RDP 2003-04: Identifying the Efficacy of Central Bank Interventions: Evidence from Australia 1. Introduction

Since the introduction of floating exchange rates, the use and efficacy of intervention in the foreign exchange market has been a controversial topic. Most central banks have at times engaged in frequent intervention and at other times followed a more laissez-faire approach to the exchange rate.^[1] No doubt the observed disparate range of policies between central banks, and within individual central banks over time, can in part be attributed to the lack of accord on the effectiveness and consequences of central bank intervention. Two key questions remain unresolved: how effective is foreign exchange intervention and, if it is effective, through which channel does it act?

A critical barrier to answering these questions has been overcoming the endogeneity of changes in the exchange rate and intervention. The central hypothesis is that intervention changes the exchange rate. But at the same time, the decision to intervene is not independent of the movements in the exchange rate. Moreover, even once a central bank has decided to intervene, the quantity of currency it buys or sells will typically depend on the response of the exchange rate to its trades.

The literature has typically dealt with the simultaneous equations problem by assuming that the contemporaneous decision of the central bank is independent of the current innovations to the exchange rate. This is a strong assumption. For example, it assumes that the central bank does not change its selling or buying behaviour by assessing the impact its actions have had on the exchange rate. On the other hand, there is strong evidence in stock markets that big players act strategically when they are unwinding large positions. Therefore, why should we expect the same behaviour is not optimal for a central bank?

In this paper we use an alternative identification method to solve the problem of simultaneous equations. We use daily Reserve Bank of Australia (RBA) interventions data over the period 1986–1993, which contains a dramatic change in intervention policy that we use for identification. We show that the estimates we obtain have the correct sign and are significantly larger than those found with more standard methods. This is exactly the direction we would have expected if endogenous variables are an important source of the bias. Further, the vast majority of the effect of an intervention on the exchange rate is found to occur during the day in which it is conducted with a smaller impact on subsequent days. This explains why small effects are usually found when lag values are used in the typical OLS specifications. The major contribution of this paper is to provide some evidence on the contemporaneous effectiveness of intervention. Although our methodology does not indicate the channels through which intervention operates, it provides an improvement from previous estimates obtained in the literature.

We concentrate our analysis on sterilised interventions, but we do not distinguish between secret and public interventions. While undoubtedly this is an important distinction, most and in particular the largest, interventions are public. Certainly, future research should reconsider this issue. In this paper the focus of our attention is the estimation problem. Indeed, we think that the simultaneous equations problem is the crucial aspect limiting our understanding of the effectiveness of policy.

The identification assumption we use is based on the fact that in 1991 the RBA decided to change its policy regarding foreign exchange rate interventions. We interpret this shift in policy as exogenous, which is an important ingredient in our solution to the problem. Other countries have also changed ‘exogenously’ their policies, but typically central banks endogenously respond to the conditions in the market. Again, future research should endogenise the policy decision and extend the present analysis to deal with a more general framework. However, as is argued in Section 3 it is the case that the Australian central bank decision to change its method of intervention was unrelated to other macro events.

The paper proceeds as follows. There is a brief review, in Section 2, of central bank intervention practices and the associated literature. A description of the data and discussion of RBA intervention follow this, in Section 3. Section 4 outlines the identification and estimation methodology used in this study. The results are presented in Section 5, followed by conclusions.

Footnote

Schwartz (2000) suggests that intervention is a dying practice despite the continued use of active intervention by the European Central Bank and Bank of Japan. However, the 18 central banks that responded to a survey reported in Neely (2001) believe it affects the exchange rate. Traders' survey responses in Cheung and Wong (2000) indicate they also believe intervention has an effect on exchange rates. [1]