the devaluation did achieve was to ignite a strong recovery in the economy and an improvement in the current account. From 1993 to 1997 a deficit of £10.6bn was transformed to a surplus of £6.6bn. More importantly, inflation did not erupt as the world economy was experiencing deflationary pressures. In 1996 sterling was again on the rise backed by high interest rates, relatively strong economic growth and subdued inflation.
2000s
The early years of 2000 were similarly characterised, although sterling found additional support from the rapid growth in financial services, which the UK dominated with the US, and the diversification of foreign exchange reserves by the world’s central bank from dollars.
During this period the UK ran deficits on the current account but these were no longer an explicit policy constraint as they were viewed as self-correcting in the long run and in a period of global monetary expansion foreign investors were prepared to finance it. This all came to a sorry end in 2008 when the global financial system, in particular in the UK, imploded. The markets reverted to risk aversion with massive flows into safe-haven assets such as US Treasuries and out of deficit currencies and emerging market equities (risk assets). Sterling capitulated as huge borrowings in low interest currencies, notably the yen and Swiss franc (CHF) (carry trades), were unwound and investors sold sterling as more bank losses and failures were revealed.
Endnotes
1 C. Fred Bergsten, Director of the P G Peterson Institute for International Economics. [return to text]
2 fraser.stlouisfed.org/publications/ERP/issue/1227 [return to text]
2. Central Banks and Foreign Exchange Intervention
What is foreign exchange intervention?
Foreign exchange intervention is often quoted in the news but rarely will you see any working definition. I shall view it as any transaction or announcement by an official agent of a government that is intended to influence an exchange rate. Typically intervention operations are implemented by the monetary authority. Central banks tend to use a narrower definition, which is the sale or purchase of foreign currency against domestic currency in the foreign exchange market.
Intervention is normally transacted directly through the large commercial banks (normally of the country in question) and can be public or secret. It can be enacted through one bank or a number of banks to achieve maximum impact or visibility. Secret interventions are difficult to hide and sometimes may be carried out by the Bank for International Settlements.
The problem central banks face is the market perception that they have set an exchange rate level to protect (commonly referred to as a line in the sand). This invariably tempts the market to test resolve and pockets of the central bank by continuing to buy or sell.
During the period in which countries followed the Bretton Woods ‘exchange rate system’ intervention operations were required whenever rates exceeded their parity bands. After the breakdown of the system in 1973 intervention was left to the discretion of individual countries. It was not until 1977 that the IMF provided its member countries three principles to adhere to in their intervention policy. [3] The principles said that countries should:
1 not manipulate exchange rates in order to prevent balance of payments adjustment or to gain unfair competitive advantage over others
2 intervene to counter disorderly market conditions
3 take into account the exchange rate interests of others.
These principles implicitly assume that intervention policy can influence exchange rates.
The US was actively involved in intervention during the 1970s but was absent from 1981 through 1984. However, in early 1985 after the dollar had appreciated by over 40% and the US trade deficit was approaching $100bn, the Federal Reserve (Fed) in the US joined with the German Bundesbank (BUBA) and the Bank of Japan (BoJ) to intervene against the dollar. In the autumn of 1985 the US and the rest of the G-5 (Germany, Japan, France and the UK) engaged in a number of large and coordinated operations as part of the Plaza Agreement. While the scale of central bank intervention was large in the post-1985 period relative to previous history, it was still small in relation to the overall market. The Plaza Agreement stated:
“In view of the present and prospective changes in fundamentals some orderly appreciation of the main non-dollar currencies against the dollar is desirable. The Minister and Governors stand ready to cooperate more closely to encourage this when to do so would be helpful.” [4]
During the period 1985-1987 the dollar fell by over 50% against the Deutschmark. Throughout the period the central banks’ stated intention was to affect the level rather than the variability of exchange rates. However, in February 1987 the G-7 produced the Louvre Accord which stated that nominal exchange rates were “broadly consistent with underlying economic fundamentals” and should be stabilised at their current levels. [5]
Sterilised and unsterilised intervention
Intervention can be distinguished by whether it is sterilised or unsterilised; i.e., intervention that respectively does not or does change the monetary base (or money supply as an approximation). When a monetary authority buys (sells) foreign exchange its own monetary base increases (decreases) by the amount of the purchase (sale). If the authority wishes to reverse the effect on the domestic monetary base – sterilise – they would buy (sell) domestic bonds. Fully sterilised intervention does not directly affect prices or interest rates and so does not influence the exchange rate through these variables as ordinary monetary policy does.
Unsterilised intervention is effectively another way of conducting monetary policy; in other words it will affect the level of the exchange rate in proportion to the change in the relative supplies of domestic and foreign money. A currency swap can be used to sterilise an intervention. A swap is a transaction where a foreign currency is bought in the spot market and simultaneously sold in the forward market. A swap will have little affect on the exchange rate. In this process the spot leg of the swap is transacted in the opposite direction to the spot market intervention, leaving the forward leg intact.
How intervention is carried out
The forward market has been used on a number of occasions for intervention purposes. This is the purchase or sale of foreign exchange for delivery at a future date. Intervention in the forward market has the advantage that there is no immediate cash outlay and therefore the impact on domestic liquidity (and the need for sterilisation) is at least delayed until the maturity of the foreign exchange contracts. Public reports indicated that the Bank of Thailand used this to defend the baht in 1997 (Moreno 1997).
Options have been used in a few cases (such as in Mexico in August 1996) to intervene in the exchange market, but not recently. As is the case with forwards, options do not immediately change the level of reserves and therefore do not require sterilisation. However, in so far as intervention operates through signalling the intentions of central banks, transactions involving options may not quite have the desired visible impact. The spot market is the favoured vehicle.
Intervention and monetary policy
The impact of floating exchange rates on monetary policy (the process by which the monetary authority of a country controls the supply of money) has changed over the years. Initially monetary policy
