Comments on “Can Foreign Exchange Intervention Stem Exchange Rate Pressures from Global Capital Flow Shocks?” by Olivier Blanchard, Gustavo Adler & Irineu de Carvalho Filho Jeff Frankel Harvard Kennedy School At NBER Summer Institute, IFM, July 6, 2015

The sort of paper that I wish I had written. Why the question is important: – True, most big advanced countries don’t intervene in the foreign exchange market these days, as they did as recently as the 1990s. The G-7 in 2013 even agreed to refrain from intervention, out of fears regarding “currency manipulation” and “currency wars.” – But major EM countries do intervene, having switched to managed floating from exchange rate targets, after the crashes of the – It is useful to figure out if intervention works as an additional tool, at least partly independent of monetary policy: for thinking about current EM options – when coping with inflows, – or their reversal. Further, it might also be useful for thinking about the big countries, when, someday, some start intervening again.

Empirical approach The two alternative approaches they mention, indeed have the problems they mention: – The endogeneity of intervention with respect to the exchange rate masks effects of intervention. – High-frequency data can help address endogeneity, but don’t tell us if the intervention effect lasts long. The authors' empirical approach: – In response to capital inflow episodes, did those countries that intervened more (buying fx) experience less currency appreciation?

Findings First: an increase in global risk appetite leads to appreciation of inflow-receiving currencies, – and an increase in gross capital inflows; – but also an increase in gross capital outflows. This is not consistent with a view of gross capital outflows as a component of the net capital flow or current account. The interpretation here is that “risk off” means everyone pulls back to their own countries, not necessarily to safe havens; “risk on” means they venture forth. That is consistent with home bias, – E.g., because different consumption baskets => different home bases. But I find it surprising if the US is treated as a safe haven only by US investors and not by EM investors.

Findings, continued Main finding: exogenous capital inflows lead to smaller currency appreciations in those countries that intervene than those that don’t. – As one might expect: » “consistent with the portfolio balance channel.” – So intervention is effective.

“Portfolio Balance” terminology In the language of research in the 1980s & early 1990s, the PB channel was one of two possible channels through which (sterilized) fx intervention could have effects. – The other was the expectations channel, or more specifically the “signaling” channel. – I used this language as much as anybody. – And I am happy to see the recent revival of the portfolio balance model in general in recent years, e.g., to think about effects of debt, current accounts, & Unconventional Monetary Policy. – Nonetheless, I am not sure the language is quite right here.

“Portfolio Balance” terminology, continued 20 or 30 years ago was a time when it was taken for granted that capital mobility had become “perfect “ among the countries in question (industrialized countries) in the specific sense of no capital controls or transactions costs and as reflected in equalization of interest rates (controlling for risk), » for example, in Covered Interest Parity. The portfolio balance model allowed for imperfect substitutability across assets, – but it differed from the earlier Mundell-Fleming model in that the differential in returns was now related to the stock of assets, rather than the flow. The Blanchard-Adler-de-Carvalho-Filho paper is about flows.

“Portfolio Balance” terminology, continued Further, 30 years ago the money supply was usually treated as the proper measure of monetary policy, – consistent with the tenets of Milton Friedman’s monetarism. – But after monetarism crashed and burned in the 1980s, we went back to considering the interest rate as the measure of monetary policy. – More recently, the proposition that doubling money doubles the price level, once universally accepted, doesn’t seem to fit the facts, at least not within a 10-year horizon. – So it may be anachronistic to assume that the alternative channel involves signaling future increases in money. – Further, since the advent of QE and other “Unconventional Monetary Policies” we have come to accept that central banks can probably have effects by changing the composition of their balance sheets, leaving aside the total level of the monetary base, e.g., as effects on the term structure from changing the composition between short-term versus long-term assets, If that is true, it follows that they can have effects by sterilized fx intervention, – which changes the composition of the central bank’s balance sheet between domestic & foreign assets without changing the total monetary base.

“Gross inflows” and “gross outflows”* defined as net Δ international liabilities and assets, respectively. – The idea is that the gross inflows = deliberate decisions by foreign residents – and gross outflows = deliberate decisions by domestic residents. Yes, some good recent papers have used gross flows [fn 3], But I still have some hesitation about the use of gross data. – It takes two to make a transaction, one in each country. – Examples: If an EM bank borrows from an Advanced Country bank, is that a positive gross capital inflow, or a negative gross capital outflow? If a firm repurchases its stock from investors, some of them abroad, which is that? Could the authors do a similar exercise with net capital flows, – measured either as gross capital inflows minus gross inflows, – or as the current account deficit minus fx intervention? A motive for looking at the current account measure: the statistical discrepancy is usually thought to be mostly unmeasured capital flows.

Classifying interveners vs. floaters Among countries with flexible exchange rate regimes, the authors classify countries as interveners those that responded to global capital flow episodes with larger intervention (relative to GDP), and as floaters those with less. Question: What if more capital flows go into some countries than others, and so the classification criterion partly reflects the magnitude of exchange market pressure, not just the propensity to respond to the pressure with intervention?

The case of Latin America in 2010 less-managed floating Source: GS Global ECS Research Inflows were reflected more as reserve accumulation in Peru, but more as appreciation in Chile & Colombia. Inference: Chile & Colombia are floaters, Peru is an intervener. Okay. more-managed floating

Korea & Singapore took inflows mostly in the form of reserves, Goldman Sachs Global ECS Research less-managed floating more-managed floating while India & Malaysia took them more as currency appreciation. The case of Asia in 2010 Inference: Thailand intervenes more than Indonesia or Hong Kong? Source: GS Global ECS Research But it may be an artefact of more exchange market pressure in Thailand.

An alternative measure of propensity to intervene. Perhaps interveners should be classified as those with larger intervention relative to total Exchange Market Pressure: – Propensity to intervene ≡ (Intervention/MB) / EMP where EMP ≡ (Intervention/MB) + Δ log Exchange Rate. – In the spirit of Calvo & Reinhart (2002) – and Levy Yeyati & Sturzenegger (2005). But this might pre-cook the result that more intervention is associated with less appreciation. – The problem is that EMP is not exogenous.

Two possibly useful follow-on exercises An alternative to using a global capital flows as the exogenous experiment: one could use global commodity prices, – tailored to the commodity trade mix of the country in question. – To what extent do those oil exporters that intervene more heavily in the forex market succeed in dampening exchange rate changes that result from oil price fluctuations? Page 16 talks about another useful extension -- An alternative to looking at effects on the nominal exchange rate: what about effects on the real exchange rate? – I didn’t see in the results reported there a clear test of whether intervention does or doesn’t dampen real appreciation. – The effect of intervention is less important if the suppression of nominal appreciation just means more inflows that show up as inflation, with the same effect on the real exchange rate.