The Hindu Business Line : Forex market intervention for transition economies

DOMESTIC monetary policy and exchange rate management are largely affected by forex flows. The kind of exchange rate regime that is followed in an economy determines the impact of forex flows on monetary policy.

While in practice, central banks do intervene in the forex market, some features of the emerging markets warrant a more intensive approach to intervention because of large inflows. Intervention is required to contain volatility and reduce risk to the market participants and for the economy as a whole. Generally, the intervention can be market-based or otherwise.

In a market-based approach, the central bank and the market are involved in financial transactions that lead to mopping up or injection of liquidity. On the other hand, the non-market-based approach involves the use of quantitative barriers, rules or restrictions in market activity to keep the potential injection of liquidity outside the domestic financial system.

In India, the Reserve Bank of India is involved in sale/purchase of currencies. For 2002-03 and 2003-04 (from April-March), the RBI has been net buyer. For the last few months, it has been on a foreign currency buying spree. Intervention is not unique to a developing nation but also happens in the developed countries. For instance, in Japan, the Foreign Exchange and Foreign Trade Law authorises the Minister of Finance to intervene to achieve forex rate stability.

Foreign exchange intervention is done by the Bank of Japan on the direction of the Minister of Finance. It is the Finance Ministry that determines the details of the intervention, including the amount, the currency pair and the method. Further, the Bank of Japan intervenes through the Government account called the Foreign Exchange Fund Special Account (FEFSA). Now, the Japanese Government holds large amounts of foreign currencies in FEFSA, partly as a result of foreign currency buying/yen selling interventions of the past factors. Investment decisions are made taking into account the liquidity and safety. On similar lines, the Government of Korea issues Foreign Exchange Stabilisation Bonds (FESBs) to purchase foreign currencies and manage overseas capital.

The medium-term bonds are generally expressed in foreign currency denominations. So, it becomes imperative for emerging market and transitions economies to retain discretion in the conduct of domestic monetary policy and keep the intervention option open. This is especially important in the context of surges in forex flows to these economies.

(The author is Senior Teaching and Research Associate, Finance and Accounting, Pharmaceutical Management Department, National Institute of Pharmaceutical Education and Research, Punjab.)