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Lesson 3: Direct government intervention in the foreign exchange market

The floating exchange rate system implemented in the international monetary system after 1973 is not a completely floating exchange rate system but a so-called dirty floating exchange rate system. This is the frequent intervention of the central banks of industrial countries in the foreign exchange market. The monetary and fiscal policies formulated by the government affect the price fluctuations in the foreign exchange market every day. Central banks of industrial countries not only indirectly intervene in the foreign exchange market by formulating monetary and fiscal policies but also often directly intervene in the foreign exchange market when the foreign exchange market fluctuates abnormally. This direct government intervention in the foreign exchange market is also an essential factor affecting the short-term trend of the foreign exchange market.

The goal of the central bank's intervention in the foreign exchange market

Since implementing the floating exchange rate system, the central banks of industrial countries have never adopted a completely laissez-faire attitude towards the foreign exchange market. On the contrary, these central banks have always retained a considerable part of foreign exchange reserves, and their primary purpose is to intervene in the foreign exchange market directly.

Generally speaking, when the price of the central bank in the foreign exchange market is abnormally large or fluctuates drastically for several days in the same direction, it will often directly intervene in the market and conduct foreign exchange transactions through commercial banks in an attempt to alleviate the drastic fluctuations in the foreign exchange market. Theoretically, there are many explanations for the central bank’s intervention in the foreign exchange market, and most people accept roughly three reasons.

First, abnormal exchange rate fluctuations are often inevitable related to international capital flows, which can cause unnecessary changes in industrial production and macroeconomic development. Therefore, a stable exchange rate helps stabilize the national economy and prices. The current cross-border flow of international capital is large-scale and has many channels, and the artificial obstacles encountered are minimal. Industrial countries began to relax financial regulations and regulations in the late 1970s, which further facilitated international capital flow. Under the conditions of a floating exchange rate system, the most direct result of large-scale global capital flows is price fluctuations in the foreign exchange market. If a large amount of capital flows into Germany, the exchange rate of the Deutsche Mark in the foreign exchange market will rise. If a large amount of money flows out of the United States, the dollar's exchange rate in the foreign exchange market will inevitably fall. On the other hand, if people expect the exchange rate of a particular country’s currency to rise, capital will inevitably flow to that country.

The relevance of capital flows and changes in the foreign exchange market has an important impact on a country's national economic, industrial allocation, and prices. For example, when a country’s capital outflows in a large amount cause the exchange rate of its currency to fall, or when people expect the exchange rate of its currency to fall, leading to capital outflows, the country’s industrial allocation and prices will inevitably benefit those connected with foreign trade—changes in the industry. From the perspective of foreign trade, the ambitions of any country can be divided into two types: those that can conduct foreign trade and those that cannot. The former is like manufacturing, where the products produced can be exported and imported, while the latter, like some service industries, must be made and consumed locally. When capital outflows and the currency depreciates, the prices of industrial sectors that can conduct foreign trade will rise. If the wages in this sector are not growing at the same rate, additional production in this sector will become profitable, and exports will also Increase. Still, from the perspective of domestic industrial structure, capital will flow from non-trade industries to trade industries. If this is a long-term phenomenon, the country’s national economy may be out of balance. Therefore, industrial governments and central banks do not want to see the exchange rate of their national currencies deviate from what they believe to be the equilibrium price for a long time. This is one of the reasons why the central bank directly intervenes in the market when its currency continues to weaken or become too strong.

Another significant impact of the correlation between capital flows and changes in the foreign exchange market on the national economy is that a large amount of capital outflow will increase domestic production capital formation cost. A large amount of capital inflow may cause unnecessary inflationary pressure and affect long-term capital investment.  The United States implemented a contractionary monetary policy and an expansionary fiscal policy in the early 1980s, which led to many capital inflows. The exchange rate of the U.S. dollar gradually rose. The Federal Reserve Bank of the United States (Federal Reserve Bank) ultimately adopted laissez-faire in the foreign exchange market in 1981 and 1982. Attitude. To prevent capital outflows, Western European countries are forced to directly intervene in the foreign exchange market when the exchange rate of European currencies continues to fall and have repeatedly requested the Federal Reserve of the United States to assist in the intervention.

Second, the central bank directly intervenes in the foreign exchange market to meet the needs of domestic foreign trade policies. The lower price of a country’s currency in the foreign exchange market is bound to benefit the country’s exports. The export issue is already a political issue in many industrial countries. It involves many aspects, such as the level of employment in many export industries, trade protectionist sentiments, and voters’ attitudes towards the government. No central bank wants to see that its foreign trade surplus is because the exchange rate of its currency is too low, and other countries catch it. Therefore, the central bank intervenes in the foreign exchange market for this purpose, mainly in two aspects.

The central bank will directly intervene in the foreign exchange market to protect exports when the domestic currency continues to strengthen. This is even more reason for those countries whose exports account for an essential proportion of the national economy. Before April 1992, the Australian dollar was bullish all the way, and the gains were flat. However, when the exchange rate of the Australian dollar against the US dollar rose to US$0.77 on March 30, the Central Bank of Australia immediately threw Australian dollars to buy US dollars in the market. For another example, Germany is the world's largest manufacturing exporter. After implementing the floating exchange rate system in the 1970s, the exchange rate of the Mark has risen along with the strength of the German economy. To maintain its export industry's international competitive position, the German government strongly advocates the implementation of Europe. Monetary system to fix the Mark and the currencies of other member states of the European Community within a range.

The importance of trade issues can be fully seen from the frequent intervention of the Central Bank of Japan in the foreign exchange market. Since the 1980s, Japan’s trade surplus with the United States has maintained an astronomical level every year, reaching 50 billion U.S. dollars in 1991, which has become a political issue in the relationship between the United States and Japan. 1992 was the U.S. election year. Trade protectionism in the U.S. against Japan was extreme. Members of Congress still criticized Japan for closing the U.S. market. To alleviate the anti-Japanese sentiment in the United States, the Central Bank of Japan often makes speeches, demanding that the yen strengthen, and checks the exchange rate situation from time to time to show its attitude. On January 17, 1992, when the U.S. dollar was in a strong trend, the Central Bank of Japan suddenly sold yen to buy U.S. dollars in the market, causing the U.S. dollar to rise from 128.35 yen to the yen exchange rate 124.05 yen. At that time, interest rates in Japan were high, and the Japanese government had no intention to cut interest rates.

Regarding the reason for the intervention, the central bank only said that it hoped that the yen would strengthen. In the next three weeks, the Central Bank of Japan intervened in the foreign exchange market several times in the same way, tossing yen to buy US dollars. Except for this time on February 7, which was more evident on the graph, the other times were ineffective.

From the perspective of the development history of the international foreign exchange market, domestic currency depreciation to expand exports is a policy often adopted by many countries in the early stages. The "neighbor begging policy" often causes trade wars between the two countries during economic downturns. Due to the numerous names of non-tariff trade barriers, this policy of artificial intervention in the foreign exchange market has been rarely adopted. It will arouse criticism from other countries.

Third, the central bank intervened in the foreign exchange market out of consideration for curbing domestic inflation. The macroeconomic model proves that in the case of a floating exchange rate system, if the currency exchange rate of a country is lower than the equilibrium price for a long time, it will stimulate exports for a certain period, resulting in a foreign trade surplus, but ultimately will cause domestic prices to rise and wages to rise. Create inflationary pressures. When inflation is already high, this possible cyclical increase in wages and prices will cause people to have expectations of future inflation, which will inevitably and high, make it challenging to implement the anti-inflation policy of the monetary authority. In addition, in some industrialized countries, voters often regard the inflationary pressure caused by the devaluation of their currencies as a sign of improper macroeconomic management by the government authorities. Therefore, after implementing the floating exchange rate system, many industrial countries took the exchange rate of their currencies as a closely monitored content when controlling inflation.

The fluctuation of the pound sterling since the 1980s clearly illustrates the relationship between currency depreciation and inflation. In the 1970s, almost all industrialized countries were caught in double-digit inflation, and the pound sterling was doomed. Throughout the 1980s, the central banks of the United States and Western European countries achieved significant results, while the United Kingdom's results were less effective. After establishing the European Monetary System in 1979, the United Kingdom was always reluctant to join because of political considerations during the Thatcher regime. It made great efforts to curb inflation in the country. In 1990, more than ten years later, Britain finally announced its accession to the European Monetary System after Major became prime minister. The primary reason is the hope that through the European monetary system, the exchange rate of the pound sterling can be maintained at a relatively high level so that inflation in the UK can be further controlled. But the good times didn't last long. In 1992, the European currency system experienced a crisis, and the foreign exchange market dumped the British pound and lira, which finally led to the official devaluation of the Italian lira. Also, based on anti-inflation considerations, the British government has spent more than 6 billion U.S. dollars intervening in the market. The German Central Bank has also spent more than 12 billion U.S. dollars to intervene in the foreign exchange market to maintain the value of the pound and lira. As the pound continued to fall sharply and the voices for the devaluation of the pound within the European monetary system were high, the United Kingdom announced its withdrawal from the European financial system, but never officially devalued the pound, and at the same time announced that it would continue to implement the anti-inflation monetary policy.

Means and benefits of central bank intervention in the foreign exchange market

There is a more formal definition of the central bank's intervention in the foreign exchange market. In the early 1980s, the exchange rate of the U.S. dollar against the currencies of all European countries showed an upward trend. Regarding whether the industrial governments should intervene in the foreign exchange market, the Versailles Industrial Countries Summit in June 1982 decided to establish an official economist. The Foreign Exchange Intervention Working Group" specializes in foreign exchange market intervention issues. In 1983, the group published the "Working Group Report" (also known as the "Jergenson Report"), in which the narrow definition of intervention in the foreign exchange market is: "Any foreign exchange transactions conducted by the monetary authority in the foreign exchange market to affect the national currency "Exchange rate" can be channeled through foreign exchange reserves, transfers between central banks, or official loans. To truly understand the nature and effects of the central bank’s intervention in the foreign exchange market, one must also understand the impact of such intervention on the country’s currency supply and policies. Therefore, the central bank's intervention in the foreign exchange market can be divided into interventions that do not change the existing monetary policy (sterilized intervention, also known as "sterilized intervention") and interventions that change the existing monetary policy (no sterilized intervention, also known as " No disinfection intervention"). The so-called intervention without changing the policy means that the central bank considers that violent fluctuations in foreign exchange prices or deviations from long-term equilibrium is a short-term phenomenon and hopes to change the current foreign exchange prices without changing the existing money supply. In other words, it is generally believed that interest rate changes are the key to exchange rate changes, and the central bank tries to change the exchange rate of the domestic currency without changing the domestic interest rate.

The central bank can adopt a two-pronged approach when conducting such interventions:

(1) When the central bank buys or sells foreign exchange in the foreign exchange market, it also sells or buys bonds in the domestic bond market so that the exchange rate changes, but the interest rate does not change. For example, the exchange rate of the U.S. dollar against the yen in the foreign exchange market has fallen sharply. The Central Bank of Japan wants to support the U.S. dollar to sell the yen. The U.S. dollar will become its reserve currency. The increase in the flow of yen in the market will increase the Japanese money supply. Interest rates are on a downward trend. To offset the impact of foreign exchange transactions on domestic interest rates, the Central Bank of Japan can dump bonds in the domestic bond market, reducing the liquidity of the Japanese yen in the market and offsetting the downward trend in interest rates. It should be pointed out that the worse the substitution between domestic bonds and international bonds, the more effective the central bank's intervention without changing the policy will be. Otherwise, it will be ineffective.

(2) In the foreign exchange market, the central bank influences exchange rate changes by inquiring about exchange rate changes, issuing statements, etc., and achieves the effect of the intervention. It is called the "signal response" of intervention in the foreign exchange market. The central bank does this hoping that the foreign exchange market will receive such a signal: the central bank’s monetary policy is about to change, or the expected exchange rate will change, and so on. Generally speaking, the foreign exchange market always reacts after receiving these signals for the first time. However, if the central bank often intervenes in the market by relying on "signal effects," and these signals are not all true, it will have the effect of a "wolf coming" in the market. The Carter administration’s support for the intervention of the US dollar from 1978 to 1979 is often regarded as an example of the effect of the "wolf is coming" signal. In 1985, the "Plaza Hotel Statement" of the finance ministers and central bank governors of the five western countries immediately caused the dollar to fall sharply, which is often regarded as a successful example of the "signaling effect." The so-called policy-changing intervention in the foreign exchange market changes the central bank’s monetary policy. It refers to the central bank’s direct trading of foreign exchange in the foreign exchange market while allowing the domestic money supply and interest rates to change in a direction conducive to achieving the intervention goal. For example, if the mark continues to depreciate in the foreign exchange market, the German Central Bank can sell foreign exchange to buy the pattern in the market to support the mark's exchange rate. Because the circulation of the effect is reduced, the German money supply is falling, and the interest rate is rising, people are willing to trade in foreign exchange. The market retains more marks, which increases the exchange rate of the sport. This kind of intervention is generally very effective. The price is that the established domestic monetary policy will be affected. The central bank is only willing to adopt it when it seems that the exchange rate of the domestic currency deviates from the equilibrium price for a long time.

To judge whether the central bank's intervention is effective, it does not depend on the number of significant bank interventions and the amount of money used. At least the following two conclusions can be drawn from the history of central bank intervention in foreign exchange.

First, if the abnormally violent fluctuations in the foreign exchange market are caused by poor information efficiency, emergencies, and artificial speculation, and the distortion of the foreign exchange market due to these factors is often short-term. The intervention of the central bank will be very effective. In other words, the direct intervention of the central bank may at least end this short-term distortion prematurely.

Second, suppose the long-term high or low exchange rate of a country’s currency is determined by the country’s macroeconomic level, interest rates, and government monetary policy. In that case, the central bank’s intervention will be ineffective in the long run. The central bank’s insistence on intervening is mainly due to the following two goals: First, the central bank’s intervention can ease the decline or rise of the domestic currency in the foreign exchange market to avoid the drastic fluctuations in the foreign exchange market affecting domestic macroeconomics. The disproportionate impact of economic development; secondly, the central bank's intervention often has apparent effects in the short term. The reason is that the foreign exchange market needs a certain amount of time to digest this sudden government intervention. This gives the central bank time to reconsider its monetary or foreign exchange policy and make appropriate adjustments.

The historical development of the central bank's intervention in the foreign exchange market

From 1973 to the present, the central banks of industrialized countries often intervened directly in the foreign exchange market. There were about five major joint interventions, both of success and failure.

Intervention on the weak dollar from 1976 to 1979 After the worldwide economic recession from 1974 to 1975, the US economy was still in high inflation, high unemployment, and low economic growth. To stimulate the economy, the Carter government decided to adopt expansionary fiscal and monetary policies. Although interest rates are rising, the inflation rate in the United States has grown even faster. Therefore, the foreign exchange market began to continuously dump US dollars, causing the US dollar exchange rate to fall all the way.

Faced with the decline of the US dollar, the Carter government decided to intervene in the foreign exchange market. At the end of October 1978, the Carter administration announced an anti-inflation plan. Still, because the U.S. currency government did not indicate the future of the U.S. currency, the U.S. dollar instead slumped in the foreign exchange market. Facing tremendous pressure from the appreciation of the mark and the yen, the central banks of Germany and Japan were forced to carry out large-scale interventions without changing their policies, buying US dollars, and throwing their currencies, but with little effect.

On November 1, 1978, President Carter announced that the exchange rate of the U.S. dollar was too low, and the U.S. Treasury Department and the Central Bank would directly intervene. Due to the disappointment of the foreign exchange market due to the anti-inflation plan of the previous week, Carter's intervention this time contains two significant policy changes. First, monetary policy will tighten. The Federal Reserve Bank will increase the discount rate by one percentage point, bringing the discount rate to 9.5% of the historical high at that time, so that this intervention will include policy content. Second, the U.S. Central Bank will use $30 billion to intervene in the foreign exchange market to stabilize the exchange rate of the U.S. dollar. Of this, 15 billion will be seconded from other central banks, 5 billion will be withdrawn from the International Monetary Fund and the sale of special drawing rights, and 5 billion will be the so-called "Carter bonds," that is, the Treasury’s foreign sales in marks and Swiss Bonds booked in francs. After the announcement of the Carter plan, the foreign exchange market was indeed shaken, and he became more alert to its first austerity policy. At 9:13 a.m. on November 1, the exchange rate of the U.S. dollar to the mark immediately rose 3.25% from the lowest point of the previous day, reaching 1.83 effects; a few minutes later, as the Central Bank released 69 million signatures and 19 million Swiss francs, The dollar continued to rise, the exchange rate against the mark rose by 1%, and the exchange rate against the Swiss franc rose to 1.567. After spending 5 million U.S. dollars for the intervention in the yen, the exchange rate of the U.S. dollar against the yen also fell to 187.5 yen. At the close of the foreign exchange market on this day, the exchange rate of the U.S. dollar against major foreign exchanges rose by an average of 7%-10%.

In the next two weeks, the foreign exchange market continued to sell dollars to test the determination of the US and other central banks to intervene in the market. Still, the US Federal Reserve, together with the central banks of Germany, Switzerland, and Japan, intervened in the market time and time again. By the end of November, the total amount of U.S. intervention in the market reached 35 billion U.S. dollars, making the U.S. dollar significantly rebound. However, by the beginning of December, the foreign exchange market began to doubt whether the United States would adopt a monetary tightening policy and began to sell the US dollar again, causing the US dollar to fall again. The United States and other central banks continued to intervene in the foreign exchange market on a large scale. The United States alone spent $31 billion, but the effect of the intervention has declined significantly. By the end of December, the exchange rate of the U.S. dollar had fallen below the level of November. The real strength of the U.S. dollar came after the new Fed President Paul Volcker took office in October 1979 and announced control of the money supply.

The intervention of the five industrial countries in the foreign exchange market in September 1985 If the intervention of the United States and other central banks in the foreign exchange market in the late 1970s was a failed protracted battle, the intervention of the five industrial countries in the foreign exchange market in September 1985 was a success. Quick, decisive action. After Reagan came to power, the U.S. dollar began to strengthen all the way, reaching its highest point on February 25, 1985, and the exchange rate against the mark was as high as 3.4794 marks per dollar. After adjustments in the spring and summer, the U.S. dollar rose again in September of that year. The finance ministers of the United States, Britain, France, Germany, and Japan met with the central bank governors at the Plaza Hotel in New York to discuss foreign exchange intervention. On Sunday, September 22, the five countries issued a statement. The statement said that the finance ministers of the five countries and the central bank governors agreed that "the exchange rate of non-US dollar currencies against the US dollar should be further strengthened" and that they "will further cooperate and intervene when necessary." The following day, the U.S. dollar immediately fell sharply in the foreign exchange market, and the exchange rate against the mark fell from 2.7352 to 2.6524 mark, a drop of more than 3%. Since then, the dollar has fallen all the way, and by the end of 1986, the central banks of Japan and Germany were forced to take intervention measures to support the dollar. The effect was still minimal. The decline of the dollar was only stopped at the beginning of 1987 when the central bank of the dollar also participated in the market intervention. Whether the intervention in September 1985 was effective or not has been controversial in the foreign exchange market. Some people believe that the US dollar has begun to weaken before the intervention; even if the central bank does not intervene, it will continue to weaken after the rebound in September. But more opinions believe that this intervention is still effective.

If this intervention is successful, it is the role played by the "signal response." In the two weeks before and after the intervention, the exchange rate changed drastically, while the interest rate differential between industrial countries did not change at all. It was not until the end of October that Japan implemented a tightening policy on the credit market, and the interest rate differential began to change. However, the alliance of the five countries gave at least two strong signals to the foreign exchange market. First of all, this announcement made the foreign exchange market aware that the five industrial countries will fully coordinate and do their best to intervene in the foreign exchange market on a larger scale. The facts later proved that the central bank did precisely that when it intervened in the foreign exchange market. Secondly, this announcement means a significant change in US foreign exchange policy. From the beginning, the Reagan administration pursued a laissez-faire policy of allowing the market to compete freely. It has always allowed the US dollar to grow stronger and ignored the demands of other countries’ central banks to intervene in the foreign exchange market. This time the United States and other industrialized countries participated in the intervention, giving the foreign exchange market reason to believe that to coordinate with other industrialized countries, the United States might adjust its currency and macroeconomic policies and make the dollar begin to weaken.

The US and other central banks’ intervention in the foreign exchange market in the summer of 1992 began in mid-March 1992. The foreign exchange market was once again disappointed with the long-awaited economic recovery in the United States. Under the influence of Germany’s high-interest rates and the United States’ adherence to loose monetary policy, it began to sell US dollars. , Resulting in the U.S. dollar's exchange rate against almost all European currencies falling all the way. The central banks of the United States and European countries intervened on a large scale in the foreign exchange market twice on July 20 and August 11, respectively. These two interventions were, in nature, interventions that did not change their respective economic policies. Although they had short-term effects, they were complete failures in the medium and long term.

The first intervention was conducted on July 20 when the exchange rate between the mark and the U.S. dollar hit a new high of 1.4430 after February 1991. The central banks of 15 industrial countries, including the United States, jointly sold the mark to buy U.S. dollars in the market. After three interventions, The exchange rate of the U.S. dollar against the mark rose from 1.4470 to 1.5000 at once, and the U.S. dollar rebounded by more than 500 points in two days. But this intervention did not stop the dollar's decline. After more than half a month of hovering, the dollar continued to fall. The central banks of 13 industrial countries, including the United States, joined forces to intervene on August 11, but the effect was worse than the first time. In the first round of intervention, the US dollar exchange rate against the mark rebounded from 1.4620 marks to 1.4780, an increase of only 150 points, and the timeliness only lasted for more than half an hour. Later, the dollar fell again. The Federal Reserve of the United States intervened in the market four times in more than three hours at the exchange rates of 1.4715, 1.4730, and 1.4770 between the US dollar and the mark, and sold the spot to buy the US dollar, but it only made the US dollar rebound slightly. In this intervention, industrial countries such as the United States spent a total of US$1 to US$1.5 billion. However, two days later, the dollar fell below its lowest point before the intervention.

The failure of this intervention is because the foreign exchange market has long expected these interventions and the interventions that do not change the policy mentioned above. The most important thing to promote the need for the foreign exchange market is unexpected events, and the scheduled events are often reflected in the foreign exchange market in advance. This is the reason why the first intervention is more effective than the second intervention. And these two interventions ultimately cannot change the weakness of the dollar because the central bank cannot convince the foreign exchange market that the exchange rate of the dollar should be higher in the market.

In September 1992, European Monetary System member states intervened in the foreign exchange market. In September 1992, the European Monetary System experienced a crisis. The foreign exchange market violently sold off almost all weak currencies in the member states. The British pound, Italian lira, and Irish pound all appeared big. A situation in which the value of the currency has fallen. The coins of non-member countries such as Finland have also fallen sharply in the foreign exchange market, forcing these countries to declare their departure from the voluntary link with the European monetary system.

In this intervention, almost all the member states of the European Community paid a high price. The German Central Bank spent more than 12 billion U.S. dollars. The United Kingdom spent nearly 6 billion. France's money from the German Central Bank to intervene in foreign exchange was not paid off until early November. This intervention has eased the contradictions in the European monetary system, but it is far from solving the problem.

Because the short-term fluctuations in the foreign exchange market are persistent and significant, creating many short-term profit opportunities. Therefore, grasping the relationship between the above-mentioned main factors and the foreign exchange market is very helpful for improving analysis ability and profitability.