Foreign exchange markets

The main trends in foreign exchange markets over 2006 and the first four months of 2007 were the gradual depreciation of the US dollar, the more marked depreciation of the yen, and the appreciation of the euro in trade-weighted terms. Foreign exchange markets were characterised by high levels of trading activity and historically low volatility, although there were two episodes of higher volatility: in May-June 2006 and in late February-March 2007.

Three main factors drove exchange rate developments during the period under review. Interest rate differentials influenced a number of exchange rates, in part through the continuing build-up of carry trades. The accumulation of official foreign exchange reserves limited the effects of upward pressure on currencies in the Asian region and in a number of oil-exporting countries. Global imbalances affected the extent to which some currencies responded to episodes of increased volatility across financial markets.

Several trends in central bank foreign exchange reserve management practices potentially have implications for financial markets and raise challenges for central bank decision-makers. The trends include an increased focus on returns, a strengthening of internal governance and risk management, and a greater degree of public disclosure. In turn, these trends have been underpinned by several key developments in the economic and institutional environment, such as the large accumulation of reserves by some countries, advances in financial technology and the development of financial markets, and changes in the external governance environment within which central banks operate.