterilized intervention is just an Open Market Operation using foreign assets It changes the domestic money supply Sterilized intervention does not change the money supply but influences FX rates anyway 42 The End 43 ...
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