RDP 2004-06: Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years After the Float 3. How the Reserve Bank Intervenes

When the RBA intervenes, it buys or sells Australian dollars against another currency, almost always the US dollar.^[1] To support the exchange rate at a time when it is depreciating, the RBA would sell foreign exchange and buy Australian dollars. If the RBA wanted to resist an appreciating exchange rate, it would buy foreign exchange and sell Australian dollars. The RBA has the capacity to deal in Australian dollars around the world, 24 hours a day.

As well as decisions about whether, and by how much, to intervene, the RBA also has discretion to vary the way the intervention is conducted and therefore the impact a given amount of intervention will have on the market. The most low-key form of intervention is to use an agent bank, so that the market as a whole is not aware of the RBA's presence. This type of transaction is also typically used when the RBA is replenishing reserves after a period of intervention, as the aim is to rebuild reserve holdings without having a significant impact on the market. In these operations, the RBA leaves orders with commercial banks and acts as a price taker rather than trying directly to push the exchange rate one way or another.

A second type of intervention involves the RBA entering the broker market directly, either through voice brokers or, in recent years, the electronic broker market. Within this broad strategy, the RBA can vary the intensity of its operations by either dealing on other banks' bids or offers or, if it wants to be more aggressive, bidding or offering directly. Because the broker market is the main mechanism used by interbank market participants to trade among themselves, knowledge of the RBA's presence in the market is immediately available to all active interbank players. They typically also inform their clients very quickly. This ‘announcement effect’ can itself have a significant impact on the exchange rate.

A third form of intervention is to bypass the broker market and deal directly with banks. Such operations involve the RBA phoning banks quoting in the Australian dollar market for two-way prices in the exchange rate. If the RBA deals on a bank's bid or offer, that bank would be left with an open position which it would need to cover. This is risky for the bank concerned, as the RBA will be dealing on other banks' bids or offers, so a number of banks may be faced with the same position which they need to cover. To try to limit their potential exposures, banks receiving a call from the RBA will shift their exchange rate quotes to make them financially less attractive to the RBA, but in the process pushing the exchange rate in the direction the RBA desires for policy reasons. For example, during a period of exchange rate weakness, when the RBA is buying Australian dollars, a bank quoting a rate to the RBA would increase its offer price, thus causing the exchange rate to rise.

If the RBA deals on the offer, the bank selling would need to enter the interbank market to buy Australian dollars in order to cover its short position. This sets in train a second round of upward pressure on the exchange rate. The process of churning in the interbank market continues until the exchange rate has risen to a point that it entices a new seller of Australian dollars to enter the market. This form of intervention tends to have the largest impact on the exchange rate for any given transaction size. The RBA can of course use several different types of intervention simultaneously, say, asking banks for prices while bidding in the electronic broker market.

As well as undertaking transactions directly with the market, the RBA can use its transactions with the Australian Government to have an impact on the exchange rate. Normally, the RBA covers foreign exchange sold to the Government by buying in the market, so there is no net effect on its reserve holdings, apart from possible short-term timing mismatches. However, if the exchange rate is relatively low, the RBA may choose to meet the Government's foreign exchange needs directly from its reserve holdings. In effect, selling reserves to the Government can be thought of as a form of intervention in that it has a similar effect on the exchange rate as intervention done in a low-key way in the market using agents. Normally, as the exchange rate is falling the RBA would stop buying foreign exchange in the market to cover Government transactions well before any direct intervention operations.

On rare occasions, such as in September 1998, the RBA has broadened its intervention to include buying call options on the Australian dollar. The buying of call options gives the RBA an additional element of flexibility in its intervention strategy, allowing it to stimulate significant demand for Australian dollars for a given outlay in options premiums. This demand is, of course, limited to the term of the option, but can still be useful in maintaining foreign exchange market stability during short-lived turbulence.

3.1 Sterilisation of Intervention

Intervention operations have implications for domestic liquidity. When the RBA buys Australian dollars, for example, there is a fall in the banking system's holdings of Australian dollars, thereby draining cash from the domestic money market. If the RBA took no further action, the market would be short of cash and domestic money market interest rates would tend to rise. This would be an example of unsterilised intervention. In effect, it would be a tightening of monetary policy since it leads to a rise in the cash rate.

The RBA can, of course, act in the domestic money market to replenish the banking system's liquidity by buying securities. This cancels, or ‘sterilises’, the liquidity effect of the intervention and leaves domestic interest rates unchanged. This is called sterilised intervention, and is the routine practice for central banks, unless they specifically set out to achieve a change in monetary policy. By using its domestic operations to keep cash rates around a target level, the RBA offsets excess demand for, or supply of, cash in the banking system whether it arises from intervention or from any other source.

At times of heavy intervention, this has the potential to cause substantial changes in the RBA's balance sheet as, for example, it sells US dollars in the foreign exchange market and sterilises this by buying domestic securities. To avoid the costs that can arise from this, the RBA has moved in recent years to greater use of foreign exchange swaps as the main vehicle for sterilising its intervention. In a situation where the RBA has bought Australian dollars and sold US dollars in its intervention operations, it subsequently undertakes a swap in which it lends Australian dollars and borrows US dollars. The settlement flows from the first leg of the swap offset those arising from the intervention transaction, and therefore remove the need for further operations to control liquidity. As each swap consists of a spot with an offsetting forward transaction, it does not alter the net balance of demand and supply for Australian dollars in the foreign exchange market, and therefore does not cancel out the effect on the exchange rate of the original intervention.

Footnote

It will usually subsequently re-balance the various currencies it holds in order to restore the proportions in line with its foreign currency benchmark. For example, a sale of US dollars for Australian dollars will require a subsequent round of transactions to sell some euros and yen (the two other foreign currencies held) and buy US dollars so that the proportions of each currency held are restored to benchmark. [1]