FX Intervention to Stabilize or Manipulate the Exchange Rate? Inference from Profitability

Summary

Focus 

Many central banks intervene in the foreign exchange rate market. Central banks generally claim that these interventions aim at stabilising the exchange rate, leaning against temporary excessive fluctuations. Yet critics argue that interventions are often geared at manipulating the exchange rate away from fundamental values, for example to gain a competitiveness advantage by keeping the exchange rate undervalued.

Contribution 

We examine the profitability of foreign exchange intervention to shed light on the underlying determinants. If foreign exchange intervention is used to lean against temporary excessive fluctuations – taking a long position in the local currency when temporarily undervalued and vice versa – intervention should be profitable in expectation. On the contrary, if intervention is used to resist adjustment to equilibrium levels, intervention should be costly.  

Findings 

We perform the analysis using data from Brazil. Brazil offers an ideal testing ground because the central bank intervenes in the foreign exchange rate market primarily using swaps. These instruments make it possible to transparently compute the expected returns on foreign exchange intervention. We find that intervention was considerably profitable in expectation during the 2013–22 period we analyse. Furthermore, the direction and size of the intervention were positively correlated with the expected profitability of the swaps. These findings suggest that intervention was aimed at stabilising the exchange rate against temporary excessive fluctuations rather than manipulating it away from fundamental levels.   

Abstract

We analyze the profitability of FX swaps used by the central bank of Brazil to shed light on the rationale for FX intervention. We find that swaps are profitable from an ex-ante perspective, suggesting that FX intervention is used to stabilize the exchange rate against temporary excessive fluctuations relative to UIP conditions. Consistent with this interpretation, we document that the direction and size of FX intervention respond to UIP deviations. We also find that FX intervention respond more aggressively to UIP deviations when there is less uncertainty about the future level of the exchange rate and when the exchange rate is overvalued.

JEL classification: E58, F31

Keywords: FX intervention, profitability, exchange rate