Foreign exchange intervention and financial stability

Summary

Focus

Managed floats remain the norm in middle-income countries - even among those that have adopted inflation targeting as their monetary policy framework. Moreover, the decision to intervene appears to be increasingly driven by the goal of limiting exchange rate volatility, rather than concerns about competitiveness, the degree of exchange rate pass-through or the need to build foreign reserves for precautionary reasons. At the same time, intervention has often been highly sterilised, with the goal of avoiding broader macroeconomic effects. However, even when sterilised, intervention can have an impact on macroeconomic fluctuations and systemic financial risks. Research on these issues has been limited, despite greater recognition in recent years of the interactions between macroeconomic and financial stability.   

Contribution

We study the effects of sterilised foreign exchange market intervention in a model with financial frictions and imperfect capital mobility. In the model, the central bank operates a managed float regime and follows a simple foreign exchange intervention rule that relates changes in its stock of foreign reserves to exchange rate movements. It also conducts sterilisation operations by issuing bonds held by commercial banks. Owing to economies of scope in managing bank assets, these bonds exhibit cost complementarity with investment loans. The model is parameterised for a middle-income country and is used to study the impact of capital inflows associated with a transitory shock to the world risk-free interest rate. We also consider the case where, when setting intervention and sterilisation policies, the central bank is explicitly concerned not only with maximising household welfare but also with the cost of sterilisation - possibly because it affects perceptions of its independence and credibility - as well as financial stability considerations.  

Findings

We find, first, that whether sterilised intervention is expansionary or not depends on the relative strengths of the standard liquidity effect and the bank portfolio effect; the stronger the portfolio effect, the more expansionary sterilised intervention can be. Second, when the central bank aims solely to maximise household welfare, the optimal degree of intervention is significantly more aggressive when the central bank can simultaneously choose the degree of sterilisation. In that sense, intervention and sterilisation are complements. However, the presence of the bank portfolio effect creates a trade-off and implies that full sterilisation is not optimal - even when the central bank is also explicitly concerned (in addition to household welfare) with exchange rate stability or financial volatility. By contrast, when economies of scope are absent, the bank portfolio effect no longer operates and full sterilisation is always optimal, and intervention and sterilisation remain complements. Third, when sterilisation costs are accounted for in the central bank's objective function and concern with these costs is sufficiently high, the optimal policy for the central bank is to intervene less and sterilise fully - regardless of whether economies of scope exist. In that sense, there is burden-sharing between instruments, and intervention and sterilisation are now (partial) substitutes. In the absence of the bank portfolio effect, a policy mix that involves less aggressive intervention and full sterilisation is also optimal - even when the central bank is also concerned with financial stability.

Abstract

This paper studies the effects of sterilized foreign exchange market intervention in a model with financial frictions and imperfect capital mobility. The central bank operates a managed float regime and issues sterilization bonds that are imperfect substitutes (as a result of economies of scope) to investment loans in bank portfolios. The model is parameterized and used to study the macroeconomic effects of, and policy responses to, capital inflows associated with a transitory shock to world interest rates. The results show that sterilized intervention can be expansionary through a bank portfolio effect and may increase volatility and financial stability risks. Full sterilization is optimal only when the bank portfolio effect is absent. The optimal degree of intervention is more aggressive when the central bank can choose simultaneously the degree of sterilization; in that sense, the instruments are complements. When the central bank's objective function depends on the cost of sterilization, and concerns with that cost are sufficiently high, intervention and sterilization can be substitutes---independently of whether exchange rate and financial stability considerations also matter.

JEL classification: E32, E58, F41