Interventions in the foreign exchange market

BRAZIL ECONOMICS - Report 26 Aug 2019 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

The Central Bank can intervene in the foreign exchange market by either buying and selling dollars in the spot market or through currency swap transactions. In all cases, these interventions have the aim of reducing the volatility of the real, not actions that prevent the exchange rate from changing due to fundamental factors. The interventions in the spot market and via swaps are equivalent in two senses. First, their effects on the exchange rate are the same. Second, no matter how complex the adjustments and payments are in each of the interventions, the costs borne by the Central Bank are the same. If the exchange rate is depreciating because of an exaggerated demand for hedging, selling swap contracts is preferable. But if that movement is rooted in the need for dollars to make current payments, and the intervention occurs via swaps, the unfulfilled demand for dollars in the spot market will raise the local interest rate denominated in dollars (the so-called “exchange rate coupon”), inducing the Bank to sell reserves with repurchase commitment (the “FX credit line auctions”). However, given their equivalent effect on the exchange rate, if the Central Bank sells dollars in the spot market and operates with reverse swaps in the same intensity, the effect on the exchange rate will be neutral, without any net gain. So what is the reason for selling reserves with equal magnitude as the swaps? The only explanation is to regularize the liquidity in the foreign exchange market, possibly resulting from a relative reduction in demand for hedging and increased demand for dollars in the spot market.

In practice it is impossible for the Central Bank to detect in advance if a drastic depreciation (excessive volatility) is triggered by an increase in demand for hedging or demand for dollars in the spot market. If companies have debts denominated in dollars and an increase in risk occurs, they will demand more exchange rate hedge transactions, and the most suitable intervention route will be to sell swap contracts. But if the Central Bank has a mistaken perception, and the excessive volatility comes from an increase of demand in the spot market, the sale of swaps will raise the exchange rate coupon, forcing it to sell dollars in the spot market with repo commitment – the “line auctions”. For this reason, the Central Bank needs to pay heed to the indications from the market to choose the ideal type of intervention in each period. In the past, the main indications were that companies needed hedge, so the Central Bank offered currency swaps.

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