Central Bank Official Intervention in the Foreign Exchange Market: Lessons from Lebanon

This book covers a specialized topic in international money and finance which is central bank official intervention in the foreign exchange market. The analysis is applied to an emerging country, Lebanon, in which domestic and foreign assets are imperfect substitutes in contrast to the case in developed nations. This enables the central bank in having another and an additional monetary policy tool. There are five main chapters in our study. The first one is the on the effectiveness of unsterilized official intervention. The second one is on the effectiveness of sterilized official intervention. Sterilized intervention is an open market operation that keeps the monetary base or the high-powered money, and the money supply unchanged. The third one is on the effectiveness of unpredicted, or secret, official intervention. The fourth chapter dwells on an alternative reaction function of the monetary authorities that is more complex than the one assumed earlier. The last chapter provides for an alternative specification of the function of official intervention. My approach necessitates two enquiries. The black market foreign exchange rates need to be computed because Lebanon follows an adjustable peg with unpublished magnitudes and bands. And, due to the absence of direct data on intervention, intervention is imputed by the monthly change in foreign securities held by the central bank. Since the central bank in Lebanon intervenes almost on a daily basis in the financial market, intervention is continuous, and not sporadic like in other countries. Official intervention, whatever its form, is found to be highly effective, and the response of the foreign exchange rate is in accordance and in line with the portfolio balance model. A purchase of foreign currency by the central bank leads to a depreciation of the domestic exchange rate. Moreover, a purchase of one billion US dollars leads to a depreciation of the foreign exchange rate within a range between 0.6% and 2%. This impact is comparable to the empirical results in the literature for other countries. Other inferences are obtained. Unsterilized intervention, whether actual or secret, has a higher explanatory power than sterilized intervention, because of the induced money supply shockwaves that strengthen the effect of unsterilized intervention. And secret intervention has a higher explanatory power than actual intervention. The reaction function of the central bank to the dollar rate is greatly statistically significant, and an alternative relation does not vary by much the results. The reaction functions are specified from a leaning-against-the-wind policy.

However, as is already known, fixed and pegged foreign exchange rates are vulnerable to a dollar run, a dearth in foreign exchange balances, recurrent budget and current account deficits, and a bank crisis, coupled with the possibility of civil unrest and dislocation. In such a case the foreign reserves of the central bank will be depleted within a short period. The financial emergency in Lebanon after October 17, 2019, may be due to the threat that foreign exchange reserves will not be enough to back up and to safeguard the domestic currency in times of crisis. Nonetheless the concurrence of more than one catastrophic event, whether economic or social, was generally unexpected. This should no prevent us from studying the relatively calm and prosperous, but peculiar, reckless and corrupt, period before October 2019.

The general conclusion from my investigation is that official intervention, whatever its definition, is highly effective, and that it has served well the country during the past mostly tranquil period.