Does Foreign-Exchange Intervention Matter? The Portfolio Effect

Until recently, there was an unusual degree of consensus among economists that intervention by central banks in the foreign-exchange market did not offer an effective or lasting instrument for affecting the exchange rate, at least not independently of monetary policy. This consensus was largely shared among policymakers and participants in the financial markets as well. The 1982 G-7 economic summit at Versailles commissioned a study of intervention, known as the Jurgenson report, which found that the effects were small and transitory at most. ' We think that the time is ripe for new statistical testing of the question. Many policymakers and foreign-exchange traders believe that the intervention operations that have taken place since the Plaza Agreement of September 1985 have had an effect, especially when operations are coordinated. Moreover, the theoretical case against the effectiveness of intervention is not as clear as a reading of the economics literature might suggest. The academic literature is predicated on the distinction between intervention operations that are sterilized and those that are allowed to affect the money supply. We study the intervention operations that actually took place between 1982 and 1988, regardless of whether they were sterilized. However, we do begin in Section I with a review of the issues involved.2 There are two possible channels through which intervention (whether sterilized or not) can influence the foreign-exchange rate: the portfolio and the expectations channels. Intervention can, even if sterilized, influence exchange rates through the portfolio channel, provided foreign and domestic bonds are considered imperfect substitutes in investors' portfolios. Intervention operations that, for example, increase the current relative supply of mark to dollar assets which private investors are obliged to accept into their portfolios, will force a decrease in the relative price of mark assets.3 Intervention can also influence exchange rates, regardless of whether foreign and domestic bonds are imperfect substitutes, through the expectations channel. The public information that central banks are intervening in support of a currency (or are planning to intervene in the future) may, under certain conditions, cause speculators to expect an increase in the price of that currency in the future. Speculators react to this information by buying the currency today, bringing about the change in the exchange rate today. In Sections II and III we describe the econometric problems that arise in the standard portfolio-balance estimation equation. We derive an alternative portfolio-balance *Dominguez: Kennedy School of Government, Harvard University, 79 J. F. Kennedy Street, Cambridge, MA 02138; Frankel: Department of Economics, University of California, 787 Evans Hall, Berkeley, CA 94720. We thank three anonymous referees for valuable comments and suggestions; Julia Marsh and Julia Lowell for research assistance; and Franz Scholl at the Bundesbank, Jean-Pierre Roth at the Swiss National Bank, and officials at the U.S. Treasury and the Board of Governors of the Federal Reserve System for making the daily intervention data available. 1Many of the econometric results, finding little or no effect, were reported in Kenneth S. Rogoff (1984) and Dale W. Henderson and Stephanie Sampson (1983). 2For authoritative statements, see Henderson (1984) or Maurice Obstfeld (1990). 3The exchange-rate reaction to an increase in the relative supply of outside foreign assets may be reduced if there is an increase in their expected rate of return that induces a corresponding increase in demand.