2. Role of Central Banks in Currency Market

Question 1

What is the Role of Central Banks in Currency Markets?

Answer 1

• responsible for the monetary policy of its country or its group of member states (as in the case of the European Union).
• headed by a governor (or president or known by another name).
• normally, central bank is state-owned + minimal autonomy — allow gov intervention in monetary policy.
• Some central banks ( eg: USA’s Federal Reserve & UK’s Bank of England) are ‘independent central banks’ which operate under rules designed to prevent political interference.

Question 2

How many functions does central banks have?

Answer 2

may be classified into two groups: primary and secondary functions.

Question 3

What are the primary functions of central banks?

Answer 3

• To issue currency — notes & coins.
• Regulation and supervision of banks & financial system.
• Provide secured & reliable payment system.
• Clearing services — clearing & collection of cheques.
• A banker to the gov & lender of last resort.
• Conduct monetary policies to create a sound & conducive environment for the development of a country.

Question 4

What are the main monetary objectives of a central bank?

Answer 4

to bring about:
• sustained economic growth
• financial system stability
• a low level of inflation and price stability
• confidence in its country’s currency

Question 5

Why under the floating exchange rate system, monetary policies have assumed greater importance?

Answer 5

exchange rates frequently deviate from their ‘desired’ equilibrium level. Once this happens, central banks must adopt the necessary monetary policies to bring their currencies back to the desired levels.

Question 6

monetary authorities may attempt to deliberately keep the ‘intended’ exchange rate below/above its presumed equilibrium value to?

Answer 6

• to give a competitive edge to its export industries — ‘competitive devaluation’.
• to curb imported inflationary pressures.

Question 7

What are the secondary functions of central banks?

Answer 7

• Management of public debt.
• Advising the government on policy matters.
• Manage FX — hedging activities & intervention in FX markets.

Question 8

What is Foreign exchange intervention & what cause the need for it?

Answer 8

• FX intervention: FX transactions conducted by the central bank to influence the market conditions and/or the exchange rates — can be initiated by a single central bank or with other central banks.
• foreign capital flows in & out, cause fluctuations in the FX market — central banks can use FX intervention as a monetary policy tool to stabilize the economy — ensure efficient functioning of the FX market.

Question 9

Why do Central banks operating flexible exchange rate regimes intervene in the foreign exchange market?

Answer 9

to (1) correct misalignment of exchange rates
(2) stabilize the exchange rate and calm a disorderly market.

Question 10

What does Correcting Misalignment of Exchange Rates involve?

Answer 10

• to achieve the desirable micro and macroeconomic objectives & maintain competitiveness.
• higher currency value makes foreign goods & services cheaper, thus stimulating imports. Domestic goods will be more expensive, leading to a reduction in exports. Rising currency value can lead to a rising trade deficit.
• If that trade deficit is deemed a problem for the economy, the central bank may intervene to reduce the value of the currency thereby reversing the rising trade deficit.

Question 11

Why do central banks need to Stabilize the Exchange Rate and Calm a Disorderly Market?

Answer 11

International trade & investment decisions are difficult to make if the exchange rate is changing rapidly — traders & investors can’t ascertain the profitability of trades & investments.

FX & interest rate interventions are also based on the view that the FX markets can be inefficient due to speculation, causing excessive exchange rate fluctuations.

Question 12

How to ensure effective currency intervention?

Answer 12

direct FX interventions should also be supported by monetary policy interventions such as interest rate adjustments.

Question 13

What are the types of foreign exchange intervention?

Answer 13

1. Direct interventions
   - FX transactions conducted by the monetary authority to influence the exchange rate.
2. Indirect interventions
   - policies that influence the exchange rate indirectly such as capital controls and exchange controls imposed by the monetary authority.

Question 14

How does FX direct intervention works?

Answer 14

• directly buy/sell domestic currencies.

1. To depreciate domestic currency
   - central bank can sell the domestic currency (MYR) in exchange for foreign currency (USD) — raise MYR supply = depreciate MYR, USD appreciates
   - Since the central bank is the ultimate MYR supply, it can flood the market with as much MYR as needed to reduce the value
2. To raise MYR value
   - buy MYR by paying foreign currencies.
   - but the ability of the central bank to raise the currency value through direct intervention is limited as it must have a stockpile of foreign currency available to exchange.

Question 15

What are the goals of instruments of monetary policy?

Answer 15

either creating or reducing banking reserves.

Question 16

How many categories of the monetary tools does the US have?

Answer 16

3 main categories:
1. General Monetary and Credit Controls
2. Other Selective Instruments and Approaches
3. Direct Forex Control and Regulations

Question 17

Describe the first category of monetary tools aka General Monetary and Credit Controls.

Answer 17

1. Open market operations (OMO) including:
   a) outright purchase /sale of gov securities — purchases will increase the money supply resulting in interest rate falling and vice versa for sale of securities
   b) repurchase agreements (repo) or reverse repo:
2. Discount and advances including:
   a) rediscounting of trade bills, banker acceptances and export bills
   b) direct advances—mainly against government securities.
3. Legal reserve requirements including:
   A variation of the minimum statutory reserves that banks must maintain with their respective central banks.

Question 18

Describe the second category of monetary tools aka Other Selective Instruments and Approaches.

Answer 18

1. Moral suasion
   Example: The central bank urging banks to lend only to certain sectors of the economy or to cut down on speculative or ‘non-productive‘ lending.
2. Margin requirement on different categories of loans
   Example: Variation in margin requirements for share financing or initial applications.
3. Regulation and control on credit facilities
   Example: Setting minimum requirements and limits on credit cards, car, property loans, etc.

Question 19

Describe the third category of monetary tools aka Direct Forex Control and Regulations.

Answer 19

involves the introduction of direct controls on foreign investments or lending and imposition of quotas and restrictions on FX purchases or sale transactions.

Question 20

Describe Sterilized FX intervention.

Answer 20

• results in no change in money supply of home & foreign currencies
• need to adopt necessary monetary policies (eg: bonds issuance, direct borrowing) to neutralize the increase/decrease in money supplies
• Eg: if Bank of Japan keeps buying USD against Yen — increase Yen money supply — to ‘sterilize’ this FX intervention, BOJ needs to adopt monetary policies that ‘drain’ the excess Yen — sell Yen treasury bonds simultaneously & in similar value as the sale of Yen in the forex market.
• Yen interest rates will not be affected (as there is no change in the Yen money supply i.e., treasury bonds equal in value to the forex sale).

Question 21

Describe non-sterilized intervention & why is it not normally used.

Answer 21

• result in increase/decrease of money supply which will affect domestic interest rates.
• Eg: if BNM decides to sell MYR to buy foreign currency assets = open market purchase of bonds to increase money supply — depreciate MYR + gain in international reserves — may not be in line with the monetary objectives of the central bank if it believes that current interest rates should be raised slowly to slow economy growth & restrain inflationary pressures.
• The forex intervention to lower domestic currency value will increase money supply & decrease interest rates, which is the opposite of what the central bank wants to achieve.
• Hence, most interventions are sterilized.

Question 22

What the main difference between spot and forward intervention?

Answer 22

Spot intervention provides immediate short-term impact on the FX market usually within two working days while forward intervention affects long-term impact after the spot date.

Question 23

Describe spot FX intervention.

Answer 23

• buy/sell currencies directly in the spot market.
• most direct & immediate effect on the spot exchange rates
• more popular compared to forward FX intervention
• if implemented on an aggressive scale, often fulfil short-term objectives.
• but must be implemented properly to prevent failures given the size of the FX market
• eg: Bank of Japan’s unsuccessful defence of the US Dollar against the Yen at different levels between USD/JPY120.00 to 100.00 during mid-1993. It was not until the Federal Reserve joined in via several rounds of foreign exchange interventions that the USD/JPY moved up from the 100.00 to 106.00 level.

Question 24

Describe forward FX intervention.

Answer 24

• buys/sells one currency against the other in the forward market.
• benefits:
  1. Doesn’t immediately require the FX sale — intervening country won’t lose immediate currency reserves unlike spot interventions — postpone the delivery of the purchase/sale of currencies to a future date.

2. supported by appropriate monetary/fiscal policy measures. As monetary/fiscal policies need time to take effect, it is felt that forward intervention is more appropriate than spot intervention.
3. as the forward market is a smaller/thinner market than the spot market, the same intervention volume will exert a greater impact on the exchange rates than if the intervention is carried out in the spot market.

Question 25

Which section of Financial Services Act 2013 (‘FSA’) & Islamic Financial Services Act 2013 (‘IFSA’) is related to FX activities?

Answer 25

• Section 214 of FSA 2013 & section 225 of IFSA 2013 empower BNM to safeguard the balance of payments position & MYR currency value.
• FSA and IFSA Schedule 14 empower BNM to allow transactions undertaken between (1) residents and non- residents; (2) residents in foreign currency transactions; and (3) non-residents in Ringgit transactions.

Question 26

Which section of Financial Services Act 2013 (‘FSA’) & Islamic Financial Services Act 2013 (‘IFSA’) is related to FX activities?

Answer 26

• Section 214 of FSA 2013 & section 225 of IFSA 2013 empower BNM to safeguard the balance of payments position & MYR currency value.
• FSA and IFSA Schedule 14 empower BNM to allow transactions undertaken between (1) residents and non- residents; (2) residents in foreign currency transactions; and (3) non-residents in Ringgit transactions.