Abstract :
· A floating exchange rate regime involves the confrontation of supply and demand for currency between different currencies on the foreign exchange market and does not presuppose the intervention of a central bank to influence the exchange rate of its currency.
· However, the monetary authority may intervene to correct excessive exchange rate fluctuations or mitigate excessive appreciation or depreciation of its currency.
· Central banks typically have two instruments at their disposal for this purpose: interest rates and foreign exchange reserves.
· However, central bank interventions produce variable results.
A floating exchange rate regime involves the confrontation of supply and demand for currency between different currencies on the foreign exchange market. Unlike a fixed exchange rate system, where the central bank undertakes to defend the value of its currency, a floating exchange rate regime does not presuppose intervention by the central bank to influence the exchange rate of its currency. Monetary policy can thus be dedicated to other domestic purposes, such as supporting economic activity, controlling price developments, or ensuring financial stability.
However, in the case of a floating exchange rate regime, the central bank may need to intervene to correct overly rapid exchange rate fluctuations or mitigate excessive appreciation or depreciation of its currency. Central bank operations on the foreign exchange market, which were exceptional in the past, have tended to increase since the early 2010s, despite the continued liberalization of this market and its size. The volume traded on the foreign exchange market is around $5.1 trillion per day (Bank for International Settlements – Dec. 2016). These interventions by central banks are observed in emerging countries such as Russia, India, and Turkey, but also in developed countries such as Switzerland, Sweden, and Denmark.
Cases of pure floating exchange rates are relatively rare. Controlling currency volatility is a matter of commercial competitiveness—avoiding unfavorable appreciation for exports—and a financial issue in terms of debt—any depreciation automatically increases debt, which is mainly contracted in foreign currencies in emerging and developing countries. Central banks typically have two instruments at their disposal for intervening in the foreign exchange market: interest rates and foreign exchange reserves. However, central bank interventions yield variable results. Their ability to influence the foreign exchange market depends in particular on the financial levers at their disposal and their institutional credibility.
1. Adjusting the key interest rate remains a useful tool for influencing the exchange rate, but it comes at a significant cost
The interest rate adjusted by a central bank corresponds, in very simple terms, to the price of borrowing a currency. It is therefore possible to conceptualize the interaction between interest rates and exchange rates in terms of supply and demand. The interest rate is understood here as the key interest rate that controls the interest rate channel used by monetary policy. A central bank can also change other rates (repo rate, reverse repo rate, deposit rate, etc.) to influence the exchange rate of its currency, but these rates typically move in line with the key interest rate.
An increase in the interest rate implies a rise in the cost of borrowing a country’s currency or a decrease in the supply of that currency, which would tend to cause an appreciation of that currency on the foreign exchange market, as investors seek higher returns. Conversely, a decrease in the key interest rate leads to an increase in the supply of money, which should cause the currency to depreciate against other currencies.
In other words, a central bank can influence the exchange rate through its key interest rate. If the central bank raises its rate, the currency will tend to appreciate. By lowering its key interest rate, the currency will tend to depreciate.
Central bank interventions are amplified to a certain extent by carry trade strategies. Investors seek to take advantage of interest rate differentials between different currencies by borrowing in a currency with a very low interest rate (e.g., the euro today) and reinvesting the borrowed funds in a currency with a higher interest rate, as is the case in Turkey and Russia, for example. A positive interest rate differential will tend to attract capital inflows, thereby exerting upward pressure on the exchange rate.
Carry trade exposes an investor to a double currency risk (the risk of appreciation of the borrowing currency and the risk of depreciation of the investment currency) and to the risk that the yield differential will reverse. These strategies are important because they explain certain movements in the capital and currency markets, particularly the yen exchange rate since 2004. The wide interest rate differential between certain emerging countries and the United States, linked to the Fed’s easing policy and the global liquidity surplus that such a policy has generated, stimulated a significant inflow of capital to emerging countries between 2010 and May 2013.
The key interest rate is therefore an important variable for the foreign exchange market and a useful tool for central banks, but it does come at a significant cost. It requires the central bank to focus its monetary policy on the exchange rate at the expense of other usual objectives such as controlling inflation, supporting economic activity, and ensuring financial stability. The most commonly agreed objective of a central bank is to achieve financing conditions that allow full use of production factors while avoiding monetary and financial tensions.
By raising its key interest rate to influence the exchange rate, a central bank can increase the cost of credit and thus impact the financing of the economy as a whole. By lowering it to influence the exchange rate downwards, the central bank runs the risk of fueling inflationary pressures or even creating financial bubbles.
2. To overcome the constraints inherent in the use of interest rates, the central bank can intervene in the exchange rate using its foreign exchange reserves.
This second instrument, foreign exchange reserves, also follows the logic of supply and demand. In the event of an undesirable appreciation of its currency, the central bank can sell a certain amount of it in exchange for other currencies, which implies an increase in the supply of its currency on the foreign exchange markets. These sales will have the effect of weighing down the exchange rate and thus reducing the appreciation of its currency.
Conversely, in the event of an unwanted depreciation, the central bank can buy a certain amount of its currency using its foreign exchange reserves, which contributes to a decrease in the supply of its currency on the foreign exchange market. These purchases will have the effect of pushing up the exchange rate and thus reducing the depreciation of the exchange rate.
However, the central bank’s balance sheet must, by definition, be balanced. Any change in assets must be offset by an equal amount on the liabilities side. The balance sheet of a central bank can be summarized as follows:
When a central bank purchases a certain amount of its currency from its foreign exchange reserves, this will reduce the amount of currency in circulation by the same amount, which is equivalent to raising interest rates to a certain extent, with potentially adverse consequences for an economy at the bottom of the cycle.
In other words, purchases or sales of foreign currency by the central bank imply a change in the monetary base that could disrupt the economy as a whole.
To get around this problem, the central bank can buy domestic sovereign securities, known asopen market operations, to « sterilize »[1] the effect on the monetary base of the decline in foreign exchange reserves. The central bank thus manages to achieve a balanced balance sheet without impacting the monetary base:
Conversely, if the central bank wishes to buy foreign currency in exchange for its own currency in an attempt to counter its appreciation, it can sell sovereign securities denominated in its currency for an equivalent amount to balance its balance sheet. The increase in foreign exchange reserves does not then lead to any unwanted surplus liquidity in the monetary base.
3. However, central bank interventions produce variable results
Foreign exchange market participants, who are constantly looking for signals to guide them, are sensitive to the measures taken by central banks and are likely to amplify them. However, experience shows that adjusting key interest rates or reserves in an attempt to influence the foreign exchange market produces mixed results.
Not all central banks have the same financial and institutional capacity to gain market acceptance and influence the foreign exchange market. Given the volume traded on the foreign exchange market of around $5.1 trillion per day (Bank for International Settlements – Dec. 2016), some central banks – especially in small and medium-sized economies – may struggle to achieve the critical financial leverage to influence the foreign exchange market.
The same is true of institutional capacities, which vary from one central bank to another. The communication and credibility of central banks are as decisive as the scale of their interventions. Investors will only act in line with the monetary authority, or even amplify the desired trends, if the interventions are credible and transparent. The surprise effect also has a more significant impact than regular interventions, sometimes in opposite directions, which, when repeated, become commonplace in the eyes of investors and lose their intended effect. The same applies to the independence, mandate, and institutional positioning of the central bank. For example, the Turkish central bank is regularly thwarted in its interventions aimed at limiting the depreciation of the Turkish lira through rate hikes by the country’s government, which pressures the central bank to lower rates in order to support growth. This situation muddies the central bank’s message to investors.
Central banks also sometimes struggle to influence exchange rate movements and convince investors of their interventions, as exchange rate movements are sometimes based on underlying factors over which they have no direct control. The Swiss franc and the yen are prime examples, as both currencies are considered safe havens. In times of high uncertainty or crisis, investors seek to acquire these currencies, then tend to abandon them when the political and economic situation calms down. Another example already mentioned is the recent case of Turkey, where political and geopolitical tensions led to a depreciation of the Turkish lira despite repeated interventions by the central bank.
Conclusion
Central banks therefore have two tools at their disposal: interest rates and foreign exchange reserves. These two mechanisms are essentially based on the logic of supply and demand for the currency against other currencies.
[1] Sterilizing an intervention means withdrawing the liquidity injected into the system as part of that intervention. This concept is generally used in the context of foreign exchange interventions: the central bank buys foreign currency in order to prevent its own currency from appreciating, and since it does not want to add liquidity to the market, it withdraws it. Reference: BSI – Sterilization of central bank interventions: concept, methods, and questions in the context of the ECB’s OMT
