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? Impact of Intervention
• Markets moving into that • As the government is selling its
currency (i.e., the preferred strong currency, it is essentially
currency) and away from other supplying the currency that the
markets are moving into (i.e., the
currencies. preferred currency).
– Interest rate differentials, safe • In doing so, the government is
haven effects, trade flows, increasing the supply of its currency
political and economic risk, in foreign exchange markets and
expectations of changes in peg, also potentially in its own domestic
etc. market.
• Government needs to sell its – The potential impact of increasing
currency to offset market the country’s domestic money supply
is to accelerate inflationary pressures
demand. and inflationary expectations for that
• Either unilaterally or through economy.
cooperative intervention. • 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 Interest Rates in Argentina,
Asian Currency Crisis 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 Exchange Rate: USD/MYR
• 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.
 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