Central bank securities and foreign exchange market intervention in a developing economy

• Published date: 01 February 2022
• Author: Eli Direye,Tarron Khemraj
• Date: 01 February 2022
• DOI: http://doi.org/10.1111/rode.12838

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     wileyonlinelibrary.com/journal/rode  Rev Dev Econ. 2022;26:280–297.

© 2021 John Wiley & Sons Ltd

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INTRODUCTION

Central bank  bills (CBBs  or securities)  are usually  adopted as  tools  for mopping  up excess  re-

serves and  enabling  the development  of  liquid money  markets  (Gevorkyan,2015;  Gray,2006; 

Gray & Pongsaparn,2015; Nyawata,2012). While the liability- side CBBs might indeed be useful 

for fostering  money markets, this  paper demonstrates  empirically that  there is  more to  CBBs. 

In particular, the  paper proposes that  the central bank's  one- sided sales  of  CBBs to the  private 

sector perform like  an instrument of monetary  policy by stabilizing  the exchange rate  through 

easing demand pressure in the domestic foreign exchange (FX) market. The central bank sells the 

Received: 18 January 2021 

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  Revised: 1 September 2021 

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  Accepted: 23 September 2021

DOI: 10.1111/rode.12838  

REGULAR ARTICLE

Central bank securities and foreign exchange

market intervention in a developing economy

EliDireye1

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TarronKhemraj2

1Bank of Papua New Guinea, Port 

Moresby, Papua New Guinea

2New College of Florida, Sarasota, 

Florida, USA

Correspondence

Tarron Khemraj, New College of Florida, 

Sarasota, Florida, USA.

Email: tkhemraj@ncf.edu

Abstract

The Bank  of Papua  New Guinea  has maintained  an ac-

tive policy of foreign exchange (FX) market intervention. 

This monetary tool is associated with a depreciating cur-

rency and a  worsening shortage of foreign  currencies in 

the domestic  market, suggesting that  at most  the policy 

instrument  leans  against  existing  FX- market  pressure. 

However, the  one- sided  sales of  central  bank securities 

(or bills) engender an appreciation of the rate and an eas-

ing of the shortage in the domestic FX market. Supported 

by empirical evidence, we demonstrate that the one- sided 

sales of central  bank bills perform like  an instrument of 

monetary policy for FX- market stability  in the presence 

of persistent nonremunerated excess bank reserves.

KEYWORDS

central bank bills, excess liquidity, exchange rate, foreign 

exchange intervention, one- sided sterilization, Papua New Guinea

JEL CLASSIFICATION

E40; E52; E58; F31; F40; F41

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DIREYE and KHEMRAJ

securities to the private sector, which then holds  them until they mature. Therefore, we use the 

term “one- sided sale” when referring to CBBs. Moreover, the terms “demand pressure” and “FX 

constraint” are used interchangeably throughout the paper.1

As an instrument for managing the exchange rate, one- sided sales of CBBs have implications 

for whether a small open  economy could maintain  monetary policy space  while managing the 

exchange rate  and  having de  facto capital  mobility. The  latter is  an  aspect  of  the well- known 

impossible  trinity. One  way  of  circumventing  the  impossible  trinity  is  to  prevent  a  hierarchy 

of  monetary  tools— as  is  the  case  of  the  primacy  of   the  benchmark  interest  rate  instrument 

under inflation targeting— while also maintaining the exchange rate as an explicit goal of policy 

(Kaltenbrunner & Painceira,2017). We argue that the one- sided sales of CBBs (or one- sided ster-

ilization) present the central bank with an instrument of monetary policy that is consistent with 

an exchange rate goal.

Figuring out  the degree  of monetary  independence under  an exchange rate  target (or  goal) 

and de facto capital account openness has been a struggle as well as a preoccupation of research-

ers from developing and emerging economies. For example, Worrell (1995) notes that a corridor 

policy space  exists  under a  fixed  exchange rate  with de facto  capital openness  because  of  the 

cost of  conversion  from national  currency assets  to foreign- currency  assets. Moreover, observ-

ing the factors  accounting for the  buildup of  excess nonremunerated bank reserves  helps us in 

determining whether fiscal  and monetary policy space  exists under the impossible  trinity. As it 

relates to fiscal policy, Primus etal.(2014) show that excess reserves in Trinidad and Tobago are 

largely determined by government spending. Furthermore, banks are likely to hold these excess 

reserves, at least for some time before they are neutralized by the  central bank, if they also have 

to provide foreign currency to long- established customers— implying  that the banks themselves 

may not want to jeopardize their business loan portfolio by denying FX to their historical debtors. 

Therefore, the banks mainly  convert excess reserves into foreign assets  after they have satisfied 

the FX demand of  their established loan customers (Khemraj,2009).2 Finally, Khemraj and Pasha 

(2012) estimate that  several Caribbean economies possess  dual monetary goals— namely  fixed/

managed exchange rates and a monetary target3— while also allowing for a high degree of capital 

mobility. They argue that the  highly oligopolistic banking  structure in the  Caribbean enables a 

markup of domestic private interest rate over the equivalent foreign rate, thereby preventing the 

complete adjustment implied by uncovered interest parity theory.

This paper proposes  that the central  bank's one- sided sale  of CBBs  is consistent with  an ex-

change rate  goal, thereby  availing an  unappreciated monetary  instrument  that could  enhance 

policy space. The Bank of Papua New Guinea (BPNG) introduced CBBs as a tool for mopping up 

excess reserves in 2004. In addition, this central bank actively intervenes in the domestic FX mar-

ket for stabilizing the exchange rate— particularly the preemption of rapid depreciation.4 Several 

researchers associated with the BPNG underscore the importance of stabilizing inflation in that 

country by maintaining a predictable exchange rate (David &  Nants,2006; Ofoi, 2017; Sampson 

et al., 2006; Vellodi etal.,2012). We also show empirically that FX interventions by the BPNG do 

not achieve the goal of exchange rate stability.

We motivate the expanded  role of  one- sided CBB  sales by drawing on  the idea  of inside– 

outside security  and money. Ronald  McKinnon was one  of  the early  scholars to present  the 

inside– outside metaphor to illustrate how government bond sales  influence international ad-

justment in  a  portfolio- balance model.  He notes that  the government  security— sold by the   

central government to private agents— is an interest- earning outside security (McKinnon,1969, 

p. 208). Tobin (1989) also discusses the notion of  inside– outside money. He suggests that when 

applied to money, the inside– outside dichotomy must be used only for  the most liquid forms