Inelastic Financial Markets and Foreign Exchange Interventions

Abstract

Are foreign exchange interventions effective at moving exchange rates? In this paper, we leverage the rebalancings of the a local-currency government bonds index for emerging countries as a quasi natural experiment and identify the required size of foreign exchange interventions to stabilize exchange rates. We show that the rebalancings create large currency demand shocks that are orthogonal to the macroeconomic fundamentals. Our results provide empirical support for models of inelastic financial markets where foreign exchange intervention serves as an additional policy tool to effectively stabilize exchange rates. Under inelastic financial markets, a fixed exchange rate does not have to compromise monetary policy independence even with free capital mobility, relaxing the classical Trilemma constraint. Our results show that to achieve a 1% exchange rate appreciation, the average required intervention is about 0.4% of annual GDP. We also show that free-floats are more than three-fold more effective at stabilizing exchange rates than managed-floats (or peggers). This is because the volatile exchange rates for the free-floats lead to more inelastic financial markets and generate further departure from the Trilemma.

Keywords: Foreign exchange intervention; index rebalancing; exchange rates; international capital flows; benchmark investments; sovereign bonds.

JEL Classification: F31, F32, G11, G15, G23