close
test_template

The Intervention in The Foreign Exchange Market

About this sample

About this sample

close

Words: 3434 |

Pages: 8|

18 min read

Published: Apr 11, 2019

Words: 3434|Pages: 8|18 min read

Published: Apr 11, 2019

Table of contents

  1. Introduction
  2. Managed Float
    Unsterilized Intervention
    Sterilized Intervention
  3. Evolution of the international financial system
  4. Introduction
    The Gold Standard Period (1880 - 1914)
    Bretton Woods System (1945 - 1971)
    International Monetary Fund (IMF)
    Reserve Currency
    Asian Reserve Management
  5. Balance of Payments
  6. Introduction
    Balance of payments
    Current Account
    Capital Account
    Official Reserve Account
    Trade Imbalances
  7. Impact of Accumulation of Reserves
  8. Introduction
    Rising foreign exchange reserves
    Growth
    Balance of payments
    Exchange rates
    Money supply
    Capital control
  9. Conclusion

Introduction

By studying the financial crises that took place since 1997 in Asia, Russia and South America, it can be found that in many cases, short-term debt crisis was aggravated through the unloading of stocks, bonds and currencies. Countries with the pegged exchange rate system were the first to be hard hit.

'Why Violent Video Games Shouldn't Be Banned'?

In fact that the collapse of the Thai Baht in July 1997 was followed by an unprecedented financial crisis in East Asia. Thai government fixed the exchange rate of Thai Baht to US Dollars at a level of 24.70 Baht to one Dollar and this rate got fixed, not allowed to float in the past 14 years (FRBSF Economic Letter August 7, 1998).

As is known to everyone, Southeast Asian countries exercise a fixed exchange rate system connected to US Dollars. In order to prevent the occurrence of similar financial crisis in Southeast Asia, Asian Central Banks have piled up their reserves into US dollars. See below:

According to the article of Asian reserve (The economist 02/08/2003), it is clearly stated that "Governments see their hefty reserves as an insurance against the vicious swings of a globalised economy and against any future crisis on the scale of 1997-98."

Managed Float

Today's international monetary system is described as a managed float. (Arnold 1998, p. 766) defined managed float is "a managed flexible exchange rate system, under which nations now and then intervene to adjust their official reserve holdings to moderate major swings in exchange rates." In other words, central banks engage in foreign exchange interventions in order to influence their countries' exchange rates by buying and selling currencies.

(Misbkin 1997, p.502) described "central bank intervention in the foreign exchange market affects exchange rates is to see the impact on the monetary base from a central bank sale in the foreign exchange market of some of its holdings of assets denominated in a foreign currency called international reserves." For examples:

A central bank's purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base. While a central bank's sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base.

Unsterilized Intervention

Central bank allows the purchase or sale of domestic currency to have an effect on the monetary base as aforesaid, is called an unsterilized foreign exchange interventions. An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency. On the contrary, an unsterilized intervention is which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency (Misbkin 1997).

Sterilized Intervention

In addition, a foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called a sterilized foreign exchange intervention. A sterilized intervention leaves the money supply unchanged and so has no way of directly affecting interest rates or the expected future exchange rate. Because the expected return schedules remain at RETD1 and RETF1 in below figure, and the exchange rate remains unchanged at E1 (Misbkin 1997, pg. 505 - 507).

Evolution of the international financial system

Introduction

Before examining the impact of international financial transactions on monetary policy, we need to understand the past and current structure of the international financial system.

The Gold Standard Period (1880 - 1914)

(Salvatore 1998, p.678) described "the gold standard operated from about 1880 to the outbreak of World War I in 1914." The world economy operated under the gold standard meaning that the currency of most countries was convertible directly into gold. Tying currencies to gold resulted in an international financial system with fixed exchange rates between currencies. The fixed exchange rates under the gold standard had the important advantage of encouraging world trade by eliminating the uncertainty that occurs when exchange rates fluctuate.

Bretton Woods System (1945 - 1971)

World War I caused massive trade disruptions. Countries could no longer convert their currencies into gold, and the gold standard collapsed. (Misbkin 1997, p.512) said "as the Allied victory in World War II was becoming certain in 1944, the Allies met in Bretton Woods, New Hampshire, to develop a new international monetary system to promote world trade and prosperity after the war. In the agreement worked out among the Allies, central banks bought and sold their own currencies to keep their exchange rates fixed at a certain level called a fixed exchange rate regime. The agreement lasted from 1945 to 1971 and was known as the Bretton Woods."

The Bretton Woods system collapsed in 1971. We now have an international financial system that has elements of a managed float and a fixed exchange rate system.

International Monetary Fund (IMF)

(Salvatore 1998, p.682) also described "the system devised at Bretton Woods called for the establishment of the International Monetary Fund (IMF) for the purposes of (1) overseeing that nations followed a set of agreed upon rules of conduct in international trade and finance and (2) providing borrowing facilities for nations in temporary balance-of-payments difficulties."

Reserve Currency

Because the United States emerged from World War II as the world's largest economic power, with over half of the world's manufacturing capacity and the greater part of the world's gold, the Bretton Woods system of fixed exchange rates was based on the convertibility of U.S. dollars into gold. The fixed exchange rates were to be maintained by intervention in the foreign exchange market by central banks in countries besides the United States who bought and sold dollar assets, which they held as international reserves. The U.S. dollar, which was used by other countries to denominate the assets that they held as international reserves, was called the reserve currency (Misbkin 1997).

Nowadays, U.S. dollar still played the dominant role of reserve currency in result of the biggest consumer market in United States. There are not other alternatives can be replaced to the U.S. dollar at this moment. However, it may be happened in future.

Asian Reserve Management

According to the article of A Golden Moment for Asian Reserve Management (DSG Asia 02/10/2003), Asian central banks have not diversified FX reserve greatly. As can be seen from the Appendix I Table 1, the share of the dollar in the currency composition of global foreign exchange reserves has barely changed since 1999.

According to the article of Asian reserve (The economist 02/08/2003), it is also described "the risk to the high-reserve policy is a steep fall in the dollar. Most Asian central bankers still won't hear of this."

As aforesaid, the most important feature of the Bretton Woods system was that it set up a fixed exchange rate regime. Central banks could intervene in the foreign exchange market by bought and sold their own currencies to keep their exchange rates fixed at a certain level. For examples: when the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it loses international reserves. On the contrary, when the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result it gains international reserves. Refer to the figure under Chapter 1.4.

Under the Bretton Woods system, Asia's high foreign exchange reserve can kept their currencies backed by the fixed exchange rate regime, the strong reserve as an insurance for government against any future financial crisis.

On the other hands, in a closed economy, bad loans caused by risky lending may not lead to a run because depositors know that the government can supply enough liquidity to financial institutions to prevent any losses to depositors. In an open economy, that same injection of liquidity can destabilize the exchange rate. As a result, during periods of uncertainty, runs or speculative attacks on a currency can be avoided only if the holders of domestic assets are assured that the government can meet the demand for foreign currency (FRBSF Economic Letter August 7, 1998).

International reserves help it maintain the foreign confidence needed for attracting FDI and securing foreign loans at good terms. However, as mentioned before that Asian central banks have not diversified FX reserve greatly, U.S. dollar still shares the significant portion. The great risk to the high reserve policy is a steep fall in the dollar.

Balance of Payments

Introduction

According to the article of Asian reserve (The economist 02/08/2003), a growing body of opinion is starting to question Asia's high foreign exchange reserves. Increasingly they are being viewed less as a virility symbol than as a kind of covert tax - a cost of the region's imbalanced model of export-driven growth and of a vulnerable financial sector. These are the underlying reasons behind the accumulation of reserves.

Balance of payments

Countries keep track of their domestic level of production by calculating their gross domestic product (GDP); similarly, they keep track of the flow of their international trade (receipts and expenditures) by calculating their balance of payments.

(Misbkin 1997, pg. 507 - 508) defined the balance of payments is "a bookkeeping system for recording all payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign countries." The balance of payments provides information about a nation's imports and exports, domestic residents' earnings on assets located abroad, foreign earnings on domestic assets, gifts to and from foreign countries (including foreign aid), and official transactions by government and central banks (Arnold 1998).

Balance of payments accounts record both debits and credits. A debit is indicated by a minus (-) sign, and a credit is indicated by a plus (+) sign. Any transaction that supplies the country's currency in the foreign exchange market is recorded as a debit. Any transaction that creates a demand for the country's currency in the foreign exchange market is recorded as a credit (Arnold 1998). See Appendix I Exhibit 1 for a summary of debits and credits.

The international transactions summarized in the balance of payments, can be grouped into three accounts - the current account, the capital account, and the official reserve account. See Appendix I Exhibit 2 for U.S. balance of payments, 1999.

Current Account

(Arnold 1998, p. 744) described the current account "includes all payments related to the purchase and sale of goods and services. Components of the account include exports, imports, and net unilateral transfers abroad." The current account balance is the summary statistic for these three items.

Exports of goods and services is referred as Americans export goods and services, and they receive investment income on assets they own abroad, which leads the increase of demand for U.S. dollars at the same time that they increase the supply of foreign currencies, thus they are recorded as credits (+).

Imports of goods and services is referred as Americans import goods and services, and foreigners receive income on assets they own in the United States, which leads the increase of demand for foreign currencies at the same time that they increase the supply of U.S. dollars to the foreign exchange market, thus they are recorded as debits (-).

Merchandise trade balance = merchandise exports - merchandise imports

Merchandise trade deficit: merchandise exports < merchandise imports

Merchandise trade surplus: merchandise exports > merchandise imports

Capital Account

(Arnold 1998, p. 746) described the capital account "includes all payments related to the purchase and sale of assets and to borrowing and lending activities. Components include outflow of U.S. capital and inflow of foreign capital." The capital account balance is the summary statistic and it is equal to the difference between these two items.

Outflow of U.S. capital is referred as American purchases of foreign assets and U.S. loans to foreigners are outflows of U.S. capital. As such, they give rise to a demand for foreign currency and a supply of U.S. dollars on the foreign exchange market. Hence, they are considered a debit.

Inflow of foreign capital is referred as foreign purchases of U.S. assets and foreign loans to Americans are inflows of foreign capital. As such, they give rise to a demand for U.S. dollars and to a supply of foreign currency on the foreign exchange market. Hence, they are considered a credit.

Official Reserve Account

(Arnold 1998, p. 746) described "a government possesses official reserve balances in the form of foreign currencies, gold, its reserve position in the International Monetary Fund, and special drawing rights. Countries that have a deficit in their combined current and capital accounts can draw on their reserves."

When we refer to a surplus or a deficit in the balance of payments, we actually mean a surplus or deficit in the official reserve transaction balance. Because the balance-of-payments account must balance, the official reserve transactions balance tells us the net amount of international reserve that must move between central banks to finance international transactions. The movements of international reserves have an important impact on the money supply and exchange rates (Misbkin 1997).

Trade Imbalances

Asia's high foreign exchange reserve is a reflection of the development policy of the Asian countries. While swelling foreign exchange reserves is an auspicious development reflecting sustained economic growth and strength. Most economies in the region are export-driven. Let say in China, in 2001, China's exports rose by 23% to $266 billion and accounted for 4.4% of all world exports. China's trade surplus in 2001 increased to over $30 billion (The Economist 02/15/2003, vol. 366).

A strong trade performance is one of factors that accounted for China's robust external payments position in 2002. The other element is linked closely to the actions of foreign investors in China. During 2002, China emerged as the leading destination for FDI, absorbing US$52.7 billion in inflows, a 12.5% increase over the previous year. They combined with the strong trade performance to raise foreign exchange reserves from US$212.2 billion in 2001 to US$286.4 billion in 2002 (China.org.cn 04/25/2003).

The building up of China foreign reserves is a corollary of surging exports and FDI together with some forms of capital control being exercised to safeguard the development of its financial system. The rapid buildup of foreign reserves is the flip side of the large surplus in the balance of payments of China.

In addition, China will keep the value of its currency. Weak currencies can help keep a country's products cheap on international markets, boosting exports. US lawmakers have threatened tariffs on Chinese imports, charging that currency controls are unfairly contributing to China's US$103 billion trade surplus with the US (Metro Post 09/16/2003)

Besides, a policy of domestic demand will affect the country reserves level. A balance-of-payments deficit is associated with a loss of international reserve; likewise, a balance-of-payments surplus is associated with a gain.

Impact of Accumulation of Reserves

Introduction

The rapid rise in China's foreign exchange reserves lately has attracted much attention. In this essay, the impact of an accumulation of reserves will be discussed on the aspect of money supply, balance of payments, exchange rates and growth in China.

Rising foreign exchange reserves

China's foreign exchange reserves have been expanding at an astonishing rate in the past two years. Its foreign reserves have nearly doubled from USD168.6 billion in January 2001 to USD316 billion in March 2003 (Appendix II Chart 1). China is now second only to Japan in reserves holding. Covering 12 months of imports and almost double the size of the country's foreign debt to USD169 billion, China's foreign exchange reserves have now reached a rather comfortable level (Hang Seng, June 2003).

Growth

As aforesaid, swelling foreign exchange reserves is an auspicious development reflecting sustained economic growth and strength. China's national saving rate is now as high as 40% of GDP (Hang Seng, June 2003).

Balance of payments

The rapid buildup of foreign reserves is the flip side of the large surplus in the balance of payments (BOP) account. China's capital account surplus has been sustained as overseas manufacturers accelerate the relocation of their production plants to its territory to capitalize on its seemingly inexhaustible labor force. Foreign direct investment (FDI) grew at an annual rate of 13.8% during 2000 - 2002 (China.org.cn 04/25/2003). China's current account surplus has also swelled as it continues to gain share in the global export market.

Exchange rates

Growing confidence in the renminbi is also contributing to the rising reserves. This is reflected in the first surplus in 10 years of USD7.9 billion in 2002 in the errors and omissions item of the BOP account, an item adopted internationally to record statistical discrepancies arising in the compilation of BOP figures (Appendix II Table).

The recent surge in China's foreign reserves has raised discussions on the appropriate level of reserves. China has a fixed exchange rate of 8.3 renminbi to the dollar (The Economist 02/15/2003, vol. 366). Calls for a revaluation of the renminbi have also surfaced. Although China could surpass Japan as the country with the largest reserves in four years if the reserves of both continue to grow at their respective rates of the past two years, China's per-capita reserve level amounts to less than one-tenth of that of Japan. Also, China's external liabilities in the form of inbound FDI and foreign loans substantially exceed those of Japan. Thus the claim that China's reserves are excessive can hardly be substantiated and the demand for a revaluation on this ground cannot be justified (Hang Seng June 2003).

Money supply

Rising foreign reserves could result in rapid money supply growth, which has also become a cause for concern. When there is a BOP surplus, the People's Bank of China (PBOC) automatically adds base money into the banking system by buying foreign exchange with domestic currency, in the process fuelling credit expansion under the fractional reserve system. Loan growth has accelerated to 20% in the first five months of 2003 compared with around 12% in the same period in 2002. However, the PBOC is well aware of the risk. Since early 2001, it has resorted to aggressive sterilization - selling government bonds and central bank bills to absorb the base money created by the BOP surplus - to mitigate the pressure for liquidity expansion (Appendix II Chart 2). The recent surge in money supply has actually been caused more by the vibrant investment in the inland provinces and a buoyant property market than by the rise in base money (Hang Seng June 2003).

Capital control

China's capital control has an important bearing on the surge of its foreign reserves. By retaining restrictive control on the outbound investment activities of domestic enterprises and residents, its trade surplus and massive FDI have been translated into foreign reserves. Under the existing capital control rules, enterprises operating in China can only keep foreign exchange equivalent to 20% of their trade-related hard currency receipts earned in the previous year. The amount in excess of the limit must be sold to the central bank through designated banks. Currently the PBOC has to purchase around USD5 billion of foreign currencies every month (Hang Seng June 2003).

Conclusion

The size of reserves is a sign of economic prowess as it reflects the ability to secure foreign exchange earnings and attract foreign capital. Rising reserves would give Asian countries an upper hand in further restructuring its economy, including pressing ahead with the liberalization of its capital account, which remains the country's ultimate goal in financial reform.

Get a custom paper now from our expert writers.

How best to judge the adequacy or appropriate level of a country's reserve is a question in dispute, because basic motives for holding do result in alternative frameworks for determining the optimal level. It is generally agreed that the more reserves, the better economy. However, refer the "Mrs. Machlip" effect following the argument put forward by Fritz Machlup (1966), is that the adjustment to a situation of deficient reserves is more rapid than it is to a situation of excess reserves.

Image of Prof. Linda Burke
This essay was reviewed by
Prof. Linda Burke

Cite this Essay

The Intervention in the Foreign Exchange Market. (2019, April 10). GradesFixer. Retrieved February 21, 2024, from https://gradesfixer.com/free-essay-examples/the-intervention-in-the-foreign-exchange-market/
“The Intervention in the Foreign Exchange Market.” GradesFixer, 10 Apr. 2019, gradesfixer.com/free-essay-examples/the-intervention-in-the-foreign-exchange-market/
The Intervention in the Foreign Exchange Market. [online]. Available at: <https://gradesfixer.com/free-essay-examples/the-intervention-in-the-foreign-exchange-market/> [Accessed 21 Feb. 2024].
The Intervention in the Foreign Exchange Market [Internet]. GradesFixer. 2019 Apr 10 [cited 2024 Feb 21]. Available from: https://gradesfixer.com/free-essay-examples/the-intervention-in-the-foreign-exchange-market/
copy
Keep in mind: This sample was shared by another student.
  • 450+ experts on 30 subjects ready to help
  • Custom essay delivered in as few as 3 hours
Write my essay

Still can’t find what you need?

Browse our vast selection of original essay samples, each expertly formatted and styled

close

Where do you want us to send this sample?

    By clicking “Continue”, you agree to our terms of service and privacy policy.

    close

    Be careful. This essay is not unique

    This essay was donated by a student and is likely to have been used and submitted before

    Download this Sample

    Free samples may contain mistakes and not unique parts

    close

    Sorry, we could not paraphrase this essay. Our professional writers can rewrite it and get you a unique paper.

    close

    Thanks!

    Please check your inbox.

    We can write you a custom essay that will follow your exact instructions and meet the deadlines. Let's fix your grades together!

    clock-banner-side

    Get Your
    Personalized Essay in 3 Hours or Less!

    exit-popup-close
    We can help you get a better grade and deliver your task on time!
    • Instructions Followed To The Letter
    • Deadlines Met At Every Stage
    • Unique And Plagiarism Free
    Order your paper now