Currency exchange and valuation - FX regimes and central ban...

Learning Outcomes

After reading this article, you will be able to distinguish between fixed, floating, and managed FX regimes, explain how central banks intervene in currency markets, and assess the effectiveness and limitations of such intervention. You will understand related exam concepts such as capital controls, objectives of intervention, and warning signs of a currency crisis.

CFA Level 2 Syllabus

For CFA Level 2, you are required to understand the mechanisms through which currency values are influenced by FX regime choice and central bank actions. The following syllabus points are directly addressed in this article:

• Describe different currency exchange rate regimes: fixed, floating, and managed.
• Explain the objectives and tools of central bank intervention in currency markets.
• Assess the effectiveness of capital controls and government/central bank intervention.
• Identify warning signs of a currency crisis.
• Evaluate the macroeconomic and investment implications of FX regime choices.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which FX regime gives central banks the greatest autonomy over domestic monetary policy?
   1. Hard peg
   2. Free float
   3. Crawling peg
   4. Soft peg
2. What is the primary channel through which a central bank intervenes in foreign exchange markets?
   1. Adjusting the policy interest rate
   2. Buying or selling its own currency
   3. Setting prudential capital requirements
   4. Imposing price controls on goods

3. True or false: Capital controls are always effective in stemming large cross-border currency flows.

4. Identify two warning indicators of a potential currency crisis.

Introduction

Currency values are shaped by the type of foreign exchange (FX) regime a country adopts and by the actions of its central bank or government. For investment professionals, understanding FX regimes and intervention policies is critical because shifts can influence asset prices, capital flows, and portfolio risk. CFA candidates must know the structure and implications of different exchange rate systems, the methods central banks employ to influence currency values, and the economic outcomes of these policies.

Key Term: exchange rate regime
The rules or practices a country uses to manage its currency's value versus other currencies, which can range from strict pegs to free floating systems.

TYPES OF EXCHANGE RATE REGIMES

Central banks and governments choose from a spectrum of exchange rate regimes:

• Fixed (Hard Peg): The currency's value is anchored to another single currency or a basket, maintained through official intervention. Examples include currency boards and dollarization.
• Soft Peg/Managed (Crawling or Adjustable Peg): The currency is allowed to fluctuate within defined bands or is adjusted periodically by official policy.
• Floating (Free Float): Currency value is set purely by market forces. Official intervention is minimal or absent. Central banks focus on domestic policy goals.

Key Term: crawling peg
An FX regime where a currency’s peg rate is adjusted frequently—typically in response to inflation differentials or other economic fundamentals.

Key Term: managed float
A regime where a country primarily lets the market determine its currency’s value but reserves the right to intervene when considered necessary.

Key Term: capital controls
Restrictions imposed by governments or central banks to limit or regulate capital inflows and outflows, often to stabilize the domestic currency.

CENTRAL BANK INTERVENTION

Most central banks intervene in currency markets for the following primary reasons:

• To prevent excessive currency appreciation or depreciation.
• To smooth volatility or maintain a target exchange rate or band.
• To accumulate or deplete foreign exchange reserves.
• To bolster credibility of monetary or inflation targeting frameworks.

The main intervention tool is buying or selling domestic currency using foreign exchange reserves. For example, a central bank wishing to support its currency may sell reserves (e.g., USD) to buy its own currency in FX markets. Conversely, limiting appreciation requires buying foreign assets (e.g., US Treasuries) and selling the domestic currency.

Key Term: FX intervention
Direct transactions by a central bank in the currency market to influence its exchange rate, usually using reserves.

OBJECTIVES AND STRATEGIES OF INTERVENTION

• Maintain stability: Prevent sharp, disruptive moves in the exchange rate.
• Support monetary policy: Pegging or managing the exchange rate can anchor inflation expectations.
• Protect external balance: Prevent sustained currency misalignments that may trigger large trade imbalances or capital flight.
• Control capital flows: Curb destabilizing short-term foreign investments.

Approaches include:

• Unsterilized intervention: Central bank FX operations that affect the domestic money supply, and thus interest rates or inflation.
• Sterilized intervention: FX purchases/sales that are offset by open market operations to neutralize effects on domestic liquidity.

Worked Example 1.1

A country's central bank notices a sharp depreciation of its currency following capital outflows. It sells $2 billion in US Treasury holdings and uses the proceeds to buy back its own currency on FX markets.

Answer:
By selling foreign reserves and buying its own currency, the central bank increases demand for its currency, attempting to slow or reverse the depreciation. If unsterilized, this also reduces domestic liquidity, often raising interest rates and potentially impacting growth.

Exam Warning

Central banks can lose significant reserves trying to defend a peg if market pressures are overwhelming. In a true fixed or hard peg system, currency crises can occur if the peg becomes unsustainable and the central bank exhausts its reserves.

EFFECTIVENESS AND LIMITATIONS OF INTERVENTION

• Short-term effectiveness: In liquid FX markets, intervention can moderately affect exchange rates in the near-term, especially if coordinated with monetary policy signals or when markets are thin.
• Long-term effectiveness: Over time, fundamentals (e.g., inflation differentials, trade balances, productivity) prevail. Persistent intervention can deplete reserves or lead to inflation/deflation.
• Moral hazard: Predictable intervention may prompt riskier investor behavior, worsening future crises.
• Coordination limits: Isolated intervention by small central banks is often ineffective without broader policy changes or support from larger central banks/institutions.

CAPITAL CONTROLS AND REGULATORY INTERVENTIONS

To stem speculative flows, governments may impose capital controls:

• Transaction taxes.
• Limits on FX conversions or foreign asset purchases.
• Mandatory holding periods for foreign investments.
• Dual exchange rate systems.

Key Term: capital controls
Legal measures to restrict or regulate cross-border movement of capital for currency stabilization or other economic policy reasons.

These can dampen volatility in the short run but distort markets, reduce investment, and may lose effectiveness as markets adjust. They are more likely to be used in emerging markets with shallow FX reserves.

Worked Example 1.2

A government introduces a tax on short-term foreign portfolio inflows to deter hot money and stabilize its currency.

Answer:
The tax raises the cost of entering and exiting the currency, reducing speculative flows. However, over time, investors may find ways to bypass controls or shift funds to other markets.

Revision Tip

Relying solely on capital controls cannot address a currency’s structural pressures. Interventions are most effective when paired with sound fiscal, monetary, and macroprudential policies.

WARNING SIGNS OF A CURRENCY CRISIS

Persistent intervention and unsustainable FX regimes frequently precede crises. Warning signs include:

• Falling foreign exchange reserves.
• Rigid or overvalued pegs diverging from economic fundamentals.
• Surging short-term external debt.
• Political or policy uncertainty.
• Deteriorating current account, rising inflation, or high money supply growth relative to reserves.

Investors should monitor changes in reserves, external balances, policy statements, and speculative activity for signs of regime pressure.

Summary

FX regimes range from hard pegs to free floats, shaping currency valuation and stability. Central bank intervention—implemented through currency trades and sometimes capital controls—may influence rates in the short run, but long-term outcomes are driven by economic fundamentals. The success of intervention depends on credible policy frameworks, consistent reserve management, and macroeconomic discipline. Excessive reliance on official support raises the risk of sudden, disruptive currency crises.

Key Point Checklist

This article has covered the following key knowledge points:

• Differentiate fixed, managed, and floating exchange rate regimes
• Outline central bank objectives in FX intervention
• Describe main intervention tools (buying/selling currency, reserve management)
• Understand sterilized vs. unsterilized intervention
• Identify when and why capital controls are applied
• Appraise limitations and risks of frequent intervention
• Recognize warning indicators of currency crises

Key Terms and Concepts

• exchange rate regime
• crawling peg
• managed float
• capital controls
• FX intervention