This paper quantifies the dynamic effects of fiscal policy using a structural model, the Global Integrated Monetary and Fiscal Model (GIMF). The analysis finds that success of fiscal policy in enhancing macroeconomic stability depends on the type of shock, the response of monetary policy, and the length of fiscal policy implementation lags. The paper also presents the basic structure of the Bayesian VAR describing its empirical implementation and the estimation results and results from the conditional forecasting exercise and remarks. It also assesses Colombia’s experience with central bank foreign exchange intervention between 2004 and 2007.

Abstract

This paper quantifies the dynamic effects of fiscal policy using a structural model, the Global Integrated Monetary and Fiscal Model (GIMF). The analysis finds that success of fiscal policy in enhancing macroeconomic stability depends on the type of shock, the response of monetary policy, and the length of fiscal policy implementation lags. The paper also presents the basic structure of the Bayesian VAR describing its empirical implementation and the estimation results and results from the conditional forecasting exercise and remarks. It also assesses Colombia’s experience with central bank foreign exchange intervention between 2004 and 2007.

III. Is Central Bank Intervention Effective Under Inflation Targeting Regimes? The Case of Colombia30

A. Introduction

1. A decade after many emerging market countries battled currency crises, they now face the challenge of adjusting to rapidly appreciating currencies. To protect the competitiveness of their tradable sectors, many central banks have tried to resist domestic currency appreciation by intervening heavily in currency markets, typically through the accumulation of international reserves. At the same time, many of these same countries have adopted inflation targeting regimes to anchor inflation expectations, most often using short-term interest rates as their main operating target. Controlling inflation—while at the same time limiting currency appreciation—has posed a policy dilemma for many emerging market countries in the last five years (see IMF, 2007a, 2007b, 2007c).

2. In light of these developments, identifying the effectiveness of intervention and the circumstances under which it can be useful has key policy implications. 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, in principle intervention should have a sizeable effect on exchange rates. In this light, it often appears to be attractive tool to respond to surges in capital flows.31 Moreover, widespread central bank intervention reflects the predominant view among policymakers that intervention is a useful policy tool to influence real exchange rates (Neely, 2007). Indeed, according to a recent BIS study in 2005, 85 percent of those interviewed characterized their interventions as being effective most of the time (Mihaljek, 2004).

3. While there is an extensive literature on foreign exchange intervention for advanced economies, much less is known about its effectiveness as an independent policy tool in emerging markets. A major hurdle for doing research in emerging market economies has been the lack of official, high frequency data on central bank intervention operations (because of valuation changes, this cannot be inferred simply from changes in reserves). Moreover, it is often not possible to know, a priori, whether the authorities accumulate reserves with the intent of affecting the exchange rate, or for other reasons, such as self-insurance against external financial shocks.

4. In this paper, we assess the impact of sterilized intervention operations on the level and volatility of the nominal exchange rate in Colombia from December 2004 to April 2007. During most of this period, the central bank engaged in frequent—and at times sizable—discretionary purchases of foreign exchange, with the intended effect of depreciating the domestic currency. The paper focuses on two central questions: (i) How effective was central bank intervention in stemming domestic currency appreciation in Colombia? (ii) What constraints—if any—did the inflation targeting regime pose on the central bank’s ability to influence the currency?

5. To answer these questions, we use a new dataset with official statistics on daily foreign exchange intervention by the Central Bank of Colombia (Banco de la República, BdR).32 During the period under study, all official discretionary intervention operations were conducted in the spot market, and were automatically sterilized to achieve the operating target of monetary policy, the short-term interest rate. These intervention operations were not publicly announced.33 A key advantage of the intervention data used in this study is its accuracy: it includes discretionary purchases of dollars by the BdR that were made with the explicit intention to depreciate the value of the domestic currency vis-à-vis the dollar. As such, it excludes changes in reserves for reasons other than—but not related to—influencing the exchange rate.34 This allows a clean identification of the impact of central bank intervention on the exchange rate.

6. Besides the availability of a unique dataset, Colombia offers an ideal case to study the effects of central bank intervention in foreign exchange rate markets for at least three reasons. First, Colombia has faced strong exchange rate appreciation pressures. Between December 2006 and May 2007, for example, Colombia ranked as the country with the highest nominal domestic currency appreciation in the world—both vis-à-vis the U.S. dollar and in nominal effective terms.35 Second, and as shown in Figure 1 below, the period under study is punctuated by frequent, and at times large, discretionary purchases of foreign exchange to resist foreign currency appreciation. During the periods of discretionary intervention, BdR activity took place on almost 80 percent of business days and the scale of official intervention was significant relative to the daily turnover in the market, reaching 50 percent in some days. Through discretionary intervention operations, the BdR accumulated approximately 11 billion dollars, almost doubling the amount outstanding in December 2004. As a share of short-term debt, reserves rose from 92 percent to 172 percent between December 2004 and April 2007.

Figure 1.
Figure 1.

Central Bank Intervention Operations and Movements in the Nominal Exchange Rate

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

7. Finally, Colombia is also an interesting case study because the two periods of discretionary intervention considered here are associated with two very different stances for monetary policy (Figure 2).36 The first period, spanning from December 2004 to March 2006, was characterized by constant or falling interest rates and a loosening of monetary policy. The second discretionary intervention episode, from January to April 2007, was characterized by a tightening of monetary policy and an increase in nominal interest rates to reduce inflationary pressures.37 This provides an ideal setting to analyze the interplay between monetary policy and exchange rate policy decisions under inflation-targeting regimes. In particular, it provides an opportunity to test the hypothesis that discretionary intervention to stem domestic currency appreciation is more effective when there is consistency between monetary and exchange rate policy goals.

Figure 2.
Figure 2.

Central Bank Intervention and Movements in the Reference Rate

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

8. The paper’s results suggest that the effects of BdR intervention varied sharply across the two periods. During the first period of unannounced, discretionary intervention (December 2004–March 2006), BdR foreign currency purchases had a statistically significant, positive impact on the exchange rate level. i.e., higher intervention led to a more depreciated exchange rate. However, while discretionary intervention contributed toward moderating the appreciation trend, its effect was economically small and short-lived. As such, substantial amounts of sterilized intervention were required to have a quantitatively important impact on the nominal exchange rate.

9. During the second period (January–April 2007), however, BdR intervention did not influence the level of the exchange rate, even in the short term. In practice, intervention operations aimed at depreciating the currency were dwarfed by offsetting movements in the EMBI spread and the market’s reaction to higher than expected GDP and inflation announcements. Thus, during this period, sterilized intervention did not provide an independent channel for monetary policy, and may have also contributed to an increase in market uncertainty.

10. The results suggest that coherence between the intervention policy and inflation objectives was a critical factor in determining the success of discretionary intervention. During the first period, there was no contradiction between monetary and exchange rate policies. Purchases of international reserves were made in the context of a negative output gap and an expansionary monetary policy (that is, decreasing policy rates). For this reason, inflation expectations were not adversely affected by the intervention in the FX market, and the BdR achieved the inflation targets with remarkable precision (Figure 3). In this way, FX intervention and monetary policy maintained target consistency, which helped to increase both the effectiveness of intervention and the credibility of inflation targets (Figure 4).38

Figure 3.
Figure 3.

Evolution of Inflation and Inflation Expectations vis-à-vis the Inflation Target

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Sources: Banco de la República; and author’s calculations.
Figure 4.
Figure 4.

Credibility of the Inflation Target

(Survey done on April of each year)

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

11. During the second period, however, there was tension between monetary and exchange rate policy goals. To stem the appreciation of the peso, the BdR intervened aggressively, accumulating US$4.5 billion (38 percent of monetary base) in the first four months of 2007. At the same time, to cope with an overheating economy and inflation pressures, it steadily increased its policy interest rate. But this had the consequence of attracting more capital inflows, thereby exacerbating appreciation pressures. Markets thus perceived that the policy of large-scale foreign currency purchases was unsustainable and inconsistent with meeting the BdR’s inflation target, which may have contributed to inflation expectations being above the inflation target ceiling (see Figure 3).39 Foreign investors, realizing that the central bank would eventually focus on taming inflation (and eventually let the exchange rate appreciate), took unprecedented amounts of short dollar positions at short maturities in the on-shore forward market (see Figure 5).

Figure 5.
Figure 5.

Traded Value in Currency Derivatives Between Local Colombian Banks and Off-Shore Entities

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

12. The rapid increase in inflation in early 2007—caused in part by supply shocks—may have made it difficult to detect this incompatibility between these goals. Inflation in Colombia was rising in early 2007, also due to shocks to food prices. 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, given the increase in inflationary expectations. In any event, after inflation and exchange rate data clearly confirmed the incompatibility of such discretionary intervention, the authorities ceased intervening in early May 2007.40

13. These results have important implications for policy design. The Colombian case suggests that successful intervention may be particularly difficult for an inflation targeter, as the commitment to an inflation target limits the scope for allowing lower interest rates, and low upward exchange rate flexibility provides incentives for carry trade and leveraged bets on the currency through derivatives markets. Thus, while a government committed to reducing the value of the currency in theory has a large supply of “ammunition” (i.e., printing money to buy reserves), the inflation objective can in practice become a binding constraint that limits its ability to do so.41

14. The rest of the paper is organized as follows. Section B provides a literature review, while Section C delineates the empirical strategy. Section D explores the motivations for the central bank to intervene in the foreign exchange market and presents the main results. Section E discusses the limits to sterilization and the role of derivatives markets in blunting intervention operations. Section F concludes.

B. Literature Review

15. There is a large literature exploring the efficacy of sterilized intervention policy in developed economies.42 Overall, the evidence suggests that sterilized interventions by industrial countries have, at times, effectively influenced currency values.43 However, these effects are typically statistically significant but economically small. The literature for advanced economies concludes that intervention systematically moves the spot exchange rate only if it is publicly announced, coordinated across countries, and consistent with the underlying stance of fiscal and monetary policy. A number of papers have additionally examined the influence of intervention operations on daily exchange rate volatility and generally find evidence that intervention increases volatility. That is, for the major currencies, evidence that sterilized intervention dampens volatility is weak.44

16. The literature on the effectiveness of intervention in emerging markets is still sparse, in large part because governments have been reluctant to provide official data on their operations. Few empirical papers analyze central bank intervention at daily frequencies in developing countries, and existing studies generally find mixed results on its effectiveness.45 Domac and Mendoza (2002) conclude, in the context of Mexico and Turkey in the period 2001–02, that central bank foreign exchange sales (but not purchases) were generally effective in influencing the exchange rate in both countries. Disyatat and Galati (2007) also find weak evidence that intervention is effective in the Czech Republic. In contrast, Tapia and Tokman (2004) found that actual intervention appeared to have a generally insignificant effect on contemporaneous exchange rate movements.46 Guimarães and Karacadag (2004) find that in Mexico, foreign exchange sales had a small impact on the exchange rate level, but not in Turkey.47 With respect to the impact of intervention on exchange rate volatility, Domac and Mendoza (2002) find that intervention reduced exchange rate volatility in both countries. In contrast, Guimarães and Karacadag (2004) find that intervention tends to increase exchange rate volatility.48

17. 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-floating countries—India, Indonesia, Korea, the Philippines, and Thailand—over the period 2000–07, 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.

C. Empirical Strategy

18. Assessing the effectiveness of intervention is complicated by two empirical challenges. First, it is not possible to directly observe the counterfactual—i.e., what would have been the exchange rate movement if intervention had not occurred, in days when the authorities did in fact intervene.49 Second, disentangling the causal effect of intervention is further complicated by the fact that the decision (and amount) of intervention may be endogenous to past exchange rate movements. That is, the central bank is more likely to buy foreign currency when the domestic currency is strengthening. Failing to account for the simultaneity of exchange rate and intervention is likely to bias towards finding no impact of intervention on the exchange rate.

19. To overcome this identification problem, we use a two-stage instrumental variable model based on estimates of BdR’s reaction function.50 For each period of discretionary intervention, we estimate a foreign exchange intervention function for the amount of intervention. We then use the predicted values from the first stage as an instrument for actual interventions, in a reduced-form model of exchange rate returns allowing for GARCH effects in the conditional variance.

20. In the first-stage, we describe the foreign exchange intervention policy as a dynamic censored regression (Tobit) model of the following form51:

INTt=max(0,γ0+γ1INTt1+γ2(lnst1lnst1T)+γ3(σt1σ))+εt(1)

where INT denotes the amount of dollar purchases and st is the nominal exchange rate (expressed in terms of local currency per U.S. dollar, such that a positive change is a depreciation of the Colombian peso). Our model links the amount of intervention to the deviation of the current exchange rate and conditional volatility from their respective target values. sT is the (time-dependent) ‘target’ nominal exchange rate, to be defined below. σ is the average conditional variance, i.e., the unconditional variance, so that the regressor (σt – σ) reflects the deviation of current conditional volatility from average volatility. In addition, and because interventions usually come in clusters, we include the lagged dependent variable as a regressor to account for persistence effects.

21. We model the target exchange rate as the weighted average of two past representative exchange rates. These comprise the exchange rate level in the previous day and its backward looking moving average. Thus, deviations from the target (in percentage terms) are given by:

(lnstlnstT)=γ21(lnstlnst1)+γ22(lnstj=122stj22)(2)

22. We thus allow interventions to be motivated by two components: a very short-term one (daily fluctuations in the exchange rate), and a moving average component. The latter can be thought of as representing past levels of the exchange rate.52 This enables us to test whether the central bank systematically “leaned against the wind” and tried to smooth deviations from the past-month moving average.53

23. In the second stage, we estimate a GARCH (1,1) model of the peso-dollar exchange rate return that is estimated with the following general specification.54

Δ(lnst)=μ+γ1Δ(lnst1)+β1INT¯t+β2(ir*)t+β3Δ(EMBIspread)t+t=13δiUNEXPit+tt=14λiDit+δ5PostHt+εt(3)
εt|Ωt1N(0,σt2)(4)
σt2=α0+α1σt12+α2εt12+α3INTt+α4(ir*)t+α5Δ(EMBIspread)t+t=13δi|UNEXPit|+t=14δiDit+δ5PostHt+εt(5)

where: Δ(ln s) is the daily percentage change in the nominal exchange rate; INT¯ is the indicator of central bank intervention in the FX market, as explained above; (i -r*) is the interest rate differential between the domestic interbank rate and the US Fed’s fund rate, in percent per year; EMBI spread is the yield spread on a sovereign foreign currency bond over a comparable U.S. treasury bond in percent per year;55 UNEXPi captures the impact of the unexpected component of public releases of macroeconomic information (i = real GDP growth, policy rate and inflation),56 Dit are day of the week dummy variables (for example, D1t = 1 for Mondays, where Friday is the omitted category); PostHt is a holiday dummy variable that is equal to one on the day following the market being closed for any reason other than a weekend; and εt is the unexpected return which is used to model the conditional volatility of the exchange rate in the volatility equation (3). Finally, σt2 is the conditional variance and allows for the possibility of time-varying conditional volatility and clustering. The conditional distribution of the disturbance term is normal with variance σ2

24. Several features of the specification are worth noting. Equation (3) of the empirical model (the “mean” equation) analyzes changes in the exchange rate return (depreciation or appreciation against the dollar) as a function of intervention, controlling for other factors affecting exchange rates at a daily frequency. Our main focus is on the estimate of β1, the contemporaneous impact of intervention on the exchange rate. If central bank intervention is effective, then purchases of the domestic currency (INT > 0) will depreciate the currency (Δ(lns) > 0) and soβ1, the parameter of interest, will be positive.

25. We control for other factors affecting exchange rates at a daily frequency. The interest differential aims to capture the possible impact of monetary policy actions and local money market conditions on the exchange rate. This is especially important during the first period, when the central bank was easing monetary policy.57 Yield spreads on sovereign external debt over a comparable U.S. treasury bond are included as a measure of country risk and foreign investor sentiment, which are possibly key determinants of demand for local currency.

26. Control variables used in the estimation also include those that capture the effect of news about macroeconomic or policy developments that may arrive on the same day on which intervention is carried out.58 When government agencies announce data measurements or policy decisions—GDP growth, inflation, benchmark interest rates, etc.—economic agents learn about the current value of fundamentals, and also revise their expectations of future fundamentals. “News” is the information contained in the announcement—the difference between the announced level of the economic variable and the market’s expectation.59

D. Summary of Results

Central bank reaction function

27. Results for the first period of intervention are consistent with the hypothesis that the BdR attempted to “lean against the wind,” i.e., slow or reverse the trend of appreciation (see Table 1).60 The negative coefficient conforms to our priors, and unofficial central bank statements, that an important motivation for the interventions during the first period was a desire to correct the deviation of the exchange rate from the (moving) target value. The point estimate implies that in response to a 1 percent deviation of the exchange rate with respect to target, the central bank is inclined to lean against the wind, purchasing on average US$17.2 million U.S. dollars to slow the appreciation.

Table 1.

Determinants of Central Bank’s Daily Discretionary Intervention in FX Spot Market

(Marginal Effect Estimates from Tobit Model)

article image
Source: Author’s calculations.Note: This table reports estimation of a Tobit model for equation (1) in the text. The dependent variable is the amount of dollars purchased (in millions) to influence the value of the currency. Estimated coefficients are the marginal effects of a unit change in the explanatory variables, evaluated at sample means. Asterisks denote significance of coefficients, with ***, ** and * indicating significance at the 1%, 5% and 10% level, respectively.

28. We also find during this period that the central bank did not intervene in response to a rise in market uncertainty. If anything, there is strong evidence that intervention during the first period was associated with a dampening of volatility. This pattern is consistent with the idea that the authorities engage in intervention to guide the exchange rate towards a target value (leaning against the wind), but not to lower market volatility (calming disorderly markets).61

29. The results suggest that during the second period, however, the Colombian authorities appeared to intervene solely in response to an acceleration of the speed of peso appreciation. The coefficient for the reaction on the short-term change in the spot exchange rate has the right sign and is statistically significant, suggesting that in 2007, the BdR reacts systematically to previous day exchange rate changes in deciding to intervene. The estimate of γ21 implies a large response by the BdR to changes in the exchange rate: a 1 percent appreciation would result in a 110 million dollar purchase the following day. In the second period, however, we find no evidence of a systematic link between intervention and excess volatility.

30. During the second period, foreign exchange interventions became highly correlated over time. The results suggest that once intervention was carried out one day, another intervention of similar magnitude was likely to take place in the following day.62 In fact, our results indicate that intervention on a given day is an excellent predictor of intervention the following day. This provides important insights into why intervention was ineffective in that period: as it became more predictable, it may have reduced the ability to surprise the market. In effect, market participants may have been better able to anticipate the central bank’s operations, especially considering the high frequency of intervention and that all interventions were carried out in the same direction.63

Effects on exchange rates

31. The estimates in Table 2 suggest that intervention during the first discretionary period had a moderately sizable effect on the exchange rate, in the direction intended by the authorities.64 65 The coefficient for the spot rate on current intervention is statistically significant. The coefficient for contemporaneous intervention, 1.067, implies that $100 million of purchases of U.S. dollars is associated (on average) with a 1.07 percent depreciation of the peso vis-à-vis the dollar. The response for Colombia is larger than most results in the literature, but closer to the calibrated impact of a 1.6 percent appreciation from a US$100 million of purchase of U.S. dollars in Domínguez and Frankel (1993a).

Table 2.

GARCH Model for Daily Nominal Exchange Rate Returns: Instrumental Variable Estimation

(Mean Returns Equation)

article image
Source: Author’s calculations.Note: This table reports estimation of the Mean Equation of the GARCH(1,1) model in equation (3)-(5) in the text. The dependent variable is the daily rate of change of the nominal exchange rate, in percent. Asterisks denote significance of coefficients, with ***, ** and * indicating significance at the 1%, 5% and 10% level, respectively.

32. Most of the effects of an intervention on the exchange rate in the first period occurred during the day in which it was conducted, with a smaller impact on subsequent days. In Table 3, we disaggregate the overall effect of intervention on exchange rates into specific effects on the first and subsequent days. The first day of official intervention is the most effective in moving the exchange rate, while the effects in successive days were more limited. Intervention operations did not have a lasting impact on exchange rate dynamics: almost 70 percent of the contemporaneous effect is reversed in two days.

Table 3.

GARCH Model for Daily Nominal Exchange Rate Returns: First and Subsequent Days Estimates (Mean Returns Equation)

article image
Source: Author’s calculations.Note: This table reports estimation of the Mean Equation and Conditional Variance Equation of the GARCH(1,1) model in equation (3)-(5) in the text, augmented with four lags of central bank purchases of dollars as regressors. Asterisks denote significance of coefficients, with ***, ** and * indicating significance at the 1%, 5% and 10% level, respectively.

33. The results also suggest that sterilized intervention operations were ineffective in influencing exchange rates during the second period. Results in Tables 2 and 3 indicate that intervention operations aimed at depreciating the currency had no statistically significant effect on the level of the exchange rate, at any horizon.

34. Exchange rates appear to be responsive to announcements of economic news. Two results stand out. First, news on GDP and inflation announcements had a significant impact on exchange rate dynamics, suggesting that fundamentals also drive the exchange rate at higher frequencies.66 Second, the effect of these announcements was exactly the opposite across periods (Table 2). During the first period, higher-than-expected inflation or GDP growth were on average associated with a depreciation of the peso. For the second period, however, the sign on the inflation and GDP surprise variables is negative and statistically significant, indicating that higher-than-expected inflation results in an immediate currency appreciation (a reduction in the nominal exchange rate). The point estimates are not small: for example, if GDP comes out 1 percentage point above expectations (year-on-year growth) during the second period, the estimated effect was to appreciate the peso by 0.33 percent daily.67

35. The differing reaction of markets to macroeconomic news releases provides new insights into the effectiveness of intervention. The fact that the peso consistently and significantly appreciated in response to unexpectedly high GDP growth and inflation, suggests that the markets apparently believed that—consistent with the predictions of the Taylor rule model—the central bank was likely to react to the announcements by increasing interest rates. That is, the announcement of a higher output gap induced traders to revise their expectations of future interest rates upwards. The prospect of an increase in domestic interest rates, in turn, made Colombian assets more attractive, inducing an immediate dollar depreciation (peso appreciation) to equilibrate the asset market. This provides insights into the reasons why intervention was ultimately not effective: markets expected that monetary policy would remain committed to the goal of reducing inflation, even if that meant increasing interest rates and thus undoing intervention efforts.

36. Also of interest is how central bank intervention affects exchange rate volatility. Volatility often reflects, among other things, uncertainty in economic policies and other fundamental determinants of exchange rates, which the market may be struggling to price accurately. As indicated by Domínguez (1998), central bank intervention is expected to reduce volatility as long as intervention is both credible and unambiguous. The results of Table 4 are consistent with this hypothesis. During the first period, BdR intervention had a powerful stabilizing effect on the exchange rate. Controlling for other factors affecting short-term exchange rate volatility, the results indicate that during the first period, BdR intervention dampened the volatility of exchange rate returns. This empirical finding is noteworthy, given that it is at odds with most of the intervention literature for developed economies. In contrast, during the second period, persistent, large-scale intervention led to increases in exchange rate volatility (especially in March and April of 2007), which suggests that official intervention may have added to market uncertainty during this period.

Table 4.

GARCH Model for Daily Nominal Exchange Rate Returns: Instrumental Variable Estimation (Conditional Variance Equation)

article image
Source: Author’s calculations.Note: This table reports estimation of the Conditional Variance Equation of the GARCH(1,1) model in equation (3)-(5) in the text. The dependent variable is the conditional volatility of the rate of change of the nominal exchange rate, in percent. Asterisks denote significance of coefficients, with ***, ** and * indicating significance at the 1%, 5% and 10% level, respectively.

E. Limits to Sterilization and the Importance of Derivatives Markets in Blunting Foreign Exchange Operations

37. Colombia’s experience also highlights the practical limits to sterilization of reserve accumulation when the macroeconomic cycle calls for tightening monetary policy. In 2007, the capacity of the central bank to sterilize intervention diminished over time, as its holdings of government securities dwindled and the central bank shifted from providing liquidity to being a net borrower vis-à-vis the financial sector. A net creditor position is regarded as more desirable for reasons of monetary control: in practice, a central bank is better positioned to move short-term interest rates if it is a net lender of liquidity to the financial sector.

38. With the BdR undertaking large-scale intervention in the first months of the year, it quickly reduced its stock of treasury bills and was soon close to a position where it would no longer be a net creditor to the financial system.68 The latter made it more difficult to control interbank rates and thus stifled the transmission channel of monetary policy.69 This is evident in the behavior of policy and inter-bank interest rates in Figure 6. While the average interbank rate tracked very closely the reference rate until the end of March 2007, the relationship weakened after that (see Figure 6).70

Figure 6.
Figure 6.

Net Creditor Position of the Central Bank vis a vis the Financial Sector and behavior of Interest Rates

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

39. 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. Investors knew that if the BdR became a net debtor of the banking system, this would greatly weaken their ability to conduct monetary policy, other things remaining equal. Under this scenario, the authorities would be forced to discontinue intervening, and the nominal exchange rate would appreciate on impact. This opened the door to massive one-way bets against the BdR by offshore entities, who built large long positions in pesos through the onshore forward market.71 Quite clearly, the sudden burst of derivatives trading that occurred at the end of March 2007 (see Figure 7) pushed the BdR into a net debtor position and laid the groundwork for the demise of intervention efforts a month later.

Figure 7.
Figure 7.

Derivative Markets Can Blunt Central Bank Intervention Operations When Policies Are Inconsistent

Citation: IMF Staff Country Reports 2008, 032; 10.5089/9781451808940.002.A003

Source: Banco de la República.

40. The results thus suggest that inflation targeting regimes may still be vulnerable to speculative attacks—but attacks that appreciate the currency. One of the major advantages of inflation targeting is often claimed to be that it does not leave an economy vulnerable to a speculative attack. The logic is that a run on reserves can be averted because the central bank can simply let the exchange rate go. In this paper we show that, if the policymaker is fully committed to the inflation target but at the same time intervenes aggressively to stop an appreciation in a manner that is not sustainable, this assertion is not generally valid. The case of Colombia shows that inflation targeting regimes can indeed experience speculative attacks—in this case, against the dollar.

41. There are several noteworthy characteristics of the Colombian experience of this “speculative attack” that may be instructive for other emerging market countries.72 First, they occur when the central bank is trying to prevent an appreciation of the currency, rather than a depreciation. Second, such attacks may occur not in the spot market, but rather in the derivatives market, by off-shores entities leveraging massive bets on the appreciation of the peso.73 Finally, the ability of the authorities to resist the attack is not determined by the level of reserves, as in the first-generation crisis models (indeed, they accumulate international reserves). Rather, there is a run is on the central bank’s net creditor position vis-à-vis the financial system.74

42. Overall, the Colombian experience shows that onshore derivatives trading can blunt foreign exchange intervention operations if forward markets are used actively as a substitute for portfolio investment. A sterilized intervention that goes against the perception of the majority of market agents has little possibility of success, and could actually lead to greater exchange rate volatility or financial instability as foreign investors engage in one-way bets on domestic currency appreciation.

F. Conclusions

43. How effective is central bank intervention in influencing the nominal exchange rate in emerging markets? This is a key question for economic policy today, as many emerging market economies have intervened heavily in FX markets, accumulating reserves on a massive scale in a deliberate attempt to limit the extent of exchange rate appreciation. While there is an extensive literature on this subject for advanced economies—with mixed results—much less is known about its effectiveness as an independent policy tool in emerging markets. This paper attempts to add to this literature by examining Colombia’s experience with central bank foreign exchange intervention between 2004 and 2007. During most of this period, the BdR engaged in large-scale, discretionary purchases of foreign exchange to resist the appreciation of the domestic currency, making it an interesting case study for assessing the efficacy of such efforts.

44. Our results suggest that the effectiveness of BdR intervention was substantially different across the two periods of discretionary intervention. During the first period of unannounced, discretionary intervention (December 2004–March 2006), we find statistically significant evidence that intervention affected the level of the exchange rate in the intended direction. Moreover, foreign exchange intervention moderated the appreciation of the peso vis-à-vis the U.S. dollar without undermining the central bank’s ability to meet the inflation target. During the first intervention episode, macroeconomic objectives were well aligned, and foreign currency purchases credibly signaled an easing of monetary policy. Thus, Colombia’s experience is indicative of the fact that an IT regime can be credible and effective even though the exchange rate regime is not an entirely clean float.

45. The Colombia experience in the first half of 2007, however, illustrates the limits of intervention as an independent policy instrument. During the second period of discretionary intervention, there was no detectable impact on exchange rate markets, as it was ineffective in moving the exchange rate in the desired direction. During this period, the BdR was torn between a concern for price stability, on the one hand, and a concern over the rapid pace of appreciation of the exchange rate, on the other. In this environment, markets perceived the BdR as pursuing two mutually inconsistent goals. The ineffectiveness and inconsistency of intervention thus became mutually reinforcing. We show that in this case, central bank intervention can be destabilizing, either by increasing uncertainty (i.e., increasing exchange rate volatility) or causing traders to speculate against the central bank (by increasing leveraged long peso positions in derivative markets).

46. We find strong support for the notion that intervention cannot systematically influence the level of the exchange rate when it creates conflicts with other goals of monetary policy that the public perceives as overriding. Paradoxically, it was the BdR’s perceived strong commitment to inflation that undermined its ability to influence the exchange rate: the market most likely believed the central bank would never subordinate its inflation objective to concerns about the exchange rate. In this context, the derivatives market appears to have played an important role in exploiting any inconsistencies in the objectives of monetary policy.

47. Additional research on the effects of intervention would be useful. Better data availability (especially at daily frequencies) and continued research into the motives, strategies, and channels for conducting foreign exchange market operations intervention in emerging markets countries could help provide more guidance on the appropriateness or effectiveness of intervention strategies.

Appendix

Table A1.

Summary Statistics on Daily Central Bank Intervention in the Foreign Exchange Market

article image
Sources: Author’s calculations based on data provided by the Banco de la Rep—blica.Note: Purchases are in millions of U.S. dollars. The first period goes from December 20, 2004 to March 1, 2006. The second period starts on January 15, 2007 and ends on April 30, 2007.

Number of days in which central bank intervened, as a fraction of total trading days.

Average magnitudes calculated over days on which intervention occurred.

The longest continuous stretch of central bank intervention within each sub-period.

Table A2.

Summary Statistics on the Unconditional Distribution of Daily Exchange Rate Returns

article image
Sources: Author’s calculations based on data provided by the Banco de la República.

The kurtosis statistic is normalized so that a value of zero corresponds to the normal distribution

QΔ(20) and QΔs2(20) are Ljung-Box tests tests for high-order serial correlation for the returns and square returns up to the 20th lag, respectively.

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30

Prepared by Herman Kamil.

31

It is also possible that central banks in emerging market countries have a better grasp of aggregate market conditions than domestic market participants, especially in those cases where local markets are not very sophisticated and remain highly segmented (see Canales-Kriljenko, 2003).

32

Data were kindly provided by the Banco de la República. 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. For that reason, the use of the daily data in this paper is subject to confidentiality agreements. Table A1 in the Appendix provides descriptive information about the central bank’s intervention operations examined in Section E.

33

Nor did the Central Bank officially confirm or deny reports in the financial press or wire services regarding its presence in the FX market.

34

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).

35

Apart from a weak U.S. dollar, much of the peso’s strength is driven by economic fundamentals, such as the improvement in the security situation and strong inflows of foreign direct investment.

36

The BdR adopted an Inflation Targeting (IT) scheme with a floating exchange rate in October 1999, after abandoning the crawling exchange rate band system in place since 1994. The IT strategy used the short-term repo interest rate as the main instrument of monetary policy. See Vargas (2005) for a detailed account of monetary policy since 1999.

37

From March 2006 until mid-January 2007, the government stopped discretionary purchases and only intervened in the foreign exchange (FX) market though FX options to smooth exchange rate volatility. The timing and amounts of these interventions were largely predetermined and known by market participants. A detailed description of the operational aspects, as well as an assessment on the efficacy of the options system, can be found in Uribe and Toro (2004).

38

Toro and Julio (2006) provide additional support for this conclusion.

39

Other factors include the steep rise in food prices and cross-border demand from Venezuela.

40

Subsequent analysis by the central bank has also noted the incompatibility of discretionary intervention at this stage of the cycle (BdR, 2007). Since May, the central bank’s involvement in the FX market has been limited to controlling exchange rate volatility through the options mechanism.

41

In contrast to a defense of the value of the domestic currency, where the stock of available reserves constrains the cumulative amount of intervention.

42

Edison (1993) surveys the literature from the 1980s through early 1990s; Sarno and Taylor (2001) provide a more recent survey of theory and empirical evidence.

43

Domínguez and Frankel (1993a) and Domínguez (2003a) 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.

44

Domínguez (2006) and Edison, Cashin, and Liang (2006) have 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).

45

Disyatat and Galati (2007) provide a comprehensive review of the existing literature on the effectiveness of intervention in emerging market countries.

46

However, public announcements of potential interventions had significant effects on the level and trend of the exchange rate in Chile.

47

Given policy objectives, however, such findings do not necessarily indicate the failure of intervention. For example, the bulk of intervention undertaken in Mexico during the sample period was aimed at accumulating reserves, rather than influencing the exchange rate.

48

Mandeng (2003) and Ramírez (2004) analyze the experience of options-based foreign exchange intervention in Colombia. The authors find that these have only been moderately successful in reducing exchange rate volatility.

49

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.

50

The same methodology is used in Guimarães and Karacadag (2004) and Disyatat and Galati (2007).

51

Edison (1993) and Almekinders (1995) survey empirical work on the determinants of intervention.

52

This is not to say that the latter is considered to be at a desirable level in the previous month.

53

This target has been commonly modeled as a moving average of the exchange rate in the past, where the order of the moving average representation varies across studies. In the case of Colombia, we set it to a 22-day backward moving average, which is close to the trigger used in operations with options under the rules based intervention for reducing volatility. Under this rule, the Central Bank auctions 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.

54

Table A2 in the Appendix 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. We thus follow Baillie and Bollerslev (1989) and Domínguez (1998) and use a univariate generalized autoregressive conditional heteroskedasticity (GARCH) model for our analysis.

55

This is measured in first differences to achieve stationarity.

56

To help distinguish the effect of intervention from the arrival of other relevant information, we constructed a new dataset for Colombia on news about macroeconomic variables announcements and policy decisions (as discussed below).

57

The distinction between un-sterilized and sterilized intervention is important: changes in the monetary stance would naturally affect the exchange rate, so it would not be surprising to find that un-sterilized intervention is effective.

58

Of the 43 different macro announcement dates that we have in the sample (with associated survey expectations), 58 percent of them coincided with central bank intervention.

59

Market expectation is measured as the median forecast of that value culled from opinion surveys conducted during the days preceding the announcements by Bloomberg News.

60

Since the motivation for BdR intervention was not announced, the policy criterion ‘leaning against the wind’ is only indicative of actual policy intentions.

61

This is consistent with the notion that the central bank uses other mechanical rules of intervention—based on options—to smooth exchange rate volatility.

62

Dynamic considerations did not play an important role in determining the intervention strategy used by the BdR in the first period.

63

The model seems to capture only a small fraction of the variance of the intervention variable, as suggested by the R-square statistic. This may suggest that other variables not captured in the model—like political factors—were also important. See Vargas (2005) for a discussion on the political economy issues related to intervention.

64

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 between 2004 and 2006.

65

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.

66

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).

67

The coefficient estimates in Table 2 can be interpreted as the effect of one percent surprise in the macroeconomic release on the exchange rate value of the dollar, in basis points.

68

While in theory the BdR could have found additional sources of financing (e.g., a special allotment of treasury bills or issuance of its own long-term bond), in practice this may have not been conceived of as an option by market participants, as evidenced by the behavior of financial markets as the BdR moved to a net debtor position.

69

Interestingly, this possibility was correctly anticipated in Vargas (2005).

70

The massive injection of liquidity due to foreign currency purchases became apparent in the money market in April, as the interbank interest rate drifted below and away from the central bank’s lending rate.

71

In turn, BdR intervention in FX markets made the Colombian carry trade more attractive, as intervention provided a counter party willing to take the long U.S. dollar risk. Kamil and Reveiz (2007) explain the mechanics underlying these carry trade operations, and discuss its policy implications.

72

These special features sets them apart from traditional first-generation currency crisis models (Krugman, 1979).

73

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.

74

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 unsustainably high levels and must be abandoned.

Colombia: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Central Bank Intervention Operations and Movements in the Nominal Exchange Rate

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    Central Bank Intervention and Movements in the Reference Rate

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    Evolution of Inflation and Inflation Expectations vis-à-vis the Inflation Target

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    Credibility of the Inflation Target

    (Survey done on April of each year)

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    Traded Value in Currency Derivatives Between Local Colombian Banks and Off-Shore Entities

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    Net Creditor Position of the Central Bank vis a vis the Financial Sector and behavior of Interest Rates

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    Derivative Markets Can Blunt Central Bank Intervention Operations When Policies Are Inconsistent