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Unit 3: FEMA Act, 1999

The difference in view is brought home by the unprecedented scale of foreign exchange Notes
reserve accumulation by the emerging market group in recent years. Between the end of
2001 and the end of 2004, global foreign exchange reserves grew by over US$ 1600 billions,

reflecting reserve accumulation by emerging market economies in Asia. Many observers
from developed economies have publicly attributed the comparatively weak appreciation
of Asian currencies against a rapidly depreciating US dollar to such intervention. Hence
there does seem to be a common belief that intervention by emerging market economies

has significantly altered the path of the real exchange rate for long enough to matter –
even if such a view runs counter to received wisdom about intervention in the markets for
major currencies.
This meeting threw some new light on these issues. Some favour of the discussion can be
gleaned from the central bank papers reproduced in this volume, along with overview
papers prepared by BIS staff. Four central questions are outlined below; it will be clear that
many important issues remain to be resolved.

Is intervention more effective in emerging markets?
The wide range of different objectives behind intervention in practice makes assessment

difficult - especially empirical assessment that uses data from different episodes and

different countries where policy objectives may vary. In flexible exchange rate cases, the
objectives of intervention are particularly varied, a point which emerges clearly from the
Moreno paper and the individual country papers in this volume. Reasons for intervention
cited by central banks that do not target the exchange rate include: to slow the rate of
change of the exchange rate; to dampen exchange rate volatility (in some cases to satisfy

an inflation target); to supply liquidity to the forex market; or to influence the level of

foreign reserves. The paper from South Africa provides an example of objectives that are
both subsidiary to the main objective and conditional on prevailing circumstances (in this
case, the process of reserve accumulation being used to help dampen volatility when that
is convenient). Other country papers show that varying mixtures of objectives are quite
commonplace.

Many central banks would argue that their main aim is to limit exchange rate volatility
rather than to meet a specific target for the level of the exchange rate. Yet others would

counter that it is better to abstain from intervention in the foreign exchange market: such
a stance would, they contend, make investors more aware of the need to hedge their own
exposures, and this would help the market in hedging instruments to develop. The papers
from Israel, Mexico, Poland and Thailand are particularly relevant in this regard. There
is indeed some evidence that exchange rate volatility has fallen a lot in some countries
where the central bank has not intervened in recent years. The papers from Korea and
Peru highlight the existence of a policy trade-off where there are reasons to intervene
to dampen volatility yet intervention may involve moral hazard with respect to market
development.
The survey reported in Mihaljek’s paper shows that many emerging market central

banks view intervention as effective in influencing the exchange rate consistent with their

objectives. Part of this may be attributable to cases in which fixed or targeted exchange
rate regimes are in place: under such a regime, monetary policy actions are primarily
dictated by what is needed to achieve and maintain the exchange rate target, intervention
in the foreign exchange market is automatic or nearly so, and the exchange rate peg has
proved reasonably durable. The papers from Hong Kong SAR and Saudi Arabia illustrate
the point.
Formal econometric research has usually thrown doubt on the conclusion of effectiveness
of intervention in flexible exchange rate cases although, as noted, such research often

conflates interventions for different purposes. In addition, the effectiveness of intervention

Contd...

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