Government Influence

on Exchange Rates
Understanding the role that
governments play in
influencing exchange rates

Government Activities that

Influence Spot Exchange Rates
The foreign exchange regime that the
government adopts.
Independent float, managed float and pegs.
Recall that market forces can result in forced
changes in foreign exchange regimes.
UK in 1992; Asian economies during the Asian
currency crisis of 1997, etc.

Direct and indirect government

intervention in foreign exchange markets.

Why do Governments Attempt

to Influence Exchange Rates?
To react to what the government feels is an
unwarranted level of the spot rate.
Generally done when the exchange rate
threatens domestic economic activity.
Japans intervention on September 15, 2010

To respond to temporary disturbances.

Generally done when sudden and unanticipated
events produce extreme moves in exchange rates.
Offsetting safe haven effects.

To establish and maintain implicit and explicit

exchange rate boundaries.
Done within the context of a pegged or managed
exchange rate regime.

Direct and Indirect

Intervention
Direct Intervention:
Buying and selling currencies in foreign
exchange markets.
Buying weak (depreciating) currencies and selling
strong (appreciating) currencies.

Indirect Intervention:
Government adjusting domestic interest rate.
Raising interest rates to support weak
(depreciating) currencies and lowering interest
rates to offset strong (appreciating) currencies.

Foreign exchange controls.

Restrictions on the exchange of currency (i.e., the
type and amount of transactions).

Direct Intervention
Through direct intervention in foreign exchange
markets, governments are attempting to offset
market forces on spot exchange rates.
If market forces strengthen a currency, a government
(central bank) could respond by selling the strong
currency (and buying the weak currency) into the foreign
exchange market (thus meeting market demand for the
strong currency).
When the government does so, it accumulates international
reserves (i.e., the weak currency it is buying).

If market forces weaken a currency, a government

(central bank) could respond by buying the weak
currency (and selling the strong currency) on the foreign
exchange market (thus reducing the supply of the weak
currency).
When the government does so, it uses its international
reserves (i.e., the strong currency it is selling).

Direct Intervention to Support

a Weak Currency
Why is the Currency
Weakening?

Markets moving out of that

currency into another
currency (i.e., into the
preferred currency).
Interest rate differentials,
safe haven effects, trade
flows, political and
economic risk, asset
bubbles, expectations of
changes in peg, etc.

Government needs to buy

its currency to offset
market selling.
Either unilaterally or
through cooperative
intervention.

Impact of Intervention
As the government is buying
its weak currency, it is also
supplying the currency that
the markets are moving into
(i.e., the preferred currency).
In doing so, the government is
reducing its international
reserves (i.e., the key currency
the market is preferring).
Success of this direct
intervention depends on
governments supply of
international reserves and
extent of international
cooperation.

Direct Intervention to Offset a

Strong Currency
Why is the Currency
Strengthening?

Impact of Intervention

Markets moving into that

currency (i.e., the preferred
currency) and away from
other currencies.

Interest rate differentials,

safe haven effects, trade
flows, political and
economic risk, expectations
of changes in peg, etc.

Government needs to sell

its currency to offset
market demand.
Either unilaterally or
through cooperative
intervention.

As the government is selling its

strong currency, it is essentially
supplying the currency that the
markets are moving into (i.e.,
the preferred currency).
In doing so, the government is
increasing the supply of its
currency in foreign exchange
markets and also potentially in
its own domestic market.
The potential impact of
increasing the countrys
domestic money supply is to
accelerate inflationary pressures
and inflationary expectations for
that economy.

Success of this direct

intervention depends on the
extent of international
cooperation.

Non-sterilized Versus Sterilized

Direct Intervention
Non-sterilized Intervention

Sterilized Intervention

Defined as a central bank

not taking any action to
offset the increase (or
decrease) in the countrys
domestic supply resulting
from direct intervention to
offset a strong (weak)
currency.
Likely to be followed if the
central bank is not
concerned about inflationary
impacts or impacts on
economic activity.

Defined as a central bank

using monetary policy actions
to offset the increase
(decrease) in the country
domestic money supply
resulting from direct
intervention to offset a strong
(weak) currency.

For example, Japan today.

Usually done through central

bank open market operations,
specifically selling or buying
government securities through
domestic financial institutions.
Sales of government securities
will reduce bank reserves and
purchases of government
securities will increase bank
reserves (see slides which
follow).

Text Book Exhibit of Non-sterilized

Versus Sterilized Intervention
The illustration below shows an example of
the U.S. Central Bank (i.e., the Federal
Reserve)intervening to offset a strong US
dollar against the Canadian dollar.
The Fed wants to weaken the U.S. dollar and
strengthen the Canadian dollar.

Text Book Exhibit of Non-sterilized

Versus Sterilized Intervention
Intervention can also produce reductions in a
countrys domestic money supply (i.e., if the
government is buying its currency and selling
the preferred currency).
In the illustration below, the Fed has used
direct intervention to strengthen the U.S. dollar
and weaken the Canadian dollar (i.e., offset
USD selling on FX markets)

Indirect Intervention
Indirect intervention generally involves two possible
actions:
Adjusting domestic interest rates.
Raising interest rates to support a weak currency i.e., increasing
the interest rate differential in favor of the weak currency country.
September 18, 1992, the Swedish Central Bank raised its marginal lending
rate to 500% to temporarily stem speculative pressures against the krona
(SEK). At the time the krona was pegged to a trade-weighted basket of 15
foreign currencies (peg was dropped in December of 1992 and an
independent float was adopted).

Lowering interest rates to offset a strong currency i.e.,

decreasing the interest rate differential in favor of the strong
currency country.

Assumption is that by adjusting the interest rate differential,

the demand for the currency is affected.
Problem with interest rate adjustments:
This policy may be inconsistent with domestic economy conditions
and required monetary policy stance for those conditions.
For example, the U.K. in 1992 when part of the Exchange Rate Mechanism
(ERM) UK needed lower interest rates to stimulate domestic demand, but
higher interest rates to maintain exchange rate in ERM.

Raising Interest Rates to

Defend a Currency
Interest Rates During the
Asian Currency Crisis

Interest Rates in Argentina,

2002 @ 125% in August

Indirect Intervention
A second type of indirect intervention involves the use of
foreign exchange controls.
Defined: Government restrictions on transactions in the
foreign exchange market.
Regulations on convertibility:
Setting the amount of foreign exchange a resident can purchase and/or
setting limits on the amount of foreign exchange a domestic company can
hold (from foreign sales) and thus must sell excess back to government.
Viet Nam Ordinance On Foreign Exchange Controls (Jan 31, 2010):
Residents must remit all foreign currency amounts derived from export
of goods and services into a foreign currency account opened at an
authorized credit institution in Vietnam. If residents wish to retain
foreign currency overseas, they must obtain approval from the State
Bank of Vietnam.

Regulations on market makers:

Central bank (or government agency) is the only bank authorized to conduct
foreign exchange transactions.

Regulation on types of transactions (i.e., capital controls):

Permitting foreign exchange transactions resulting from commercial
transactions, but not from speculative transactions (e.g., closing the
markets for short term capital flows).
In 1997 (Sep 1), Malaysia, in response to the ringgit currency attack,
imposed capital controls which essentially closed down transactions in
short term capital movements out of the ringgit by requiring that any
investment transactions involving ringgits had to be held for 12 months
in approved banks. Restriction was lifted in December 2000.

Case Study of Malaysias

Response to the 1997
Crisis
Sequence ofCurrency
Events
Exchange Rate: USD/MYR

During the mid 1990s, Malaysia attracts a

substantial volume of volatile capital (short
term and portfolio; i.e., mobile capital) which
were driven by the boom in the equity market
(an equity bubble occurs).

May 14-15, 1997: Malaysia ringgit comes

under attack. At the time the ringgit is highly
managed to the USD (@a rate of 2.5).

FDI investment peaks in 1996; but volatile

capital inflows continue to rise.

Part of a contagion effect in Asia (started in

Thailand)
Market concerns about weak corporate
governance and weakness in the financial sector
in Malaysia results in outflows of volatile capital.

July 2, 1997, Malaysia drops its managed float,

and the ringgit falls 18%, but the government
continues to use direct intervention to support
the currency. Malaysia continues to raise
interest rates during the crisis.
September 1, 1997, Malaysia imposes a set of
capital controls which shut down the
offshore market in ringgit and stop
speculative trading.
September 2, 1998, Malaysia introduces a peg
regime (@3.8).
Capital controls are lifted from Feb 1999
through Jan 2003.
July 21, 2005, Malaysia announces abolition of
the ringgit peg in favor of a managed float.

Case Study of U.K. Currency

Crisis of 1992
Background

Germanys Role in the ERM

Britain joined the European

Exchange Rate Mechanism
(ERM) in October 1990.

ERM was designed to promote

exchange rate stability within
Europe.

Under the ERM, European

currencies were pegged to
one another at agreed upon
rates.
In October 1990, the British
pound was locked into
the German Mark at a
central rate of about
DM2.9/
General feeling at the time
was that this rate
overvalued the pound
against the mark.

While the ERM included many

European countries, Germany
was the leading player
because of its economic
dominance.
Thus, the German mark was also
the dominant currency in this
arrangement and German
monetary policy set the tone for
the rest of the ERM members.

Thus, German monetary policy

had to be followed by the
other members in order for the
other member states to keep
their currencies aligned with
the German mark.
This was especially true with
regard to Germanys interest
rate.

Case Study of U.K. Currency

Crisis of 1992
Events Leading up to the
Speculative Attack

While the markets felt the pound was

overvalued when it joined the ERM, a
combination of two critical events, one
just before and a second just after
Britain joined the ERM convinced some
in the market that the pound was now
ready for speculation.
These events were:

Fall of the Berlin Wall: As a result,

German decided to raise interest rates
in order to attract needed capital for
the reunification of East and West
Germany.

The fall of the Berlin Wall in Nov 1989

The economic recession in the U.K. in
1991-92.

A recession would be properly addressed

by lower interest rates.
Thus there was both a political and
economic component to the potential
decision to raise rates.
Markets thought the UK would not be
willing to raise rates to defend the pound.

Pound currency attack begin in

September 1992

Short selling of the pound was led by

hedge funds: particularly George
Soros.

The British Governments initial

response to the attack occurred on
Wednesday, September 16

Government raised interest rates

twice from 10% to 12 and then to 15%

Other ERM countries need to follow with

higher interest rates.

UK Recession: However, the issue for

the U.K. was having to raise interest
rates during their recession.

The Attack and Response

During the attack the Bank of England

used $4 billion in hard currency in
defense of the pound. Bank of England
bought $4 billion worth of pounds which
were being sold short (it did this by
selling U.S. dollars and German marks
to speculators).

Estimates: 1/3 of its hard currency

was spent.

On Wednesday at 7pm (UK time), the

U.K. government announced they would
be leaving the ERM the next day and
that interest rates would go back to
10%. (referred to as Black
Wednesday).

Attempt to make U.K. investments

more attractive.

Thursday, September 17, the pound

returned to an independent float.

By late October, the pound had fallen

about 13% against the mark and 25%
against the U.S.

Sterling Exchange Rate

Around the Time of the
1992 Crisis

GBP/DEM

GBP/USD