In fact, this was a de facto rather than official policy until the global financial crisis, after which it conspicuously appeared in official speeches and documents. The policy has an operational framework, which covers daily intervention strategy, timing, rationale, and tentative reserve adequacy metrics.
As for the timing, it is associated with a set of indicators, including appreciation trends, capital inflows, and growth in foreign debt liabilities that occur in the context of global liquidity—such as the ones prevalent in the two major periods of international reserve accumulation.
As explored in the foreign exchange market microstructure literature Evans and Lyons ; Vitale , net order flow is the main proximate driver of exchange rate dynamics. The rationale for this result is that interdealer trade based on private customer order flow reveals the aggregate order flow to the market, and this public information is fully priced by the market at the end of the day. If the central bank buys from dealers based on central bank observations of aggregate order flow, it affects interdealer trade but conveys no additional information to the market.
The same result follows if the central bank buys order flow less than proportionally or up to an error. This flexibility is relevant for the actual operation of daily interventions, given its interaction with onshore dollar liquidity. Onshore interest rates tend to respond to dollar liquidity. As a result, systematically buying in excess of order flow tends to attract even more order flow.
To avoid these negative feedback dynamics, the operational rule could react less than proportionally to the order flow and include a random component to the decision. This operational rule is a good description of actual interventions during accumulation episodes. In addition, the proportion between intervention and order flow might be modulated in the presence of policy trade-offs, such as appreciation trends that help control inflation through their effect on tradable goods, while still offering some support to activity through favorable investment conditions.
The central bank communicated its rules-based intervention strategy to convey that it was not targeting any specific level for the exchange rate or any specific target for the rate of change of the exchange rate. This is the case in Brazil, where policymakers have complete information on the net order flow, based on the electronic records of private transactions reported by financial institutions.
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Each participating institution in the over-the-counter spot market collects partial information through its own order flow, but not the aggregate total. As a result, even though the central bank is following a rules-based approach, market participants cannot anticipate the size of the intervention on any single day and must incorporate these transactions in the interdealer market.
There is no official reserve adequacy metric. However, the reality check from the initial years of floating made clear the importance of the reserves to foreign debt ratio. The excess of debt relative to reserves prompts negative feedback loops in depreciation episodes. This was presented sufficiently many times in official central bank communication to make it a plausible de facto adequacy metric.
Other metrics, such as the ratio to short-term debt or imports, were also mentioned with some frequency, but reserves were much larger than what would be indicated by such metrics. During the second accumulation period, from to , reserves increased almost in tandem with external debt, so again the ratio looked like a good adequacy metric candidate, although with a large safety margin.
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One missing piece of the argument is the cost of holding international reserves. In a rare public assessment by Central Bank of Brazil staff, based on precautionary models, Silva discusses a range of scenarios for international reserves cost and the expected output loss during a crisis and finds that if a crisis occurred only once every decade or so, the avoided losses would compensate the cost. Such exercises are viewed with skepticism in policy circles, where self insurance is not usually seen as the exclusive rationale for accumulating reserves. For example, it is often mentioned in international policy circles that reserves might have a role in reducing external credit constraints, improving financial stability, or stabilizing net foreign asset positions.
It is also mentioned that reserves might be at whatever level results from leaning-against-the-wind policies of the past, given the reputational cost of reducing them afterward. Even in the context of very simple models that are based on self insurance, one must recognize that there is a high level of uncertainty regarding the effect of international reserves on crisis incidence and severity. High uncertainty aversion typically means that holding excessive reserves is much better than holding just the exact amount of reserves. The global financial crisis was very much a US dollar liquidity crisis.
During the crisis, the Central Bank of Brazil effectively acted as a foreign currency liquidity provider of last resort in spot, credit, and futures markets. The credit market shortage came from exporters that lost credit lines abroad. The interventions were successful, judging by the normalization of US dollar liquidity captured, for example, by the spread between onshore and offshore US dollar interest rates in January , these measures were back to the levels of August Interventions were also short-lived in comparison with the protracted consequences of the crisis in global financial markets.
They also benefited from the extraordinary swap arrangements by the US Federal Reserve on a global scale. Communication was a key element of the policies. The Central Bank of Brazil preannounced a ceiling to the entire volume of swap interventions to reassure private participants, and it announced it would offer as many US dollars as necessary in the spot and credit markets. Stone, Walker, and Yasui provide an interesting empirical assessment of the effects of interventions by the central bank during the financial crisis in In general, announcements are found to have a greater impact on the level of the exchange rate than the interventions themselves.
This result signals two things: First, there was sufficient central bank credibility; and second, there were sufficient reserves to support the claims. Another communication strategy was that the central bank continued to report its trade credit assets as qualified international reserves. Calibrating the size of the interventions captured in Figure 7.
For the spot market, the central bank had complete information from the order flow, disaggregated to the transaction level, and so could make a good diagnosis of the source of the liquidity demand. The bank also had good estimates of the net international liability position at a disaggregated level, particularly the debt instruments.
The data indicated that repatriation was manageable, given that the central bank would also reduce hedging costs with swap interventions.
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The central bank also had full information on trade credit operations down to the transaction level, which is not large in Brazil, relative to the size of the economy, and there is a stable relationship between trade credit and trade activity. Based on this assessment, authorities committed to offer as much US dollar credit as necessary, until credit markets resumed normal operations.
As already noted, preannouncing a high ceiling for swap operations was essential to the intervention communication strategy. The central bank has access to registers at the central derivative clearing of the country, which provide a good basis for estimating the total hedging needs. Matching this with debt information registered with the central bank, one has a good idea of the rollover needs, in case there is a mismatch in maturity of debt and hedges.
The coarse granularity of the market, with enough big players and public comprehensive balance sheet information, also helped in the assessment. Because the swap is a nondeliverable forward contract with domestic currency settlement, there was essentially no pressure on international reserves.
It is worth commenting on the interaction of foreign exchange intervention policy and monetary policy during the crisis. As noted, for the first time Brazil was able to use countercyclical monetary policy during a crisis. However, the monetary easing did not come immediately after the crisis. The strategy at the time, communicated by central bank authorities, was first to normalize the transmission channels and then begin monetary policy normalization.
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Accordingly, the central bank first announced its intervention package, including foreign exchange intervention, and then made sure the liquidity squeeze subsided before beginning a new easing cycle. In this context of the global financial crisis, it is fair to assume that an aggressive easing would interact adversely with the US dollar liquidity crisis.
The liquidity squeeze in spot and futures US dollar markets was not as large as during the crisis, but private balance sheets were more fragile. The main concern was accumulated foreign debt from the quantitative easing period. There was a lot of anxiety in global markets with policy normalization.
From the taper tantrum in May to liftoff in December , and the second hike in federal funds in November , the normalization process advanced by a sequence of bold moves intercalated with setbacks and financial turbulence. The motivation for the intervention policy was to avoid panic and allow rational calculations to dominate the adjustment of debt profiles and foreign currency exposures.
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Spot interventions could have the opposite effect and induce market participants to liquidate positions as soon as possible. Swap interventions create conditions for adjustment, and by the nature of nondeliverable forwards, preserve international reserves for use in case of panic. Unlike the crisis intervention that set a total ceiling and left some freedom for daily operations, this time around, both the total amount and the daily interventions were set in advance see the previous section for the exact timing and content of the announcements.
The very strict rules-based intervention was designed, in part, to avoid signaling any preference for the level of the exchange rate. To set the size of the swap intervention, policymakers must consider a large number relative to foreign liabilities, based on the consolidated information from the central bank and central clearings datasets. The level of corporate sector debt in the country around the tapering of quantitative easing was close to the average emerging market, just below 50 percent of GDP, with 65 percent in local currency versus 35 percent in foreign currency. Of the 35 percent in foreign currency, 12 percent referred to exporters, 6 percent to nonexporters with local hedge, 5 percent to nonexporters without local hedge but with foreign headquarters, 5 percent to nonexporters without local hedge but with foreign assets, and 6 percent to unhedged exposure.
It is difficult, however, to distinguish what is the normal level of risk taking from what is excessive and therefore susceptible to instability. One alternative is to estimate what the debt levels would have been without quantitative easing. Estimates known to policy-makers at the time point to a figure of the same order of magnitude as unhedged plus some imperfectly unhedged positions Barroso ; Barroso, Pereira da Silva, and Sales By this metric, it was clear that conditions warranted a sizable intervention.
However, large interventions are not without their problems. First, lower cost of hedging could induce more debt-taking abroad to build arbitrage positions, which is self-defeating, for the stated purpose of the policy.
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Second, market participants must believe there will be no convertibility problems in the future to keep hedging positions with nondeliverable forwards, so that a large enough swap position might lead the market to self-fulfilling concerns with convertibility, and again the policy is self-defeating. Garcia and Volpon provide an insightful discussion of the problems, which only increased with the accumulation of swaps in the balance sheet of the central bank. At some point, market participants began focusing on international reserves net of swaps, which was probably an early sign that the intervention was reaching its limit.
Policymakers recognized these issues. In particular, the link between swap interventions and US dollar liquidity was clear enough to lead policymakers to conduct regular repo line auctions, either as a feature of the program or conditionally on the onshore US dollar rate an indicator of liquidity demand. The policy would start to be reversed once domestic political volatility reduced, and global liquidity conditions improved—at first by discretionary rollovers and then by the auction of reverse swaps to imprint a fast-paced reduction of the swap position.
There was no official statement on the goal of reducing swaps to zero, and so there was considerable flexibility in the conduct of the intervention policy.
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The reality check from the first years of floating maintains that leaning against the wind is a sensible strategy. However, this requires sterilized intervention or swap intervention to have an actual effect on the exchange rate, which is a controversial proposition.
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Empirically, it is usually difficult to estimate the effect of intervention due to the simultaneity problem. If the central bank sells foreign currency when the domestic currency depreciates, a naive empiricist might say it caused the depreciation. Indeed, this is the sign of the correlation and the sign of coefficients in ordinary regressions. The traditional econometric solution to get the right causal effect is to find an instrumental variable, that is, a random variable related to the depreciation only through its impact on the central bank.