Chapter 5 Monetary and Exchange Rate Policy Responses

Ana Corbacho, and Shanaka Peiris
Published Date:
October 2018
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Managing the global financial cycle is a key challenge for Association of Southeast Asian Nations–5 (ASEAN-5) monetary frameworks. The results presented in Chapter 4 suggest there is a global financial cycle emanating from changes in US monetary policy and global risk aversion that drives domestic financial conditions and business cycles in the ASEAN-5 economies. This discovery calls into question the traditional “trilemma” view of the independence of monetary policy with a flexible exchange rate because a flexible exchange rate alone is unable to fully insulate economies from the global financial cycle when the capital account is highly open and financial flows are driven by monetary conditions in the United States (Rey 2013). The domestic monetary policy response to changing financial conditions and the degree of monetary autonomy retained in such an environment are an open question (Edwards 2015; Obstfeld 2015). Although the observed co-movement of interest rates across countries could be the result of limited monetary autonomy, it could alternatively reflect the behavior of fully independent central banks that react to synchronized and interdependent economic cycles. This chapter revisits this question by estimating monetary policy reaction functions, or Taylor rules, and the degree of monetary autonomy in the ASEAN-5.

Volatile capital flows can complicate macroeconomic management. Greater exchange rate flexibility helped the ASEAN-5 retain a degree of monetary policy autonomy, but asset prices and credit conditions were susceptible to global financial factors and volatile capital flows. To lean against the wind of capital inflows, policymakers have relied on, among other tools, macroprudential and microprudential measures, capital flow management measures, countercyclical fiscal policy, and foreign exchange market intervention (IMF 2012). The effects of many of these policies—let alone their desirability—remain open to debate in the literature (Blanchard, Adler, and de Carvalho Filho 2015). While progress on financial sector reforms and microprudential supervision has helped mitigate financial stability risks (see Chapter 3), ASEAN-5 central banks also broadened the policy toolkit to include macroprudential policies to address financial stability risks at the systemic and sectoral levels (see Chapter 6 and IMF 2015a). This chapter takes a closer look at the rationale for foreign exchange market intervention—in combination with other policies—in the ASEAN-5 in response to the global financial cycle, following a number of studies on emerging market economies (see Benes and others 2013; BIS 2013; Escudé 2013; Ostry, Ghosh, and Chamon 2012). In this respect, the chapter seeks to contribute to the literature on the optimal combination of policies used by emerging market economies to manage external shocks (IMF forthcoming).

The policy responses to capital outflow episodes have drawn on lessons from past crises. The global financial crisis was a clear reminder of the risks of sudden stops of capital inflows. The chapter also outlines the policy responses to the postcrisis capital outflow episodes in the ASEAN-5. These economies used a wide range of policy tools to supplement monetary policy when addressing market pressures and their economic impact, based on the lessons from the Asian financial crisis of the late 1990s.

Monetary Policy Response

Estimates of Taylor rule reaction functions are used to gauge monetary policy responses and drivers (see Figure 5.1). The standard Taylor rule uses the output gap and inflation (or deviation from its target) and policy interest rate settings to estimate the policy reaction function (Taylor 1993). For Singapore, the rule is modified to reflect the country’s use of the nominal effective exchange rate as the main monetary policy instrument (see, for example, McCallum 2006; Parrado 2004; MAS 2013). Augmentation of the Taylor rule to an open-economy setting permits analysis of the relevance of other variables, such as the exchange rate and global uncertainty, in monetary policy settings in the ASEAN-5 economies (Clarida, Galí, and Gertler 2001; Taylor 2001; Svensson 1999). This chapter uses a reduced form generalized method of moments estimation approach following the literature on the estimation of Taylor rules (Clarida, Galí, and Gertler 1998; Mohanty and Klau 2005).

Figure 5.1.
Taylor Rule Estimates for ASEAN-5

Source: IMF staff estimates.

Note: The bars represent the explanatory variables’ coefficient values ±2 standard deviations, which were derived by estimating generalized method of moments models. For models using actual inflation and output gap data, quarterly data from 2000 to 2017:Q2 were used. Models using expectations data were of monthly frequency from January 2000 to June 2017. Labels in the figure use International Organization for Standardization country codes. ASEAN-5 = Indonesia, Malaysia, Philippines, Singapore, Thailand.

The Taylor rule estimations provide valuable insights into policy directions. The lagged dependent variable plays a large role in all ASEAN-5 economies, indicating a strong preference for interest rate smoothing, except in Singapore, which may be attributed to Singapore’s use of the nominal effective exchange rate as its main policy instrument instead of interest rates. The analysis confirms the strong role of actual or expected headline inflation, or both, in guiding policy rate settings in all countries. Thailand, an inflation-targeting regime, stands out for its stronger response to core inflation; the inflation-targeting framework for many years focused on core inflation developments. On the other hand, the response to output developments among the ASEAN-5 appears to be more subdued or difficult to distinguish from their concern for inflation.

Nontraditional factors also play a role in the ASEAN-5 economies (Figure 5.2). Previous studies have found the exchange rate to have an impact on monetary policy decisions in emerging market economies with inflation-targeting regimes (Ostry, Ghosh, and Chamon 2012; Mohanty and Klau 2005).1 The coefficient estimates are statistically significant and negative in some countries and specifications, but the marginal impact is very small, of only a few basis points, suggesting the real exchange rate played only a small role in affecting the policy interest rate in the ASEAN-5 countries. In Indonesia and the Philippines, the results indicate some resistance to raising policy interest rates when the real exchange rate is appreciating, perhaps out of concern that it may attract further capital inflows. The results for Malaysia and Thailand are generally not statistically and economically significant. Looking at the possible role of global shocks, a dummy variable for the global financial crisis is strongly negative. The Chicago Board Options Exchange Volatility Index (VIX) was also found to be significantly negative in most countries, as the policymakers attempted to cushion their economies from spikes in global risk aversion.

The role of US interest rates and degree of monetary autonomy are explored in more detail given the finding of US interest rate spillovers on domestic financial conditions.2 Higher US interest rates are generally associated with higher policy and market rates in the ASEAN-5 countries (see Chapter 4), in line with studies of other emerging markets.3 This relationship calls into question the prediction of the classical trilemma that floating exchange rates enable open economies to implement an independent monetary policy (Rey 2014; Hofmann and Takáts 2015). Although the observed co-movement of interest rates across countries could be due to limited monetary autonomy, it could alternatively reflect the behavior of fully independent central banks that react to synchronized and interdependent economic cycles (Caceres, Carrière-Swallow, and Gruss 2016). Whether these spillovers constitute evidence of impaired monetary autonomy will depend crucially on whether the policy decision was consistent with domestic developments or was above and beyond what can be explained by the pursuit of domestic objectives.

Degree of Monetary Autonomy in the ASEAN-5

The degree of monetary policy autonomy in the ASEAN-5 is estimated by a two-step approach, building on the Taylor rule estimates of the previous section following Caceres, Carrière-Swallow, and Gruss (2016) (see Annex 5.1). Autonomy-impairing spillovers correspond to those movements in domestic interest rates that are triggered by foreign shocks but are not aligned with domestic monetary objectives. The first stage of the regression approach estimates traditional Taylor rules, as in the previous section, as aligned with central banks’ ultimate goal of maintaining price stability while fostering economic growth. The exercise then obtains the residuals from the first-stage regression that are unaligned with the objectives of monetary policy and then measures how much of the movement of these residuals is attributable to US interest rates.4

The regression results for the ASEAN-5 show that policy rates are susceptible to global monetary shocks, controlling for the interdependence of economic cycles. The effective federal funds rate and shadow federal funds rate were found to be significant factors for monetary policy movements in all of the ASEAN-5 economies (Table 5.1). Indonesia and the Philippines were the most responsive. The deeper bond markets of Malaysia and Thailand were less affected, whereas Singapore was more sensitive, reflecting its exchange-rate-based inflation-targeting regime and highly open capital account. Finally, 10-year US Treasury bond rates were also found to be significant factors for the Philippines and Indonesia.

Figure 5.2.
Estimated Coefficients in Policy Rates

Source: IMF staff estimates.

Note: Estimates were generated by running Taylor-type rules, augmented with nontraditional factors as follows: Model 1 includes the real effective exchange rate, Model 2 includes a dummy variable for the global financial crisis, and Model 3 includes the Chicago Board Options Exchange Volatility Index. The average coefficient estimates are represented by the red dots, while the range represents ±1 standard deviation.

Table 5.1.Regression Estimates: US Monetary Policy Spillover to Domestic Policy Rates
Effective Federal Funds RateVIX IndexTreasury Bond Yields















Source: IMF staff estimates.Note: Standard errors are in parentheses.P denotes the p-value as the probability of obtaining a result equal to or more extreme than observed. VIX = Chicago Board Options Exchange Volatility Index.*p < 0.1; **p < 0.05; ***p < 0.01.

The dynamic interactions of domestic and external factors can provide further insights into policy responses. The single-equation regression approach above does not take into account the potential feedback effects of shocks to monetary policy rates on domestic macroeconomic factors. It also assumes contemporaneous relationships and does not fully capture inertial effects. To accommodate the dynamic relationships, the regression models are extended to structural vector autoregression (SVAR) models, following the methodology of Caceres, Carrière-Swallow, and Gruss (2016). The analysis imposes block exogeneity on global factors such that domestic conditions may only affect global factors with a lag, and only global factors may affect domestic factors contemporaneously.

The ASEAN-5 enjoy varying degrees of monetary autonomy, with policy rates continuing to respond largely to local factors despite significant spillovers to domestic interest rates.5 The two-stage SVAR impulse response functions show that Singapore’s domestic short-term interest rates are the most susceptible to movements in external monetary and financial markets, which is to be expected, as the trade-weighted nominal effective exchange rate nominal anchor and highly open capital account provide little autonomy for setting domestic interest rates (Figure 5.3). The Philippines and Indonesia also exhibited heightened sensitivity to the federal funds rate and US 10-year sovereign yield, respectively. Malaysia and Thailand showed less sensitivity to US interest rates. The variance decompositions showed a similar pattern but highlighted that policy rates continued to be determined largely by domestic factors, with most of the variance attributed to the countries’ own innovations or interest rate smoothing (Figure 5.4). However, US interest rates explain a significant share of the variance of policy rates not attributed to domestic factors. In addition, the share of variance of short-term market rates in the ASEAN-5 appears to be more susceptible to and driven by US interest rates, indicating lower de facto monetary autonomy than implied by policy rates in some instances.

Figure 5.3.
Twelve-Month Cumulative Response of Domestic Policy Rates to US Policy Rates and Other Global Factors

Source: IMF staff estimates.

Note: Labels in the figure use International Organization for Standardization country codes.

Figure 5.4.
Variance Decomposition of the Two-Stage Vector Autoregression

Source: IMF staff estimates.

Note: Labels in the figure use International Organization for Standardization country codes. EFFR = effective federal funds rate; 10Y = 10-year.

Beyond the impact on the policy rates, changes in external conditions significantly affect domestic financial conditions and constrain monetary policy effectiveness. Chapter 4 showed that global financial factors have a significant and pervasive impact on the domestic economies, partly transmitted through capital flows and domestic financial conditions. This investigation follows the approach of IMF 2014 to analyze the role of external factors in driving business cycles in the ASEAN-5, extended to encompass the monetary transmission mechanism as in Chapter 4. The impulse response function of monetary policy shocks in the ASEAN-5 shows significant impacts on real GDP and inflation, but with a significant lag. Policy rates’ ability to dampen the volatility of growth is much weaker than that of inflation in the ASEAN-5, which perhaps explains in part the weaker response to output developments in the Taylor rule estimates reported earlier. However, the variance decompositions show that monetary policy and domestic shocks do not explain variations of business cycle fluctuations as much as external factors, which highlights the importance of understanding global spillovers and the effectiveness of policy combinations (see IMF, forthcoming). This understanding, in turn, is based on how key macroeconomic aggregates and financial prices (mainly interest rates, exchange rates, and domestic financing conditions) respond to the external factors. Effectiveness is thus intertwined with macroeconomic and other policy transmission channels and any potential interactions between these policies. Global commodity prices, proxied by country-specific terms-of-trade changes, also have a significant impact, particularly on inflation dynamics in the ASEAN-5, further reducing the efficacy of monetary policy in influencing inflation.

External Adjustment to Capital Flows in the ASEAN-5

Global financial cycles have also complicated external policymaking in the ASEAN-5 economies. These economies experienced a surge in gross capital inflows in the period of low volatility (as measured by the VIX) before the global financial crisis and in the period of unconventional monetary policies in advanced economies after the crisis (Figure 5.5). As noted in IMF 2013, there are two ways in which countries can adjust to a surge in gross capital inflows: financial adjustment through increases in resident capital outflows or reserves accumulation, or real adjustment through an appreciation of the exchange rate and a larger current account deficit. Before the global financial crisis, all ASEAN-5 economies adjusted through the financial channel, with resident capital outflows rising in tandem with foreign capital inflows. But the effect was not sufficient to offset the massive influx of foreign exchange because these economies were also running current account surpluses. Thus, central banks complemented resident capital outflows with reserves accumulation through foreign exchange market intervention to avoid an excessive appreciation of their exchange rates. This policy response was in line with the goal of rebuilding reserve buffers after the Asian financial crisis. Reserve levels were below or at the lower end of the IMF’s reserve adequacy metric range early in the first decade of the 2000s, but were brought to comfortable levels by 2007 (Figure 5.6).

Figure 5.5.
ASEAN-5: Financial versus Real Adjustment to Gross Capital Inflows

Sources: Country authorities; and IMF staff estimates.

Figure 5.6.
ASEAN-5: International Reserves and Adequacy Metric

Sources: Country authorities and IMF staff estimates.

The policy trade-off for the ASEAN-5 economies was more severe after the global financial crisis. The surge in foreign capital inflows after the crisis as a result of the unconventional monetary policies in advanced economies was not offset by similar outflows from domestic residents, except in Singapore, a financial center, and to some extent in Malaysia where capital markets were deeper. To avoid a deterioration in current account balances (real adjustment), central banks stepped up reserves accumulation, with mostly one-sided foreign exchange market intervention, particularly in Indonesia, the Philippines, and Thailand, and to some degree in Malaysia. This additional accumulation of reserves was not motivated purely by precautionary motives, given that reserve buffers were already at comfortable levels. Moreover, Indonesia also experienced a real adjustment, with its current account balance moving from surplus to deficit in 2012. Reserves remained within the adequacy range in Indonesia and Malaysia, and well above this level in the Philippines and Thailand.6 The large accumulation of reserves and partial sterilization in some instances resulted in a persistent liquidity overhang and low domestic borrowing costs, which fueled credit growth and asset price inflation. Countries were reluctant to tighten monetary policy as they were concerned that doing so could attract even more capital inflows. Instead, they relied on macroprudential policies, but their effectiveness was limited in countries with financial supervisory gaps, in which tighter prudential measures on banks could divert financial intermediation to the less regulated nonbank sector (see Chapter 6).

Nonresident capital inflows and reserves accumulation have eased since 2013, with foreign exchange market intervention becoming two sided and more symmetric. The ASEAN-5 economies’ foreign reserves have stabilized or fallen following the taper tantrum episode in mid-2013. Nonresident capital inflows have moderated or turned negative as US monetary policy has gradually normalized. All ASEAN-5 economies, except Indonesia, experienced net capital outflows, which sometimes surpassed the current account surplus, leading to more two-sided foreign exchange market interventions. Indonesia’s current account balance has remained in deficit, and the country has continued to receive net capital inflows. But these inflows were not always sufficient to cover the current account deficit, thus also leading to two-sided foreign exchange market interventions. During the recent episodes of large capital outflows, the ASEAN-5 economies have relied more on currency depreciation than on reserves drawdown than they had in previous outflow episodes (Figure 5.7). Reserves were drawn down, in some cases below the IMF’s reserve adequacy metric range (Indonesia and Malaysia), but have remained above this range in the Philippines and Thailand.

Figure 5.7.
Changes in Exchange Rate and Foreign Reserves


Sources: Bloomberg L.P.; and IMF staff estimates.

Foreign Exchange Intervention and Costs of Holding Reserves

The experiences of the ASEAN-5 economies in managing capital inflows indicate that the move to a more flexible exchange rate regime was gradual (IMF 2016a). The ASEAN-5 economies accumulated foreign reserves for precautionary reasons between the Asian financial crisis and the global financial crisis and in response to large capital inflows after the global crisis. In both cases foreign exchange market interventions were generally one-sided, although central banks let their currencies partially appreciate while leaning against the wind. Since 2013, these economies have stopped accumulating reserves, and foreign exchange market intervention has become two sided and more symmetric. Exchange rates have fluctuated more freely, serving as effective shock absorbers. Greater exchange rate flexibility may also have mitigated the slowdown in capital inflows, as shown in IMF 2016b, where more flexible exchange rate regimes lower the share of the total variance in capital inflows explained by common global factors.

Despite the extensive use of foreign exchange market intervention, the ASEAN-5 economies are not among the heaviest interveners, except for Singapore. Adler, Lisack, and Mano (2015) built an indicator of the degree of foreign exchange market intervention for 52 economies using monthly data during 1996–2013 (see Figure 5.8). The indicator is defined as the standard deviation of the central bank’s net foreign asset position divided by the sum of that standard deviation and the standard deviation of the nominal exchange rate. A higher value indicates more foreign exchange market intervention. Among the ASEAN-5 economies, Indonesia has the lowest degree of intervention, comparable to that of some advanced economies. The Philippines and Thailand follow, with slightly higher degrees of foreign exchange market intervention. Malaysia is near the median of the sample, while Singapore has a very high degree of intervention, comparable to that of China, consistent with its exchange rate–based monetary policy framework. However, this indicator does not measure whether foreign exchange market intervention has been one or two sided and thus should not be interpreted as a measure of exchange rate flexibility.

Figure 5.8.
Degree of Exchange Rate Management

Source: IMF staff calculations.

Note: The figure reports a measure ρjσjNFAσjNFA+σjS,inwhich σjNFAandσjΔS denote the standard deviations of changes in net foreign assets and in the nominal exchange rate, respectively. The last six bars correspond to countries with de jure pegs for most of the sample.

Studies have found a significant and persistent effect of foreign exchange market intervention on the exchange rate level, validating the view that the move to exchange rate flexibility in the ASEAN-5 economies has been gradual. Adler, Lisack, and Mano (2015) investigate the impact of foreign exchange market intervention on exchange rate levels using an instrumental-variables panel approach for 52 economies based on monthly data during 1996–2013. They find that intervention affects the exchange rate in a persistent manner. A purchase of foreign currency equivalent to 1 percent of GDP causes the nominal exchange rate to depreciate by 1.7 to 2.0 percent, with a half-life cycle of between 12 and 23 months. These findings suggest that the persistent one-sided foreign exchange market intervention by the ASEAN-5 economies before the global financial crisis and during 2010–12 kept their currencies weaker than they would have been otherwise. Since 2013, however, interventions have been two sided and more symmetric, suggesting that although exchange rate fluctuations have been smoothed, the average level of the exchange rate has not necessarily been affected.

The ASEAN-5 central banks have generally sterilized their foreign exchange market interventions to avoid inflation pressure arising from reserve inflows (IMF 2016a). The intensity of sterilization in the ASEAN-5 economies is estimated following the approach of Aizenman and Glick (2008), regressing the central bank’s annual change in net domestic assets (NDA) on the annual change in net foreign assets (NFA), both scaled according to the level of the reserve money stock 12 months earlier (RM (−12)), as follows:

ΔNDA / RM(−12) = α + βΔNFA / RM(−12) + ε.

The regression is estimated using 1-month extended and 60-month rolling windows. The coefficient β measures the intensity of sterilization, with β = –1 representing full sterilization of reserve changes, β = 0 implying no sterilization, and −1 < β < 0 indicating partial sterilization. Average sterilization coefficients in the ASEAN-5 economies have remained close to β = –1 in the post–Asian financial crisis period (Figure 5.9; Table 5.2). In general, the ASEAN-5 countries have attempted to fully sterilize their foreign exchange market intervention even during the period of exceptionally easy monetary policy in advanced economies (albeit with temporary periods of partial sterilization in Indonesia, Malaysia, and the Philippines), when the buildup of reserves was especially strong and sterilization may have attracted greater capital inflows.

Figure 5.9.
ASEAN-5 Economies: Sterilization Coefficients

Source: IMF staff estimates.

Note: Red line = 1-month extended window; blue line = 60-month rolling window for Indonesia, Malaysia, the Philippines, and Thailand, and 80-month rolling window for Singapore. Sample period for Indonesia, the Philippines, and Thailand: monthly data for 2001–15; for Malaysia and Singapore: monthly data for 2002–15. GFC = global financial crisis.

Table 5.2.Sterilization Coefficient
Pre-GFCGFCPost-GFCTaper Tantrum
Source: IMF staff estimates.Note: Average sterilization coefficient using one-month extended window in the following periods: pre-GFC (starting January 2005 or onward data available up to August 2008), GFC (September 2008 to March 2009), post-GFC (April 2009 to April 2013), taper tantrum (May 2013 to December 2013). GFC = global financial crisis.

Foreign exchange market intervention and reserve holdings may be costly, and their benefits need to be weighed against their costs. Adler and Mano (2016) estimate the marginal cost of intervention (per US dollar) and the total cost of rolling over reserve positions, both ex post and ex ante, for 73 economies during 2002–13. Ex post costs consider domestic and external interest rates as well as actual realization of the exchange rate. These costs have been large because of sizable deviations from uncovered interest rate parity and elevated foreign reserve holdings. Although ex post costs measure the actual cost of foreign exchange market intervention and reserve holdings, they are not relevant for policymaking because ex post exchange rate realization is unknown at the time policy decisions are made. Instead, the authors use ex ante costs estimated with survey- and model-based exchange rate expectations. Their estimated ex ante costs are lower than the ex post costs, but they are still sizable, with marginal costs of foreign exchange market intervention ranging between 2 and 5.5 percent per US dollar, and the total cost of holding reserves hovering between 0.2 and 0.7 percent of GDP a year. The average ex ante total cost of holding foreign reserves for Indonesia, the Philippines, Thailand, Malaysia, and Singapore are 0.6, 0.7, 0.9, 1.0, and 1.3 percent of GDP a year, respectively (Figure 5.10). The total cost for the median emerging market economy, in comparison, is 0.5 percent of GDP a year. Thus, the cost of holding foreign exchange reserves in the ASEAN-5 countries is on the high side of the sample, likely because of their large international reserve holdings.

Figure 5.10.
Average Ex Ante Total Cost of Foreign Exchange Market Intervention, 2002–13

(Percent of GDP)

Source: IMF staff estimates.

1 Range between the minimum and maximum estimated ex ante country average across different methods.

2 Average (across methods) of ex-ante measures.

3 Ex post country average.

Cost-benefit analysis of reserve holdings requires a richer framework. Some studies have analyzed the benefits and costs of holding reserves and have calculated the optimal level of reserves for emerging market economies. For example, to address this question, Jeanne and Rancière (2011) calibrated a small open economy model in which reserves allow the country to smooth domestic absorption in response to sudden stops in capital flows, but yield a lower return than the interest rate on the country’s long-term debt. Plausible calibrations of the model justify reserves of the order of magnitude observed in many economies. However, reserves in Asia are larger than those implied by a motive to insure against sudden stops in capital flows. Similarly, Calvo, Izquierdo, and Kung (2013) use an empirical model to address this question. The benefits of holding reserve buffers are a lower risk of sudden stops in capital flows, while the cost is the spread of public sector bonds over the interest earned from reserve holdings. The model finds that reserve holdings in Latin America were the closest to the model-based optimal levels, while reserves in eastern Europe were lower than the optimal levels and those in Asia higher. This outcome is consistent with the findings of Adler and Mano (2016), who find that the costs of rolling over reserve holdings in Asia are larger than for those in other regions—mainly because of the larger size of their reserves holdings—and argue that countries with high credit ratings, such as the ASEAN-5, could therefore lower their foreign exchange reserves and costs of sterilization (Domanski, Kohlscheen, and Moreno 2016).

Two-Target–Two-Instrument Approach Applied to the ASEAN-5

In some circumstances, a two-target–two-instrument monetary policy framework may be consistent with a symmetrical approach to managing the global financial cycle. Under such a framework, foreign exchange market intervention together with movements in the policy interest rate are designed to achieve exchange rate and inflation objectives (Benes and others 2013; Escudé 2013; IMF, forthcoming; Ostry, Ghosh, and Chamon 2012). In particular, when the exchange rate becomes too strong or too weak, competitiveness or balance sheet concerns would lead to foreign exchange market intervention to influence exchange rate movements. Such intervention can be sustained but needs to be two sided, as recently observed in the ASEAN-5 countries. Such a regime is not without risks, especially to the extent that frequent intervention may undermine the clarity and credibility of the monetary policy framework, although good communication and enhanced transparency can help to clarify the objectives. A related issue is the consistency of the overall policy mix and the need to ensure that objectives are congruent and that foreign exchange market intervention does not substitute for other needed policy changes (IMF 2012).

The interaction of a Taylor rule with foreign exchange market intervention is studied in a standard monetary model used by many central banks. To study the effectiveness of intervention in leaning against the wind of the global financial cycle, this section explores the rationale for its use in combination with a standard Taylor rule–type monetary policy function in a modified Forecasting and Policy Analysis System (FPAS) model (Berg, Karam, and Laxton 2006). The IMF’s FPAS model involves a core macro structure consisting of a number of behavioral equations, based on conventional links familiar to most macro modelers and policymakers. Following the literature on the effectiveness of foreign exchange market intervention in emerging market economies (for example, Blanchard, Adler, and de Carvalho Filho 2015; Ostry, Ghosh, and Chamon 2012), the standard FPAS model is modified by introducing foreign exchange market intervention as an additional tool for the central bank; through intervention, the central bank can affect the exchange rate, which, in turn, will affect output and inflation gaps. The modified FPAS model is consistent with a stripped-down version of Escudé’s (2013) dynamic stochastic general equilibrium model in which the author compares two policy regimes: a pure float in which the central bank follows only its Taylor rule and a combination of interest rate policy based on a Taylor rule and market intervention, a so-called managed float regime. For simplicity, this chapter assumes that the amount of foreign exchange market intervention, defined as the net purchase of foreign currencies, is a function of the deviation of the real exchange rate from its long-term average and the speed of appreciation or depreciation. In other words, the larger the gap or the faster the rate of appreciation or depreciation of the home currency, the larger the foreign exchange market intervention. To evaluate the impact of intervention on exchange rates, this analysis follows Adler, Lisack, and Mano (2015) by expressing the exchange rate as a function of foreign exchange market intervention and using this function to replace the uncovered interest rate parity equation in the FPAS model, as in Escudé 2013.

A modified FPAS model is a better fit for the data for the Philippines and Thailand and thus illustrates the potential trade-offs associated with using foreign exchange market intervention to manage the global financial cycle in the ASEAN-5 context. The model is estimated using Bayesian techniques based on prior distributions for the parameters from previous studies, including those on the effectiveness of foreign exchange market intervention. Quarterly data from the early 2000s (the starting point varies depending on data availability) are used for the Philippines and Thailand. For foreign exchange market intervention, the exercise follows the literature by using quarterly changes in foreign exchange reserves as a proxy for intervention. The results suggest that the modified FPAS model incorporating foreign exchange market intervention fits the data better for the Philippines and Thailand than the standard FPAS model does (Table 5.3).

Table 5.3.Estimation Results of the Modified FPAS Model with Foreign Exchange Intervention
Philippines: Root Mean-Squared Errors
FPAS ModelModified Model
1 Quarter ahead4 Quarters ahead8 Quarters ahead1 Quarter ahead4 Quarters ahead8 Quarters ahead
Ratio (Modified/FPAS)
1 Quarter ahead4 Quarters ahead8 Quarters ahead
Thailand: Root Mean-Squared Errors
FPAS ModelModified Model
1 Quarter ahead4 Quarters ahead8 Quarters ahead1 quarter ahead4 Quarters ahead8 Quarters ahead
Ratio (Modified/FPAS)
1 Quarter ahead4 Quarters ahead8 Quarters ahead
Source: IMF staff estimates.Note: FPAS 5 Forecasting and Policy Analysis System; PIE 5 quarterly rate of inflation; REER 5 real effective exchange rate; RS 5 policy interest rate; YGAP 5 output gap.

The benefits of inflation targeting coupled with intervention are apparent. In the face of a capital outflow shock (due to higher global interest rates or risk premiums), inflation targeting without foreign exchange market intervention implies raising the policy interest rate more than in the case of intervention, similar to Escudé 2013. This forces central banks to tolerate a more depreciated currency (and, conversely, with positive shocks, a more appreciated one), lowering welfare relative to the central bank’s objective of keeping the exchange rate close to its fundamental value. Consequently, foreign exchange market intervention can help to manage extreme external pressure, especially if the country has substantial exchange rate pass-through effects or currency mismatches (which would exacerbate balance sheet risks following a currency depreciation). For the Philippines and Thailand, the modified FPAS model shows that foreign exchange market intervention can also help reduce output and inflation gaps when the economy is facing a capital outflow shock given its influence on the exchange rate, in line with the findings of Adler, Lisack, and Mano (2015) and Escudé (2013) (Figure 5.11). These results provide the rationale for the use of foreign exchange market intervention as a tool for macroeconomic management in the ASEAN-5 economies.

Figure 5.11.
Impact of Foreign Exchange Intervention

Source: IMF staff calculations.

Note: FPAS = Forecasting and Policy Analysis System.

The use of foreign exchange market intervention for other types of shocks and interactions with policies other than Taylor rule–type monetary rules requires further research. Whether foreign exchange market intervention is optimal in the presence of an array of shocks is debatable. Escudé (2013) shows that the degree of smoothing depends critically on the nature of the shock given that intervention has a far greater impact on economic developments in the case of an external financing shock than for a demand shock. Benes and others (2013) also show the importance of balance sheet considerations in assessing the impact and efficacy of foreign exchange market intervention in response to external shocks. Anand, Delloro, and Peiris (2014 and Chaianant, Pongsaparn, and Tansuwanarat (2008) show the potential benefits of more unconventional monetary policies in the Philippines and Thailand, respectively, that may interact with foreign exchange market intervention. More generally, the more extensive use of macroprudential policies in the ASEAN-5 (see Chapter 6) suggests that foreign exchange market intervention could be evaluated in richer models with macroprudential policies to get a better sense of their desirability in combination with other macro policies (see Chapter 9; Chen and Laseen, forthcoming; Harmanta and others 2015; Ghilardi and Peiris 2016).

Policy Responses to Capital Outflow Episodes

ASEAN-5 economies used a wide range of policy tools—including fiscal measures, macroprudential policies, capital flow management measures, foreign exchange market intervention, and provision of liquidity to money markets—to supplement monetary policy to address market pressure and its economic impacts (Figure 5.12; Table 5.4). In particular, while all countries raised their policy rates during the Asian financial crisis to support their external positions, they eased their policy rates following the global financial crisis to support growth (Figure 5.12). By comparison, only Indonesia raised its policy rates during the taper tantrum to support its external position; Malaysia and the Philippines tightened modestly in consideration of domestic stability. Singapore and Thailand gradually eased their monetary policy stances during 2011–12, reflecting the weakening economic outlook. During the turbulent summer of 2015, policy rates were left unchanged in all ASEAN-5 economies because policymakers had to weigh concern about capital flow reversals—largely confined to portfolio equity flows—against worries about slowing economic activity. However, Indonesia did not begin easing monetary policy to support domestic demand until January 2016.

Figure 5.12.
ASEAN-5: Policy Interest Rates


Sources: Haver Analytics; and IMF staff estimates.

Note: NEER = nominal effective exchange rate.

Table 5.4.Policy Tools Used during the Global Financial Crisis and Taper Tantrum
GFCTaper TantrumSummer 2015GFCTaper TantrumSummer 2015GFCTaper TantrumSummer 2015GFCTaper TantrumSummer 2015GFCTaper TantrumSummer 2015
Policy Rate1LoweredRaisedUnchangedLoweredUnchangedUnchangedLoweredUnchangedUnchangedLoweredLoweredUnchanged
Exchange Rate Corridor Band1Recentered to validate a weaker currency1UnchangedUnchanged
Exchange Rate DepreciationYesYesYesYesYesYes
Drawdown of ReservesYes
Macroprudential PolicyTightened LTV for motor vehicles and residential propertiesImposed limit on mortgage term, maximum tenure of financing for personal useRestricted motor vehicle and public housing loans, measures of property loans; imposed limits on total debt servicing ratio
Reserve RequirementsLoweredRaisedLoweredLowered
Capital Flow MeasuresShortened minimum holding period for central bank billsImposed limits on banks’ NDF exposures
Foreign Exchange InterventionsYesYesYesYesYesYesYes
Liquidity Provision MeasuresYesYesYesYes
Expansion of Deposit Insurance CoverageYesYesYesYesYes
Expansion of Eligible Collateral for Short-Term FinancingYes
Loan GuaranteesYes
Fiscal PolicyExpansiveReduced fuel subsidiesExpansiveExpansiveExpansiveExpansive
Other MeasuresSwap arrangements with other countries; contingent loans
Sources: IMF, ASEAN-5 countries’ staff reports for their Article IV consultations.Note: GFC 5 global financial crisis; LTV 5 loan-to-value ratio; NDF 5 nondeliverable forward.

Various responses were observed across countries and episodes depending on country circumstances (Table 5.4). During the global financial crisis, Indonesia, Malaysia, and the Philippines lowered banks’ reserve requirements and expanded liquidity provision measures to preserve orderly money market conditions. Moreover, all ASEAN-5 economies expanded deposit insurance. Fiscal stimulus packages were also implemented to support growth. In contrast, during the taper tantrum episode, Indonesia—the ASEAN-5 country under the most pressure—had to prioritize stability over supporting economic activity. Reserve requirements and the loan-to-value ratio were tightened to contain credit growth, while the exchange rate and long-term bond yields were allowed to move freely after an initial period of containment. Fiscal policy was also tightened, with an average 33 percent increase in subsidized fuel prices, to address external and fiscal imbalances. Conversely, the minimum holding period for central bank bills was shortened to increase their liquidity and attract more foreign inflows. During the turbulent summer months of 2015, reserve requirements were left unchanged, but were reduced in December in Indonesia and in February in Malaysia to provide liquidity to the money markets.

Foreign reserves were used as a buffer, coupled with greater exchange rate flexibility, to help cushion the economy and avoid disorderly market conditions. All ASEAN-5 currencies came under severe pressure and depreciated significantly during the global financial crisis, allowing the exchange rate to act as a shock absorber (Figure 5.13). Net capital outflows during the taper tantrum were not as large as during the global financial crisis, but the markets monitored the strength of the countries’ macroeconomic fundamentals more closely. Indonesia, in particular, faced severe pressure because of its twin deficits, which prompted more foreign exchange market intervention to avoid disorderly market conditions (Figure 5.14) (IMF 2016a). Moral suasion in the foreign exchange market and reduced purchases of government securities by Bank Indonesia were also used to manage price adjustments; transparency of market interventions was increased and communication with market participants enhanced. During the summer 2015 turbulence, all ASEAN-5 economies suffered from financial market volatility, particularly in equity markets. However, the foreign reserves drawdown was most pronounced in Indonesia and Malaysia, the two commodity exporters that were most affected by the commodity price collapse, requiring an external adjustment to smooth the external shock, with reserves falling close to the IMF’s reserve adequacy metric. Overall, greater exchange rate flexibility helped smooth “excessive” volatility and preserve orderly market conditions during the turmoil.7

Figure 5.13.
Foreign Exchange Responses to Capital Outflow Episodes

Sources: Haver Analytics; IMF, International Reserves and Foreign Currency Liquidity Database; and IMF staff estimates.

Note: Labels in the figure use International Organization for Standardization country codes. GFC = global financial crisis; RMB = renminbi.

Figure 5.14.
Reaction to Disorderly Market Conditions


The sensitivity of emerging market asset prices and capital flows to global factors is well recognized, and the pervasive global spillovers to domestic interest rates and credit conditions highlight the susceptibility of the main monetary transmission channel in the ASEAN-5. This calls into question the traditional “trilemma” view of the independence of monetary policy with flexible exchange rates because flexible rates alone cannot fully insulate economies from the global financial cycle when the capital account is highly open. The estimates of monetary policy reaction functions, or Taylor rules, suggest that ASEAN-5 monetary authorities respond predominantly to domestic stability considerations but external considerations also play a role. Policy rates are susceptible to global monetary shocks, controlling for the interdependence of economic cycles, and the degree of monetary policy autonomy varies across the ASEAN-5, with monetary transmission influenced by global financial and commodity price shocks.

In some circumstances, foreign exchange market intervention may be motivated by the desire to mitigate capital flow shocks. ASEAN-5 countries accumulated foreign exchange reserves to strengthen their external positions and build reserve buffers to enhance their resilience, partly based on their experience during the Asian financial crisis and the global financial crisis. However, the degree of reserves accumulation in some ASEAN-5 countries may have exceeded levels deemed necessary for precautionary purposes. It may also have been motivated by the objective of smoothing exchange rate fluctuations or volatility, without targeting a particular exchange rate level (see Chapter 2). Combining foreign exchange market intervention with a standard Taylor rule–type monetary policy function estimated for the ASEAN-5 indicates that it could help reduce business cycle fluctuations in response to capital flow shocks in some circumstances. In particular, during periods of excessive currency volatility, the exchange rate can stop operating as a shock absorber and may become a shock amplifier, operating through balance sheet concerns. However, the benefits of intervention, such as dampening shocks, should also be weighed against sterilization costs and their potential to undermine the credibility of the policy framework, particularly when foreign exchange market intervention becomes too frequent and market conditions are not disorderly.

The susceptibility of ASEAN-5 capital flows to global financial factors heightens the risk of a sudden stop and a reversal in capital flows, which can have large macroeconomic consequences on emerging markets. Foreign exchange market interventions were generally one-sided before the global financial crisis—as these economies were rebuilding reserve buffers for precautionary reasons—and in the wake of the crisis, when they were struggling to mitigate the liquidity impact of large capital inflows triggered by the exceptionally easy monetary policies in advanced economies. However, intervention became two sided and more symmetric, and exchange rates more flexible, after the taper tantrum episode in 2013. Moreover, the ASEAN-5 economies have relied more on currency depreciation than on reserve depletion during recent episodes of large capital outflows than during previous outflow episodes. A key aspect of the policy responses was the timely use of policy combinations to mitigate disorderly market conditions and severe economic fallout, taking into account macro-financial linkages, which holds lessons for other emerging market economies and future challenges.

Frameworks for the conduct of monetary policy are likely to evolve further under the “new normal” (Bayoumi and others 2014). The normalization of US monetary policy should provide greater scope for monetary policy independence in the ASEAN-5 economies given the limited impact of conventional and unconventional monetary policy in other jurisdictions. Additional intermediate objectives (such as financial and external stability) will play a greater role in the future than they have in the past (Bayoumi and other 2014). When possible, these objectives should be targeted with additional instruments (for example, macroprudential policies and foreign exchange intervention). The use of intervention in the ASEAN-5 economies is a case in point, but new challenges may arise if, for example, reserve buffers fall below critical levels and if nonfinancial shocks dominate in the future.


Two-Step Regression Approach to Assessing Monetary Autonomy

The first stage of the approach measures the degree to which domestic monetary policy is affected by domestic macroeconomic conditions by estimating the following regression model:

in which inti,t is the domestic interest rate of country i at time t and domestic macroeconomic conditions are represented by gdpi,t , and infi,t , which are one-year-ahead expectations of real GDP growth and headline inflation of country i at time t, respectively.

The second stage of the methodology then aims to determine the extent to which the dynamics of foreign monetary policy affect movements in domestic interest rates that are not accounted for by domestic macroeconomic conditions. Building on the regression models estimated in the first stage, the exercise takes the residuals of the regression models for each country, then regresses them against foreign monetary policy rates to measure how much of the movement of domestic policy rates not explained by domestic macroeconomic factors is explained by external factors:

in which εi,t is the error term at time t from the regression model for country ii,t , and intt* is the level of the base country indicator at time t. In this study, four base or reserve currency country indicators were tested. To estimate the explicit effect of policy rates in the United States, the residuals were regressed against the effective federal funds rate. However, because the Federal Reserve implemented unconventional monetary policies and the US policy rate reached its lower bound (thus, there was no longer any movement in the series), alternative regression models using the shadow federal funds rate were used to capture the “theoretical movement” of interest rates. Regression models using US 10-year Treasury bond yields were also estimated because, although policy rates move only at the direction of the monetary authorities, movements in the economy attributable to the effects of the policy rates are said to be mirrored in bond yield data.

Structural Vector Autoregression with Block Exogeneity (SVARX)

To measure the dynamic relationships between domestic macroeconomic factors, a vector autoregression model was also estimated. As in the regression models, the SVARX models are estimated in two stages.

For the first stage, a Taylor-type rule is used that models the dynamic relationship between domestic interest rates and domestic macroeconomic conditions:

To eliminate possible contemporaneous correlation between the error terms, the residuals from the domestic interest rate are regressed on the residuals from GDP and inflation expectations:

By following this approach the analysis eliminates the systemic policy response of monetary policy to domestic macroeconomic shocks, and we are able to extract the part of the domestic interest rates that is unexplained by movements in domestic variables. This residual is used for the second stage, wherein we try to quantify the degree to which these residuals are influenced by foreign shocks. Note that in this study, assumptions on the exogeneity of foreign factors were imposed such that domestic factors do not affect foreign factors contemporaneously, but can affect them with a lag. On the other hand, foreign factors are assumed to affect domestic factors contemporaneously.


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At a theoretical level, De Paoli (2009) shows that in the presence of terms-of-trade externalities, the central bank’s loss function in a small open economy may also include the real exchange rate.

In most settings, the theoretical literature has argued that the foreign monetary policy rate should not be included as an additional argument in the central bank’s policy function (Woodford 2007).

The concept of monetary autonomy is intimately related to the notion that interest rates “spill over” from large to small open economies or from reserve currency economies to non–reserve currency economies.

The estimations considered various interest rates of reserve currency economies but report the results for US interest rates because they were the most robust factors.

Many studies have found that even if floaters enjoy more autonomy than peggers, the pass-through of international to domestic interest rates remains significant in both groups (some examples include Frankel, Schmukler, and Servén 2004; and Edwards 2015).

Note that Malaysia’s exchange rate regime was reclassified to “floating” with effect from September 26, 2016, and the reserve adequacy level adjusted accordingly.

Exchange rate volatility or overshooting a level consistent with macroeconomic fundamentals does not constitute disorderly market conditions per se, but only to the extent that adverse shocks are amplified.

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