Analysis Of Central Bank Intervention In The Foreign Exchange Market In An Open Environment

Since the Bretton Woods System collapsed in1973, foreign exchange rate hasfluctuated more violently and frequently and the globalization has been accelerated.The foreign exchange intervention to stabilize the exchange rate has become a criticaleconomic policy. At present, whatever the exchange rate regime is implemented by astate, the central bank would operate the foreign exchange intervention more or less.A state attempts to keep the foreign exchange rate stable or obtain the goals thegovernment expects.The foreign exchange intervention in China is not a temporary policy and hasbeen normalized. The direct intervention is the main method applied by the centralbank. The central bank purchases and sells the foreign exchange in the market to pegthe nominal exchange rate to the USD. The behavior of the central bank tries to keepthe competition of the exports and maintain the growth of the economy. Theintervention policy has been effective but raised some problems. It is significant tochange the behavior of the intervention to get the benefit and avoid the negativeeffects. The research of the intervention has become a topic not only concerned withthe practical situations but with the theoretical exploration.This study is mainly focus on the foreign exchange intervention in China. Thepurpose of the study is to solve the problem raised by the intervention. The studyconstructs the goals of the intervention in short run and long run. The improvement ofthe intervention methods is also considered. In this study the macro-economic policiesand infrastructure is exhibited as a base to promote the rationality of the intervention.In addition of the development of the foreign exchange market, the construction of theinformation responding mechanism would play a key role to enhance the intervention.The whole paper is divided into4sectionsThe first section covers Chapter One and Two. Main contents include the objectof the research and the principal factors that influence the intervention. The analysis isexpanded from these factors. In this section, the theoretical framework is introducedeither.Chapter One is the introduction. It presents the object of the research and definesthe main factors, which would affect the behavior of the intervention. In this chapter, the structure and the importance of the paper are described in brief.Chapter Two illustrates the theoretical framework. The first part is the relevantresearch of the intervention. Afterwards there is the comparison of the sterilizedintervention and the non-sterilized intervention. This chapter introduces MeadeConflict, the Impossible Trinity, the Mundell-Fleming Model and the Tobin Tax.These theories explain the operation of the direct intervention and indirectintervention. The last part is about the research achievement of the early-warningsystem to forecast the risk of Balance of Payments. The early-warning systemenlightens to set up the information responding mechanism to assist the intervention.Section two includes Chapter Three, Four and Five. This section presents thebackground of the research and the situation of the open market. The current state ofthe intervention in China is proved to be inevitable and has caused some seriousproblems.Chapter Three displays the history of the foreign exchange market in China andthe current situation of the offshore market of RMB. The formation and developmentof these two markets would affect the intervention.Chapter Four demonstrates the process of the open-up of economy in China andthe system called the settlements and sales of foreign exchange implemented in China.From the historical and economic perspective, the intervention in China is testified tobe necessary and inevitable. The final part of the chapter describes the evolution ofthe intervention.Chapter Five emphasizes that the current intervention in China has caused someeconomic problems. The responsibility of the central bank concentrates on thecompetition of the exports and the employment rate. For this reason the central bankundergoes the intervention. Therefore the intervention gives rise to the accumulationof foreign exchange reserves and the pressure of inflation. The intervention begins tobecome an obstacle to the adjustment of economic structure. This is not thereasonable aim of the intervention.Section three includes Chapter Six, Seven, Eight, Nine and Ten. This section isthe most important part of the study and sets up the whole analytical structure. Theanalysis starts from the standards of the rational intervention behavior. The standardsdeduce the goals of the intervention. The improvement of the methods of theintervention and the relevant economic reform are to achieve the rational intervention behavior. In the final part of this section the information responding mechanism isconstructed and the mechanism is to upgrade the intervention behavior.Chapter Six tries to define the level of rationality of the intervention. Two factorsare critical to fulfill this task. One is macro-prudential and micro-prudential regulation.The other is market failure, especially the foreign exchange market failure. When theintervention is to make up the market failure and accelerate the maturity of the market,it is rational. When the intervention is to prevent the financial risk, it is rational.Chapter Seven presents the goals of the intervention. The central bank of Chinaneeds to change the goals in order to avoid the economic problems. The interventionhas its ultimate aim to make the RMB independent and free from any nominal anchor.In the end the RMB will be an international currency. Meanwhile the interventionserves the build-up of market-oriented economy with Chinese characteristics. It is nota simple task. At first the intervention should stabilize the value of the currency andproves the RMB is reliable. Then the central bank should detect the equilibriumexchange rate that is accommodated with the open market. Therefore the goal of theintervention should be transformed from the growth of economy to curbing theinflation, preventing the financial risks and forming market-oriented economy. In theshort run the intervention of the central bank attempts to maintain real effectiveexchange rate stable. In the long run, the central bank tries to obtain the equilibriumexchange rate.Chapter Eight discusses the improvement of the methods of the intervention. Theindirect and direct interventions have their own features. Both of them areimplemented in China. The direct intervention needs to be coordinated with moreways of sterilization. The principal way of indirect intervention is to supervise thecross-border capital flows in China. On account of the Impossible Trinity and theMundell-Fleming Model, the supervision on the cross-border capital flows issupplementary to the direct intervention. Therefore the indirect intervention would bemodified. The supervision on the cross-border capital flows would be more effective.The steps of capital account opening should be gradual and carefully planned.Chapter Nine specializes in the macro-economic policies and infrastructure tosustain the rational intervention behavior. The adjustment of infrastructure is relatedto the economic structure, the foreign exchange market and the exchange rate regime.The proper infrastructure is useful to achieve the goals of the intervention. The reasonable economic structure would balance the demand and supply in the foreignexchange market. The development of the internal foreign exchange market should besuitable to the actual situations in China. The maturity of the foreign exchange marketmakes the intervention overcome the market failure easily. The reform of theexchange rate regime should be able to internationalize the RMB and improve theintervention. The intervention is in favor of the reform of the regime.Chapter Ten demonstrates the function of the information responding mechanism.It could make the central bank implement the intervention more scientifically andpromptly. The mechanism guides the intervention by the change of the coincidentindicators and index. These indicators and index would move violently when the gapof the foreign exchange demand and supply increases or decreases beyond thepresetting threshold value. In this chapter the leading indicators of the coordinateindicators have also been explored. Based on simple, easily accessible, and significantprinciples, the investigation system is established. The system pays close attention tothe behavior and expectation of the market participants. The investigation system is apart of the mechanism and would direct the intervention.The forth section has Chapter Eleven and Twelve. They are the internationalcomparison of the intervention and the conclusion. This section compares theintervention behavior of four economies including America, Japan, Thailand andHong Kong. The analytical structure of the study is applied in these four cases and therationality of their intervention is estimated. In this section the drawbacks of the studyand the further research plan are also exhibited.Chapter Eleven analyzes the intervention occurred in some other economies,America, Japan, Thailand and Hong Kong. The interventions happened in these foureconomies are evaluated. The goals and methods of the intervention, infrastructure,foreign exchange market etc. are compared that proves the arguments presented in theprevious chapters. America and Japan that represent the big economies have similargoals of the intervention but their behavior is different. The opening-up of the marketsin America and Japan shows the process of the economic globalization. In the openmarket, the goal of the intervention in America is to get the internal equilibrium andkeep the USD at the core position in the international monetary system. All the effortsof the intervention serve this goal. Japan is on the other side. It regards the exports asthe engine to enhance the economy so the intervention is tagged mercantilism. Its intervention commonly tries to depreciate Yen and get the competition. However thecentral bank of Japan wishes to realize the internationalization of Yen. Its goalconflicts to its behavior. The cases of Thailand and Hong Kong occurred in1997and1998. During that period, the financial crisis hauled down the economy of the SouthEast Asia and the East Asia. In the open market, both Thailand and Hong Kong pegtheir currency to the USD. Taking into account their intervention, the intervetion ofthe monetary authority in Hong Kong is more rational and supported by its marketsystem and more foreign exchange reserves. Thailand endeavored to keep Thai bahtstable but it was defeat by the Hedge Funds. For the simple reason the behavior ofThailand was not rational and it had less foreign exchange reserves.Chapter Twelve concludes the preceding analysis and research. It discusses thedrawbacks of this study and the direction of the future research.Due to the analysis, this study presents the main factors to affect changes of theintervention behavior. There are three factors, the goals of the foreign exchangeintervention, the situation of foreign exchange market and the exchange rate regime.According to the adjustment of these factors, the intervention should be adjusted atthe same time.Firstly, the central bank should clarify the goals of the intervention. The originalgoal in China is to increase the exports and enhance the economic vigor. At presentthe goals have to be changed from mercantilism and play roles in preventing financialrisks, preserving the market order, and achieving the equilibrium. Secondly, thecentral bank is apt to develop the foreign exchange market and reform the exchangerate regime. In accordance with the overall reform and open-up policies, theintervention should become a positive policy. Thirdly, the central bank reduces thefrequency of the direct intervention and commits rational indirect interventions. Thesupervision of the cross-border capital flows should be the main part of the indirectintervention. The management and guidance of the expectation are also important.The information responding mechanism is helpful to the rationalization of theintervention. The intervention is not a temporary policy and is critical to form theeconomic equilibrium and the independence of the RMB.