FRBSF Economic Letter
2003-20; July 18, 2003
Is Official Foreign Exchange Intervention Effective?
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific Basin Monetary
and Economic Studies within the FRBSF's Economic Research Department.
Many governments have intervened in foreign exchange markets to try to
dampen volatility and to slow or reverse currency movements. Their concern
is that excessive short-term volatility and longer-term swings in exchange
rates that "overshoot" values justified by fundamental conditions
may hurt their economies, particularly sectors heavily involved in international
trade. And the foreign exchange market certainly has been volatile recently.
For example, one euro cost about $1.15 in January 1999, dropped to only
$.85 by the end of 2000, and recently climbed to over $1.18. Over this
same period, one U.S. dollar bought as much as 133 Japanese yen and as
little as 102 yen—a 30% fluctuation. Many other currencies also experienced
similarly large price swings in recent years.
Official intervention in the foreign exchange market means that the central
bank or other agent of the government buys or sells foreign currency in
an attempt to influence the exchange rate value. Purchases of foreign
exchange usually are intended to push down the home currency value of
the exchange rate, and sales usually are intended to push it up.
Conventional academic wisdom holds that "sterilized" interventions
have little impact on the exchange rate and are a waste of time and of
the government's foreign exchange reserves. In a sterilized intervention,
the central bank offsets the purchase or sale of foreign exchange by selling
or purchasing domestic securities so as to keep the domestic interest
rate at its target. Since the domestic interest rate usually is considered
the main determinant of the value of the domestic currency, many argue,
it must change in order to influence the exchange rate. However, a body
of work by Fatum and Hutchison—summarized in this Economic Letter—suggests
that sterilized intervention is more effective than commonly believed.
Governments still intervene
 Despite
academic skepticism, many central banks intervene in foreign exchange
markets. The largest player is Japan (Figure 1). Between April 1991 and
December 2000, for example, the Bank of Japan (acting as the agent of
the Ministry of Finance) bought U.S. dollars on 168 occasions for a cumulative
amount of $304 billion and sold U.S. dollars on 33 occasions for a cumulative
amount of $38 billion. A typical case: on Monday, April 3, 2000, the Bank
of Japan purchased $13.2 billion of dollars in the foreign exchange market
in an attempt to stop the more than 4% depreciation of the dollar against
the yen that had occurred during the previous week.
These magnitudes dwarf all other countries' official intervention in
the foreign exchange market—exceeding U.S. intervention over the
same period, for example, by a factor of more than 30. It is also much
greater than German Bundesbank intervention operations when it had been
responsible for exchange rate policy. Over September 1985 to December
1995, the Bundesbank intervened in the mark/dollar exchange rate market
on a total of 234 days—selling dollars on 169 days (for a total of
$18 billion) and purchasing dollars on 65 days (for a total of $9.5 billion).
Since the introduction of the euro in January 1999, the European Central
Bank has been very reluctant to intervene in the foreign exchange markets,
doing so only four times in late 2000 (buying euros and selling dollars)
in an attempt to stem the slide of its currency at that time.
The magnitudes of these interventions—even those by the Bank of
Japan—are very small compared to overall market transactions in the
foreign exchange market. The Bank for International Settlements survey
on foreign exchange market activity in April 2001, for example, reports
that average daily transaction value amounted to $1.2 trillion (U.S.)
in "traditional" instruments and $387 billion in spot market
transactions alone.
Because the magnitudes of official intervention are small, and because
few studies have found evidence supporting a link between intervention
and exchange rates, many professional economists tend to be skeptical
about whether official intervention could play an important role as an
effective policy instrument to influence exchange rates. Does this mean
that official intervention policies—especially Japan's—are misguided
and that central bankers are irrational? Or is evidence showing the effectiveness
of sterilized intervention being overlooked?
New methodology
Fatum and Hutchison (2002, 2003a, b) and Hutchison (2003) report new
empirical work investigating the effectiveness of intervention operations
using daily data from the German Bundesbank, the Bank of Japan, the European
Central Bank, and the Federal Reserve. By contrast with other studies,
this research finds that official intervention is effective when used
selectively and directed to short-run objectives. Active exchange rate
management is alive and well, as long as the authorities have limited
objectives, cooperate with other central banks, and are persistent!
The studies look at intervention "episodes"—periods of
several days running when intervention is intense and persistent—and
link intervention with systematic exchange rate changes. One example of
a single event is the three consecutive days of the Bank of Japan's intervention
on December 17-19, 1997 (during which a total of $8.2 billion in U.S.
dollars were sold—and yen purchased—to support the yen exchange
rate).
Once these separate intervention "episodes" or "events"
are identified, the authors analyze the subsequent effect on the exchange
rate. Using several criteria for "success," they find that intervention
operations are usually successful in either slowing or reversing the direction
of exchange rate change—the objective of most central banks—over
periods of up to two weeks. (The success criteria are based on changes
in either the level or rate of change in the exchange rate in the days
following the intervention operation, compared to those prevailing prior
to intervention.)
Evidence of effectiveness
The authors identified 34 intervention episodes (yen sales or purchases)
by the Bank of Japan between April 1991 and December 2000 of which 24
were successful. The odds that this rate of success is random are less
than 1%. Similarly, they identified 26 intervention episodes (deutsche
mark sales or purchases) by the German Bundesbank between 1985 and 1995
(daily data) in response to either an appreciating or depreciating currency
of which 24 were successful. Again, the odds of this rate of success being
"random" are less than 1%.
Not surprisingly, intervention supported by central bank interest rate
changes has an even larger impact than intervention alone—but both
are effective in moving exchange rates. Similarly, cases where intervention
was coordinated between the Bank of Japan and the Federal Reserve or the
Bundesbank and the Federal Reserve—that is, where both central banks
were in the market at the same time—had a larger impact on exchange
rates than unilateral foreign exchange operations. (Episodes of coordinated
intervention are rather rare, however, as the Fed has intervened in the
foreign exchange market against the yen on only 22 occasions during the
sample period.) Furthermore, the likelihood of success was greater the
larger the volume of intervention and the longer the central bank was
persistently "in the market."
Why do these studies find that intervention is effective in moving the
exchange rate over periods of several days to several weeks when other
studies have failed to find a link? The main reason is methodological.
Previous work has tried to link the intense and sporadic bursts of intervention
activity episodes that occur infrequently to exchange rates that change
almost continuously on a daily basis. (Too few intervention episodes relative
to the overall size of the sample give low power in statistical tests).
The episodic approach employed by Fatum and Hutchison—an "event
study" framework—is better suited to detecting statistical linkages
in this circumstance, as long as the focus is on short-term exchange rate
changes.
Caveats
There are costs and benefits to using any methodology, and the great
benefit of the event study approach is that it can find a connection in
a simple and intuitive way between intervention and exchange rate fluctuations.
One drawback, however, is that an event study approach does not help
identify the particular channel through which intervention works; that
is, it cannot say much about why intervention works, in terms of distinguishing
among alternative explanations. The event study findings are consistent
with recent literature interpreting intervention as a means to "signal"
future monetary policy and the central bank's views on the fundamental,
or equilibrium, value of the exchange rate. But the findings also may
be consistent with other channels of transmission through which central
bank intervention moves exchange rates. A second drawback is that an event
study methodology in our context is really useful only in analyzing the
short-run linkages between intervention and exchange rates—up to
a one month period with this sample of daily data. If the period of investigation
following the event is too long (for example, longer than three to four
weeks), then one episode of intervention runs into another, and a clear
identification of separable events is not possible.
Policy implications
Policymakers often are constrained in their use of fiscal and monetary
policy to influence exchange rate values. Sterilized intervention is one
additional instrument that may help. The body of literature reviewed here,
based on event study methodologies, suggests a role for sterilized intervention
in the short run. An even stronger case may be made for concerted or coordinated
sterilized intervention policy.
These results shed light on why central banks continue to pursue sterilized
intervention despite widespread academic skepticism over its effectiveness.
Intervention events—when viewed as a related set of daily intervention
operations—appear to influence exchange rates in the short run. These
effects are likely to be missed in the standard time-series analysis that
generally have been used in this context.
Sterilized intervention may be especially useful when the exchange rate
is under speculative attack (that is, when a change in the exchange rate
is not justified by fundamentals) or to help coordinate private sector
expectations. Recent research has emphasized that several equilibrium
exchange rate values may be consistent with the same set of "fundamentals"
but with different sets of private market expectations (see, for example,
Obstfeld 1996). In these cases sterilized intervention may play a particularly
important role since it can move the market toward the desired point without
changing such fundamentals as monetary policy.
The empirical evidence discussed here supports only the short-run effectiveness
of intervention. Therefore, the results should not be interpreted as a
rationale for intervention as a longer-term management tool for exchange
rates that supplants more fundamental policy actions. Nonetheless, in
many cases the effectiveness of intervention in the short run may be all
that is needed.
Michael Hutchison
Visiting Scholar, FRBSF, and
Professor of Economics, UC Santa Cruz
References
Fatum, Rasmus, and Michael M. Hutchison. 2002.
"ECB Foreign Exchange Intervention and the Euro: Institutional Framework,
News, and Intervention." Open Economies Review 13(4), pp.
413-425
Fatum, Rasmus, and Michael M. Hutchison. 2003a. "Effectiveness
of Official Daily Foreign Exchange Market Intervention Operations in Japan."
NBER Working Paper 9648 (April). http://www.nber.org/papers/w9648 [URL
accessed July 2003.]
Fatum, Rasmus, and Michael M. Hutchison. 2003b. "Is
Sterilized Foreign Exchange Intervention Effective After All? An Event
Study Approach." The Economic Journal pp. 390-411.
Hutchison, Michael M. 2003. "Intervention and
Exchange Rate Stabilization Policy in Developing Countries." International
Finance 6, pp. 41-59.
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