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Lesson 19: Central Bank Intervention And Equivalance Approach to Exchange Rate Learning objective:

To make you aware and be observant about how central bank reputation and currency values determine and dictate exchange rates To help you examine the desirability, need and impact exchange market intervention vis –a –

vis the role of central bank To tell you to take a look into the virtue of adopting equilibrium approach to exchange rates To illustrate before you with suitable examples as to how exchange rate forecasts help in

corporate financial decision-making. Central Bank Reputations And Currency Values Another critical determinant of currency values is central bank behavior. A central bank is the nation's official monetary authority; its job is to use the instruments of monetary policy. Including the sole power to create money, so as to achieve one or more of the following objectives: price stability low interest rates or a large currency value. As such the central bank affects the risk associated with holding money. This risk is inextricably linked to the nature of fiat money. Until 1971 every major currency was linked to a commodity. Today no major currency is linked to a commodity. With a commodity base, usually gold there was a stable long-term anchor to the price level. Prices varied a great deal in the short term but they eventually returned to where they had been.

With a fiat money there is no anchor to the price level--that is, there is no standard of value that investors can use find out what the currency’s future value might be. Instead, a currency's value is largely determined by the central bank through its control of the money supply. The central bank creates too much money inflation will occur and the value of money will fall. Expectations of central bank behavior will also affect exchange rates today currency will decline if people think the central bank will expand the money supply in the future. Viewed this way money becomes a brand name product whose value is backed by the reputation of the central bank that issues it. And just as reputations among automobiles vary from Mercedes Benz to Yugo so currencies come backed by a range of quality reputations - from the Deutsche mark. Swiss franc and Japanese yen on the high side 10 the Mexican peso, Brazilian cruzeiro and Argcnrine austral on the low side. Underlying these reputations is trust in the willingness of the central bank to maintain price stability.

The high-quality currencies are those expected to maintain their purchasing power because they are issued by reputable central banks. In contrast, the low-quality currencies are those that bear little assurance their purchasing power will be maintained. And as in the car market, high-quality currencies sell at a premium, and low-quality currencies sell at a discO\U1t (relative to their values based on economic fundamentals alone). That is, investors demand a risk’ premium to hold a riskier currency, whereas safer currencies wilt be worth more than their economic fundamentals would indicate.

Because good reputations are slow to build and quick to disappear many economists recommend that central banks adopt rules for Price stability that are Variable, unambiguous, and enforceable absent such rules, the natural accountability of central banks to government becomes an

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avenue for political influence. The greater scope for political influence will, in turn, add to the perception of inflation risk.

The Fundamentals of Central Bank Intervention The exchange rate is one of the most important prices in a country because it links the domestic economy and the rest-of-world economy. As such, it affects relative national Competitiveness. We have already seen the link between exchange rate changes and relative inflation rates. The important point for now is that an appreciation of the exchange rate beyond that necessary to offset the inflation differential between two countries raises the price of domestic goods relative to the price of foreign goods. This rise in the real or inflation adjusted exchange rare-measured as the nominal exchange rate adjusted for changes in relative price levels proves to be a mixed blessing. For example, the rise in the value of the U.S. dollar from 1980 to 1985 translated directly into a reduction in the dollar prices of imported goods and raw materials. As a result prices of imports and of products that compete with imports began to ease. This development contributed significantly the slowing of U.S. inflation in the early 1980s.

Yet the rising dollar had some distinctly negative consequences for the U.S. Economy as well. Declining dollar prices of imports had their counterpart in the increasing foreign currency prices of U.S. products sold abroad. As a result, American exports became less competitive in world markets and American-made import substitutes became less competitive in the United States, Sales of l1omestic traded goods declined, gendering unemployment in the traded-goods sector and inducing a shift in resources from the traded-to the non -traded-goods sector of the economy.

Alternatively, home currency depreciation results in a more competitive traded-goods sector stimulating domestic employment and inducing a shift in resources from the non-traded to the traded-goods sector. The bad part is that currency weakness also results in higher prices for imported goods and services, eroding living standards and worsening domestic inflation.

From its peak in mid-985 the U. S dollar fell by more than 50% over the next few years enabling Americans to experience the joys and sorrows of both a strong and a weak; currency in less than a decade, The weak dollar made U, S. companies; non.' competitive worldwide at the same time it lowered the living standards of Americans who enjoyed consuming foreign goods and services, Exhibit 4.4 charts the real value of the U.S. dollar from 1976 to 1990.

Depending on their economic goals some governments will prefer an over value domestic currency, whereas others will prefer an undervalued currency. Still others just want a correctly valued currency. But economic policymakers may feel that the rate set by the market is irrational: that is they feel they can better judge the correct exchange rate than the marketplace can.

No matter what category they fall in, most governments will be tempted to intervene in the foreign exchange market to move the exchange rate to the level consistent with their goals or beliefs. Foreign exchange market intervention refers to official purchases and sales of foreign exchange that nations undertake through their central banks to influence their currencies.

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Foreign Exchange Market Intervention Although the mechanics of central bank intervention vary, the general purpose of each variant is basically the same; to increase the market demand for one currency by increasing the market supply of another. To see how this purpose can be accomplished, suppose in the previous example that the Bundesbank wants to reduce the value of the DM from e1 to its previous equilibrium value of e0. To do so the Bundesbank must sell an additional (Q3 - Q2) DM in the foreign exchange market, thereby eliminating the shortage 6fDM that wOl1ld otherwise exists at e0. This sale of DM (which involves the purchase of an equivalent amount of dollars) will also eliminate the excess supply of (Q3 - Q2) e0 dollars that now exists at e0. The simultaneous sale of DM and purchase of dollars will balance the supply and demand for DM (and dollars) at e0.

If the Fed also wants to raise the value of the dollar, it will buy dollars with Deutsche marks. Regardless (if whether the Fed or the Bundesbank initiates this foreign exchange operation, the net result is the same: The U.S. money supply will fall, and Germany's money supply will rise.

The Effects of Foreign Exchange Market Intervention The basic problem with intervention IS that it is likely to be either ineffectual or irresponsible. Because sterilized intervention entails a substitution of DM-denominated securities for dollar-denominated ones, the exchange rate will be permanently affected only " if investors view domestic and foreign securities as being imperfect substitutes. If this is the case, then the exchange rate and relative interest rates must change to induce investors to hold the new portfolio of securities.

But if investors consider these securities to be perfect substitutes, then no change in the exchange rate or interest rates will be necessary to convince investors to hold this portfolio. In this case, sterilized intervening is ineffectual this conclusion is consistent with the experiences of the United States and other industrial nations in their intervention policies. Between March 1973 and April 1983, industrial nations bought and sold a staggering $772 billion of foreign currencies influence exchange rates. More recently, the U.S. government bought over $36 billion of foreign currencies between July 1988 and July 1990 to stem the rise in the value of the dollar. Despite these large interventions, exchange rates appear to have been moved largely by basic market forces.

On the other hand, unspecialized intervention can have a lasting effect on exchange rates, but insidiously-by creating inflation in some nations and deflation in others. In the example presented above, Germany would wind up with a permanent (and inflationary) increase in its money supply, and the United States would end up with a deflationary decrease in its money supply. If the resulting increase in German inflation and decrease in U.S. inflation were sufficiently large, the exchange rate would remain at e0 without the need for further government intervention. But it is the money supply changes and not the intervention by itself that affect the exchange rate. Moreover, moving the nominal (or actual) exchange rate from e1 to e0 should not affect the real exchange rate because the change in inflation rates offsets the nominal exchange rate change.

If forcing a currency below its equilibrium level causes inflation. It follows that devaluation cannot be much use as a means of restoring competitiveness. Devaluation improves competitiveness only to the extent that it does not cause higher inflation. If the devaluation causes domestic wages and prices to rise, any gain in competitiveness is quickly eroded.

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The Equilibrium Approach To Exchange Rates We have seen that changes in the nominal exchange rare are largely affected by variations or expected variations in relative money supplies. These nominal exchange rate changes are also highly correlated with changes in the real exchange rate. Indeed, many commentators believe that nominal exchange rate changes cause real exchange rate change as defined earlier; the real exchange rate is the relative price of foreign goods in terms of domestic goods. Thus changes in the nominal exchange rare through their impact on the real exchange rate are said to help or hurt companies and economies. One explanation for the correlation between nominal and real exchange rate changes is supplied by the disequilibria theory of exchange rates. According to this view, various frictions in the economy cause goods prices to adjust slowly over time, whereas nominal exchange rates adjust quickly in response to new information changes in expectations. As a direct result of the differential speeds of adjustment in the goods and currency markets, changes in nominal exchange rate caused by purely monetary disturbances are naturally translated into changes in real exchange rates and can lead to exchange rate” overshooting “. Whereby the short-term change in the exchange rate exceeds, Overshoots, the long – term change in the equilibrium exchange rate (see Exhibits1). This view underlies most popular accounts of exchange rate changes and policy discussions that appear in the media. It implies that currencies may become “overvalued” or “undervalued” relative to equilibrium, and that these disequilibria affect international competitiveness in ways that are not justified by changes in comparative advantage. Money supply Equilibrium prices level Prices Equilibrium nominal exchange rate Nominal exchange rate Time EXHIBIT 1. Exchange Rate Overshooting According to the Disequilibrium Theory of Exchange Rates Exchange rate forecasts are an important input into a number of corporate financial decisions. Whether and how to hedge a particular exposure, the choice currency for short- and long-term borrowing and investment, choice of invoicing Currency, pricing decisions, all require some estimates of future exchange rates. Financial institutions such as mutual funds, hedge funds, and even some non-financial corporation may wish to generate trading profits by taking positions in the spot and forward markets. A treasurer many have access to in-house

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forecasting expertise or may buy forecasts from an outside service. Even in the latter case, some evaluation of the forecasting methodology and the forecasts themselves is unavoidable.

Forecasting methodologies can be divided into two broad categories. The first is the class of methods. Which have a structural economic model of exchange rate determination such as the PPP or the monetarist model. The model is econometrically estimated and used for prediction. Note that this approach requires forecasts of variables, which are thought to be determinants of the exchange rate-no easy task in it. The other category of methods eschews all fundamentals and aim to discover patterns in past exchange rate movements which can be extrapolated to the future. These are called "pure forecasting models within this broad class are included time series methods which try to model the stochastic process, which is supposed to be generating successive exchange rate values and "technical analysis" using charts and or some statistical procedures such as averaging and smoothing. While some success has been achieved in explaining cross sectional exchange rate differences – why a dollar is worth say CHF 1.50 and ¥120 – and long term exchange rate trends, short term exchange rate forecasting day to day, week to week has proved to be a very difficult undertaking. Further, for operating exposure management long term financial and investment decision real exchange rate forecasts are needed. It is not difficult to cite numerous episodes when nominal and real exchange rates have shown divergent movements.

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