## The Case for Intervention ## Source details **Canonical URL:** [The Case for Intervention](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/em-perspectives-singh.pdf) ## Other formats - [Markdown version](/-/media/files/publications/fandd/article/2023/march/em-perspectives-singh.pdf.md) - [Structured JSON version](/-/media/files/publications/fandd/article/2023/march/em-perspectives-singh.pdf.json) --- ### Context and challenges - After 2008 cuts in interest rates by central banks in large economies, many smaller emerging market economies, especially in Asia, experienced a flood of capital that caused currencies to appreciate and interest rates to fall. - With major central banks rapidly tightening policy, financial flows have reversed: emerging market currencies are depreciating, inflation is increasing, and central banks face pressure to raise interest rates even as growth stalls. - Global economic and financial integration has weakened national transmission of monetary policy and made international factors a stronger driver of domestic prices and economic conditions. - Free-floating currencies are ideal for most emerging market economies, but external developments can quickly misalign exchange rates with fundamentals; policy autonomy requires economies strong enough to withstand volatile exchange rates and significant misalignment. - Intervention in the foreign exchange market can moderate the pace and extent of currency appreciation or depreciation and can counter one-sided expectations about a currency’s future value. - A deeper financial system improves intermediation but may attract more capital inflows; open emerging market economies with large globally integrated financial systems must hold more foreign exchange reserves and intervene more aggressively to avoid excessive volatility. - Successful intervention is not guaranteed. ### Factors that increase likelihood of successful intervention (focus on defending a depreciating currency) - Level of foreign exchange reserves: - Foreign reserves are invaluable when the exchange rate comes under unwarranted depreciation pressure. - Reserves are especially important for countries with linked exchange rates (such as Hong Kong Special Administrative Region) or exchange-rate-based monetary frameworks (Singapore). - Strength of domestic economy and financial system: - Strong fundamentals give the central bank greater flexibility on how much to intervene and let the exchange rate move. - Strength allows more effective intervention because the central bank does not have to engage actively in liquidity operations that undermine foreign exchange interventions. - An intended exchange rate that is “defensible” and reflects economic fundamentals: - Pressure from sustained outflows on the trade and current accounts often reflects structural economic weaknesses; intervention in such cases will not help. - If weak domestic fundamentals (large fiscal deficit, excessive monetary growth, or high inflation) affect the exchange rate, intervention is likely futile unless those weaknesses are addressed. - Actions by central banks to manage liquidity consequences of intervention: - Intervention to defend the exchange rate decreases supply of the local currency and increases supply of foreign currencies, which should support the local currency. - The decrease in local currency liquidity pushes up domestic interest rates, providing additional support to the exchange rate. - Central banks often inject liquidity back into the banking system to protect the domestic economy from higher interest rates, which undermines support for the currency. - If a weaker currency causes higher domestic inflation, these liquidity operations can weaken both the exchange rate and domestic price stability, reducing effectiveness of monetary policy and intervention. - Openness of the capital account: - Open capital accounts facilitate two-way flows under normal circumstances, but large one-way flows during instability can overwhelm central bank stabilization efforts. - Avoiding large swings in the exchange rate is crucial because short-term financial flows by residents and nonresidents respond easily to exchange rate expectations. - Private sector foreign currency exposure and hedging: - Central banks must track and potentially regulate private foreign currency exposure to ensure it poses no risk to national economic and financial stability. - Panicked buying of foreign exchange by the private sector can negate interventions supporting the currency. ### Adequacy and sustainability of reserves - Maintaining a sufficiently large stock of reserves is important for intervention capacity and for instilling confidence in a country’s ability to pay its way internationally. - Developing the local foreign currency market can reduce demand on central bank reserves by increasing private intermediation of foreign exchange flows and hedging instruments, thereby reducing frequency of intervention. - A common problem in times of uncertainty is that foreign currency dries up due to excess demand or hoarding; ultimately, central bank reserves provide the market safety mechanism. - Reserves built from current account surpluses and flows of foreign direct investment are generally more reliable than reserves from short-term portfolio flows. - Reserves should be built during good times. - Central banks in emerging market economies are often vulnerable to political pressure that diverts existing reserves to other purposes, leaving countries vulnerable and limiting central bank capacity to intervene when needed. - Emergency sources of reserves: - Funding from the IMF is an option but often a last resort for many countries, especially in Asia. - Bilateral swap arrangements can provide emergency liquidity in dollars or local currencies. - Among the ASEAN+3 economies, a $240 billion resource-pooling arrangement known as the Chiang Mai Initiative Multilateralisation Agreement provides liquidity support to regional economies in times of external stress, but it has not diminished member economies’ desire to build their own reserves for reasons including policy independence. ### Capital controls and policy implications - When reserves are running low or capital flows are so large that intervention is unlikely to succeed, more direct intervention (including measures to restrict financial flows) may be needed to restore stability. - Many factors that make for successful foreign exchange intervention also influence the success of capital controls. - Policymakers imposing capital controls must be cautious in timing their removal—premature removal can be as risky as keeping them in place too long. - Done right, capital controls can act as a circuit breaker to preserve foreign reserves and provide temporary breathing room for reforms to reduce vulnerabilities and support the economy without the worry of external instability. - Restoring confidence in the local economy requires credible policies; after credibility is restored, controls can be gradually relaxed and removed. *Sukudhew Singh was a deputy governor at Bank Negara Malaysia from 2013 to 2017.* --- _Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/em-perspectives-singh.pdf_