Thu, Dec 02, 2004 - Page 9 News List

Costs of forex intervention are greater than benefits

Ironically, the increasing foreign exchange reserves of countries pursuing an export-led growth strategy become part of the problem

By Christopher Lingle


China's refusal to allow its currency to respond to market forces has attracted unwanted and widespread criticism. Of course, China is not the only sinner.

For their part, generations of Japan's corporate and political leadership have revealed a preternatural fear of a rising international value of the yen. At the same time, South Korea's financial and monetary authorities have been very active.

With the won at its highest level against the dollar in almost seven years, the Bank of Korea stepped up its intervention on the foreign exchange markets. Citing "excessive" appreciation, it bought up to US$2 billion.

Whereas the Korean currency gained almost 10 percent against the dollar this year, the yen and the New Taiwan dollar and Singaporean dollar are also up substantially. Given attempts to keep the won undervalued to support the price competitiveness of exporters in overseas markets, it is unsurprising that the adjustment has been so large. Only recently, the government has withdrawn from currency markets after criticism that heavy dollar buying pushed up costs of imported oil and other raw materials.

Indeed, virtually every country following an export-led growth strategy follows the same path. An artificially-low currency is seen as aiding local exporters in maintaining their global price competitiveness and allowing foreign currency reserves to rise.

Ironically, the increasing foreign exchange reserves become part of the problem that lead to costs that almost certainly outweigh the presumed benefits. In particular, most of the remedial steps lead to creating public-sector debt instruments that lead to substantial interest payments.

It turns out that export-led growth and currency intervention are logically inconsistent from an economy-wide perspective. In defending a local currency from appreciating, import prices of capital goods and raw materials are kept higher while local facility investments are sluggish. However, the artificially-low foreign exchange values kept import prices of consumer products and capital goods. This adds to upward price pressures on the domestic economy that lower the real income of workers.

A hidden loss from defending a targeted exchange rate is measured by differences between interest paid on the bonds and what was generated with the foreign currency bought by the government.

Government actions to keep a local currency weak against major currencies cause more foreign currencies to flow into the domestic banking system. In response, central banks issue bonds to absorb excessive liquidity from the financial system and thus relieve upward price pressure on the economy.

As it is, export-oriented economic policies contribute to the decision for governments to intervene in foreign currency markets that tend to push up domestic consumer prices. At the same time, forays into foreign exchange markets usually lead to increased volatility in currency markets since speculators sniff out profit opportunities created by the interventions.

It might be helpful to trace the impact of monetary policy on foreign exchange markets to see what steps are taken to avoid appreciation of a currency. If the central bank or finance ministry wishes to hold down the international value of the domestic currency, foreign currencies are purchased. This will increase the supply of the domestic currency in money markets combined with increased demand for the foreign currency that causes the value of the former to fall relative to the value of the latter.

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