IMF identifies three circumstances for central banks’ FX Intervention

The International Monetary Fund (IMF) has identified three circumstances under which central banks may consider implementing Foreign Exchange Intervention (FXI) to address large shocks.

With major central banks now cutting policy rates, the global interest rate cycle is turning.

in a new blog post obtained from its website, the IMF’s Suman Basu, Sonali Das, Olamide Harrison, and Erlend Nier wrote that when foreign exchange markets become illiquid, a central bank can use FXI to manage sharp changes in financial conditions that may arise from capital flow and exchange rate pressures and that threaten macroeconomic and financial stability.

According to the IMF, FXI may be warranted when: foreign exchange markets become illiquid. This could be as a result of a sudden stop or reversal of capital flows which threatens exchange rate stability and disrupts the economy; when there is a sharp drop in the currency that would otherwise lead to a crisis and where a sharp depreciation is likely to cause inflation expectations.

It stated that disorderly market conditions, characterized by extreme exchange rate volatility, require central bank action to maintain financial stability.

In these situations, the IMF believes that FXI can help mitigate the impact of the shock, maintain confidence in the currency, and support economic recovery.

Most stakeholders in Nigeria have argued that Nigeria’s major challenge is the persistent FX illiquidity occasioned by limited foreign exchange inflows to the country.

Without sufficient FX reserves, confidence in the Nigerian economy will remain low, and Naira will remain under pressure. The economy will have no firepower to support its currency. Besides, a fixed exchange rate system is akin to running a subsidy regime! Some feared.

Offering an alternative, stakeholders suggested that the country adopt a managed-float system where the Central Bank of Nigeria (CBN) intervenes to control and stabilise the Naira’s value, primarily to curb speculative activities.

“On the other hand, given Nigeria’s underlying economic conditions, adopting a floating exchange rate system would be an overkill,” said former Vice President Atiku Abubakar.

However, the IMF emphasizes that FXI should be used judiciously, with clear objectives, and in conjunction with sound macroeconomic policies.

“Our Integrated Policy Framework, or IPF, recognizes that financially open economies may be more vulnerable to shocks, so fully flexible exchange rates may not always work well. That’s why we identify three circumstances in which central banks could consider FXI to address a large shock, “ the Fund stated.

According to the global institution, for unhedged currency exposures, a central bank can use FXI to counteract a sharp drop in the currency that would otherwise lead to a crisis, such as one involving large-scale private sector defaults on dollar-denominated debt

“Where a sharp depreciation is likely to cause not just a temporary increase in the prices of goods and services but also raise inflation expectations, the central bank can consider FXI along with raising interest rates to contain those impacts. The complementary use of FXI can reduce the adverse growth impact from the tighter monetary policy.

“These cases are embedded in the Fund’s conceptual and quantitative IPF models, and also draw on empirical work and considerations from outside the models, “ it said.

On drawbacks, the IMF disclosed that framework also recognizes that FXI may forgo some benefits of full exchange rate flexibility when it comes to macroeconomic adjustment, such as people and businesses switching between domestic and foreign goods and services.

Another important consideration is that accumulating and holding reserves for FXI is costly.

Intervention according to the Fund, can also have unintended side-effects. Overuse may hinder development of FX markets by reducing incentives for private-sector currency trading or hedging.

Expectations that the central bank will step in to stem losses can also create moral hazard. Moreover, poorly communicated FXI may cause confusion about the central bank’s policy reaction function and main instrument for achieving its inflation target, it said.

Given such drawbacks, it observed that the IPF recommends intervention only in the cases described above and when shocks are large enough to threaten economic or financial stability, such as an unusually sharp fluctuation in the exchange rate or financial conditions.

“In these cases, intervention should not be used to avoid adjusting monetary and fiscal policies. And if reserves are scarce, it may be best to preserve them until bigger shocks loom. When it is determined that intervention is appropriate, such intervention is most effective as part of a combined policy approach that integrates other macro and financial tools.

“Even before a shock, countries should want to deepen their FX markets, making them more resilient to strains. Appropriate macroprudential measures can reduce risky borrowing in foreign currencies. And countries can better anchor inflation expectations to reduce the need for intervention in the event of shocks, “ the Fund advises.

The IMF stated that its framework updates advice by considering more integrated use of a wider range of policy levers to address market frictions and large shocks. It is also intended to foster policy discussions with member countries as it regularly assesses their vulnerabilities and potential responses.

The IPF can help countries adapt to their unique circumstances as they prepare for enduring uncertainty and future shocks it concluded.

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