Do foreign exchange interventions work as coordinating signals in Colombia?

Ensayos sobre Política Económica 33 (2015) 169–175 Ensayos sobre POLÍTICA ECONÓMICA www.elsevier.es/espe Do foreign exchange interventions work as coordinating signals in Colombia? Juan David Durán-Vanegas Universidad Nacional de Colombia, Colombia a r t i c l e i n f o Article history: Received 20 January 2015 Accepted 14 May 2015 Available online 14 August 2015 JEL classification: C50 F31 F41 Keywords: Foreign exchange intervention Coordination channel Threshold models a b s t r a c t This paper analyses the effectiveness of official interventions of the Colombian Central Bank in the foreign exchange market over the period of June 2008–December 2013. The estimation procedure suggested by Hansen (2000) is used to estimate a threshold model for the spot exchange rate that splits the data sample into two different regimes that depend on the extent of the misalignment of the exchange rate from a fundamental value. The estimation results provide empirical evidence of the existence of a coordination channel of intervention proposed by Sarno and Taylor (2001). According to the theory of the coordination channel, interventions by central banks work as signals that solve a coordination failure in the foreign exchange market when speculation moves the exchange rate from its fundamental value. The results suggest that foreign exchange interventions had a considerable and statistically significant effect in depreciating the domestic currency when the spot exchange rate was sufficiently below from its fundamental value. © 2015 Banco de la República de Colombia. Published by Elsevier España, S.L.U. All rights reserved. ¿Funcionan las Intervenciones Cambiarias como Señales de Coordinación en Colombia? r e s u m e n Códigos JEL: C50 F31 F41 Palabras clave: Intervenciones cambiarias Canal coordinación Modelos de umbrales Este artículo analiza la efectividad de las intervenciones del Banco de la República en el mercado cambiario colombiano durante el período junio 2008 - diciembre 2013. Para ello, se realiza la estimación de un modelo de umbrales para la tasa de cambio spot en el que la muestra es separada en dos regímenes que dependen en el grado de desviación de la tasa de cambio de un valor fundamental de acuerdo al procedimiento especificado por Hansen (2000). Los resultados de la estimación proporcionan evidencia sobre la existencia del canal coordinación de las intervenciones propuesto por Sarno and Taylor (2001). Según esta teoría, las intervenciones funcionan como señales que solucionan un problema de coordinación en el mercado cambiario cuando la tasa de cambio se desvía de su valor fundamental. Se concluye que las intervenciones cambiarias tuvieron un efecto considerable y estadísticamente significativo para depreciar la moneda local cuando la tasa de cambio estuvo suficientemente apreciada. © 2015 Banco de la República de Colombia. Publicado por Elsevier España, S.L.U. Todos los derechos reservados. 1. Introduction A considerable amount of literature has focused on several issues related to official interventions in foreign exchange markets E-mail address: during the last two decades. While there is no consensus about the effectiveness of these operations, its use remains attractive in developing countries where, as Hutchison (2003) refers, exchange rate movements are usually related to unstable market expectations, herding behaviour and contagion. Besides, the issue is not only whether interventions are effective or not but which is the channel of transmission. By knowing the channel through which interventions influence the exchange rate, authorities are able to http://dx.doi.org/10.1016/j.espe.2015.05.001 0120-4483/© 2015 Banco de la República de Colombia. Published by Elsevier España, S.L.U. All rights reserved. 170 J.D. Durán-Vanegas / Ensayos sobre Política Económica 33 (2015) 169–175 improve the way in which they execute these operations in order to achieve better results. This paper explores the effectiveness of official foreign exchange interventions in Colombia using daily data collected during the period of June 2008–December 2013. The empirical approach adopted is useful to investigate the existence of a ‘coordination channel’ proposed by Sarno and Taylor (2001) through which foreign interventions act as signals that correct a coordination failure in the foreign exchange market. The point of departure of the reasoning behind this theory is the movement of the spot exchange rate away from the equilibrium level generated by the existence of non-economic factors as speculative bubbles. In this context, it may be very difficult for individual market participants to reverse the trend of the exchange rate because agents may experience substantial losses by trading at a value consistent with the economic fundamentals (Taylor, 2005). Then, publicly announced interventions of central banks may be seen as coordinating signals that bring about a reversion of the exchange rate back to its fundamental value (Taylor, 2004). An important implication of the coordinating channel is that interventions are more likely to be effective when the exchange rate sufficiently deviates from the level consistent with the underlying economic fundamentals. Therefore, in line with Jun (2008), I propose a threshold model in which the degree of misalignment of the exchange rate from the fundamental level is used to split the sample into two regimes. I have found that official interventions in Colombia are indeed significant in explaining the exchange rate return when the misalignment is below the estimated threshold, but that their effect is negligible otherwise. Consequently, results provide supportive evidence for the existence of a coordination channel of transmission in Colombia. Furthermore, results are useful to explain the mixed findings reported in the literature about the effectiveness of official foreign interventions conducted by the Colombian Central Bank. The paper is organized as follows. Section 2 reviews the coordination channel proposed by Sarno and Taylor (2001). The econometric model is presented in Section 3. Section 4 describes the data. Estimation results are presented in Section 5. Finally, Section 6 provides some final remarks. 2. The coordination channel of transmission of foreign exchange intervention Research on foreign exchange interventions reports three channels by which official interventions influence the exchange rate: the portfolio balance channel, the signalling channel and the coordination channel.1 The theory of the portfolio balance channel asserts that when authorities intervene in the exchange markets, the relative supply of domestic currency bonds is modified and the exchange rate must change as investors try to rebalance their portfolios. For example, when authorities increase the supply of domestic bonds, demand of these kinds of assets must rise in order to restore the market equilibrium. Then, as Edison (1993) puts it: “The rise in demand can be ach (...truncated)