Foreign Exchange Intervention and Inelastic Financial Market

Abstract

Are foreign exchange interventions effective at stabilizing exchange rates? In this paper, we empirically assess the effectiveness of foreign exchange rate interventions by leveraging the rebalancings of a local-currency government bonds index for emerging countries as a natural experiment. We show that the rebalancings create large currency demand shocks that move exchange rates and are uncorrelated with the macroeconomic fundamentals. Our results provide empirical support for models of inelastic financial markets where foreign exchange interventions serve as an additional policy tool to effectively stabilize exchange rates. Under inelastic financial markets, a managed exchange rate does not have to fully compromise monetary policy independence even with free capital mobility, relaxing the classical ``Trilemma" constraint. Our results also show that free-floaters are more than five-fold more effective at stabilizing exchange rates than crawling-peggers, as the volatile exchange rates for floaters generate further departure from the ``Trilemma" constraint.

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

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