Foreign Exchange Intervention in Developing and Transition Economies
Results of a Survey

Based on evidence obtained from the IMF's 2001 Survey on Foreign Exchange Market Organization, the author argues that, for several reasons, some central banks in developing and transition economies may be able to conduct foreign exchange intervention more effectively than the central banks of developed countries issuing the major international currencies. First, these central banks do not always fully sterilize their foreign exchange interventions. In addition, they issue regulations and conduct their foreign exchange operations in a way that increases the central bank's information advantage and the size of their foreign exchange intervention relative to foreign exchange market turnover. Some of the central banks also use moral suasion to support their foreign exchange interventions.

Abstract

Based on evidence obtained from the IMF's 2001 Survey on Foreign Exchange Market Organization, the author argues that, for several reasons, some central banks in developing and transition economies may be able to conduct foreign exchange intervention more effectively than the central banks of developed countries issuing the major international currencies. First, these central banks do not always fully sterilize their foreign exchange interventions. In addition, they issue regulations and conduct their foreign exchange operations in a way that increases the central bank's information advantage and the size of their foreign exchange intervention relative to foreign exchange market turnover. Some of the central banks also use moral suasion to support their foreign exchange interventions.

I. Introduction

The literature on foreign exchange intervention has focused on the experience of central banks in developed countries, especially those issuing the major international currencies.2,3 Its results suggest that sterilized foreign exchange intervention conducted by these central banks over the last 20 years may well have had an effect on the exchange rate over the short run, but not over the long run. Some authors have argued that the short-run effects have been weak and difficult to identify.4 Other authors, however, have presented a slightly more positive view about foreign exchange intervention, especially when it was conducted simultaneously by several central banks in a concerted fashion.5 These documented experiences with foreign exchange intervention have taken place in an environment of floating exchange rates, full capital mobility, and large international use of the currencies involved.

This paper explores how foreign exchange intervention can be more effective in developing and transition economies, which follow a wide array of exchange rate regimes and have in place many controls on capital mobility, currency substitution, dollarization, and the international use of their currencies. Special attention is given to the microstructure of the foreign exchange market in which the foreign exchange intervention takes place, in particular, to the aspects that can be influenced by foreign exchange regulations, monetary regulations, and central bank foreign exchange operating practices.

Foreign exchange intervention practices in developing and transition economies are characterized with information from the IMF’s 2001 Survey on Foreign Exchange Market Organization, which targeted those developing and transition economies that are members of the IMF.6 Ninety members responded to the survey, accounting for 85 percent of the exports, 91 percent of the imports, and 85 percent of the GDP of developing and transition economies in the year 2000. These countries also held about 90 percent of the developing and transition economies’ international reserves.7

The survey results suggest that official foreign exchange intervention conducted by some central banks in developing and transition economies may have more of an impact on the path of the exchange rate than official foreign exchange intervention by the central banks of developed countries issuing the major international currencies, at least in the absence of a major crisis. Several reasons can be offered. First, unlike the U.S. Federal Reserve Board (the Fed), the European Central Bank (ECB), or the Bank of Japan, not all central banks in developing and transition economies routinely fully sterilize their foreign exchange interventions. Second, unlike the central banks issuing the major international currencies, some central banks in developing and transition economies conduct foreign exchange intervention in amounts that are important 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 and transition economies have a greater information advantage over the central banks issuing the major international currencies because, among other things, they can infer the aggregate foreign exchange order flow from reporting requirements. Many central banks in developing and transition economies also use foreign exchange and monetary regulations, as well as their own foreign exchange operating practices, among other things, to increase the central bank’s information advantage and the size of foreign exchange intervention relative to the market.8 Finally, many central banks in developing and transition economies exert moral suasion to reinforce the effects of their foreign exchange market interventions.

The remainder of this paper is organized as follows. Section II describes the prevalence of foreign exchange intervention across different exchange rate regimes and degrees of market access. Section III discusses the survey responses on the issue of sterilization and compares them with the sterilization practices by the central banks issuing the major international currencies. Section IV presents evidence on the size of foreign exchange intervention relative to the market in developing and transition economies and discusses how foreign exchange regulations, monetary regulations, and central bank foreign exchange operating practices could increase the relative size and effectiveness of foreign exchange intervention. Section V discusses the asymmetric information in favor of central banks in developing and transition economies and discusses how the information asymmetry could increase the effectiveness of foreign exchange intervention. Section VI discusses moral suasion and Section VII concludes the analysis.

II. Prevalence of Foreign Exchange Intervention

Central banks issuing the major international currencies are not active participants in their foreign exchange markets. The economies in which they operate have adopted monetary policy frameworks that target short-term interest rates and exchange rate policies that limit foreign exchange intervention to calm disorderly market conditions.9 Foreign exchange intervention takes place infrequently, and although it could be of large absolute magnitude when it does take place, its size is estimated to be small relative to total foreign exchange market turnover.10 Partly because conditions in the foreign exchange market were orderly during 2001, only the Bank of Japan conducted foreign exchange intervention operations on a very small number of days in 2001. In particular, the Bank of Japan intervened on seven days following the terrorist attacks of September 11 and on three of those days, the ECB conducted foreign exchange interventions on behalf of the Bank of Japan under an existing agreement.11 However, neither the Fed nor the ECB conducted official foreign exchange intervention on its own behalf in their spot foreign exchange markets.12

Most central banks in developing and transition economies participated in their foreign exchange markets across all exchange rate regimes and degrees of market access during 2001. Almost all of the survey respondents reported that their central banks traded foreign exchange in the spot foreign exchange market and virtually all of those who answered the corresponding question indicated conducting foreign exchange intervention (Appendix Table 2).13 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 (Appendix Table 3).14

The prevalence of foreign exchange intervention can be seen even in the more flexible exchange rate regimes.15 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 of the exchange rate and preventing undue fluctuations in the exchange rate, rather than establishing a level for it. These intervention policies are consistent with the Fund’s Principles for the Guidance of Members’ Exchange Rate Policies, which call for a Fund member’s foreign exchange intervention “if necessary to counter disorderly conditions, which may be characterized, among other things, by disruptive short-term movements in the exchange value of its currency.”16

Conversely, little foreign exchange intervention is seen in some of the less flexible exchange rate regimes. The survey results do not support the view that central banks manage all the least flexible exchange rate regimes with frequent foreign exchange intervention. This finding may be surprising because, in the typical textbook exposition of fixed exchange rate regimes, the central bank stands ready to buy or sell foreign exchange to defend a given level of the exchange rate. Killeen and others (2001) provide a possible explanation within a foreign exchange market operating without controls. In their model, the private sector, not the central bank, absorbs the innovations in the foreign exchange order flow when the fixed exchange rate regime is credible.17 When exchange rate expectations are anchored, foreign exchange intermediaries would buy foreign exchange in the presence of pressures for domestic currency depreciation and sell it in the presence of those for currency appreciation. In other words, foreign exchange intermediaries would conduct stabilizing speculation, whose profitability would depend on the size of the bid-offer spread.

III. Sterilized or Not Sterilized?

Foreign exchange intervention by central banks in developing and transition economies may be more effective in affecting exchange rates than foreign exchange intervention by the central banks issuing the major international currencies, among other things, because the foreign exchange intervention by the former is not always fully sterilized.

The economic literature on foreign exchange intervention recognizes that unsterilized foreign exchange intervention has an effect on the path of exchange rates (Almekinders, 1995). Changes in the money supply have a long-run effect on its price in terms of goods and other currencies, although the adjustment on the exchange rate is usually much faster than that on goods’ prices and may involve overshooting. The change in the money supply used to achieve an exchange rate objective may be accomplished by either unsterilized foreign exchange intervention or changes in the central bank’s net domestic assets.18

When central banks issuing the major international currencies intervene, they tend to sterilize their foreign exchange interventions to achieve their short-term operating targets of monetary policy, usually short-term interest rates (Craig and Humpage, 2001). The Fed sterilizes its foreign exchange intervention to keep the amount of bank reserves at levels that are consistent with the established monetary policy goals.19 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 and others, 2001).20The Bank of Japan conducts foreign exchange intervention as the agent of the Minister 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 by selling foreign exchange funds from the special account in the market (Bank of Japan, 2000 and Ito, 2002).

Unlike the Fed, the ECB, or the Bank of Japan, not all central banks in developing and transition economies routinely fully sterilize their foreign exchange interventions. In particular, 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.

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 (Appendix Table 4). The countries that never sterilize are concentrated in the less flexible exchange rate regimes as could be expected, but account for only a small share of all countries following these exchange rate regimes (Appendix Table 5). 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 can also be found in countries following soft peg exchange rate regimes (Appendix Table 6).

The finding that central banks in developing and transition economies do not always fully sterilize their foreign exchange interventions should not be surprising. Unlike the major central banks that follow short-term interest rate targets, these countries follow a wide array of monetary policy frameworks that allow some room for unsterilized intervention. In addition, many authors have argued that under certain conditions, the optimal degree of sterilization is not necessarily fully sterilizing one’s foreign exchange intervention and depends on the nature of the shocks that hit the economy and the objectives of the authorities.21 This literature revolves around the issue of the optimal exchange rate regime. Of course, whether developing and transition economies were actually following optimal sterilization rules is an empirical issue that is beyond the scope of this paper.

IV. Relative Size of Foreign Exchange Intervention

The size of foreign exchange intervention is in theory an important factor influencing the effectiveness of foreign exchange intervention. In particular, it must be large relative to the total turnover in the foreign exchange market, the stock of domestic money, or the stock of publicly traded domestic and foreign bonds held by the private sector to be effective under several possible channels of influence identified in the literature, namely the balance-of-payments-flows, monetary, and portfolio-balance channels (Rosenberg, 1996).22 Moreover, the literature has suggested that in the presence of noise traders large amounts of foreign exchange intervention may need to be involved to change the trend of the exchange rate, especially if foreign exchange intervention needs to be kept secret to be effective (Hung, 1997).23

Foreign exchange intervention by the central banks issuing the major international currencies accounts for a very small fraction of annual foreign exchange market turnover. Even in the case of the Bank of Japan, foreign exchange intervention against U.S. dollars during the year 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 during the period.24

Foreign exchange intervention by some central banks in developing and transition economies accounts for a much larger fraction of foreign exchange market turnover than that conducted by central banks issuing the major international currencies, especially at the interbank level of trading (Appendix Table 7). 25 In six of those 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 and transition economies usually accounts for only a fraction of turnover in the bank-customer segment of the market.26

Several reasons could help explain the larger size of foreign exchange intervention by some central banks in developing and transition economies relative to the sizes of their foreign exchange markets. First, central banks in these economies are usually large customers in the foreign exchange market. Second, many central banks in developing and transition economies use a variety of foreign exchange, monetary, and banking regulations to, among other things, increase their relative size in the foreign exchange market. 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.

A. Central Banks as Large Customers in the Foreign Exchange Market

In contrast to the Fed, the ECB, and the Bank of Japan, many central banks in developing and transition economies are important players in the foreign exchange markets, whether on their own behalf or on behalf of their governments. Central banks in developing and transition economies may buy or sell foreign exchange as customers on their own behalf for several reasons. For instance, 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. 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, central banks in developing and transition economies 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 and transition 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 (Appendix Table 8).27 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. This occurs with state-owned enterprises in about 8 percent of the survey respondents and government agencies in 15 percent of them.

The governments and their agencies in developing and transition economies are often a very important source of foreign exchange, especially in nonemerging markets where the size of the government in the economy is relatively large. In particular, the government, state enterprises, and nonbudgetary government agencies account for a large portion of foreign exchange traded in many countries. The concentration arises naturally in many developing and transition economies where financial aid from foreign donors is the main source of foreign exchange. It also occurs in countries where state enterprises obtain the bulk of the export receipts of the country and in some open economies where foreign exchange traded domestically mainly arises 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 and transition economies sometimes conduct foreign exchange operations with government entities to achieve exchange rate policy objectives. In particular, 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 to finance 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.

B. Regulations that Increase the Relative Size of Foreign Exchange Intervention

Many central banks in developing and transition economies often use foreign exchange controls and monetary regulations not only to directly reduce pressures on the foreign exchange market, but also to increase the effectiveness of their foreign exchange intervention by raising the size of intervention relative to the foreign exchange market.28

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 by concentrating the foreign exchange supply in the hands of the central bank.

Capital controls

If comprehensive, 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.29 Banning cross-border investments is a way of discouraging nonresidents from using the domestic currency and residents from using foreign currencies and thus reducing the potential volume of transactions in the foreign exchange market. Comprehensive capital controls prevent the large movement of capital and large increases in foreign exchange market turnover that accompany deviations from interest rate parity not explained by differences in risk premiums. Thus, besides the effect of increasing the relative size of foreign exchange intervention, they provide some room for maneuver to conduct independent monetary and exchange rate policies.

Surrender requirements to the central bank

A surrender requirement is an obligation to sell foreign exchange proceeds within a specified timeframe, usually from exports. When directed to the central bank, surrender requirements increase the central bank’s relative size of foreign exchange intervention, bargaining position, and information advantage. Comprehensive surrender requirements of this kind concentrate the foreign exchange supply in the hands of the monetary authority and turn the central bank into the main foreign exchange intermediary. In this position, the central bank can better influence the path of the exchange rate by partially controlling the supply of foreign exchange. In practice, surrender requirements exist in about 40 percent of the survey respondents, but they are seldom directed to the central bank (Appendix Table 9).30

Prohibitions on interbank foreign exchange trading

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 and transition 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 cannot engage in market making activities. The prohibitions are more likely in nonemerging markets and in the less flexible exchange rate regimes (Appendix Table 10).31

Regulations hindering the taking of net open foreign exchange positions

Limits on net open foreign exchange positions reduce the size that the foreign exchange market would have in the face of pressures on the value of the domestic currency. The rapid building of net open foreign exchange positions, such as those that take place during speculative attacks, rapidly increases the size of the foreign exchange market, decreasing the relative size of the foreign exchange intervention that is feasible with available international reserves.32

Many central banks in developing and transition economies put in place a combination of measures to hinder the taking of net open foreign exchange positions by financial institutions.33 Most developing and transition economies impose limits on the level and daily variations of net open foreign exchange position of financial institutions (Appendix Tables 11 and 12). The net open foreign exchange 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 the survey respondents have in place measures that restrict the operation of forward markets reducing the ability of nonfinancial institutions to fund speculative positions, but also to hedge 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 for offering 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 of survey respondents consider them to be undeveloped, illiquid, and shallow (Appendix Table 13).34

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 currencies (Baliño and Canales-Kriljenko, 2001). 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 (Appendix Table 14).

Most countries permit residents to use foreign currencies as a store of value. Practically all survey respondents allowed banks to accept foreign currency deposits, especially from exporters.35 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 was smaller. The degree of dollarization of private sector deposits was above 10 percent in about half of the survey respondents, reaching the 75–100 range in a few countries (Appendix Table 15).36

In addition, many countries imposed controls on the use of their domestic currencies by nonresidents abroad. This was the case in about a third of developing and transition economies. In addition, many countries include outright prohibitions on short-term lending in domestic currency to nonresidents to avoid fueling speculation in foreign exchange markets. In particular, about 30 percent of survey respondents explicitly prohibit their banking systems to lend domestic currency to nonresidents (Appendix Table 16).

C. Central Bank Foreign Exchange Operating Practices That Increase the Relative Size of Foreign Exchange Intervention

Foreign exchange operating practices by central banks can increase the size of foreign exchange intervention relative to the foreign exchange market. For example, many central banks in developing and transition economies act like market makers and set extremely narrow bid-offer spreads.37 This practice reduces foreign exchange transactions, particularly at the level of interbank trading because banks cannot compete with the central bank in conducting foreign exchange intermediation.38 The low level of foreign exchange market turnover tends to increase the relative size of the central bank intervention in the foreign exchange market.

Central banks can act as market makers in most exchange rate regimes. The central bank becomes a market maker when it sets firm two-way (buying and selling) exchange rates at which other dealers can trade, usually up to a certain amount established by market practices. For example, under a fixed exchange rate regime, central banks fix a rate and stand ready to meet any supply or demand imbalance at that rate. They may also behave as market makers in several other exchange rate regimes with different degrees of flexibility. In a crawling band, for example, the central bank sets two-way quotations with a wide bid-offer spread. In addition, central banks often conduct heavy intramarginal foreign exchange intervention to try to keep the exchange rate away from the band margins. They also could do the same even in countries following independently floating exchange rate regimes as long as they limit their foreign exchange intervention to preventing undue fluctuations in the exchange rate, rather than establishing a level for it.

A fixed bid-offer spread offered by the central bank may be smaller than the one that would prevail in the market. Without central bank participation, the bid-offer spread may vary over time and depend on country specific variables and market conditions. The bid-offer spread could increase with the exchange rate volatility (which in turn depends on the rate of currency depreciation) and decrease with expected trading volumes. The bid-offer spread increases to compensate foreign exchange intermediaries for the higher exchange rate risk associated with higher exchange rate volatility, which affects the unwanted net open foreign exchange positions that arise in the process of trading. They may decrease with expected trading volumes reflecting economies of scale and competition among market makers. In addition, bid-offer spreads and (unexpected) trading volumes may both rise in response to the arrival of information.39 The bid-offer spread could also depend on the presence of the central bank in the foreign exchange market. In particular, when the central bank does not behave as a market maker, foreign exchange intervention can either increase or decrease the bid-offer spread.40

V. Information Advantage

Central banks in some developing and transition economies may be more effective in affecting exchange rates through foreign exchange intervention than those in economies issuing the major international currencies because the former have a greater information advantage over the latter.41

Foreign exchange intervention can be more effective when the central bank has an information advantage if market participants change their expectations about the future path of the exchange rate after intervention operations take place.42 In such a situation, foreign exchange intervention will affect exchange rates well in excess of its contribution to aggregate foreign exchange order flow. A change in the expected exchange rate path could lead market participants to modifying their net open foreign exchange position. This could lead to a change in aggregate foreign exchange order flow, multiplying the effect of the foreign exchange intervention.

A. What Information Advantage Do Central Banks Have?

Central banks in developing and transition economies—especially in those economies that are not emerging markets—may not only have a better idea of the path for the supply of domestic currency or the targeted level of the exchange rate than other market participants, but also on the supply of foreign currency. More technically, they may have a better grasp of aggregate foreign exchange order flow than the rest of market participants. The advantage relative to the central banks issuing the major international currencies, however, consists of having a better grasp on foreign exchange order flow.

More information about monetary and exchange rate developments and policies

Like the central banks issuing the major international currencies, many central banks in developing and transition economies may, in principle, know better than other foreign exchange market participants their own intentions with respect to monetary and exchange rate policies (including foreign exchange intervention), while other market participants have to infer them from publicly available information and behavior. For example, central banks in developing and transition economies may know better their target value for the exchange rate, if any, than the rest of the participants in the foreign exchange market. In addition, some central banks in developing and transition economies may have access to information affecting exchange rates before other foreign exchange market participants, either because they compile the statistics or obtain them from the official statistical agency before the data are released.43

Some central banks in developing and transitional economies, however, may not have a real information advantage with regard to the future path of monetary policy. First, many central banks in developing and transition economies already abide by the IMF’s Code of Good Practices on Transparency in Monetary and Financial Policies, which implies that they already disclose vast amounts on information about their intended policies. Second, many central banks in developing and transition economies do not have real central bank independence. Although they may formulate a comprehensive monetary program, monetary policy may need to be changed with shifting political circumstances. Moreover, the private sector may have a better sense about the potential political shifts by hiring political analysts than the authorities in charge of formulating policy. The private sector may also realize that central bank operations to contain large pressures on the currency may be futile. In particular, managing money supply in the face of large pressures may not be credible, raising interest rates may not be feasible, and foreign exchange intervention may be considered a desperate measure with no chance of success, signaling a position of vulnerability rather than of strength. Finally, the marginal advantage of getting information about fundamentals in advance of the market may not always be relevant, as sometimes high-frequency movements in the exchange rate do not reflect fundamental developments.

More information about foreign exchange order flow

To infer exchange rate pressures embedded in foreign exchange market activity, the literature on the microstructure of foreign exchange markets emphasizes the importance of foreign exchange order flow. Intuitively, 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 currency depreciation and Vitale (2001) puts forward a theoretical argument in the context of foreign exchange intervention.

Some central banks in developing and transition economies make use of their ability to issue regulations to obtain an information advantage over other market participants, among other things, about foreign exchange order flow.44 They require market participants to submit information about their foreign exchange activities, sometimes in great detail.45The information advantage arises because only a subset of the information collected is made available to the other foreign exchange market participants. The data requested varies significantly across countries, ranging from all information on each of the foreign exchange transactions made by each authorized dealers to summary statistics, sometimes weighted by the size of the transactions. The collected information available to central banks in developing and transition economies 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 (Appendix Table 18).46

From the information on foreign exchange transactions, central banks could infer the size of foreign exchange order flow aggregated at some levels of trading.47 For example, in transactions between banks and their customers, foreign exchange 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 in which market makers operate. However, in transactions among banks, foreign exchange market turnover usually differs from foreign exchange order flow. It is not possible to know in a transaction among banks which bank initiated the transaction by just looking at the volume of the transaction. The lack of foreign exchange order flow data at the interbank level is less important in developing and transition economies with shallow interbank markets because 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 could 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 and transitions countries, banks must report to the central bank their net open foreign exchange positions usually more than once a month, but the information obtained is usually never published.48 The most prevalent frequency of reporting is daily. Weekly reporting is more common than monthly in all regions, except in Eastern Europe. About 70 percent of the countries with net open foreign exchange position limits, however, reported that they never published this information (Appendix Table 20).

Besides the information obtained from reporting requirements, some central banks in developing and transition economies obtain privileged information about foreign exchange order flow in some centralized trading environments, for instance, when conducting foreign exchange auctions. Central banks conducted most foreign exchange auctions in 15 countries developing and transition economies that responded to the survey (Appendix Table 21). The central bank actively participated in the auctions in three countries, but it indirectly participated in many other auctions by deciding the amounts auctioned. A few central banks in developing and transition economies also have privileged access to the information generated in electronic broking systems.49 The central bank either is the main provider or has access to the information from electronic broking systems provided by the private sector, usually adapting infrastructure available for securities’ trading at stock exchanges.50,51 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 only cover a fraction of the total foreign exchange order flow, since banks can usually trade among each other outside of those trading platforms.

The control of the payment and settlement systems in the country could also give a marginal information edge to the central bank, as many central banks in developing and transition economies are directly involved in the settlement of foreign exchange transactions. In particular, they allow the settlement of one or both legs of foreign exchange transactions at central bank accounts. In many of the countries represented by 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 (Appendix Table 23).52 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.

Some other central banks in developing and transitional economies, however, may not have a real information advantage with regard to foreign exchange order flow. In economies where the banking system is highly concentrated, the few institutions controlling the bulk of foreign exchange transactions can get a very good grasp of the direction of aggregate foreign exchange order flow by observing a representative fraction of it. Being in close contact with the end customers, these institutions can arguably have a better understanding of prevailing market sentiment than the central bank, even if the central bank sees the aggregate foreign exchange order flow on a daily basis.53 The same could take place even in economies without high concentration of foreign exchange trading activity when foreign exchange dealers exchange information over the course of trading. Moreover, foreign exchange intermediaries may have access to the information about foreign exchange order flow faster than the central bank in some developing and transition economies as they get the information in real time while the central bank gets the information at the end of the day.54

B. Information Advantage and the Transparency of Foreign Exchange Intervention

Based on their information advantage, the central banks can choose the degree of transparency of foreign exchange intervention that makes it more effective.55,56 To produce a change in exchange rate expectations, on some occasions the central bank would need to announce its foreign exchange intervention either directly or through visible operations. For example, when the central bank believes, based on its information advantage on market fundamentals and developments, that the level the exchange rate has reached is unwarranted, the central bank could signal its intentions (or threaten) to tighten monetary policy in the future if the misalignment is not corrected. This can be done by announcing this policy and simultaneously conducting foreign exchange intervention in support of the domestic currency. An announced foreign exchange intervention could be required, besides the monetary policy announcement, to achieve the change in exchange rate expectations in countries where the authorities and institutions suffer from credibility problems (Mussa, 1981).

On other occasions, however, the central bank would benefit from keeping its foreign exchange intervention secret.57 The information advantage could allow the central bank to detect situations in which market sentiment is shifting (by observing foreign exchange order flow and bank-by-bank net open foreign exchange positions), which could allow for a change in the exchange rate trend to take place. In the presence of noise traders, secret foreign exchange intervention could produce an effect on the trading rules followed by noise traders that could lead them to change their net open foreign exchange positions and reinforce the effect of foreign exchange intervention. This effect on trading rules would be easier to achieve in when trading becomes thin in the market, but it may come at the cost of temporarily increasing exchange rate volatility (Hung, 1997). The central bank may also want to keep its foreign exchange intervention secret when it fears that the private sector would use the disclosed information against the central bank. The informational advantage to the central bank may protect it to some degree from speculative attacks and falling into speculative trading games from large traders in the market.58

How transparent is foreign exchange intervention?

The central banks issuing the major international currencies report their foreign exchange interventions with a lag, but they do not always announce their foreign exchange interventions. The Fed does not normally announce or confirm its foreign exchange intervention. The financial press often reports foreign exchange intervention activity, but formal studies disagree about their accuracy (Klein, 1993 and Osterberg and Humes, 1993). Foreign exchange intervention activity is officially reported quarterly on the web. The Fed has released daily foreign exchange intervention data with a one-year lag, for about the last 10 years. The ECB has announced some of its foreign exchange intervention operations and acknowledged that it conducted foreign exchange intervention that was not reported in the press (Fatum and Hutchinson, 2002). Foreign exchange interventions by the Bank of Japan are reported soon after they occur by news agencies and they become public information, but the Bank of Japan seldom confirms these foreign exchange interventions (Ramaswamy and Samiei, 2000). In 2002, however, the authorities released their daily foreign exchange intervention data since the early 1990s, information that is updated quarterly.59

Central banks in developing and transition economies are divided on the issue of transparency of foreign exchange intervention. The survey results suggest that about half of the central banks in developing and transition economies that conduct foreign exchange intervention announce their presence in the foreign exchange market. The responses were very similar across emerging and nonemerging markets, but varied somewhat by exchange rate regime. In particular, countries with conventional fixed pegs and with exchange rates within crawling bands tend not to announce their foreign exchange interventions maybe because these exchange rate regimes imply that the central bank will intervene when the pegs or bands are under pressure (Appendix Table 25). In only a few countries is the announcement made before the actual foreign exchange intervention. In particular, about 16 percent of central banks in developing and transition economies conducting foreign exchange intervention announce ex ante their foreign exchange interventions in the more flexible exchange rate regimes and in some countries with conventional fixed pegs against a single currency. These announcements never take place in other exchange rate regimes (Appendix Table 26). About 25 percent of central banks that responded to the question about transparency of foreign exchange intervention indicated that they publish data on their foreign exchange interventions, sometimes with a lag (Appendix Table 27), although the figure is slightly higher for emerging markets.

VI. Moral Suasion

Many central banks in developing and transition economies use moral suasion to support their foreign exchange intervention. Moral suasion is possible because the central bank usually requires a foreign exchange license for allowing institutions to conduct foreign exchange intermediation in their foreign exchange markets (Appendix Table 27). In addition, central banks in developing and transition economies are often the supervisory authority for the main authorized dealers, which are usually banks. Central banks in these countries monitor the behavior of individual market participants and threaten to withdraw the foreign exchange license, suspend an authorized dealer from conducting foreign exchange intermediation, or trigger close on-site inspections of the institutions that, for example, are perceived to increase exchange rate volatility. In addition, they use their large presence in the market to threaten not to trade with those agents that challenge the central bank’s objectives in the foreign exchange market.60 Central banks could also threaten to modify foreign exchange regulations to make foreign exchange intervention more effective and affect the profitability of banks speculating against the central bank.

Foreign exchange intervention may be, or at least appear to be, more effective when the central bank exerts moral suasion. Moral suasion would provide an extra signal to market participants that the authorities are serious about a given exchange rate objective, but of course, how serious the signal is taken would depend on the funds available to the central bank for foreign exchange intervention and rate of growth of the central bank net domestic assets. In addition, excessive use of moral suasion would contribute to a lack of development of the interbank foreign exchange market and increase the relative size of the central bank in the foreign exchange market. While both moral suasion and foreign exchange intervention could contribute to a particular effect on the exchange rate, formal tests are likely to attribute the entire effect to foreign exchange intervention because it would be very difficult to control for moral suasion.

VII. Conclusions

The evidence obtained from the IMF’s 2001 Survey on Foreign Exchange Market Organization indicates that foreign exchange intervention is a widely used policy instrument in developing and transition economies. The survey provides a wealth of information about foreign exchange intervention practices, such as the degree of sterilization and transparency, as well as the environment in which these operations take place, including the main foreign exchange market structures and regulations.61

Central banks in some developing and transition economies may be able to conduct foreign exchange intervention more effectively than those issuing the major international currencies because they not always fully sterilize their foreign exchange intervention. In addition, central banks in many developing and transition economies issue regulations and conduct their foreign exchange operations in a way that increases the relative size of foreign exchange intervention in foreign exchange market turnover and the central bank’s information advantage. In some of these countries, the regulations and foreign exchange market practices turn the central bank into one of the main foreign exchange intermediaries. Based on their information advantage, the central banks can choose the degree of transparency of foreign exchange intervention that makes it more effective. In addition, some central banks in these countries often use moral suasion to support their foreign exchange intervention. Thus, foreign exchange regulations, including pervasive capital controls, as well as moral suasion could make foreign exchange intervention more effective and are not necessarily just a substitute for intervention.

Future research should assess empirically the effectiveness of central bank foreign exchange intervention in developing and transition economies and analyze its costs and benefits when the intervention is supported by foreign exchange controls and monetary regulations. While these regulations could make foreign exchange intervention more effective, they could also force the central bank to intervene more often than otherwise. The central bank would bear all the cost of smoothing discrepancies in the arrival of orders to the foreign exchange market, because other market participants would not have the incentive to conduct stabilizing speculation.62 This could potentially increase the exchange rate volatility that would exist in the absence of foreign exchange intervention.

Moreover, even if foreign exchange intervention were effective in reducing, for example, exchange rate volatility, it would be useful to test whether the benefits of reducing exchange rate volatility compensate for the potential costs of these regulations, which may create distortions in resource allocation in the real sector and reduce the opportunities for investment, consumption smoothing, and risk sharing. Moreover, the administrative cost of enforcing the regulations could be substantial, as the authorities spend resources to enforce and update the regulations while the private sector spends resources trying to circumvent them. Efforts at circumvention may also give rise to corruption and other governance problems. Finally, exchange rate stability may be counterproductive in economies where the private sector can borrow abroad, as the private sector may underestimate the risk of loss associated with an eventual currency depreciation, which may encourage international overborrowing.