Central Bank Intervention and Inflation Targeting in Emerging Markets
By Herman Kamil
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. Thus, limiting currency appreciation—while at the same time controlling inflation—is posing a policy dilemma for many emerging market countries. As such, identifying the effectiveness of intervention, and the circumstances under which it can be a useful policy tool, are key questions for economic policy today.
As of April 2008, nine out of thirteen Latin American and Asian emerging market economies intervened in foreign exchange markets. Widespread central bank intervention seems to reflect the predominant view among policymakers that intervention is a useful policy tool to influence real exchange rates. Indeed, according to a 2005 study of the Bank of International Settlements, 85 percent of those policymakers interviewed characterized their interventions as being effective most of the time. However, while an extensive literature on intervention exists for advanced economies, much less is known about the effectiveness of foreign exchange intervention as an independent policy tool in emerging markets.
In a recent paper , I add to this literature by examining Colombia’s experience with central bank foreign exchange intervention under an inflation targeting regime, between 2004 and 2007. During most of this period, the Central Bank of Colombia (Banco de la República, henceforth BdR) engaged in large-scale, discretionary purchases of foreign exchange to resist appreciation of the domestic currency, making it an interesting case study for assessing the efficacy of such efforts. The paper focuses on two central questions: (1) How effective was BdR’s intervention in stemming domestic currency appreciation in Colombia? (2) What constraints—if any—did the inflation-targeting regime pose on the BdR’s ability to influence the currency?
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, the magnitude of intervention operations cannot be inferred simply from changes in reserves). Moreover, it is often not possible to know, a priori, whether the authorities accumulate international reserves with the intent of affecting the exchange rate or for other reasons, such as self-insuring against external financial shocks.
In this study, I use a new data set that includes official statistics on daily foreign exchange intervention by the BdR. A key advantage of the intervention data used in this study is that it accurately reflects discretionary purchases of dollars made with the explicit intention to depreciate the value of the domestic currency vis-à-vis the U.S. dollar. As constructed, this data set excludes changes in reserves for reasons other than—and not related to—influencing the level of the exchange rate. This allows a cleaner identification of the impact of central bank intervention on the exchange rate.
Besides the availability of a novel dataset, Colombia offers an ideal case to study the effects of central bank intervention in foreign exchange rate markets and derive policy lessons, 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. Second, the period under study is punctuated by frequent, and at times large, discretionary purchases of foreign exchange to resist domestic currency appreciation. Figure 1 below shows the two distinct episodes of discretionary intervention in the foreign exchange rate market analyzed in the study: the first period, spanning from September 2004 to March 2006, and a more recent period from January 2007 to April 2007. During these periods of intervention, BdR activity took place on almost 70 percent of business days and the scale of official intervention was significant relative to the daily turnover in the market, reaching 50 percent on some days.
Colombia is also an interesting case study because the two periods of discretionary intervention considered here are associated with two very different stances of monetary policy. The first period was characterized by constant or falling interest rates and a loosening of monetary policy. The second discretionary intervention episode, in turn, was marked by a tightening of monetary policy and an increase in nominal interest rates to reduce inflationary pressures in an overheating economy (see Figure 2 below). This provides an ideal setting to analyze the interplay between monetary policy and exchange rate policy decisions under inflation-targeting regimes. In particular, the Colombian case 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.
This paper’s results suggest that the effects of BdR intervention varied sharply across the two periods. During the first period of discretionary intervention (September 2004–March 2006), BdR foreign currency purchases had a statistically significant, positive impact on the exchange rate level, i.e., intervention led to a more depreciated exchange rate. However, while discretionary intervention was successful in moderating the appreciation trend, the effect of BdR’s foreign currency purchases on daily exchange rate movements was economically small and short-lived. As such, substantial amounts of sterilized intervention were required to have a quantitatively important impact on exchange rate dynamics.
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 increases in domestic interest rates and the market’s reaction to higher-than-expected inflation announcements—both of which tended to appreciate the currency. Thus, during this period, sterilized intervention did not provide an independent channel for monetary policy.
The results suggest that coherence between intervention policy and inflation objectives was a critical factor in determining the success of discretionary intervention. During the first intervention episode, no contradiction existed between monetary and exchange rate policies. Purchases of international reserves were made in the context of decreasing policy rates and an economy operating below potential capacity. Because macroeconomic objectives were well aligned, foreign currency purchases credibly signaled an easing of monetary policy and the BdR was able to stem appreciation pressures without undermining its ability to meet the inflation target (see Figure 3). Thus, Colombia’s experience between 2004 and 2006 indicates that an inflation-targeting regime can be credible and effective even though the exchange rate regime is not an entirely clean float.
During the second period, however, tension existed between monetary and exchange rate policy goals. The BdR was torn between a concern for price stability in an overheating economy, on the one hand, and concern over the rapid pace of appreciation of the exchange rate, on the other. The BdR sought simultaneously to maintain price stability by raising interest rates, and preserve competitiveness by resisting currency appreciation. Rising interest rate had the consequence of attracting more capital inflows, thereby exacerbating appreciation pressures. At the same time, resisting currency appreciation (which typically feeds into lower domestic prices of imported goods) worked at cross-purposes with the goal of containing inflation.
In this environment, markets perceived the BdR as pursuing two mutually inconsistent—and ultimately unsustainable—goals. Using estimates on the domestic currency’s response to unexpectedly high inflation announcements, I show that markets expected monetary policy to remain firmly committed to the goal of reducing inflation—even if that meant increasing interest rates and, thereby, undoing intervention efforts. Foreign investors, realizing that the central bank would eventually focus on taming inflation (and eventually let the exchange rate appreciate), took unprecedented amounts of leveraged bets against the central bank (and the dollar) in the derivatives market—thereby limiting the effectiveness of intervention. Paradoxically, then, the BdR’s perceived strong commitment to inflation actually undermined its ability to influence the exchange rate.
These results have important implications for policy design. The Colombian case suggests that successful intervention to stem domestic currency appreciation may be particularly difficult for an inflation targeter at advanced stages of the business cycle. The commitment to an inflation target limits the scope for lowering 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 its currency has, in theory, a large supply of “ammunition” (i.e., printing money to buy reserves), the inflation objective can in practice become a binding constraint that puts a limit to the amount of foreign reserves that a central bank can accumulate.
More generally, Colombia’s experience provides useful policy lessons for other emerging markets facing the challenge of resisting domestic currency appreciation while at the same time controlling inflation. The analysis yields three key results. First, discretionary intervention can only be successful when there is no conflict between exchange rate and inflation objectives. In particular, central bank’s discretionary intervention to resist currency appreciation is likely to be effective when the economy is operating below full capacity and thus monetary easing is consistent with meeting the inflation target.
Second, the case of Colombia highlights the practical limits to sterilization of reserve accumulation when the macroeconomic cycle calls for tightening monetary policy. Much of the literature emphasizes that the high costs of sterilization is what ultimately limits intervention efforts. Yet, the actual constraint faced by policymakers in Colombia in offsetting the monetary consequences of intervention was not given by the quasi-fiscal costs of intervention, but rather by the central bank’s net creditor position vis-à-vis the financial system. 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 to its desired level if the monetary authority is a net lender of liquidity to the financial sector. With the BdR undertaking large-scale intervention in the first months of 2007, the BdR quickly reduced its stock of treasury bills and, by mid-march 2007, reversed its position from being a net creditor, to being a net debtor to the financial system (see Figure 4 below). This made it more difficult to control inter-bank rates. This is evident in the behavior of policy and inter-bank interest rates in Figure 4. While the average inter-bank rate tracked very closely the reference rate until the end of March 2007, the inter-bank interest rate drifted below and away from the BdR’s lending rate after that. This stifled the primary transmission channel of monetary policy and layed the groundwork for the demise of intervention efforts a month later.
Third, when one-sided, protracted discretionary intervention is perceived as unsustainable, inflation targeting regimes may be vulnerable to speculative attacks against the central bank—but attacks that appreciate the currency. Such attacks may occur in the derivatives market rather than in the spot market, as speculators leverage massive bets on appreciation of the domestic currency. Predicting that sterilization efforts would become unsustainable, offshore entities speculated heavily on a real exchange rate appreciation by building-up large long-positions in pesos through the onshore forward market. The turnover value in peso forwards bought by off-shores to local banks increased more than three times between end-2006 to its peak in March 2007 (see Figure 5 below). The size and speed of execution of this leveraged market positions substantially reduced the ability of the central bank to influence exchange rate market conditions by buying international reserves. In summary, with financial systems in emerging markets growing in depth and sophistication, inconsistencies in monetary policy objectives are eventually arbitraged in the derivatives markets, thereby limiting the effectiveness of intervention.
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 and effectiveness of intervention strategies.