To Peg Or Not To Peg Part II: FX Intervention Under A Floating Rate Regime

FX intervention is de rigueur under a fixed exchange rate regime – it’s a basic requirement to maintain exchange rate parity.

But there’s also, for various reasons, FX intervention in floating rate regimes. Leaving aside soft pegs, crawling pegs, snakes and the like, how effective is FX intervention under a largely free float?

I don’t think it’s very effective at all.

Let’s take the prototypical case of a monetary policy regime with an open capital account and an interest rate or inflation targeting approach, which describes most of the policy regimes in use today.

Assume, for whatever reason, that the central bank wishes to support the value of its exchange rate, or is trying to contain currency depreciation. Intervention here means the central bank buys local currency while selling foreign currency (international reserves). But the act of buying local currency reduces the domestic money supply, and puts an upward bias to domestic interest rates.

But remember this is an interest rate targeting central bank. To keep the domestic interest rate at the policy determined target, the central bank has to add back liquidity it has taken out of the system, typically by buying back its own short term liabilities (government bills or bonds) in return for domestic currency. That puts the domestic interest rate back on target.

But this addition to domestic liquidity also increases the supply of local currency vis-à-vis foreign currency i.e. the exchange rate returns to approximately where it was before. The net effect of all this is a reduction of foreign exchange reserves, for a very minimal impact on the exchange rate (since the subtraction and addition of domestic currency are rarely precisely the same).

Our schizophrenic central banker can’t have his cake and eat it too. Under a floating rate exchange rate regime and an open capital account, you cannot target both the level of the exchange rate or the domestic interest rate simultaneously. Targeting one almost always means foregoing the other. FX intervention in this sense doesn’t work at all, unless you’re willing to take the risk of telling the market that you’re not fully committed to your own explicit policy objectives. Heightened uncertainty is a sure way of making things worse, not better.

So why bother with FX intervention?

Two reasons I can think of:

1. Liquidity – sometimes the demand for FX is so high, only the central bank can supply market needs. This is really about ensuring “orderly market conditions”, as BNM is fond of saying. This type of intervention tends to be on the quiet side.
2. Correcting overshooting – ever since Dornbusch’s 1976 paper, economists have realised that the exchange rates over the short term tend to overshoot their long run fundamental valuations. FX intervention in this sense could be used as a signal to the market that it has been over-exuberant in one direction and things have gone too far. In this case, FX intervention should be very large, very obvious, and very loud.

Right now in Malaysia, I think BNM is doing option one – providing FX liquidity to the market, as weaker global growth and the pending Fed rate hike means investors are positioning themselves in USD denominated assets. But if things continue to deteriorate, we might see option two come into play.