Public Savings and the Effectiveness of Sterilized Foreign Exchange Intervention

Ensayos sobre Política Económica Volumen 36, Núm. 85 • Edición especial de 2018 117 Public Savings and the Effectiveness of Sterilized Foreign Exchange Intervention Juan Camilo Medellín Martínez* Article Info: Received 12 June 2017; accepted 28 November 2017 Abstract Although theoretical models exist that support the Effectiveness of Sterilized Foreign Exchange Intervention (FXI), practiced by central banks with the objective of affecting the level and reducing the volatility of the exchange rate, empirical works provide mixed testimony for developed and emerging countries. Using a GARCH model, this paper aims to offer empirical evidence of how periods of public savings enhance the effectiveness of sterilized FXI for Colombia. To do so, it is necessary to estimate a policy shock measure Keywords based on the determinants of foreign exchange (FX) purchases made by the Colombian Uncovered interest parity Central Bank over the 2010-2014 period. During this time span, Banco de la República sterilized foreign exchange intervention performed an innovative type of foreign exchange purchases known as Pre-Announced public savings Day-to-Day Interventions. A reaction function for this type of intervention has not yet inflation targeting been estimated. Here, this reaction function will be estimated with an ordinary least floating exchange rate squares (OLS) model. JEL Classification E42 E58 E61 Efectividad de las Intervenciones Cambiarias en presencia de Ahorro Público Resumen Clasificación JEL E42 E58 E61 Palabras claves Paridad de interés cubierta intervención cambiaria esterilizada ahorro público inflación objetivo flotación cambiaria A pesar de que existen modelos teóricos que dan soporte a la efectividad de las intervenciones cambiarías practicadas por los bancos centrales con el objetivo de afectar la volatilidad o nivel de la tasa de cambio, la literatura empírica otorga resultados mixtos tanto para países desarrollados como en vía de desarrollo. Con la ayuda de un modelo GARCH, este trabajo quiere dar sustento empírico para Colombia sobre como las intervenciones cambiarías pueden realzar su efectividad en períodos de ahorro público. Para lo anterior, es necesario estimar una medida de choque de política a partir de los determinantes de las intervenciones cambiarías realizadas durante el período 2010-2014. A lo largo de este período de tiempo el Banco de la República realizó un novedoso tipo de intervención llamado compras pre anunciadas día a día. Una función de reacción no ha sido aún estimada para dicha intervención. Aquí se utilizará un modelo de mínimos cuadros ordinarios para su cálculo. https://doi.org/10.32468/espe.8507 * Asistente de investigación en Fedesarrollo, Bogotá Colombia. Email: . Quisiera agradecer a Mauricio Villamizar por su guía, a Alberto Zuleta y Marc Hofstetter por sus comentarios. También quisiera agradecer a los participantes del seminario en Fedesarrollo en noviembre de 2016. En particular a Leonardo Villar, Roberto Steiner, María Inés Agudelo y Nataliza Salarzar. Asimismo, agradecer los valiosos comentarios por parte de los asistentes al seminario sobre la decimocuarta edición especial de la revista Ensayos sobre Política Económica en Octubre de 2017. Finalmente, agradezco profundamente las sugerencias realizadas por los dos árbitros anónimos que sin lugar a dudas hicieron de este un mejor trabajo. Public Savings and the Effectiveness of Sterilized Foreign Exchange Intervention Juan Camilo Medellín Martínez / 117-136 118 1. Introduction Since the enactment of the new Colombian Political Constitution (PC)1 in 1991, Banco de la República2 (BR) started a process of extreme make over3. Before 1991, BR acted as a development bank that funded the public and private sector alike, with resources coming from inflationary emission4, 5. The new PC established a clear mandate for BR of maintaining the purchasing power of the peso, with political independence from the Government, and technical and asset autonomy. BR became the monetary, exchange rate and credit authority. This was the first of two steps in gaining a much higher credibility that would help BR to bring inflation rates down6. The second step was the implementation of the Inflation Targeting Regime (IT) framework with a floating exchange rate, as a replacement for the exchange rate bands7 used from 1994 to 19998. With the IT framework, BR gained a broader credibility and managed to anchor inflationary expectations9, to the point of using the monetary policy in a countercyclical sense, something never before accomplished in the history of Colombia´s monetary policy10. The IT framework has been very popular among developed and developing countries because of its main features –including the use of a repo rate as the policy 1 All acronyms are defined and listed in Appendix A, in order of appearance. 2 The Colombian Central Bank. 3 See Steiner (1995) and Edwards & Steiner (2008). 4 From 1970-1990, Colombia had an average annual inflation of 21.94%, and was known as the moderate inflation country par excellence (Dornbush & Fisher, 1991). 5 See Rincón & Steiner. (1992). 6 From 1991 to 2015, average annual inflation in Colombia was of 10.97%, 11 percentage points less than the average annual inflation of the previous 20 years. 7 An exchange rate framework that replaced the crawling peg in Colombia. It is an exchange rate policy located in the middle point between a fixed and a floating exchange rate. It consisted of maintaining the exchange rate between a maximum and a minimum. When the exchange rate was surpassing the ceiling of the band BR had to sell USD. Conversely, when the exchange rate was surpassing the floor of the band BR had to buy USD. 8 The IT framework implementation happened in a context of international turmoil (the sudden stops of Asia 1996-1997 and Latin America 1997-1998), and severe internal macroeconomic imbalances such as a fast growing public debt. See Gómez (2006) and Villar (1999). 9 Since the early nineties, BR began announcing inflation goals, but it was not until the adoption of IT that the Central Bank managed to accomplish those targets. From 1990 to 1998, BR hit 4 out of 8 targets; from 1999 to 2015, BR hit 14 out of 17 targets. 10 Unfortunately, this has not been the case in recent years. In a context of rare global macroeconomic conditions, and a brutal reversal in the terms of change, Colombia is now experiencing high inflation (partially explained by the pass-through from the overly depreciated exchange rate) and a much slower economic growth, therefore BR will not be able to use the monetary policy countercyclically in the near future. instrument, the announcement of medium-term inflation targets, and a clear and comprehensive communication strategy–, but also because of its evolution over time in response to new economic difficulties11. Plausible changes to the IT framework include: i) additional policy goals other than delivering l (...truncated)