Central Bank interventions in Iceland s foreign exchange market and its effect on the exchange rate of the króna

Transcription

1 Gerdur Ísberg and Thórarinn G. Péursson 1 Cenral Bank inervenions in Iceland s foreign exchange marke and is effec on he exchange rae of he króna Since he esablishmen of an organised foreign exchange marke in mid-1993, he Cenral Bank s role in he marke has changed considerably. For mos of he period he Bank was an imporan paricipan in he marke and ook par in a large share of rading in order o ensure coninuous rading of foreign exchange and as effecive pricing of foreign currency as possible. Wih he developmen of he marke, however, he Bank s role has gradually decreased, wih he Bank only inervening on is own iniiaive, eiher direcly o influence he exchange rae of he króna or under special circumsances which are no direcly relaed o moneary policy. This aricle discusses Cenral Bank of Iceland inervenions in he foreign exchange marke and heir effeciveness. The aricle mainains ha he direc effecs of inervenions have been fairly limied and generally shor-lived. However, i canno be ruled ou ha he Bank managed o delay he weakening of he króna sufficienly o make is main impac fel when he mos serious economic overheaing was over. 1. Inroducion From he second half of January 2001 o mid- Ocober he same year, he Cenral Bank of Iceland sold foreign currency for more han 24 b.kr. in exchange for domesic currency. Wih hese acions, he Cenral Bank aimed o couner he weakening of he króna and o reduce exchange rae volailiy. However, he exchange rae weakened by 15% over his period and he Bank does no seem o have succeeded o hal he deprecaion, alhough i is impossible o say wha would have happened had i no ried. 1. Gerdur Ísberg is Depuy o he Direcor of he Cenral Bank of Iceland s Moneary Deparmen and Thórarinn G. Péursson is Division Chief of Research a he Cenral Bank s Economics Deparmen and an Assisan Professor a Reykjavík Universiy. The auhors would like o hank he Moneary Bullein Ediorial Board for consrucive remarks. The views presened here are hose of he auhors and do no necessarily reflec he views of he Cenral Bank of Iceland. These acions are known as cenral bank inervenions in he foreign exchange marke, i.e. he cenral bank eners he foreign exchange marke on is own iniiaive and buys or sells deposis in domesic currency in exchange for deposis in foreign currency. A disincion is normally made beween wheher a cenral bank inervenes in he marke wih he objecive of influencing he exchange rae and wheher he aim is solely, for example, o preven changes in he size or composiion of is foreign reserve from having a emporary effec on he exchange rae of he domesic currency. Such cenral bank rades are no defined as inervenion in his paper (see, for example, Baillie, Humpage and Oserberg, 1999). This aricle discusses cenral bank inervenions in he foreign exchange marke and is success. The second secion of he paper is a general discussion of inervenions, heir implemenaion and he resuls of inernaional sudies of heir success. Secion hree discusses he differen moivaions behind inervenion and secion four addresses he secrecy ha gen- 50 MONETARY BULLETIN 2003/1

2 erally seems o surround hem. The fifh secion discusses alernaive ways o implemen inervenions. Secion six discusses inervenions by he Cenral Bank of Iceland and he way hey have developed as Iceland s foreign exchange marke has evolved and he moneary policy framework has changed. Implemenaion of inervenions is hen discussed, followed by an appraisal of heir effeciveness and conclusions. 2. Cenral bank inervenions in foreign exchange markes Cenral bank moneary policy acions are always refleced in changes in he composiion and size of heir balance shees. The mos imporan moneary policy acions involve changes o he marginal cos of new financing a he cenral bank. The cenral bank usually achieves his by using open marke operaions which involve changing he ineres rae on repurchase agreemens (repos) wih he financial sysem. For example, if he cenral bank wishes o increase liquidiy in he financial sysem in order o simulae economic aciviy, i will lower is repo rae (referred o as he policy ineres rae), which makes he financial sysem s shor-erm funding from he bank cheaper. All hings being equal his will spur demand for liquid funds. The ineres rae cu hen increases general demand in he economy which ulimaely leads o a rise in he inflaion rae (a more deailed discussion of he ransmission mechanism of moneary policy can be found in Péursson, 2001). By such measures, he cenral bank conribues o an increase in supply of domesic currency relaive o oher currencies, which all hings being equal ough o reduce is relaive value, i.e. bring down is exchange rae, as he exchange rae defines he relaive price of currencies. As Box 1 shows, he cenral bank can achieve he same effec wih direc inervenions in he domesic marke for foreign exchange, i.e. by buying foreign currencies (deposis denominaed in foreign currencies) in exchange for domesic currency, insead of exchanging domesic currency and domesic securiies, as i does in convenional open marke operaions. The effecs are he same: he value of he domesic currency decreases and money supply increases, causing marke ineres raes o fall. Thus moneary policy has he same impac as before and effecively one and he same moneary insrumen is a work, i.e. he cenral bank can eiher lower is policy rae direcly or buy currency in he foreign exchange marke. In boh cases liquidiy increases, ineres raes fall and economic aciviy is simulaed Serilised and unserilised inervenion The inervenion described above is known as an unserilised inervenion, i.e. he cenral bank does no adop any counermeasures o preven is inervenion from affecing he size of is balance shee. Box 1 The effecs of foreign exchange inervenions on banking sysem s balance shees If he Cenral Bank wans o increase liquidiy in he sysem, i reduces is policy ineres rae which makes marginal funding of he financial sysem hrough he Bank less expensive, hence increasing he demand for liquidiy, all oher hings being equal. 1 This is refleced in he balance shees of he Cenral Bank and he banking sysem as a whole (i.e. he Cenral Bank and deposi insiuions). The accompanying able shows a simple example of how his can occur. The Cenral Bank s holding of domesic securiies, which deposi insiuions use as collaeral or repo loans, increases by 1. A more deailed discussion of he arrangemen of repo aucions wih he Cenral Bank of Iceland is found in Krisinsson (2000). 1 m.kr. 2 The Bank deposis his amoun a he deposi insiuions accoun a he Bank, leading o a corresponding increase in base money (noes and coin in circulaion and reserves wih he Cenral Bank). This is offse by a 1 m.kr. decrease in he deposi insiuions domesic securiies porfolio since he Cenral Bank owns he securiies emporarily, unil he repo rade 2. Under he accouning mehod used o record Cenral Bank repo aucions, i is in effec he Cenral Bank's claims on credi insiuions which increase by 1 m.kr. raher han is domesic securiies porfolio. By he same oken, i is he deposi insiuions' claims on domesic agens ha decrease by 1 m.kr., raher han heir domesic securiies porfolios. The scenario is presened in his way for consisency wih he main ex, which is a convenional descripion of he impac of moneary policy on cenral bank balance shees. In economic erms, he wo effecs are idenical. MONETARY BULLETIN 2003/1 51

3 The banking sysem s balance shees (m.kr.) Moneary policy acion Marke operaion (Cenral Bank buys domesic securiies) Unserilised inervenion (Cenral Bank buys foreign securiies) Serilised inervenion (Cenral Bank buys foreign securiies and sells domesic securiies) Cenral Bank Asses Liabiliies Domesic securiies +1 Base money +1 Cenral Bank Asses Liabiliies Foreign reserves +1 Base money +1 Cenral Bank Asses Liabiliies Foreign reserves +1 Domesic securiies -1 Deposi insiuions Asses Liabiliies Domesic securiies -1 Reserves wih Cenral Bank +1 Deposi insiuions Asses Liabiliies Foreign securiies -1 Reserves wih Cenral Bank +1 Deposi insiuions Asses Liabiliies Foreign securiies -1 Domesic securiies +1 revers wo weeks laer. Insead, deposi insiuions have more liquidiy which hey can use o increase lending o he public. The banking sysem s liabiliies owards he public increase and so does he money supply, and because of he money muliplier he acual increase exceeds ha in base money. Unserilised inervenions have virually he same effec. All ha changes is ha, insead of an increase in he Cenral Bank s domesic securiies porfolio, is foreign porfolio increases, i.e. he Bank s foreign reserves increase. The Cenral Bank sells deposis denominaed in domesic currency in exchange for deposis denominaed in foreign currency amouning o 1 m.kr. The Bank deposis his sum in he insiuions accoun a he Bank and base money increases by 1 m.kr. By he same oken, he deposi insiuions foreign securiies porfolio falls, bu heir liquidiy increases. The liabiliies of he banking sysem as a whole increase, as does money supply jus as if his were a convenional open marke operaion. However, if he Cenral Bank serilises he inervenion in he foreign exchange marke, i reduces liquidiy again by reducing is repo ransacions wih deposi insiuions, since i removes liquidiy from he sysem and replaces i wih domesic securiies o he amoun 1 m.kr. The overall impac of his ransacion is ha base money remains unchanged and all ha has alered is he relaive shares of domesic and foreign asses held by he Cenral Bank and deposi insiuions. The Cenral Bank now owns less domesic securiies and larger foreign reserves, while he deposi insiuions foreign porfolio shrinks o mach is greaer domesic securiies. Thus he liabiliies of he banking sysem as a whole owards he public remain unchanged, and so does he money supply. The above analysis is a simplificaion of he process behind hese ransacions. I ignores he possibiliy ha he Cenral Bank could inervene by buying foreign deposis from foreign banks (for example wih foreign-denominaed borrowing) or ha domesic insiuions could borrow abroad and sell he equivalen amoun o he Cenral Bank. Domesic deposi insiuions foreign liabiliies would hen increase by 1 m.kr. insead of heir foreign securiies porfolio decreasing by he same amoun. Thus he above analysis shows in effec he oal impac on (domesic and foreign) credi insiuions, bu he impac on he money supply remains he same. In evaluaing he economic effecs of inervenions, such a simplificaion is irrelevan. 52 MONETARY BULLETIN 2003/1

4 Unserilised inervenions hus ineviably have an impac on he economy and hereby on he exchange rae of he domesic currency. However, a crucial poin is ha he impac on he exchange rae of he domesic currency is no caused by he inervenion iself (excep o a limied exen, while he effec of he acual rade in he marke lass, as discussed laer) bu raher by is effec on he money supply and domesic ineres raes. If a cenral bank does no wan is inervenion o have any effec on he money supply and domesic ineres raes, i can serilise he inervenion. As Box 1 shows, he cenral bank hen removes he liquidiy, which i injecs ino he marke wih is original currency purchase, from he marke again by reducing is repo ransacions, i.e. by selling domesic securiies in exchange for liquid funds. The inervenion will consequenly have no effec on he money supply. All ha changes is he composiion of he banking sysem s porfolio of domesic and foreign asses. The cenral bank s foreign reserves have increased, bu is holding of domesic asses has declined by a corresponding amoun. Likewise he deposi insiuions foreign exchange holdings have fallen and heir domesic asses increased correspondingly. Economiss are unanimous ha unserilised inervenions effec exchange raes, insofar as convenional marke operaions do so a all, since hey have an idenical effec on liabiliies of he cenral bank. 2 However, he impac of serilised inervenions on exchange raes is much more uncerain. If a serilised inervenion influences exchange raes, i effecively represens a hird policy ool (besides moneary and fiscal policy), i.e. moneary policy can affec he economy (and he exchange rae) solely by alering he composiion of domesic and foreign asses held by he cenral bank, and hereby by he public. 2. Exchange raes are deermined by numerous facors, some of which remain unaffeced by moneary policy, such as commodiy prices, capial flows and domesic and foreign produciviy rends, along wih expecaions abou all of hem. Moneary policy is herefore only one of many deerminans of exchange raes. High-frequency volailiy in exchange raes is herefore deermined o a much greaer exen by invesor expecaions, new informaion and he marke s inerpreaion of i, han by moneary policy. In he long run, however, exchange raes should in principle be deermined by he relaive supply of he value ha hey measure, i.e. he relaive supply of domesic and foreign monies. Theoreically his canno be ruled ou and several possible channels have been suggesed The impac of serilised inervenions on exchange raes The porfolio-balance effec As poined ou above, serilised inervenions affec he composiion of domesic and foreign asses held by he cenral bank and he public. By purchasing foreign securiies he cenral bank increases is foreign reserves and is domesic securiies holdings are reduced by he same amoun. Since he volume of ousanding securiies (domesic and foreign) has no increased, and as asse markes mus clear, his change is refleced in he fac ha he public has increased is holdings of domesic securiies and reduced is holdings of foreign ones. According o he porfolio-balance effec, he public will only be willing o hold relaively more domesic asses if he price of hese asses falls, i.e. if he domesic currency depreciaes. 3 A precondiion for he porfolio-balance effec o be presen is ha invesors mus no regard domesic and foreign securiies as perfec subsiues. 4 If domesic and foreign asses are perfec subsiues, agens will be indifferen as o he relaive amouns of domesic and foreign asses hey are holding - all ha maers is heir oal amoun, which remains unchanged. Hence, no change in marke clearing prices or quaniies is required. Obsfeld and Rogoff (1996) also poin ou ha imperfec subsiuion beween domesic and foreign securiies is no a sufficien condiion for serilised inervenions o affec exchange raes, bearing in mind ha he cenral bank balance shee is par of he overall governmen balance shee. An increase in he 3. See, for example, Branson and Henderson (1985). Surveys can be found in Sarno and Taylor (2001) and Weber (2001). Noe ha he depreciaion of he domesic currency has o be sufficienly large o leave he real supply of domesic asses relaive o foreign asses he same as before. 4. The reason ha invesors do no regard domesic and foreign securiies as perfec subsiues could be some ypes of marke fricions such as capial conrols and he risk ha such conrols migh be imposed in he fuure. Likewise, agens migh be risk averse and prefer domesic securiies since invesmen in hem enails less risk han foreign securiies, due o uncerainies abou exchange rae developmens or differences in defaul risk. MONETARY BULLETIN 2003/1 53

5 cenral bank s holdings of domesic asses resuling from serilised inervenions implies a reducion in public secor deb, which ough o lead o a lower expeced ax burden in he fuure, assuming ha governmen spending remains unchanged. If agens ake his consideraion ino accoun, he domesic currency need no depreciae despie he increase in privae agen s holdings of domesic asses, since heir ne fuure ax burden will decrease correspondingly. 5 Noneheless, research suggess ha while his effec may be presen o some exen, i is far from complee. The public does no appear o fully ake ino accoun he effec on is fuure ax burden when purchasing governmen asses. All he same, he imporance of he porfolio-balance effec in explaining he impac of serilised inervenion on exchange raes sill seems limied, excep perhaps in he very shor erm (see, e.g., Weber, 1986, and Obsfeld and Rogoff, 1996). There appears o be a high level of subsiuion beween asses denominaed in differen currencies, especially he main currencies, in addiion o which sudies of relaive supply of securiies in differen currencies indicae very lile impac on exchange raes. These findings have, however, been challenged in papers such as Dominguez and Frankel (1993). However, economiss generally seem o agree ha he imporance of his effec is fairly limied and will probably diminish wih increasing inernaional rade and more acive global currency markes. Even hough his effec probably makes lile difference for he main world currencies, heir imporance for less developed foreign exchange markes and currencies which are less raded in inernaional currency markes canno be ruled ou The signalling effec Even under perfec subsiuabiliy of domesic and foreign asses, serilised inervenions can sill in heory affec he exchange rae if i is regarded as signalling fuure moneary policy decisions which are no ye refleced in exchange raes. Assuming ha he cenral bank has beer informaion han privae agens, for example abou he sae of he economy or is own responses o i, a serilised inervenion can inform markes of he bank s views on exchange rae 5. This is he Ricardian equivalence effec, see Barro (1974). developmens and where i should go in he fuure. In his way he cenral bank would possibly be relaying informaion abou fuure moneary policy decisions which would impac he exchange rae immediaely because of he effec on exchange rae expecaions. 6 I is imporan o realise ha, in order for his signalling effec o work, he signal mus be credible, i.e. i mus evenually followed up by he response ha i implies. Thus a serilised inervenion is no really an independen moneary policy insrumen, as i migh seem on firs impression, bu raher serves he sole purpose of signalling fuure moneary policy decisions. In effec i is herefore he message abou fuure moneary policy decisions which influences he curren exchange rae, and no he inervenion in is own righ. An increased number of sudies of he signalling effec have been made now ha improved access is available o daa abou cenral bank inervenions in many pars of he world. 7 I should be remembered ha here may be a long lag in ransmission of he signalling effec, making empirical evaluaion of i difficul (see, e.g. Heikensen and Borg, 2002). Noneheless, hese sudies sugges ha serilised inervenions may exer an influence hrough he signalling effec, especially if i is clearly explained in public by he cenral bank and conduced in cooperaion wih several oher cenral banks. This effec is paricularly imporan in he shor erm, e.g. if an unrealisic price bubble can be burs (see e.g. Sarno and Taylor, 2001, and Heikensen and Borg, 2002). I should be emphasised, however, ha he effec is no he resul of he inervenion iself, bu raher of is impac on invesor expecaions abou fuure moneary policy decisions. Thus i is someimes claimed ha serilised inervenion is an effecive way for cenral banks o signal fuure moneary policy acions as hey ake an open currency posiion, which could cause financial losses if hey do no follow he inervenion hrough wih he measures hey are seen as signalling. However, he sums involved are really minor in comparison wih annual governmen ax revenues. I is herefore no obvious ha his is 6. See Mussa (1981). A survey can be found in Sarno and Taylor (2001). 7. The Federal Reserve began publishing hisorical daa on is inervenions in he early 1990s. Bank of Japan and he Bundesbank followed soon aferwards (see Sarno and Taylor, 2001). 54 MONETARY BULLETIN 2003/1

6 necessarily he mos effecive or credible way for cenral banks o relay heir view of fuure moneary policy, as poined ou by Obsfeld and Rogoff (1996) The ineracion of serilised inervenions wih he funcioning of foreign exchange markes A number of sudies indicae ha foreign exchange marke rading is characerised by herd behaviour and self-fulfilling expecaions (see, e.g., Box 3 in Moneary Bullein 2001/4). Such behaviour can cause he exchange rae o deviae from underlying economic fundamenals for a proraced period. A correcion may no happen, even hough a significan share of marke paricipans believes ha he exchange rae is misaligned, unless hey aced simulaneously o prick he bubble. For an individual rader such an aemp o play agains he marke rend would ake a grea deal of courage. Hence, he marke would be characerised by a coordinaion failure as no single rader dears making he firs aemp o correc he misalignmen. In his case a publicly announced serilised inervenion could fulfil his coordinaion role in ha i migh organise he smar money o ener he marke a he same ime, hus urning he marke senimen and pricking he bubble (see Sarno and Taylor, 2001). A serilised inervenion migh also have an effec on exchange raes hrough he impac of he cenral bank s order on he foreign exchange marke. In a perfecly funcioning foreign exchange marke where he exchange rae reflecs all relevan and publicly available informaion, he impac of individual currency orders should no have any effec on price formaion (see, e.g. Evans and Lyons, 2001). If his assumpion is relaxed, he marke srucure and response of marke paricipans o order flows can cause a serilised inervenion o influence he exchange rae, 8 especially in a hinly raded marke. This order flow effec can prove paricularly imporan when he foreign exchange marke is characerised by a ho poao problem. 8. I is impossible o explain he large-scale rading ha akes place in a foreign exchange marke every day wihou assuming ha informaion is cosly and asymmerically disribued beween marke paricipans, see e.g. Grossman and Sigliz (1980) and Baillie, Humpage and Oserberg (1999) Summary: The effecs of serilised inervenions on exchange raes The above overview specifies a number of poenial channels for serilised inervenions o affec exchange raes. The findings from empirical sudies are somewha ambiguous abou he imporance of hese effecs. Following he end of he Breon- Woods sysem, economiss in general had lile faih in he effeciveness of serilised inervenions, as refleced for example in he Jurgensen Repor (1983), he firs sudy based on deailed daa abou cenral bank inervenions in many pars of he world. According o his repor, he effeciveness of serilised inervenions was non-sysemaic and only shor-lived if a all. This view may have slighly changed in recen years. A survey by Sarno and Taylor (2001), for example, finds some suppor for he idea ha serilised inervenions can have greaer affecs on exchange raes han previously assumed. They emphasize however ha a posiive resul is no always guaraneed, bu he likelihood of success increases subsanially if inervenions are clearly presened o marke paricipans and he public, and are implemened joinly by a number of cenral banks. Findings by Faum (2000) also appear o sugges ha he likelihood of success diminishes as he frequency of inervenions increases. Ohers are more scepic, such as Weber (1986) and Baillie, Humpage and Oserberg (1999) who mainain ha he effecs of inervenions are highly uncerain and difficul o evaluae. The effecs of inervenions on exchange rae flucuaions have also been examined. As discussed laer, cenral banks commonly refer o excessive exchange rae flucuaions when inervening in he foreign exchange marke. These sudies sugges, however, ha he effecs are minimal, and in fac mos of hem indicae ha inervenions amplify exchange rae flucuaions raher han dampening hem (see, e.g. Heikensen and Borg, 2002, and Brandner, Grech and Six, 2001). Nor is i heoreically clear ha a serilised inervenion should reduce exchange rae volailiy. If hey manage o reduce uncerainy hey could do so, bu if heir aim is o communicae new informaion, for example abou fuure moneary policy, i is no unnaural o assume a emporary increase in volailiy while marke paricipans rade on he basis of his newly received MONETARY BULLETIN 2003/1 55

7 informaion. Inervenions could also heighen uncerainy abou moneary policy, especially if i is conduced in secrecy, while publicly announced inervenions could reduce exchange rae volailiy (Dominguez, 1998, and Faum, 2000). Despie he uncerainy surrounding he impac of serilised inervenions, cenral banks ofen adop his measure, alhough is use has diminished. 9 Cerainly insances can be cied when serilised inervenions appear o have succeeded, alhough i is difficul o ell wheher his is he resul of he inervenions hemselves or some oher facors. An example is when he US dollar weakened by roughly 20% (rade-weighed exchange rae) in he six monhs following he Plaza Agreemen of Sepember 1985, when he G5 counries (he USA, UK, France, Japan and Germany) agreed o aemp o depreciae he dollar, which was fel o be overvalued. The Plaza Agreemen was followed hrough wih he Louvre Accord in which he G7 counries (G5 plus Ialy and Canada) underook o reduce volailiy in he US dollar by inervenions. An example of a less successful coordinaed cenral bank inervenion o reverse an exchange rae rend was he European Cenral Bank s effors, in cooperaion wih he Federal Reserve, Bank of England, Cenral Bank of Japan and Bank of Canada o srenghen he euro agains he US dollar in Sepember The euro weakened soon aferwards and has only recenly reurned o is original pariy wih he dollar afer he US economy slowed down and some confidence in i was los. Thus here are clear examples boh of how coordinaed inervenions by he cenral banks of many counries have managed o boos marke paricipans confidence in he exchange rae, and ohers which have also been less successful. 9. For example, he Federal Reserve inervened in he foreign exchange marke 235 imes from February 1987 o July 1990 (he duraion of he Louvre Accord), or roughly once every four business days. This was noneheless much less frequen han in he 1970s and firs half of he 1980s. In he following hree years he Federal Reserve inervened only 38 imes, and since 1995 i has done so only wice. A he same ime as he number of inervenions decreased, he average amoun of each inervenion increased, however. See Baillie, Humpage and Oserberg (1999) and Neely (2001). 3. Differen objecives of inervenions Cenral bank inervenions may have differen objecives. The moive could be o ry o reverse an exchange rae rend, for example if he domesic currency is fel o have weakened excessively so as o hreaen moneary policy arges, be i eiher an inflaion arge or a fixed exchange rae arge. Anoher moive could be o reinforce an exchange rae rend, for example if he cenral bank idenifies an opporuniy o expedie or consolidae an upward or downward exchange rae rend in he marke. Preserving financial sabiliy could be anoher moive. For example, he bank migh wish o dampen excessive shor-erm volailiy which reflecs uncerainy in he marke, or o ry o reduce or resolve some marke failure in he foreign exchange marke. The cenral bank could regard new informaion or changes in he ineres rae differenial wih abroad as causing an overshoo in he exchange rae which would lead o excessive volailiy due o herd behaviour by marke paricipans. An appropriae move for he cenral bank could hen be o inervene in order o preven such herd behaviour from becoming enrenched. Anoher objecive behind an inervenion could be o profi from rading. For example, if a cenral bank manages o reverse a downward domesic exchange rae rend i could laer buy back he currency i had used for he inervenion, a a more favourable price. Even hough he survey by Neely (2001) of 22 cenral banks in various pars of he world indicaes unequivocally ha he profi moive plays no par in heir inervenion decisions, bad experience of previous inervenions could be one reason for relucance on behalf of he cenral bank o ener he marke again. Cenral banks would no be expeced o inervene in he marke in order o reverse an exchange rae rend or dampen volailiy if hey see lile likelihood of success bu feel hey would probably susain considerable losses from i. Kim and Sheen (2002), for example, find evidence of such behaviour by he Reserve Bank of Ausralia. Finally, cenral banks could ener he foreign exchange marke in order o adjus heir foreign reserve posiion if hey consider reserves oo small or oo large. They could ake advanage of he opporuniy o do so in periods of marke ranquilliy, so ha heir inervenion would be unlikely o have much impac on he 56 MONETARY BULLETIN 2003/1

8 domesic exchange rae. Research has shown ha he mos common reasons for inervenions seem o be o aemp o reverse exchange rae rends and dampen volailiy (see he summary given in Sarno and Taylor, 2001). This is also consisen wih Neely s survey (2001). I is also obvious ha he moivaion behind inervenions is deermined by he moneary policy framework of he cenral bank in quesion. If he cenral bank pursues some form of fixed exchange rae policy, he main reason for inervenions will clearly be o conribue owards mainaining he exchange rae of he domesic currency as closely aligned o he arge as possible. However, as experience from many counries shows, a cenral bank has exremely limied abiliy o mainain an exchange rae arge which is inconsisen wih underlying economic fundamenals or views of marke paricipans. Inervenions could also remain an opion even if he cenral bank has an inflaion arge and he exchange rae floas. Alhough he cenral bank s main insrumen for aaining is inflaion arge is is policy ineres rae, cases may arise where i can be useful o use inervenions as well. The mos obvious example is if he counry has become caugh in a liquidiy rap, i.e. he cenral bank has los conrol of inflaion developmens so ha he economy is disinflaing a he same ime as he bank s policy rae is close o zero and real ineres raes are very high. The cenral bank s abiliy o bring down he real inflaion rae and aain is inflaion arge solely by cuing ineres raes would hen be very resriced. In such a case he bank could use inervenions in order o ry o depreciae he exchange rae, in order o ge he economy moving again and urn he disinflaion process around (see, e.g. Heikensen and Borg, 2002). Inervenions can also be an aracive opion for reducing exchange rae volailiy which may hreaen financial sabiliy, and for conribuing owards achieving he inflaion arge. For example, if he bank regards he domesic exchange rae developmen o be in obvious conradicion o he assumpion on which i bases is inflaion forecas, and hereby he prevailing moneary sance, i can use inervenions along wih a change in he policy rae o achieve he inflaion arge. The chief argumen would hen be ha, by also using inervenions, he bank would need a smaller ineres rae change han would oherwise be he case o aain he inflaion arge, so ha he negaive effecs on he real economy would be smaller (Heikensen and Borg, 2002). Cenral banks wih inflaion arges have, however, in general no used inervenions o aain he arge since i is difficul o exer a permanen effec on he exchange rae wih inervenions. Furhermore, he exchange rae pass-hrough o domesic prices varies from one ime o anoher, and he impac of shorlived exchange rae changes on inflaion is only emporary. 4. Transparency of inervenions and cenral bank openness Given ha he mos imporan effec of serilised inervenions is deemed o be signalling fuure moneary policy, i is puzzling ha cenral banks seem o have a endency o keep heir inervenions secre. Deails of inervenions are generally revealed some ime afer heir implemenaion, if hey are made public a all (see, e.g. Neely, 2001). 10 Implemenaion of inervenions and decisions on hem herefore remain largely secre, which differs significanly from he curren rend owards openness and ransparency in moneary policy (see Péursson, 2000). A firs sigh one could suppose ha he argumens in favour of more ransparen moneary policy would also apply o inervenions. More ransparency imposes furher discipline on he cenral bank, enabling he public o make a beer evaluaion of he bank s capabiliy and credibiliy. Greaer ransparency can also srenghen he ransmission of moneary policy. However, informaion abou fuure inervenions and heir implemenaion can also clearly have derimenal effec on heir effeciveness. Balke and Haslag (1992) demonsrae he need for cenral banks o mainain asymmeric informaion beween hemselves and marke paricipans if serilised inervenions are o signal fuure moneary decisions. In his ligh, i is inappropriae for a cenral bank o inform marke paricipans of is fuure inervenion decisions. Compleely ransparen inervenions are 10. The survey by Neely (2001) reveals, in fac, ha few cenral banks considered serilised inervenion an imporan insrumen for relaying informaion o markes abou fuure moneary policy decisions. MONETARY BULLETIN 2003/1 57

9 Box 2 The Cenral Bank of Sweden s procedures on foreign exchange marke inervenions Heikensen and Borg (2002) presen he Riksbank posiion on foreign exchange inervenions and is procedures regarding heir implemenaion. These procedures are he mos deailed ha have been made public by any cenral bank. Alhough ransparen, he bank assumes ha excepions may be made if condiions demand. Experience suggess ha he decision-making process mus no be oo complex, in order o be able o respond o differen condiions in he foreign exchange marke. Alhough he bank has prepared clear procedures for inervenions i will coninue o use inervenions wih resrain, since Sweden has a floaing exchange rae regime and inervenions in he foreign exchange marke are decided solely wih reference o is main objecive of price sabiliy. General rules are herefore made o apply, jus as in he case of ineres rae decision. Decisions on inervenions in he foreign exchange marke are made as a rule by he Cenral Bank of Sweden s execuive board. However, he Governor can decide an inervenion unilaerally if he need is so urgen ha i canno wai for a decision by he enire board. The board shall be noified of such decisions as soon as possible, however. Furhermore, he board can mandae he bank o make an inervenion, alhough his is only valid unil is nex meeing, when i shall be reviewed and renewed if necessary. As a rule, inervenions shall be prepared in he same way as ineres rae decisions. This secures a clear connecion o oher moneary policy decisions a he same ime as he risk of misakes is minimised. Before inervenions are pu ono he execuive board s agenda, hey should normally have been prepared by he drafing commiee for moneary and foreign exchange policy. The execuive board needs o make wo separae decisions on inervenions in he foreign exchange marke, which are also recorded separaely in he minues. Firsly, i needs o decide on an inervenion and issue a mandae for i. How deailed he mandae should be depends on he circumsances, bu should normally sae he ime period for implemening he inervenion and give a framework for is scope. Secondly, he board needs o presen a moivaion for he inervenion, he main elemens of which should be published in he form of a press release. Minues are published for each meeing of he execuive board. Deliberaions wih regard o he moives for he inervenions should be repored in he minues of he meeings, he same form as hose for oher moneary policy issues. The minues are normally published wih a ime lag of a minimum of one monh and a maximum of one year afer he meeing. Minues concerning an inervenion need no be published a he same ime as he regular minues if informaion in hem can be assumed o counerac he purpose of he decided or anicipaed measures. The Riksbank may delegae is inervenions o oher cenral banks, in which cases i may have reason o deviae from pars of he procedural sysem. herefore no appropriae. 11 However, his does no change he fac ha he grea secrecy surrounding cenral bank inervenions is difficul o explain given ha some openness could increase heir effeciveness. Several explanaions for his secrecy puzzle have been suggesed (see, e.g. Sarno and Taylor, 2001). The cenral bank migh wan o be less open if decisions on inervenion are no exclusively made by he bank (for example, parly or enirely in he hands of he minisry of finance insead, as in he case of he USA), in order o reduce he ambiguous signal ha hey gave abou moneary policy. Anoher explanaion could be ha he cenral bank fears ha a publicly announced inervenion would amplify exchange rae volailiy. Thirdly, he cenral bank migh simply be adjusing he composiion of is foreign reserves and sees no reason o make his adjusmen public. 12 A fourh reason could be ha he 11. Thus a cerain amoun of secrecy abou he iming of inervenions, heir volume and duraion, choice of currencies and counerparies, a he ime of implemenaion and some ime afer, could enhance heir effeciveness. 12. The survey by Neely (2001) reveals ha none of he 22 cenral banks regarded an adjusmen of he composiion of he foreign reserve as an imporan reason for secrecy abou is inervenions. More han 75% of hem cie as a reason always or someimes rying o maximise he yyyyy 58 MONETARY BULLETIN 2003/1

10 cenral bank knows ha he exchange rae i is rying o achieve hrough he inervenion is incompaible wih underlying economic fundamenals, so he bank aemps o inervene secrely in order o reduce he poenial damage on is credibiliy. Despie hese argumens, cenral bank inervenions have gradually been becoming more ransparen. I was menioned above ha in he early 1990s he world s main cenral banks began publishing deails of heir inervenions afer hey were made, whereas previously such informaion was no even made public. Oher cenral banks have gone even furher, for example in Swizerland and Sweden (see Neely, 2001, and Heikensen and Borg, 2002). The Riksbank in Sweden has recenly published is procedures for deciding and implemening inervenions (see Box 2). Heikensen and Borg (2002) argue ha general argumens for moneary policy ransparency also apply o inervenions, and in line wih he Riksbank general commimen o moneary policy ransparency i is naural o make hese procedures public. Noneheless, hey emphasise ha inervenions are o some degree inherenly differen from convenional moneary policy measures, so ha he bank mus have a cerain amoun of scope for deviaing from hem. 5. Technical implemenaions of inervenions According o he survey by Neely (2001), inervenions are almos always implemened hrough he spo marke wih he counerpary being domesic financial insiuions. 13 The fac ha cenral banks mos commonly use domesic commercial banks when hey inervene in he foreign exchange marke should hardly come as a surprise, since domesic financial insiuions generally specialise in rading wih heir own currency. Roughly half he respondens in he survey also raded wih oher cenral banks and invesmen banks. effec of he inervenion. On he oher hand, more han 57% menioned ha he reason was someimes o minimise he effec. These disparae resuls could reflec insances where cenral banks are no alone in deciding on inervenions. 13. Spo rades have a wo day selemen period. Cenral banks also use he forward and opions markes for inervenions. 14 One advanage of rading in hese markes is ha paymen is deferred, and in he case of opions i is no cerain ha he righ will be exercised. An example is he Cenral Bank of Thailand s forward conrac o buy is own currency in Currency swaps have also been used by cenral banks, bu primarily o serilise heir inervenions. They have also been used for liquidiy managemen purposes, for example he Cenral Bank of Swizerland used swaps heavily when he bank had a money supply arge. In effec a currency swap involves wo separae conracs, a spo conrac and a couneracing forward conrac. Such conracs herefore do no have a direc impac on exchange raes. The Reserve Bank of Ausralia has used currency swaps o serilise is inervenions, for example by selling Ausralian dollars in he spo marke and buying hem back in he forward marke. Such agreemens are classified as off balance shee iems, i.e. he principal of he rade does no affec he cenral bank s or is counerpary s balance shee, and alhough he bank s flexibiliy increases, is balance shee becomes less ransparen as a resul (see, e.g. Blejer and Schumacher, 2000). Opions have also been used in inervenions. A cenral bank aemping o preven he domesic currency from depreciaing can sell a pu opion for he domesic currency or a call opion for foreign currency. Opion prices do no have a direc effec on he spo price of he domesic currency, bu invesors prefer o buy opions raher han shorening heir posiions in a weak currency. By wriing opions and hereby increasing he flow in he marke, he cenral bank creaes a hedge and reduces he probabiliy of an aack on an already weak currency. The risk exposure of he cenral bank is he same as if he bank conducs spo or forward rades wih he currency. A side-effec is ha he cenral bank earns revenue on he issue of opions. I is common for cenral banks o issue opions o reduce heir need o resor o direc inervenions. The Cenral Bank of Spain is hough o have used 14. Forward rades have a selemen period beyond wo days. Opions involve he sale of he righ o buy or sell currency a a specified price, eiher on a specified day or over a specified period. MONETARY BULLETIN 2003/1 59

11 opions and sold calls on he pesea in order o preven i from depreciaing in 1993, alhough he bank has never admied i (Neely, 2001). The Cenral Bank of Mexico has also been using opions since Augus 1996 in order o bolser is foreign reserves. I sold pu opions on he US dollar, eniling buyers of he opion o sell dollars back o he bank a a srike price based on he previous day s exchange rae. This opion may only be exercised if he peso has appreciaed during he previous monh, i.e. if he exchange rae is no higher han a 20-day moving average of previous srike prices. This resricion is designed o preven he bank from having o buy dollars during a period of peso depreciaion and from being forced o ener he marke o acquire dollars asses (Neely, 2001). 15 The survey by Neely (2001) suggess ha inervenions are almos always made in he spo marke, a leas in par, and more han 95% of respondens repored ha inervenions always included spo rades. Some 53% repored someimes using he forward marke, for example, in conjuncion wih he spo marke, bu none repored using he forward marke exclusively. One cenral bank repored using he fuures marke for inervenions. The mos common arrangemen is ha cenral banks phone direcly hose paries hey wish o rade wih, and all respondens said hey had arranged heir inervenions parly or enirely by elephone. A he ime of he survey 44% used elecronic ransacions for heir inervenions and cenral banks appear o be moving increasingly owards elecronic rading along wih oher marke paricipans. Furhermore, he survey reveals ha mos inervenions ake place during he business day. Half of he sample had inervened in he marke ouside business hours, boh prior o and afer. One ou of four cenral banks repored hey always inervene in he marke a a specific ime of day, eiher in he mornings or jus before closing. 15. The Cenral Bank of Columbia has used similar mehods. Numerous oher examples can be cied where cenral banks use he possibiliies offered by derivaives for heir foreign exchange marke inervenions. The cenral banks of Brazil and Chile, for example, have issued exchange rae-indexed securiies o ensure ample liquidiy in he domesic marke and fulfil demand from domesic deposi insiuions for hedging insrumens, and he Cenral Bank of he Philippines has used forward sale equivalens o provide he marke wih hedging insrumens. Finally, according o he survey, governmens have someimes used indirec mehods for influencing he exchange rae. These refer o measures which fall ouside he definiion of cenral bank currency rading wih he aim of exering an influence on he exchange rae. Examples are governmen resricions on capial flows, currency resricions or effors o conrol capial flows by legislaion or oher means. In he 1970s, for insance, he governmens of Spain, Ialy, France and he UK managed foreign asses of sae enerprises wih he aim of influencing heir counries exchange raes wihou direc inervenion in he foreign exchange marke. In he early 1990s he governmens of Spain, Ireland and Porugal counered speculaive aacks by imposing resricions on capial flows. 6. Cenral Bank of Iceland inervenions in he foreign exchange marke An organised foreign exchange marke was formally esablished in Iceland in May Prior o ha, he exchange rae was unilaerally deermined by he Cenral Bank of Iceland, and was adjused when he need was fel. Wih he esablishmen of an organised marke in 1993, fixing meeings were inroduced a he Cenral Bank, where marke paricipans raded wih each oher and he Bank. The exchange rae of he króna was hen deermined a he end of he meeings, alhough rading could also be conduced ouside he meeings. The final sep owards a fully funcion marke was aken on July 1, 1997 when he foreign marke rading hours were exended o mach bank business hours, i.e. from 9:15 o 16:00 weekdays. 17 Coninuous price formaion of he króna was esablished as marke paricipans underook marke making responsibiliies. The reference amoun for marke quoes was 1 million US dollars from July unil Ocober 2000, when i was raised o 1½ million US dollars. Marke makers also agreed o mainain a specified bid-ask spread. 18 The Cenral 16. A survey of he developmen of he foreign exchange marke in Iceland is found in Moneary Bullein 2001/ Previously, capial movemens beween Iceland and abroad had been deregulaed in seps which essenially were compleed in he beginning of The bid-ask spread was deregulaed as of January 1, MONETARY BULLETIN 2003/1

12 Table 1 Cenral Bank of Iceland rading in he foreign exchange marke Purchases of Sales of Toal Number Toal marke Cenral Bank foreign cur- foreign cur- rade of urnover share (% of rency (m.kr.) rency (m.kr.) (m.kr.) days (m.kr.) oal urnover) ,861 30,686 45, , ,530 26,089 48, , ,474 24,532 65, , ,715 22,593 59, , ,960 16,980 50, , ,628 3,649 19, , ,787 15,643 17, , ,538 29, ,218, , , , Bank may rade wih he marke makers a any ime, bu does no rade wih ohers agens (Regulaion no. 913/2002 on he foreign exchange marke) apar from he Treasury. Wih he changes made o he marke in 1997 and hose ha had aken place in is exernal environmen, for he firs ime a genuine foreign exchange marke was formed on he lines of hose in oher counries. Financial insiuions could increasingly hedge heir foreign exposures and offer enhanced services for invesors. An organised currency swap marke was esablished on November 26, 2001 and became regulaed as oher inerbank markes in March 2002 (see Ísberg, 2002). Marke paricipans are he same as in he foreign exchange marke. The marke faciliaes he Cenral Bank in using swaps in is ransacions wih marke paricipans if, for example, o serilise is inervenions. As Table 1 shows, urnover in he foreign exchange marke has grown subsanially since is esablishmen. In 1994, he firs whole year of is operaion, urnover amouned o 53 b.kr., of which he Cenral Bank s share was more han 85%. Turnover in he marke grew and he Cenral Bank s share shrank from one year o he nex and in 2002 i was less han 1% Changed Cenral Bank role in he foreign exchange marke The foreign exchange marke s almos en-year hisory can be divided ino five periods on he basis of he Cenral Bank s role in he marke and he differen funcions ha is inervenions have assumed. The firs period, from he marke s esablishmen unil is reorganisaion in mid 1997, were is formaive years afer capial movemens o and from Iceland were deregulaed in he beginning of Over his period he Cenral Bank was responsible for he bulk of rading and is share was as high as 90%, in The Bank s main role was o ensure coninues rading of foreign exchange and as effecive pricing of currency as possible. The Cenral Bank was on boh sides of he marke and raded in a number of currencies, alhough mos of he rading involved US dollars. The Bank enered he marke almos every business day, even many imes during he day. Lile rade was, however, beween he commercial banks hemselves. Turnover in he foreign exchange marke increased beween he years bu he Bank s share remained very high hroughou he whole period. As Table 2 shows, he Cenral Bank bough foreign currency almos as ofen as i sold currency in his period. The Bank enered he marke on 93% of business days, alhough he ransacions were usually very modes in size. On one occasion he Bank purchased foreign currency for he equivalen of more han 2 b.kr., bu oherwise mos of is rading involved less han ½ b.kr. Is larges selling amoun was ½ b.kr. a a ime. This period was herefore characerised by a srong Cenral Bank presence in he marke and very small rading inensiy. The second period was from mid 1997 o June 15, During hese firs years of coninuous operaion, urnover in he marke grew even furher bu MONETARY BULLETIN 2003/1 61

13 Cenral Bank rading was sill significan. Almos all he Bank s rading was now in US dollars. Gradually he Bank s share diminished bu i coninued o aemp o smooh exchange rae flucuaions and ensure coninues rading in foreign currency. The reform in July 1997 involved a shif he marke making role from he Bank o oher marke paricipans, which was a precondiion for reducing he Cenral Bank s ransacion share. Alhough he Bank s share declined noiceably, he Bank was sill an imporan paricipan in he marke and he marke makers dayo-day rading environmen. Table 2 clearly shows he Bank s involvemen in he marke declining, wih he Bank s frequency falling o 40% of business days. The Bank was slighly more acive on he buying side of he marke bu inensiy remained relaively low. Thus he Cenral Bank sill had an imporan role o perform in susaining he marke and rying o ensure as effecive pricing of foreign currency as possible. During he hird period, from June 16, 1999 o June 14, 2000, he Cenral Bank did no ener he marke a all. The Bank s rading frequency had gradually been falling since mid 1997 wih marke urnover increasing rapidly. The Bank herefore considered i imporan o allow he marke o operae wih lile inervenion. The exchange rae of he króna srenghened for he greaer par of his period and he rade weighed foreign exchange index reached is lowes poin on April 28, 2000 a poins. The arge zone band for he index was exended o 9% from a cenral value in February Table 2 Cenral Bank rading frequency and rading volume in he domesic inerbank currency marke Number of days Sum of Foreign currency rade all periods T-I T-II T-III T-IV T-V Purchases in excess of 3.5 b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases in he range b.kr Purchases less han 0.25 b.kr No ransacions... 1, Sales for less han 0.25 b.kr Sales in he range b.kr Sales in he range b.kr Sales in he range b.kr Sales in he range b.kr Sales in he range b.kr Sales in he range b.kr Sales in he range b.kr Sales in excess of 3.5 b.kr Toal number of business days... 2, Number of Cenral Bank rading days... 1, Cenral Bank rading days as a percenage of oal number of business days... 48% 93% 40% 0% 13% 12% Cenral Bank purchase days as a share of Cenral Bank rading days... 51% 48% 62%. 36% 95% T-I is he period from January o July T-II is he period from July o June T-III is he period from June o June T-IV is he period from June o Ocober T-V is he period from Ocober o December MONETARY BULLETIN 2003/1

14 2000, as he index began o approach he lower limi of he previous band. The Bank fel ha he previous band was beginning o hinder i from ighening he moneary policy sance in order o preven overheaing, which was beginning o permeae he economy, from leading o an excessive rae of inflaion a a laer sage. The fourh period exends from June 15, 2000 o Ocober 12, The period began when he Cenral Bank enered he marke for he firs ime in almos a year. In he preceding weeks he króna had been weakening and he Bank fel i imporan o lean agains he wind. The inervenion was small and did no manage o hal or reverse he depreciaion of he króna. The Bank re-enered he marke owards he end of June and again in mid July The following period was characerised by a coninuing depreciaion of he króna and aemps by he Cenral Bank o reverse his rend and laer o defend he arge zone band. However, over he wo-monh period from Augus 9 o Ocober 10, 2000 he Cenral Bank bough US dollars for he equivalen of 1.7 b.kr. As he marke had seled afer he urmoil in he summer he Bank ook advanage of he opporuniy o bolser is foreign reserve when marke makers had currency o sell. The maximum amoun in any rade was 1 million US dollar. The Bank did no ener he marke for a while afer he change o he moneary framework on March 27, 2001, bu as he króna sared o depreciae again in June, he Bank enered he Box 3 Special foreign exchange rades by he Cenral Bank of Iceland in 2001 and he preannounced program o buy back foreign currency in From he summer 2000, when he Cenral Bank reenered he foreign exchange marke, and unil Ocober 2001, mos of is ransacions wih marke makers were direc inervenions in order o influence he exchange rae of he króna. On several occasions he Bank has made special rades wih marke makers. In December 2001 he Bank sold 10 million US dollars o one marke maker and 38½ million US dollars o anoher a few days laer. Simulaneous wih he laer rade, he Cenral Bank made a corresponding currency swap wih he marke maker, spli ino four equal pars wih a erm of one, wo, hree and four monhs, whereby he Bank bough dollars and sold hem forward. This is he only occasion on which he Bank has formally serilised is inervenions in he foreign exchange marke. A he end of Augus 2002 he Bank sold foreign currency forward for he equivalen of 3 b.kr., for hree differen mauriies in four differen currencies. These wo rades are he only imes ha he Cenral Bank has used forward conracs in is ransacions. In Sepember 2002 he Cenral Bank began buying foreign currency wih he aim of srenghening is ne foreign posiion. Earlier he same year, he Bank had announced in Moneary Bullein ha i would buy foreign currency when i considered ha circumsances permied i o do so. The Cenral Bank conaced foreign exchange marke makers before a final decision was made abou he mos suiable arrangemen for he purchases. A press release was issued on Augus 27, 2002, saing ha he Cenral Bank inended o purchase he equivalen of up o 20 b.kr. before he end of The Bank purchases 1½ million US dollars each ime on Mondays and Wednesdays, wih he possibiliy of buying on Fridays as well. I also reserves he righ o rade wih marke makers on heir iniiaive for higher amouns, provided ha he króna has srenghened from he day before. The Bank may also cancel his program if i considers ha marke condiions have deerioraed. Purchases are made before he marke opens, beween 9:00 and 9:15 in he morning, when he Bank receives bids from marke paricipans and acceps he mos favourable one. The Bank s firs regular purchase under his program was on Sepember 2 and by he end of 2002 i had bough 52½ million US dollars, or he equivalen of 4½ b.kr. These regular purchases represen he Cenral Bank s firs ransacions ouside he foreign exchange marke s business hours, and also he firs ime ha i has announced in advance he forma in which i plans o rade. I should be reieraed ha he Bank s aim is no o ry o influence he exchange rae of he króna hrough hese purchases, and hey are no par of moneary policy measures. Above all hey are designed o improve he bank s ne foreign posiion, which deerioraed considerably in MONETARY BULLETIN 2003/1 63

15 marke again in an aemp o preven furher weakening of he króna. The Bank s involvemen in he foreign exchange marke had changed fundamenally, so ha inervenions were only used when he marke was very igh, he króna was under pressure and volailiy pronounced. Inervenions were no longer based on he need for marke making on behalf of he Bank, since he marke makers had aken up ha responsibiliy. Char Daily spo exchange rae (rade-weighed index) and Cenral Bank of Iceland ne purchases of foreign currency Dec 31, 1991=100 Trade-weighed exchange rae index T-I T-II T-III T-IV T-V Table 3 Number of rades and Cenral Bank rade inensiy in inra-day ransacions Upper deviaion band Number of rades All wihin each day periods T-I T-II T-III T-IV T-V Average Maximum Minimum Toal amoun of CBI rading each day (m.kr.) Average Maximum... 4,017 2,197 2, ,768 4,017 Minimum... < 1 2 < Average amoun of CBI rading each day (m.kr.) Average Maximum... 4, ,017 Minimum... < 1 2 < T-I is he period from January o July T-II is he period from July o June T-III is he period from June o June T-IV is he period from June o Ocober T-V is he period from Ocober o December Lower deviaion band Cenral Bank ne purchases of foreign currency B.kr. 3 T-I T-II T-III T-IV T-V Source: Cenral Bank of Iceland. This is refleced in less frequen bu more inensive inervenions, as Table 2 shows. The Cenral Bank enered he marke on 13% of business days during he period and significanly more ofen on he selling side of he marke han before. Transacions were larger and on several occasions he Bank sold currency during he period for he equivalen of more han 2½ b.kr, and once for more han 3½ b.kr. This change in Cenral Bank involvemen reflecs he fac ha for much of he period he Bank was leaning agains he wind o defend he króna, which called for more inensive inervenions. The Cenral Bank s las inervenion for hese purposes was made on Ocober 12, During he fifh period, from Ocober 13, 2001 o he ime of wriing, he Bank has enered he marke on several occasions, alhough he purpose is no o affec he exchange rae of he króna. As discussed before, hese ransacions (discussed in more deail in Box 3) are no defined as inervenions. The changes in Cenral Bank involvemen in he marke can also be seen in Table 3 which shows he number of rades conduced each day by he Cenral Bank and he Bank s inra-day rading inensiy over he whole period. The Bank enered he marke frequenly every day over he firs wo periods, even enering boh sides of he marke wihin he same day depending on marke makers demand. 19 The frequency of rades per day increased even more in he fourh 19. The las ime he Cenral Bank bough and sold currency wihin he same day was April 28, MONETARY BULLETIN 2003/1

16 period, wih rading inensiy increasing as well. In he mos recen period, however, he Bank has only raded wih one marke maker on each occasion. Char 1 shows he developmen of he exchange rae index from he beginning of 1994 o he end of 2002 and ne Cenral Bank purchases of foreign currency over he same period. I shows how he Cenral Bank fulfilled he role of a marke maker during he firs wo periods, wih he Bank enering he marke frequenly and on boh sides of he marke. A he same ime, he ransacion inensiy was relaively small. Thus he Bank s role was primarily o smooh ou exchange rae flucuaions and o fulfil a marke making role in an undeveloped marke. Afer he Bank re-enered he marke in mid 2000 is main role was o lean agains he wind and o curb he risk of a spiral forming in siuaions of significan one-way flows and uncerainy in he marke. Is role had herefore changed o monioring he marke and inervening solely if i idenified he need o ensure he effeciveness of is moneary policy sance. In fac, his changed role was esablished before he moneary framework was changed a he end of March Afer order was resored in he foreign exchange marke he Cenral Bank s involvemen alered again and i now eners he marke only under special condiions which are no direcly relaed wih advancemen of he prevailing moneary policy. The declared aim of he recen purchases of foreign currency is o boos he Bank s ne foreign posiion. Noneheless, he possibiliy remains open for he Bank o ener he marke if i considers ha his would conribue o aaining is moneary policy objecives or if i considers exchange rae volailiy a poenial hrea o financial sabiliy Decisions on inervenions and heir objecive Decisions on inervenion are made by he Governors of he Cenral Bank afer consulaion wih he Bank s saff. The Governors decides on he scope of he inervenion and is duraion. The Moneary Deparmen, in addiion o monioring marke movemens and communicaing wih he marke, implemens he ransacions. Changes in he objecives of Cenral Bank inervenions have refleced revisions of he moneary framework. Unil March 27, 2001 he inermediae arge of moneary policy was o mainain he exchange rae agains a rade weighed average of foreign currencies wihin a specific arge band. Unil Sepember 6, 1995 he band was ±2¼% from a cenral value, laer exended o ±6%. The band was exended again o ±9% on February 14, 2000, before finally being abolished on March 27, 2001 when he króna was floaed and a formal inflaion arge was adoped as a nominal anchor of moneary policy. During he exchange rae peg he main objecive of Cenral Bank inervenions was obviously o ensure ha he króna remained wihin he exchange rae band. For mos par of he period, however, he Cenral Bank enered he marke more frequenly han would probably have been necessary in order o ensure his, which reflecs he fac ha Iceland s foreign exchange marke was very underdeveloped a he ime and could hardly have wihsood major flucuaions, even if hey had remained wihin he exchange rae band. As he band was exended and he foreign exchange marke maured, he Bank could increasingly focus on ensuring a low and sable rae of inflaion, and for a while i wihdrew from he marke compleely. However, i reurned o reverse he depreciaion of he króna and defend he exchange rae band unil he peg was abolished. Afer he Bank adoped inflaion argeing, he role of inervenions as a moneary policy insrumen has obviously been grealy reduced. The Cenral Bank has announced ha inervenions will be used solely if he Bank considers ha exchange rae developmens pose a hrea o he inflaion arge or excessive exchange rae flucuaions could hreaen financial sabiliy. Inervenions will herefore no be applied o defend a specific exchange rae, as was he case when he Bank followed an exchange rae peg Implemenaion of Cenral Bank inervenions As common among oher cenral banks, he Cenral Bank of Iceland mainly conducs inervenions hrough elephone. The Bank conacs all marke makers a he same ime and asks for a quoe for he reference rading amoun. However, here is nohing o preven he Bank from requesing quoes for differen amouns, alhough his has no been done in recen years. The Bank can rade wih marke makers as ofen as i deems necessary. Once he Bank eners he marke, marke prices move, and he aim behind placing orders wih all MONETARY BULLETIN 2003/1 65

17 marke makers simulaneously is o avoid creaing informaion asymmeries among hem. 20 As discussed earlier, cenral banks have more han one mehod of inervening in he foreign exchange marke a heir disposal. The Cenral Bank of Iceland has almos exclusively conduced inervenions in he spo marke. There are, however, wo excepions, once he Bank used a forward conrac and once a currency swap. As discussed in Box 3, in boh cases hese were ad hoc rades wih a single marke maker. Some cenral banks ener he marke a specific imes of day. The Cenral Bank of Iceland has no done so, apar from he pre-announced program o buy back foreign currency o srenghen he Bank s ne foreign reserve posiion described in Box 3. The Cenral Bank of Iceland has no made sysemaic announcemens of is inervenions. Occasionally i has issued an announcemen afer an inervenion has been made, and he Bank has also described hem in is publicaions. 21 News of inervenions have ofen been repored by he marke makers hemselves. Cenral Bank purchases o improve is ne foreign posiion were announced in advance in a press release. Oher marke makers have likewise been noified when he Bank has raded larger amouns wih a single marke maker. Formally, he Cenral Bank does no serilise is inervenions in he foreign exchange marke in order o eliminae heir effec on is base money (wih he excepion of he rade in December 2001 menioned in Box 3). However, in pracice hey become more or less serilised due o he formulaion of repo aucions a he Bank. Since March 1998, he Bank has held weekly aucions of repo conracs wih domesic credi insiuions which are subjec o required reserve 20. This is a differen approach from ha of he US Federal Reserve, for insance, which chooses a subse of counerparies from a lis of marke makers when inervening. The counerpary wih which an order has been placed is hen obliged o communicae his informaion o he marke. This is no a general rule, however, as i depends on wheher he counerpary is a commercial bank or a currency broker, who does no need o announce ha he placer of an order in he marke is he Federal Reserve. Research also suggess ha alhough he Federal Reserve uses commercial banks as counerparies, i does no ensure ha informaion abou he inervenion is shared equally among all marke paricipans simulaneously, so ha he seleced counerpary enjoys an informaional advanage for a while. See Baillie, Humpage and Oserberg (1999). 21. Moneary Bullein 2002/1, pp , saes he daes and amouns of he Bank s inervenions in Char 2 Daily developmen of he rade-weighed exchange rae index and Cenral Bank inervenions June 15, 2000 o December 31, Dec. 1991= Source: Cenral Bank of Iceland. Upper deviaion band for index Verical lines indicae Cenral Bank sales of foreign currency Exchange rae index provisions. The aucions have from he ouse been implemened using a fixed price forma implying ha he counerparies have unlimied access o funds a he Bank as long as hey hold enough of accepable securiies ha hey can use as collaeral. The erm of he repo agreemen is wo weeks, afer which he rade is revered. Insiuions subjec o required reserve provisions also have access o overnigh funding wih he Bank, using he same collaeral. This arrangemen for repo aucions enables marke paricipans o respond o liquidiy changes caused by Cenral Bank inervenions, and in effec serilise hem even hough he Cenral Bank does no formally do so iself. For example, in 2001 Cenral Bank inervenions in he foreign exchange marke amouned o 29½ b.kr., or 25½ b.kr. excluding he 4 b.kr. sale of currency o one marke maker in December 2001 which he Bank formally serilised wih a currency swap. Ousanding repo conracs increased by almos 22 b.kr. a he same ime, while base money decreased by only 1½ b.kr. The liquidiy ha he Cenral Bank wihdrew from he marke wih is inervenions was hus channelled back ou o i hrough increasing demand for repo conracs, implying ha he inervenions were more or less serilised A he same ime here was a considerable increase in demand for Cenral Bank s overnigh funding. Alhough he Bank does no impose ceilings on he amoun of available funding hrough repos conracs and overnigh loans, heir holdings of accepable securiies o use as collaeral may can someimes limi heir access o Cenral Bank funding. Such a liquidiy drain appears, for example, in he form of rising money marke raes and increasing spreads beween he Cenral Bank policy rae and money marke raes, as happened in 2001 and ino MONETARY BULLETIN 2003/1

18 Table 4 Cenral Bank of Iceland inervenions o srenghen he króna (sales of foreign currency) June o Ocober (T-IV) Changes in exchange rae index Share of wihin wihin same day Sale of foreign oal urnover same day and he following Dae currency (m.kr). (%) (%) day (%) June June , June July , July , July , Sepember November , November , November November , November December January , January , January , February , March , March , March , June , Sepember , Ocober , Ocober , Ocober , Ocober , Ocober , Changes in he exchange rae index wihin he same day measure changes from marke opening o closing prices on he day of he inervenion. Changes in he exchange index wihin he same and following day measure changes from marke opening prices on he day of he inervenion o he close price he day afer he inervenion The effeciveness of Cenral Bank inervenions on he exchange rae of he króna As discussed earlier, empirical findings sugges ha serilised inervenions have a fairly limied effec on exchange raes. There are examples of successful reversals of depreciaion rends, bu more examples of failure. This is consisen wih heoreical findings suggesing ha serilised inervenions have limied effecs on exchange raes, if any. Given ha adjusmens in he demand for repo conracs causes he Cenral Bank s inervenions o be more or less serilised, i is no surprising ha heir impac on he exchange rae has been fairly limied, especially in he long run. This is eviden from Char 2 which shows he developmen of he exchange rae index and Cenral Bank inervenions since June 15, As can be seen, he exchange rae of he króna reurns o is earlier level shorly afer he inervenion, hence affecing he level of he exchange rae only for a shor period. There are, however, insances which have coincided wih periods of grea uncer- 23. I should be reieraed ha he char shows only he Bank s rading ha his paper defines as inervenions, i.e. rades aimed o affec he exchange rae of he króna. Hence, he Bank s rading in December 2001 and 2002 are excluded, since hese did no consiue convenional inervenions aimed a influencing he exchange rae. MONETARY BULLETIN 2003/1 67

19 Box 4 Cenral Bank inervenions in he foreign exchange marke in he build up o and wake of he changed moneary policy framework in March 2001 When he Cenral Bank inervened in he foreign exchange marke on March 23, 2001 rumours had begun o circulae ha an announcemen of a change in is moneary policy framework was pending a is annual meeing hree days laer. I was said ha he Bank planned o move ono an inflaion arge and floa he króna, which would probably cause greaer exchange rae volailiy, in he shor erm a leas. Las bu no leas, i would remove he invesors safey ne, i.e. he Cenral Bank s obligaion o defend he exchange rae band. Fuelling his speculaion was a remark by he Prime Miniser ha major news was expeced from he meeing (quoed in Morgunbladid on March 27, 2001). Grea uncerainy broke ou in he foreign exchange marke and he króna came under heavy srain o sell. The Cenral Bank inervened in an aemp o hal he depreciaion, bu wih lile effec. In spie of sizeable inervenions he foreign exchange rae index rose over hese days and was higher a he close of he day han when he marke opened. The Cenral Bank s annual meeing was held on March 27, 2001 (afer he closure of he foreign exchange marke) where i announced ha i would inroduce inflaion argeing and floa he króna. When he marke closed on March 27, 2001 he foreign exchange rae index sood a poins, while he upper band was Thus he Cenral Bank had succeeded in defending he band, alhough i was a close call and i was uncerain wheher he Bank could have managed o do so for much longer. Subsequenly, he króna coninued o weaken. Turnover was heavy in he foreign exchange marke and paricipans ried o pu pressure on he Cenral Bank o inervene. Difficul days followed in he marke, and May 2, 2001 is probably he mos memorable. The paricipans posiions had worsened and he marke was very one-sided. Under srong pressure, he króna fell by 5.8% over he day. Turnover in he foreign exchange marke amouned o more han 36 b.kr., he highes volume ever in a single day. The subsequen period was very one-sided oo, and on June 21, 2001 he Cenral Bank decided o re-ener he foreign exchange marke for he firs ime afer he reform of he moneary policy framework. By hen he foreign exchange rae index had risen above 145 poins and he króna had fallen by more han 13% since he Bank moved ono an inflaion arge. As well as enering he marke, he Cenral Bank had negoiaed wih marke paricipans on he paymen of a emporary commission for marke making (which was disconinued a he end of 2002). A he same ime i was announced ha he governmen had made a new 25 b.kr. foreign loan which would be used o srenghen he Cenral Bank s foreign reserve. This calmed he marke down and he index wen below 135 poins in Augus. Noneheless, i rose again and passed 141 on Sepember 20. The Cenral Bank s nex inervenion was a he end of Sepember, when par of he foreign loan ha had been promised in June was disbursed. I was hoped ha he króna could be srenghened and he rend possibly even reversed. From Sepember 28 o Ocober 12, 2001 he Cenral Bank sold US dollars o marke paricipans for he equivalen of almos 10 b.kr. Following a shor-lived srenghening in he wake of he inervenion, he króna coninued o weaken unil November 28 when he highes index value for he year was recorded, or Afer ha he rend reversed and by he end of he year he króna had srenghened by 6½% since November 28. News on more favourable foreign rade and inflaion developmens were published a he same ime. In December labour marke paricipans also announced ha a wage agreemen review scheduled for February 2002 would be posponed unil May, serving o reduce he likelihood of excessive wage rises which could have weakened he króna and caused mouning inflaionary pressure. I can herefore be said ha he exchange rae depreciaion rend was no reversed unil domesic economic developmens improved, which caused marke paricipans views and expecaions o become more favourable for he króna. 68 MONETARY BULLETIN 2003/1

20 ainy among marke makers as o where he currency is heading. In hese insances he Bank seems o have been able o hal or reverse he króna depreciaion for a more susainable period, such as on June 21, This, however, coincided wih a declaraion by he governmen on a new foreign loan o srenghen he Bank s foreign reserves and a new compensaion scheme for marke making in he foreign exchange marke (see Box 4). I is herefore unclear how much of his change can be aribued o he inervenion iself. Table 4 presens an overview of he Bank s inervenions over he period June 15, 2000 o Ocober 12, 2001 (period IV). No sysemaic relaion is apparen beween he inensiy of he inervenion and is impac on he exchange rae index in he following wo days (which is saisically confirmed). 24 For example, he Cenral Bank sold currency on November 24, 2000 in rades amouning o less han 12% of oal urnover ha day. Noneheless he exchange rae index fell by almos 2% over he day and he impac had no disappeared he following day. In comparison, he Bank sold currency on January 26 which amouned o 40% of oal urnover ha day. In spie of such a large share of oal urnover, he foreign exchange index remained virually unchanged. Similarly, here are numerous examples of inervenions which have failed o reverse a depreciaing exchange rae rend even hough hey accouned for a fairly large share of he day s urnover. Thus he oucome of inervenions seems o be deermined more by curren condiions han by heir inensiy. This is also seen from Char 3 which shows he developmen of he exchange rae index over he day during he period jus before and afer he abandonmen of he fixed exchange rae regime in favour of inflaion argeing in March The firs hree chars show he las hree days before he Cenral Bank adoped inflaion argeing. One inervenion was hen made in he summer and a series of hem in Sepember and Ocober (hese developmens are described in more deail in Box 4). As a rule he 24. According o he survey by Neely (2001), mos cenral banks regard ha he impac of heir inervenions is primarily fel during he following hours, and lass for he days immediaely following he inervenion. exchange rae index fell immediaely afer he inervenion bu rose again aferwards, alhough generally he increase was somewha less han he original decrease following he inervenion. Noneheless, he index had generally risen o he same, or higher, level by he end of he day. A clear increase in volailiy can also be seen following an inervenion. Furher confirmaion is given by an economeric analysis which is discussed in more deail in Box 5. The empirical resuls imply ha inervenions generally did no manage o reverse a weakening of he króna. More posiive resuls are apparenly achieved, however, if he Bank makes a more inensive effor wih larger inervenions lasing several days. Likewise, he Bank does no seem o succeed in dampening exchange rae volailiy wih is inervenions. On he conrary, his appears o increase, which is consisen wih he experience of oher cenral banks, especially afer he widening of he fixed exchange rae band in February Volailiy in he wake of inervenions increased somewha less afer he fixed exchange rae framework was abolished in March 2001, however. Volailiy also appears o increase less, he larger he scope of he inervenion. Thus he resuls appear o be ha Cenral Bank inervenions have had a relaively limied effec. They did no succeed in prevening he weakening of he króna, or in sysemaically reducing volailiy. On he oher hand, i is virually impossible o guess wha would have happened if no inervenion had aken place when uncerainy was a is heigh in he marke. I can be argued ha he weakening of he króna and exchange rae volailiy could have become even more pronounced wihou any inervenions. Nor can i be ruled ou ha he Bank managed o delay he depreciaion rend so ha he main weakening of he króna was no fel when he overheaing of he economy was a is peak, and he risk of being ransmied o domesic prices was hereby greaes, bu raher somewha laer when he economy had cooled down and he inflaionary risk was less han oherwise. The possible indirec effec of inervenions o quell uncerainy and slow down a depreciaion rend should herefore no be underesimaed, alhough he Bank clearly did no manage o reverse he rend permanenly wih inervenions. This required radiion- MONETARY BULLETIN 2003/1 69