3. Stages of constructing the monetary programme
3.3 Foreign exchange market intervention and its components
Forecasts of foreign exchange market in-tervention and its components comple-ment the projection of financing capacities
With knowledge of the sectors’ financing capacities, we can forecast foreign exchange market intervention and its components. In this phase, we focus on foreign currency-denominated financing items and develop a forecast of the foreign exchange items in the central bank’s and commercial banks’ aggregate balance sheet. Comple-menting these with the forecast of balance of payments items, the
measure of foreign exchange market intervention can also be deter-mined.
The following is a description of relationships between the above factors. The three variables which can be viewed as being of key importance are: the (1) current account deficit, (2) changes in international reserves and (3) foreign exchange market intervention.
The equations below establish a relationship among these three key variables:
– the schematic balance sheet of commercial banks, which helps determine the relationship among the changes in com-mercial banks’ on-balance sheet open positions and other balance sheet items as well as commercial banks’ foreign borrowings;
– the structure of current account financing, which, given a bal-ance of payments deficit, shows how international reserves change as a result of capital and credit flows; and
– the measure of oversupply (conversion) in the foreign ex-change market, which must be equal to the ex-change in net for-eign exchange assets in the central bank balance sheet.
As a result of these three relationships, we obtain the compo-nents of foreign exchange market intervention. The individual equa-tions are presented in the following.
3.3.1 Open position of commercial banks
Using the schematic balance sheet drawn up for commercial banks’
foreign exchange assets and liabilities, we are able to express com-mercial banks’ on-balance sheet open positions on the basis of their foreign borrowings, foreign currency deposits with the central bank and foreign currency lending by the central bank as well as foreign currency deposits placed with them.
Table H Schematic balance sheet of commercial banks’ foreign exchange assets
and liabilities
Asset Liability
CD$ Foreign currency deposits
with central bank Household and corpo-rate sector foreign currency deposit
D$
DL$BV Foreign currency lending
to corporate sector Net foreign borrowing of commercial banks
L$FB
OP On-balance sheet open position
Changes in commer-cial banks’ open posi-tions play an important role in for-eign exchange mar-ket intervention
Commercial banks’ on-balance sheet open position shows the surplus of foreign exchange liabilities in the balance sheet over and above foreign exchange assets. Accordingly, ifOP>0, that is, if the value of commercial banks’ foreign exchange liabilities exceeds that of their foreign exchange assets, the balance sheet is characterised by a short position in foreign exchange, or, in other words, a long fo-rint position. Conversely, if OP<0, then foreign exchange assets show a surplus over foreign exchange liabilities, indicating a short forint position.
The change in on-balance sheet open positions can be ex-pressed from Table H using the following equation:
DOP =DD$+DLFB$ –DCD$–DL$BV (8) If DOP>0, resulting in a shift towards a long forint position, commercial banks enter the market with a demand for forint funds, while in the opposite case they appear as suppliers of forint funds, resulting in a shift towards a long foreign exchange position.
Table I shows changes in commercial banks’ balance sheet items as expressed by equation (8). Taking into account the value of financial derivatives, commercial banks’ total open position can be calculated as the sum of their on-balance sheet open position and net foreign currency claims from financial derivatives.
Table I Changes in commercial banks’ open positions (1998, 1999 and 2000 H1)
millions Variables 1998 1999 2000
H1
I Assets (1+2) 740 –249 274
1 Claims on NBH DCD$ 404 –818 –427
2 Foreign currency lending
to enterprises DL$BV 336 568 701
II Liabilities (3+4+5) –152 –532 471
3 Net foreign liabilities DLFB 311 299 715
4 Corporate and household sector
foreign currency deposit DD$ 18 –47 –9
5 Net other liabilities –481 –784 –235
III On-balance sheet open position
(long forint: II– I) DOP –892 –283 197
6 Net foreign currency claims from
derivatives 781 231 –128
IV Total open position
(long forint: III+6) –111 –52 69
3.3.2 Changes in the central bank’s foreign exchange position
Conversion is a broader category than intervention
The total amount of foreign currency converted by the central bank into forint is called conversion. This includes the net forint demand of both the private and the general government sectors. Here, the forint demand of the private sector is exactly equal to the value of foreign exchange market intervention. Forint demand of the general government sector is comprised of the items of the current and cap-ital accounts and a few other items linked to general government (CAG+KAG), foreign currency revenues from privatisation (PvF) and net foreign currency borrowings of the general government sector.
Later, privatisation revenue is divided into two categories, such that can be categorised into foreign direct investments and such that can be classified into foreign currency proceeds from privatisation (PvF
=PvFFDI+PvFE).13Net foreign currency borrowings also include for-eign currency borrowing transactions between general government and the NBH. In practice, this item is primarily the balance of foreign currency borrowings of the central government abroad (DLFK) and repayments of foreign currency lending to the NBH (DLJK). Thus, using the earlier variables, the items comprising conversion are the following:
conversion = Int + CAG+ KAG+ PvF+DLFK+DL$JK
However, conversion is also recorded in the central bank’s bal-ance sheet and is equal to the change in the central banks’ net for-eign exchange assets after elimination of the effects of movements in exchange rates. Table J contains the major foreign currency-denominated items of the central bank balance sheet.
On the basis of the central bank balance sheet, the major items of the change in net foreign exchange assets are the increase in
in-13The balance-of-payments categorisation depends on whether the given non-resident investor has acquired a stake of more than 10 per cent in the company in question. Acquisitions of more than 10 per cent in companies are recorded on the foreign direct investment row of the table.
14This item includes the special foreign currency deposit of the central government with the NBH.
Table J Schematic balance sheet of the central bank’s foreign currency assets
and liabilities
Asset Liability
Res International reserves Foreign currency deposits
of commercial banks CD$ LJK$ Net foreign currency lending
to central government14 Foreign borrowings
of central bank LFJ
ternational reserves, the increase in foreign currency lending to the central government, the decrease in commercial banks’ foreign rency deposits, and the decrease in the central bank’s foreign cur-rency borrowings. Conversion can be broken down into the following items based on the central bank balance sheet:
conversion =DRes –DCD$–DLFJ+DL$JK
The right sides of the latter two equations must be equal, as both determine the individual conversion items in the foreign ex-change market. Taking this parity as a basis, we obtain the following relationship(Table K):
DRes –DLFJ–DCD$= Int + CAG+ KAG+ PvF+DLFK (9)
3.3.3 Components of foreign exchange market intervention
From equations (1), (8) and (9) above, foreign exchange market intervention items can be determined. Introducing the variable DLFG = DLFJ + DLFK we can aggregate the foreign borrowings of the central bank and general government into the expression, DLFG, which represents consolidated general government foreign borrowings. Equation (9) can now be expressed in the following for-mula:
DRes = Int + CAG+ KAG+ PvF+DLFG+ DCD$
Table K Relationship between foreign exchange market intervention
and the central bank balance sheet
millions Variables 1998 1999 2000 I Net foreign assets of NBH (1–2) 1,160 3,898 930
1 International reserves DRes 760 2,241 123
2 Foreign lending DLFJ –400 –1,657 –807
II Foreign borrowing by central
government DLFK –119 2,274 223
III Foreign current and capital items
of consolidated general government CAG+KAG –531 –300 –164 IV Foreign currency revenue from
privatisation PvF 158 351 8
V Foreign currency deposits
of commercial banks with NBH DCD$ 404 –818 –427
VI Other 318 –534 –250
VII Foreign exchange market
intervention (I–II–III–IV–V–VI) Int 929 2,806 1,540
Let us substitute the above expression for the change in inter-national reserves in equation (1) of the balance of payments, which renders the following:
Int = CAP+ KAP + (FDI – PvFFDI) + DBF + (DEF– PvFE)
+DLFV+DLFB–DCD$ (10) When substituting, foreign borrowings of the central govern-ment and foreign currency revenue from privatisation are elimi-nated. The variableCAP=CA–CAGrepresents the balance of private sector current items,KAP=KA–KAG showing the balance of private sector capital items.
Forint demand, arising in connection with the conversion of in-ward foreign currency flows, can be labelled as an ‘exogenous factor’
of foreign exchange market intervention. We can primarily identify this with the items of the balance of payments which have arisen as a result of private sector transactions. Independently of foreign eco-nomic relations, the change in commercial banks’ foreign currency deposits with the central bank can be labelled as an ‘endogenous factor’. The components, in accordance with equation (10), are shown inTable L.
This breakdown of foreign exchange market intervention can be further refined with the measure of foreign borrowing, which, in
Table L Components of foreign exchange market intervention
1 Exogenous factor (Variables)
Balance of payments components affecting intervention
I Current account of the private sector CAP
II Capital account of the private sector KAP
III Financial account
Foreign direct investment FDI–PvFFDI
Portfolio investments
a) Government paper DBF
b) Shares (net of privatisation revenue) DEF–PvFE Change in outstanding borrowing
a) Foreign borrowings of the corporate sector DLFV b) Foreign borrowings of commercial banks DFFB
2 Endogenous factor
Change in commercial banks; foreign currency deposits
with central bank –CD$
turn, can be determined from commercial banks’ balance sheet.
This, using equation (8), can be stated as follows:
DLFB–DCD$=DL$BV +DOP –DD$ (11) Now, substituting this in equation (10), we find that foreign ex-change market intervention can be disaggregated into the following components:
Int = CAP+ KAP+ (FDI – PvFFDI) +DBF+ (DEF– PvFE) +DOP –DD$+
+DLFV+DLBV$ (12)
Forint demand arising in intervention can be broken down into the following components(see Table M):
– current and capital items of the private sector (CAPandKAP);
– foreign direct investment (net of privatisation revenue) (FDI-PvFFDI);
Table M Components of foreign exchange market intervention
(1998, 1999, 2000 H1)
millions Variables 1998 1999 2000 H1 Foreign exchange market intervention
(I+...+IX)
Int. 929 2,806 1,540 I Balance of private sector current
items (1+2) CAP –1,444 –1,577 –677
1 Current account balance CA –2,020 –1,970 –860
2 Current items of general –CAG 577 394 183
II Foreign direct investment FDI–PvFFDI 1,387 1,612 906 III Banks’ conversion effect15 DOP –111 –52 69
IV Effect of derivatives –781 –231 128
V Conversion effect of domestic foreign
currency deposits –DD$ –18 47 9
VI Net portfolio investments (1+2) 1,125 972 294
1 Government paper DBF 795 601 583
2 Shares DEF–PvFE 330 371 –289
VII Corporate sector foreign currency
borrowings (1+2) 484 897 316
1 Domestic DL$BV 336 568 701
2 Abroad DLFV 148 329 –385
VIII Capital account of private sector KAP 124 –63 65
IX Other 163 1,199 431
15The forint demand generated by commercial banks can be defined as the sum of two compo-nents; we, however, have aggregated these two items into changes in on-balance sheet positions, for the sake of simplicity. These two components are of commercial banks’ conversion effect, which denotes the change in overall positions, and the change in outstanding derivative transac-tions.
– portfolio investments (government securitiesDBFand shares DEF–PvF);
– the change in commercial banks’ on-balance sheet open po-sition (DOP); and
– forint demand arising from changes in foreign currency de-posits and loans (DL$-DD$).
Isolation of interest-sensitive components of intervention
Whereas the short, in-terest-sensitive com-ponents of intervention are vola-tile, …
Some intervention items are influenced by the annual cycles of eco-nomic activity and production, i.e. mainly by real ecoeco-nomic factors.
However, in respect of certain items we can assume that yield con-siderations underlie changes in stocks. These latter components of foreign exchange market intervention are known as interest-sensitive items. The following are categorised into this group:
– the change in non-resident holdings of government securities (with a positive sign);
– the change in commercial banks’ on-balance sheet open po-sition (with a positive sign);
– the change in corporate and household sector foreign cur-rency deposits (with a negative sign); and
– the change in corporate sector foreign currency borrowings in Hungary and abroad (with a positive sign).
The interest-sensitive component can be further disaggregated according to maturity. On this basis, we can distinguish between short and long interest-sensitive components. The short inter-est-sensitive component includes
– the change in commercial banks’ on-balance sheet open po-sition;
– the change in non-resident holdings of short-term govern-ment securities; and
– the change due to transactions in short-term foreign currency loans and deposits.
Accordingly, the long-term interest-sensitive component in-cludes
– the change in non-resident holdings of long-term govern-ment securities; and
– the change due to transactions in long-term foreign currency loans and deposits.
… the long or non-interest-sensitive components are more stable and are easy to forecast
Chart 1plots the short and long items of the interest-sensitive component, complemented with the value of the non-interest-sensitive component for the period January 1996–July 2000. In ad-dition to the stable upward trend in non-interest-sensitive items, it is clear that the long interest-sensitive component is also stable, with an upward trend. The variability of intervention, as plotted by Chart 1, is mainly attributable to the volatility of the short component –
large increases and decreases in intervention are accompanied by similar movements in the short component.
The major reason for choosing a breakdown by maturity is that the short and long components react rather differently to changes in the macroeconomic environment. As Chart 1 illustrates, during the Russian financial crisis it was mostly the constituents of the short component that fell, in contrast with the long component, which, fol-lowing a brief pause, resumed its upward course. The varying de-grees of past volatility clearly underline the need to separate the short interest-sensitive component from the long one. The major dif-ference between the short and long components (in terms of behav-iour), which justifies the inclusion of on-balance sheet positions as well, is theirpredictability. Movements in the short component are mainly influenced by short-term exchange rate and yield consider-ations, as well as by developments in the international capital mar-kets. This item, therefore, is less predictable over the short run. The path of the long component, in contrast, is rather stable: it is influ-enced by the structural factors of economic transition and is less sensitive to short-term fluctuations in yields.
When predicting the items of foreign capital inflow, the charac-teristics of the short and long components, as presented above, are taken into account. Nevertheless, this does not mean that the fore-cast of the short components is produced by assuming the volatility experienced in the past. This is because it is difficult to predict ex-actly when the short interest-sensitive items of foreign currency
in--500
1996 1997 1998 1999 2000
Chart 1 Components of foreign exchange market intervention
Cumulative values: December 1995 = 0
flow will be replaced by an outflow, and vice versa. Hence, when constructing the monetary programme, an average monthly inflow of short-term foreign currency is assumed, with due consideration of the outlook on international capital markets for the given period, which is complemented only with occasional seasonal effects. This method produces the smallest forecast error in the expected value.