Should a central bank use its currency reserves to support the value of its country's currency in the foreign-exchange market? What can be achieved by such intervention?

Why did these countries agree to a fixed exchange rate system?

The main reason was to reduce the riskness of international trade transactions and the therefore firms have greater assurance of stability in the value of these currencies. These would lead to greater international trade and a growing economy. Also having a fixed exchange rate acts as an important anti-inflationary tool because the loss of official reserves forces a country to counteract inflationary tendencies in its economy. Having wild swings in the values of currencies (especially key ones) that occur in flexible exchange rate systems can disrupt sound investment decision making.

Another reason why Thailand was fixed was because the U.S. dollar is the tradable currency in the world and has the strongest economy and therefore would attract good Foreign Direct Investment (FDI).

In theory, this was very benefit for Indonesia and Thailand . But , in fact, that was not.

In the case of Thai and Indonesia problems arose when U.S. dollar began to rise in value, Thai baht and Indonesia rupiah were not in so much demand. This essentially meant that the Thai and Indonesia central bank had to use its foreign currency reserves to buy baht and rupiah and keep the value pegged to the dollar. By doing this however,it meant that Thai and Indonesia exports were becoming increasingly expensive relative to other countries, and so had a Balance Of Payment trade deficit. This led to speculation that the baht and rupiah might have to devalue to regain its competitiveness and so led to speculators selling baht and rupiah before they lost any value. The speculators would buy a safer currency, for example, the U.S. dollar.

In the case of Thailand this proved to be unsustainable for the Thailand central bank and on July 2nd 1997 allowed market forces to devalue the baht by 20%. The bank of Thailand spend almost $10 billion of its foreign-currency reserves defending the fixed value of the baht before throwing. This had many other implications and made Thailand far more competitive in its exports, so much so that its neighboring Asian countries were also forced to devalue, creating effects known as the "Asian Contagion" which effected the rest of the world to different degrees. With the devaluation of baht, Thailand exports suddenly became 20% cheaper, making Indonesia, Malaysia, and Philippine exports relatively more expensive. By early September 1997 the baht had devalued 26% relative to its value against dollar. Thailand stock lost 60% of its dollar value.

In the case of Indonesia , Indonesia early was hit on July 1997. Indonesia rupiah devalued 21%, and stock loss 30%. Bank Indonesia floated the rupiah on August 14, 1997. Intervention in both the forward and spot markets were continued. To support the currency intervention, monetary tightening, through monetary and fiscal means, was conducted. After Bank Indonesia intervened in the market several times and exercised monetary tightening, the problems started to spread to include the banking sector. The Indonesian banking industry started to experience distress. And, as the problems continued, confidence in the banking sector started to decline. The banking sector experienced the familiar process of flight to quality and flight to safety. A crisis of confidence started to appear, through the weakening of the rupiah, tiering of the interbank money market, and a loss of confidence from bank depositors and creditors. After some time, the real sector started to feel the impact since banks reduced their lending and lending rates rose dramatically. The banking sector experienced a crisis, especially after the closing of the 16 insolvent banks. Thus, starting from currency shocks and the rupiah crisis, through to banking distress and a banking crisis, the final result was a total economic crisis.

Faced with persistent pressure on the rupiah, the government intervened in the foreign exchange market, first by selling dollar forward, and later, in the spot market. When these efforts could not strengthen the rupiah, Bank Indonesia discarded the system of a managed float, and floated the rupiah freely in mid August 1997. These were done with the support of monetary tightening through interest rates policy, sterilization as well as fiscal tightening. But, partly due to the monetary and fiscal tightening, the weak banking sector started to suffer from distress. Some banks even suffered from bank runs as early as August 1997. Realizing the fact that the problem had spread to the banking sector, in early September 1997 the government launched a broad economic policy initiative, which encompassed not just monetary and fiscal measures, but also deregulation steps in the real sector. This was a precursor of an IMF-supported program which came later, at the end of October 1997.

In both cases as devaluation occurred it meant much relief for the domestic economy making exports much more competitive and put people back into jobs they had lost due to the overvalued currency. Many other entities benefited from the devaluation including domestic export industries, speculators and incoming tourists. So the two cases indicate what happened when a central bank intervenes in its currencies value too much.

In the case of Thailand they kept their currency pegged to the dollar for too long and this meant a larger devaluation was needed later on. Malpass (1997) articulated that "as early as mid-1996 the IMF had decided that Thailand dollar-linked economic program and trade imbalance was unsustainable. It warned Thailand in private, leaving international investors to find out a year later that a devaluation was in order".

Having false valuations of currencies also have a major effect on that countries business, who, as in Thailand case, suffered greatly due to loans incurred with foreign banks. When the sudden drop in value occurred the firms had to pay back more money, relative to the extra value of the foreign currency. There is an argument for saying that a central bank should not intervene. This way the rates are determined by supply and demand and Thailand would not have experienced the economic troubles that they did. They spent much of their reserves buying their currency and this represents a huge opportunity cost-their reserves into a bottomless pit and essentially gained nothing as a result.

In the long-term fixed exchange rate is economically unfeasible for a central bank to support its currency as it would eventually run out of official currency reserves.

In short-term Thailand and Indonesia experienced many of the benefits associated with having a fixed exchange rate and used their currency reserves. Once they started doing this they needed to address the issue of why their currency was weakness and a large trade deficit.

CONCLUSION:

Central bank choice by itself whether or not support their currency. They may consider whether the country is developing or developed and therefore use different strategies. If currency fluctuations occur in the short-term a central bank can use its currency reserves and remain fixed and enjoy all the benefits that comes with it, but the economic must be similar enough and the country must have a good economic policy to eliminate the need for long-term central bank support. When fixing currencies together it is important that the economics are coherent, which protects the currency from asymmetric shocks, this will ensure success in the long run.

References:

MalPass,D (1997) Break the IMF Shackles . Wall Street Journal 1997.

CENTRAL BANKING IN THE MIDST OF CRISIS :The Case of Indonesia [Online]

Available : http://www.pacific.net.id/pakar/sj/woodrow_wilson.html. [4Nov,2003]

Asian Currency Crisis, Part Two? [Online]. Available:

http://www.businessweek.com/2000/00_31/b3692083.htm. [4 Nov,2003]