Chapter

X Foreign Exchange Intervention Practices: Selected Cases

Author(s):
Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
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This section chronicles the foreign exchange market intervention practices of selected inflation-targeting emerging economies and emerging economies with other anchors. The first subsection offers detailed case studies of the foreign exchange market intervention practices of nine countries chosen to represent the analytical country groupings:

  • Inflation-targeting emerging economies—Brazil, Chile, Colombia, Turkey;

  • emerging economies with other anchors—Azerbaijan, Romania, Serbia;

  • inflation-targeting advanced economies—New Zealand, Sweden.

This selection was based also on their experiences with the role of the exchange rate in the monetary and exchange rate policy framework. The case studies focus on the most relevant foreign exchange intervention episodes in recent years and thus are not meant to provide up-to-date descriptions.

The second subsection comprises summary tables of the intervention practices and foreign exchange markets of all the inflation-targeting emerging economies and emerging economies with other anchors, as well as six of the inflation-targeting advanced economies. The tables are for the most part based on information available as of mid-2007.

Azerbaijan

Azerbaijan is transitioning from a monetary policy framework anchored on the exchange rate to an inflation-targeting strategy. Nevertheless, the policy framework remains strongly focused on the exchange rate, implying that foreign exchange interventions are frequent. The heavy management of the exchange rate is also a result of the lack of financial market development, in particular a shallow foreign exchange market. The focus on exchange rate stability is negatively affecting the incentive to develop foreign exchange hedging instruments; at the same time, the lack of foreign exchange market development, in particular the absence of foreign exchange hedging instruments, is complicating the transition toward a more flexible exchange rate, because interventions become an important “market management” tool.

Foreign Exchange Market Development

The foreign exchange market consists mainly of spot market operations, and the interbank money market is thin. The foreign exchange market is largely U.S. dollar based, and most transactions take place in the spot market. The foreign exchange swap market is less developed; it is mostly bank-customer oriented, with only a limited number of interbank transactions. Moreover, foreign exchange swaps are typically built up through the interbank deposit market (by entering into a deposit-and-lending transaction in local and foreign currency), owing to the absence of an active interbank market for forward/swap transactions.

Market concentration is high, and imbalances in foreign exchange market flows lead to active participation by the central bank. Two large players have emerged as the dominant forces in supplying the bulk of foreign exchange: the oil company, SOCAR, and its transfers to the budget; and the oil fund, SOFAZ. The International Bank of Azerbaijan (IBA) is the dominant player in the wholesale market, because the IBA is SOCAR’s exclusive bank and thus the main transmitter to the interbank market of the considerable oil-related foreign exchange inflows.

Trading is supported by a developed electronic trading infrastructure with transparent reporting of daily market turnover. The foreign exchange market is organized around the Baku Interbank Currency Exchange (BICEX) and the over-the-counter interbank market. BICEX runs the electronic matching system (BEST), where banks’ buy and sell orders are matched in two daily trading sessions.

Institutional Framework

Azerbaijan implements an eclectic monetary framework, including a de facto conventional fixed peg arrangement.95 The National Bank of Azerbaijan (ANB) intends to allow greater exchange rate flexibility, with the objective of moving to full-fledged inflation targeting over the medium term. In its monetary policy statement for 2007, the ANB affirms that it “will apply a money-currency policy directed to hold basis inflation at the one-digit level and to defend financial stability for 2007.” Central bank autonomy is limited both with respect to policy and instrument independence.

The ANB publishes information about intervention amounts, but there is limited overall transparency regarding the framework for foreign exchange interventions. Other than referring to the need to regulate supply and demand, the ANB reveals little about the role of foreign exchange interventions in the monetary policy framework, how these interact with the overall policy regime, and the modalities for their implementation. The fact that intervention activity has taken place, together with the accumulated intervention amount, is recorded in regular reports on monetary policy.

Objectives and Modalities of Foreign Exchange Intervention

Foreign exchange interventions aim to stabilize demand-supply pressures and to maintain economic competitiveness.96 The 2007 monetary policy statement notes that the ANB will “apply active sterilization strategy in the currency market to neutralize the negative effect that may occur with the exchange rate of Azerbaijan and foreign strategic trade conditions of the country.” The ANB intervenes frequently by supplying domestic currency to manage the exchange rate impact of the high amount of oil-related foreign exchange inflows, which has put upward pressure on the domestic currency.

An intervention framework to fully support a transition toward inflation targeting has not yet been developed. Interventions are not based on clear and transparent rules for their role and implementation. Instead, the strong focus on exchange rate stability, coupled with a lack of foreign exchange market development, seems to trigger an ad hoc intervention style. Interventions are mainly determined by end-of-day clearing operations to manage imbalances in demand and supply, rather than by a focus on price stability over the medium to long term.

The ANB conducts spot interventions through an electronic matching system. The ANB frequently intervenes through the electronic trading system to manage end-of-day imbalances between supply and demand. Because of the high amount of foreign exchange inflows, interbank market trading typically results in a shortage of domestic currency, which the ANB supplies by purchasing the necessary foreign exchange. Transactions are conducted for spot value and with the relevant counterparty forming the interbank market in the electronic trading system.

Interaction between Foreign Exchange Intervention and the Policy Regime

Exchange rate management plays a prominent role in the overall monetary policy strategy. Although the de facto pegged exchange rate implies that foreign exchange interventions play a more central role than in an inflation-targeting framework, the strong focus on the exchange rate presents challenges for monetary policy management. This is illustrated in the IMF 2007 Article IV report (IMF, 2007a), which notes, “If fiscal restraint is not considered in 2007, it is all the more important to tighten monetary policy to facilitate the real exchange rate adjustment through nominal appreciation rather than through higher inflation.”

Concerns about financial system stability and competitiveness are obstacles in the transition to greater exchange rate flexibility (IMF, 2007a). Despite improved prudential regulations, vulnerabilities in the banking sector create concerns about the impact of greater exchange rate variability. Further, concerns about the impact on competitiveness from an appreciating exchange rate seem to have spurred foreign exchange interventions. At the same time, active management of the exchange rate presents challenges for further development of the foreign exchange market, because this creates a disincentive for the development of risk-management instruments.

The balance between greater exchange rate flexibility and inflation-targeting objectives is being challenged by the shallow foreign exchange market. Greater orientation toward inflation objectives implies a gradual reduction of the prominent role of the exchange rate in monetary policy. At the same time, the lack of instruments for managing exchange rate risk leaves foreign exchange market participants and the market structure vulnerable to greater exchange rate movements. Furthermore, the concentrated market structure implies that a few market participants control the bulk of foreign exchange market transactions, which complicates further market development, because this makes them dominant in the overall foreign exchange distribution process and results in a thin market structure that is prone to greater volatility. In the absence of risk-management instruments, this is hard to accommodate.

Consequences of Foreign Exchange Intervention

The bilateral exchange rate against the U.S. dollar remained stable despite the formal exit from the pegged exchange rate regime in early 2006. The rise in foreign exchange reserves, negligible exchange rate volatility, and limited day-to-day variability in the exchange rate suggest that the high degree of exchange rate stability reflects primarily the dominant role of the ANB in the foreign exchange market. The relatively underdeveloped foreign exchange market structure, with large oil-related foreign exchange inflows, little ability for foreign exchange hedging, and high market concentration, creates a market structure in which undue pressures could potentially emerge.

Brazil

The monetary policy framework is founded on an inflation-targeting regime, but foreign exchange market interventions are more frequent than normally prescribed in an independently floating regime. Interventions are not clearly set out in the inflation-targeting framework, reducing transparency about their role. The foreign exchange market is well developed, with ample instruments for economic agents to manage excess volatility. Nonetheless, central bank activity is heavily focused on managing excess volatility. Combined with the goal of accumulating international reserves, central bank participation in the foreign exchange market is frequent.

Foreign Exchange Market Development

The foreign exchange market in Brazil is well developed, with particularly heavy activity in foreign exchange derivatives. Spot and forward foreign exchange can be carried out only onshore, and is characterized as liquid by market participants active in this market. The 2007 Bank for International Settlements (BIS) Triennial Survey on foreign exchange reported an average daily turnover of US$5 billion, which is an increase from US$3 billion in the 2004 survey. In the offshore market, the real trades only on a nondeliverable basis. The nondeliverable forward market is available up to two years out, but liquidity is reported to be highest in maturities up to one year. Nondeliverable options are available in the offshore market, where exotic options are also primarily traded. Plain vanilla options are traded both on- and off-shore. Price discovery is reportedly highest in the foreign exchange swap and futures market, which might explain why the central bank intervenes primarily through the derivatives market (see HSBC, 2008).

Institutional Framework for Foreign Exchange Interventions

The Central Bank of Brazil (BCB) has set as its primary objective promoting the stability of the purchasing power of the currency and the soundness of the financial system. Since June 1999, monetary policy has been based on a formal inflation-targeting regime with an independently floating exchange rate (established in Decree 3.088 of 1999). The National Monetary Council (CMN), which is the government’s economic decision-making body, is responsible for deciding general monetary policy, including setting the inflation target as well as foreign exchange and credit policies.97 The monetary policy committee of the BCB is responsible for setting short-term interest rates in line with the inflation target defined by the CMN.

The exchange rate regime is formulated as independently floating, but the central bank reserves the right to intervene in periods of excess volatility. The role of the exchange rate is not explicitly described in the inflation targeting framework. However, the central bank has stated that it retains the right to intervene to manage excess volatility. In addition, it conducts a program of accumulating international reserves.

Objectives and Modalities of Foreign Exchange Intervention

The exchange rate regime is independently floating, but interventions are conducted more frequently than in the typical regime. Intervention objectives include managing the level of foreign exchange reserves and excess exchange rate volatility. In achieving these two objectives, the BCB is an active participant in the foreign exchange market, with interventions taking place weekly or more.

The BCB uses a combination of direct purchases, auctions, and issuance of foreign-exchange-linked debt denominated in domestic currency when operating in the foreign exchange market. The use of foreign-exchange-linked debt denominated in domestic currency dates to the mid-1990s, when it was used to safeguard the administered foreign exchange regime. It was also used to smooth the transition to the floating regime in 1999. The introduction of these instruments was based in particular on the need for the public sector to provide a foreign exchange hedge. The BCB is a consistent seller of debt-related dollar-linked “reverse swaps,” with the purpose of reducing the exposure that the central bank and the government have to dollar-linked debt. At the same time, however, the BCB is accumulating reserves through direct purchases in the market.

Interaction between Foreign Exchange Intervention and the Policy Regime

Foreign exchange interventions appear to be driven by exchange rate management considerations rather than the inflation target. The BCB actively participates in the foreign exchange market both through reverse swaps and direct purchases to accumulate reserves. The primary purpose of its activities seems to be to reduce the exposure to dollar-linked debt, emanating from the historical issuance of such debt, and reserves/exchange rate management. The high-frequency foreign exchange activity is unusual in a typical inflation-targeting economy.

Consequences of Foreign Exchange Intervention

Daily nominal exchange rate volatility and exchange rate developments indicate a closely managed exchange rate. The frequent participation to reverse the exposure to dollar-linked debt and to accumulate reserves appears to have a dampening impact on exchange rate movements. This is consistent with the BCB’s expressed intent to manage excess volatility. The well-developed and liquid market for hedging instruments suggests, however, that market participants are well placed to manage exchange rate volatility more independently. As such, interventions to manage excess volatility do not seem to be driven by the lack of market development.

Chile

Chile made the transition to an inflation-targeting floating exchange rate regime in 1999. Since then, foreign exchange interventions have been a rare event. The Central Bank of Chile (CBC) enjoys policy and instrument autonomy, reporting regularly to the president and the parliament to ensure accountability. Chile differs from other countries with respect to the high degree of transparency surrounding its intervention framework. Working through the information and signaling channel, it announces its preparedness to intervene and follows up with actual transactions to ensure the credibility of its announcements. The clear rules for the role of intervention and its high transparency are referred to as the very pillars safeguarding them from being overused as a tool. Chile is also unusual in an international context—although not from a Latin American perspective—in that it may issue foreign-currency-denominated debt as a tool for foreign exchange intervention.

Foreign Exchange Market Development

The foreign exchange market offers a developed market for hedging through foreign exchange forwards. The floating of the Chilean peso in 1999 contributed to the development of a derivatives market, which is seen as an important factor in having strengthened the flexible exchange rate regime, because market participants can use hedging instruments to protect against exchange rate volatility. The 2007 BIS Triennial Survey reported that activity in overall foreign exchange market turnover increased from a daily average of US$2 billion in 2004 to US$4 billion in 2007. Measured in GDP, annual foreign exchange market turnover is significantly higher than in other economies in the region and at comparable levels to actively traded emerging economies such as South Africa. The Chilean peso is actively traded in the onshore spot and forward markets but trades on a nondeliverable basis in the offshore market. The onshore forward market is available only to residents, but there is also an offshore nondeliverable forward market that offers hedging up to three years’ maturity (HSBC, 2008).

Institutional Framework for Foreign Exchange Interventions

Chile has an inflation-targeting framework with an independently floating exchange rate regime. The exchange rate was allowed to float freely in September 1999 to enhance the credibility of the inflation target. The Basic Constitutional Law sets out as the main objective of the CBC “safeguarding the stability of the currency and the normal functioning of the internal and external payment systems.” The CBC interprets the “stability of the currency” as maintaining price stability, which it defines as maintaining an average annual inflation rate around 3 percent, with a tolerance range of ±1 percent. The CBC has full autonomy in policy decisions to meet its objectives and reports to the president of Chile and the Senate.

Foreign exchange interventions are characterized by a high degree of transparency. Chile is exceptional in that it communicates its interventions and modalities in advance, as well as at the beginning and the end of the intervention period. The daily intervention amount is the only variable that is not communicated in advance, although this is published with a two-week lag. The unusually high degree of transparency is associated with the authorities’ intention to work through the information channel when intervening. Specifically, the aim is to signal that it considers a development related to the exchange rate to be unjustified on the basis of fundamentals. Because the purpose of foreign exchange interventions is to provide liquidity and stabilize markets, transparency is also deemed necessary so as not to create, or add to, volatility.

Objectives and Modalities of Foreign Exchange Intervention

The inflation-targeting framework enables the central bank to intervene under exceptional circumstances, but in practice interventions are rare. Intervention can take place in response to excessive depreciation or appreciation of the Chilean peso that may have a negative impact on economic developments. Consistent with the inflation-targeting regime, interventions are not pursued to defend a certain level of the exchange rate; rather they aim to avoid excessive depreciation or appreciation of the exchange rate. Motivated by volatility in international financial markets and excessive depreciation of the Chilean peso to levels regarded as misaligned with fundamentals, the central bank intervened in 2001 and 2002, with a view to providing liquidity and foreign currency coverage. In Chile, the credibility and effectiveness of foreign exchange interventions are attributable to the fact that these interventions are rare and carried out only in extreme circumstances. The CBC argues that the principles of clear rules and transparency help ensure that this intervention is used only on occasion as a policy tool (Gregorio and Tokman, 2005).

Chile intervenes in the foreign exchange market through a combination of spot foreign exchange interventions and issuance of dollar denominated central bank bills. The intervention framework states that in addition to intervening through foreign exchange operations, the CBC may intervene by providing hedging instruments. In 2002, the central bank used dollar-denominated debt as its sole instrument to influence the exchange rate. The principle behind these interventions was to meet the private sector’s desire to hedge foreign exchange risk in an environment of Chilean peso depreciation pressure. Not only was this consistent with the aim of providing foreign currency coverage, it also made it possible to intervene without using foreign exchange reserves. The active use of currency-denominated debt instruments for intervention purposes is more common in Latin America than elsewhere. In addition to Chile, Brazil, Mexico, and Peru make use of such transactions as an intervention instrument (Archer, 2005).

Interaction between Foreign Exchange Intervention and the Policy Regime

The authorities turn to foreign exchange interventions when the domestic economic environment does not warrant a change in interest rates. In 2001 and 2002 the Chilean peso experienced a rapid depreciation in response to the Argentine financial market turmoil in 2001 and a capital account reversal in Brazil in 2002. Because domestic economic fundamentals did not show signs of deterioration, worsening financial market conditions in Chile were seen as a direct result of contagion from across the region. Domestic inflation and growth developments did not warrant an interest rate increase to safeguard the inflation target, in particular in 2001, when deflation pressures and the positive output gap suggested downward-moving interest rates. In this case, interventions were regarded as a first line of defense to protect against inflation pressures from excessive and prolonged exchange rate depreciation (Gregorio and Tokman, 2005).

Consequences of Foreign Exchange Intervention

Foreign exchange intervention appears to have succeeded in bringing stability to foreign exchange markets. Exchange rate developments stabilized during the two intervention periods in 2001 and 2002, suggesting that the intervention strategy of the central bank made a successful impact on financial market conditions. The intervention strategy included announcements about the interventions, and proof of the commitment to follow up was the direct intervention that followed. The credibility of intervention announcements is viewed by the authorities as critically linked with the commitment to follow up with actual intervention. Research by Tapia and Tok-man (2004) suggests that, in addition to the actual interventions, exchange rate developments were also affected by public announcements.

Colombia

The Central Bank of Colombia (CBC) operates under an inflation-targeting regime but also pays close attention to exchange rate developments. Under the law, exchange rate policy is determined by the CBC, but according to the objectives set by Congress. Intervention objectives and rules are transparent and stress the importance of consistency with monetary policy.

Foreign Exchange Market Development

The spot foreign exchange market is relatively liquid, and foreign exchange hedging instruments have grown significantly in recent years. The 2007 BIS Triennial Survey reports an average daily turnover of US$2 billion (spot, outright forward, and swap transactions), which is an increase from US$1 billion in the 2004 survey. Offshore, the Colombian peso trades strictly on a nondeliverable basis. The market consists of on- and off-shore forward markets, nondeliverable forwards, foreign-exchange-linked notes with maturities ranging from one month to two years, foreign exchange options, and cross-currency swaps. Despite significant growth in the past few years, Colombia’s derivatives market is still not fully developed by international standards. An IMF paper (IMF, 2004) noted that Colombia’s forward market is still considerably smaller when measured as a percentage of GDP or total trade than those of other economies in the region that have a flexible exchange rate system.

Institutional Framework

The central bank has a constitutional mandate to reach and maintain low and stable inflation and achieve long-term GDP growth. The CBC is responsible for setting the quantitative inflation target. The inflation target range for 2008 was 3.5–4.5 percent, and the long-term inflation target range is 2–4 percent. The bank law stipulates that the CBC must present a report to Congress twice a year on economic developments and monetary and exchange rate policy.

Monetary policy is implemented with a managed floating exchange rate regime. The CBC law assigns the CBC the task of formulating exchange rate policy within the framework of the criteria and objectives laid down by Congress, with the aim of regulating foreign trade and the international exchange rate regime. To manage the effects of the external situation on monetary conditions, the CBC states that one of its functions is to “organize and regulate the foreign exchange market and intervene with the purpose of defending the exchange rate, in order to regulate the conditions of the country’s borrowing abroad.” The CBC also administers the country’s foreign exchange reserves as part of its responsibility for foreign exchange interventions.

Objectives and Modalities of Foreign Exchange Intervention

The implementation of the managed floating regime is guided by stability objectives. The intervention rules set the following objectives: (1) an adequate level of international reserves to protect the economy from external shocks, in both the current and the capital accounts, (2) control of excess volatility of the exchange rate in the short term, and (3) control of excessive appreciation or depreciation of the nominal exchange rate, which could jeopardize the achievement of future inflation targets and the economy’s external stability.

Colombia makes use of both cash and derivative instruments for foreign exchange interventions. Options play an important role in the intervention framework. To limit excessive volatility, there is an automatic auction of options that gives the holder the right to sell or buy foreign exchange to or from the central bank every time the nominal exchange rate deviates by an average of 2 percent over the preceding 20 working days. Further, the CBC, at its discretion, can call for a new option auction if (1) the options issued in the previous auction have not expired (regardless of whether the previous options have been exercised), and (2) the exchange rate moves more than 2 percent above the 20-day moving average. In practice, the automatic interventions to limit volatility have been quite small. Discretionary option auctions may also be initiated to buy or sell foreign exchange for the purpose of accumulating or reducing foreign exchange reserves. In addition, the central bank may conduct spot operations directly in the foreign exchange market. Currently, the CBC is targeting an increase in reserves implemented through previously announced monthly options auctions.

Interaction between Foreign Exchange Intervention and the Policy Regime

When conducting foreign exchange interventions, the central bank aims for consistency with the direction of monetary policy. A set of intervention criteria have been established to ensure that interventions are consistent with the inflation-targeting framework. Specifically, the purchase of foreign exchange does not occur when the policy rate is being raised, and the sale of foreign exchange does not take place when the policy rate is being lowered. On the contrary, if projected inflation is below target, the central bank considers the purchase of foreign exchange to reduce the appreciation of the domestic currency to be consistent with the inflation-targeting framework. During 2004–06, the CBC applied these principles when it intervened actively to counter domestic currency appreciation. In early 2007, it appears these criteria were not applied; a high level of sterilized discretionary intervention occurred in the face of rising inflation and interest rates. Since mid-2007, however, the CBC has refrained from this form of intervention and has focused on the inflation objective (Kamil, 2008).

The foreign exchange intervention framework is transparent. The central bank argues that a high degree of transparency in foreign exchange intervention is necessary to be consistent with the inflation-targeting framework. This is clearly the case for the automatic intervention to limit volatility. Moreover, the CBC has stated that it will refrain from discretionary interventions (which has been the case since mid-2007) and is currently using previously announced interventions to accumulate reserves.

Consistency with monetary policy is ensured primarily by sterilizing the impact of foreign exchange operations. Because of the automatic characteristics of the options program, the direction of foreign exchange intervention may not always be consistent with the cycle of the policy rate. On such occasions, the central bank compensates the liquidity impact of the foreign exchange intervention in its monetary operations. This suggests that, even though as a rule the CBC views consistency in terms of the direction of sales and purchases of foreign exchange and interest rate moves, it concludes that consistency is ultimately ensured through monetary sterilization.

The management of intervention indicates that it is currently designed to influence the exchange rate while maintaining consistency with the monetary policy stance. Intervention objectives and rules stress the importance of consistency with the monetary policy objective of low and stable inflation, and the high degree of transparency makes intervention and its aims highly visible.

Consequences of Foreign Exchange Intervention and Sources of Exchange Rate Vulnerability

The effectiveness of intervention appears to have been mixed. Inflation targeting does not make it easy to identify whether automatic intervention has been effective. Automatic intervention has been limited, and the Colombian peso has been very volatile. Kamil (2008) concludes that discretionary intervention has not always worked, even on a large scale. The results indicate that exchange rate intervention was effective during 2004–06, during a period of monetary easing. In contrast, intervention was less effective in reversing or slowing down domestic currency appreciation during 2007, as large-scale intervention became incompatible with meeting the inflation target in an overheating economy.

New Zealand

New Zealand adheres to inflation targeting in a floating-exchange-rate environment with rare foreign exchange interventions. Foreign exchange interventions take place in accordance with the principles of the Policy Targets Agreement (PTA), and the Reserve Bank of New Zealand (RBNZ) has the operational independence to decide when and whether to intervene. The parameters according to which intervention decisions are made are transparent, which helps ensure accountability. Interventions are not used as a signaling tool for future monetary policy direction; rather, they are a tool to signal exchange rate misalignment and manage the extremes of the exchange rate cycle. The authorities recently introduced changes to the intervention process, including allowing the RBNZ to hold foreign exchange reserves on a partly unhedged basis.

Foreign Exchange Market Development

The foreign exchange market in New Zealand is well developed. The spot and over-the-counter derivative instruments are similar in structure to the global foreign exchange market. According to the 2007 BIS Triennial Survey, average daily turnover in New Zealand rose from about US$4 billion to US$12 billion between 2001 and 2007. Although activity and liquidity are regarded as high, average daily turnover is small in comparison with countries such as Australia (US$170 billion), Canada (US$60 billion), Norway (US$32 billion), and Sweden (US$42 billion). Foreign exchange derivatives turnover (cross-currency swaps and foreign exchange options) increased by 330 percent compared with the turnover reported in the 2004 RBNZ survey. Foreign exchange swaps made up about 74 percent of total foreign exchange turnover in 2007, which is comparable with the global foreign exchange market, where foreign exchange swaps constitute the major share of foreign exchange market trading. Trading in foreign exchange forwards was largely unchanged at 6 percent of total turnover.

Institutional Framework for Foreign Exchange Interventions

New Zealand pursues an inflation-targeting strategy with an independently floating exchange rate regime. Price stability as a monetary policy objective was introduced in 1989 and strengthened further when legislation went into effect in 1998, making the achievement and maintenance of price stability the single focus of monetary policy. The legislation also gave the RBNZ operational independence to achieve its primary objective. The RBNZ Act of 1989 gives the RBNZ the authority to intervene in the foreign exchange market, requires it to hold foreign exchange reserves to meet its capacity to intervene, and provides it with operational independence to decide on foreign exchange interventions. The inflation target is formulated and approved by the minister of finance and the governor of the RBNZ and is stated in the PTA 98

The PTA includes a provision that, while implementing monetary policy, the RBNZ shall “seek to avoid unnecessary instability in output, interest rates and the exchange rate.” Although interventions are not a frequent tool in New Zealand, this provision enables the RBNZ to include foreign exchange interventions as a tool within the inflation-targeting strategy. The provision was introduced in the 1999 PTA on the initiative of the government, with the explanation that it reflects a “concern not to repeat the experience of the mid-1990s, when the export sector was placed under immense pressure by a sharp increase in the value of the dollar.”

Foreign exchange market intervention policy is further detailed in a letter sent from the governor of the RBNZ to the minister of finance in March 2004.99 The letter states that “Foreign exchange intervention under section 16 of the [RBNZ] Act is for the purpose of influencing the level of the exchange rate to reduce exchange rate variability when the exchange rate is exceptionally and unjustifiably high or low” and “when, in the Bank’s assessment, that level is clearly unjustified by economic fundamentals.”

The objectives and mechanics of intervention are transparent, but the RBNZ regards intervention as an ongoing process and does not comment on specific activities. The financial accounts provide information about specific intervention activities on a monthly basis, announced with a one-month lag. At the time of its most recent intervention in June 2007, the RBNZ published a press release confirming that it had intervened in the foreign exchange market.

Objectives and Modalities of Foreign Exchange Intervention

Foreign exchange intervention is rare, but the capacity of the RBNZ to intervene was broadened in July 2007. Intervention that aims at reducing the cyclical variability in the exchange rate is included as an additional intervention objective.100 Including the new approach, foreign exchange intervention may occur in the following three cases: (1) for the purpose of influencing the level of the exchange rate to reduce volatility when the exchange rate is exceptionally high or low, (2) to restore liquidity in a period of foreign exchange market dysfunction, or (3) to reduce extreme highs and lows in the exchange rate when these are well above economic fundamentals.

The broader intervention objective is combined with a strategy of moving from fully hedged to partly unhedged foreign exchange reserves.101 Contrary to the previous practice of fully hedging foreign exchange reserves with foreign currency liabilities, reserves are now held on a partly unhedged basis; that is, a portion of reserves are funded with liabilities in New Zealand dollars. This provides more flexibility in managing the “growth and maintenance of the intervention capacity,” because foreign exchange intervention is no longer restricted by the need to finance it with foreign exchange liabilities. The need for increased flexibility in using foreign exchange reserves suggests a move toward a more active intervention policy than in the past.

Under the new approach, intervention modalities include using the balance sheet position to send indirect signals about the appropriateness of the exchange rate level. This involves the actual sale or purchase of foreign exchange in the spot foreign exchange market for the purpose of creating an open foreign exchange position. Strictly speaking, this is a foreign exchange intervention, but it is not the foreign exchange transactions themselves but the open foreign exchange position that is the intended signal. By showing its willingness to assume foreign exchange exposure, the RBNZ seeks to influence the attitude of private sector investors, possibly triggering a reassessment of their exposure in the desired direction.102, 103

Interaction between Foreign Exchange Intervention and the Policy Regime

Decision-making parameters dictate that foreign exchange intervention must “always” be consistent with the PTA. Consistency with inflation targeting suggests that foreign exchange intervention should be supportive of the direction of monetary policy in order not to contradict the primary objective of price stability. Intervention purchases of New Zealand dollars in an interest rate tightening cycle would typically support the direction of monetary policy. Such a strategy would be consistent with the generally accepted view that intervention in the opposite direction of monetary policy may send conflicting signals, which could reduce the effectiveness of the intervention.

Intervention in June 2007 aimed at depreciating the New Zealand dollar was executed in an environment of rising policy interest rates. When intervening to sell New Zealand dollars, the RBNZ referred to exchange rate developments as exceptional and unjustified in terms of economic fundamentals, declaring that the action did not “prejudge the future direction of monetary policy.”104 Rather than signaling the future stance of monetary policy, further clarifications reveal that intervention serves the purpose of signaling that the exchange rate is misaligned with fundamentals, moderating trends in the exchange rate, and rebalancing monetary policy pressures (Spencer, 2007).

Intervention is supportive of medium- to long-term external stability objectives. In addition to the primary objective of inflation targeting, the PTA requires monetary policy to prevent unnecessary instability in the exchange rate. Concerns about exchange rate stability are especially germane to New Zealand, because it is a small and open economy. In this particular case, instability in the exchange rate could potentially emerge as a result of the New Zealand dollar’s association with carry trading, which allows investors to take advantage of the positive interest rate spread by entering into long positions in New Zealand dollars financed by borrowing in low-interest-rate currencies such as the Japanese yen. Because the strong appreciation of the New Zealand dollar is believed to be attributable largely to these types of capital inflows, intervention to signal exchange rate misalignment could be viewed as consistent with management of potential future vulnerabilities associated with sudden stops in capital inflows.

Consequences of Foreign Exchange Intervention

Intervention purchases of foreign currency in June 2007 resulted in an open position on the RBNZ balance sheet.105 More recent intervention resulted in a net long exposure to foreign currencies of just over $NZ 2.2 billion in July 2007. Consistent with its recent announcement regarding reserves management procedures, the RBNZ is now using a combination of direct foreign exchange intervention and its balance sheet position to signal an overvaluation of the New Zealand dollar.

The intervention purchases of foreign currency in June 2007 did not immediately halt the appreciation pressure on the New Zealand dollar. Market impact may have been complicated by the prevailing interest rate tightening cycle, in which expectations for further rate increases were strong and later materialized, when the RBNZ hiked rates further in July. The experience of New Zealand points to the difficulties in conducting effective foreign exchange intervention when these are not consistent with the direction of monetary policy, in particular in an environment where the appreciation pressure on the New Zealand dollar is, among other things, a result of investors taking advantage of the significantly positive interest rate differential (carry trading).

Nevertheless, the New Zealand dollar later depreciated when carry trades were unwound in response to a general decline in global investor risk appetite in the summer of 2007. Because the attractiveness of carry trades is based on a low-volatility environment, the increase in foreign exchange market volatility in association with the crisis in the U.S. subprime mortgage market led to a strong reversal in carry trade positions and a subsequent correction in the currencies associated with these trades. These events provided a supportive environment for New Zealand dollar depreciation, illustrating the important contribution of overall financial market sentiment to the success of intervention.

Romania106

Romania has adopted inflation targeting with a managed floating exchange rate regime, but implementation of interest rate and foreign exchange policy seems to be influenced by the exchange rate. The exchange rate’s influential role can be attributed to concern about the possible impact of external imbalances on foreign investor sentiment—that is, the risk of sudden stops. Although the foreign exchange market is still in the early stages of development, activity has increased significantly since 2004.

Foreign Exchange Market Development

Foreign exchange market activity is typical of the early stages of market development, with most activity concentrated in the spot foreign exchange market. Interbank market activity started to take off in association with increased exchange rate flexibility in 2004, progress in macrostabilization, and a more open economy. In 2004, overall foreign exchange market turnover surpassed GDP for the first time (to just under 109 percent). The 2007 BIS Triennial Survey reports an average daily turnover of US$3 billion. The spot market remains the most liquid market segment, with volume in the forward market increasing but still accounting for only a small portion of overall activity.

Institutional Framework for Foreign Exchange Interventions

The primary objective of the National Bank of Romania (NBR) is to ensure and maintain price stability, in accordance with the central bank law, which also authorizes the NBR to define and implement monetary and exchange rate policy. Without prejudice to the price stability objective, the law establishes that monetary policy should also support the general economic policies of the government, as is the case in the European System of Central Banks.

In August 2005, the NBR introduced an inflation-targeting regime and a managed exchange rate arrangement. The implementation of this regime relies on anchoring inflation expectations around the announced inflation target, which was set at 4 percent for end-2007 and 3.8 percent for end-2008, with an accepted deviation band of ±1 percentage point around the central target. The role of intervention and the rules and procedures for its implementation are not explicit. This may be because foreign exchange intervention has not played an important role in the framework in recent years (there has been no intervention since October 2005). 107 However, although foreign exchange intervention is not frequent, the 2007 IMF Article IV report indicates that the exchange rate plays an important role in setting the policy interest rate (IMF, 2007b).

Objectives and Modalities of Foreign Exchange Intervention

Intervention does not aim at a specific level or range for the exchange rate, but the NBR appears sensitive to the pace of appreciation. Concern about sudden stops is an important focus in exchange rate management. The size of the current account deficit and the emphasis on consumption create concern about excessive short-term appreciation because of the vulnerability to changes in foreign investor sentiment and to a sudden reversal in capital flows (see Box 3 in IMF, 2007b).

Foreign exchange intervention is not highly transparent. More specific modalities of foreign exchange intervention are not disclosed, the publication of explicit intervention data was discontinued in early 2005, and information on possible intervention activity can only be inferred from the publication of changes in foreign reserves.

Interaction between Foreign Exchange Intervention and the Policy Regime

Intervention is rare, but the role of the exchange rate is more prominent than usual in an inflation-targeting regime. Since October 2005, upward pressure on the exchange rate appears to have been managed through changes in the policy interest rate rather than foreign exchange intervention. The 2007 Article IV report (IMF, 2007b) states that “upward exchange rate pressures has prompted it [NBR] to reduce interest rates. On current policies, the end-2007 inflation target will likely be missed, unless sizeable appreciation occurs, and the current account deficit will widen further.” The report also states that reductions in the official policy rate have been interpreted by market participants as a sign that the NBR prefers to “focus on recent appreciation, rather than future inflation.”

Consequences of Foreign Exchange Intervention and Sources of Exchange Rate Vulnerability

Concern about sudden stops in capital inflows might explain the focus on the exchange rate. There is considerable concern that excessive short-tem appreciation could leave the economy vulnerable to changes in financial market sentiment and sudden reversals in capital flows. In particular, this is seen as potentially negative for the pace of disinflation and for the financial sector (IMF, 2007b).

Serbia

During 2007, monetary policy focused on maintaining price stability, defined as a core inflation objective of 4-8 percent by the end of the year. Intervention remained a supporting tool in the monetary framework, and its more prominent role reflects primarily the early stages of market development. As a result, the National Bank of Serbia (NBS) retains the right to intervene for a broad set of purposes, including in the event of excessive daily exchange rate fluctuations, without resisting cumulative longer-term pressure on the exchange rate. Foreign exchange market development will facilitate the move toward inflation targeting. NBS transactions have gradually decreased over the past few years, and the NBS has discontinued daily fixing sessions, allowing the interbank market to function more independently.

Foreign Exchange Market Development

Activity in the interbank spot foreign exchange market increased significantly after 2003, but there is no forward foreign exchange market. Interbank foreign exchange activity reached about €3.2 billion in July 2007, an increase of about €1.4 billion since June 2007. In the first seven months of 2007, the volume of interbank trading stood at nearly €10.9 billion, compared with €5.9 billion for all of 2006. Despite increasing volume in the spot foreign exchange market, foreign exchange forwards remain underdeveloped, mainly because of the lack of a reliable money market curve for pricing forwards. Small-scale forward transactions have been recorded, but these are mainly bank-customer driven, and an active and liquid interbank market has yet to develop.

Institutional Framework

The Law on the National Bank of Serbia states that price stability is the bank’s primary objective. Until the adoption of an inflation-targeting regime, monetary policy is formulated in a separate “Memorandum of the National Bank of Serbia on the Principles of the New Monetary Policy Framework Aiming at Low Inflation Objectives.” For 2008, the core inflation objective was set at 3-6 percent by year-end. The NBS achieves the inflation objective by using the two-week repo interest rate, with foreign exchange instruments playing a supportive role.

Exchange rate flexibility has gradually increased, and the NBS is implementing a managed floating regime with no predetermined path for the exchange rate. Because the interbank market is relatively new, participation of the NBS in the foreign exchange market is higher than under more developed floating exchange rate systems. To this end, the NBS describes its exchange rate regime as a soft managed floating regime in which it retains the right to intervene for a broader set of purposes, reflecting its position as a country in transition (see below).

Objectives and Modalities of Foreign Exchange Intervention

The main objective of the managed exchange rate regime is to ensure a balanced foreign exchange market. Daily fixing sessions were discontinued in early June 2007 and are organized only when the NBS considers that its participation is required in order to stabilize the foreign exchange market. The reduced role of the NBS in bringing together demand and supply has helped increase the interbank market’s role in exchange rate determination and supported the growth of interbank transactions.

The NBS interacts with (nonbank) foreign exchange offices in the foreign exchange market. The NBS on a daily basis sells foreign exchange purchased from licensed foreign exchange dealers to commercial banks. The main purpose of these transactions is to rechannel foreign exchange to the interbank market, and when conducting these transactions, the NBS aims to deal in the prevailing and most favorable interbank exchange rate without affecting the exchange rate.

Foreign exchange intervention practices are shaped by Serbia’s macroeconomic vulnerabilities and still-undeveloped financial markets. The role of the NBS in the foreign exchange market remains important, and intervention objectives are focused on supporting the transition to a full-fledged interbank market. To this end, the NBS has defined three instances for intervention: (1) to limit daily volatility, but without resisting cumulative pressure over the long term; (2) to contain potential threats to financial and price stability (after the potential to influence inflation through changing the key policy rate has been exhausted) or to prevent inflation from dropping below the planned level; and (3) to safeguard an adequate level of international reserves.

Intervention is carried out primarily through fixing sessions, but the NBS also can intervene directly in the interbank market. Only one fixing session was held during the three months after June 2007, suggesting a qualitative reduction in the direct market role of the NBS.

Interaction between Foreign Exchange Intervention and the Policy Regime

The NBS is gradually moving toward a more flexible exchange rate regime, but foreign exchange market intervention remains an important part of the framework. Although the role of the NBS in the interbank market remains larger than that of the central bank in more developed inflation-targeting economies, it is in the process of gradually reducing its market role in light of the increased capacity and functioning of the interbank market. The frequency of intervention, which once played a significant role in moderating volatility in the exchange rate, has decreased significantly since 2006. This is evident from the significant decrease in purchases and sales of foreign exchange in the daily fixing sessions, a development that was further cemented by the discontinuation of daily fixing sessions in June 2007.

Consequences of Foreign Exchange Intervention and Sources of Exchange Rate Vulnerability

Prudential risks and vulnerabilities in the banking system present challenges in moving toward a flexible exchange rate regime. Rapid credit growth and the rising exposure of unhedged borrowers to exchange rate risk constitute the major risks in the planned transition to a flexible exchange rate. Moreover, the IMF staff identified structural characteristics of the economy that pose challenges regarding the choice of exchange rate regime, including high euroization, high exchange rate pass-through, a long history of high inflation, and limited financial intermediation (IMF, 2006a). A relatively high degree of trade openness, a concentrated trade pattern, a synchronized cycle with trade partners, and the prevalence of monetary over real shocks are additional factors.

Sweden

Sweden has pursued inflation targeting with a floating exchange rate regime since 1992, when it discontinued the pegged exchange rate. The central bank (Riksbank) is permitted to make autonomous decisions on the implementation of monetary policy, including foreign exchange intervention. The Riksbank views foreign exchange intervention as a tool to be used sparingly but argues that intervention may be necessary even under an inflation-targeting regime. The intervention framework is highly transparent, as a result of intervention over the years since exiting the peg, and intervention is seen by the Riksbank as working primarily through the signaling channel.

Foreign Exchange Market Development

The foreign exchange market is well developed and able to support active trading and risk management. This well-functioning foreign exchange market means that the central bank should not need to engage in “market management” operations. Central bank foreign exchange operations not related to intervention are carefully planned to achieve a transaction strategy that minimizes market impact. This includes announcing the operational plan in advance, maintaining it independently of market conditions, and limiting such transactions to the opening hour of the markets. The 2007 BIS Triennial Survey shows average daily turnover of US$42 billion, an increase from US$31 billion in 2004.

Institutional Framework

Sweden pursues inflation targeting with an independently floating exchange rate. The Swedish Parliament has provided the Riksbank with a mandate to achieve price stability, which is set forth in the Riksbank Act. The Riksbank’s defined objective is to keep inflation at about 2 percent a year, with a tolerance range of ±1 percent around this target. Policy and instrument independence is contained in the Riksbank Act. The implementation of the exchange rate system and intervention are handled by the Riksbank in accordance with the law, which states that “The Riksbank shall decide on the application of the foreign exchange system decided on by the Government.”

In 2007, the Riksbank published a set of intervention procedures to clarify its procedures regarding preparation for, decisions about, and communications regarding foreign currency intervention. These reflect the Riksbank’s aim to adhere to an intervention framework characterized by openness and clarity and to follow procedures that reflect those of other monetary policy measures. The framework for intervention is specifically designed to be consistent with the policy regime of a floating exchange rate and inflation targeting. At the same time, the rules allows for some flexibility to respond to situations not foreseen by the rules regarding the procedures.108

Objectives and Modalities of Foreign Exchange Intervention

The Riksbank views intervention as working mainly through the signaling channel. Intervention is primarily a means of signaling changes in monetary policy motivated by the goal of achieving price stability. In accordance with its floating exchange rate regime, intervention is not conducted with an exchange rate target in mind, and as long as inflation is in line with the target, foreign exchange intervention is not used to influence the exchange rate. In addition, to maintain flexibility in case of unforeseen events, the Riksbank reserves the right to make use of intervention under exceptional circumstances. Without impairing the primary objective, intervention could, under exceptional circumstances, be carried out in support of the general objectives of economic policy.

Another reason for intervention would be for the purpose of addressing exchange rate misalignments, but the Riksbank recognizes that decisions to intervene in such cases could be problematic. Intervention may, in the long run, support the objectives of the general economic policy, which is the secondary objective of monetary policy—for example, when the exchange rate is seen as significantly misaligned with what is considered to be the equilibrium exchange rate. However, several issues may complicate an intervention decision in this situation. First, the decision to intervene should be based on the possibility of achieving the desired exchange rate effect. Second, it is difficult to determine the equilibrium rate, and third, aiming to achieve a particular exchange rate or stabilize exchange rate developments could conflict with the inflation target.

Nevertheless, the Riksbank is of the view that even inflation-targeting countries need to maintain intervention as a tool in their monetary policy framework. In particular, intervention may be warranted when the interest rate instrument is no longer effective, for example, when deflation precludes negative real interest rates. Intervention could in this situation be used as a measure to achieve more expansionary monetary conditions through a weakening of the exchange rate.

The framework for intervention is highly transparent, but the degree to which detailed information is released is balanced between efficiency and openness. Foreign exchange intervention and monetary policy operations differ because of the different position of the central bank in these two markets. In the money market, the central bank can determine the level of the short-term rate through its position in the daily overnight interbank market. In foreign exchange interventions, the central bank is only one operator among many. This may argue for a different degree of transparency with respect to the readiness to intervene, length of operations, time of decision, and currencies involved. Thus, the Riksbank is transparent about the process for intervention and its role in the monetary policy framework, but reserves the right to keep some information to itself should it be deemed necessary to ensure the efficiency of intervention.

Interaction between Foreign Exchange Intervention and the Policy Regime

To secure a clear link with the overall monetary policy regime, intervention decisions are usually handled like other monetary policy decisions. The release of a public notice of the intention to intervene further contributes to thorough preparation, which strengthens the link to overall monetary policy. Furthermore, minutes of the deliberations on the reason for intervention are released quite a while after the intervention mandate has run out.

Although there have been no interventions under the new framework, the most recent episode prior to the new framework shows close interaction between foreign exchange interventions and the policy regime. The new rules were modeled on the intervention experiences of 2001. At that time, intervention was performed with a view to strengthening the currency. The decision to intervene was made at a time when there was increased risk that inflation would exceed the target, in particular because of continued exchange rate depreciation.

The intervention in June 2001 was followed by a rate increase in July 2001. Intervention to strengthen the currency was in this way a signal of tighter monetary policy to come. The assessment that future inflation prospects were threatened by the weaker exchange rate developments was signaled first with foreign exchange intervention.

Consequences of Foreign Exchange Intervention

The combination of foreign exchange interventions and interest rate hikes was initially successful in causing the exchange rate to appreciate, but the effects did not last long. Events in the global financial markets, in particular the terrorist attacks in the United States, led to a significant interest rate cut in September 2001. At this time, the currency markets reacted with a depreciation of the exchange rate.

Outside events and continued weakening of economic activity make it difficult to assess the effectiveness of the 2001 intervention. The economic slowdown domestically as well as internationally led to a significantly different environment from the one that prevailed at the time of the foreign exchange intervention. In the short term, the consistent monetary policy action would appear to have supported the effectiveness of the foreign exchange intervention.

Turkey

Turkey pursues inflation targeting with a floating exchange rate regime. The exchange rate is independently floating, and the foreign exchange market for Turkish liras is well developed. The central bank has intervened occasionally through discretionary operations while conducting regular foreign exchange auctions to build up official reserves in a gradual and predictable manner. The design of the auctions suggests that there is little interference with the foreign exchange price discovery mechanism.

Foreign Exchange Market Development

The interbank market for Turkish liras (YTL) is well developed, including liquid and deep markets for foreign exchange forwards and options.109 Lira foreign exchange forwards trade on a deliverable basis with unrestricted access for nonresidents in the local market. The options market is deep, and interbank quotes are available for maturities of up to three years. Exchange-traded US$/YTL futures are available from the Turkish Derivatives Exchange (TURKDEX), located in İzmir. Indicative trading volumes and spreads suggest a good degree of liquidity in both the spot and forward markets (HSBC, 2008). According to the 2007 BIS Triennial Survey, daily average turnover stood at US$3 billion in 2007, which was unchanged from the survey in 2004.

Institutional Framework

The Central Bank of Turkey (CBT) law sets forth price stability as the primary objective of monetary policy. The law establishes that the central bank has the power to determine, at its own discretion, the implementation of monetary policy and the use of instruments to achieve price stability. Without damaging price stability, CBT policies shall support the growth and employment policies of the government.

The CBT adopted formal inflation targeting in 2006. This followed a period of implicit inflation targeting with a floating exchange rate regime following the 2001 financial crisis. The inflation target is defined as the end-year rate of inflation based on the annual percentage change of the consumer price index. The target horizon is set for three years. Formerly the medium-term inflation target was set jointly with the government at 4 percent. As a result of supply shocks in 2007–08, the targets were revised to 7.5 percent for 2009, 6.5 percent for 2010, and 5.5 percent for 2011.

The CBT operates an independently floating exchange rate regime. Within this regime, it holds small daily foreign exchange purchase auctions with the purpose of accumulating reserves in a gradual and predictable manner. These are characterized by a high degree of transparency to avoid a price impact. In addition, the CBT maintains the right to intervene through discretionary operations, if necessary to curb volatility.

Objectives and Modalities of Foreign Exchange Intervention

Discretionary intervention may be undertaken to manage excessive volatility. The CBT emphasizes that exchange rate stability is important for price stability. For this purpose, it may enter the foreign exchange market to prevent actual and expected excessive volatility to ensure foreign exchange market stability.

The regular foreign exchange auctions are designed to allow the accumulation of reserves in a way that is consistent with the flexible exchange rate and inflation targeting. The auctions are announced in advance. They are held daily and the volume is kept low so as not to alter foreign exchange demand significantly. Auctions have typically been held in an environment of strong capital inflows, which makes it easier to accumulate reserves without interfering with the market; these auctions have been temporarily suspended when such conditions were not in place.

Interaction between Foreign Exchange Intervention and the Policy Regime

The CBT focuses on the interest rate as the main tool for monetary policy, but may conduct foreign exchange intervention to prevent excessive exchange rate volatility. Since formally adopting inflation targeting in 2006, the CBT has conducted only a limited number of discretionary interventions (four in 2006, and none since then) to curb excessive volatility, suggesting that the exchange rate is not tightly managed compared with other large emerging market countries. Intervention is generally sterilized. The well-developed foreign exchange market may contribute to the ability of the central bank to limit its participation to extraordinary circumstances, because the availability of risk-management instruments helps market participants manage exchange rate volatility in the interbank market.

Consequences of Foreign Exchange Intervention and Sources of Exchange Rate Vulnerability

Discretionary intervention occurred most recently in 2006, when a strong rise in global risk aversion led to a sudden reversal of capital inflows. The sell-off of Turkish assets in May–June 2006 was met with relatively limited foreign exchange intervention, but was combined with significant interest rate hikes. Foreign exchange intervention did not immediately halt a depreciation of the Turkish lira, which experienced high volatility and significant depreciation. Instead, portfolio inflows later resumed in response to the increase in interest rate differentials and an improvement in global risk sentiment (IMF, 2006b).

Economic and political strains exposed Turkey to a sudden shift in market sentiment. The IMF November 2006 staff report (IMF, 2006b) identified that Turkey was particularly vulnerable in an emerging market context because of “comparatively weak fundamentals, unfavorable investor base and positions, and high sensitivity to shifts in global market sentiment.” Inflation targeting uncovered three factors explaining the sudden reversal of capital inflows in 2006: (1) a current account deficit, (2) real currency overvaluation, and (3) past credit growth. Low reserve cover, high public debt, an uncertain inflation outlook, and a high degree of dollarization were other “less favorable fundamentals.” To help preserve market confidence and economic progress, the IMF staff recommended that the authorities implement a disciplined fiscal policy, a tight monetary policy, and effective communication with markets and strive for continued progress on structural reform.

Foreign exchange operations have since been aimed at accumulating foreign exchange reserves in a gradual and predictable manner. After temporary suspension in May 2006, reserve accumulation operations were resumed in November 2006, when capital inflows recommenced. These do not target the exchange rate and are consistent with prudential considerations. In particular, the IMF November 2006 staff report (IMF, 2006b) identified a need to raise the level of international reserves (which were still below 100 percent of short-term debt on a residual maturity basis) to reduce vulnerability. Furthermore, the accumulation of reserves is achieved through auctions in which the CBT does not directly influence the exchange rate, implying that operational features are consistent with a floating exchange rate regime. Still, reserve accumulation operations may have marginally contributed to slowing the trend toward appreciation.

The 2007 issue of the IMF’s Annual Report on Exchange Arrangements and Exchange Restriction notes that the de facto regime is different from the de jure regime. In March 2008, the ANB reportedly adopted the two-currency basket (U.S. dollar and euro) under the pegged arrangement.

The IMF 2007 Article IV report notes that “[…] in line with the Fund’s advice, the authorities exited the fixed peg in early 2006, but they did not allow the exchange rate to appreciate sufficiently to contain inflation due to concerns regarding financial system stability and competitiveness.”

The CMN comprises the minister of finance (chair), the minister of planning and budget, and the BCB governor.

Section 12 of the Reserve Bank Act gives government the power to override the PTA. Inflation targeting can do so by directing the RBNZ to use monetary policy for a different economic objective altogether for a 12-month period. Such an instruction by the government must be made public. (The override section has so far never been used.)

See www.rbnz.govt.nz/finmarkets/foreignreserves/interven-tion/0148214.html. Foreign exchange intervention under section 17 of the RBNZ Act, for the purpose of restoring liquidity in a period of foreign exchange market dysfunction, is treated separately in a standing directive from the minister of finance.

See the RBNZ press release on “Reserve Bank announces changes to FX management,” July 13, 2007.

Foreign exchange reserves were fully financed by borrowing the required foreign currency from the New Zealand Debt Management Office, as opposed to using the RBNZ’s own pool of liabilities to fund reserves.

Movement away from the benchmark position, which is the fully hedged position, thus constitutes the key signal in the new intervention approach. By increasing the level of unhedged foreign reserves when the exchange rate is at the high end of the exchange rate cycle, the RBNZ sends a signal that the New Zealand dollar is overvalued compared with its long-run fundamental value. Reducing the level of unhedged reserves signals that the New Zealand dollar is undervalued with respect to the long-run fundamental value.

The new approach to reserves management and foreign exchange intervention has much in common with that used by the Reserve Bank of Australia.

Indeed, the RBNZ followed the intervention sales of New Zealand dollars with an interest rate hike on July 26, 2007.

Prior to this, net open foreign currency positions were relatively small and related to interest income on foreign reserves.

This case study draws on information in IMF Country Reports (2007b and 2007c).

Statement by Age Bakker, IMF Executive Director for Romania, and Lucian Croitoru, senior adviser to the executive director, May 23, 2007.

Should a situation arise that is not foreseen by the procedures, the rules allows the Riksbank to take measures it deems appropriate to fulfill its objectives.

As assessed by investment banks active in the Turkish lira market.

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