Question

Please explain why this Central Bank decided to intervene in the Forex market then evaluate the results provided in the paper. Please find other examples of intervention by Central Banks and describe the rationale behind their policies. Do these policy choices seem useful or disruptive? Why or why not? How are these actions examples of Political Risk to MNCs?

Answer 1

Foreign Exchange Intervention :- A foreign exchange intervention is a monetary policy tool used by a central bank. When the central bank takes an active, participatory role in influencing the monetary funds transfer rate of the national currency. It usually does so with its own reserves or is own authority to generate the currency.
Central banks, especially those in developing countries, intervene in the foreign exchange market in order to build reserves for themselves or provide them to the country's banks. Main aim/goal is often to stabilize the exchange rate.

Key Note features :-
Foreign Exchange Intervention refers to efforts by central banks to stabilize a currency.
Destabilizing effects can come from both market or non-market forces.
Currency stabilization may require short-term or long-term interventions.
Stabilization allows investors to be more comfortable with transactions using the currency in question.

Understanding for analysing of Foreign Exchange Intervention by Central Bank :-

When a central bank increases the money supply through its various means of doing so, it must be careful to minimize unintended effects such as runaway inflation. The success of foreign exchange intervention depends on how the central bank sterilizes the impact of its interventions, as well as general macro-economic policies set by the government. Two difficulties that central banks face are determining the timing and amount of intervention, as this is often a judgment call rather than a cold, hard fact.

The amount of reserves, the type of economic trouble facing the country, and the ever-changing market conditions require that a fair amount of research and understanding be in place before determining how to take a productive course of action. In some case a corrective intervention may have to be taken shortly after the first attempt.

Requirement of Intervene (with Example) :-

Foreign exchange intervention comes in two typical flavors.
1) Firstly, a central bank or government may assess that its currency has slowly become out of sync with the country's economy and is having adverse affects on it.
In Simple terms Says, Countries that are heavily reliant on exports may find that their currency is too strong for other countries to afford the goods they produce. They may intervene to keep the currency in line with the currencies of the countries which export their goods.

Example of this kind of intervention occurred by the Swiss National Bank (SNB) from September 2011 to January 2015. The SNB set a minimum exchange rate between the Swiss Franc and the Euro. This kept the Swiss Franc from strengthening beyond an acceptable level for other European importers of Swiss goods. This was successful for three and half years but then the SNB determined that it had to let the Swiss Franc float freely and without prior warning they released the minimum exchange rate. This had highly negative consequences to some businesses, but generally the Swiss economy has been unfazed by the intervention.

2) Secondly, intervention can be a short-term reactionary to a certain event. Often, times a one-off event may cause a countries currency to move in one direction in a very short space of time. Central banks will intervene with the sole purpose of providing liquidity and reducing volatility. After the SNB lifted the floor in its currency against the Euro, the Swiss franc plummeted by as much as 25 percent. The SNB intervened in the short term to stop the Franc from falling further and curb the volatility.

The Effectiveness of Foreign Exchange Intervention in Emerging Market Countries :-

Effectiveness of foreign exchange intervention in emerging market countries is done in two steps.
First, an extensive review of the literature on this topic is conducted.
Second, new evidence from a systematic study using actual intervention data is presented.
A major stumbling block in assessing the effectiveness of intervention in emerging markets has been a lack of data. In constructing an overview of the results, it is therefore useful to combine the evidence that is available with the sizeable literature from advanced economies and to take into account specific institutional differences that may lead to considerable divergence in the effectiveness of intervention. Indeed, differences in the exchange rate regime pursued, the history of policy actions, the depth and sophistication of the foreign exchange market, and regulatory controls on various aspects of foreign exchange transactions, can significantly influence the impact of intervention. That foreign exchange intervention appears to be more common in emerging market countries is partly a reflection of structural characteristics of such economies that often contribute not only to greater exchange rate volatility, but also to larger effects of such fluctuations on the real economy. Indeed, when the foreign exchange market is thin and dominated by a relatively small number of agents, it is likely that the exchange rate will be volatile if the authorities do not provide some guidance and support. This problem is compounded if there is no track record of stable macroeconomic policies that can firmly anchor market expectations about future monetary and exchange rate policy. Underdeveloped and incomplete financial markets also imply that hedging against exchange rate risk is costly and sometimes impossible, so that the costs of exchange rate volatility can be substantial for individual agents and for the economy as a whole.

Intervention of central banks in exchange rate markets :-

Interventions can be classified into different types:
Direct intervention and Indirect intervention;
Sterilized intervention and Unsterilized intervention;
Unilateral intervention and Joint intervention etc.

Mostly Use Approaches of Intervention :-

There are two intervention approaches the central bank may take. The direct method involves intervention by buying or selling currency in an attempt to manipulate the market. Whereas indirect approaches, attempt to make changes the domestic money supply.
Direct Method :-The direct method is a more obvious method of intervention. The central bank can reduce the value of a currency by flooding the market with it. A raise in the supply of a specific currency will lead to its depreciation n value. Conversely, the central bank can raise the value of a currency by purchasing large amounts of it. The increased demand of the currency will cause it to appreciate.
The long-term effect of this direct intervention is limited. Eventually the market will stabilize and resume its previous trends.

Indirect Method :-The indirect method of intervention attempts to change the exchange rate through changes in the money supply. By increasing the supply of money the value for that currency will decrease. Similarly if the money supply is decreased the value for it will increase. This approach is effective but often takes several weeks to have an impact. This is because it must traverse all market operations before affecting the exchange rate. Another disadvantage of this method is that it also requires the central bank to alter the domestic interest rate to compensate for the change in money supply.

Intervention in the foreign exchange market is done sparingly because of the long-term effects it may have on other domestic factors. For example, changing the money supply will affect interest rates and price levels. This will contribute to a higher inflation rate, higher unemployment rates, and less gross domestic product growth in the long run.

To avoid these long-term effects, a sterilized intervention may be used. Sterilized intervention is intended to change the exchange rate without changing the money supply or interest rates. This type of intervention happens when the central bank offsets its direct intervention by making a simultaneous change in the domestic bond market. Studies have shown that a sterilized intervention of the foreign exchange market will yield short-term temporary results but ultimately have no lasting effects on the county’s currency value. A more lasting effect can be possible if the intervention leads to investors changing their future expectations in the market.

Intervention Impact on Current Market :-

Before listing the determinants of a successful FX intervention, it is important to define “success”. Thus, a central bank that spends about $5 billion (medium-size) on intervention and manages to raise/lift the value of its currency by about 2% against the major currencies over the next 30 minutes is said to be successful. Even if the currency ends up losing its gains over the next two trading sessions, the proven ability of that central bank to move the market in the first place gives it some kind of respect for the next time it “threatens” to step in.

Size Matters : The magnitude of the intervention is usually proportional to the resulting move of the currency. Central banks equipped with substantial foreign currency reserves (usually denominated in dollars outside the US), are those that command the most respect in FX interventions.

Timing : Successful FX interventions depend on timing. The more surprising the intervention, the more likely it is that market players are caught off-guard by a large inflow of orders. In contrast, when intervention is largely anticipated, the shock is better absorbed and the impact is less.

Momentum : In order for the “timing” element to work best, intervention is more ideally implemented when the currency is already moving in the intended direction of the intervention. The large volume of the FX market ($1.2 trillion per day) dwarfs any intervention order of $3-5 billion. So central banks usually try to avoid intervening against the market trend, preferring to wait for more favourable currents. This may be done through verbal posturing (jawboning), which sets the general tone for a more fruitful action when the actual intervention begins.

Sterilization. Central banks engaging in monetary policy measures in line with their FX actions (unsterilized intervention) are more likely to trigger a more favourable and lasting change in the currency.

Broadly speaking there are 03 main channels through which central bank intervene:

1- Portfolio channel : To bring the large swings in the exchange rates, changes in the desired allocation of currencies in the investor’s portfolio are made. Central bank can reduce the fluctuations to desired level by providing necessary supply of currency.

2- Signaling Channel : An intervention provides signals about the future course of monetary policy, which in turn affects asset prices. For example, when intervention is undertaken to avoid depreciation, the next step would be to tighten monetary policy, which should strengthen the domestic currency.

3- Information channel : Authorities transmit certain information to the market via an intervention and its announcements. More uncertain the market gets by information, the more fluctuation results in exchange rates.

For MNC's, political risk refers to the risk that a host country will make political decisions that prove to have adverse effects on corporate profits or goals. Adverse political actions can range from very detrimental, such as widespread destruction due to revolution, to those of a more financial nature, such as the creation of laws that prevent the movement of capital.

Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policymakers or military control.

The Two Types of Political Risk -

Macro Political risk & Micro Political rsik

Macro risk refers to adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas
Micro risk refers to adverse actions that will only affect a certain industrial sector or business, such as corruption and prejudicial actions against companies from foreign countries.

All in all, regardless of the type of political risk that a multinational corporation faces, companies usually will end up losing a lot of money if they are unprepared for these adverse situations.

For example, after Fidel Castro's government took control of Cuba in 1959, hundreds of millions of dollars worth of American-owned assets and companies were expropriated. Unfortunately, most, if not all, of these American companies had no recourse for getting any of that money back.

Minimize Exposure to Political Risk ;-

There are a couple of measures that can be taken even before an investment is made. The simplest solution is to conduct a little research on the riskiness of a country, either by paying for reports from consultants that specialize in making these assessments or doing a little bit of research yourself, using the many free sources available on the internet (such as the U.S. Department of State's background notes). Then you will have the informed option to not set up operations in countries that are considered to be political risk hot spots.

While that strategy can be effective for some companies, sometimes the prospect of entering a riskier country is so lucrative that it is worth taking a calculated risk. In those cases, companies can sometimes negotiate terms of compensation with the host country, so that there would be a legal basis for recourse if something happens to disrupt the company's operations. However, the problem with this solution is that the legal system in the host country may not be as developed, and foreigners rarely win cases against a host country. Even worse, a revolution could spawn a new government that does not honor the actions of the previous government.

Buying Political Risk Insurance

If you do go ahead and enter a country that is considered at risk, one of the better solutions is to purchase political risk insurance. Multinational companies could go to one of the many organizations that specialize in selling political risk insurance and purchase a policy that would compensate them if an adverse event occurred. Because premium rates depend on the country, the industry, the number of risks insured and other factors, the cost of doing business in one country may vary considerably compared to another.

However, be warned that buying political risk insurance does not guarantee that a company will receive compensation immediately after an adverse event. Certain conditions, such as trying other channels for recourse and the degree to which the business was affected, must be met. Ultimately, a company may have to wait for months before any compensation is received.