Identifying the Size of Open Market Operations in Foreign Exchange Interventions

Abstract

How large should open market operations be to stabilize exchange rates in foreign exchange interventions? In this paper, we leverage the mechanical rebalancings of the largest local-currency government bonds index for emerging countries (GBI-EM Global Diversified Index) to provide a valid identification on the required amount of foreign reserves an emerging market central bank should buy (or sell) in foreign exchange interventions. The rebalancings of index create demand shocks on the currency composition of government bonds that are orthogonal to the macroeconomic fundamentals of the sovereign. We show that the rebalancings resemble the noise trader shocks in a segmented market model (Itskhoki-Mukhin 2021) and identify the required size of the open market operations to stabilize exchange rates. We find that in order to achieve a 1 percentage point exchange rate appreciation, the required intervention is 0.4% of annual GDP for a median country in our sample.

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

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