Another orthodoxy falls - foreign exchange interventions may be effective

Olivier Blanchard has presided over arguably the most tumultuous period in the IMF's history. His tenure as Chief Economist has seen several dramatic reversals in the conservative institution's long-held positions. Even as he enters his last lap, the latest reversal comes from an acknowledgement that foreign exchange interventions may after all be useful.

Capital flows management has emerged as one of the biggest challenges facing emerging economies. As the evidence from recent events show, no country can insulate itself from cross-border capital flows volatility. Irrespective of their economic fundamentals, markets tend to lump all emerging economies into one category. And cross-border flows are characterized by episodes of massive capital inflows followed by sudden-stops. 

The orthodoxy on capital flows, long espoused and propagated by the IMF, has advocated capital account convertibility and floating exchange rates, and the futility of policies that seek to manage capital flows. In 2011, the edifice started to crumble with the acceptance that capital controls may be useful on occasions. Now, in a just released NBER working paper, Blanchard and two others go one further step to support foreign exchange interventions to manage currency volatility arising from capital flows. They write,

Many emerging market economies have relied on foreign exchange intervention (FXI) in response to gross capital inflows. In this paper, we study whether FXI has been an effective tool to dampen the effects of these inflows on the exchange rate. To deal with endogeneity issues, we look at the response of different countries to plausibly exogenous gross inflows, and explore the cross country variation of FXI and exchange rate responses. Consistent with the portfolio balance channel, we find that larger FXI leads to less exchange rate appreciation in response to gross inflows... The magnitude of the effect is relevant from a macroeconomic perspective, suggesting that FXI can be a valid policy tool for macroeconomic management.

Comparing the respective exchange rate performances of countries following floating exchange rate (floaters) and those intervening in forex markets (interveners) in response to exogenous shocks, they find,

The difference in FXI responses between the two groups is sizeable, close to 1 percent of quarterly GDP (0.25 percent of annual GDP) on impact. Interveners display a smaller appreciation of their currencies in response to the gross inflows. Specifically, we find a 1.5 percentage point differential in appreciation between interveners and floaters over the first 3-4 quarters. The differential fades afterwards. This difference is significant, both statistically and economically... Moreover, comparing the differential between the two groups of FXI and ER responses suggests a large effect of FXI: a quarterly annualized intervention of 1 percent of GDP (0.25 percent non annualized) leads to about 1.5 percent lower appreciation on impact. There is no evidence of a different interest rate behavior between the two groups, at least on average, suggesting that neither interveners nor floaters rely on the interest rate to ‘defend’ their exchange rates in response to exogenous capital flow shocks... Consistent with the predictions of the simple model presented earlier, gross capital inflows respond equally or more markedly in intervening countries, in comparison to floaters. Gross outflows increase for both groups, pointing to an offsetting role by domestic investors, but more in floaters.

They interpret the negative correlation between the sizes of FXI and gross capital outflows as being explained by causality running from FXI to outflows. Central banks indulge in sterilized foreign exchange market interventions, which limit exchange rate depreciation, and thereby contains capital outflows.