Does Foreign Exchange Intervention Slow the Pace of Currency Appreciation?

IMF Blog, May 4, 2011

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Abundant global liquidity and high exposure to capital movements have put foreign exchange intervention at center stage of the policy debate in Latin America.
The analysis covers intervention practices and effectiveness for a group of economies in Latin America and other regions during 2004-10.
Key questions examined:
- 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.
Intervention in the region came in waves—frequently corresponding with shifts in global financial conditions—and there are cross-country differences:
- Chile, Colombia, Guatemala, and Mexico were moderate interveners.
- Peru and Uruguay (dollarized economies) and Brazil intervened more heavily.
Intervention has often been accompanied by exchange rate appreciation, complicating causal assessment because:
- Intervention affects the exchange rate.
- The decision to intervene depends on the exchange rate.
- The counterfactual (what would have happened absent intervention) is unknown.

Information gaps exist on central bank intervention practices; a qualitative database was developed using central bank publications, statements, and press releases to fill some gaps.
Most common stated rationales:
- To build international reserve buffers.
- To contain exchange rate volatility.
- Other stated reasons tend to be vague.
Rule-based versus discretionary approaches:
- Central banks in one third of the countries looked at have used some form of rule-based approach to intervention.
- Rule-based approaches are more common in Latin America, with country variation:
- Chile and Mexico always used rules when intervening.
- Colombia and Guatemala relied on rules while giving themselves room for discretionary purchases.
- Brazil, Peru, and Uruguay did not use rules.
Market instruments used:
- The spot market is the most commonly used market, possibly reflecting higher liquidity.
- As derivative markets expanded, some central banks increased use of such instruments:
- Central Bank of Brazil uses forward and swap markets.
- Central Banks of Colombia and Mexico have used options.
Transparency:
- Latin America is among the most transparent regions in terms of its operations, publishing better and more timely information.

No immediate impact of interventions on the rate of appreciation was detected.
Statistically significant effects were found on the pace of appreciation:
- 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.
Effectiveness by institutional/design features:
- Effectiveness is not dependent on the use of rules or discretionary frameworks, or on the degree of transparency.
- Greater financial integration may significantly reduce the effectiveness of interventions.
- Intervention is more effective in Asia than in Latin America, consistent with regional differences in financial integration.
Timing and misalignment:
- Interventions are most effective when there are signs of the currency being overvalued compared to its recent history.
- This highlights the importance of intervening “when the time is right,” and never “too early”.

Foreign exchange market interventions may help to mitigate appreciation temporarily.
The impact of intervention depends on country-specific circumstances and characteristics.
Key factors influencing effectiveness:
- Degree of capital account openness.
- Exchange rate misalignment.
Policymakers should weigh benefits against costs:
- Foreign exchange intervention carries major quasi-fiscal costs and other nonfinancial costs.

Source: Does Foreign Exchange Intervention Slow the Pace of Currency Appreciation? (Gustavo Adler, Camilo E. Tovar, May 4, 2011)