Such broad-based grounds for skepticism aside, some researchers have undertaken analyses to rank individual types of foreign exchange interventions by their effectiveness in moving exchange rates (Dominguez 2003, 2006). For industrialized countries, it appears that the most effective intervention activities — defined in terms of magnitude and persistence of exchange rate effects—are those that are coordinated across major currencies, publicly announced, and “unsterilized,” meaning that the central bank does not conduct open market operations to neutralize the consequences of the intervention for domestic money supplies. Researchers have also examined how these interventions actually affect exchange rates. Some contend that the effects of intervention work through portfolio channels—that is, the interventions influence exchange rates by changing the relative supply of currencies and related assets in the hands of private investors. Others argue that the strongest effects of foreign exchange interventions occur through “signaling” channels. In other words, the interventions are viewed as communicating the intentions of domestic and foreign policymakers with respect to monetary aggregates. The most effective signals, the research suggests, are those consistent with the intended path of future interest rates.
Interestingly, the studies of foreign exchange intervention do not offer a clear account of the level of foreign exchange reserves needed to intervene in foreign exchange markets for the purpose of influencing exchange rates. Hence, a bit of a paradox arises.
Suppose signaling is the most effective channel for foreign exchange intervention effects on exchange rates. How much foreign currency must be bought or sold in foreign exchange markets—if any—to achieve a viable signal of policy intention? Perhaps the purchase or sale of a small amount of reserves would be enough to send the appropriate message, as long as this transaction was accompanied by a clear statement of intent on exchange rate goals and monetary trajectories.A minimalist approach to intervention activity might be particularly effective when interventions are coordinated across countries.
These arguments are relevant for countries that seek to resist appreciation or weaken the value of their currencies—including those countries facing large capital inflows and currency appreciation pressures because their currencies are regarded as “safe havens.” Certainly, a central bank can provide the extra domestic currency demanded by markets, buy up foreign currency, and accumulate substantial holdings in official reserve accounts.Yet it may be the case that policymakers do not need to use foreign exchange reserves to achieve their goals.As an alternative to this type of foreign exchange accumulation, policymakers could implement—if feasible—expansionary monetary policies. However, such expansionary policies entail their own costs and benefits, which would have to be weighed.
Central banks that acquire a large stock of reserves through foreign exchange interventions, purchasing foreign currency in return for (an elastically supplied) domestic currency, face
another, longer-term issue. Once reserve balances become high, the central bank may need to identify an exit strategy. This exit strategy defines the path that should be pursued to return foreign exchange reserve holdings to less elevated levels. The strategy chosen depends in part on the circumstances surrounding the initial growth of reserves. If reserves grew as part of a central bank’s effort to offset the exchange rate effects of safe-haven inflows from a transitory risk event in another country, the central bank might wait until the excess inflows have reversed, and then sell foreign exchange reserves in a way that minimizes appreciation pressures on its own currency. Exchange rate impacts may be weaker when such sales are conducted without signal content and without coordination across countries—though too few episodes of such reserve balance “unwinding” have been explored by researchers to produce evidence definitively supporting this approach. In general, operations guided by principles such as transparency, predictability, and gradualism may be less likely to have undesirable signaling content and, for this reason, are less likely to have large impacts on the exchange rate.
Most industrialized countries mandate that reserves be invested in highly liquid assets such as foreign government securities; while these assets provide insurance against a loss of access to the capital markets, they generally yield relatively low rates of return.
Foreign exchange interventions in which the central bank seeks to counter a currency depreciation represent a much less sustainable strategy than interventions aimed at resisting currency appreciation. In responding to depreciation pressures, a central bank has finite stocks of foreign exchange reserves that can be depleted rapidly by speculative activity in foreign exchange markets betting on currency depreciation. Persistent sales of foreign currency in support of a domestic currency would drain foreign exchange reserves quickly to some floor level. Hence, the sale of reserves might end up being just a transitory measure that has no lasting effect on currency values. To ensure that the intervention will have a more lasting effect, the central bank will probably want to rely on the signaling channel. The most effective signals are those coming from convincing guidance on monetary policy and credit conditions across countries.
In both appreciation and depreciation episodes, exit strategies from suboptimal reserve balances—whether too high or too low—pose difficulties because they may distort prices for a period of time.Accumulated reserves above and beyond normal levels for countries are presumably excessive from a longer-run perspective, raising the issue of how best to reduce balances and minimize the resulting period of exchange rate distortions. Likewise, when reserves are depleted and below desired levels, they can be difficult to replenish unless exchange rates are maintained at levels that keep the home currency more depreciated than market forces would otherwise dictate.
Another issue relevant to optimal reserve quantities pertains to the insurance motive. Some of the demand for reserves as insurance against liquidity losses could be mitigated by other options available to industrialized economies in the event of a liquidity disruption. In 2007 and 2008, a number of bilateral measures were arranged across central banks to alleviate funding pressures in their domestic currencies. One such measure was the central bank network of swap lines (see McGuire and von Peter [2009]). For example, the Federal Reserve’s foreign exchange swaps program allowed some countries to address disruptions to U.S. dollar funding markets for local institutions rather than deploy their foreign exchange reserves (see Goldberg, Kennedy, and Miu [2011]).A group of central banks that have entered into various bilateral swap agreements may reduce the need for their own reserve accumulations, although the provision of large amounts of currency and the establishment of lines across other central banks are not always made as long-term commitments.
Central banks that acquire a large stock of reserves through foreign exchange interventions . . . face another, longer-term issue. Once reserve balances become high, the central bank may need to identify an exit strategy.
Significantly, these swap lines are not aimed at funding foreign exchange intervention or adjustments to the exchange rate. The International Monetary Fund’s Flexible Credit Line is also designed for insurance purposes.
The Experiences of Six Industrialized Economies
To examine in more concrete terms the issues surrounding industrialized country reserve holdings, we consider the experiences of a few advanced countries: Canada, Japan, Switzerland, the United Kingdom, the United States, and the euro area. The foreign exchange reserve balances of these economies have grown over the past decade (Chart 1). [Other central bank reserve assets include gold, special drawing rights, and International Monetary Fund reserve positions. It is mainly the foreign exchange reserves component that is actively managed and used for most official transactions.] However, the reserve growth rates, levels, and sources of reserve accumulation differ markedly across two subsets of these countries. The United States, Canada, the euro area, and the United Kingdom have similarly sized reserves holdings, ranging from $50.5 billion (for the United States) to $66.7 billion (for the United Kingdom) at the end of 2012. Each of the four countries experienced gains in their reserve holdings over the decade, ranging from a 39 percent increase in the reserves held by the European Central Bank to a more substantial 68 percent increase in the reserves held by the Bank of Canada. For these countries, reserve increases have stemmed primarily from market-based fluctuations in exchange rates between U.S. dollars and euros or yen, from capital gains, and from interest accrued on investment portfolios.