Analysis: Would 2020 Be the Year of RBA FX Intervention?

• Published on
• 24 Jan 2020, 12:00 AM

(this is the second of my two-part story on forex intervention)

By Sophia Rodrigues

There was one line in the recent U.S. Treasury report on foreign-exchange policies of major trading partners that went largely unreported – the one where it complimented India for its “transparent” foreign-exchange policy.

“India has been public about the need to bolster foreign currency reserves and the Reserve Bank of India purchased close to $10 billion over the first six months of 2019. Other economies are not as transparent about their foreign exchange policies and practices,” the report said.

The comment was made in the context of modest rise in global foreign currency reserves in the first half of 2019, up $254 billion to $11.7 trillion, versus broadly stable growth the year before. The rise was mainly due to increase in foreign exchange purchases.

What I found interesting was the praise RBI got for being transparent, even though the transparency was related to purchase of forex reserves to prevent appreciation in its exchange rate.

If RBI can do it, surely other central banks could accumulate forex reserves when their currency is facing strong upward pressure.

Could the Reserve Bank of Australia be one such central bank?

A BIT OF BACKGROUND

The Indian rupee is fully convertible on current account but only partly on capital account. The  exchange rate is floating, though “managed floating” is a more appropriate term.

The RBI’s exchange rate policy has been to allow the rupee to be determined by market forces. It intervenes only to maintain orderly market conditions, without reference to any pre-determined level or band.

According to the RBI,  in the absence of any intervention, “surges and sudden stops in capital flows and the associated disorderly movements in the exchange rate can often have a deleterious impact on trade and investment, besides endangering overall macroeconomic and financial stability.”

It’s no different with the RBA.

The RBA’s approach to forex intervention has evolved over the past 30-plus years as the market matured. Even though Australia has a floating exchange rate, the RBA can still intervene in the forex market if it becomes disorderly or dysfunctional. The RBA also retains the discretion to intervene to address gross misalignment of the exchange rate.

RBI’S PILE OF RESERVES

The RBI is known to intervene when there is strong downward pressure on the rupee and also when there is a lot of upward pressue.

In the last three decades, there were several episodes of intervention to stem the appreciation in the rupee. In the process, the RBI has accumulated a big pile of reserves -- $461 billion currently from a mere $6 billion in March 1991.

For much of the last decade, the Australian dollar had witnessed a lot of upward pressure due to inflows related with the resources boom, “yield-seeking” and also due to “diversification” flows driven by Australia’s AAA credit rating.

While the rise in the exchange rate appeared to be in line with fundamentals, there were episodes when the Australian dollar was misaligned. In a speech in 2013, then-governor Glenn Steves acknowledged that some would have seen the exchange rate as “significantly misaligned” but he believed the Australian dollar was “probably above its longer-run equilibrium.”

Irrespective of how the RBA characterized the level of the Australian dollar, in hindsight it is clear the exchange rate was left too high for too long.

But not once in the past decade did the RBA intervene to correct the overvaluation – small or large.

COST OF HOLDING RESERVES

To stem an appreciation in the Australian dollar via intervention, the RBA would have to buy the foreign currency. Most likely this would be the U.S. dollar because the pair is widely traded. And depending on how persistent the appreciation is, the RBA has to be prepared to continue buying the foreign currency.

As Stevens said in 2014, buying foreign currency would have meant exchanging domestic asset yielding 2-3% with a foreign one yielding pretty much nothing in the expectation that the RBA could influence the exchange rate.

“So we could be taking a bet. I am conscious that this is public money, it is not my money,” Stevens said.

In a nutshell, the RBA didn’t intervene because it was trying to strike the right balance between taking risks with public money, and the needs of the economy.

That the RBA never intervened means each time the discussion to intervene happened, the ruling went in favour of not taking risk with public money. To put it the other way, the needs of the economy was compromised.

Compared this with India. The RBI is well aware there is a cost to hold reserves but that is weighed against its benefits. Sure, in India’s case the benefits are far higher than for a developed country like Australia but the key point is earning profit should never be the motive for intervention neither should incurring a loss be a disincentive.

No cost can be bigger than the price the economy might potentially pay if its exchange rate remains too high.

WHERE TO NOW?

The RBA’s cash rate is currently at a record low of 0.75%, and there’s only 50bps of space left before the rate hits the effective lower bound of 0.25%.

One important driver for three rate cuts last year was the exchange rate which according to the RBA, would be higher if there were no cuts. If the economy needs more stimulus, the RBA will lower the cash rate again but after two cuts, the only remaining option it has is Quantitative Easing.

The Australian dollar is currently around $0.685. A further fall would be helpful for the economy and rise above $0.70 would hurt.

Would the RBA intervene this time if it sees persistent upward pressure on the exchange rate? I think yes.

2020 may well be the year of forex intervention. It is an option worth trying before the cash rate is cut to 0.25% and QE remains the only option thereafter.

--Contact: sophia@centralbankintel.com