CENTRAL BANK INTERVENTION IN FOREIGN EXCHANGE MARKET

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Q2.) (a.) Why do central banks intervene in the foreign exchange market? What are the consequences of their intervention?

Ans: Foreign exchange intervention is the process whereby a central bank buys or sells foreign currency in an attempt to stabilize the exchange rate or to correct misalignments in the forex market. This is often accompanied by a subsequent adjustment, by the central bank, to the money supply to offset any undesirable knock-on effects in the local economy.

The primary purpose of the intervention is to alter the liquidity of the markets by providing either supply or demand for home currency in the foreign exchange market. Central banks generally agree that intervention is necessary to stimulate the economy or maintain a desired foreign exchange rate. Central banks will often buy foreign currency and sell local currency if the local currency appreciates to a level that renders domestic exports more expensive to foreign nations. Therefore, central banks purposely alter the exchange rate to benefit the local economy.

Central bank's main objective is to stabilize exchange rate fluctuations. Because, if the exchange rate continuously will change then it will automatically create hurdle in global/international trading and investment decisions in business. Because, if traders will not confident against the stability of the exchange rate they will automatically reduce their investment actions due to these uncertain conditions, and because of this reason investors normally put pressure on Central Bank or Government to intervene id the exchange rate continuously fluctuating too much.

Another reason for the central bank's intervention is an attempt to stop or reverse a country's trade deficit. This is because a higher exchange rate will make countries' goods and services cheaper. This will motivate imports while oppressive exports, creating a trade deficit.

If a central bank no longer has foreign currency reserves, it may borrow them from other central banks or get accommodation from world financing agencies like IMF, World Bank. Excessive foreign currency reserves may be lent in the markets. What this means is that spot interventions always lead to other money market operations with clear interest rate implications. Therefore, central banks, in order to intervene effectively in spot, markets undertake forward swap transactions in sizeable amounts in their domestic market. However, there are very clear cut lessons which the central banks have learned: 

1) It is difficult to fight a market trend unless the trend is about to shift; 

2) Acting in a manner that the market is anticipating is futile and self-defeating; 

3) It is only by keeping the markets guessing that some degree of success can be achieved;