The Case for Intervention
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Bibliographic details
- Authors: Sukudhew Singh
- Published: March 1, 2023
Overview
- Context: After 2008 large-economy rate cuts produced capital inflows that appreciated emerging market currencies and lowered interest rates; subsequent rapid tightening by major central banks has reversed flows, causing emerging market currency depreciation, higher inflation, and pressure to raise interest rates while growth stalls.
- Core claim: Under the right conditions, intervention in the foreign exchange market can reduce unwarranted currency volatility and counter one-sided expectations about a currency’s future value.
- Target audience: Emerging market economies, especially open economies with large globally integrated financial systems.
Factors determining successful intervention (focus on defending a depreciating currency)
- Level of foreign exchange reserves:
- Foreign reserves are essential when the exchange rate faces unwarranted depreciation pressure.
- Reserves are especially important for economies with linked exchange rates or exchange-rate-based monetary frameworks.
- Strength of domestic economy and financial system:
- Strong fundamentals give the central bank greater flexibility in the scale of intervention and reduce the need for liquidity operations that undermine interventions.
- Intended exchange rate that is “defensible”:
- Intervention will not help when currency pressure reflects sustained outflows on the trade and current accounts or when weak domestic fundamentals (large fiscal deficit, excessive monetary growth, high inflation) are the underlying causes.
- Actions to manage liquidity consequences of intervention:
- Intervention reduces local currency supply and raises foreign currency supply, which should support the local currency.
- The resulting decrease in local-currency liquidity pushes up domestic interest rates, supporting the exchange rate; but central banks often re-inject liquidity to avoid higher rates, which undermines the intervention and can weaken price stability.
- Openness of the capital account:
- An open capital account can enable two-way flows but large one-way flows during instability can overwhelm the central bank’s ability to stabilize the currency.
- Private sector foreign currency exposure and hedging:
- Central banks must track and sometimes regulate private sector foreign currency exposure to prevent panicked foreign exchange demand that can negate interventions.
Adequacy and sustainability of reserves
- Reserves serve both intervention needs and to instill confidence in a country’s international payment capacity.
- Ways to reduce demand on central bank reserves:
- Develop the local foreign currency market to enable private intermediation and provide hedging instruments, reducing the frequency of central bank intervention.
- Quality of reserve accumulation matters:
- 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; political pressure diverting reserves to other purposes undermines intervention capacity.
- Emergency sources of reserves mentioned:
- IMF funding (described as an option of last resort for many countries, especially in Asia).
- Bilateral swap arrangements.
- ASEAN+3 $240 billion resource-pooling arrangement (Chiang Mai Initiative Multilateralisation Agreement) provides liquidity support but has not removed member economies’ desire to build their own reserves.
Role and design of capital controls when reserves are insufficient
- When reserves are running low or capital flows are too large for intervention to succeed, more direct measures to restrict financial flows can be considered.
- Parallels with intervention: Many factors that enable successful intervention also affect the likely success of capital controls.
- Important cautions:
- Timing of removal of capital controls matters—removing them prematurely can be as risky as keeping them too long.
- Done right, capital controls can act as a circuit breaker to preserve reserves and provide temporary breathing room for reforms aimed at reducing vulnerabilities and supporting the economy.
- Controls should be accompanied by credible policies to restore confidence, after which controls can be gradually relaxed and removed.
Key takeaways and policy implications
- Free-floating currencies are generally ideal, but external developments can quickly misalign exchange rates with fundamentals.
- Open emerging market economies with large globally integrated financial systems must:
- Hold more foreign exchange reserves.
- Intervene more aggressively to avoid excessive volatility.
- Successful intervention requires:
- Adequate and sustainably built reserves.
- Strong domestic fundamentals and financial systems.
- A defensible intended exchange rate consistent with economic fundamentals.
- Careful management of liquidity operations to avoid undermining intervention and price stability.
- Monitoring and regulation of private-sector foreign currency exposure.
- When intervention is unlikely to succeed, temporary capital flow measures, if well-designed and timed, can preserve reserves and buy time for structural reforms.
Source: The Case for Intervention — Sukudhew Singh, F&D Magazine, March 2023.
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