Measuring The Effectiveness Of Forex Intervention

One of the basic tools used by emerging market central banks to manage high capital inflows is intervention in the foreign exchange markets. While foreign capital inflows are generally welcomed, they cause problems through overly expanding the domestic money supply (and credit), putting upward pressure on the exchange rate, and – the biggest problem – can be the trigger for a liquidity crisis should they reverse.

A new working paper from the IMF seeks to discover just under what conditions forex intervention can be effective, or if it’s any use at all (abstract):

Foreign Exchange Intervention: A Shield Against Appreciation Winds?
Adler, Gustavo ; Tovar Mora, Camilo E

This paper examines foreign exchange intervention practices and their effectiveness using a new qualitative and quantitative database for a panel of 15 economies covering 2004 - 10, with special focus on Latin America. Qualitatively, it examines institutional aspects such as declared motives, instruments employed, the use of rules versus discretion, and the degree of transparency. Quantitatively, it assesses the effectiveness of sterilized interventions in influencing the exchange rate using a two-stage IV-panel data approach to overcome endogeneity bias. Results suggest that interventions slow the pace of appreciation, but the effects decrease rapidly with the degree of capital account openness. At the same time, interventions are more effective in the context of already ‘overvalued’ exchange rates.

Note the results: it jives with the Malaysian experience as well. As capital controls were slowly dropped and then largely abandoned over the past decade, successive intervention episodes have yielded a reduced impact on the MYRUSD rate, even as the scale of intervention has increased.

From a practical viewpoint, this paper also confirms econometrically that changes in international reserves (at more than weekly frequencies) forms a good proxy for actual central bank intervention. That’s useful to know given that BNM neither announces the motive, timing, scale or modality of their intervention in the forex market. Knowing we have a good handle on at least the scale and relative timing of intervention episodes is comforting, even if we don’t know why (RM millions):

For most of the past three years, BNM's interventions have been mainly in support of the Ringgit, but that has changed in the last couple of months. As to why, I'd hazard a guess at two motives: to slow the appreciation of the Ringgit in the context of the higher capital inflows we've seen in the past few months, and to increase the insurance cushion of international reserves available should the flows reverse.

Note that neither of these motives imply a level target, though a speed target might not be ruled out. There's also the possibility that BNM considers that the current level of the Ringgit is near fair value relative to economic fundamentals, and doesn't want it to outrun Malaysia's economic growth and development. But this is a moving target, not a static one, so it's hard to prove, especially since BNM has explicitly avowed using econometric models for exchange rate valuation.

Technical Notes:

Adler, Gustavo ; Tovar Mora, Camilo E, "Foreign Exchange Intervention: A Shield Against Appreciation Winds?", IMF Working Paper No 11/165, July 2011