Market Volatility and Foreign Exchange Intervention in EMEs: What Has Changed? - An Overview
10 Pages Posted: 6 Oct 2014
Date Written: October 2013
Over the past five years, huge swings in capital flows to and from emerging market economies (EMEs) have led many countries to re-examine their foreign exchange market intervention strategies. Quite unlike their experiences in the early 2000s, several countries that had at different times resisted appreciation pressures suddenly found themselves having to intervene against strong depreciation pressures. The sharp rise in the US long-term interest rate from May to August 2013 led to heavy pressures in currency markets. Several EMEs sold large amounts of forex reserves, raised interest rates and – equally important – provided the private sector with insurance against exchange rate risks.
This volume, summarising the discussion and papers presented at the meeting of Deputy Governors of major EMEs in Basel on 21 – 22 February 2013, focuses on three main questions concerning foreign exchange intervention. First, what is the role of a flexible exchange rate in stabilising the economy and promoting financial stability and development? Second, how have the motives and strategy behind the interventions changed since the 2008 global financial crisis? Finally, is intervention effective and, if so, how can its efficacy be measured?
The main conclusion emerging from the discussion is that a flexible exchange rate plays a crucial role in smoothing output volatility in EMEs. However, as highlighted by several papers in this volume, a highly volatile exchange rate can increase output volatility and itself become a source of vulnerability. Second, over the past five years, most official forex interventions in EMEs were intended to stem volatility rather than to achieve a particular exchange rate. Finally, the majority view was that exchange rate intervention needs to be consistent with the monetary policy stance. Persistent, one-sided intervention, associated with sharp expansion of central bank balance sheets, creates risks for the economy.
Yet there was no consensus about the effectiveness of forex intervention. Whereas intervention was viewed as an instrument that could potentially curb forex volatility and support market functioning, many participants were skeptical about its effectiveness in the face of a shift in the equilibrium exchange rate. A review of replies from central banks to a survey questionnaire suggested that, while intervention may work mainly through the signalling channel, some of its effectiveness may be due to the fact that it was combined with other measures to moderate capital flows or prevent the build-up of certain positions in the foreign exchange market. In several cases, intervention had no persistent effects on the exchange rate and might have helped to exacerbate exchange rate volatility in the wrong direction.
This overview is organised around the three main themes of the meeting. Section I looks at the role of a flexible exchange rate. Section II discusses the motives and objectives behind intervention. Section III reviews lessons learned about the effectiveness of intervention.
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