III Survey of Foreign Exchange Intervention in Developing Countries
Author: Mr. Jorge I Canales Kriljenko, Mr. Cem Karacadag, Roberto Guimarães-Filho, and Mr. Shogo Ishii
Language:
English
Keywords:
OP; intervention; central bank; order flow; information advantage; operating practice; interest rate change; leg settlement; forward contract; Currency markets; Currencies; Exchange rate arrangements
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Abstract

Jorge Iván Canales-Kriljenko

Jorge Iván Canales-Kriljenko

Acomprehensive survey conducted by the International Monetary Fund in 2001 systematically documented the structure and main characteristics of the foreign exchange market in developing countries. The 90 countries classified as …developing” or …in transition” that responded to the survey accounted in 2000 for 85 percent of exports, 91 percent of imports, and 85 percent of GDP of all the world’s developing economies.1 They also held about 90 percent of the developing economies’ international reserves.

Based on the survey results, this chapter discusses the prevalence of foreign exchange intervention in developing countries across different exchange rate regimes and degrees of market access; the degree of sterilization practices; the size of foreign exchange intervention relative to the foreign exchange market; and central banks’ information advantage.

Prevalence of Foreign Exchange Intervention

The central banks in developed countries that issue the major international currencies are not active participants in the foreign exchange market. Their monetary policies target short-term interest rates, while foreign exchange intervention is limited to calm disorderly market conditions. Foreign exchange intervention, in general, does not take place frequently. Although it can be large in absolute size, it is estimated to be small relative to total foreign exchange market turnover. In recent years, only the Bank of Japan was active in the foreign exchange market and intervened to any sizable degree. By contrast, neither the U.S. Federal Reserve (the Fed) nor the European Central Bank (ECB) conducted official foreign exchange intervention on its own behalf.2

Most central banks in developing economies intervened in the foreign exchange market across all exchange rate regimes and degrees of market access during 2001 (Table 3.1). Most of the foreign exchange intervention took place in spot foreign exchange markets through foreign exchange transactions arranged by telephone conversations with banks as main counterparties (Table 3.2).

Table 3.1.

Foreign Exchange Intervention by Exchange Rate Regime and Market Access, 2001

(Percentage of countries answering the corresponding survey question in each category)1

article image
Source: Survey on the organization of foreign exchange markets conducted in 2001 by the IMF.Note:—stands for not applicable, zero, or negligible amount.

Refers to the percentage of the 90 countries classified as …developing” and …in transition” that responded to the IMF 2001 survey on the foreign exchange market.

Follows the IMF’s de facto exchange rate regime classification as published in the IMF’s International Financial Statistics.

As so defined in the IMF’s quarterly publication Emerging Market Financing: A Quarterly Report on Developments and Prospects.

The Central African Economic and Monetary Community (CAEMC) is a conventional fixed peg arrangement.

Table 3.2.

Characteristics of Foreign Exchange Intervention in Developing and Transition Economies, 2001

(Percentage of countries answering the corresponding survey question in each category)1

article image
Source: Survey on the organization of foreign exchange markets conducted in 2001 by the IMF.

Refers to the percentage of the 90 countries classified as …developing” and …in transition” that responded to the IMF’s 2001 survey on the foreign exchange market.

Follows the IMF’s de facto exchange rate regime classification as published in the IMF’s International Financial Statistics. The pegged regimes are those without a country-specific currency, currency boards, and conventional fixed peg arrangements. Intermediate regimes have pegged exchange rates within horizontal bands, crawling pegs, and exchange rates within crawling bands. Flexible regimes have managed and independently floating exchange rate regimes.

As so defined in the IMF’s quarterly publication Emerging Market Financing: A Quarterly Report on Developments and Prospects.

Foreign exchange intervention is prevalent even under flexible exchange rate regimes.3 For example, in a managed floating exchange rate regime, the monetary authority influences the movements of the exchange rate through interest rate changes and active foreign exchange intervention, without specifying (or precommitting to) a preannounced path for the exchange rate. In an independently floating exchange rate regime, foreign exchange intervention may be conducted to moderate the rate of change and prevent undue fluctuations in the exchange rate, rather than establish a level for it.

Sterilized or Not Sterilized?

When the central banks that issue the major international currencies intervene, they tend to sterilize foreign exchange interventions to achieve their short-term operating targets of monetary policy, usually short-term interest rates. The Fed sterilizes its foreign exchange intervention to keep the amount of bank reserves at levels that are consistent with established monetary policy goals. In particular, liquidity is adjusted for consistency with the federal funds target. The ECB has sterilized its foreign exchange intervention on the few occasions that it has been in the market (Frenkel, Pierdzioch, and Stadtmann, 2001).4 The Bank of Japan conducts foreign exchange intervention as the agent of the ministry of finance, with funds from a special account of the Japanese government. Thus, foreign exchange intervention does not affect the money base. Foreign exchange purchases are funded by issuing short-term, yen-denominated bills, and yen purchases are funded by selling foreign exchange funds from the special account in the market (Bank of Japan, 2000; and Ito, 2002).

Unlike the Fed, the ECB, and the Bank of Japan, most central banks in developing economies do not fully sterilize their foreign exchange interventions on a regular basis (Table 3.3). About 10 percent of the survey respondents reported that foreign exchange intervention is never sterilized; about half indicated that it is sometimes sterilized; and about 20 percent said it is always sterilized. About 25 percent of survey respondents did not answer the corresponding section of the survey.

Table 3.3.

Developing and Transition Economies That Do Not Always Sterilize Foreign Exchange Intervention, by Exchange Rate Regime and Market Access, 2001

(Percentage of countries answering the corresponding survey question in each category)1

article image
Source: Survey on the organization of foreign exchange markets conducted in 2001 by the IMF.Note:—stands for not applicable, zero, or negligible amount.

Refers to the percentage of the 90 countries classified as …developing” and …in transition” that responded to the IMF 2001 survey on the foreign exchange market.

Follows the IMF’s de facto exchange rate regime classification as published in the IMF’s International Financial Statistics.

As so defined in the IMF’s quarterly publication Emerging Market Financing: A Quarterly Report on Developments and Prospects.

The Central African Economic and Monetary Community (CAEMC) is a conventional fixed peg arrangement.

The frequency of sterilization varied slightly by exchange rate regime and market access. Countries that sometimes sterilize their foreign exchange interventions can be found in almost all types of exchange rate regimes. The countries that never sterilize are concentrated in the less flexible exchange rate regimes, as would be expected, but account for only a small share of all countries following these regimes. The countries that always sterilize their foreign exchange interventions are more likely to be found in the more flexible exchange rate regimes with market access, but they can also be found in soft peg exchange rate regimes.

Relative Size of Foreign Exchange Intervention

Foreign exchange intervention by the central banks that issue the major international currencies accounts for a small fraction of annual foreign exchange market turnover. Even in the case of the Bank of Japan, foreign exchange intervention against U.S. dollars in 2000 accounted for less than 0.2 percent of estimated annual foreign exchange market turnover. However, the size of foreign exchange intervention on any given day may be substantial, reaching a peak of 16 percent of foreign exchange market turnover.5

Foreign exchange intervention by some central banks in developing economies accounts for a much larger portion of foreign exchange market turnover than that conducted by the central banks that issue the major international currencies, especially at the level of interbank trading (Table 3.4).6 In six of the countries that responded to the survey, the size of foreign exchange intervention exceeds the volume of interbank foreign exchange market turnover (excluding trades with the central bank). In contrast, the size of intervention is below 10 percent of the volume of interbank trading in four countries. The size of foreign exchange intervention is usually significantly smaller as a fraction of bank-customer trading, reflecting the fact that interbank trading in developing economies usually accounts for only a small amount of turnover in the bank-customer segment of the market.7

Table 3.4.

Magnitude of Foreign Exchange Intervention in Selected Developing and Transition Economies, 2000

(Percentage of foreign exchange market turnover at different levels of trading)

article image
Sources: Survey on the organization of foreign exchange markets conducted in 2001 by the IMF; Bank for International Settlements (2001), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity; and Bank of Japan.

The names of the countries are omitted for purposes of confidentiality.

The different levels of foreign exchange market turnover exclude transactions with the central bank.

Foreign exchange intervention conducted in U.S. dollars in 2000 versus spot market turnover of the yen against the U.S. dollar on a yearly basis, as published in Table E-2 of the 2001 triennial survey statistical annex of the Bank for International Settlements. To compute the figure on a yearly basis, 22 trading days are assumed each month.

Several reasons may help explain the relatively large size of foreign exchange intervention by some central banks in developing economies. First, these central banks are usually large customers in the foreign exchange market. Second, they use a variety of foreign exchange, monetary, and banking regulations to increase their relative size in the foreign exchange market, among other objectives. Third, central bank foreign exchange operating practices may prevent the development of an interbank foreign exchange market containing the growth of the turnover in the foreign exchange market.

Central Banks as Large Customers in the Foreign Exchange Market

Many central banks in developing economies are important players in the foreign exchange markets on their own behalf or on behalf of their governments. These central banks may buy or sell foreign exchange as customers on their own behalf for several reasons. Foreign exchange can be used to meet their foreign expenditures, such as paying their own external debt, or to sell the foreign exchange received from loans to support the balance of payments, including those from multilateral lending institutions. These central banks can also enter the foreign exchange market to adjust the actual level of international reserves to the desired level, for example, to meet some reserve adequacy targets. In addition, they often buy and sell foreign exchange to defend the level of the exchange rate or to reduce exchange rate volatility.

Many central banks in developing economies also conduct foreign exchange operations on behalf of their governments, state enterprises, and nonbudgetary government agencies. More than half of the survey respondents reported that the central bank is the exclusive foreign exchange agent of the government, with the government trading foreign exchange only with the central bank.8 State-owned enterprises and nonbudgetary government agencies in many developing and transition economies are also required to trade foreign exchange exclusively with the central bank. The survey found that about 8 percent of respondents had this exclusive arrangement with state-owned enterprises and about 15 percent had it with government agencies.

The governments and their agencies in developing economies are often an important source of foreign exchange, especially where the size of the government in the economy is large. In particular, the government, state enterprises, and nonbudgetary government agencies account for a large portion of foreign exchange traded in many countries. Concentration arises where financial aid from foreign donors is the main source of foreign exchange. It also occurs in countries where state enterprises account for the bulk of the export receipts and in some open economies where foreign exchange traded domestically arises mainly from taxes and royalties paid in foreign exchange. Finally, the government often becomes a large supplier of foreign exchange in countries where the fiscal deficit is financed abroad.

Moreover, many central banks in developing economies conduct foreign exchange operations with government entities to achieve exchange rate policy objectives. On several occasions, governments and state-owned companies have borrowed abroad with the main purpose of affecting the evolution of the exchange rate rather than financing fiscal expenditures or the companies’ operations. As documented by Taylor (1982), this form of secret foreign exchange intervention was also practiced in some developed countries in the late 1970s.

Regulations

Many central banks in developing economies use foreign exchange controls and monetary regulations that increase the size of intervention relative to the foreign exchange market. In contrast, none of the measures described in this section are currently used by the central banks that issue the major international currencies.

Foreign Exchange Controls

Foreign exchange controls increase the size of foreign exchange intervention relative to the market by either reducing the size of the foreign exchange market or concentrating the foreign exchange supply in the hands of the central bank.

Capital controls can reduce cross-border movements of capital and the volume of foreign exchange market turnover, increasing the relative size of central bank foreign exchange intervention. Banning cross-border investments is a way of discouraging nonresidents from using the domestic currency and residents from using foreign currencies, thus reducing the potential volume of transactions in the foreign exchange market. Capital controls can prevent large capital movements and significant increases in foreign exchange market turnover that accompany deviations from interest rate parity not explained by differences in risk premiums.

Surrender requirements to the central bank are obligations to sell foreign exchange proceeds (usually from exports) within a specified time frame. When directed to the central bank, surrender requirements concentrate the foreign exchange supply in the hands of the central bank, turn the central bank into the main foreign exchange intermediary, and increase the relative size of foreign exchange intervention. In practice, surrender requirements exist in about 40 percent of the survey respondents, but they are seldom directed to the central bank.9

Prohibitions on interbank foreign exchange trading limit the size of the foreign exchange market, increasing the relative size of foreign exchange intervention. In a few developing economies, banks are allowed to conduct foreign exchange trading only on behalf of their customers. Banks can still conduct foreign exchange intermediation, buying from sources of foreign exchange and selling to end users of foreign exchange. But they cannot engage in market making activities.10

Many central banks in developing economies establish a combination of measures to discourage financial institutions from taking net open foreign exchange positions.11 The measures include limits on the level and daily variations of the financial institutions’ net open foreign exchange positions. The positions subject to limits usually include open forward foreign exchange positions, since unhedged forward foreign exchange positions can trigger large pressures on the spot exchange rates when banks need to hedge their exposure and cannot find an adequate counterparty to take the opposite forward foreign exchange position.

About half of the survey respondents have in place measures that restrict the operation of forward markets, reducing the ability of nonfinancial institutions to fund speculative positions and hedging exchange rate risk. In particular, about 15 percent of survey respondents explicitly prohibit banks from issuing forward contracts, and about 40 percent impose certain requirements on banks that offer forward contracts, most notably the requirement that banks offer these contracts only for hedging the exchange rate risk of legally permitted, underlying, international transactions. Foreign exchange regulations in some countries also control the maturity of the forward contracts offered to customers. About 45 percent of survey respondents allow banks to issue forward contracts without any controls. However, the scope for speculative net open position taking is limited by the level of development, liquidity, and depth of the market. In particular, only 9 percent of survey respondents consider their forward foreign exchange markets to be developed, liquid, and deep, while 30 percent consider them to be undeveloped, illiquid, and shallow (Table 3.5).12

Table 3.5.

Selected Regulations on Forward Foreign Exchange Transactions in Developing and Transition Economies, 2001

(Percentage of countries answering the corresponding survey question in each category)1

article image
Source: Survey on the organization of foreign exchange markets conducted in 2001 by the IMF.

Refers to the percentage of the 90 countries classified as …developing” and …in transition” that responded to the IMF 2001 survey on the foreign exchange market.

Follows the IMF’s de facto exchange rate regime classification as published in the IMF’s International Financial Statistics.

As so defined in the IMF’s quarterly publication Emerging Market Financing: A Quarterly Report on Developments and Prospects.

Monetary Regulations

Monetary regulations can increase the relative size of central bank foreign exchange intervention by reducing the residents’ use of foreign currencies and nonresidents’ use of the domestic currency.

To reduce the scope for currency substitution, most countries that issue their own currencies have granted a series of legal privileges to their domestic currency. Residents usually must use their domestic currency as means of payment. In particular, monetary regulations in many of the survey respondents give the domestic currency the exclusive role of means of payment (forced tender) or, at least, the advantage of legal tender so that it must be accepted in payment for financial obligations. Moreover, about half of the survey respondents explicitly prohibit their residents from making payments to other residents in foreign currencies.

Most countries allow residents to use foreign currencies as a store of value. Nearly all survey respondents allowed banks to accept foreign currency deposits, especially from exporters.13 Some developing countries explicitly prohibit other private sector residents from holding foreign currency deposits in domestic banks. Banks may also accept foreign currency deposits from the public sector, especially from state enterprises. The number of countries allowing their financial systems to offer foreign currency deposits to nonresidents is smaller. The degree of dollarization of private sector deposits is above 10 percent in about half of the survey respondents, reaching the 75 to 100 percent range in a few countries.14

In addition, about one-third of developing economies impose controls on the use of their domestic currencies by nonresidents abroad. To avoid fueling speculation in foreign exchange markets, many countries—about 30 percent of survey respondents—explicitly prohibit their banking systems from extending short-term loans in domestic currency to nonresidents.

Information Advantage

To infer exchange rate pressures embedded in foreign exchange market activity, the literature on the microstructure of such markets emphasizes the importance of foreign exchange order flow. A positive foreign exchange order flow reflects an excess demand for foreign exchange that would tend to depreciate the domestic currency. Lyons (2001) surveys the literature that has empirically documented the positive relationship between order flow and exchange rate changes, and Vitale (2001) puts forward a theoretical argument in the context of foreign exchange intervention.

Some central banks in developing economies make use of their ability to issue regulations to obtain an information advantage over other market participants, requesting, among other things, specifics about foreign exchange order flow. They require market participants to submit information about their foreign exchange activities, sometimes in great detail.15 The information advantage arises because only a subset of the information collected is made available to other foreign exchange market participants. The data requested vary significantly across countries, ranging from all information on each of the foreign exchange transactions made by each authorized dealer to summary statistics, sometimes weighted by the size of the transactions. The collected information available to central banks often includes data for every licensed dealer on exchange rates (whose dispersion reflects the uncertainty in the foreign exchange market) and foreign exchange transaction volumes.

From the information on foreign exchange transactions, central banks can infer the size of foreign exchange order flow aggregated at some levels of trading.16 For example, in transactions between banks and their customers, market turnover usually equals aggregate foreign exchange order flow because customers are usually those initiating the foreign exchange transaction at the exchange rate quoted by dealer banks, especially in competitive foreign exchange markets where market makers operate. However, in transactions among banks, foreign exchange market turnover usually differs from foreign exchange order flow. The lack of order flow data at the interbank level is less important in developing and transition economies with shallow interbank markets since interbank trading accounts for a smaller fraction of the total foreign exchange order flow in the market.

Information about the net open foreign exchange positions of authorized dealers can be used to anticipate changes in order flow, as dealers with currency exposure are likely to go to the market to cover their positions, affecting order flow, when changes in the expected path of the exchange rate take place. This information also helps identify foreign exchange dealers that may be taking large net open foreign exchange positions and contributing to pressures on the exchange rate. In most developing countries, banks must report to the central bank their net open foreign exchange positions more than once a month, but the information obtained is seldom published.17 Most reporting is done daily. Weekly reporting is more common than monthly in all regions except Eastern Europe. About 70 percent of the countries with net open foreign exchange position limits, however, never publish this information.

In addition to obtaining information from reporting requirements, some central banks in developing economies obtain privileged information about foreign exchange order flow in certain centralized trading environments, for instance, when conducting foreign exchange auctions. Central banks conduct most foreign exchange auctions in 15 developing and transition economies that responded to the survey. The central bank actively participated in the auctions in three countries, but it indirectly participated in many other auctions by deciding the amounts to be auctioned. A few central banks also have privileged access to the information generated in electronic broking systems.18 The central bank may be able to compute foreign exchange order flow directly in countries where it observes foreign exchange transactions that take place among banks through an electronic broking system. However, this would cover only a fraction of the total foreign exchange order flow, since banks can usually trade among themselves outside of those trading platforms.

Control of the payment and settlement systems in the country can also give an information edge to the central bank, as many central banks in developing economies are directly involved in the settlement of foreign exchange transactions. In particular, control of these systems allows the settlement of one or both legs of foreign exchange transactions at central bank accounts. In many of the survey respondents where financial institutions are often required to open accounts at the central bank to meet reserve requirements, the debiting and crediting take place at central bank accounts. The foreign currency leg settlement requires that foreign currency accounts be opened at the central bank, a situation that often arises in dollarized economies in which the reserve requirements on foreign currency deposits are denominated in foreign currency.19 However, the information advantage obtained from the control of the payment and settlement systems may be difficult to obtain in practice unless special arrangements for the settlement of foreign exchange transactions are in place to distinguish foreign exchange from other transactions.

Conclusions

The evidence from the IMF’s 2001 survey on the organization of foreign exchange markets indicates that foreign exchange intervention is a widely used policy instrument in developing and transition economies.

The survey results show that official foreign exchange intervention conducted by some central banks in developing economies differs in a number of ways from that of the central banks of developed countries that issue the major international currencies. First, unlike the U.S. Federal Reserve Board, the European Central Bank, and the Bank of Japan, not all central banks in developing economies fully sterilize their foreign exchange operations on a regular basis. Many developing-country central banks back up their foreign exchange interventions with adjustments to their monetary policy stance. Second, unlike the central banks that issue the major international currencies, some central banks in developing economies conduct foreign exchange intervention in amounts that are significant relative to the level of foreign exchange market turnover, the money base, and the stock of domestic bonds outstanding. Third, some central banks in developing economies have a greater information advantage over the central banks that issue the major international currencies because, among other reasons, they can infer the aggregate foreign exchange order flow from reporting requirements. Finally, many central banks in developing economies also use foreign exchange and monetary regulations, as well as their own foreign exchange operating practices, to increase their information advantage and the size of foreign exchange intervention relative to the market.

1

The survey was sent to all 160 IMF member countries classified as …developing” or …in transition.” For more detail on the survey results, see Canales-Kriljenko (2003). See also Cheung and Chinn (1999) and Neely (2001).

2

The ECB drew from a foreign exchange swap arrangement signed with the Federal Reserve Bank of New York in the aftermath of the September 11, 2001, terrorist attacks, which alleviated liquidity demands that could have otherwise generated large pressures on the exchange rate. However, it cannot be considered foreign exchange intervention because the purpose of the operation was not to affect exchange rates but to smooth potential disruptions in the payment systems. Moreover, although a foreign exchange swap theoretically involves simultaneous spot and forward foreign exchange operations, market makers hedge their exposure by operations in the money market rather than in the foreign exchange market.

3

See Ishii and others (2003) for a discussion of exchange rate regime classification based on de facto policies.

4

The intervention operations conducted during 2001 by the ECB, and not considered in Frenkel, Pierdzioch, and Stadtmann (2001), were also sterilized. In particular, the foreign exchange intervention conducted on behalf of the Bank of Japan did not affect the money base.

5

This calculation considers only total turnover in the spot market between yen and U.S. dollars, as documented by the Triennial Central Bank Survey of the Foreign Exchange and Derivatives Market Activity of the Bank for International Settlements (2001). About 95 percent of foreign exchange intervention by the Bank of Japan is conducted against U.S. dollars.

6

Only a few survey respondents provided information about the amounts of foreign exchange intervention and foreign exchange market turnover that allows for the comparison.

7

In contrast, interbank trading accounts for most of the foreign exchange market turnover among the major international currencies.

8

In some countries, the government is not allowed to hold foreign currency deposits and must surrender its foreign exchange to the central bank. In others, the government may keep foreign exchange deposits in or out of the central bank, but when it decides to exchange them, it has to conduct the exchange through the central bank.

9

Surrender requirements to the government may be motivated by a desire to allocate foreign exchange to particular uses, make more foreign exchange available to the central bank for foreign exchange intervention in periods of pressure on the exchange rate, or meet public foreign exchange expenditure commitments.

10

The central bank thus reduces competition from the market in setting exchange rates, which increases the impact of foreign exchange intervention on the exchange rate.

11

Net open foreign exchange positions also play an important prudential role by limiting banks’ exposure to exchange rate risk.

12

In contrast, about 40 percent of the survey respondents perceived their spot foreign exchange markets to be developed, liquid, and deep, while only 6 percent perceived them to be undeveloped, illiquid, and shallow.

13

When the country imposes the requirement to surrender export receipts to the foreign exchange market, the exporter can often keep foreign exchange earnings in a foreign currency account for a period before it must sell the foreign exchange.

14

The survey did not capture information on the number of countries prohibiting financial contracts from being indexed to the exchange rate, which would preserve the store-of-value role of foreign currencies and could give rise to exchange rate pressures.

15

The provision of such information is often a condition for conducting foreign exchange intermediation, to the extent that some-times the obligation to provide information to the central bank is embedded in the foreign exchange license.

16

Reporting requirements provide a good picture of foreign exchange market turnover in a country where institutions reporting to the central bank make up the bulk of foreign exchange market turnover. This is more likely to be the case in about half of the countries in the sample, which actually prohibit the offshore trading of their currencies.

17

The United States requests information on the net open foreign exchange positions of the internationally active international banks every quarter. That information is available at http://www.fms.treas.gov/bulletin/index.html.

18

According to the survey, electronic broking systems are in place in about 40 percent of emerging market economies.

19

The fact that most countries also report that the foreign currency leg is settled at the accounts of correspondent banks abroad suggests that the central bank accounts serve as an intermediate netting scheme but that the final payments must be done at the accounts of correspondent banks, transferring money to or from the central bank.

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Cover Official Foreign Exchange Intervention
Official Foreign Exchange Intervention
Author: Mr. Jorge I Canales Kriljenko, Mr. Cem Karacadag, Roberto Guimarães-Filho, and Mr. Shogo Ishii
ISBN:
9781589064218
ISSN:
0251-6365
Publication Date:
02 Mar 2006
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589064218.084
Pages:
52

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