Abundant global liquidity and high exposure to capital movements have put foreign exchange intervention at center stage of the policy debate in Latin America. Although intervention is widely used, there is limited evidence about its effects on the exchange rate, and particularly in terms of slowing the pace of currency appreciation.
In the latest Regional Economic Outlook: Western Hemisphere we took a fresh look at this issue, examining intervention practices and effectiveness for a group of economies in Latin America and other regions during 2004-10. In particular, we sought to answer the following questions:
- How do Latin American countries intervene and in what respects do they differ from other economies?
- What are the rationales for these policies?
- How effective have they been in affecting the exchange rate?
Most central banks in Latin America were actively involved in foreign exchange markets and, on average, about one third intervened on any given day, a relatively high number considering most declare themselves to have a flexible exchange rate. Although intervention in the region came in waves—frequently corresponding with shifts in global financial conditions—there are cross-country differences. Chile, Colombia, Guatemala, and Mexico were moderate interveners, whereas Peru and Uruguay (dollarized economies) and Brazil intervened more heavily.
In many cases, intervention has been accompanied by exchange rate appreciation. This illustrates the difficulty of assessing the effects of intervention policies. For one thing, there is a two-fold cause-and-effect relationship between the intervention and the exchange rate: intervention affects the exchange rate, but the decision to intervene also depends on the exchange rate. For another, we do not know what might have happened to the exchange rate in the absence of intervention.
How do countries intervene?
Knowledge of the manner in which central banks intervene in foreign exchange markets is limited. This is partly due to a lack of information. However, we have attempted to fill in these information gaps by using various central bank publications, statements, and press releases to develop a qualitative database on intervention practices.
The reasons most often stated for intervening have been to build international reserve buffers and to contain exchange rate volatility. Other reasons sometimes given for intervening tend to be vague.
Central banks in one third of the countries we looked at have used some form of rule-based approach to intervention. And that approach is more common in Latin America, although there are differences within the region. The central banks of Chile and Mexico always used rules when intervening. Colombia and Guatemala also relied on rules, while giving themselves room for discretionary purchases. Brazil, Peru, and Uruguay did not use rules.
The most commonly used market is the spot market, possibly reflecting a higher degree of liquidity vis-à-vis other markets. As derivative markets have expanded over time, however, some central banks have increased the use of such instruments. In the region, the Central Bank of Brazil is the main example, with operations in the forward and swap markets, while the Central Banks of Colombia and Mexico have used options.
Latin America is among the most transparent regions in terms of its operations, publishing better and more timely information.
How effective is intervention?
Our results do not detect an immediate impact of interventions on the rate of appreciation, but do find statistically significant effects on the pace of appreciation: on average, increasing interventions by 0.1 percent of GDP will produce—in one week and in comparison to a country that does not intervene—a 0.3 percent slowdown in the pace of appreciation.
Looking at the role of various intervention methods, we found that effectiveness is not dependent on the use of rules or discretionary frameworks, or on the degree of transparency. However, greater financial integration may significantly reduce the effectiveness of interventions. In fact, intervention is more effective in Asia than in Latin America, which is consistent with the differences in financial integration across the two regions.
Furthermore, interventions are most effective when there are signs of the currency being overvalued compared to its recent history. This is especially noticeable in Latin America and highlights the importance of intervening “when the time is right,” and never “too early”.
Our analysis suggests that foreign exchange market interventions may help to mitigate appreciation temporarily. However, the impact depends on the circumstances and characteristics of each country. The degree of capital account openness and exchange rate misalignment are key factors. At the same time, we should not forget that foreign exchange intervention carries major quasi-fiscal costs and other nonfinancial costs.