For months now the Central Bank (BCRA) He was very active intervening, explicitly and implicitly, in the exchange market. This is a topic that will surely be present in the upcoming negotiation with the International Monetary Fund (IMF), and that it is very dear to the feelings of the minister Luis Caputo that in his previous management earned him several short circuits with the organization’s technicians.
Now, after several analyzes and models designed by the Fund’s economists, established only a triad of cases in which exchange intervention is advisablewhich according to the organization, plan to incorporate these new criteria in the analyzes of the economic situation of the member countries, known as the “Article IV” examinations.
Why now? From the Fund, economists Basu, Das, Harrison, and Nier, They consider that as the main central banks are cutting monetary policy rates and the global rate cycle is changing, but, as economic uncertainty remains high, it also raises concerns about possible indirect effects.
And, as history shows, “Reducing policy rates could stimulate capital flows as investors seek returns, and these flows may reverse sharply when adverse shocks lead to a further tightening of financial conditions.”they warn.
Hence, they point out that the IMF’s Integrated Policy Framework can help calibrate the best possible combination of policies in the face of this volatility. “In a world more prone to disruptions, authorities must be even more agile in using well-calibrated tools appropriate to specific circumstances. “Our Framework shows that, in the absence of market frictions, monetary and fiscal policies are often sufficient to address the impact of external shocks, but it also shows how the use of additional tools can be useful in certain circumstances,” they claim.
They give as an example the scenario in which if a rapid capital outflow paralyzes crucial financial markets and causes an abrupt fall in the exchange rate, a central bank can sell foreign exchange reserves or lend them to stabilize the markets and safeguard financial stability.
However, “Exchange intervention can have costs and involve important trade-offs. Intervening too frequently can lead to complacency regarding increasing exposure to exchange rate fluctuations, and should not be used as a pretext to gain unfair competitive trade advantages.”highlight the Fund’s economists.
Dollar: the new intervention menu
As the authors explain, the principles for foreign exchange intervention (FXI), They detail when it can help countries with floating exchange rates (in other words, where the exchange rate is predominantly determined by the market). They also highlight when intervention is not advisable. “We are working to incorporate these principles, first published in late 2023, into our annual reviews of the economic health of member countries, known as Article IV reviews, and will discuss these issues during events and discussions with members in the next Annual Meetings of the IMF and the World Bank in Washington”, they anticipate.
Now, how do they consider exchange rate intervention within the set of tools. In this sense, they highlight that countries with Floating exchange rates typically set an inflation target and use interest rates to achieve itand in these cases, exchange rates can adjust freely to help better balance import and export demand and help maintain external balances.
At the other end of the spectrum, “About two-thirds of countries peg their currency to another or otherwise manage the exchange rate; in these cases, central bank interest rates closely follow those set by the anchor country and cannot be used in any way.” independent to respond to domestic demand or supply shocks. Parallel intervention is generally used to maintain parity,” they point out.
It is worth remembering that the principles focus on countries with flexible exchange rates, as in most advanced economies that have completely flexible exchange rates, known as freely floating. “Some, like Canada, the United Kingdom and the United States, almost never intervene. Instead, they let markets determine the values of their currencies, even in times of stress. However, central banks in other floating regimes do intervene on occasion,” they explain.
He Integrated Monetary Policy Framework (MIP) of the Fund recognizes that financially open economies may be more vulnerable to shocks, so fully flexible exchange rates may not always work well. Therefore, they identify three circumstances in which central banks could consider currency investment to deal with a major shock:
- When currency markets become illiquid, a central bank can use foreign exchange investment to manage sharp changes in financial conditions that may arise from capital flows and exchange rate pressures and threaten macroeconomic and financial stability.
- In the case of unhedged currency exposures, a central bank can use FXI to counter a sharp currency decline that would otherwise lead to a crisis, such as one involving large-scale private sector defaults on dollar-denominated debt.
- When a sharp depreciation is likely to not only cause a temporary rise in the prices of goods and services but also raise inflation expectations, the central bank may consider using foreign exchange in conjunction with an increase in interest rates. to contain those impacts. The complementary use of currencies can reduce the adverse impact on growth of a more restrictive monetary policy.
Advantages and disadvantages
These cases are integrated into the Fund’s conceptual and quantitative IPF models, and are also based on empirical work and considerations external to the models, in which, among others, the now old acquaintance of Caputo’s economic team, Gita Gopinath, intervened. , current manager of the IMF.
“Our framework also recognizes that investing in foreign currencies may cause some of the benefits of full exchange rate flexibility to be lost when it comes to macroeconomic adjustment, such as when people and businesses switch from domestic to foreign goods and services. Another important consideration is that accumulating and maintaining reserves for foreign currency investment is expensive,” hold Basu, Das, Harrison, and Nier.
Of course, the intervention can also have unwanted side effects.. “Its excessive use can hinder the development of foreign exchange markets.” by reducing incentives for trading or hedging currency risks by the private sector. Expectations that the central bank will intervene to contain losses can also generate moral hazard. Furthermore, poor communication of the exchange intervention can generate confusion over the reaction function of monetary policy of the monetary entity and its main instrument to achieve its inflation goal,” they explain.
Therefore, in view of these drawbacks, the Fund’s MIP recommends intervention only in the cases mentioned and when the shocks are large enough to threaten economic or financial stability, such as an unusually large fluctuation in exchange rates or financial conditions. “In these cases, intervention should not be used to avoid adjusting monetary and fiscal policies. And if reserves are tight, it may be better to preserve them until bigger shocks are coming.”
“When an intervention is determined to be appropriate, it is most effective as part of a combined policy approach that integrates other macroeconomic and financial tools. Even before a shock, countries should want to deepen their currency markets, making them more resilient to stresses. Appropriate macro-prudential measures can reduce risky borrowing in foreign currencies, and countries can better anchor inflation expectations to reduce the need for intervention in the event of shocks,” they say.
Source: Ambito
