Foreign exchange intervention and exchange rate volatility in Peru

Abstract

Flexible exchange rate experience in Peru has been accompanied by frequent official interventions in the form of foreign exchange purchases or sales. Monetary authority pursues reducing excess volatility in the exchange rate through its direct intervention. However, in recent years, this intervention has concentrated on US dollar purchases, apparently signalling a bias towards defending a given exchange rate level (not necessarily fixed). For the period 1994 to 2007, this document assesses consistency of the empirical evidence with the goal of reducing exchange rate volatility. Thus, it uses univariate and multivariate time series models subject to stochastic shifts to study currency pressures. Results suggest consistency with the reduced-volatility goal. Nonetheless, in line with other studies, factors such as the foreign exchange gap with respect to its trend also induce foreign exchange intervention.

Acknowledgements

We thank participants for their useful comments to the XXV Meeting of Economists of the Central Bank of Peru in December 2007. The views expressed in this article are those of the authors and do not reflect necessarily the position of the Central Bank of Peru.

Notes

¹Sterilized intervention leaves the money market quantity balance undisturbed. Nonsterilized intervention would affect domestic monetary base.

²See Sarno and Taylor (2002) for an overview of such arguments.

³Carranza et al. (2003) found evidence that, for highly dollarized firms in Peru, investments decisions are negatively affected by real depreciation of the domestic currency.

⁴For a discussion on fear of floating, see Calvo and Reinhart (2000).

⁵Arena and Tuesta (1999) found that official intervention in Peru is efficient in reducing exchange rate volatility and that it could actually influence the level of nominal exchange rate.

⁶Empirical literature attributes frequently a regime-switching stochastic behaviour to exchange rates. For a recent discussion about these exchange rate nonlinearities, see Sarno (2005).

⁷Net international position from the central bank is considered here as a proxy of reserve variations. Alternatively, available intervention data could be directly used.

⁸Event studies are not directly used here as the frequency at which intervention in Peru takes place makes it difficult to isolate the effects of any single intervention day or episode. See, for example, Fatum and Hutchison (2003) for an application to daily US official intervention operations.

⁹Which presents a similar case study than Peru. Appreciation pressures on the domestic currency because of recent macroeconomic performance and international trends have prompted the central bank to intervene largely in the foreign exchange market, risking consistency with the inflation targeting regime in place.

¹⁰Alternatively, regime-switching modelling through a Time-Varying Smooth Transition Autoregressive (TV-STAR) model is found in Sollis (2008).

¹¹Recent applications also include the possibility of conditional heteroscedasticity (MS-GARCH) and exogenous variables (MS-ARX).

¹²See Martínez and Soledad (2002) for a similar MS-VAR, with the addition of shifts in regime being with endogenously determined (through time-varying transition probabilities). More recently, Arias and Erlandsson (2005) present a variation of this modelling for an early warning system for financial crises including a similar variable set.

¹³This representation could be extended to include exogenous variables and time-varying transition probabilities.

¹⁴To be more precise, a MSIH(2)–VAR(1) model is estimated, where I and H stand for the intercept and the variance (heteroscedasticity) being conditionals to the regime.

¹⁵See Fig. 1 for the smoothed probabilities in each data observation.

Fig. 1. Exchange rate, net international position and interest rate differential

¹⁶See Fig. 2 with the regime-smoothed probabilities.

Fig. 2. Exchange rate, net international position and interest rate differential