Foreign Exchange Intervention - Bank of Sierra Leone

1. THE EFFECTIVENESS
OF
FOREIGN EXCHANGE
INTERVENTION
1

STRUCTURE OF PRESENTATION
1. Title Page
2. Definitions
- Foreign Exchange Intervention
- Exchange Rate
3. Relevance of Foreign Exchange Rate to the Government
4. Development of Foreign Exchange Regimes in Sierra Leone
5. Reasons for Foreign Exchange Intervention
6. Why do policy Makers want stability in Exchange Rates
7. Drawbacks of Foreign Exchange Intervention
8. Theoretical Framework of Foreign Exchange Intervention
9. Mechanics of Foreign Exchange Intervention
10. Review of the Mechanics of Foreign Exchange Intervention
11. Is Foreign Exchange Intervention Effective or Not
12. The Effectiveness of Foreign Exchange Intervention
13. Ways of measuring the Effectiveness of Foreign Exchange Intervention
14. Data and Analysis
15. Conclusions
2

2.
FOREIGN EXCHANGE
INTERVENTION
Definition:
Central Banks engage in international
transactions by buying foreign denominated
assets and selling their currency
or by selling foreign assets (from their
international reserves) and purchasing the
domestic currency.These activities can affect
the exchange rate.
3

2. (Cont’d.)
EXCHANGE RATE
Definition
An Exchange rate is the price of one foreign
currency in term of another currency at a
particular date. For example the official BSL
Leone per US dollar exchange rate as at 16-09-
05 is Le2,883.72 (buying) and Le2941.98
(selling).
4

3.
RELEVANCE OF FOREIGN
EXCHANGE RATES TO THE
GOVERNMENT
Foreign Exchange rates are of particular concern to
governments because changes in foreign exchange
rates affect the value of products and financial
instruments. As a result, unexpected or large changes
can affect the health of nations’ markets and financial
systems. Exchange rate changes also impact a
nations’ international investment flows, as well as
export and import prices. These factors, in turn, can
influence inflation and economic growth. In the light
of these different Exchange regimes have existed.
5

4. DEVELOPMENTS OF FOREIGN
EXCHANGE REGIMES IN SIERRA LEONE
PERIOD
TYPES OF
REGIMES
EXCHANGE
RATE
COMMENTS
1 1964 - 1978 The Leone was pegged
to the Pound Sterling
Le2.00 = GBP1.00
The Leone was pegged to the Pound
Sterling due to the stability of the
latter.
2 1978 – 1982 The Leone was linked
to the IMF’s Special
Drawing Rights (SDR)
3 1982 – 1983 The Two Tier System or
dual Exchange Rate
System
Le1.00 = SDR0.731556
Official market determined
rates for Government
transactions Le2.45 =
US$1.00 (commercial
market determined rates for
other transactions
The Pound became very unstable in
1979. This period was referred to as
“The winter of discontent” which had
unstabilizing effect on the British
Pounds which resulted into delinking
from the latter.
The depletion of the Reserve during
the OAU meetings in the 80s led to the
two tier system to attract more foreign
exchange to beef up the Reserves.
Commercial market rates were
determined at fortnightly auctions held
by the Central bank
6

4. (Cont’d.)
DEVELOPMENTS OF FOREIGN EXCHANGE
REGIMES IN SIERRA LEONE
Period
Types of
Exchange
Comments
Regimes
Rate
4 1983 –1986 The Leone was
linked to the U S
Dollar
5 1986 – 1990 Flexible Floating
Exchange Rate
Le1.00 = US$1.3984 (1983)
Le37.19 = US$1.00 (1986)
Le37.19 = US$1.00 (1986)
Le122.00 = US$1.00 (1990)
Unification of the dual rates
The exchange rate was determined
weekly at ‘fixing’ sessions between the
Bank of Sierra Leone and the
Commercial Banks
6 1990 to
current
Market
Determined
Le122.00 = US$1.00 (1990)
Le2,914.28 = US$1.00 (2005)
The BSL determines the Exchange Rate
to be used in official transactions and is
based on the weighted average mid rate
of purchases and sales made by
Commercial Banks and Foreign
Exchange Bureaux during the last five
business days and the weekly auction.
Source: Annual Report on Exchange Arrangement Arrangements and Exchange
Restrictions for various years
7

5.
REASONS FOR
FOREIGN EXCHANGE
INTERVENTION
It is to make some contribution towards the
following:
Reduce the extent of overshooting.
Reduce the duration of overshooting.
To bring about a little more short-term
stability when markets threaten to
overreact to news.
8

5 (Cont’d.)
The latter is amenable to intervention but the first
and second are not. This is so because
intervention cannot be used to correct a
monetary policy imbalance, or to resist
changing fundamentals such as world growth or
commodity prices. However it can be used in the
following circumstances:
‣ A medium term movement based on fundamentals
was going too far, i.e. overshooting; or
‣ A short term overreaction to a piece of news that is
intrinsically difficult to interpret. In these
circumstances intervention is said to bring about
stability in exchange rates.
9

6.
WHY DO POLICYMAKERS WANT
STABILITY
IN EXCHANGE RATES?
1. Stability in Exchange Rates
More (short and medium term) stability in prices
Planning easier for businesses, individuals
Less uncertainty in general (although exchange rate
stability may imply interest rate instability!)
Smaller countries worry about importing inflation.
Beggar-thy-neighbor trade policies (temporary gains in
competitive advantage with weak currencies)
10

6. (Cont’d.)
WHY DO POLICYMAKERS WANT
STABILITY
IN EXCHANGE RATES?
2. Intervention is sometimes used to help avert currency
crises, full scale speculative attacks.
Sharp unexpected currency realignments are costly.
Begs larger question: when is a fixed rate / currency
peg truly unsustainable? If economic fundamentals
are inconsistent with the currency strength,
intervention may not be effective. Exchange rate
regime exit strategies need to be developed.
Difficult to determine whether shocks are temporary
or permanent (and if realignment should be avoided).
11

7.
DRAWBACKS OF FOREIGN
EXCHANGE INTERVENTION
• Monetary Policy is relegated to task of exchange rate
stabilization. It becomes unavailable for other primary
goals (like output and inflation stabilization)
• Intervention can lead to a substantial loss or accumulation
of foreign currency reserves. (Total amount offered at the
Foreign Exchange Auction) = US$260,250,000.00
• Unsustainable regimes may ultimately require large
discreet realignments.
12

THEORETICAL FRAMEWORK OF FX
8.
INTERVENTION
From a simple balance sheet of a Central Bank
the identity given below can be extracted thus:
Change in NFA cb = Change in H- Change in DC.
Where:
NFA=Net Foreign Asset
Cb= central bank
H= high-powered money
DC= domestic credit.
13

8. (Cont’d.)
THEORETICAL FRAMEWORK OF FX
INTERVENTION
The above identity shows that a change in
net reserves of the monetary authorities is
equal to the excess of money creation over
domestic credit creation.
The frame work, although still rather
simple, does suggest the following
scenarios.
14

8. (Cont’d.)
THEORETICAL FRAMEWORK OF FX
INTERVENTION
External deficits or reserve losses can be
controlled.
Secondly, the framework could be used to
explain the mechanics of foreign exchange
intervention. How this is done could be
observed as we go through the mechanics
given on the other page.
15

9.
MECHANICS OF FX INTERVENTION
Three Main Tools:
1. Interest Rates or Unsterilized Intervention
» used by many small countries
When the central bank sells foreign assets, it is said to be purchasing
the domestic currency, and the purchaser of the asset has to pay the
central bank with either currency or domestic deposits. In either case,
this decreases the monetary base by the amount of the transaction. The
appreciation of the domestic currency causes the exchange rate to
increase. Conversely, the central bank can sell the domestic currency
by purchasing foreign assets which increases the monetary base, the
domestic currency depreciates and the exchange rate declines.
2. Sterilized Currency Purchases in Open Market
used by large countries, some small countries
The central bank can offset its international transaction with an
offsetting open market operation. In this case the monetary base and
money supply remain unchanged, so there is no change in exchange
rates.
3. Jawboning / Announcements: Talk, Talk, Talk
Please note that interventions (sterilized or unsterilized) can be accompanied by
statements to clarify the intent of the action.

10.
1. The Starting Point
Review of the Mechanics of FX intervention
Le. – USD @ Le2912.85/USD1.00 (= 0.00034 Dollars per
Leone).
A Bank of Sierra Leone L A Commercial Bank L
------------------------------------------------ --------------------------------------------
Le500M S.L. Gov’t Securities Le1000M Bank Reserves Le100M Bank Reserves Le250M Private Deposits
USD 400 Currency
(=Le1,165,140)
USD40 Currency (=Le116,514)
Le50 S.L. Gov’t Securities
Le50 Loans
2. Intervention to Weaken the Dollar / Support the Leone:
BSL Sells Dollars, Buys Leones in Currency Markets
A Bank of Sierra Leone L A Commercial Bank L
------------------------------------------------ ---------------------------------------------
- USD 4 (Le.11,651.40) -Le.11,651.40 Bank Reserves - Le11,651.40 Bank Reserves
+ USD 4 (= Le11,651.40)
17

10 (Cont’d.)
REVIEW OF THE MECHANICS OF FX
INTERVENTION
On the day of these transactions, Dollar sales put downward
pressure on the dollar’s leone value.
Suppose the BSL does nothing more. What sustains the new, lower
value of the dollar after the transaction?
The decline in bank reserves leads to a smaller S.L money supply
and higher S.L interest rates. This maintains the stronger leone.
2. Intervention to Weaken the Dollar / Support the leone:
BSL Sells dollars, Buys Leone in Currency Markets
A Bank of Sierra Leone L A Commercial Bank L
------------------------------------------------ ----------------------------------------------
-U.S Dollars 4 (Le11,651.40) -Le11,651.40 Bank Reserves
- Le11,651.40 Bank Reserves
+U.S $ 4 (=Le11,651.40)
18

10. (Cont’d.)
What if the monetary authority does not want
interest rate changes?
3. Sterilized Intervention:
BSL Enters Sierra Leone Gov’t Securities Market as a Buyer
A Bank of Sierra Leone L A Commercial Bank L
------------------------------------------------ --------------------------------------------
+ Le11,651.40 S.L Gov’t + Le11,651.40 Bank Reserves + Le11,651.40 Bank Reserves
Securities
– Le11,651.40 S.L.Gov’t Securities
The net result of sterilized intervention is that bank reserves and the
money base are unchanged. As a consequence, interest rates are likely to
be stable.
A Bank of Sierra Leone L A Commercial Bank L
----------------------------------------------- -------------------------------------------
+ Le11,651.40 S.L. Gov’t Securities + USD 4 Currency (= + Le11,651.40)
- USD 4 Currency (= + Le11,651.40) - Le11,651.40 S.L. Gov’t Securities
19

10. (Cont’d.)
What if the monetary authority does not want
interest rate changes?
But, if S.L interest rates are unchanged, this
leads to questions about why and how the
immediate exchange rate effect (weaker
Dollar) is sustained.
20

11.
IS FOREIGN EXCHANGE INTERVENTION
EFFECTIVE OR NOT?
Proving the effectiveness or otherwise of
Foreign Exchange Intervention is fraught
with difficulties.
In fact, there existed until very recently a
strong presumption among academic
economists that intervention was
ineffective.
21

11. (Cont’d.)
There were two main planks to this argument. First, there was a
view that the market would get it right without our help
(efficient market hypothesis), and so intervention could only
make things worse. Second, there was a view that central banks
usually lose money through intervention and therefore their
efforts must have been destabilizing.
However, others believed that Foreign Exchange intervention is
very effective as a policy tool.
There is no disagreement, either theoretical or empirical, that
non-sterilized foreign exchange intervention significantly
affects the exchange rate. A non-sterilized foreign exchange
operation amounts to a change in the domestic supply of
money, and all models predict that changes in the stock of
money affect the nominal exchange rate, both in the short run
and in the steady state. The effectiveness of non-sterilized
intervention is clearly evident in the empirical exchange rate
models (Driskill and Sheffrin (1981) and Frenkel (1981).

12.
THE EFFECTIVENESS OF FOREIGN
EXCHANGE INTERVENTION.
This simply means how quickly the Central
Bank could curb the extent and duration of
overshooting and bring about a little more
short-term stability when the market
threatens to overreact to news.
23

WAYS OF MEASURING THE
13. EFFECTIVENESS OF FOREIGN
EXCHANGE INTERVENTION.
The Friedman “profit test” is one way of looking
at the effectiveness of foreign exchange
intervention. Friedman (1953) argued that a
central bank, which was stabilizing the exchange
rate, would tend to buy foreign exchange when
its price was low, and sell when its price was
high, and hence its operations would be
profitable.
24

13.(Cont’d.)
Secondly, using market participant’s response to the
auction (intervention) rate is another.
The Auction determined rate serves as a reference rate
by other foreign exchange market operators namely
commercial banks, bureaus, parallel market, and others.
In the light of this, to give us an indication as to how
effective foreign exchange intervention by the Sierra
Leone monetary authority been over the period 2000 to
current, the graph in table 1 shows the comparison of
Auction Rate with other exchange rates determined by
other foreign exchange operators in the market.
25

Jul.05
Apr.05
Jan.05
Oct.04
3500.00
3000.00
2500.00
2000.00
1500.00
1000.00
DATA AND ANALYSIS
Auction rates and Other foreign exchange rates
26
Jul.01
Oct.01
Jan.02
Apr.02
Jul.02
Oct.02
Jan.03
Apr.03
Jul.03
Oct.03
Jan.04
Apr.04
Jul.04
End month period
Auction Rate C/banks Sell Bureaux Sell Parallel Sell
Apr.01
Jan.01
Oct.00
Jul.00
Apr.00
Jan.00
Le/USD rates