## 1. Inflation Performance Against Intervention Strength

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### I. Introduction — context and purpose
- Over the past twenty years, many central banks in emerging market economies (EMEs) moved away from fixed exchange rate regimes and introduced Inflation Targeting (IT) frameworks with largely floating exchange rates.
- Despite de jure floating regimes, foreign exchange intervention (FXI) has remained widely used among inflation-targeting EME central banks.
- Paper objective: provide a policy-oriented analytical overview of theory and empirical evidence to determine under what circumstances it may make sense for inflation-targeting central banks to undertake (sterilized) FXI, and to distill tentative policy directions.
- Working assumptions and scope:
  - Focus on sterilized FXI in IT frameworks aimed at smoothing short- or medium-term exchange rate volatility rather than targeting a specific exchange rate level.
  - Perspective taken is that of the intervening country; spillovers to other countries are not considered.
  - The paper presupposes that FXI is, at least at the margin, effective in influencing exchange rates.
- Motivations for currency intervention in EMEs include weaker financial markets, greater exposure to external shocks, financial transmission channels dominating competitiveness channels, and the desire to limit excessive exchange rate volatility.

### II. FXI to help promote output/price stability

A. Control Inflation — findings, evidence, and considerations
- Findings and evidence:
  - Pass-through effects from exchange rate movements significantly affect inflation level and volatility in EMEs (Stone 2009; Brandao-Marques et al. 2020).
  - Studies suggest some degree of exchange rate management with FXI may improve inflation outcomes in EMEs (Berganza and Broto 2012; Buffie et al. 2018).
  - FXI can reduce incentives for the central bank to switch away from IT to discretionary policies in the face of large capital inflows (Ostry, Ghosh and Chamon 2012).
  - FXI has been recommended as an additional instrument when conventional monetary policy is ineffective (e.g., at the effective-lower bound) and was applied in the Czech Republic and Switzerland with some success (Badescu 2016; Lizal and Schwarz 2013; Caselli 2017).
- Key considerations:
  - If inflation and exchange rate objectives are mutually consistent, the policy rate should suffice; however, where transmission is weak, FXI may be a temporary additional instrument if it more effectively affects the exchange rate.
  - FXI may be easier to fine-tune for short-term developments; complementary policies are needed to improve transmission over time.
- Case: Colombia (Banco de la República, BR) — episode details and outcomes:
  - April 2002–April 2003: the real effective exchange rate had depreciated by about 20 percent (y/y), and inflation rose to 8 percent, well above target.
  - BR tightened monetary policy, raising its main refinancing rate by cumulatively 200 basis points to 7.25 percent; commercial deposit and lending rates were slow to respond.
  - BR complemented interest rate hikes with FX sales (via options) to stem depreciation.
  - May 2016 episode:
    - BR offered $500 million (50 percent of the daily trading volume) in options; $256 million was exercised.
    - Call options gave private agents the right to buy foreign exchange if the daily exchange rate depreciated more than its 20-day moving average (plus 3 percent for the May 2016 options).
  - Observed outcome: in both episodes the inflation trend reversed after the interventions, though causality is difficult to claim given concurrent factors and lagged monetary policy effects.

B. Prevent Dutch Disease and Promote Competitiveness — findings and cautions
- Findings and evidence:
  - FXI is often used to counter sustained appreciation pressures to protect competitiveness and address Dutch disease concerns.
  - Models supporting intervention include scenarios where exporting firms are financially constrained (Caballero and Lorenzoni 2014) or where learning by doing matters (Faltermeier et al. 2017).
  - Political economy considerations: FXI can be preferable to distortionary alternatives such as protectionism or targeted subsidies.
- Risks and cautions:
  - Hard to discern in real time whether intervention resists overshooting or an equilibrium adjustment (Chamon et al. 2019).
  - Intervention against persistent inflows may encourage more inflows as investors expect continued exchange rate support.
  - Little empirical evidence that FXI can affect the exchange rate over extended periods; alternative instruments (monetary-fiscal mix, structural reforms) may be preferable for persistent shocks.
- Case: Israel (Bank of Israel, BOI) — intervention chronology and rationale:
  - BOI historically used interest rates as main instrument and intervened to keep the exchange rate within a band; the band was abolished in 2005.
  - Post-global financial crisis and discovery of large gas fields, BOI resumed FX purchases in 2008 to build reserves and address rapid appreciation.
  - FX purchases started at a fixed daily amount of $25 million and were increased to a daily amount of $100 million.
  - In August 2009 fixed daily purchases were discontinued; purchases were ad hoc thereafter.
  - BOI argues interventions moderated over-appreciation of the shekel and helped mitigate negative effects on exports and growth.
  - By end 2018, Israel stopped FX purchases for the purpose of offsetting natural gas effects on the exchange rate as it established a sovereign wealth fund expected to become operational soon.

### III. FXI to ensure financial stability

A. Build Reserves — rationale and caveats
- Findings and considerations:
  - Official reserves provide precautionary buffers in times of liquidity pressures; building reserves requires FX purchases.
  - Reserve-building FXI should minimize impact on exchange rate level by spreading purchases, preannounced schedules, or transparent rules (e.g., using options as in Mexico and Colombia).
  - The case for FXI for reserve building weakens once reserves reach an adequate level.

B. Manage Balance Sheet Mismatches — evidence, mechanisms, and trade-offs
- Findings and evidence:
  - Foreign currency exposure of unhedged balance sheets (liability dollarization) makes sharp exchange rate movements highly disruptive and can precipitate bankruptcies and recessions.
  - Balance sheet effects have been crucial in many emerging market crises.
  - Literature supporting FXI in presence of mismatches:
    - Benes et al. (2013): FXI can help insulate the economy from shocks, especially shocks to international financial conditions.
    - Ostry, Ghosh, and Chamon (2012): a regime of (two-way) sterilized intervention-cum-inflation targeting can improve outcomes and safeguard financial stability in the presence of balance sheet mismatches.
- Drawbacks and risks:
  - FXI may prevent necessary exchange rate adjustment to a new equilibrium (Benes et al. 2013).
  - FXI-induced exchange rate stability may encourage more unhedged foreign currency exposures over time.
  - Increased exchange rate flexibility is associated with a reduction in vulnerabilities such as currency mismatches (Mohanty 2013).
  - Less flexible intermediate regimes exhibit greater macroeconomic and financial vulnerabilities; floating regimes are associated with lower risk of financial crises and smoother external adjustment than pegged or intermediate regimes (Ghosh, Ostry, and Tsangarides 2010; Ghosh, Ostry and Qureshi 2014).
- Country illustrations: Chile and Peru cited as examples demonstrating mechanisms where FXI interacts with balance sheet vulnerabilities.

Box 3 — Chile: reducing currency mismatches (firm-level and policy evidence)
- Historical and institutional points:
  - Chile historically not highly dollarized because many loans and deposits were indexed to inflation (Jadresic 2005).
  - Herrera and Valdes (2004) argue Chile’s tightly managed exchange rate in the 1990s:
    - helped hide currency risk,
    - created incentives for currency mismatches and dollarization,
    - slowed development of hedging markets.
  - After adoption of a full-fledged flexible IT regime in the late 1990s and abandonment of a target zone, the Central Bank of Chile has been committed to preserving exchange rate flexibility (Claro and Soto 2013).
- Firm-level evidence:
  - Cowan et al. (2006) find significant changes in corporate currency exposure after the 1999 floating regime, showing previous exchange-rate insurance led to higher FX exposure of corporates.
- BIS deputy governors consensus (2013):
  - Exchange rate flexibility helps reduce currency mismatches and tends to lower foreign currency borrowing.
  - FXI-induced lower FX volatility would encourage investors to exploit interest differentials more aggressively through carry trades.

Box 5 — Indonesia: smoothing the credit cycle and promoting financial stability
- Case summary: Indonesia 2009–2011
  - Post-global financial crisis growth attracted foreign short-term investors; gross international reserves grew rapidly from 2009 to 2011 due to frequent central bank intervention.
  - August 2011: amid a worsening global environment (US sovereign downgrade and deepening crisis in Greece), Indonesia experienced sharp capital outflows coinciding with domestic policy developments:
    - Bank Indonesia (BI) lowered its policy rate and allowed market interest rates to fall.
    - BI stepped up government purchases of government debt.
  - From September 2011, BI combined FX sales with purchases of government securities in the secondary market (“dual intervention”) to:
    - stabilize the exchange rate;
    - counter sales of government securities by foreign investors;
    - recycle liquidity into the domestic market;
    - support financial stability.
  - Outcomes and trade-offs:
    - The 2011 intervention contributed to stabilizing foreign exchange and government securities markets.
    - Earlier heavy FX intervention without government bond purchases caused domestic liquidity shortages and pressures on domestic financial conditions (Warjiyo 2013).
    - Interventions, by producing a more stable rupiah and suppressing appreciation potential, may have attracted more short-term foreign investors into government securities and SBIs.
    - Excess liquidity built up in the money market partly due to BI’s sharp increase in government securities purchases.
    - Surplus liquidity and strong credit growth contributed to price and exchange market pressures and asset quality deterioration (IMF 2012).
  - Episode illustrates difficulty of fine-tuning policy and assessing ex-ante demand for liquidity or deviations of the exchange rate from equilibrium.
- General considerations:
  - FXI can strengthen central bank ability to manage domestic credit amid large and volatile capital flows, help achieve inflation objectives, and contain build-up of financial stability risks.
  - Trade-offs include communication challenges and potential loss of clarity of the monetary policy framework with adverse credibility effects.
  - Macroprudential measures could provide a preferable alternative to FXI.

D. Ensure liquidity (in shallow markets)
- Rationale:
  - Providing liquidity to shallow and underdeveloped FX markets is a common motivation for central banks in LICs and EMEs (BIS, 2005).
  - Shallow markets can amplify exchange rate shocks and cause undue short-term volatility and disorderly market conditions (Stone et al. 2009).
  - Even in more developed markets, central banks intervene to provide FX liquidity when faced with large liquidity shocks (example: Brazil during the global financial crisis and the taper tantrum) (Barroso 2019).
  - Central banks may intervene to keep short-term costs of liquidity insurance in check, preserve market functioning, and help investors close positions in an EME currency in a timely and cost-effective manner (Domanski et al. 2016).
- Costs and drawbacks:
  - Extended interventions may dull incentives for market development and private sector currency risk management (Mohanty 2013; Gadanecz and Mehrotra 2013).
  - Intervention can be costly through reserve losses for the central bank.
  - Poorly understood interventions can send mixed signals about central bank objectives, undermining credibility.
- Key consideration summary:
  - FXI may be needed in underdeveloped and structurally illiquid markets to ensure market functioning and avoid excessive exchange rate volatility.
  - Interventions should be transitional tools alongside initiatives to promote market deepening.
  - Interventions should be properly sterilized.

### IV. FXI and monetary policy credibility in emerging markets

Operational costs and credibility concerns
- Operational/traditional costs:
  - Sterilization costs of interventions and holding reserves.
  - Significant reserve depletion increases vulnerability to crises (Frenkel and Saravelos 2012; IMF 2015).
- Specific credibility concerns for IT central banks:
  - Using FXI as a second policy instrument may muddle clarity of the IT framework, especially if FXI pursues objectives beyond narrow price stability.
  - Possible negative mechanisms:
    - FXI may help a central bank manipulate the short-term inflation-output trade-off, with adverse long-term inflation consequences.
    - FXI may have a negative signaling effect if markets believe only non-credible central banks use FXI.
    - Adoption of FXI may invite political pressure to add further objectives (e.g., export promotion, shoring up unhedged SOEs).
    - For central banks with short IT experience, FXI may make it harder for foreign investors to learn the monetary policy rule.
- Heterogeneity matters:
  - Credibility costs of FXI depend on initial conditions: IT credibility and length of experience, financial market depth, foreign participation in FX markets, capital account openness, and political pressures.

Empirical findings on intervention and credibility (sample and results)
- Focus: relatively mature EMEs with broadly credible IT regimes.
- Empirical approach and data specifics:
  - Intervention strength measured by the standard deviation of changes in the reserves to GDP ratio, calculated from the FFA database.
  - Measure does not capture intervention with derivatives, and does not distinguish motives for intervention.
  - Inflation expectation: average one-year-ahead inflation forecast in the Consensus Forecasts database.
  - Inflation calculated from the WEO database.
  - Sample covers quarterly data over 2010–18.
  - Sample EMEs: Brazil, Chile, Colombia, Peru, Mexico, Indonesia, India, Korea, Philippines, Thailand, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, and Turkey.
  - Czech Republic excluded from graphs as a large outlier; including it does not change cross-sectional relation.
- Findings:
  - For the set of credible IT EMEs considered, there is no statistically significant relation between inflation outcomes and the strength of intervention; result generally robust for subsamples over different time periods.
  - Country-specific time series: no general de-anchoring of inflation expectations from the target after episodes of intervention; inflation expectations broadly stable in many countries.
  - Panel regressions exploiting cross-country and within-country variation in past intervention intensity (Ostry et al. 2019) confirm results: no evidence that intervention affects the dispersion of market forecasts in the short-term rate (a measure of uncertainty over upcoming monetary policy changes).
  - Implication: For this specific set of EMEs, FXI could deliver gains in policy flexibility without clear negative side-effects on IT credibility.

### V. Modalities of FXI

- Modalities vary and can affect perceptions of consistency with IT:
  - FXI can be open or secret, rules-based or discretionary, and take place in spot or derivative markets.
- Transparency and communication:
  - Transparency and communication strategies may manage potential tensions between FXI and IT (Chamon et al. 2019).
  - If intervention is not perceived to conflict with IT, modalities may matter less; where credibility is not well established, transparency can help reassure markets.
  - Transparency can be ex ante (disclosing criteria guiding interventions) and ex post (publishing intervention data).
- Secret interventions:
  - Do not optimally use signaling channels.
  - May prevent speculative behavior and allow more use of the order flow channel (Archer 2005).
- Rules-based interventions:
  - Pre-announced rules helpful when objective is reserve building or attenuating excessive volatility.
  - Examples: pre-announcing daily intervention amounts (Brazil, Mexico); rules with triggers and amounts (Colombia and Mexico).
  - In practice, rules often short-lived and require fine-tuning or abandonment as conditions change.
- Spot vs. derivatives:
  - Choice typically responds to where pressures arise (spot FX need vs. excess hedging demand).
  - Brazil’s experience: intervention in deeper forward market can obviate immediate reserve use.
- Summary:
  - Transparency can help communicate the role of FXI and its consistency with IT.
  - Highly credible central banks may intervene less transparently without harming credibility.
  - If tension between FXI and IT is a concern, a robust rules-based approach can help, provided rules are designed to accommodate diverse developments and market pressures.

### VI. Concluding remarks — policy-relevant takeaways
- Legitimate motivations for occasional FX intervention by inflation-targeting central banks in EMEs:
  - Large unhedged currency mismatches.
  - Underdeveloped markets where few alternative instruments are available short-term.
  - Low reserve levels (to buy foreign exchange).
  - Buffering capital in- or outflows and helping manage the credit cycle where interest-rate policy may be counterproductive.
- Interventions as transitional instruments:
  - Intervention to shield vulnerable balance sheets, provide liquidity to shallow markets, or build reserves should often be transitional; their value will diminish as adverse initial conditions are remedied.
  - An exit strategy and concurrent policies to promote de-dollarization and market development are important.
- Two main potential costs highlighted:
  1. FXI may entrench structural weaknesses by reducing market incentives for risk management and market liquidity provision, possibly encouraging foreign currency borrowing and weakening hedging market development.
  2. FXI may create confusion about central bank objectives and undermine IT credibility if used alongside the policy rate for goals beyond narrow inflation control.
- Empirical note:
  - Early evidence in this paper suggests that for relatively established IT EME central banks, intervention practices have little impact on the anchoring of inflation expectations around the target.
  - Thus, for credible EME central banks, tensions between FXI and IT may be manageable.

*Source: wpiea2020009-print-pdf — https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020009-print-pdf.pdf*

### 1. Inflation Performance Against Intervention Strength ..........................................................15

### 1. Inflation Performance Against Intervention Strength ..........................................................15

### I. Introduction — context and purpose
- Over the past twenty years, many central banks in emerging market economies (EMEs) have moved away from fixed exchange rate regimes and introduced Inflation Targeting (IT) frameworks with largely floating exchange rates.
- Despite de jure floating regimes, foreign exchange intervention (FXI) has remained widely used among inflation-targeting EME central banks.
- Paper objective: provide a policy-oriented analytical overview of theory and empirical evidence to determine under what circumstances it may make sense for inflation-targeting central banks to undertake (sterilized) FXI, and to distill tentative policy directions.
- Working assumptions and scope:
  - Focus on sterilized FXI in IT frameworks aimed at smoothing short- or medium-term exchange rate volatility rather than targeting a specific exchange rate level.
  - Perspective taken is that of the intervening country; spillovers to other countries are not considered.
  - The paper presupposes that FXI is, at least at the margin, effective in influencing exchange rates.
- Motivations for currency intervention in EMEs include weaker financial markets, greater exposure to external shocks, financial transmission channels dominating competitiveness channels, and the desire to limit excessive exchange rate volatility.

### II. FXI to help promote output/price stability
- General finding: In some EMEs, FX pass-through and weak policy-rate transmission (e.g., due to dollarization) mean leaving the exchange rate entirely free may not be optimal for achieving the inflation target. FXI can be used as a complementary instrument.

A. Control Inflation
- Findings and evidence:
  - Pass-through effects from exchange rate movements significantly affect inflation level and volatility in EMEs (Stone 2009, Brandao-Marques et al. 2020).
  - Studies suggest some degree of exchange rate management with FXI may improve inflation outcomes in EMEs (Berganza and Broto 2012, Buffie et al. 2018).
  - FXI can reduce incentives for the central bank to switch away from IT to discretionary policies in the face of large capital inflows (Ostry, Ghosh and Chamon 2012).
  - FXI has been recommended as an additional instrument when conventional monetary policy is ineffective (e.g., at the effective-lower bound) and was applied in the Czech Republic and Switzerland with some success (Badescu 2016, Lizal and Schwarz 2013, Caselli 2017).
- Key Considerations:
  - If inflation and exchange rate objectives are mutually consistent, the policy rate should suffice; however, where transmission is weak, FXI may be a temporary additional instrument if it more effectively affects the exchange rate.
  - FXI may be easier to fine-tune for short-term developments; complementary policies are needed to improve transmission over time.
- Case: Colombia (Box 1)
  - Banco de la Republica (BR) has been an inflation targeter since 1999 using interest rates to maintain low and stable inflation; BR has also intervened to build reserves, provide FX liquidity, and mitigate exchange rate fluctuations that could adversely impact inflation.
  - Episode details:
    - The Colombian peso depreciated significantly from April 2002. By April 2003, the real effective exchange rate had depreciated by about 20 percent (y/y), which due to high exchange rate pass through had increased inflation to 8 percent, well above target.
    - BR tightened monetary policy, raising its main refinancing rate by cumulatively 200 basis points to 7.25 percent; commercial deposit and lending rates were slow to respond.
    - To contain inflation, BR complemented interest rate hikes with FX sales (via options) to stem the depreciation.
  - May 2016 episode:
    - BR used FX sales (via options) after the peso depreciated in response to a sharp drop in the oil price.
    - Amount offered was $500 million (50 percent of the daily trading volume), of which $256 million was exercised.
    - Call options gave private agents the right to buy foreign exchange if the daily exchange rate depreciated more than its 20-day moving average (plus 3 percent for the May 2016 options).
  - Observed outcome: in both episodes the inflation trend reversed after the interventions, though causality is difficult to claim given concurrent factors and lagged monetary policy effects.

B. Prevent Dutch Disease and Promote Competitiveness
- Findings and evidence:
  - FXI is often used to counter sustained appreciation pressures to protect competitiveness and address Dutch disease concerns.
  - Models supporting intervention include scenarios where exporting firms are financially constrained (Caballero and Lorenzoni 2014) or where learning by doing matters (Faltermeier et al. 2017).
  - Political economy considerations: FXI can be preferable to distortionary alternatives such as protectionism or targeted subsidies.
  - Risks and cautions:
    - Hard to discern in real time whether intervention resists overshooting or an equilibrium adjustment (Chamon et al. 2019).
    - Intervention against persistent inflows may encourage more inflows as investors expect continued exchange rate support.
    - Little empirical evidence that FXI can affect the exchange rate over extended periods; alternative instruments (monetary-fiscal mix, structural reforms) may be preferable for persistent shocks.
- Case: Israel (Box 2)
  - Bank of Israel (BOI) used interest rates as main instrument and intervened historically to keep the exchange rate within a band; the band was abolished in 2005.
  - In response to large capital inflows after the global financial crisis and discovery of large gas fields, BOI resumed FX purchases in 2008 to build reserves and address rapid appreciation.
  - Intervention details:
    - FX purchases started at a fixed daily amount of $25 million and were increased to a daily amount of $100 million.
    - In August 2009 fixed daily purchases were discontinued; purchases were ad hoc thereafter.
  - BOI argues interventions moderated over-appreciation of the shekel and helped mitigate negative effects on exports and growth.
  - By end 2018, Israel stopped FX purchases for the purpose of offsetting natural gas effects on the exchange rate as it established a sovereign wealth fund expected to become operational soon.

### III. FXI to ensure financial stability
- FXI is also used to pursue financial stability objectives: build reserves, avoid negative balance sheet impacts from exchange rate moves, affect credit growth and risk taking, and provide FX liquidity.

A. Build Reserves
- Findings and considerations:
  - Official reserves provide precautionary buffers in times of liquidity pressures; building reserves requires FX purchases.
  - Reserve-building FXI should minimize impact on exchange rate level by spreading purchases, preannounced schedules, or transparent rules (e.g., using options as in Mexico and Colombia).
  - The case for FXI for reserve building weakens once reserves reach an adequate level.

B. Manage Balance Sheet Mismatches
- Findings and evidence:
  - Foreign currency exposure of unhedged balance sheets (liability dollarization) makes sharp exchange rate movements highly disruptive and can precipitate bankruptcies and recessions.
  - Balance sheet effects have been crucial in many emerging market crises.
  - Literature supports use of FXI to protect balance sheets in certain circumstances:
    - Benes et al. (2013): FXI can help insulate the economy from shocks, especially shocks to international financial conditions.
    - Ostry, Ghosh, and Chamon (2012): a regime of (two-way) sterilized intervention-cum-inflation targeting can improve outcomes and safeguard financial stability in the presence of balance sheet mismatches.
  - Drawbacks and risks:
    - FXI may prevent necessary exchange rate adjustment to a new equilibrium (Benes et al. 2013).
    - FXI-induced exchange rate stability may encourage more unhedged foreign currency exposures over time.
    - Evidence suggests increased exchange rate flexibility is associated with a reduction in vulnerabilities such as currency mismatches (Mohanty 2013).
    - Studies find macroeconomic and financial vulnerabilities are significantly greater under less flexible intermediate regimes; floating regimes are associated with lower risk of financial crises and smoother external adjustment than pegged or intermediate regimes (Ghosh, Ostry, and Tsangarides 2010; Ghosh, Ostry and Qureshi 2014).
  - Country experiences illustrating trade-offs: Chile (Box 3) and Peru (Box 4) are cited as examples demonstrating mechanisms where FXI interacts with balance sheet vulnerabilities.

*Source: https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020009-print-pdf.pdf*

### Box 3. Reducing Currency Mismatches: Chile

### Box 3. Reducing Currency Mismatches: Chile

### Historical context and institutional framework
- Chile has traditionally not been a highly dollarized economy overall, mostly because many loans and deposits were indexed to inflation (see, Jadresic 2005).
- Herrera and Valdes (2004) argue that Chile’s tightly managed exchange rate regime during the 1990s:
  - helped hide currency risk,
  - created incentives for currency mismatches and dollarization,
  - slowed the development of hedging markets.
- Since the adoption of a full-fledged flexible IT regime with a permanent inflation target in the late 1990s, and the abandonment of a target zone for the exchange rate, the Central Bank of Chile has been one of the most committed central banks in preserving/promoting exchange rate flexibility, allowing the currency to adjust freely to shocks (see, Claro and Soto 2013).

### Firm-level evidence on currency exposure
- Cowan et al. (2006) find significant changes in the level of currency exposure of Chilean corporates after the implementation of the floating exchange rate regime in 1999.
- Their firm-level analysis includes foreign currency debt, foreign currency assets, and foreign currency derivative positions, correcting for omitted variables present in many previous studies of balance sheet effects.
- They find that the previous policy of reducing exchange rate volatility by targeting a zone for the exchange rate (an implicit exchange-rate insurance) had led to higher FX exposure of the corporate sector.

### Central banking consensus at BIS (2013)
- At the 2013 BIS meeting referenced, EME central bank deputy governors generally agreed that:
  - exchange rate flexibility helps to reduce currency mismatches and tends to lower foreign currency borrowing,
  - FXI-induced lower FX volatility would encourage investors to exploit any existing interest rate differential more aggressively through carry trades.

*Source: Box 3. Reducing Currency Mismatches: Chile (wpiea2020009-print-pdf).*

### Box 5. Smoothing the Credit Cycle and Promoting Financial Stability: Indonesia

### Box 5. Smoothing the Credit Cycle and Promoting Financial Stability: Indonesia

### Case summary: Indonesia’s 2009–2011 episode
- The Indonesian economy grew robustly after the global financial crisis, attracting foreign short-term investors.
- Indonesia’s gross international reserves grew rapidly from 2009 to 2011 due to frequent central bank intervention.
- In August 2011, amid a worsening global environment (downgrade of the US sovereign rating and deepening crisis in Greece), Indonesia experienced sharp capital outflows that coincided with domestic policy developments:
  - Bank Indonesia (BI) lowered its policy rate and allowed market interest rates to fall.
  - BI stepped up government purchases of government debt.
- BI judged volatile capital flows to cause undue exchange rate volatility and intervened. From September 2011, BI supplemented FX sales with purchases of government securities in the secondary market (“dual intervention”).
- Motivations for the dual intervention:
  - Stabilize the exchange rate.
  - Counter sales of government securities by foreign investors.
  - Recycle liquidity into the domestic market.
  - Support financial stability.
- Outcomes and trade-offs observed:
  - The 2011 intervention contributed to stabilizing foreign exchange and government securities markets.
  - Contrast with the global financial crisis episode: heavy FX intervention without government bond purchases caused a shortage of domestic liquidity and pressures on domestic financial conditions (Warjiyo 2013).
  - The interventions, by producing a more stable rupiah and suppressing appreciation potential, may have attracted more short-term foreign investors into government securities and SBIs.
  - Excess liquidity built up in the money market partly due to BI’s sharp increase in government securities purchases.
  - The surplus liquidity and strong credit growth contributed to price and exchange market pressures and led to asset quality deterioration (IMF 2012).
- The episode illustrates the difficulty of fine-tuning policy and assessing ex-ante the demand for liquidity or deviations of the exchange rate from equilibrium.

### Key considerations (general)
- FXI (foreign exchange intervention) as an additional policy instrument can strengthen a central bank’s ability to manage domestic credit in the face of large and volatile capital flows, helping to:
  - Achieve inflation objectives.
  - Contain the build-up of financial stability risks.
- Trade-offs to weigh:
  - Communication challenges around interventions.
  - Loss of clarity of the monetary policy framework, with potentially adverse effects on credibility.
- Macroprudential measures could provide a preferable alternative to FXI.

### D. Ensure liquidity (in shallow markets)
- Rationale for intervention:
  - Providing liquidity to shallow and underdeveloped foreign exchange markets is a common motivation for central banks in LICs and EMEs (BIS, 2005).
  - Shallow markets can amplify exchange rate shocks and cause undue short-term exchange rate volatility and disorderly market conditions (Stone et al. 2009).
  - Even in more developed markets, central banks sometimes intervene to provide FX liquidity (and currency hedging instruments) when faced with large liquidity shocks (example: Brazil during the global financial crisis and the taper tantrum (Barroso 2019)).
  - Central banks may intervene to keep short-term costs of liquidity insurance in check, preserve market functioning, and help investors close positions in an EME currency in a timely and cost-effective manner (Domanski et al. 2016).
- Costs and drawbacks:
  - Extended interventions may dull incentives for market development and private sector currency risk management (Mohanty 2013, Gadanecz and Mehrotra 2013).
  - Intervention can be costly through reserve losses for the central bank.
  - Poorly understood interventions can send mixed signals about central bank objectives, undermining credibility.
- Key considerations summary:
  - FXI may be needed in underdeveloped and structurally illiquid markets to ensure market functioning and avoid excessive exchange rate volatility.
  - Interventions should be transitional tools alongside initiatives to promote market deepening.
  - Interventions should be properly sterilized.

### IV. FXI and monetary policy credibility in emerging markets
- Operational and traditional costs:
  - Sterilization costs of interventions and holding reserves.
  - Significant reserve depletion increases vulnerability to crises (Frenkel and Saravelos 2012; IMF 2015).
- Specific credibility concerns for inflation-targeting (IT) central banks:
  - Using FXI as a second policy instrument may muddle the clarity of the IT framework, especially if FXI pursues objectives beyond narrow price stability.
  - Possible negative mechanisms:
    - FXI may help a central bank manipulate the short-term inflation-output trade-off, with adverse long-term inflation consequences.
    - FXI may have a negative signaling effect if markets believe only non-credible central banks use FXI.
    - Adoption of FXI may invite political pressure to add further objectives (e.g., export promotion, shoring up unhedged SOEs).
    - For central banks with short IT experience, FXI may make it harder for foreign investors to learn the monetary policy rule.
- Heterogeneity matters:
  - The credibility costs of FXI depend on initial conditions: IT credibility and length of experience, financial market depth, foreign participation in FX markets, capital account openness, and political pressures.
- Empirical findings presented:
  - Focus on relatively mature EMEs with broadly credible IT regimes.
  - Figure 1 analysis: plots deviation of inflation expectations from the target and volatility of inflation against intervention strength.
  - Finding: For the set of credible IT EMEs considered, there is no statistically significant relation between inflation outcomes and the strength of intervention; result generally robust for subsamples over different time periods.
  - Country-specific time series: no general de-anchoring of inflation expectations from the target after episodes of intervention; inflation expectations broadly stable in many countries; interventions appear secondary and may reduce inflation volatility by stabilizing exchange rates.
  - Panel regressions exploiting cross-country and within-country variation in past intervention intensity (Ostry et al. 2019) confirm results:
    - No evidence that intervention affects the dispersion of market forecasts in the short-term rate (a measure of uncertainty over upcoming monetary policy changes).
  - Implication: For this specific set of EMEs, FXI could deliver gains in policy flexibility without clear negative side-effects on IT credibility.
- Data and sample specifics (as reported):
  - Intervention strength measured by the standard deviation of changes in the reserves to GDP ratio, calculated from the FFA database.
  - Measure does not capture intervention with derivatives, and does not distinguish motives for intervention.
  - Inflation expectation: average one-year-ahead inflation forecast in the Consensus Forecasts database.
  - Inflation calculated from the WEO database.
  - Sample covers quarterly data over 2010–18.
  - Sample EMEs: Brazil, Chile, Colombia, Peru, Mexico, Indonesia, India, Korea, Philippines, Thailand, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, and Turkey.
  - Czech Republic excluded from graphs as a large outlier; including it does not change cross-sectional relation.

### V. Modalities of FXI
- Modalities vary and can affect perceptions of consistency with IT:
  - FXI can be open or secret, rules-based or discretionary, and take place in spot or derivative markets.
- Transparency and communication:
  - Transparency and communication strategies may manage potential tensions between FXI and IT (Chamon et al. 2019).
  - If intervention is not perceived to conflict with IT, modalities may matter less; where credibility is not well established, transparency can help reassure markets.
  - Transparency can be ex ante (disclosing criteria guiding interventions) and ex post (publishing intervention data).
- Secret interventions:
  - Do not optimally use signaling channels.
  - May prevent speculative behavior and allow more use of the order flow channel (Archer 2005).
- Rules-based interventions:
  - Pre-announced rules helpful when objective is reserve building or attenuating excessive volatility.
  - Examples cited: pre-announcing daily intervention amounts (Brazil, Mexico); rules with triggers and amounts (Colombia and Mexico).
  - In practice, rules often short-lived and require fine-tuning or abandonment as conditions change.
- Spot vs. derivatives:
  - Choice is typically a response to where pressures arise (spot FX need vs. excess hedging demand).
  - Brazil’s experience: intervention in deeper forward market can obviate immediate reserve use.
- Summary:
  - Transparency can help communicate the role of FXI and its consistency with IT.
  - Highly credible central banks may intervene less transparently without harming credibility.
  - If tension between FXI and IT is a concern, a robust rules-based approach can help, provided rules are designed to accommodate diverse developments and market pressures.

### VI. Concluding remarks
- Legitimate motivations for occasional FX intervention by inflation-targeting central banks in EMEs:
  - Large unhedged currency mismatches.
  - Underdeveloped markets where few alternative instruments are available short-term.
  - Low reserve levels (to buy foreign exchange).
  - Buffering capital in- or outflows and helping manage the credit cycle where interest-rate policy may be counterproductive.
- Interventions as transitional instruments:
  - Intervention to shield vulnerable balance sheets, provide liquidity to shallow markets, or build reserves should often be transitional; their value will diminish as adverse initial conditions are remedied.
  - An exit strategy and concurrent policies to promote de-dollarization and market development are important.
- Two main potential costs highlighted:
  1. FXI may entrench structural weaknesses by reducing market incentives for risk management and market liquidity provision, possibly encouraging foreign currency borrowing and weakening hedging market development.
  2. FXI may create confusion about central bank objectives and undermine IT credibility if used alongside the policy rate for goals beyond narrow inflation control.
- Empirical note:
  - Early evidence in this paper suggests that for relatively established IT EME central banks, intervention practices have little impact on the anchoring of inflation expectations around the target.
  - Thus, for credible EME central banks, tensions between FXI and IT may be manageable.

*Source: Box 5. Smoothing the Credit Cycle and Promoting Financial Stability: Indonesia, wpiea2020009-print-pdf*

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*Source: wpiea2020009-print-pdf - References*

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_Source: https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020009-print-pdf.pdf_