Foreign Exchange Interventions: A Comparison of the Mexican and Brazilian Models

Over the past several years, foreign exchange rates among Latin American countries have fluctuated significantly. These oscillations have been caused by several factors, including the U.S. presidential elections, changing oil prices, the Taper Tantrum (the expectation of a reduction in bond purchases by the Federal Reserve), interest rate hikes by the U.S. Federal Reserve, and idiosyncratic economic and political events. In response, central banks have had to choose between letting exchange rates fluctuate according to supply and demand, mitigating fluctuations through interventions in foreign exchange markets, and/or through manipulations of interest rates. While these interventions have the potential to stabilize foreign exchange rates among Latin American countries, the long-term efficacy of such interventions remains uncertain.

A recent study by Martin Tobal and Renato Yslas from the Central Bank of Mexico compared two different models of foreign exchange (FX) interventions: one in Mexico and one in Brazil. For each model, they examine its impact on the exchange rate, the inflation rate, and the interaction between the exchange rate and interest rate from 2000 to 2013. The two models differ in several characteristics. Overall, Mexican interventions resulted in the sale of U.S. dollars by the central bank based on a predetermined rule, and only on an occasional basis (such as during the 1995 crisis and in the aftermath of the 2008 financial crisis). By contrast, the Central Bank of Brazil had purchased U.S. dollars in the foreign exchange market on a regular, discretionary basis—without publicly disclosing the amount that was being purchased. The effects of these two models on each country’s exchange rate, inflation rate, and interest rate were varied.

First, FX interventions between 2000 and 2013 had a short-term impact on the exchange rate in both countries: lasting two months for Mexico and one month for Brazil. Second, FX interventions did not result in inflation costs in Mexico, but did in Brazil. Inflation rates were examined at two stages following the FX interventions: after one month, and after two years. In Brazil, 3.7 percent (after one month) and 20.8 percent (after two years) of the variance in the Brazilian inflation rate was explained by the shock. However, just 0.8 percent (after one month) and 3.2 percent (after two years) of the Mexican inflation rate was explained by the shock. The exchange rate pass-through (ERPT)—the reaction of inflation to a change in the exchange rate—does not fully explain the high inflation costs in Brazil. For this reason, the authors argue that intermediary mechanisms, such as inflationary expectations, may have contributed to FX interventions affecting the increased inflation rate.

Finally, regarding the impact of an FX intervention shock on interest rates, the authors found that the Central Bank of Mexico increased the interest rate immediately following a shock, while the Central Bank of Brazil waited four months longer. As FX interventions in Brazil were implemented on a discretionary basis, it was more difficult for the central bank to increase the interest rate after every shock to compensate for its inflationary pressures.

This study is relevant to central banks for two reasons. First, inflationary costs were higher when FX interventions were discretionary and occured at a higher frequency. Second, although interventions in the foreign exchange market can ensure the orderly functioning of that market, they sometimes have a limited effect on maintaining a specific exchange rate or affecting the exchange rate in the long-run. Evidence suggests that announcements regarding interventions in the foreign exchange market may have a significant and more persistent impact. Therefore, central banks should consider using verbal cues in the foreign exchange market—i.e. publicly reiterating their concern regarding the exchange rate without actually intervening in the foreign exchange market—to ensure the smooth functioning of the market.

Article source: Tobal, Martín and Renato Yslas. “Two Models of FX Market Interventions: The Cases of Brazil and Mexico.” Banco de México. Working Papers, No. 2016-14. (2016).

Featured photo: cc/(roberthyrons, photo ID: 452221767, from iStock by Getty Images)