RDP 2004-06: Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years After the Float 1. Introduction

When the Australian dollar was floated over 20 years ago, the Australian Government and the Reserve Bank of Australia (RBA) gave up the determination of the exchange rate to market forces. However, while allowing the exchange rate to move freely in a wide range, the RBA retained the discretion to intervene in the foreign exchange market from time to time if conditions warranted.

Have the RBA's efforts to stabilise the exchange rate through intervention achieved the desired outcome?

As the counterfactual exchange rate path in the absence of intervention is unobservable, we invoke an indirect test of the effectiveness of intervention. The basic thesis postulated is that intervention aimed at stabilising the exchange rate will require the central bank to buy the currency when the exchange rate is relatively low and to sell it when the exchange rate is high. Such a policy, if pursued successfully, will generate a trading profit as a by-product. Applying this logic in reverse, it follows that if a central bank has generated profits from its intervention, it must have bought low and sold high, which would work to stabilise the exchange rate. This approach, first applied to Australia by Andrew and Broadbent (1994) derives from the work of Milton Friedman who, in his 1953 book, argued that currency speculators would, on balance, be stabilising as they would not survive if they did not buy low and sell high.

We find that the RBA has made a profit of A$5.2 billion from intervention since the float. We identify three distinct cycles in the exchange rate and in the intervention activities of the RBA, and find that intervention has been profitable, not only over the entire post-float period, but also in each of the three cycles. We conclude from these findings that the RBA's transactions have helped to stabilise the currency.

The paper is organised in the following sequence. Section 2 gives a brief account of why the RBA retains the discretion to intervene in the foreign exchange market. Section 3 gives a technical account of how intervention is conducted. Section 4 details how intervention has evolved since the time of the float. Section 5 lays out the calculation of profits from intervention. The final section offers some concluding remarks. The Appendix provides a survey of studies of Australian intervention.