Foreign Exchange: The Complete Deal. James McDowell. Sharpe
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from the end of 2002 to 16 March 2004. To give some idea of the scale of intervention, on 5 March 2004 the Japanese purchased USD 11.2bn and sold yen.
By the end of 2003 there were signs of Japanese economic recovery and in March 2004 Alan Greenspan, the US Federal Reserve Bank Chairman, indicated that the intervention strategy had worked. He said:
“Partially unsterilised intervention is perceived as a means of expanding the monetary base of Japan, a basic element of monetary policy. In time, however, as the present deflationary situation abates, the monetary consequences of continued intervention could become problematic. The current performance of the Japanese economy suggests that we are getting closer to the point where continued intervention at the present scale will no longer meet the monetary policy needs of Japan.”
It should be noted that intervention had the full support of the US administration, which felt that economic stagnation was not in the interests of the US. [6] By not registering objections to the intervention the US effectively made it possible for the Japanese to operate in the market.
The efficacy of intervention
The effects of sterilised intervention are somewhat debatable. The standard approach is to view the potential impact through two routes: the portfolio channel and the signalling channel. In the former an intervention that changes the relative outstanding supply of assets denominated in domestic and foreign currencies will require a change in expected relative returns on the asset whose outstanding stock has increased, thereby leading to a change in the exchange rate. This is based on the assumption that investors consider foreign and domestic assets to be imperfect substitutes. The portfolio channel approach no longer carries much weight because the scale of possible intervention has declined relative to the size of the foreign exchange market. It may, however, have greater relevance in emerging markets where central bank reserve holdings are large relative to local market turnover.
It is widely thought that intervention operates mainly through the signalling channel. This may convey to the market future changes in monetary or exchange rate policy or that the authorities view the exchange rate to be out of line with economic fundamentals. A sterilised purchase (sale) of domestic currency reflects a desire for a stronger (weaker) domestic currency and this desire eventually leads to a tighter (looser) monetary policy. However, monetary policy may cause the exchange rate to appreciate or depreciate too much and prompts intervention to moderate or even reverse the trend of exchange rate movements. Dealers’ reactions (and success) will much depend on the perceived credibility of the central bank.
A signal may be used to reduce market expectations of current and future volatility. In recent years this has been the dominant theme – to reduce excessive exchange rate volatility. That being said, central banks may desire an increase in short-term volatility if they are faced with an undesirable exchange rate trend. The central bank will attempt to remove or reduce the one-way bet mentality by restoring two-way risk. Signalling intentions can of course be made clear via verbal commentaries, or ‘jawboning’ as it is described in the market.
There is secret intervention which fits neither the portfolio channel nor the signalling channel. By definition it is virtually impossible to get a handle on this. It is difficult to see this changing a trend but it may well slow down the process, providing a two-way risk dimension.
One way that intervention can be made more visible is through concerted efforts and this can indicate a strong commitment to exchange rate changes. The difficulty arises when too many central banks get involved. The market loses faith in the message in so far as a wide range of countries with skewed economic fundamentals may indicate a different policy requirement.
Coordinated intervention, however, is rare. A recent case of coordinated intervention was on 18 March 2011 when the Japanese were joined by the Group of Seven (G7) major industrialised countries to stall the surge in the yen after the tsunami and nuclear incident in Japan prompted market chaos. The G7 statement said that this action was to stabilise “excess volatility” and “disorderly movements in exchange rates”. The last previous coordinated intervention was in 2000 when the euro was bought.
Models of exchange rate behaviour assume that currency prices are efficient aggregators of information and market expectations are rational. In practice the foreign exchange markets may not be efficient and intervention signals may not always be credible or unambiguous. The question of whether intervention policy influences exchange rate volatility obviously depends on the definition of ‘volatility’. According to Dominguez and Frankel (1993) unanticipated and coordinated interventions are most effective. When there is high frequency of intervention the market has become too familiar and the impact is reduced.
Studies on the Japanese experience by Fatum and Hutchison, and Ito, revealed that intervention tends to be effective during a period of infrequent interventions (1999 to 2002) but ineffective (2003) or counterproductive during a period of very frequent interventions (first quarter 2004). An and Sun suggest that there is no uniform answer as to whether it is monetary policy or foreign exchange intervention which is more influential on exchange rates.
The importance of the policies on exchange rate fluctuations are country- specific; i.e., in some countries policy might effect the exchange rate to a similar degree as foreign exchange intervention while in other countries the impact of intervention might be much stronger. It is no great surprise therefore that Kim (2003) finds that foreign exchange interventions have a much greater impact on the exchange rate in the US as they do not target the exchange rate and interventions are infrequent.
Recessions and intervention – the case of the Swiss franc
Exchange rates become increasingly important in recessions as governments (in the absence of inflation constraints) look to combat deflationary pressures by promoting a weak currency. An insight to this thinking comes from the statement from Thomas Jordan, member of the Governing Board of the Swiss National Bank on 25 the September 2009:
The Swiss franc plays a key role in the development of the Swiss economy. Through the competitiveness of our export pricing, it impacts on our exports and consequently affects the business cycle. Via import prices, it has a direct impact on consumer prices. In addition, the Swiss franc has been – and still is – a factor in the success of the Swiss financial sector. The Swiss National Bank (SNB) takes the exchange rate into account in its monetary policy although it does not normally exert any direct influence on it. In the past, it has only been in rare emergency situations that the SNB intervened to directly influence exchange rate developments. However, from March 2009, the appreciation of the Swiss franc induced by safe haven effects, in an exceptionally difficult economic situation entailing deflation risks, prompted the SNB to prevent an appreciation of the Swiss franc against the euro by purchasing foreign currency.
For Switzerland, trade with the EU is very important to the economy. Exports to the EU as a percentage of total exports are 60%, while exports to the EU as a percentage of GDP are 23%. Therefore, the level of EUR/CHF is critical.
In 2009 and 2010 ongoing weakness of the euro and the reinstatement of the Swiss franc as a primary safe haven currency prompted action on a number of occasions. On 12 March 2009 the SNB bought at 1.4790 to move the price to 1.5340. This price movement can be seen in Figure 2.1.
Figure 2.1 – SNB buying CHF to move it from 1.4790 to 1.5340 against the euro
Source: Reuters
On 24 June 2009 the SNB bought and moved the CHF rate from 1.5020 to 1.5380 against the euro, which can be seen in Figure 2.2.
Figure 2.2 – SNB buys CHF to move it from 1.5020 to 1.5380 against the euro
Source: Reuters
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