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Unsterilized Foreign Exchange Intervention



Definition

Unsterilized Foreign Exchange Intervention is a monetary action where central banks purchase or sell foreign currency to influence the value of their own domestic currency, without a counteracting action to offset the impact on the domestic money supply. This can result in changes to interest rates and inflation. It contrasts with sterilized intervention where such counteracting measures are taken.

Phonetic

ʌnˈsterəˌlaɪzd ˈfɔrən ɪksˈtʃeɪndʒ ˌɪntərˈvenʃən

Key Takeaways

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  1. Direct Impact: Unsterilized foreign exchange intervention involves the purchase or sale of foreign currency by a central bank, directly affecting the exchange rate without altering the monetary base.
  2. Market Influence: This type of intervention can sway market expectations and sentiments about the value and stabilization of a currency. It not only directly guarantees the price but also indirectly signals the central bank’s views and commitment.
  3. Risk of Inflation: Unlike sterilized interventions, unsterilized interventions can affect the domestic money supply. If a central bank does not counteract the purchase or sale of foreign currency with domestic bond transactions, it could lead to inflation or deflation.

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Importance

Unsterilized Foreign Exchange Intervention is a significant term in business/finance as it directly involves a country’s central bank active role in managing and influencing the national economy’s exchange rates. In such a scenario, the central bank purchases or sells foreign currency to affect the value of the domestic currency, hence influencing exchange rates. This intervention, however, leads to a change in the country’s money supply as there is no offsetting domestic monetary operation paired with it. Therefore, an unsterilized intervention can lead to significant changes in inflation and interest rates. In essence, this strategy acts as a double-edged sword, providing the potential to correct exchange rate disparities quickly but also carrying the risk of fueling inflation. Consequently, its importance lies in its ability to strengthen or weaken a nation’s currency against others, thereby influencing economic parameters, including trade balance, inflation, and overall economic stability.

Explanation

Unsterilized Foreign Exchange Intervention is a monetary policy tool employed by central banks to influence the value of their domestic currency, with the primary aim of addressing fluctuations in the foreign exchange market that could impact the economy. The action involves the central bank buying or selling foreign currencies (mostly in the form of government bonds) without offsetting its impact on the domestic money supply. For example, if a country’s currency is depreciating rapidly, the central bank may choose to buy its own currency using foreign currencies to increase demand for the domestic currency, which could help stabilize or increase its value.The goal of unsterilized foreign exchange intervention is commonly to manage currency volatility, boost exports, cut import costs, or keep domestic inflation in check. By controlling exchange rates, a country could make its products cheaper for foreign buyers, hence supporting the domestic businesses’ capacity to compete internationally. Conversely, if import costs are getting too high due to an excessively strong currency, a central bank may sell its currency to reduce its value. Likewise, unsterilized intervention could be used to manage inflation, as exchange rates can affect the price of imported goods and services, which in turn, affect the country’s inflation levels.

Examples

Unsterilized foreign exchange intervention refers to the act of a country’s central bank intervening in foreign exchange markets to buy or sell foreign currencies in an attempt to balance the exchange rates, without corresponding changes in the domestic monetary base. Here are some real world examples:1. China’s Unsterilized Intervention: Known as the world’s largest unsterilized foreign exchange intervention, the People’s Bank of China has been accused of manipulating the value of the yuan through buying and selling foreign currency, mainly US dollars, for domestic yuan. This intervention was done without offsetting these transactions in their domestic monetary base, therefore it’s considered “unsterilized”. As a result, the value of the yuan versus the dollar was kept relatively low, which inadvertently promoted Chinese exports.2. Swiss National Bank Intervention in 2012: The Swiss National Bank intervened in the foreign exchange markets to lower the value of the Swiss Franc. It wanted to stop the rapid appreciation of the franc caused by investors seeking a safe haven during the European debt crisis. The SNB created new francs and used them to buy foreign currency, without offsetting these transactions with other domestic operations, classifying it as an unsterilized foreign exchange intervention.3. Japan’s Unsterilized Intervention in the 2000s: During the early 2000s, the Bank of Japan frequently intervened in the foreign exchange market using unsterilized methods to prevent the appreciation of the yen. They sold yen and bought foreign currencies to keep the yen weak, benefiting Japan’s export-driven economy. This process was done without an offsetting operation within their domestic monetary base, thus it’s considered unsterilized.

Frequently Asked Questions(FAQ)

What is an Unsterilized Foreign Exchange Intervention?

An Unsterilized Foreign Exchange Intervention is a monetary action undertaken by a central bank where it buys or sells foreign currency to influence the exchange rate without accompanying it with offsetting domestic monetary controls.

Why do central banks use Unsterilized Foreign Exchange Intervention?

Central banks use this strategy to regulate their country’s exchange rates. They aim to protect their economy from volatile fluctuations in the rates and maintain economic stability.

How does an Unsterilized Foreign Exchange Intervention work?

The central bank either purchases or sells its own currency in the foreign exchange market against a foreign currency without changing the monetary base. This is in contrast to a ‘sterilized intervention’ where the central bank offsets the purchase or sale with a corresponding sale or purchase of domestic bonds.

What is the effect of an Unsterilized Foreign Exchange Intervention on money supply and inflation?

An Unsterilized Foreign Exchange Intervention can lead to a change in the domestic money supply. If not managed properly, it could result in inflation or deflation.

Can Unsterilized Foreign Exchange Intervention affect the interest rates?

Yes, it may impact interest rates. When a country’s central bank purchases foreign currencies and increases the domestic money supply, it can cause domestic interest rates to fall.

What are the risks associated with Unsterilized Foreign Exchange Intervention?

This strategy can lead to inflation if there is an excess supply of money. It may also lead to foreign exchange risk, as the country’s money could devalue on the global market.

How is Unsterilized Foreign Exchange Intervention different from Sterilized Foreign Exchange Intervention?

In a Sterilized Foreign Exchange Intervention, the change in foreign reserves would typically be offset by sale or purchase of domestic bonds, nullifying the effect on domestic money supply. This is not the case in an Unsterilized Foreign Exchange Intervention, where no such offsetting transaction is made, thus impacting domestic money supply.

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