When Foreign Exchange Intervention Can Best Help Countries Navigate Shocks
IMF Blog, October 10, 2024
Source details
- Canonical URL
- When Foreign Exchange Intervention Can Best Help Countries Navigate Shocks
Other formats
Bibliographic details
- Authors: Suman Basu, Sonali Das, Olamide Harrison, Erlend Nier
- Published: October 10, 2024
Overview
- Publication date: October 10, 2024.
- Authors: Suman Basu, Sonali Das, Olamide Harrison, Erlend Nier.
- Context: With major central banks now cutting policy rates, the global interest rate cycle is turning, raising concerns about spillovers and volatile capital flows as investors search for yield.
- Purpose: Describe IMF Integrated Policy Framework (IPF) guidance on when foreign exchange intervention (FXI) may help countries with floating exchange rates navigate large shocks, and highlight trade-offs and policy complementarities.
FXI in the toolkit
- Exchange-rate regimes:
- Countries with floating exchange rates typically target inflation using interest rates; the exchange rate freely adjusts to help balance demand for imports and exports and maintain external balances.
- About two-thirds of countries peg their currency to another one or otherwise manage the exchange rate; in these cases central bank interest rates closely track those set by the anchor country and intervention is typically used to maintain the peg.
- Many advanced economies have fully flexible exchange rates (free-floating); some, like Canada, the United Kingdom, and the United States, almost never intervene.
- IPF recognition:
- The IPF recognizes financially open economies may be more vulnerable to shocks and that fully flexible exchange rates may not always work well.
- The IPF identifies three circumstances in which central banks could consider FXI to address a large shock:
- When foreign exchange markets become illiquid, a central bank can use FXI to manage sharp changes in financial conditions that may arise from capital flow and exchange rate pressures and that threaten macroeconomic and financial stability.
- For unhedged currency exposures, a central bank can use FXI to counteract a sharp drop in the currency that would otherwise lead to a crisis, such as one involving large-scale private sector defaults on dollar-denominated debt.
- Where a sharp depreciation is likely to cause not just a temporary increase in the prices of goods and services but also raise inflation expectations, the central bank can consider FXI along with raising interest rates to contain those impacts; the complementary use of FXI can reduce the adverse growth impact from the tighter monetary policy.
- These cases are embedded in the Fund’s conceptual and quantitative IPF models and also draw on empirical work and considerations from outside the models.
Drawbacks and limitations of FXI
- Trade-offs and costs:
- FXI may forgo some benefits of full exchange rate flexibility for macroeconomic adjustment (for example, switching between domestic and foreign goods and services).
- Accumulating and holding reserves for FXI is costly.
- Potential unintended side-effects:
- Overuse may hinder development of FX markets by reducing incentives for private sector currency trading or hedging.
- Expectations that the central bank will step in can create moral hazard.
- Poorly communicated FXI may cause confusion about the central bank’s policy reaction function and main instrument for achieving its inflation target.
- Guidance:
- IPF recommends intervention only in the specified cases and when shocks are large enough to threaten economic or financial stability, such as an unusually sharp fluctuation in the exchange rate or financial conditions.
- Intervention should not be used to avoid adjusting monetary and fiscal policies.
- If reserves are scarce, it may be best to preserve them until bigger shocks loom.
Policy recommendations and integrated approach
- Use FXI as part of an integrated policy mix that includes other macro and financial tools for maximum effectiveness.
- Pre-shock preparedness:
- Deepen FX markets to make them more resilient to strains.
- Use appropriate macroprudential measures to reduce risky foreign currency borrowing.
- Anchor inflation expectations to reduce the need for intervention when shocks occur.
- Implementation principles:
- FXI is most effective when well-calibrated to the country’s circumstances and used sparingly in coordination with monetary and fiscal policy.
- The IPF updates advice by considering more integrated use of a wider range of policy levers to address market frictions and large shocks and is intended to foster policy discussions during Article IV reviews and at IMF–World Bank events.
Source: IMF blog post “When Foreign Exchange Intervention Can Best Help Countries Navigate Shocks,” October 10, 2024.