Chapter 1 Introduction: Book in Brief

International Monetary Fund. Western Hemisphere Dept.
Published Date:
January 2019
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Marcos Chamon, David Hofman, Nicolas E. Magud and Alejandro Werner 

There is a growing interest in the use of foreign exchange intervention as a policy tool, particularly in emerging markets. Yet our understanding of many aspects of foreign exchange intervention remains limited, especially in countries with flexible exchange rate regimes. To contribute to the discussion, this book examines the experience of several key inflation-targeting central banks in Latin America.

Most Latin American countries have adopted floating exchange rate regimes in the past two decades, often in combination with a move to inflation targeting. Still, official intervention in foreign exchange markets has remained an important feature of policy frameworks. Many countries in the region have steadily accumulated reserves as they have leaned against sustained capital inflows, first in response to the commodity super cycle, and then as advanced economies responded to the global financial crisis with a large monetary stimulus. In some cases, countries have also deployed those reserves to counter depreciation pressures.

The modalities of such interventions, however, have varied widely. In some cases, interventions took place under a clearly laid out framework and defined set of rules; in others, intervention was more ad hoc and discretionary. Often, intervention took place directly in spot markets and was aimed at accommodating immediate foreign exchange liquidity needs. But in some episodes, pressures in foreign exchange markets were due to hedging demand, and intervention was carried out through derivatives.

Although inflation-targeting central banks in Latin America, on average, tend to be relatively transparent about their interventions, countries’ disclosure practices have differed considerably, both across countries and over time.

The Latin American experience with foreign exchange intervention is of interest because it provides insights into several key issues faced by policy makers in many emerging economies. In particular, what is—or should be—the role of interventions under a floating exchange rate regime and of inflation targeting? What are the motives for interventions under such regimes? How effective are foreign exchange interventions? Indeed, do they work at all? How should they be best conducted? And what are the costs of interventions?

To help answer these questions, this book provides the reader with an up-to-date review of foreign exchange intervention practices in Latin America and distills tentative lessons from this rich and varied experience. Building on evidence and country experience with intervention, the book aims to provide a consistent analytical framework to facilitate policy discussion.

The first part of the book covers the main thematic issues in a set of analytical chapters prepared by IMF staff. The chapters provide a broad cross-country perspective of the motives and means of intervention, by exploring the different frameworks, instruments, and operational and implementation issues. It also reviews the existing literature on the effectiveness of interventions, including a chapter that presents new evidence on the effectiveness of forward intervention. This first block of background chapters concludes with a detailed discussion of the operational challenges of foreign exchange intervention under inflation-targeting regimes.

In the second part of the book, chapters by staff of the central banks of Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, and Uruguay provide insightful narratives, as well as specific details of each country’s individual experience. Topics include the developments that motivated intervention—ranging from mitigating the risks of financial dollarization (Costa Rica, Peru, and Uruguay) to managing the impact of large and sustained capital inflows and their often-sudden reversals (Brazil). Topics also include the specific modalities of interventions and their short- and medium-term effectiveness in achieving policy goals.

The chapters also describe the process with which central banks decide how and how much to intervene—in some cases presenting an illustrative intervention decision tree—and how communication around interventions takes place. One key message from the accumulated experience of inflation-targeting Latin American countries is a strong preference for transparency when intervening. Transparency can allow the market to internalize the reaction function of the central bank, helping to reduce excessive exchange rate volatility and uncertainty.

The following overview briefly summarizes each chapter.

Chapter 2 begins with a focus on intervention motives. Marcos Chamon and Nicolas E. Magud briefly review the theoretical literature on foreign exchange intervention and then explain why central banks may decide to intervene. Intervention plays a central role in fixed exchange rate regimes. However, in a floating regime (the focus of the book) the role of intervention is not clear. Yet, there are several reasons why central banks intervene. The motives for intervention include international reserve accumulation for precautionary reasons, attenuating financial stability risks from sharp exchange rate movements, managing short-term/high-frequency shocks on the exchange rate as a result of inflation pass-through concerns, and managing more persistent shocks or shocks to the real exchange rate due to competitiveness/Dutch disease considerations. The discussion focuses on the potential benefits from those channels, but the overall desirability of intervention will also depend on its cost.

In Chapter 3, Oscar Hendrick, Nicolas E. Magud, and Asad Qureshi present a taxonomy of foreign exchange intervention. The chapter discusses several ways in which intervention takes place in practice. Specifically, it presents different frameworks in which foreign exchange intervention can be implemented. These include whether intervention is transparently communicated to the market or conducted secretly. It also considers whether intervention is rules-based or discretionary. Beyond this taxonomy, the chapter delves deeper into the motives behind each type of foreign exchange intervention, including if intervention is done in the spot market or in the derivatives market—and the motivation behind the use of each type of intervention. Throughout the analysis, the costs and benefits of these modalities are considered.

In Chapter 4, Marcos Chamon, David Hofman, Sergi Lanau, Umang Rawat, and Miklos Vari document the evidence in the existing literature of how interventions impact exchange rates. This sheds light on why central banks are often willing to incur the costs of intervention. The chapter reviews the inherent identification challenges of assessing intervention effectiveness and the empirical strategies that have been used to tackle this problem. It reviews the evidence for the effect on the exchange rate level, volatility, and the duration of these effects. It also reviews the evidence of the relative effectiveness of foreign exchange sales versus purchases, spots versus derivatives, and rules-based versus discretionary interventions.

Chapter 5 presents new evidence of the effectiveness of foreign exchange intervention. Chris Walker examines the effectiveness of forward intervention in foreign exchange markets, employing a simple analytical framework and presenting econometric estimates for the experience with forward intervention. Its effectiveness is assessed for the impact on spot currency markets, as well as for domestic interest rates, dollar availability in domestic markets, and capital flows. The chapter provides an analytically underpinned taxonomy of the circumstances in which forward intervention may be preferred to spot intervention or to other policy measures.

In Chapter 6, Marcos Chamon, David Hofman, Nicolas E. Magud, Umang Rawat, and Alejandro Werner explore how foreign exchange intervention is integrated under inflation targeting in Latin America. The authors discuss the challenges central banks face, including (1) tensions between foreign exchange interventions and monetary policy actions aimed at an inflation target, (2) whether the responses to appreciation or depreciation pressures have been symmetric, (3) the costs of intervention, (4) the trade-offs of transparency and communication of the monetary policy objectives, and (5) intervention under currency mismatches. They find that Latin American central banks, on balance, appear to have managed these tensions with a considerable degree of success. Clear communication policies appear crucial to conveying the primacy of the inflation objective and anchoring inflation expectations.

Turning to individual country experiences, in Chapter 7, João Barrata R. B. Barroso presents the case of Brazil. The author highlights that international reserve accumulation involved “leaning against the wind,” which enabled the accumulation of a large buffer of international reserves to insure against potentially destabilizing situations. Intervention also enabled the Central Bank of Brazil to offer hedging instruments at times of excess market demand. There was a significant provision of foreign exchange liquidity through repo auctions during the 2008–09 global financial crisis. Swap auctions have also been very common. Another significant episode of foreign exchange sales took place in the aftermath of the “taper tantrum” that emerged in 2013, as the US Federal Reserve announced it would eventually withdraw the monetary stimulus that had been put in place during the financial crisis. The Central Bank of Brazil intervened taking place mostly through preannounced rules for the sale of derivatives to provide foreign exchange liquidity and to meet hedging demand. At the height of that intervention program, the outstanding volume of derivatives exceeded $100 billion. The chapter also presents a flow chart that helps explain how the central bank decides whether and how to intervene.

Diego Saravia and Catalina Larraín describe the Chilean experience in Chapter 8. Since floating its currency in 1999, Chile has intervened only four times—in 2001, 2002–03, 2008, and 2011. In the first two cases, the central bank intervened to provide foreign currency liquidity by selling US dollars and US dollar-denominated bonds. In contrast, in 2008 and 2011, preannounced programs involved regularly scheduled purchases of US dollars to reach an international reserve target. In all cases, the central bank clearly communicated the intervention programs to the public. Their results show that the announcement of an intervention program had clearer effects on the exchange rate than the actual interventions (consistent with the market pricing in the effect of the intervention in the aftermath of the announcement).

In Chapter 9, Pamela Cardozo describes foreign exchange intervention in Colombia. The Bank of the Republic intervened to accumulate international reserves to reduce external vulnerabilities, to mitigate fluctuations in the exchange rate that do not clearly reflect fundamentals and that may have adverse impact on inflation and economic activity, and to provide foreign liquidity to the market to ensure normal functioning of internal and external payments. Colombia has used options to accumulate international reserves, which are exercised when the exchange rate is below its 20-day moving average. This rule led to stronger reserve accumulation at times of appreciation pressure. Options were also used to implement analogous rules for selling foreign exchange during times of depreciation pressures. The central bank has also undertaken discretionary interventions. The chapter provides a decision tree to illustrate how the central decides to intervene.

In Chapter 10, Rodrigo Cubero, Evelyn Muñoz, and Valerie Lankester look at Costa Rica. This is a much more dollarized economy than others covered in this book—it only started to officially float its currency in 2015. The country is also fairly open to international trade and finance. As a result, the Central Bank of Costa Rica frequently intervenes to maintain financial stability, “lean against the wind,” and avoid excessive volatility in the exchange rate. Managing the supply and demand of foreign exchange by the various public entities is also an important consideration. All interventions in Costa Rica are conducted through the spot market, because derivative markets are not well developed. These interventions are discretionary, with no formal intervention rule communicated to the public.

Chapter 11 presents the case of Mexico. Rodrigo Cano, Daniela Gallardo, and Jaime Acosta highlight the Bank of Mexico’s independence in instruments and objectives. Interest rates are only used for responding to inflation deviations from target, while foreign exchange interventions seek to mute excessive exchange rate volatility and accumulate reserves for precautionary reasons. Most interventions have taken place through preannounced programs. Reserve accumulation has been achieved through put options and following specific rules, similar to Colombia. Some rules also involved steady daily foreign exchange sales. Though less common, outright discretionary sales of US dollars have been used under extreme conditions. More recently, the Bank of Mexico has been using foreign exchange hedge auction programs (nondeliverable forward auctions) to meet market hedging needs while preserving reserves. The central bank clearly communicates intervention rules, and the markets and the public are kept informed of their implementation.

In Chapter 12, Adrian Armas and Marco Vega discuss foreign exchange intervention in Peru. The authors stress that the high degree of financial dollarization calls for active foreign exchange intervention to mitigate exchange rate volatility and potential balance sheet effects. Intervention in Peru is essentially discretionary. The Central Reserve Bank of Peru accumulates sizable reserves during tranquil times so it can comfortably deploy them if needed. Operations in the foreign exchange market are done through both spot and forward markets. Currency swaps are mostly aimed at reducing exchange rate volatility. The country’s foreign exchange intervention policy appears to have been quite effective in smoothing shocks to the exchange rate, even in the case of fairly persistent shocks.

Finally, in Chapter 13, Elizabeth Bucacos, Alberto Graña, Gerardo Licandro, and Miguel Mello present the case of Uruguay. In a highly dollarized economy, the Central Bank of Uruguay intervenes frequently to reduce exchange rate volatility, which could otherwise lead to adverse balance sheet effects. Intervention also helps manage the supply and demand balance for US dollars in the domestic market, including from government entities. Uruguay is unique in its use of monetary aggregate targets instead of interest rates to achieve its inflation target.

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