[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.
