Foreign exchange intervention can help countries navigate shocks – IMF

The International Monetary Fund (IMF) has highlighted the importance of foreign exchange intervention (FXI) in helping countries navigate economic shocks. It stated this in a new report released on Thursday.

The report, titled: ‘When foreign exchange intervention can best help countries navigate shocks’, outlines key scenarios where such interventions could prove beneficial, especially for financially open economies that are vulnerable to market disruptions.

“The Integrated Policy Framework (IPF) acknowledges that fully flexible exchange rates may not always perform well, especially when economies are more exposed to shocks,” the IMF said in its report, authored by Suman Basu, Sonali Das, Olamide Harrison, and Erlend Nier. “Central banks might need to intervene under certain circumstances.”

According to the IMF, FXI can be crucial when foreign exchange markets become illiquid. “A central bank can use FXI to stabilise financial conditions arising from capital flow and exchange rate pressures, which could jeopardise macroeconomic stability,” the report noted.

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Additionally, the IMF pointed out the role of FXI in cases where unhedged currency exposures might lead to a crisis. “For example, if the local currency drops sharply, FXI can help prevent large-scale private sector defaults on dollar-denominated debt,” the authors explained.

The report also emphasised how central banks can use FXI to manage inflation expectations during periods of sharp currency depreciation. “FXI, when combined with raising interest rates, can help contain the impacts of inflation and reduce the adverse effects on economic growth,” the IMF stated.

In its broader discussion, the IMF pointed to the global interest rate cycle, which is turning as major central banks cut rates. “While the fight against inflation in advanced economies has made significant progress, there is growing concern about spillovers,” the IMF warned.

With lower policy rates, the likelihood of capital flows increases, as investors seek higher yields, potentially leading to instability if financial conditions tighten suddenly.

The IMF’s IPF offers guidance for dealing with such volatility. “Our framework shows that monetary and fiscal policies are often sufficient to address external shocks in the absence of market frictions, but it also demonstrates how additional tools, like FXI, can help in specific situations,” the report highlighted.

The Fund cautioned, however, that FXI comes with risks. “Intervening too frequently can encourage complacency in managing currency exposure and should not be used as a tool for competitive trade advantages,” the IMF said, stressing the need for careful consideration of the costs and trade-offs involved.

In line with its findings, the IMF noted that it is integrating these principles into its regular economic assessments of member nations, known as Article IV reviews. “We are committed to exploring these issues further during discussions with members at our upcoming annual meetings,” the report said.