Did the Central Bank of Cyprus manipulate the exchange rate?

COMMENT: By Fiona Mullen

 

So we finally made it. On Tuesday July 10th the Cyprus pound was “irrevocably fixed” to the euro at its central parity rate of CYP 0.585274 per euro. And contrary to the doomsayers, there was no devaluation, no last-minute objections by a big foreign power and no sky falling on our heads. Nothing can stop us from adopting the euro on January 1, 2008.

Now that we are safely on the inside track, it is time to examine a question which has been bugging me for some time, namely whether the Central Bank micro-managed the pound to ensure that it came as close as possible to the central parity rate by July 10th.

The Central Bank always denied that it manipulated the exchange rate. The official line was that it intervened for the smooth operation of the small foreign exchange market. It did not intervene to push the exchange rate up or down.

However, recent evidence has suggested the opposite.

Why didn’t I write about this before? Because, if reports are to be believed, I and the Financial Mirror came close once before to ruining Cyprus’s euro chances, by accurately predicting in late April 2005 the date on which the pound would enter the Exchange Rate Mechanism (ERM2).

Some careless talk/ very big hints to me by a senior official led us to predict that Cyprus would enter ERM the following weekend. It duly did, but not before Cypriot officials got a severe roasting for letting the information leak. A European Commission official later confirmed that Cyprus nearly didn’t make it, so this time I have bided my time.

 

Smooth convergence to the central parity rate…

 

One of the most striking features of the Cyprus pound in the past few months has been its conspicuously smooth convergence towards the central parity rate.

When Cyprus joined EU, the CYP rose in value, both because of a rise in local interest rates but also because of an increase in foreign exchange inflows, which in turn was caused by a sharp increase in foreign borrowing as restrictions were lifted.

The pound rose again in value when it entered ERM2. But for the past 21 months, it has very gently drifted towards the central parity rate.

The Cyprus pound reached a peak rate of CYP 0.5729 per EUR (EUR 1.7455 per CYP), or 2.1% stronger that the central parity rate, on September 20, 2005.

But by Monday July 9, the day before the exchange rate was fixed, the exchange rate was down to CYP 0.5841  per EUR (EUR 1.741 per CYP), or 0.2% stronger. This is not big enough to be called a devaluation, but depreciation it certainly is.

 

…despite a very large increase in FX inflows…

 

Another remarkable feature of this is that this very gentle depreciation in the pound came while there was a falling budget deficit and huge influx of foreign exchange via foreign borrowing.

Bank lending to customers in foreign currency (mainly euros) has been both rising very fast and accelerating, from growth of 20% year on year in January 2005 to 52% by May 2007.

In a normal economy, a falling budget deficits and a huge influx of foreign exchange are accompanied by a sharp appreciation of the local currency.

But not so in Cyprus, when there is a central parity rate to target.

 

…and no obvious matching outflows

It is theoretically possible that the huge inflows of foreign exchange were exceeded by even larger outflows in Cyprus, and that this is why the currency depreciated slightly.

However, there is no evidence for this. The largest monthly outflows in Cyprus on the current account come from the trade deficit and here the numbers are just no big enough.

On the financial account, there is also a large ebb and flow on “other investment assets”, which represent mainly loans and deposits by non-residents (the old offshore companies).

Here, there are no monthly data to check, but based on quarterly data, there has been a large net monthly inflow on this item: another reason for the currency to rise, not fall.

 

Mopping up

 

How, therefore, has the pound managed to depreciate under these circumstances?

The only plausible reason is that, not unlike China, the Central Bank appears to have been gathering up foreign exchange and sitting on it.

Official foreign exchange reserves, designated by the IMF as “monetary authority assets”, have risen by CYP 230 mln since the beginning of 2005 to CYP 2.1 bln in March 2007.

In the same period the Central Bank has purchased a net CYP 778 mln in foreign exchange.

By keeping extra FX out of circulation, this creates greater demand for it. You have to pay a little bit more in Cyprus pounds to get your hands on it, so the foreign currency becomes more valuable and the Cyprus pound falls slightly in value.

The amount “mopped up” in net purchases is quite small relative to total reserves. But given the small size of the foreign exchange market in Cyprus, it might just have been enough to push the exchange rate down that magical number. 

 

* Fiona Mullen is Director of Sapienta Economics Ltd. www.sapientaeconomics.com