Official Foreign Exchange Intervention

Jorge Canales Kriljenko, Cem Karacadag, Roberto Guimarães, and Shogo Ishii

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2006
• ISBN:
  9781589064218

NONE

II Best Practices in Official Interventions in the Foreign Exchange Market

Jorge Iván Canales-Kriljenko, Roberto Guimarães, and Cem Karacadag

This chapter provides an overview of the policy, technical, and administrative questions that must be addressed to effectively intervene in the foreign exchange market, particularly in developing economies with flexible exchange rate regimes. It includes a review of selected country experiences and the academic literature on operational aspects of official intervention. Key issues include the following:

• Amount and timing. When and in what amounts should a central bank intervene in the foreign exchange market? Should official interventions be based on rules or discretionary? What market factors (liquidity, order flow, etc.) should be used to help determine the timing and amount of intervention?
• Degree of transparency (secret versus public). Should central bank interventions be announced or kept secret? What are the pros and cons of secrecy versus openness?
• Markets and counterparties. In which currency pair, instruments (spot or forward contracts), and trading locations (onshore or offshore) should intervention take place? With whom should the central bank trade (any authorized dealer or primary dealers), and how should it approach them (directly through agents, or through brokers) to achieve its intervention objectives?

The focus in this chapter is primarily on intervention under flexible exchange rate regimes. Under more rigid exchange rate arrangements, including various forms of pegs, central banks have little discretion over intervention policies. Official foreign currency sales and purchases automatically bridge the gap between supply and demand to ensure equilibrium at the predetermined exchange rate. The policy trade-offs and operational issues discussed here apply mainly to countries with independently floating or managed floating exchange rate regimes in which the monetary policy framework is not anchored by an exchange rate target.

Intervention can be defined as official purchases and sales of foreign exchange to achieve one or more of the following four objectives: (i) to moderate exchange rate fluctuations and correct misalignment, (ii) to address disorderly market conditions,¹ (iii) to accumulate foreign exchange reserves, and (iv) to supply foreign exchange to the market. The aim is to capture what are known to be widely adopted policy objectives of foreign exchange operations in many developing countries to which the best practices advocated here are primarily intended to apply.

Following the convention in the literature, the definition of intervention in this paper is narrowed to …sterilized” intervention that does not affect domestic monetary conditions (base money or short-term interest rates). To the extent that a foreign exchange operation is not, or is only partially, sterilized, then the component that is left …unsterilized” is equivalent to a monetary policy operation.²

How Can Intervention Be Effective?

Exchange rates are supposed to reflect basic supply and demand conditions, which in turn should be linked to underlying macroeconomic fundamentals. The literature provides favorable evidence on the relationship between exchange rates and fundamentals in the long term in economies with full capital mobility (Sarno and Taylor, 2002). The parity conditions also hold in developing economies with partial capital mobility (Tanner, 1998).

Exchange rates deviate substantially from values implied by fundamentals in the short term, even in well-functioning foreign exchange markets (Sarno and Taylor, 2002). Exchange rate movements violate the uncovered interest rate and purchasing power parity conditions and appear to be excessively volatile compared with underlying macroeconomic fundamentals (Mark, 2001). Moreover, macroeconomic models of exchange rate determination generally fail to outperform a naive random-walk model in out-of-sample forecasting at short time horizons (Rogoff, 1999).

The disconnect between short-term exchange rate levels and macroeconomic fundamentals creates a role for sterilized intervention. In particular, intervention may be used, possibly in conjunction with monetary policy, to stabilize market expectations, calm disorderly markets, and limit unwarranted exchange rate movements resulting from temporary shocks. Intervention may also be used in conjunction with policies to redress macroeconomic imbalances, and it can complement efforts to place macroeconomic policies on a sustainable path by resisting disruptive changes in the exchange rate, but only if there is a credible commitment to, and tangible progress on, macroeconomic adjustment.

Intervention is not an independent policy tool. Its effectiveness is based on the consistency of targeted exchange rates with macroeconomic policies. Moreover, with a high level of capital mobility, exchange rate and monetary policies cannot be conducted independently. Intervention is especially unlikely to be effective when adverse exchange movements reflect persistent macroeconomic imbalances. Protracted, one-sided intervention on a large scale probably indicates that the current policy mix is unsustainable and that changes in exchange rate policy or other macroeconomic policies are necessary.³ Large capital inflows or fragility in the financial sector, for example, may require adjustments on several fronts, including the exchange rate, interest rates, and fiscal policies.

Channels of Influence

Intervention can affect the exchange rate through various channels. Under the signaling channel, market participants may adjust their exchange rate expectations when they perceive intervention as signaling a change in future monetary policy. Under the portfolio balance channel, the change in the currency composition of asset portfolios associated with sterilized intervention generates a change in the risk premium, which triggers an exchange rate adjustment as agents rebalance their portfolios. Under the microstructure approach, dealers are the price setters and base their pricing decisions in part on the order flow they observe, which is private information. Intervention—central bank–generated order flow—may thus affect dealers’ expectations and the exchange rate if those dealers view it as informative.

Signaling Channel

Under the signaling channel, intervention can be effective if it is perceived as a signal of the future stance of monetary policy. In models that support this channel, the exchange rate is treated as an asset price, and is a function of the expected path of money supply. To the extent that intervention, even when sterilized, influences market expectations on future money supply, it can influence the exchange rate. For example, the sale of U.S. dollars by a developing country central bank will lead to a local currency appreciation, not because the intervention changes the fundamental supply and demand conditions in the market, but because it signals a contractionary monetary policy (i.e., higher interest rates) in the future if downward exchange rate pressures persist.

A central bank has an incentive to follow through with policy actions that justify intervention ex post to safeguard its credibility and avoid financial losses. For instance, the central bank may tighten monetary policies if the domestic currency remains under downward pressure. The central bank puts its reputation and capital at stake either because it wants to signal a policy change that would not be credible otherwise or because it believes, based on its information advantage, that the level and direction of the exchange rate are unwarranted. Intervention, then, would aim to change expectations in line with the central bank’s assessment.

The signaling channel depends in part on the institutional and policy credibility of the central bank.⁴ The effectiveness of intervention through signaling relies on influencing market expectations by transmitting information on fundamentals or future policy actions. Interventions must be perceived as credible signals (or threats) of future monetary policies to influence expectations. The signaling channel is most effective when interventions are publicly announced, which enhances the visibility of intervention, thus strengthening the central bank’s policy signal.

The signaling channel, however, may be less effective in developing countries. First, central banks in many developing economies are at a disadvantage with respect to institutional and policy credibility. They tend to lack the record of prudent macroeconomic management that underpins the strong credibility of monetary authorities in advanced economies. As such, the relative size of their interventions, all else being equal, may have to be greater in order to …buy credibility” and signal their commitment to future monetary policies (Mussa, 1981). Second, ongoing structural shifts in many developing economies—among them financial deepening, economic opening, private sector orientation, and shifts in the exchange rate regime—make it difficult to establish predictable and stable links between real and financial variables and, therefore, between intervention and future monetary policies.

Portfolio Balance Channel

Intervention can be effective by altering the currency composition of agents’ portfolios. The key assumptions are that domestic and foreign currency–denominated government securities are imperfect substitutes and that market participants are risk averse. As a result, investors demand a risk premium on the bonds denominated in the riskier currency (which constitutes a violation of the uncovered interest parity condition).⁵ Through the portfolio balance channel, a sterilized intervention operation alters the relative supply of domestic versus foreign currency securities, leading agents to rebalance their portfolios to equalize risk-adjusted returns, which in turn causes a change in the exchange rate. The exchange rate serves as the adjustment mechanism for risk-adjusted returns when base money and interest rates remain unchanged following sterilized intervention.⁶

Unlike the signaling channel, the portfolio balance channel does not require credibility as a precondition for effectiveness. As such, it potentially can be more potent in some developing economies, where policy credibility tends to be lower, domestic currency debt is an imperfect substitute for foreign currency debt, and interventions are large relative to foreign exchange market turnover.⁷

Microstructure Channel

The microstructure channel provides a new window into the functioning of foreign exchange markets and the effectiveness of intervention (Lyons, 2001).⁸ Microstructure finance analyzes the impact of order flow on exchange rates. Aggregate order flow is the balance of buyer-initiated and seller-initiated orders; as such, it is a measure of net buying pressure in the foreign exchange market (Evans and Lyons, 2002, 2005). In this framework, analyses of the effectiveness of interventions focus on the extent to which central bank trades affect aggregate order flow.

According to the microstructure approach, central banks are uniquely positioned to affect the transmission of fundamentals to the exchange rate through order flow. Central bank intervention can cause market participants to change their expectations on the future path of the exchange rate and lead them to modify their net open foreign exchange positions, triggering a change in aggregate order flow well in excess of the central bank’s contribution. The impact of official intervention on order flow and exchange rates can be greater in the presence of noise traders, which follow past trends, and often trade in a correlated fashion (Hung, 1997). Central bank intervention, even in small amounts, can trigger a tide of buy or sell orders by trend-chasing traders. Interventions need not be announced and should be timed to maximize the exchange rate impact. Intervention in this context may also lead to higher volatility, which can help promote a sense of two-way risk in the market.

The impact of official intervention on market expectations can be even greater if the central bank trades aggregate or disseminate information (Popper and Montgomery, 2001). When central banks are perceived to be more knowledgeable about future monetary and exchange rate policies or better equipped to monitor and interpret fundamentals, such as balance of payments trends, market participants may try to learn from central bank trades.⁹ In this context, central bank intervention emits information to the market. Stated differently, order flow serves as the vehicle through which the market aggregates information. To the extent that central bank–initiated order flow transmits information, it can potentially ignite an even greater flow of foreign exchange orders.

The microstructure channel also emphasizes that the size of intervention relative to market turnover determines the effectiveness of that intervention. In principle, the larger the intervention relative to market turnover, the higher its effect on the exchange rate. Thus, intervention has the potential to be more effective in developing countries, where foreign exchange markets are less liquid.

Trends in Foreign Exchange Intervention

Central banks in most advanced economies and some emerging market economies rarely intervene. The central banks of the countries issuing international reserve currencies—including the U.S. Federal Reserve and the European Central Bank (ECB)—seldom intervene anymore. The trend among other advanced economies is similar. Although the Bank of Canada actively intervened for many years, it has not done so since 1998. The Reserve Bank of New Zealand has not intervened since 1985.

Some emerging market economies have followed suit. The Bank of Israel has not intervened since 1997, despite its strong presence in the market in the early 1990s. The South African Reserve Bank, which pursued an active...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Preface
• I Introduction
• II Best Practices in Official Interventions in the Foreign Exchange Market
• III Survey of Foreign Exchange Intervention in Developing Countries
• IV The Empirics of Foreign Exchange Intervention in Emerging Markets: Mexico and Turkey
• Empirical Analysis and Evidence on Intervention
• Policy Context of Intervention in Mexico and Turkey
• Effectiveness of Foreign Exchange Intervention
• Conclusions
• Appendix
• References
• Boxes
• Footnotes