## IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — ppea2023061

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### Executive summary and scope
- Purpose and scope:
  - Guides policy advice on the use of foreign exchange intervention (FXI) as part of the Integrated Policy Framework (IPF) in Fund surveillance.
  - Brings together insights from the conceptual and quantitative IPF models, empirical literature, and central bank practical challenges.
  - Tailored to open economies operating under a floating exchange rate, typically alongside inflation targeting.  
  - Date: November 28, 2023.
- Main IPF use cases for FXI:
  - Use Case A: address destabilizing premia from arbitrage frictions in shallow FX markets.
  - Use Case B: counter financial stability risks from FX mismatches (unhedged currency exposure of balance sheets).
  - Use Case C: help preserve price stability when exchange rate changes risk de-anchoring inflation expectations (high exchange rate pass-through).
- Definition and operational focus:
  - FXI includes outright spot purchases/sales; forward and other derivatives that reallocate exchange rate risk; temporary provision of FX liquidity via loans or swaps; transactions to accumulate FX reserves buffers.
  - Emphasis on sterilized FXI (offsets or remunerates monetary base changes to avoid changes in short-term interest rates).
  - Changes in reserves are neither necessary nor sufficient indicators of FXI (e.g., NDFs do not change reserves).

### Core principles for advice
- Principle 1: FXI is warranted only with well-identified frictions that limit benefits of exchange rate flexibility (shallow FX markets, FX mismatches, inflation expectations formation).
- Principle 2: Use FXI only if shocks are large, pose significant risks to central bank objectives, and FXI can be effective; consider costs including sterilization costs, market development hindrance, moral hazard, erosion of monetary anchor, risk of speculative attacks, and political pressures.
- Principle 3: FXI should not substitute for warranted adjustment of macroeconomic policies; prioritize correcting inappropriate domestic policy settings.
- Principle 4: Integrate FXI within the overall policy response with monetary policy, MPMs, CFMs, fiscal policy, and structural measures.
- Principle 5: Strong central bank governance, legal/operational autonomy, and clear communication are necessary for successful FXI.
- Principle 6: Consider intertemporal trade-offs in spending and accumulating FX reserves; accumulation involves sterilization costs and valuation risk.
- Principle 7: Advice must consider multilateral effects; FX purchases that maintain undervalued exchange rates can generate adverse spillovers.

### When to undertake FXI and preconditions (¶24–¶27)
- FXI should be undertaken only when clear evidence that risks have become elevated.
- Contemporaneous indicators to monitor regularly include:
  - an increase in the UIP premium,
  - an unusually sharp change in the exchange rate,
  - incipient signs of inflation expectations’ de-anchoring.
- Traction requires limited FX market depth via the portfolio balance channel; empirical measures include price impact, price reversal, time series variation of UIP premia, transaction volume, bid-ask spreads, market turnover.
- Preconditions for effective FXI:
  - sufficient reserves for credibility,
  - strong central bank governance,
  - clear communication linking FXI to price and financial stability objectives.

### Use cases overview and common guidance (Table 1 summary)
- Three use cases:
  - A. FXI to Smooth Destabilizing Premia
  - B. FXI to Counter Risks from FX Mismatch
  - C. FXI to Address Risks to Price Stability
- Common features:
  - Each use case improves policy trade-offs that would otherwise fall solely on monetary policy.
  - Staff should establish relevance ex ante and ex post using indicators and analyses.
  - Indicators differ by use case but include premia measures (UIP, CIP, onshore-offshore spreads), capital flow data, FX debt stocks, pass-through estimates, and inflation expectations metrics.

### Use Case A — FXI to smooth destabilizing premia (¶29–¶46)
- Rationale:
  - Capital flow shocks can generate sharp changes in premia (UIP, CIP, onshore-offshore) that destabilize activity and financial stability even when domestic policies are appropriate.
  - FXI can ensure market functioning, smooth premia entering pricing decisions, and allow monetary authority to focus on internal stabilization objectives.
- Limits and cautions:
  - FXI is not recommended if premia deviations arise from inappropriate domestic policy settings.
  - FXI should mitigate only large, inefficient premia deviations; avoid over-smoothing small movements.
- Modalities and targeting:
  - Intervene in the market where FXI is most effective and target premia rather than the exchange rate per se.
  - Some exchange rate adjustment may be necessary to absorb fundamentals.
- Indicators and analysis (Box 3):
  - Ex ante: high-frequency benchmarks for UIP, CIP, LC premia; transaction volumes; market depth; volatility of premia; co-movement with capital flows.
  - Vulnerability: foreign investor share in local debt/equity; balance sheet strength of market participants.
  - Contemporaneous: non-resident and resident inflows/outflows; exchange rate volatility; FX reserve pressure; anecdotal evidence.

### Use Case B — FXI to counter FX-mismatch financial risks (¶48–¶69)
- Rationale:
  - Large depreciations raise LC value of FX liabilities, increasing debt service costs, default risk, and potential banking sector stress. FXI can lean against severe depreciations to reduce solvency and liquidity pressures.
- Conditions and limits:
  - Use FXI only to smooth severe depreciations and restrict to large shocks to mitigate moral hazard.
  - FXI should not prevent warranted macroeconomic adjustment.
- Assessment and indicators (¶54–¶61, Box 4):
  - Assess FX balance sheet mismatches and FX maturity mismatches across financial, non-financial corporate, and household sectors.
  - Use solvency/liquidity stress tests, satellite models mapping distress probabilities to exchange rate moves, econometric analysis allowing nonlinearities, and high-frequency private credit risk premia.
  - Contemporaneous forward-looking indicators: corporate and banking default spreads; FX spreads over foreign interest rates; LC lending spread over the policy rate.
- Modalities:
  - Spot interventions for widespread unhedged exposures; targeted FX provision for concentrated vulnerabilities (where legally/operationally permitted).
  - FX swaps and ELA can alleviate FX liquidity squeezes without changing exchange rate risk exposures.
- Policy mix:
  - Ex ante: MPMs (borrower-based, capital buffers, liquidity measures) and, if insufficient, preemptive CFM/MPMs subject to the IV.
  - Ex post: FXI can complement monetary/fiscal tightening; relaxing MPMs or buffers may help but are unlikely to replace FXI in crises. Temporary outflow CFMs are an option in imminent crises but have substantial enforcement challenges.
- Special case: financial dollarization increases difficulty of reducing vulnerabilities; macroprudential measures have limited power against persistent dollarization.

### Use Case C — FXI to support price stability (¶70–¶73, Box 5)
- Principle:
  - FXI can support monetary policy when a large depreciation risks de-anchoring inflation expectations, provided the cost of monetary policy alone is high, reserves are sufficient, and the costs of including FXI are low.
- Key findings:
  - Pass-through to inflation is stronger for larger exchange rate changes; non-linearities and threshold effects matter.
  - FXI is a “second-best” option in a narrow set of circumstances and should be used sparingly to avoid undermining the nominal anchor.
- Conditions making FXI more likely appropriate:
  - Exchange rate moves induce inflation and output to move in opposite directions (contractionary depreciation).
  - Monetary response faces severe trade-offs or lacks effective transmission.
  - Distortions from FXI-induced income effects are quantitatively small.
  - FXI does not deplete reserves below adequate levels and has traction in shallow FX markets or as part of an integrated future policy plan.
- Indicators and analysis (Box 5):
  - Ex ante: estimate pass-through across horizons and shock sizes; share of imported goods in final consumption; degree of price indexation; labor market indexation.
  - Contemporaneous: high-frequency price data; measures of inflation expectations (absolute deviation from target; variability; dispersion; sensitivity to inflation surprises).
  - Assess whether the shock is tail-sized and persistent enough to threaten anchoring.
- Sequencing and institutional prerequisites:
  - Monetary policy should be primary; if monetary policy is inappropriate, adjust it first.
  - Strong communication and a preestablished FXI strategy reduce credibility risks.

### Governance, transparency, and communication (¶88–¶106)
- Governance elements recommended:
  - (i) a well-articulated policy strategy for FXI;
  - (ii) a preestablished decision-making process including processing of supporting information and scope for judgment;
  - (iii) an internal guideline on FXI implementation;
  - (iv) an ex post assessment of FXI.
- Transparency best practices:
  - Disclose overall policy strategy, decision-making processes and supporting analysis, instruments used and selection of counterparties, and publish regular FXI assessment analyses (accountability).
- Communication content:
  - (i) the policy regime and objectives;
  - (ii) the policy strategy explaining links to objectives and data;
  - (iii) policy decisions with explanations.
- Institutional risks:
  - FXI can invite lobbying and political pressures; joint use of multiple tools increases communication complexity and may weaken credibility if capacity is limited.
- Assessment tools:
  - Use existing metrics (safeguards assessments, central bank transparency code reviews) and toolkits (e.g., Unsal and others (2022)) to evaluate frameworks and communication capacity.

### Reserves, intertemporal trade-offs, and optimal reserves (¶106 and related)
- Trade-offs:
  - Spending reserves reduces future response capacity; replenishing reserves is often slow and costly.
  - Accumulating reserves increases sterilization costs and valuation risk.
  - Credible communication can reduce required reserve size for effective FXI.
- Fund practice and guidance:
  - ARA metric range used: 100–150 percent (with most LICs still using months of imports).
  - Recommendations beyond 150 percent of the ARA metric should be justified on precautionary grounds and linked to use-case indicators.
- Use-case indicators for reserve adequacy:
  - Use Case A: size of FX market, markets that are dysfunctioning, required intervention to affect premia.
  - Use Case B: level/distribution of FX mismatches, stress tests, illiquidity measures.
  - Use Case C: exchange rate pass-through estimates, volatility of inflation expectations, illiquidity measures.
- Operational principles for accumulation:
  - Accumulate reserves in ways that avoid impacting the exchange rate (e.g., pre-announced purchases, auction calendars, fixed volume/variable price formats).
  - Opportunistic purchases have costs and can harm credibility.
- Multilateral considerations:
  - Caution against reserve accumulation that strengthens external position beyond fundamentals, causes adverse spillovers, or exceeds ARA without policy justification.
  - Fund multilateral surveillance assesses spillovers and may advise measures to achieve objectives with smaller multilateral spillovers.

### Empirical and theoretical evidence on FXI effectiveness (Annex I and studies)
- Theoretical channels:
  - Portfolio balance channel: effective when limits to arbitrage relax perfect substitutability.
  - Signaling channel: effective if FXI conveys new information about future policy stance.
- Empirical findings (consolidated):
  - Transparency, strong communication, and rules-based intervention increase effectiveness.
  - Oral intervention and announcements can amplify effects; announcements sometimes have greater immediate effect than operations.
  - Larger interventions aligned with prior exchange-rate trends and fundamentals are more effective.
  - FX sales tend to be more effective than FX purchases in less open capital account and shallower FX markets.
  - FXI effectiveness is higher when consistent with fundamentals and monetary policy stance and stronger in shallower FX markets following global risk shocks.
  - Potential downsides: FXI can encourage buildup of unhedged FX liabilities and raise corporate leverage; limited evidence on credibility erosion and pass-through effects.

### Staff operational guidance and decision-making
- Staff should:
  - Use indicators and analysis to frame policy discussions; avoid mechanical rules.
  - Integrate IPF considerations into baseline and risk scenarios in surveillance outputs.
  - Advise FXI only when evidence supports elevated risk, considering alternatives (monetary, fiscal, MPMs, CFMs), governance conditions, reserves, and multilateral effects.
  - Present supporting indicators and analysis in staff reports and engage authorities on preestablished conditions for FXI.

*Source: IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — excerpts from content unit ppea2023061.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Purpose and scope
- Guides policy advice on the use of foreign exchange intervention (FXI) as part of the Integrated Policy Framework (IPF) in Fund surveillance.
- Brings together insights from the conceptual and quantitative IPF models (e.g., Basu and others, 2020, Adrian and others, 2021), empirical literature, and central bank practical challenges.
- Tailored to open economies that operate under a floating exchange rate, typically alongside inflation targeting, but notes principles may apply beyond this core group.
- Date: November 28, 2023.

### IPF approach and main use cases
- The IPF provides a structured, frictions-based approach to policy discussion and advice, underpinned by explicit analysis of frictions that may give rise to financial stress and disruptive exchange rate movements.
- Three principal IPF use cases for FXI are identified:
  - Use Case A: to address destabilizing premia from arbitrage frictions in shallow FX markets.
  - Use Case B: to counter financial stability risks from FX mismatches (unhedged currency exposure of balance sheets).
  - Use Case C: to help preserve price stability when exchange rate changes risk de-anchoring inflation expectations (high exchange rate pass-through).
- The IPF does not replace the Integrated Surveillance Decision (ISD) or other Fund policies; it complements them and can overlap with DMC-based advice.

### Principles for advice and indicators
- The note outlines general principles to guide staff advice on FXI within the IPF and principles specific to each use case (A, B, C).
- For each friction/use case the note:
  - Articulates the key conditions that may justify FXI.
  - Suggests indicators and analysis to help identify the strength of the relevant friction, drawing on metrics and other information available to Fund staff and the authorities.
  - Emphasizes indicators should not be used mechanically but to frame and structure policy discussions.
- Examples of indicator-focused guidance are organized in Boxes 3–5 (Indicators for Use Case A, B, and C).

### Integration with the policy mix and trade-offs
- FXI advice is integrated with other policy tools within the IPF, including:
  - Monetary policy (interest rate setting under inflation targeting).
  - Macroprudential measures (MPMs).
  - Capital flow management measures (CFMs) and combined CFM/MPMs.
  - Fiscal policy.
- For each friction, the note examines how FXI might complement or be weighed against other instruments to achieve an efficient overall policy response.
- The note discusses costs of using FXI, including considerations outside the models, and trade-offs in accumulating and spending reserves.

### Institutional conditions, governance, and multilateral considerations
- The note outlines key institutional conditions that increase the likelihood of successful FXI, including issues of central bank independence, credibility, and governance.
- It discusses how multilateral considerations and existing IMF policy frameworks (e.g., ISD, Article IV, MCP policy, Institutional View on capital flows) should inform and condition advice.
- Highlights that staff advice under IPF should be consistent with ISD principles, including that members “should intervene in the exchange market if necessary to counter disorderly conditions (DMC),” while noting ISD does not preclude FXI outside DMC.

### Operational definitions and focus
- FXI in this note refers to FX transactions between the central bank or government and the private sector that have the potential to affect conditions in FX markets; this includes:
  - Outright spot purchases/sales.
  - Forward and other derivatives that reallocate exchange rate risk.
  - Temporary provision of FX liquidity via loans or swaps.
  - Transactions to accumulate FX reserves buffers in preparation for future FXI.
- The focus is on sterilized FXI to maintain distinction with monetary policy: sterilized FXI offsets or remunerates changes in the monetary base induced by FXI to avoid changes in short-term interest rates.
- Notes that changes in reserves are neither necessary nor sufficient indicators of FXI under this definition (e.g., non-deliverable forward contracts do not change reserves but are FXI).

### Expected outcomes and judgment
- The IPF-based guidance aims to improve specificity and consistency of FXI advice across countries by making explicit the conditions under which FXI can be useful.
- The framework supports guided discretion: indicators and analysis inform policy discussion but significant judgment remains necessary when deciding whether FXI is warranted in a given situation.

*Source: EXECUTIVE SUMMARY, ppea2023061.*

### 11. Central banks may use FXI in ways outside of the scope of the IPF and thus this note.

### 11. Central banks may use FXI in ways outside of the scope of the IPF and thus this note.

### Alternative uses of FXI (outside IPF scope)
- In a fixed exchange rate regime, unsterilized intervention is driven by demand and serves as a monetary policy operation aimed at maintaining the peg.
- In countries with stabilized arrangements, the central bank may forego exchange rate flexibility irrespective of the macroeconomic impact of specific shocks.
- Countries at the effective lower bound have used FXI to achieve quantitative easing when employing unconventional monetary policy strategies.
- In countries with less developed financial markets, central banks may:
  - Intervene for market development or act as market makers by taking in and re-providing FX to the private sector, directly transacting with exporters or importers.6
  - Conduct agency transactions for the government (e.g., buying FX the government receives from commodity exports, or from loans and grants, and selling this for the local currency in the local market). While legitimate, such uses would typically be outside the scope of the IPF.7

### Modalities of FXI under the IPF
- FX markets segments:
  - (i) the spot FX market;
  - (ii) the derivatives FX market; and
  - (iii) FX funding markets (borrowing and lending FX).
- FXI is often conducted in the spot market and directly impacts the size of central banks’ FX reserves.
- Many central banks have started using derivatives such as FX forwards, including non-deliverable forwards (NDFs) that are denominated but not settled in FX, and may then not have an impact on reserves.8
- Operations such as FX swaps or the provision of emergency liquidity assistance (ELA) in FX typically involve provision of FX assets against a promise to repay FX at a later date, and may not involve a transfer of local currency assets for FX assets.
- Such operations are useful in managing FX liquidity pressures in FX funding and derivatives markets and may affect the exchange rate when they relieve FX shortages in these markets.

### General principles for FXI under the IPF
- Principle 1. Under the IPF, FXI is warranted only in the presence of well-identified frictions that limit the benefits of exchange rate flexibility for macroeconomic adjustment.
  - FXI should be considered only when exchange rate flexibility is associated with costly frictions (shallow FX markets, FX mismatches, and inflation expectations formation). In their absence, exchange rate flexibility typically yields stabilization benefits via expenditure switching.
- Principle 2. In view of costs from FXI, FXI should be used only if shocks are large, posing significant risks to central bank objectives, and if FXI can be effective in supporting these objectives.
  - Costs include sterilization costs from purchasing and holding FX assets, and endogenous reactions of domestic and international agents (not present in the IPF models).
  - Specific costs highlighted:
    - Frequent FXI may hinder development of FX and hedging markets and reduce private entry and liquidity in the spot market.
    - FXI as insurance can create moral hazard, incentivizing expansion of FX exposures; literature finds increases in FX debt following intense FXI (Kim and others, 2020) and reductions in FX debt with more flexible exchange rate regimes (Csonto and Gudmundsson, 2020).
    - Frequent FXI can blur the primary objective of monetary policy and undermine the nominal anchor, especially in young inflation-targeting regimes or where communication capacity is weak.
    - FXI to support exchange rates far from fundamentals can invite speculative attacks if reserves are insufficient.
    - FXI can invite lobbying and political pressure to lean against exchange rate changes.
  - Managing these costs implies FXI should be confined to shocks that lie towards the tails of the distribution and that create significant risks to price and financial stability.
- Principle 3. FXI should not substitute for a warranted adjustment of macroeconomic policies.
  - FXI should not be used as a substitute where shocks are caused primarily by inappropriate domestic policy settings; policy advice should prioritize correcting domestic policies to restore investor confidence.
  - FXI can be complementary when credible policy correction is committed but requires time to enact.
  - Examples of inappropriate domestic settings where correction should be prioritized:
    - Excessive current account positions (as measured by the ESA): policy advice should focus on fiscal and exchange rate adjustment rather than reserve dynamics that leave imbalances unaddressed.
    - Monetary policy that does not stabilize inflation expectations: adjust the policy rate or repair monetary transmission mechanisms rather than using FXI to undo inappropriate interest rate setting.
    - Unsustainable public deficits: focus on fiscal adjustment and medium-term fiscal framework reforms rather than depleting FX reserves to offset foreign investor outflows.
- Principle 4. FXI should be integrated within the overall policy response.
  - Advice should consider adjustments to monetary and fiscal policies and the use of MPMs, CFMs, and CFM/MPMs.
  - MPMs and CFM/MPMs may be appropriate ahead of adverse shocks; ex ante policies can reduce the need for ex-post FXI (e.g., MPMs to contain FX mismatches).
  - Structural policies to develop FX and local currency markets can be part of the IPF policy mix.
- Principle 5. Strong central bank governance and communications are necessary to ensure success of FXI under the IPF.
  - Operationalization of FXI requires legal, decisional, and operational autonomy and effective communication about multiple instruments.
  - The IPF can help strengthen governance and communication by elaborating a policy strategy to rationalize and constrain FXI use.9
  - If institutional conditions cannot be met, staff should be more cautious in advising FXI under the IPF.
- Principle 6. Countries should consider intertemporal trade-offs in spending and accumulating FX reserves.
  - Spending reserves today may reduce ability to respond to future shocks; replenishing reserves quickly is often difficult without affecting the exchange rate.
  - FX reserve accumulation can boost credibility of FXI but involves sterilization costs and valuation loss exposure.
  - Clear communication of objectives can increase FXI effectiveness and reduce reserves needed.
- Principle 7. Advice on FXI under the IPF needs to consider its multilateral effects.
  - FX purchases aimed at maintaining an undervalued exchange rate strengthen international competitive position and can generate adverse spillovers (“beggar-thy-neighbor”).
  - Staff should caution against further reserve accumulation if: (i) external position is stronger than implied by fundamentals and desirable policies; (ii) such effects are caused by the country’s policies; and (iii) the country is already beyond the assessing reserves adequacy (ARA) metric.

### Use cases and crosscutting guidance
- The IPF articulates three “use cases” for FXI:
  - Use case A: counter destabilizing premia from FX market frictions.
  - Use case B: counter financial stability risks from FX mismatches.
  - Use case C: prevent potential de-anchoring of inflation expectations.
- Common features:
  - Each use case improves trade-offs that would otherwise arise when only monetary policy is available ex post.
  - Staff should establish relevance of each use case both ex ante and ex post using indicators and analyses.
- Indicators and analyses across use cases:
  - For FX premia (use case A): assess FX market shallowness, sensitivity of credit markets to premia; establish benchmarks for financing and hedging premia; monitor structural liquidity measures, foreign investor share in local debt, balance sheet strength; ex post monitor UIP, CIP, FX onshore-offshore spreads, high-frequency capital flows and appropriateness of macro settings.
  - For FX-mismatch financial stability (use case B): assess unhedged FX exposures and their amplification of credit market risks; use forward-looking indicators such as credit and funding spreads alongside exchange rate developments; constrain FXI to tail-risk management due to moral hazard.
  - For inflation de-anchoring (use case C): examine sensitivity of inflation and inflation expectations to exchange rate movements, pass-through thresholds and state dependence; examine co-movement between exchange rates and output/output gaps; judge appropriateness of monetary and fiscal settings and whether de-anchoring reflects lack of credibility in inflation targeting regime. FXI should be considered only when monetary policy alone creates severe trade-offs and when the cost of including FXI is low.

*From: ppea2023061 - 11. Central banks may use FXI in ways outside of the scope of the IPF and thus this note.*

### 24. For each of these cases, FXI should be undertaken only when there is clear evidence

### 24. For each of these cases, FXI should be undertaken only when there is clear evidence that risks have become elevated

### When to undertake FXI (¶24)
- FXI should be undertaken only when there is clear evidence that risks have become elevated.
- Advice in favor of FXI should be based on clear evidence that a shock is raising risks to elevated levels.
- Contemporaneous indicators staff should monitor regularly include:
  - an increase in the UIP premium,
  - an unusually sharp change in the exchange rate,
  - incipient signs of inflation expectations’ de-anchoring.
- Decisions and advice should be evidence-based but guard against waiting until material macroeconomic costs have already accrued; timing requires judgment.

### Traction and market depth (¶25)
- FXI needs traction through the portfolio balance channel, which requires limited FX market depth due to imperfect substitutability between domestic and foreign assets.
- Empirical measures that support assessment of pre-shock FX market depth:
  - price impact and price reversal measures,
  - time series variation of UIP premia in response to global shocks and correlation with capital flows,
  - transaction volume, bid-ask spreads, market turnover.
- FX market liquidity may be time-varying and state-contingent, potentially allowing FXI greater traction in responding to larger shocks.

### Integration with monetary policy and signaling (¶26)
- Effectiveness of FXI depends on being part of an integrated policy response.
- FXI can gain traction when it signals new information about the future stance of monetary policy, provided FXI is deployed consistent with the central bank’s price stability objectives.
- If FX sales or purchases are at odds with the central bank’s stated objectives, the net effect on the currency may be small and transient.

### Preconditions: reserves, governance, and communication (¶27)
- Effective FXI requires:
  - sufficient reserves for credibility,
  - strong central bank governance to shield against political pressures and lobbying,
  - clear communication linking FXI to central bank price and financial stability objectives.
- Intertemporal tradeoffs: spending reserves today reduces the ability to respond to future shocks and to provide FX liquidity later.
- The IPF can help clarify the policy framework and enable more effective communication, but challenges call for caution in the use of FXI under the IPF.

### Use Cases Overview (Table 1)
- Three use cases for FXI under the IPF:
  - A. FXI to Smooth Destabilizing Premia
  - B. FXI to Counter Risks from FX Mismatch
  - C. FXI to Address Risks to Price Stability
- Table structure (high level):
  - Type of shock: examples include inefficent financing/hedging premia from private capital flow shocks; sharp exchange rate depreciation from real or financial shocks; persistent appreciation.
  - Frictions: examples include arbitrage frictions, unhedged FX liabilities, nominal frictions generating non-linear exchange rate-to-inflation effects.
  - Other policy instruments: CFMs, MPMs, structural policies, monetary policy as first line of defense.
  - Key challenges: identifying premia in real time, targeting FXI to the affected market, assessing FX mismatch size and distribution, identifying de-anchoring of inflation expectations.
  - Main drawback: reduction in private trading volume and market development; moral hazard; risk of confusion regarding the nominal anchor.

### Staff advice and operational guidance (¶28)
- Staff advice should integrate the range of elements and country-specific circumstances.
- Staff should dialog with country authorities to lay out conditions under which FXI can be considered as part of the overall policy response, considering other instruments.
- Considerable judgment is required based on flow of data and information.
- Supporting indicators and analysis should be presented in the staff’s report; IPF considerations should inform overall policy advice under baseline and risk scenarios, not be separate.

### Use Case A: FXI to Smooth Destabilizing Premia (¶29–36)
- Principle: FXI may be appropriate to smooth large changes in hedging and financing premia that generate risks to macroeconomic and financial stability, and that arise even though domestic policy settings are appropriate.
- Capital flow shocks can generate sharp changes in premia that destabilize macroeconomic activity and financial stability; effects depend on the nature of the premia:
  - UIP premia and other local currency (LC) premia:
    - Non-residents may absorb LC debt only at a premium; deviations can indicate temporary relaxation or tightening of portfolio constraints.
    - Inflow surge → premia may be excessively low or negative → may stimulate excessive borrowing and macroeconomic overheating.
    - Outflow episode → premia may rise excessively → may force private deleveraging and rapid growth slowdown, possibly compounded by fire sales in LC assets.
  - Covered interest parity (CIP) premia:
    - CIP premia should be close to zero under perfect arbitrage; deviations indicate arbitrage breakdown in hedging markets and can raise hedging costs or encourage unhedged borrowing.
  - Premia between onshore and offshore FX financing:
    - Arise from counterparty/credit risks and structural impediments; large premia can make rollover of FX debt on domestic markets difficult and force deleveraging.
  - Spillovers between FX markets:
    - Disruptions in forward and FX financing markets can spill over into spot FX, increasing volatility and risk of overshooting, hampering transactions and generating FX shortfalls.
- When premia deviations arise from external investors’ portfolio shifts despite appropriate domestic settings, FXI can be desirable to mitigate those changes.
- Objective of FXI in inflow/outflow episodes: ensure markets continue to function, smooth premia that enter pricing decisions, and allow monetary authority to focus on internal stabilization objectives.
- FXI is not recommended if premia deviations arise from inappropriate domestic policy settings; monetary and fiscal settings should be corrected instead.
- FXI should mitigate only large changes in premia:
  - Small movements likely do not lead to material adverse effects.
  - Central bank should avoid over-smoothing to preserve price formation and avoid reducing market volume.
  - Frequent FXI to smooth small changes could exacerbate moral hazard and increase FX borrowing.
- Ideally, only inefficient premia deviations should trigger intervention, but decomposing premia in real time is difficult; staff should seek corroborating evidence across indicators and re-evaluate when shocks are persistent.
- FXI should be undertaken in the market where it is most effective and with minimal distortions; target premia rather than the exchange rate per se.
  - Some exchange rate adjustment may be necessary to absorb fundamentals while FXI addresses excessive premia deviations.
  - FXI appropriate until premia are stabilized, not until exchange rate level is stabilized.
  - Exchange rate path may inform staff judgment about the nature of the shock.

### Indicators and Analysis (¶37–38)
- To assess FX market frictions, staff should consider a range of indicator variables and the country-specific structure of FX markets.
- Steps to assess FX market functioning ex ante:
  - Prepare high-frequency reference benchmarks for premia and volume in key FX markets used for financing and hedging (spot, FX forward, FX swap, FX and LC financing markets at various maturities).
  - Assess whether premia in these markets have historically been volatile and co-moved negatively with capital inflows and outflows.
  - Recognize that FX markets can appear deep in normal times but be state dependent and dry up in stress; allow for a time-varying “Gamma” (Γ) in balance sheet constraints when estimating models.
  - Bear in mind that country policies (e.g., FXI and CFMs) influence collected series; staff should assess how premia would have moved in the absence of such instruments, aided by quantitative models estimated on historical evolution of country-specific variables, including volume of FXI.

*IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — INTERNATIONAL MONETARY FUND*

### 39. Assessing the structure of LC or FX debt markets can also help determine the

### 39. Assessing the structure of LC or FX debt markets can also help determine the likelihood and impact of movements in premia ex ante.

### Market structure and vulnerability assessment (¶39)
- A higher share of foreign investors in LC or FX debt markets increases the likelihood that premia in FX markets emerge as a result of changes in their risk appetite.
- Local participants’ capacity (banks and non-bank financial institutions (NBFIs)) to absorb flows at the onset of a shock reduces the potential for premia to emerge and to become amplified through the local economy.
- Measuring and monitoring balance sheet vulnerabilities of key local debt market players helps assess likelihood of stressed deleveraging:
  - Open-ended mutual funds with liquidity mismatch increase scope for fire sales in a change in risk sentiment.
  - Cross-border investments by non-resident insurance companies, pension funds, and banks can be relatively more stable.
  - The scope for destabilizing outflows from resident NBFIs’ outward investment should be assessed.

### Monitoring premia and capital flows (¶40, Box 3)
- Staff should monitor premia where data are available:
  - The IPF metrics dataset includes a cross-country series on UIP premia.
  - LC, CIP, and onshore-offshore FX financing premia should be selected and collected according to country context.
  - Some measures may be real-time; others rely on lower-frequency data.
- Complement premia data with capital flow information (non-resident and resident debt inflows and outflows).
  - In shallow markets: risk-off shocks → spikes in premia as inflows decline/turn into outflows; risk-on shocks → compressed yields as inflows surge.
- Future method development suggestion:
  - Develop empirical models to filter premia, capital flows, and global variables to assess whether movements in premia are large (e.g., identify whether a capital flow episode is large in historical perspective and provide forward-looking trigger points).
- Box 3 — Indicators for Use Case A — Shallow FX Markets
  - Ex ante assessments — key variables for important FX markets:
    - High-frequency benchmarks for UIP, CIP, LC (e.g., short-term rates and term premia) and onshore/offshore financing premia
    - Transaction volumes
    - Levels and changes in market depth—structural liquidity measures, volatility of premia, co-movement of premia with capital flows
  - Vulnerability assessment can include:
    - Foreign investor share in local debt and equity markets
    - Balance sheet strength and liquidity measures for key market participants
  - Assessment of impact of premia changes:
    - Sensitivity of credit markets (spreads, volumes) to changes in premia
  - Contemporaneous assessment at onset of shock — monitor:
    - Non-resident and resident debt and equity inflows and outflows
    - If premia/flow data limited, form assessment based on:
      - Exchange rate volatility
      - FX reserve pressure
      - Anecdotal evidence on external creditor portfolio constraints
      - Prior judgment on FX market shallowness

### Data availability and use of proxies (¶41)
- High-frequency capital flow data are most useful, but flows data are often lower frequency and must be combined with priors on market shallowness.
- If premia data are unavailable and market is judged shallow, capital flows data alone may identify abrupt changes reflecting foreign investors’ portfolio frictions.
- Where premia and capital flow data are limited, staff should use all available information (exchange rate volatility, FX reserve pressure, anecdotal information, priors on shallowness) to judge causes and magnitude of premia movements.
- If FXI and CFMs data are limited, staff should use proxies and anecdotal/administrative information about FX market participants to back out parameters (e.g., market depth) for quantitative models.
- Where premia are available only at long frequencies, intraday exchange rate volatility can be an early indicator of spot market liquidity and should be part of early warning indicators.

### Linking premia assessment to macro policy judgments (¶42)
- If there is a large and potentially inefficient change in premia, staff should judge whether monetary and fiscal policies are at appropriate settings as part of Article IV surveillance.
- The appropriateness of FXI depends on contemporaneous judgments about macroeconomic policy settings.

### Ex ante policies to build resilience (¶43–44)
- Structural reforms to deepen FX and LC debt markets reduce sensitivity of premia to external developments (e.g., develop local intermediaries such as pension funds to absorb LC debt).
- Steps to liberalize the capital account (in line with the IV) and develop legal framework for FX markets help deepen FX markets and increase resilience.
- If FXI is constrained (e.g., limited reserves), consider preemptive CFM/MPMs to contain stock vulnerabilities, as laid out in the review of the IV (IMF 2022a):
  - In shallow markets, future spikes in LC and FX premia may cause fire sales of domestically issued LC and FX assets; accumulated stock vulnerabilities can amplify fire sales into severe economic downturns.
  - CFM/MPMs may be appropriate to reduce lending intermediated from abroad if IV conditions are satisfied.
  - Outside inflow surges, CFM/MPMs on FX debt inflows are more likely appropriate than on LC debt inflows; preemptive measures on LC debt inflows can be appropriate when FXI is not available or constrained and IV conditions are met.

### Ex post policy mix during shocks (¶45–46)
- If monetary and fiscal policies are at inappropriate settings, staff advice should focus on adjusting them; adjustment is preferred to FXI and to MPMs/CFMs.
- If authorities commit to gradual policy adjustment because immediate adjustment is too disruptive, FXI and other instruments may be appropriate in the interim.
- The IV governs the policy mix between FXI and CFMs:
  - Inflow surge that threatens macroeconomic stability:
    - If overheating and overvaluation exist while FX reserves are adequate, inflow CFMs may be appropriate under the IV; they should be transparent, targeted, temporary, and preferably non-discriminatory.
    - Precise policy mix depends on costs of FXI, country-specific costs/effectiveness of CFMs, and institutional characteristics.
  - Inflow surge that threatens financial stability:
    - If excessively low premia, excessive borrowing, and financial stability risks build, FXI can be complemented by MPMs to reduce domestic credit in compressed-premia segments and increase resilience to future outflows.
    - Targeted, transparent, temporary CFM/MPMs to reduce credit intermediated from abroad could be appropriate under the IV (examples: unremunerated reserve requirements for short-term external debt inflows; restrictions on corporate external debt).
  - Outflows:
    - Under the IV, capital outflows should be handled primarily with macroeconomic, structural, and financial sector policies rather than CFMs.
    - Macroeconomic policy response should address domestic triggers and foster orderly external adjustment via exchange rate depreciation, monetary policy, and possible FXI.
    - Relaxing inflow CFMs may be useful when FX reserves are relatively low; in crisis/imminent crisis (sharp depreciation + rapidly falling FX reserves + tightening financial conditions), easing inflow CFMs would likely be insufficient and comprehensive outflow CFMs may be needed.

### Relative instruments and market focus (¶47)
- Effectiveness of FXI should be judged against alternative domestic market interventions:
  - Premia arise in LC markets as well as FX markets; central bank should determine which markets matter most for premium formation and intervene preferentially.
  - Central banks may have additional instruments (e.g., asset purchases aimed at preserving LC market functioning) that could be more effective than, or complement, FXI.
  - Such instruments should target premia rather than the exchange rate and should not alter domestic monetary conditions if monetary policy is appropriately set.

### FXI to address financial stability risks from FX mismatches — principle and rationale (¶48–53)
- Principle: If a large depreciation increases financial stability risks from FX mismatches (e.g., private sector defaults), FXI can be provided to help prevent adverse financial amplification, provided that reserves are sufficient.
- Rationale and channels:
  - Large unexpected depreciation increases value of FX liabilities in LC when LC assets are funded by unhedged FX liabilities, raising debt service costs and default risk.
  - Depreciation shocks can stress the banking system through credit and market losses, valuation effects, and funding pressures; banks with open net short FX positions may suffer valuation losses.
  - Higher private sector default risk can trigger reversal of FX debt inflows and reduce foreign supply of credit, potentially causing a “sudden stop” and amplifying depreciation.
  - FXI can mitigate these risks by leaning against large depreciations to reduce solvency and liquidity pressures from unhedged FX debt:
    - FX sales by central bank prevent LC value of FX obligations from rising as much, abating repayment pressures and reducing risk of fire sales.
    - Early and effective FXI can reduce macro-financial feedback loops and downside risks to portfolio outflows by signaling policy commitment.
- Conditions and limits on FXI use:
  - FXI should be used only to smooth severe depreciations:
    - Non-linear amplification via FX mismatches arises only if the shock is large.
    - Restricting FXI to large shocks mitigates moral hazard from private agents increasing unhedged FX exposure expecting policy support.
    - FXI that removes tail risks may lower hedging costs and foster development of private hedging markets.
  - FXI should not prevent warranted macroeconomic adjustment but should counter welfare losses from inefficient amplification:
    - Where financial frictions exist and shocks are large, FXI to prevent amplification can yield macroeconomic benefits that exceed costs.
    - Use of FXI should not discourage pre-shock policies aimed at reducing financial vulnerabilities from FX debt stocks.

_Italic: IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — excerpts (¶39–¶53)._

### 54. Evaluating this case for FXI should begin by assessing unhedged FX exposures and the

### 54. Evaluating this case for FXI should begin by assessing unhedged FX exposures and the 

### Assessing unhedged FX exposures and financial stability risks
- Financial stability risks from a sharp depreciation are larger the greater the extent of unhedged FX exposures (IV Background Note IMF 2022c).
- Two types of FX mismatches to assess:
  - FX balance sheet mismatches—currency denomination of borrower liabilities differs from that of assets.
  - FX maturity mismatch—there is an FX financing gap.
- Assessments should be conducted for:
  - The financial sector.
  - The non-financial corporate sector.
  - The household sector.
- Use IPF metrics data available to staff and complement with more detailed authority-provided data for granular analysis.

### Amplifying factors and vulnerability channels
- Risks from FX mismatches can be amplified by leverage: households, corporates, and banks with smaller equity cushions are less able to absorb valuation and funding effects of a large depreciation and more likely to decrease consumption, operations, and lending respectively.
- A large presence of foreign investors in LC debt markets can strengthen the case for policy action, as these investors’ flows might be particularly sensitive to exchange rate movements.

### Ex ante analysis of macro-financial feedbacks (paragraph 56)
- Recommended analyses:
  - Solvency and liquidity stress tests to assess sector resilience to large depreciation shocks (see IV Background Note, IMF 2022c).
    - Satellite models can map individual or sectoral distress probabilities to exchange rate movements and other macro variables.
  - Econometric analysis to determine impact of exchange rate shocks on output and its components, non-performing loans, and measures of distress probabilities.
    - Specifications should permit nonlinearities, distinguishing between small and large shocks.
  - Use high-frequency data on private credit risk premia (e.g., corporate/bank CDS spreads) to identify strength of co-movements with exchange rate depreciations, possibly past an estimated depreciation threshold.

### Contemporaneous monitoring at shock onset (paragraph 57–58)
- Monitor a range of forward-looking indicators to determine whether FXI is needed, beyond the exchange rate change itself.
- Focus indicators on credit and funding spreads to enable timely policy response (see Box 4).
- Prior ex ante analysis helps frame contemporaneous evidence, including identifying the exchange rate change size that leads to deterioration in financial variables and output.
- Necessary conditions for FXI to support financial stability under this use case:
  - High degree of FX mismatch.
  - Evidence of sectoral vulnerabilities to these FX mismatches.

### Distribution of vulnerability and appropriate FXI modality (paragraph 59–61)
- Modality depends on distribution of FX vulnerability:
  - Spot interventions may be needed to smooth severe exchange rate fluctuations when unhedged FX exposures are widespread (Lafarguette and others, 2021), including exposures outside the central bank perimeter.
  - If unhedged exposures are concentrated in a few known, individually systemic institutions, targeted provision of FX to those institutions may be preferable to limit market distortions and save reserves, where legally and operationally permitted.
- Role of FX swaps and FX liquidity provision:
  - FX swaps do not transfer exchange rate risk to the central bank but can alleviate liquidity squeezes; a sharp increase in FX spreads over the USD rate may indicate lack of FX liquidity prompting swaps.
  - FX swaps are useful as immediate crisis-time response and can prevent liquidity shortages spilling into the wider economy.
  - Emergency lending in FX supports individual institutions facing FX liquidity stress (Cespedes and Chang, 2020).

### Alternatives and complementary financial sector policies (paragraph 61)
- When unhedged exposures are concentrated in a limited number of institutions, consider targeted support measures (capital provision or fiscal measures) as alternatives to central bank FXI.
- Market-wide FXI may buy time for implementing targeted measures, while preserving sufficient reserve levels should be considered.

### Box 4 — Indicators for Use Case B: FX Mismatches
- Ex ante assessments — variables of interest:
  - FX debt stocks at relevant maturities across households, non-financial corporations, banks, and non-bank financial institutions.
  - FX assets and hedges (natural or contractual) at the relevant maturities for these sectors.
- Indicators to assess amplification channels:
  - Sectoral measures of leverage.
  - Foreign investor share of LC debt markets.
- For a given FX exposure, assess strength of macro-financial feedback via:
  - Solvency and liquidity stress tests; satellite models mapping distress probabilities to exchange rate movements.
  - Econometric analysis of exchange rate shocks on output, components, non-performing loans, and distress probabilities; allow nonlinearities and threshold effects.
  - High-frequency private credit risk premia co-movements with exchange rate depreciations (e.g., corporate/bank CDS spreads).
- Contemporaneous assessment — forward-looking indicators at shock onset:
  - Corporate and banking default spreads.
  - FX spreads over foreign interest rate, including spreads between onshore and offshore FX debt.
  - LC lending spread over the policy rate as an indication of a reduction in loan supply.

### Policy mix — Ex ante policies (paragraphs 62–65)
- Ex ante policy advice should focus on reducing vulnerabilities from FX debt stocks, including use of macroprudential measures (MPMs).
  - Examples:
    - Borrower-based measures (tighter DSTI limits on FX borrowing) to limit FX mismatch buildup by households.
    - Broad-based tools (capital buffer requirements) to build additional banking sector buffers.
    - Liquidity measures (FX reserve requirements or the Liquidity coverage ratio (LCR)) to protect against rollover risks and counter moral hazard.
- When MPMs are insufficient, consider preemptive CFM/MPMs, subject to the revised IV, to restrict excessive external FX borrowing by the non-financial corporate sector.
- Limitations and costs:
  - Fully eliminating risks ex ante may be impossible or too costly; prudential tightening can be prohibitively costly and politically challenging.
  - Borrower-based measures primarily affect flows and require time to reduce stock vulnerabilities.
  - Macroprudential policies are prone to leakages to nonbank or foreign entities.
  - CFMs/CFM-MPMs can entail substantial enforcement, distortionary, reputational, governance, and distributional costs (IMF, 2022c).

### Financial dollarization (paragraph 65)
- Reducing risks is especially challenging in financially dollarized economies:
  - Households often prefer FX deposits; domestic banks use FX deposit base to lend in FX.19
  - Even with small bank net open FX positions, unhedged corporate or household borrowers—and thus banks—are exposed to exchange rate risk.
  - Macroprudential measures can reduce risks but usually cannot address driving forces of dollarization, which can be persistent (Kokenyne and others (2010), Levy-Yeyati (2006), Levy-Yeyati (2021), Georgia FSAP (IMF 2021), IMF (2014c)).

### Policy mix — Ex post policies (paragraphs 66–69)
- FXI can complement broader ex post response, including monetary or fiscal tightening:
  - Without FXI, monetary policy may need to be relatively tighter to prevent depreciations that threaten systemic stability (the interest rate defense), but this can raise LC debt servicing costs and output contraction.
  - In shallow FX markets, sterilized FXI can temporarily lean against large depreciations, allowing more accommodative policy rates.
- FXI must be consistent with monetary and fiscal policy and not substitute for warranted macroeconomic adjustment.
  - If loose fiscal or monetary policy erodes investor confidence, those policy settings must be adjusted; FXI can be temporary complement while adjustment takes effect.
- Relaxation of MPMs and inflow CFM/MPMs may help limit depreciation and stimulate credit but is unlikely to replace FXI:
  - Releasing FX liquidity buffers (lower FX reserve requirements or temporary reduction in required FX liquidity buffers) can ease FX liquidity pressures (see IMF 2017).
  - Releasing capital buffers can support bank lending (Nier and Olafsson, 2020).
  - Easing inflow restrictions may have limited benefit under widespread capital flight and risks creating future vulnerabilities from volatile short-term flows.20
- In imminent crisis circumstances, temporary outflow CFMs may help preserve reserves but are typically harder to implement effectively than FXI:
  - Outflow CFMs can prevent free-fall of exchange rates, preserve FX reserves and financial sector liquidity, and provide time for macro-financial policies to work (IMF, 2012a).
  - Practical challenges: substantial enforcement costs, infrastructure requirements, poor design or leakages can exacerbate damage.
  - Longstanding capital account restrictions can complement FXI by limiting offsetting private flows and lowering the required size of FXI (Bayoumi and Saborowski, 2012).

### FXI to support price stability (Principle and explanations, paragraphs 70–72)
- Principle: FXI can support monetary policy when a large exchange rate depreciation risks de-anchoring inflation expectations, provided:
  - Costs of using monetary policy alone are high.
  - Reserves are sufficient for FXI to be effective.
  - Costs of including FXI are low.
  - There can also be a role for FXI to lean against sustained appreciation.
- Rationale:
  - Nominal frictions (backward-looking expectations, price/wage indexing) can produce strong second-round inflation effects from depreciations, threatening price stability.
  - Raising policy rates sharply to counter depreciation effects may cause economic slowdown and higher cost of stabilizing prices.
  - The IPF quantitative model (Adrian and others, 2021) shows FXI may improve policy trade-offs where nominal frictions are severe and depreciations are contractionary, by limiting depreciation and pass-through to inflation.
- Reasons for sparing use of FXI:
  - If inflation expectations are well anchored, exchange rate flexibility can support warranted macroeconomic adjustment via expenditure switching; FXI may delay adjustment and cast doubt on commitment to a flexible exchange rate.21
  - If depreciation leads to simultaneous increases in output and inflation, monetary tightening alone can achieve objectives.
  - If a positive output gap contributes to de-anchoring when the shock hits, tighter monetary policy is preferable.
- Credibility risks:
  - Use of FXI where it is ineffective can undermine central bank credibility, especially during transitions away from a peg or where the nominal anchor is uncertain.
  - Systematic FXI by an inflation-targeting central bank can confuse primary objectives and signal a shift from inflation targeting, destabilizing expectations.
  - To limit credibility harm, establish ex ante a clear monetary policy strategy specifying conditions for FXI use and communicate the rationale for chosen policy levers.22
- When de-anchored inflation expectations reflect deep credibility problems, priority is to establish or reestablish a credible monetary anchor rather than rely on FXI.

*IMF: IPF — PRINCIPLES FOR THE USE OF FX INTERVENTION (excerpts from paragraphs 54–72, Box 4, and related sections)*

### 73. FXI should be used to pursue price stability objectives only if the depreciation is large,

### 73. FXI should be used to pursue price stability objectives only if the depreciation is large,

### Rationale and key findings
- Only a large exchange rate depreciation is likely to set in motion amplification mechanisms that jeopardize the price stability objective, increasing the central bank's policy tradeoff.
- Empirical research finds that the pass-through to inflation of a change in the exchange rate is stronger for larger changes in the exchange rate.23
  - Non-linearities arise from variable or fixed transaction costs (such as shipping or menu costs), information acquisition costs, and nonlinearity in expectations formation.
  - Price adjustment may begin only once a particular exchange rate change threshold is reached; small shocks can be absorbed into profit margins or not considered in pricing decisions.
- Systematic use of FXI by inflation-targeting central banks—even for small exchange rate changes—may cause confusion about the primary objective of monetary policy and undermine the inflation target as the nominal anchor. Related costs are not incorporated in some models (Adrian and others, 2021; Basu and others, 2020, 2023).
- Large exchange rate depreciations are often a combination of fundamental and financial shocks:
  - Risk appetite shocks account for much exchange rate variation in estimated standard open economy DSGE models (Justiniano and Preston, 2010).
  - Large movements can reflect an overlay of “risk-off” shocks on fundamentals via changes in risk sentiment and premia (Calvo and Mendoza, 2000; Hofmann and others, 2022).
- Exchange rate depreciations can induce divergent movements in inflation and output, particularly in emerging market and developing economies (EMDEs):
  - Empirical evidence suggests depreciations could be associated with a slowdown in economic activity in EMDEs, but not in advanced economies (AEs) (Brandao and others, 2023).
  - Limited expenditure-switching channel, shallow markets, and FX mismatches can amplify financial-channel effects in EMDEs.

### When FXI is more likely to be appropriate (use-case conditions)
- The case for FXI to maintain price stability is stronger when exchange rate movements induce inflation and output to move in opposite directions, creating a trade-off for monetary policy.
- FXI may be considered where inflation expectations risk de-anchoring and the central bank cannot “look through” a large exchange rate change.
- FXI can be part of a “second-best” policy response in a narrow set of circumstances if the following are met:
  - First, judgment that both first- and second-round effects of the depreciation would be large in the absence of any policy response, arguing for slowing the pace of exchange rate change—by hiking monetary policy, or combining this with FXI.
  - Second, a strong monetary policy response faces trade-offs (sharp output contraction, adverse financial stability effects) or policy hikes lack effective transmission to inflation.
  - Third, distortions from boosting domestic consumption via FXI-induced income effects must be quantitatively small enough that the overall impact of FXI is beneficial.
  - Fourth, use of FXI should not deplete reserves below adequate levels; for persistent real shocks there should be a planned transition from FXI to other macro adjustments.
  - Fifth, FXI is judged to have traction because FX markets are shallow and/or because FXI is part of an integrated response where the policy plan includes tighter monetary policy responses in future.

### Costs, drawbacks, and asymmetries
- Exchange rate adjustment can help stabilize domestic aggregate demand and demand-driven price pressures after fundamental shocks; FXI that resists equilibrium adjustment can:
  - Reduce these stabilizing mechanisms, distort intertemporal choices, increase consumption of imported goods, and raise borrowing from abroad.
  - Be ineffective and risk reserve depletion.
- Depreciations can have larger and longer macroeconomic consequences than appreciations:
  - Large depreciations could have persistent effects on medium- and long-term inflation expectations and larger second-round effects on inflation outcomes than do large appreciations, which are often capped by downward rigidities.
- FXI could be recommended when sustained appreciations yield persistently low inflation and an accommodative monetary response risks overheating the economy; however, costs of reserve accumulation and multilateral implications must be considered.

### Role of monetary policy and policy mix
- Monetary policy should be the primary lever to address shocks; FXI used in support only when trade-offs are severe.
  - FXI could be used in addition to monetary policy only if (a) the cost of using monetary policy alone is high, and (b) the cost of including FXI is assessed as low (see ¶90 and ¶91 in the source).
  - When inflation and inflation expectations are well-anchored, no policy response is needed; monetary policy should “see through” exchange rate swings.
  - Any use of FXI must consider higher-level frictions and other use cases (A or B in the source).

### Indicators and analytical guidance for assessment
- Ex ante and empirical assessments required:
  - Estimate pass-through of exchange rate to inflation over different horizons, exploring non-linearities by shock size, interactions with the state of the economy, and asymmetries by sign.
  - Proxy first-round effects with measures such as the share of imported goods in final consumption; consider price indexation to foreign currencies.
  - Persistence of shocks via potential second-round effects (e.g., wage-inflation spirals) is necessary to justify FXI.
- In absence of direct inflation expectations data, staff should:
  - Assess persistence of pass-through on headline or core inflation as a proxy for anchoring.
  - Use survey information (Survey of Business Opinions, Purchasing Managers Index) and soft information from private/financial sector contacts.
  - Encourage central bank–run surveys of professional observers (small sample of external economists, banks, university macroeconomists, regional economists).
- Contemporaneous assessment when a shock materializes:
  - Judge whether the shock is large enough (belongs to the tails of the relevant distribution over a period long enough to affect inflation expectations).
  - Movements reversing over short periods (e.g., intraday) are unlikely to justify FXI.
  - Monitor high-frequency price data and inflation expectations to assess pass-through and anchoring.
  - Use a broad approach across measures of medium- to long-term inflation expectations, including survey distribution moments (see Box 5).

### Assessing macroeconomic co-movement and policy appropriateness
- Determine whether the exchange rate shock causes a contractionary depreciation or expansionary appreciation:
  - Contractionary depreciation: assess real-time output gap and economic slack; require negative co-movement of inflation and economic activity strong enough to threaten central bank objectives with monetary policy alone.
  - Expansionary appreciation: readings of inflation below target should be accompanied by indications of overheating (large and widening output gap) and supporting indicators (EBA overvaluation measures, allocative distortions, excess borrowing, credit-to-GDP gaps).
- If de-anchoring of inflation expectations is evident due to sharp exchange rate movement:
  - Judge whether monetary and fiscal policies are at appropriate settings as part of Article IV surveillance.
  - If monetary policy is inappropriate, adjust the policy rate rather than using FXI.
  - If fiscal policy conflicts with monetary stance, advise correcting fiscal policy to avoid institutional tensions and fiscal dominance.

### Box 5 — Indicators for Use Case C: Supporting Price Stability
- Ex ante assessments (regularly assess risks to pass-through of exchange rate to inflation):
  - Explore non-linearities in shock size, asymmetries by sign, interactions with pre-shock levels of inflation and uncertainty.
  - Share of imported goods (and commodities such as oil) in total final consumption.
  - Degree of price indexation, such as rents and traded durable goods.
  - Labor market characteristics, e.g., share of inflation-indexed or negotiated wages (risk of wage-inflation spiral).
- Indicators/structural characteristics to assess trade vs financial channels:
  - Currency of invoicing and elasticity of exports and imports to exchange rate changes.
  - Imported component in production of consumption goods (share of intermediate and capital goods imports in total imports).
  - FX mismatches in private and public balance sheets.
  - Large share of foreign investors in domestic debt markets.
- Contemporaneous assessment — key metrics to infer degree of anchoring of inflation expectations (following IMF (2018)):
  1. Absolute deviations in inflation expectations from the central bank target
  2. Variability of inflation expectations over time
  3. Dispersion of inflation expectations across individual forecasters or stakeholders
  4. Sensitivity of inflation expectations to surprises about current inflation
- To assess whether there is a stronger case for FXI, staff should determine whether the exchange rate shock is causing:
  - Contractionary depreciation: use high-frequency price data and inflation expectations; correlation of real-time output gap/economic slack with current or expected inflation.
  - Expansionary appreciation: use overvaluation measures from EBA and indicators of allocative distortions; monitor excess borrowing from local agents and credit-to-GDP gaps.
- Note: While each measure has advantages and shortcomings (including data coverage), combining the four anchoring measures conveys a consistent picture for each country. Bems and others (2021) construct a country-specific index of the above metrics.

*IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — INTERNATIONAL MONETARY FUND*

### 88. Pre-shock policy advice should focus on lowering the sensitivity of inflation and

### 88. Pre-shock policy advice should focus on lowering the sensitivity of inflation and inflation expectations to movements in the exchange rate

### Pre-shock policy advice: objectives and instruments
- Main objective: lower the sensitivity of inflation and inflation expectations to exchange rate movements.
- Building central bank credibility is key to improving policy trade-offs.
- Strengthening the credibility of the monetary policy framework may firm inflation expectations and can help reduce pass-through of exchange rate changes (see Kabundi and Mlachila, 2019, and Carriere-Swallow and others, 2021).25
- Policy measures to consider:
  - Ensure a high degree of central bank independence and a credible monetary policy framework.
  - Adopt a coherent operational strategy and clear communication to limit exchange rate–emanating vulnerabilities (for example, lowering dollarization or indexation in the economy).
  - Structural reforms to improve monetary policy transmission: develop and deepen LC markets; reduce the share of wages subject to indexation.
  - Design fiscal policy frameworks and settings to minimize institutional conflicts between fiscal and monetary authorities.

### Ex post policies: role of monetary policy and conditional use of FX intervention (FXI)
- Monetary policy should play the primary role in responding to shocks ex post.
- FXI should support price stability only when monetary policy is the primary tool to lean against the shock.
- Guidance on sequencing:
  - If depreciation is caused by relatively loose domestic monetary policy ex ante, first adjust the monetary policy stance.
  - If an advanced country tightening moves interest rate differentials, adjust monetary policy first to stabilize inflation expectations; staff should judge whether FXI could support monetary policy when differentials induce a large depreciation that triggers second-round effects.26
- Use FXI in support of price stability only if:
  - The cost of responding to the shock with monetary policy alone is assessed as high.
  - Raising policy rates sufficiently to lean against large depreciation shocks could trigger sudden increases in debt servicing costs and default risk of LC borrowers, possibly leading to systemic financial stresses where variable interest rate or inflation-indexed debt contracts prevail and leverage is high (Akinci and others, 2020).27
  - Monetary policy may be constrained by an effective lower bound in responding to sustained appreciations that reduce inflation and inflation expectations.
  - Transmission of policy rate changes along the yield curve is structurally weak or temporarily clogged.
- FXI should be considered to reduce the burden on monetary policy only when the cost of using FXI is assessed to be low (see Figure 1 referenced in source).

### Conditions for FXI: cost assessment and alternatives
- FXI should be used in support of price stability only if the costs of including FXI in the policy response are assessed as low:
  - Costs of spending reserves can be high if likely traction of FXI is weak based on the level of reserves, FX market liquidity, and signaling effects.
  - Intertemporal trade-offs: holding reserves may be preferable if they could be needed for future FX liquidity operations.
  - Absence of a well-defined and clearly communicated FXI strategy can undermine central bank credibility and destabilize inflation expectations.
- When costs are assessed as high, rely on monetary policy alone.
- In appreciation episodes, inflow CFMs could be appropriate if reserves are already more than adequate and the exchange rate is overvalued and the economy is overheating; if difficult to implement, FXI may be preferred.
- Countercyclical fiscal policies can complement efforts to address overheating but may also exacerbate trade-offs (tight fiscal policy could add to appreciation pressures by lowering country risk premium).

### Institutional conditions, governance, and communication
- Principle: strong central bank governance and communications are necessary to ensure success of FXI under the IPF; weak elements warrant greater caution in advising FXI.
- Even if warranted by policy goals and macro conditions, FXI benefits likely outweigh costs only when:
  - Strong central bank governance and transparency ensure legal, decisional, and operational autonomy on intervention policies.
  - Central bank communication capacity and credibility are sufficient to manage the additional complexity introduced by FXI.
- Potential risks:
  - Use of FXI can invite intense lobbying from stakeholders because exchange rate fluctuations create clear near-term winners and losers (exporters vs. importers).
  - Joint use of multiple tools increases communication challenges and could weaken central bank credibility, especially for central banks with poor track records or low initial credibility.28
- IPF can help by clarifying policy frameworks and improving communication capacity; a well-communicated policy strategy improves FXI effectiveness.

### Governance and transparency improvements (dimensions)
- Suggested governance elements:
  - (i) a well-articulated policy strategy for FXI;
  - (ii) a preestablished decision-making process, including method to process information supporting FXI and scope for judgment;
  - (iii) an internal guideline on FXI implementation;
  - (iv) an ex post assessment of FXI.
- Transparency best practices (from the CB transparency code):29
  - (i) disclose overall policy strategy for FXI, avoiding vague language;
  - (ii) disclose FXI decision-making processes and supporting analysis;
  - (iii) transparency on instruments utilized and on selection of counterparties;
  - (iv) accountability for outcomes via publication of regular FXI assessment analyses.
- Communication content should cover three elements:
  - (i) the policy regime and objectives;
  - (ii) the policy strategy explaining how decisions relate to objectives and available data;
  - (iii) policy decisions with explanations for actions taken.
- Communication should be clear, transparent, regular, tiered to audiences, and information equally accessible; publishing information with a lag can be considered where market impact is a concern.

### Indicators and analysis for governance and communication assessment
- Assessment should be guided by staff judgment and existing metrics evaluating monetary policy frameworks (e.g., safeguards assessments, central bank transparency code reviews).
- The Unsal and others (2022) toolkit provides a comprehensive, granular assessment of monetary policy frameworks and can be used flexibly.
- Where metrics are unavailable, capacity development can close data gaps to enable adequate assessment.
- Relevance of preconditions varies by IPF use case:
  - Use case A: governance must be strong to resist stakeholder pressure to maintain a specific exchange rate.
  - Use case B: central bank must exercise restraint to avoid moral hazard incentivizing excessive borrowing.
  - Use case C: effective communication strategy is paramount for explaining FXI use within an inflation-targeting framework.

### Accumulating and spending reserves: intertemporal trade-offs and functions
- Principle: advice should evaluate intertemporal trade-offs in spending and accumulating FX reserves.
- Intertemporal trade-offs arise from:
  - First, sufficient reserves are necessary for FX sales to be effective; an expectation that reserves will run out can lead to speculative attacks.
  - Second, countries vulnerable under use cases A, B, and C should accumulate FX reserves in normal times while weighing costs of carrying reserves.
  - Third, spending reserves today reduces ability to respond to future shocks because replenishing reserves takes time.
- Roles of sufficient reserves:
  - Credibility: reserve accumulation can signal resilience and provide ammunition for FX sales, reducing probability of successful speculative attacks (literature on global games following Morris and Shin, 1998).
  - Effectiveness: higher reserves may increase FXI effectiveness by allowing objectives to be reached with smaller intervention amounts (see Basu and others, 2018).
  - Resilience building: broad consensus that FX reserves provide buffers for EMDEs, reducing vulnerabilities and increasing policy space (see Frankel and Saravelos, 2012; Eichengreen, Rose, and Wyplosz 1996; Frankel and Rose 1996).
- Costs of accumulating sizeable reserves:
  - Opportunity costs: resources held as reserves could instead be used to pay down costly external debt.
  - Sterilization costs: interest cost on LC liabilities may far exceed return on FX reserve assets.
  - Valuation risk: large FX purchase–induced reserve accumulation exposes central bank to valuation losses in the event of large LC appreciation.

*Source: IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION (excerpts from content unit ppea2023061)*

### 106. These benefits and costs suggest the existence of an optimal level of reserves for

### ppea2023061 - 106. These benefits and costs suggest the existence of an optimal level of reserves for

### Optimal level of reserves for FXI under the IPF
- Benefits and costs of FX intervention (FXI) imply an optimal level of reserves exists and must be assessed case-by-case, depending on country characteristics and intention to use FXI as part of the IPF toolkit.
- Assessment involves trade-offs between benefits of accumulating/holding higher reserves and associated costs (e.g., interest rate differential on FX and LC assets, valuation risks).
- Where the capital account is fully open and FX market frictions are few, large amounts of reserves may be required to affect the exchange rate, reducing the attractiveness of FXI as a policy tool.

### Fund policy and reserve adequacy
- Current Fund policy uses the ARA metric for precautionary reserve assessment and applies a range of 100–150 percent (though for most LICs ARA is still based on months of imports).
- Scenario analysis and additional considerations may complement the ARA metric where specific risks and vulnerabilities warrant higher precautionary reserve holdings.

### Elements to consider when determining FX reserves for IPF use
- Recommendation beyond 150 percent of the ARA metric should be justified on precautionary grounds and build on indicators and metrics relevant to each use case.
- Use case A (shallow FX markets):
  - Reserves should be sufficient to allow FXI to ensure market functioning during large inflows and outflows.
  - Indicators: size of overall FX market, size of markets not functioning efficiently, required intervention to affect premia/exchange rate levels, structural liquidity measures (Vayanos and Wang, 2012), etc.
- Use case B (FX mismatches):
  - Indicators: level and distribution of FX mismatches, nature of cross-border debt contracts, stress tests, structural measures of illiquidity (for effectiveness of FXI).
  - Higher reserves than 150 of ARA metric could be justified on precautionary grounds given the direct link to financial and macroeconomic stability.
- Use case C (price stability):
  - Indicators: estimates of exchange rate pass-through, volatility of inflation expectations, structural measures of illiquidity (to gauge how much intervention may be needed).
  - In certain cases, higher reserves for use case C can be justified on precautionary grounds because large ER movements could jeopardize macroeconomic stability when they de-anchor inflation expectations.

### Building and replenishing reserves: operational principles
- Accumulation of reserves outside the discussed use cases should generally proceed in a manner that avoids impacts on the exchange rate.
- Strengthen communications with market participants, minimize market disruptions, and increase confidence.
- Example operational practice: pre-announce purchases with predefined auction calendars and apply a fixed volume/variable price format.
- Opportunistic purchases to take advantage of capital inflows can entail costs and may harm credibility.

### Intertemporal trade-offs in spending reserves
- Available reserves are bounded; spending reserves now reduces capacity to respond to future shocks.
- Countries that find accumulating reserves difficult face greater intertemporal trade-offs.
- Central banks often find it difficult to replenish reserves quickly without affecting the exchange rate, especially where FX inflows from exports and access to international capital markets are limited.
- Additional scrutiny is warranted before FX sales:
  - Spending reserves may leave the central bank below its reserve target and less able to respond efficiently to subsequent shocks.
  - Central banks may wish to retain reserves for dedicated purposes (e.g., FX liquidity support—market-wide FX swaps or ELA in FX).
- Effectiveness considerations:
  - FXI yields less “bang for the buck” in highly liquid FX markets, requiring larger reserve outlays.
  - Presence of arbitrage frictions that strengthen the portfolio balance channel increases traction for FXI, reducing required reserve spending.

### Credibility, communication, and limits of FXI when reserves are low
- Credible, clearly communicated FXI objectives can reduce the amount of reserves needed for intervention by influencing market expectations.
- High reserves coupled with clear communication can lower the sufficient level of reserves required for credible interventions.
- Low reserves impair central bank credibility to commit to FXI and can trigger mechanisms that further reduce FXI effectiveness and may induce speculative attacks.
- Under low-reserve conditions, recommending FXI is not advisable; countries should rely more on other IPF tools (e.g., macroprudential, monetary, fiscal policy).

### Multilateral considerations
- Fund advice on FXI under the IPF must consider multilateral effects and “beggar-thy-neighbor” policies that can create negative externalities and currency wars.
- Fund policy practice: External Sector Assessments in Article IV or other staff reports judge the strength of a country’s external position and whether it reflects domestic policies.
- Fund generally recommends FX reserve purchases for precautionary reasons, interpreted for EMs as reserves within the relevant ARA metric unless systemic vulnerabilities warrant higher coverage.
- Fund advice may caution against further reserve accumulation if all three conditions hold:
  - (a) The member’s external position is stronger than the level implied by medium-term fundamentals and desirable policies.
  - (b) Such effects are caused by the member’s policies.
  - (c) The country is already beyond the ARA metric.
- When these conditions are met, country teams jointly with MCM, RES, and SPR must judge whether the specific use of FXI outweighs multilateral considerations and whether authorities will take policy measures to reduce domestic policy gaps.

### Multilateral surveillance and systemic implications
- The Fund’s multilateral surveillance examines spillovers from members’ policies that significantly influence the international monetary system, per the Integrated Surveillance Decision (ISD).
- Simultaneous similar responses by a group of countries (e.g., coordinated reserve sales) could raise yields on reserve assets and exacerbate outflows for EMDEs as a whole.
- In such circumstances, the Fund may advise countries on achieving policy objectives with smaller multilateral spillovers.

### Annex I — Effectiveness of FX interventions: key empirical and theoretical points
- Theoretical channels for sterilized FXI effectiveness: portfolio balance channel and signaling channel, relying on financial and information frictions.
- Portfolio balance channel: FXI alters asset compositions when perfect substitutability is relaxed; limits to arbitrage strengthen this channel.
- Signaling channel: FXI can signal future monetary policy stance and thus affect forward-looking exchange rates if FXI conveys new information.
- Recent theoretical work (e.g., Cavallino, Chang) supports FXI effectiveness under financial frictions or occasionally binding borrowing constraints.
- Empirical literature evolution:
  - Early studies were inconclusive; more recent cross-country, higher-frequency studies for EMDEs find FXI can affect the exchange rate at least in the short term and can help manage volatile capital flows and reduce financial market stress.
  - FXI is more effective when the capital account is less open, interventions align with the monetary policy stance, interventions move the exchange rate closer to fundamentals, and interventions are transparent and well communicated.
  - Evidence also indicates potential downsides: FXI can encourage the buildup of unhedged FX liabilities and increases in FX reserves can increase corporate leverage.
  - Limited evidence exists that FXI use reduces central bank credibility and thereby affects pass-through from exchange rates to domestic prices.

*International Monetary Fund — IPF: Principles for the Use of FX Intervention (excerpt)*

### 7. Finally, recent empirical findings have also shed light on some of the modalities under

### ppea2023061 - 7. Finally, recent empirical findings have also shed light on some of the modalities under

### Evidence on modalities that increase FXI effectiveness
- Chamon and others (2019) — cross-country study on Latin America:
  - Two key characteristics increase FXI effectiveness in this region: the importance of transparency and strong communication policies, and the benefits of rules-based intervention.
  - Both elements helped central banks strengthen the effectiveness of interventions and preserve the credibility of their monetary policy regimes.
- Fratzscher and others (2019) — comprehensive cross-country dataset on FXI:
  - Appropriate communication by the authorities can enhance effectiveness.
  - FXI is more effective if it is accompanied by oral intervention, even more so during turbulent times.
  - Interventions tend to be more effective if they are large in size, are executed in line with the prior exchange rate trend, and go toward the longer run fundamental equilibrium.
- Arenas and Griffith-Jones (2023) — daily and intra-day data on recent FXI in Chile in 2019 and 2022:
  - These actions had significant effects.
  - Announcements had greater effects compared to the interventions themselves.
- IMF (2020b):
  - FXI is most effective when it is consistent with fundamentals and the monetary policy stance.
- Gelos and others (2022):
  - FX sales are effective in reducing downside risks to portfolio flows and can improve the outlook for median flows as well.
  - Evidence consistent with earlier finding that FXI can have a stabilizing effect on capital flows (Ehlers and Takáts (2013)).
- Magud and Pienknagura (2023):
  - In response to VIX shocks, FXI has a greater impact in shallower FX markets.

### Consolidated empirical findings (enumerated)
- Transparency and strong communication policies enhance FXI effectiveness and help preserve monetary-policy credibility.
- Rules-based interventions increase effectiveness.
- Oral intervention/communication can amplify the impact of FXI, particularly in turbulent periods.
- Announcements can have greater immediate effects than actual intervention operations (evidence from Chile 2019 and 2022).
- Larger interventions, aligned with prior exchange-rate trends and directed toward longer-run fundamental equilibrium, are associated with greater effectiveness.
- FX sales tend to be more effective than FX purchases, notably in countries with less open capital accounts and shallower FX markets.
- FX sales can reduce downside risks to portfolio flows and improve median flow outlooks.
- FXI effectiveness is higher when consistent with fundamentals and the monetary policy stance.
- FXI has a stronger impact in shallower FX markets following global risk shocks (e.g., VIX shocks).

### Policy implications and recommendations
- Prioritize transparency and clear communication strategies when conducting FX intervention to strengthen intervention effectiveness and preserve policy credibility.
- Consider adopting rules-based intervention frameworks to increase predictability and effectiveness of FXI.
- Use oral intervention and public announcements as complementary tools to market operations, especially during turbulent periods—announcements may deliver substantial market effects.
- Align the timing, size, and direction of interventions with existing exchange-rate trends and with assessments of longer-run fundamentals.
- Recognize the asymmetric effectiveness of FX sales versus purchases:
  - In economies with less open capital accounts and shallower FX markets, FX sales may be particularly effective for stabilizing portfolio flows.
- Ensure FXI is consistent with the monetary policy stance and fundamental macroeconomic conditions to maximize effectiveness.
- Pay attention to market depth: interventions may have larger effects in shallower FX markets, particularly during global risk-off episodes.

*IPF: PRINCIPLES FOR THE USE OF FX INTERVENTION — excerpt and referenced empirical findings*

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_Source: https://www.imf.org/-/media/files/publications/pp/2023/english/ppea2023061.pdf_