Watch the introduction video to the course here: https://youtu.be/U7dQzqtIFVg The Asia-Pacific region contains some of world’s most dynamic economies. Economies around the globe rely on credible monetary policy implemented by central banking institutions. Monetary policy governs the liquidity available to the payment systems that underlie trade and finance. Smooth adjustment of liquidity can minimize instability in money and foreign exchange markets and keep inflation and growth on a secure footing. The industrial giants of China, Japan, and Korea; the Southeast Asian emerging markets of Indonesia, Malaysia, Philippines, and Thailand; and the international entrepots at Hong Kong and Singapore each face unique challenges in implementing liquidity policy. This advanced course will build a foundation for understanding liquidity policy implementation in the Asia-Pacific using standard economic models. The course will discuss the effects of high level discussion of a key element of national level public policy, monetary policy. Modern monetary policy connects macroeconomic conditions and key financial market indicators. It will also analyze the way that central bank goals for macroeconomic stability will determine outcomes in interest rates and exchange rates. The rigorous theoretical foundation should also build analytical skills that might be applied to policy and market analysis in a broad range of economies and even in the Asia-Pacific region as policy-making evolves in the future. The topics covered each week are: Module 1 - Monetary Policy Implementation Module 2 - Monetary Policy Strategy Module 3 - Exchange Rates and Monetary Policy After taking this course, you will be able to: (1) Describe Monetary Policy instruments central banks use (2) Interpret on-going actions of central banks (3) Apply graphical analysis and calculate basic economic measures used as tools by central banks or analysts (4) Analyze the way that central bank goals for macroeconomic stability will determine outcomes in interest rates and exchange rates
3.6 Foreign Exchange Intervention
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From the course by The Hong Kong University of Science and Technology
Monetary Policy in the Asia Pacific
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From the lesson
Monetary Policy and Exchange Rates
This module will focus on the various interactions between monetary policy and exchange rates. We study how monetary policy affects the balance of supply and demand in foreign exchange markets and policies required to stabilize the relative value of domestic currency
Meet the Instructors
David CookProfessor
Department of Economics
[MUSIC]
In the previous segment, we saw that international financial markets can create
volatility in exchange rates which passes through into inflation.
This volatility gives central banks an incentive to intervene to
achieve stability.
How do central banks stabilize foreign exchange markets?
Foreign currency assets of the central bank are described as foreign reserves.
Beyond traditional open market operations, the central bank may also purchase or
sell foreign currency, referred to as foreign exchange intervention.
Intervention can influence forex markets.
We categorize intervention as sterilized or unsterilized.
Sterilized intervention is executed in select
domestic money markets from the liquidity effects of the intervention.
Unsterilized intervention will effect both foreign exchange markets and
domestic interbank markets, making it potentially more powerful.
In this segment, we'll focus on comparing the impact of sterilized and
unsterilized intervention.
After viewing this segment, you should be able to, 1,
model the effects of intervention on forex rates and money market interest rates.
2, describe forex intervention using T-accounts.
Traditional monetary policy adjustment will have an impact on exchange rates.
Many central banks in the region also operate directly in foreign exchange
markets, buying and
selling foreign currency, usually US dollars, to stabilize exchange rates.
Consider exchange rate instability in Korea in 2014.
Between March and May, the exchange rate appreciates by nearly 5%.
Several months later, the exchange rate depreciates by 9%.
At the outset of this period, interest rates in Korea's money market were
substantially higher than US interest rates.
The relatively high interest rates in the Korea market
attracted a flow of funds into Korean won.
Excess currency inflows put pressure on the exchange rate to appreciate.
Official purchases of those inflows by the central bank can fill the gap and
alleviate some of that pressure.
During late 2013, the relatively high Korean interest rate began to draw traders
with US dollars who wanted to acquire Korean won.
However, the Bank of Korea was buying US dollars to match the inflows.
During this period, the Korean won exchange rate was stable.
However, in April 2014,
the inflow of currency accelerated without a commensurate currency intervention.
During this period, the won appreciated by close to 5%.
The central bank began buying US dollars in the summer of 2014,
which seemed to stabilize the currency.
We distinguish between two types of intervention,
unsterilized intervention and sterilized intervention.
Unsterilized and sterilized interventions both feature the purchase or
sale of foreign currency by the central bank.
The distinction between the two types of interventions
comes in the way these are conducted.
Under unsterilized intervention, the central bank will buy or
sell foreign currency using domestic commercial bank reserves as a vehicle.
This will change domestic liquidity conditions,
which will have an impact on money market interest rates.
Suppose that the central bank purchases foreign currency.
We can demonstrate this with T-accounts.
The central bank takes possession of foreign currency,
which is deducted from the counter-party bank's balance sheet.
The central bank then credits the counter-party bank
with additional funds in their reserve account.
Return to the liquidity preference model of the interbank market that
we learned in the first module.
If the central bank buys foreign exchange using domestic bank reserves,
this will increase domestic liquidity and push down interbank interest rates.
Changes in the domestic interest rates will reinforce the effects of currency
intervention on the forex rate.
Unsterilized intervention increases liquidity and
pushes down domestic interest rates.
Lower domestic interest rates make currency inflows less attractive and
outflows more attractive.
The interest rate adjustment then will also allow the central bank to avoid
appreciation.
Central bank in the region implement currency intervention, but
the operation of monetary policy limits the effect.
Consider the case of the Philippines in late 2010,
when the peso sharply appreciated by close to 10% against the US dollar.
The central bank increases purchases of foreign assets to stabilize their
currency, increasing deposits of commercial banks in return.
However, the central bank also operates an interest rate corridor.
If the central bank conducts unsterilized currency purchases,
this will push down the interest rate.
But if the central bank operates facilities to control the interest rate,
this effect will be limited.
If the central bank operates a standby deposit facility, for instance,
an increase in liquidity pushes interest rates down to the floor of the corridor.
And any excess liquidity is absorbed by the facility.
In the Philippines, the excess liquidity pushes the interbank rate down to
the floor of the interest rate corridor.
There's a conflict between interest rate policy and
unsterilized intervention, therefore.
To implement sterilized interventions,
the central bank will go to longer-term markets to raise domestic currency
in order to implement transactions with domestic currency.
The critical point is that sterilized interventions won't affect domestic
liquidity conditions.
During 2014, Korea financed a purchase of foreign currency
by issuing what are called stabilization bonds.
These are longer-term debt securities issued to bond markets.
When the central bank issues these bonds, they get funds from investors,
which they use to purchase foreign currency.
Suppose a central bank that purchases forex in the currency market
also issues bonds in the domestic bond market.
They sell the bonds to the counter-party bank.
This increases the non-monetary liabilities of the central bank.
They, in turn, debit the reserve holdings of the bank that purchases the bond
on its own account or its clients.
On net, there is no change in the level of reserves available to provide liquidity to
domestic money markets.
The central bank, in effect, finances the purchases of foreign currency
by issuing long-term non-monetary liabilities.
Since the millennium, many Asian central banks have issued large quantities of
non-monetary liabilities to finance acquisitions of foreign currency.
Sterilized intervention receives no reinforcement from domestic money market
interest rates.
Thus, to stabilize exchange rates, a sterilized intervention
needs to be sufficiently large on its own to offset any private sector flows.
Without the reinforcement of interest rate changes,
currency intervention may have limited effects.
Return to Korea in 2014,
relatively high domestic interest rates in Korea drew financial inflows.
The central bank met those and financial inflows with currency intervention.
But without a change in market fundamentals,
there will still be an incentive for currency to flow into the country.
Currency intervention in 2014 stabilized the currency, but since the intervention
was sterilized, there was no effect on policy interest rates.
However, the intervention may have signaled
a change in the monetary policy stance.
Late in the summer, the central bank began cutting interest rates,
which has a stronger impact on exchange rates.
After completing this segment, you should be able to, 1,
model the effects of intervention on forex rates and the money market interest rate.
2, describe forex intervention using T-accounts.
Let's summarize by answering the key question,
how do central banks stabilize foreign exchange markets?
Central banks can adjust the liquidity in the foreign exchange market
through intervention, changing supply and demand conditions.
However, even very large interventions may have only limited impacts
on very deep currency markets.
Unsterilized interventions will also have important liquidity effects
on domestic money markets.
The effect of unsterilized interventions on interest rates draws private currency
flows that reinforce the direct effect of the intervention.
By definition, sterilized interventions are implemented to insulate domestic
liquidity and policy rates from the effect of the intervention.
By definition, this limits their impact on market exchange rates.
However, sterilized interventions may also signal future policy movements.
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