Two Types of Currency Intervention

There are two types of currency intervention; policies aimed at moving the nominal exchange rate, and policies aimed at moving the real exchange rate.  I notice that many economists confuse these two policies, even though they are so different that they shouldn’t even be taught in the same course.  Nominal exchange rate control is properly taught in monetary economics, and real exchange rate control is properly taught in intermediate macro.

To make this distinction easier to see, I’m going to create two imaginary examples; Switzerland and China.  Switzerland will try to depress the nominal exchange rate to prevent deflation, and China will attempt to depress the real exchange rate to boost exports.  I am not claiming that these examples conform to the actual policies of Switzerland and China, indeed I think they do not.  Rather they conform to how many people visualize these two countries, so I’ll play along and use them as pedagogical devices.

Let’s say that both countries implement their policies by having the central bank buy foreign exchange.  Why are these policies totally different?  To answer that question, we need to focus on two key variables; the monetary base and government saving.  You decrease the real exchange rate by increasing government saving.  Period.  End of story.

You reduce the nominal exchange rate (and prevent deflation) by increasing the monetary base.  It doesn’t much matter what you buy, although the Swiss might find it convenient to buy euros, as they are using the euro/SF exchange rate as a policy instrument.  They change the monetary base in order to change the exchange rate, in order to change the price level.  Why not cut out the middleman and target CPI futures?  Good question.

A recent Wall Street Journal article discussed recent Swiss policy

The Swiss National Bank SNBN.EB +1.00% has pulled off what was thought to be a near-impossible trick: unloading billions of euros without the wider market noticing.

Switzerland’s central bank said Wednesday that the proportion of its currency reserves held in euros fell to 48% at the end of September, down from 60% at the end of June, indicating that it aggressively sold euros for other currencies throughout that time, most notably in favor of sterling and dollars.

.  .  .

The SNB had imposed its lower limit on the euro’s exchange rate against the Swiss franc in September 2011, amid a relentless surge in the value of the franc against the euro—the currency of its biggest trading partners. As a result, the bank bought a huge pile of euros in order to keep the franc competitive. A too-strong currency makes it more difficult for Swiss exporters to compete in global markets, because their products either become more expensive overseas or their profit margins drop, or a combination of both.

So far, the SNB’s so-called floor has been broken only once, when the euro dipped fractionally under 1.20 franc in April.

The bank has repeated its resolve to hold the floor in place, and with the situation in the euro zone improving, its policy is unlikely to change.

“We feel that the central bank can easily still defend the floor, so there is very limited downside to the euro against the Swiss franc,” said Jaco Rouw, senior investment manager at ING Investment Management in Amsterdam.

Of course if the Swiss swapped those dollars for US equities, nothing would happen to the SF/euro exchange rate.  And if they swapped the US equities for Swiss equities, nothing would happen to the SF exchange rate.  It makes no difference what the SNB purchases, what matters is the monetary base.  The only reason they purchased euros is that it made it slightly easier to hit their SF/euro target exchange rate.  That’s all.

During normal times when interest rates are positive, you only need a very small purchase of foreign exchange to raise the base enough to hit your nominal exchange rate target.  Have the central bank buy 1% of GDP in financial assets, and you’ll depreciate your currency by 10% to 20%.  (Of course when at the zero bound central bank purchases may be less inflationary, especially if viewed as temporary.)

In contrast, even during normal times it takes massive government saving to have a significant impact on the level of national saving, and hence the real exchange rate.  And a central bank purchase of forex need not have any effect of national saving.  If they add T-securities to the balance sheet of the central bank and delete an equal amount of domestic assets, then there is no impact on national saving.

I’m no expert on Chinese forex purchases, but the amounts are so large that I presume it’s not being used as ordinary “open market operations.”  That is, I assume the $3 trillion in purchases far exceeds the rise in the monetary base.  So somehow the central bank is acting as an agent of the Chinese government, and making purchases that boost total government saving.  And this depreciates the real exchange rate.

Why do people confuse these two types of intervention?  Because they look similar at first glance. Although the Swiss central bank may buy foreign currency, it is obviously the quantity of SF that matters, not the asset being bought.  And although the PBofChina might buy lots of foreign exchange, it’s obviously the impact on Chinese government saving that matters, not the fact that saving is being boosted via central bank purchases of US Treasury debt.  The same impact on the real exchange rate would occur if a Chinese sovereign wealth fund gobbled up lots of French and British and Brazilian equities, and the central bank let the yuan float.

However because wages and prices are sticky, any policy that depreciates the real exchange rate will also tend to depreciate the nominal rate in the short run. And vice versa.