FX intervention: echoes of “currency wars” - Capital Economics
Emerging Markets Economics

FX intervention: echoes of “currency wars”

Emerging Markets Economics Update
Written by Shilan Shah
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The announcement of FX purchase programmes by several EM central banks has evoked comparisons with the “currency wars” that followed the Global Financial Crisis. One lesson from this period is that FX intervention is unlikely to prevent further currency appreciation against the dollar. Upwards pressure on EM currencies, at the margin, reinforces our dovish views on EM monetary policy.

  • The announcement of FX purchase programmes by several EM central banks has evoked comparisons with the “currency wars” that followed the Global Financial Crisis. One lesson from this period is that FX intervention is unlikely to prevent further currency appreciation against the dollar. Upwards pressure on EM currencies, at the margin, reinforces our dovish views on EM monetary policy.
  • Central banks in Chile, Poland, India and Israel have all recently announced (or strongly hinted at) plans to purchase foreign exchange over the next year or so. The Chilean central bank has announced that it will make regular daily purchases of $40mn, totalling $12bn (5% of GDP) by Q2 2022. Israel’s central bank plans to purchase $30bn (almost 8% of GDP) over the course of 2021.
  • Comments from central banks in India and Poland also suggest that more FX purchases are likely, although details are scarce. In India’s case, intervention towards the end of last year can be used as a guide as to what may lie in store. The RBI purchased an average of $14.5bn per month in FX, or $174bn (6% of GDP) annualised – the programme this year could be of a similar size.
  • These FX purchases are fairly large. They are about as big as the peak in Brazil’s intervention programme during the 2010-13 currency wars (5% of GDP over a 12m period), and larger than Colombia’s (2% of GDP) – two countries where central banks were particularly active in trying to stem appreciation pressures.
  • One interesting difference compared to the currency wars of 2010-13 is that EM currencies in general do not look overvalued now. Countries in Latin America and elsewhere ran current account deficits back then. And various other measures of real exchange rate overvaluation were flashing red. But for the time being, perennial current account deficit countries like India, Mexico, Chile and South Africa are all running surpluses – as are Israel and Poland.
  • The motives for FX intervention by central banks in Chile, Poland, India and Israel this year appear three-fold. The first is to prevent currencies from becoming overvalued in the first place. Overvalued currencies can hold back GDP growth by dragging down net trade. This can lead to large current account deficits, which can make currencies vulnerable to large and disorderly falls, particularly when external conditions deteriorate.
  • The second is to build up FX reserves while external conditions are favourable. Indeed, this has been a stated aim of most central banks. Chile’s central bank is concerned about financial market volatility ahead of a busy political calendar with a number of potential flashpoints. And in all cases, there is a risk that a withdrawal of US monetary stimulus causes a rise in US treasury yields, triggering a re-run of the 2013 “Taper Tantrum”. Greater FX reserves provide a buffer which can help to prevent destabilising currency falls when conditions become less favourable.
  • Third, in Poland’s case, there appears to be a clear intent to loosen monetary conditions. We know that Chile’s central bank plans to sterilise its FX purchases. And based on past form, Israel’s central bank will do so too. The situation is less clear-cut in India and Poland. But in the latter, policymakers’ desire to boost the economic recovery suggests that FX purchases may not be fully sterilised.
  • The direct impact of FX intervention over the coming months is likely to be small. Chile’s planned daily purchases are equivalent to just 0.2% of average daily foreign exchange turnover. The equivalent figures for Israel and India are 0.6% and 0.5% respectively.
  • The indirect impacts of FX intervention (via signalling) could be larger, but we think these effects should be modest too. For a start, much of the initial impact should already be priced in. For instance, the Chilean peso fell by 4% against the dollar in the week that the central bank’s FX intervention programme was announced. And although intervention programmes in India and Poland are more opaque, sizeable FX purchase are still unlikely to come as a surprise as they have been well telegraphed.
  • More generally, while FX intervention can sometimes limit appreciation (or depreciation) pressures, rarely does it alter the direction of travel. This was true in Latin America during the currency wars of 2010-13 (even though currencies looked overvalued). Indeed, it was only falls in commodity prices that eventually turned the tide for the region’s exchange rates.
  • And it’s also true in India’s recent experience. The RBI’s aggressive $65bn in FX purchases in the second half of last year may explain why it is one of the weakest performing major EM currencies over that period. But the purchases didn’t prevent a further 3% appreciation in the currency.
  • FX intervention tends to have limited success at altering the direction of travel because it doesn’t change the fundamental reasons behind the appreciation pressure. We expect the US dollar to continue to weaken further over the coming quarters, and risk appetite to remain strong. Against that backdrop, capital inflows to EMs should remain strong, and upward pressure on EM currencies is likely to persist.
  • As a result, other EM central banks may follow suit and announce FX purchase programmes too. Turkey’s central bank has hinted at FX intervention to rebuild reserves following last year’s lira crisis. Meanwhile, central banks in parts of Asia (China, Thailand, Taiwan, Vietnam and Malaysia) will continue to manage their currencies to varying degrees.
  • Admittedly, central banks in Asia are becoming concerned about rebukes and retaliation from the US. Indeed, the US Treasury recently labelled Vietnam a currency manipulator. And China, Korea, Singapore, Malaysia, Taiwan, Thailand and India are on the “watch list”.
  • Policymakers in the region will be watching the fate of Vietnam closely. It’s most likely that talks between the two countries will continue for some time. Aggressive US retaliation, such as large tariffs on imports, looks unlikely – particularly given that President Biden is set to be more conciliatory than his predecessor. Moreover, from a US perspective, retaliation could be counterproductive if the currency of the country on the receiving end weakens against the dollar in response to the news.
  • Finally, further capital inflows and upwards pressure on EM currencies, at the margin, reinforce our dovish views on EM monetary policy. Keeping policy rates lower than discounted in financial markets could be another way for central banks to keep currencies weak and lock in external competitiveness gains. This is particularly the case in Poland, where we expect FX intervention to be accompanied by policy interest rate cuts.

Shilan Shah, Senior Economist, shilan.shah@capitaleconomics.com
Edward Glossop, Senior Emerging Markets Economist, edward.glossop@capitaleconomics.com