RDP 2004-06: Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years After the Float 2. Why the Reserve Bank Intervenes

The decision to float the Australian dollar allowed market forces to determine the value of the currency. Since the float, the exchange rate has moved freely in a wide range around an average of US70½ cents, peaking at US96½ cents in March 1984 and reaching a low of just under US48 cents in April 2001. The adoption of a floating exchange rate regime, however, did not mean that the RBA had become indifferent to either the level of, or movement in, the exchange rate, since these can have a powerful influence on important aspects of the economy, particularly economic growth and inflation. As such, the RBA has from time to time intervened in the foreign exchange market.

This approach had its roots in the findings of the Campbell Committee which concluded that an absolutely ‘clean’ float was unrealistic and acknowledged that the authorities might wish to deal in the market from time to time, while at the same time cautioning against exchange rate targeting. There was also a widespread expectation in financial markets that the RBA would intervene, as suggested by an Australian Financial Review (AFR) headline on the first trading day of the float entitled, ‘The question now is when and how to intervene’ (12 December 1983, p 5).

It is interesting to note that the academic literature over the past couple of decades has come to acknowledge that financial markets can overshoot. There is extensive literature, for example, on speculative bubbles, herding, fads and other behaviour which can drive market prices away from their equilibrium values, even in a market which is deep and liquid. When such overshooting occurs, intervention may help in limiting the move or returning the exchange rate towards its equilibrium level, thus obviating the need for costly adjustment by the real economy to the incorrect signals which the exchange rate would otherwise give.

The RBA's approach to intervention has evolved over the past 20 years. The various phases in its approach to intervention are outlined below, but in broad terms there has been a shift away from concern about short-term volatility in the early days following the float to a focus on episodes where the exchange rate has ‘overshot’ – i.e. moved to a level that does not seem reasonable in the context of a range of economic and financial developments. Broadly, this change in emphasis has resulted in intervention strategy moving from small daily interventions with frequent changes in direction (often described as ‘testing and smoothing’) to less frequent but larger scale intervention once the exchange rate had moved a long way.

Of course, the important issue is to identify in practice when the exchange rate has in fact overshot. Typically, the RBA has come to regard overshooting as unlikely to be occurring unless the exchange rate has moved a long way and, as noted, the move does not appear to be supported by economic and financial factors. This approach effectively means that the bulk of the RBA's intervention takes place around the cyclical highs and lows in the exchange rate.

In addition to circumstances where there appears to be misalignment, the RBA will also consider intervening in the market when conditions threaten to become disorderly. Persistent volatility, a sharp widening in bid-ask spreads or erratic movements of the exchange rate (especially at times of uncertainty about macroeconomic policy) may result in intervention to help restore order. Having said this, the RBA has become more comfortable with the ability of the market to cope with shocks of various types, so episodes when intervention is motivated by the desire to avoid disorderly conditions have become much less frequent.

Neither of the two reasons for intervention discussed above suggests that intervention could be used as an effective instrument of policy for achieving a particular level for the exchange rate. Nor does it imply the use of intervention to correct a monetary policy imbalance or to resist changes in the exchange rate which are in line with broader economic or financial developments.

In addition to intervention (i.e. transactions aimed purely at influencing the exchange rate) the RBA also undertakes more routine operations in the foreign exchange market, such as covering Government foreign exchange needs and rebuilding reserve holdings after periods of intervention. These give the RBA a fairly regular presence in the foreign exchange market.