International capital flows
The mechanics of central bank intervention in foreign exchange markets
The efficient way to intervene in the foreign exchange market
Authors:
K. Basu
Publisher:
Bureau for Research and Economic Analysis of Development, 2008
Central banks in developing countries, wanting to devalue the domestic currency, usually intervene in the foreign exchange market by buying up foreign currency using domestic money often backing this up with sterilisation to counter inflationary pressures.
In India, when the Reserve Bank of India (RBI) wants to devalue the rupee it typically does so by using rupees to buy up foreign currency from the market. This strengthens the foreign currency and weakens the rupee. People’s Bank of China does this and so does the Federal Reserve in the United Stated, though only on occasions. One fall-out of this kind of intervention to keep a nation’s currency undervalued is that it leads to a build-up of foreign currency reserves beyond what a nation might need.
It seems so axiomatic that buying a good is the way to boost the price of the good that most central banks give very little thought to the design of such interventions beyond deciding on how much foreign exchange to purchase. The paper proposes new kinds of interventions which have the same desired effect on the exchange rate, without causing a build up of reserves.
