Appendix II: Robustness Tests
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The author would like to thank Kathryn Domínguez and Linda Tesar for their comments and guidance; also to Roberto Benelli, Andrew Berg, Jean-Francois Dauphin, María Gonzalez, Robert Rennhack, Jim Rowe, Jeromin Zettelmeyer and, in particular, Ben Clements for their useful feedback on previous drafts. This paper would not have been possible without the generous support of several colleagues at the Banco de la República de Colombia: Diana Mejía, Silvia Mera, Ximena Recio, Alejandro Reveiz, Luisa Silva, Carlos Varela, Hernando Vargas, and especially Jorge Toro. Genevieve Lindow provided excellent research assistance. All remaining errors and omissions are the author’s own. The views expressed in this paper are those of the author and do not necessarily represent those of the International Monetary Fund.
Widespread central bank intervention seems to reflect the predominant view among policymakers that intervention is a useful policy tool to influence real exchange rates (Neely, 2007). Indeed, according to a 2005 study of the Bank of International Settlements, 85 percent of those interviewed characterized their interventions as being effective most of the time (Mihaljek, 2005). In this light, it often appears to be an attractive tool to respond to surges in capital inflows (see IMF, 2007c).
Data on official intervention was kindly provided by the Banco de la República, and is not disclosed to the public at a daily frequency. For this reason, the use of the daily data in this paper is subject to confidentiality agreements.
These include valuation effects, capitalization of interest gains, portfolio adjustment operations, or other foreign exchange transactions not aimed at influencing the exchange (such as the trading of foreign exchange to meet the needs of the central government).
From March 2006 until mid-January 2007, the Colombian government stopped discretionary purchases and only intervened in the foreign exchange market through rules-based, non-discretionary foreign currency auctions to smooth exchange rate volatility. A more detailed description is provided in Section III.
On the other hand, in the case of a defense of the value of the domestic currency, the cumulative amount of intervention is constrained by the stock of available reserves.
See Holub (2004) for a very similar policy implication based on the experience of the Czech Republic with central bank intervention.
Dominguez and Frankel (1993) and Dominguez (2003) provide empirical evidence in this regard. For Japan, Ito (2002) found that large and infrequent intervention had quantitatively small but statistically significant effects on the dollar-yen nominal exchange rate.
Dominguez (2006) and Cashin, Edison and Liang (2006) found that intervention increases exchange rate volatility, in contrast with claims by central banks that intervention does not increase (or is not associated with an increase in) volatility (Neely, 2007).
Canales-Kriljenko (2003) argues that foreign exchange intervention may be more effective in developing and transition economies than in industrialized countries. Given the lower degree of international substitutability of emerging market assets, and the large size of interventions relative to currency market turnover in these countries, foreign exchange intervention could—in principle—have a sizeable effect on exchange rates.
Disyatat and Galati (2007) provide a review of the existing literature on the effectiveness of intervention in emerging market countries. BIS (2005) contains descriptive case studies for a large number of emerging economies.
Recent cross-country empirical evidence, using monthly changes in gross reserves as a proxy for intervention operations, suggests intervention is unlikely to be effective in dealing with capital flows. Using a sample of emerging markets and small advanced countries, IMF (2007a) finds that resisting nominal exchange rate appreciation through sterilized intervention is likely to be ineffective when capital flows are persistent. Looking at the experience of five managed-float countries (India, Indonesia, Korea, the Philippines, and Thailand) over the period 2000–2007, IMF (2007b) finds limited evidence of systematic links between exchange rates and intervention. The authors also find mild evidence that intervention may be associated with lower exchange rate volatility.
Ho and McCauley (2003) provide an earlier analysis of the use of intervention in the context of money or inflation targets, while Mohanty and Turner (2006) discuss the possible distortions in the domestic financial caused by sustained sterilization efforts of central bank intervention. Edwards (2006) and Chang (2007) provide a discussion on whether the exchange rate should play a role in determining the monetary policy stance under inflation targeting in emerging markets, and analyze the rationale for reserve accumulation and foreign exchange intervention in these countries. More recently, Lavigne (2008) discusses the recent trends in sterilized intervention among emerging market economies, the fiscal costs associated to them and the recent increase in alternative sterilization methods, such as the rise in reserve requirement ratios.
This reform replaced a system of pre-announced exchange rate bands that had been in place since 1994 and was subject to speculative attacks during 1998-99. See Vargas (2005) for a detailed account of monetary policy since 1999.
A detailed description of the operational aspects can be found in Uribe and Toro (2004). Mandeng (2003) and Ramirez (2004) analyze the experience of options-based foreign exchange intervention in Colombia before 2004. The authors find that these have only been moderately successful in reducing exchange rate volatility.
A policy response to the appreciation was also deemed necessary because the appreciation was expected to reduce inflation significantly below the 2004 inflation target of 5.5 percent.
Historical data on official intervention is not available to the public at a daily frequency, and the BdR only publishes the aggregate monthly amount of its net purchases of dollars, ten days after the end of each month.
Under this mechanism, the Central Bank auctions call (put) options to sell (buy) foreign exchange for up to 180 million when the peso depreciates (appreciates) by more than 2 percent from its 20-day moving average. They expire one month after the auction date and can only be exercised when the official exchange rate is above (US$ call) or below (US$ put) its 20-day moving average. During this period, the volatility rule was triggered 11 times and led to a net reduction of reserves of US$360 million.
Almost two weeks later, in its official Communiqué dated January 26, the BdR made public its determination to carry out ‘massive’ foreign exchange rate intervention, aimed at preventing what the central bank perceived as temporary appreciation pressures derived from the conversion of large privatization revenues to the domestic currency.
Over the whole sample period, the BdR accumulated approximately US$ 11 billion through discretionary intervention operations, almost doubling the amount outstanding in September 2004. As a share of short-term debt, reserves rose from 92 percent in September 2004 to 172 percent in April 2007.
Central banks in several developing countries (Croatia, Czech Republic, Mexico and South Africa, among others) have at times engaged in “passive intervention”, i.e., outright transactions conducted off-market aimed at insulating the foreign exchange market from large external receipts (such as oil revenue sales by state owned enterprises, proceeds from privatization revenues, foreign aid or surrender requirements). Moreno (2005) notes that in Mexico, for example, the Mexican oil company Pemex can only acquire pesos by depositing its dollars at the central bank.
In other words, simultaneous observation of foreign exchange purchases and domestic currency appreciation cannot be interpreted as evidence that intervention was ineffective. For instance, in the absence of intervention, the exchange rate might have followed a more appreciated path. The lack of a counterfactual is typical of policy evaluation, as described in the literature of treatment effects (see Imbens, 2004, for a recent survey). However, in the case of the exchange rate intervention literature, the problem is compounded by the lack of a consensus model on exchange rate determination to estimate the counterfactual.
The same methodology is used in Guimarães and Karacadag (2004) and Disyatat and Galati (2007). For recent reviews of the empirical literature on the impact of foreign exchange interventions on the level and variance of exchange rates, see Hutchinson (2003) and Neely (2005).
Other authors (most notably, Fatum and Hutchison, 2003) have used an event—study approach to analyze the effectiveness of intervention. This methodology, however, is well suited when interventions take place only sporadically—which is not the case in Colombia, as described above.
The order of the moving average representation has varied across studies. In the case of Colombia, I set it to a 20-day moving average, which is the trigger used in operations with options under the rules-based intervention scheme.
Market expectation is measured as the median forecast of the monthly inflation value culled from opinion surveys conducted by Bloomberg News Service. The surveys are taken very close to the time of the announcement, and ask about expectations of the change in domestic CPI over the previous month.
The nominal exchange rate data is provided by the BdR and corresponds to the value-weighted average of all foreign exchange rate transactions in the spot market throughout the day (officially known as TRM, or Tasa Representativa de Mercado). The daily returns for the peso/dollar exchange is calculated as the difference in the logarithm of the exchange rate of two consecutive business days. Table A1 in Appendix I reports various descriptive statistics on the unconditional distribution of exchange rate returns. All the series appear to have non-normal distributions, with significant linear and non-linear serial correlations, especially during the first period. Thus, I follow Baillie and Bollerslev (1989) and Dominguez (1998) and use a univariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model for the analysis.
This is measured in first differences to achieve stationarity.
During the discretionary intervention episodes, the intervention rule was triggered twice: on December 20, 2004 and on March 30, 2007. The empirical model above accounts for the impact of these automatic interventions in assessing the effects of discretionary intervention.
Given the reduced-form nature of the estimation, the framework can only identify the average response of exchange rate returns to intervention operations. It does not, however, identify a structural relationship or the channels through which intervention may affect exchange rates.
The distinction between unsterilized and sterilized intervention is important: changes in the monetary supply would naturally affect the exchange rate, so it would not be surprising to find that unsterilized intervention is effective in depreciating the currency.
Since the motivation for BdR intervention was not announced, the policy criteria of ‘leaning against the wind’ and ‘reverse the trend of appreciation’ are only indicative of actual policy intentions. However, the negative estimated coefficients on γ2 and γ3 conforms to our priors and those of market participants, as well as unofficial BdR statements.
Dynamic considerations did not play an important role in determining the intervention strategy used by the BdR in the first period.
The model seems to capture only a small fraction of the variance of the intervention variable as suggested by the R-square statistic, in particular during the first period. This may suggest that other variables not captured in the model—such as political factors—were also important. See Vargas (2005) for a discussion of political economy issues related to intervention.
These results are consistent with Toro and Julio (2006), who use ultra-high frequency data to analyze the impact of intervention on exchange rate dynamics in Colombia between 2004 and 2006.
Maximum likelihood estimation was carried out using the Berndt-Hall-Hall-Hausmann algorithm using Eviews 5.1 package. In all cases, the skewness and kurtosis of the standardized regression residuals indicate that the assumption of conditional normality in equation (2) does not hold. Therefore, robust standard errors using the method described in Bollerslev and Wooldridge (1992) were reported.
The appreciation of the Colombian peso in 2005 was fairly moderate and less acute than the corresponding appreciation that took place in other countries in the region such as Brazil and Chile.
This result is robust to modeling the GARCH(1,1) model with a different error distribution, such as the Student’s t or the Generalized Error Distribution.
The systematic relationship between the surprise component of macroeconomic releases and one-day exchange rate changes is noteworthy, given that the literature has pointed out that this connection is weak and hard to detect (Edison, 1997).
Results for the second period of intervention are consistent with the recent findings by Clarida and Waldman (2007), who look at the reaction of nominal exchange rates to inflation surprises using intra-daily data across 10 countries. The authors show that if a central bank has an inflation target that it implements via a Taylor rule, an unexpectedly high inflation announcement leads to a stronger domestic currency.
Consistent with market expectations, repo rates were reduced by an additional 50 basis points during 2005 (see Figure 2).
During the first discretionary intervention episode, 75 percent of the monthly announcements of inflation were higher than what the market was expecting. The average value of these positive inflation surprises was 0.25 percent. During the second intervention episode, however, all four inflation announcements between January 15 and April 30, 2007 were above market expectations and the average value of the inflation surprises was five times higher than during the first period (1.3 percent).
In unreported results, I find that the stabilizing effect on the exchange during the first intervention period was stronger after December 20, 2004, when the BdR reduced interest rates and simultaneously announced that interventions would continue indefinitely, with no predetermined amount or duration.
During the first period, monthly inflation announcements led to an economically significant drop in conditional volatility of exchange rates in the subsequent day. Interestingly, during the second period foreign exchange market uncertainty did not decrease in the day following the official announcement of inflation. As noted in Footnote 45, during the second period, the actual inflation rates announced were systematically underestimated by the market, possibly leading to major revision in expectations following these official announcements.
It is telling that— in spite of massive foreign currency purchases by the BdR that reached 4.53 billion dollars (39 percent of monetary base) in the first four months of 2007—the exchange rate continued its steep appreciation path, the second-highest among emerging markets during this period.
The rapid increase in inflation in early 2007—caused in part by supply shocks—may have made it difficult to detect the incompatibility between these goals. Inflation in Colombia was rising in early 2007, also due to food price shocks. When inflation is rising, it may not always be clear that the cause is excess demand or a temporary supply shock. If it is a supply shock, then intervention may not be perceived as incompatible with achieving the inflation target. Economic agents, however, appeared to have believed that excess demand pressures were present (especially coming from Venezuela), given the increase in inflationary expectations.
Offshore players shorted the dollar in the forward market to gain exposure to the Colombian peso, and indirectly to the prevailing interest rate differential. Kamil and Reveiz (2008) analyze in detail the role of derivatives markets as a conduit for this carry trade, and discuss its policy implications.
As opposed to the information on intervention operations, the net creditor position of the BdR is updated daily in the BdR’s official website. Thus, as the BdR soon approached a position in which it would become a net debtor, financial markets may have perceived that the scope for additional intervention would be coming to an end.
Speculative demand for the peso was also buttressed by the prospect that the underlying forces putting upward pressure on the real exchange rate (such as the improvement in the security situation, better terms of trade and strong inflows of foreign direct investment) were expected to persist over time.
Lall (1997) describes a theoretical model that resembles the experience of Colombia but in reverse, where forward markets are the main channel used by speculators to mount a speculative attack against the domestic currency in a fixed exchange rate regime.
That day, off-shore entities bought the equivalent of almost US$ 600 million in pesos forward, seven times the daily average in the previous six months. This attack against the dollar which was ultimately met by BdR’s foreign currency purchases in the spot market of US$740 million, or 7 percent of the monetary base (in a single day).
The possibility that large scale foreign currency purchases could eventually turn the BdR from a net provider of short-term liquidity to being a net borrower vis-à-vis the financial sector was correctly anticipated in Vargas (2005).
To preserve the control of monetary conditions, the BdR opened its own deposit facility on April 2, 2007 to mop up the excess liquidity from the financial system. Finding it increasingly difficult, however, to offset their massive purchases, the authorities decided to stop intervening on April 30, 2007. While in theory the BdR could have found additional ways of regaining control of the inter-bank rate (e.g., a special allotment of treasury bills or issuance of its own long-term bond), in practice, these were not conceived as options by monetary authorities. Since May 2007, BdR’s involvement in the foreign exchange market has been limited to controlling exchange rate volatility through the options mechanism.
Kumhof, Li and Yang (2007) analyze a small open economy model under inflation targeting, and show that an inflation-targeting regime can be also vulnerable to speculative attacks. In their model, however, the central bank intervenes to avert a currency depreciation and the attack depletes central bank’s reserves.
These special features set them apart from traditional first-generation currency crisis models (Krugman, 1979).
It is important to note that the strength of such a “speculative attack” depends on how attractive the country is as a destination for carry trade vis-à-vis other emerging market countries at that point in time. In the case of Colombia in 2007, conditions were very favorable for such inflows, with correspondingly large effects.
Much of the literature emphasizes that the high quasi-fiscal costs of intervention is what ultimately limits sterilization efforts. In Calvo (1991) and Calvo, Leiderman and Reinhart (1993), for example, it is argued that resisting currency appreciation keeps domestic money market interest rates high, attracting more inflows and thus continuously increasing the need for sterilization. Eventually, the cost of sterilization rises to unsustainable levels and must be abandoned.
Using a novel identification strategy, Kearns and Rigobon (2005) exploit exogenous structural breaks in the Japanese and Australian authorities’ intervention strategies to estimate the effects of central bank intervention. Their identification method, however, hinges crucially on the assumption that the parameters of the authorities’ intervention reaction function are stable across periods— something that is very difficult to justify in the Colombian case in light of the evidence presented in Section V.
As in the previous section, I also use a two-stage instrumental variable model based on estimates of the BdR’s reaction function. Results from the first-stage are available upon request.
The median daily value of the predicted probability of intervention using the Probit model is 0.84 and 0.74 during the first and second period, respectively.