Readers Question: Is it possible for central banks to fail in devaluing their currency since they can print unlimited amounts of money e.g like in the Swiss bank intervention. Do their losses matter, since they can write off their losses at essentially no cost?
In theory, there is no limit to the amount of money that a Central Bank can create. Therefore, in theory, a Central Bank should be able to always devalue its currency – if it is really determined.
By printing money they devalue the currency in three ways.
- Firstly, printing money tends to be inflationary. Higher inflation makes a country less competitive leading to relatively lower demand for their exports and hence currency.
- Secondly, increasing the money supply enables the Central Bank to buy more foreign currency, which drives down the value of the domestic currency.
- Statement of intent. By promising to print money and keep currency low, it discourages speculators from buying that currency as it is less likely to be a good bet.
In the case of Switzerland, they have committed themselves to peg the Swiss France against the Euro. They are committed to buying sufficient foreign currency to prevent any further appreciation of the Swiss Franc.
The Swiss are hoping this intervention will not be inflationary. The Swiss France has risen in the past (which tends to reduce inflationary pressure) by keeping the Swiss France pegged at a certain level, they are hoping there will be more economic stability avoiding too much deflationary pressure.
To answer your question. I think a Central Bank can definitely decide to devalue its currency if determined. However, there will come a point when printing money and devaluing the currency causes other more significant problems. i.e. inflation. A Central Bank would be very wary of creating unsustainable inflationary pressure through printing too much money.
This policy of foreign currency intervention makes sense it certain situations.
If you look at Switzerland and Japan, their currency is appreciating because of demand from speculators. Because of fears over all the other currencies, Japan and Switzerland have been viewed as safe havens. This can cause a very damaging appreciation in the currency – much more than economic fundamentals would suggest. The appreciation in the Swiss France was threatening exports and economic growth.
Readers Question Why is it easier for a central bank to devalue instead of strengthening their currency?
As we mentioned above, it is easy for the Central Bank to create money, inflation and therefore devalue the exchange rate.
However, it can be difficult to strengthen the currency if markets don’t agree it is worth that much.
- A Central Bank can try to increase interest rates (usually this attracts hot money flows) to take advantage of better rates of return leading to higher value of currency. But, when the UK tried in 1992, it failed. Markets were not convinced that higher interest rates were sustainable given the state of the economy (i.e. in recession, markets correctly believed the government couldn’t maintain interest rates at 15%)
- A weak currency may be due to a fundamental decline in competitiveness due to falling productivity, higher wages and lower output. This cannot be solved by a Central Bank. It would need a long term strategy to increase competitiveness and productivity. A central bank can deflate an economy through higher interest rates, but this alone doesn’t restore competitiveness and vibrancy of the export sector
- Debt Crisis. A currency may be falling because of fears over government debt. If markets fear a possible default, they will sell that currency. A Central Bank cannot solve a fiscal crisis. That requires attention to the budget deficit and fiscal policy.
- Successful inflation targeting
- Maintain sustainable economic growth.