Working Paper Series. Do China and oil exporters influence major currency configurations? No 973 / December by Marcel Fratzscher and Arnaud Mehl

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1 Working Paper Series No 973 / December 2008 Do China and oil exporers influence major currency configuraions? by Marcel Frazscher and Arnaud Mehl

2 WORKING PAPER SERIES NO 973 / DECEMBER 2008 DO CHINA AND OIL EXPORTERS INFLUENCE MAJOR CURRENCY CONFIGURATIONS? 1 by Marcel Frazscher and Arnaud Mehl 2 In 2008 all publicaions feaure a moif aken from he 10 banknoe. This paper can be downloaded wihou charge from hp:// or from he Social Science Research Nework elecronic library a hp://ssrn.com/absrac_id= We wish o hank Barbara Meller for excellen research assisance, Claus Brand, Philippine Cour-Thimann, Michael Ehrmann and Jean-Pierre Vidal for discussion as well as paricipans in wo seminars for commens. The views expressed in he paper are hose of he auhors and do no necessarily reflec hose of he European Cenral Bank. 2 European Cenral Bank, Kaisersrasse 29, D Frankfur am Main, Germany; and

3 European Cenral Bank, 2008 Address Kaisersrasse Frankfur am Main, Germany Posal address Posfach Frankfur am Main, Germany Telephone Websie hp:// Fax All righs reserved. Any reproducion, publicaion and reprin in he form of a differen publicaion, wheher prined or produced elecronically, in whole or in par, is permied only wih he explici wrien auhorisaion of he or he auhor(s). The views expressed in his paper do no necessarily reflec hose of he European Cenral Bank. The saemen of purpose for he Working Paper Series is available from he websie, hp:// eu/pub/scienific/wps/dae/hml/index. en.hml ISSN (prin) ISSN (online)

4 CONTENTS Absrac 4 Non-echnical summary 5 1 Inroducion 7 2 Daa and mehodology 10 3 Empirical findings Benchmark model and resuls Exensions and robusness 18 4 Conclusions 21 References 23 Appendices Figures and ables European Cenral Bank Working Paper Series

5 Absrac This paper analyses he impac of he shif away from a US dollar focus of sysemically imporan emerging marke economies (EMEs) on configuraions beween he US dollar, he euro and he yen. Given he difficuly ha fixed or managed US dollar exchange rae regimes remain pervasive and reserve composiions mosly kep secre, he idenificaion sraegy of he paper is o analyse he marke impac on major currency pairs of official saemens made by EME policy-makers abou heir exchange rae regime and reserve composiion. Developing a novel daabase for 18 EMEs, we find ha such saemens no only have a saisically bu also an economically significan impac on he euro, and o a lesser exen he yen agains he US dollar. The findings sugges ha communicaion hining a a weakening of EMEs US dollar focus conribued subsanially o he appreciaion of he euro agains he US dollar in recen years. Ineresingly, EME policy-makers appear o have become more cauious in heir communicaion more recenly. Overall, he resuls underscore he growing sysemic imporance of EMEs for global exchange rae configuraions. Keywords: communicaion, exchange rae regime, reserves, euro, dollar, emerging economies JEL Classificaion: E58, F30, F31, F36, G15 4

6 Non-echnical summary How would a change o he exchange rae regimes of China and oil-exporing counries affec exchange rae configuraions across major currencies? And similarly, how does a diversificaion and rebalancing of global foreign exchange reserves aler hese currency configuraions? These are arguably wo of oday s mos perinen issues influencing exchange rae dynamics, in paricular of he US dollar, he euro and he yen. Undersanding he answers o hese quesions is also crucial for gauging he direcion in which he inernaional moneary sysem may evolve, and he role ha he US dollar and he euro will play in he fuure. This paper explois he marke reacion o official communicaions by key policy-makers of sysemically imporan emerging marke economies (EMEs) in order o idenify heir effec on G3 exchange raes. These are saemens ha provide informaion o financial markes abou policy-makers views and preferences abou exchange raes and reserves. While his empirical sraegy surely only capures a limied share of he rue informaion ha becomes available o financial markes abou EME currency and reserve choices, he srengh of his approach is ha i allows for a clean idenificaion of facors ha are specific o hese EMEs, and he measuremen of how hey affec global exchange rae configuraions. In shor, he esimaion of he impac of such communicaions a daily frequency enables us o obain an idea of how global exchange rae configuraions are affeced by an overall shif of EMEs away from pursuing an exchange rae sraegy wih a sole focus on he US dollar. The paper develops a novel daabase of saemens by key policy-makers of 18 EMEs including China, Russia, counries of he Gulf Cooperaion Council (GCC: Saudi Arabia, Oman, UAE, Kuwai, Bahrain and Qaar) as well as oher smaller EMEs comprising saemens on hese counries exchange rae regimes and reserve composiion. Overall, our novel daabase includes 199 saemens on he exchange rae regime and 68 saemens on foreign reserves by policy-makers in he 18 EMEs. Our primary ineres is on how such communicaion affecs G3 exchange raes, i.e. he reacion of he euro and he yen vis-à-vis he US dollar. The moivaion for analysing his issue is boh academic as i helps shed ligh on wha drives major exchange raes and of relevance from a policy perspecive as he impac of exchange rae regime choices by China and oil exporing counries coninues o dominae he policy debae on global currencies. We es his hypohesis using daily exchange rae reurns of he US dollar-euro, US dollar-yen and he nominal effecive exchange raes of he euro, US dollar and yen in he period The main finding of he paper is ha saemens on exchange raes and reserves by EME policy-makers exer a saisically significan and economically meaningful impac on he euro and on he yen vis-à-vis he US dollar. Overall, i is he euro ha is affeced he sronges. On average, an EME saemen poining a he possibiliy of loosening he US dollar peg or diversifying reserves leads o an appreciaion of 0.25% of he euro, and 0.15% of he yen agains he US dollar. In urn, he US dollar nominal effecive exchange rae depreciaes by an average 0.11% when such saemens occur. Wha seems sriking is ha he average effec of a saemen by 5

7 Chinese or GCC officials on he euro or yen agains he US dollar is comparable in size o ha of euro area and Japanese officials. Of course i needs o be sressed ha he laer policy-makers generally communicae much more frequenly on exchange raes han he former. Bu, overall, he resul underlines ha financial markes pay very close aenion o saemens by hese EMEs, and ha his reflecs no only expecaions abou he susainabiliy of EMEs currency regimes, bu has a marked impac on he US dollar agains he yen and in paricular agains he euro. I is of course difficul o gauge o wha exen he magniude of hese esimaes is economically relevan. Calculaing he cumulaed effec of EME saemens by year shows ha saemens by EME officials led o an appreciaion of he euro agains he US dollar by as much as 7 percenage poins in This indeed seems very subsanial. Neverheless, here is srong ime variaion in he effec of EME communicaion on major currencies. Few EME policy-makers alked openly abou reforming exchange rae regimes or diversifying reserves before 2003, so ha such communicaion had a relaively small overall relevance for he US dollar-euro exchange rae before Ineresingly, he effec of EMEs on global exchange rae configuraions also seems o have declined markedly in This migh reflec he much more cauious communicaion of EMEs, possibly due o he increased pressure on heir currency pegs from capial inflows and expecaions abou currency reform. The findings of he paper have a number of policy implicaions. Firs, hey poin ou clearly ha imporan EMEs, such as China, Russia and he GCC economies, have a sysemaic and sizeable impac on global exchange rae configuraions. In paricular given he magniude of he reserves held by hese counries, any shif in marke expecaions ha one or several of hese counries could loosen heir close US dollar peg or diversify reserves affecs also he major currency pairs, and in paricular he euro. The resuls obviously do no conain any implicaions abou wha an opimal exchange rae regime choice is for hese economies. Bu he findings sugges ha policy-makers in hese economies are increasingly becoming aware of he impac of heir saemens on global financial markes. This underlines ha communicaion can be an imporan and effecive policy ool ha needs o be used wih cauion and wih a clear idea of wha i aims o achieve. 6

8 1. Inroducion How would a change o he exchange rae regimes of China and oil-exporing counries affec exchange rae configuraions across major currencies? And similarly, how does a diversificaion and rebalancing of global foreign exchange reserves aler hese currency configuraions? These are arguably wo of oday s mos perinen issues influencing exchange rae dynamics, in paricular of he US dollar, he euro and he yen. Undersanding he answers o hese quesions is also crucial for gauging he direcion in which he inernaional moneary sysem may evolve, and he role ha he US dollar and he euro will play in he fuure. The fundamenal difficuly for undersanding he poenial implicaions of his regime shif is ha many of he sysemically imporan emerging marke economies (EMEs) sill mainain a fixed or a leas highly inflexible exchange rae regime vis-àvis he US dollar. Hence i is difficul o predic wha major currency configuraions will be once EMEs have moved o more flexible and open currency regimes. Moreover, he composiion and diversificaion decisions of reserves by mos EMEs are mosly closely held secre. This paper explois he marke reacion o official communicaions by key policy-makers of sysemically imporan EMEs in order o overcome hese difficulies. These are saemens ha provide informaion o financial markes abou policy-makers views and preferences abou exchange raes and reserves. While his empirical sraegy surely only capures a limied share of he rue informaion ha becomes available o financial markes abou EME currency and reserve choices, he srengh of his approach is ha i allows for a clean idenificaion of facors ha are specific o hese EMEs, and he measuremen of how hey affec global exchange rae configuraions. In shor, he esimaion of he impac of such communicaions a daily frequency enables us o obain an idea of how global exchange rae configuraions are affeced by an overall shif of EMEs away from pursuing an exchange rae sraegy wih a sole focus on he US dollar. The paper develops a novel daabase of saemens by key policy-makers of 18 EMEs including China, Russia, counries of he Gulf Cooperaion Council (GCC: Saudi Arabia, Oman, UAE, Kuwai, Bahrain and Qaar) as well as oher smaller EMEs comprising saemens on hese counries exchange rae regimes and reserve composiion. In fac, here have been frequen saemens in recen years by policymakers from mos of hese EMEs in ha hey are considering or pursuing an objecive of moving away from a pure US dollar peg, or ha hey are conemplaing reserve diversificaion ou of US dollar asses. These inensified in 2003/04 as he US dollar sared declining, and hey peaked in Ineresingly, policy-makers in China and in oil-exporing counries appear o have become much more cauious in heir communicaion abou moving away from he US dollar in 2007, possibly parly reflecing he increased capial flows ino hese economies due o changed expecaions abou currency and reserve policies. Overall, our novel daabase includes 199 saemens on he exchange rae regime and 68 saemens on foreign reserves by policy-makers in he 18 EMEs. 7

9 Our primary ineres is on how such communicaion affecs G3 exchange raes, i.e. he reacion of he euro and he yen vis-à-vis he US dollar. The moivaion for analysing his issue is boh academic as i helps shed ligh on wha drives major exchange raes and of relevance from a policy perspecive as he impac of exchange rae regime choices by China and oil exporing counries coninues o dominae he policy debae on global currencies. Our hypohesis is ha if marke paricipans consider such saemens as credible and expec hem o have an impac on major currencies, hen we would expec ha hese saemens have a depreciaing effec on he US dollar agains he euro and he yen. This prior follows he following logic. EME saemens indicaing a reserve diversificaion ou of US dollars or he desirabiliy of an appreciaion of he domesic currency agains he US dollar should boh weaken he US dollar agains oher major currencies, and primarily hrough a porfolio balance channel as i may indicae ongoing or planned diversificaion ou of US dollar asses. This channel has indeed been shown o have played some role in he pas for FX inervenions by cenral banks (see e.g. Branson, 1977; Dominguez and Frankel, 1993). Bu he effec of saemens by EME auhoriies may also occur hrough a coordinaion channel, as formulaed by Sarno and Taylor (2001), in which hey may rigger and help coordinae expecaions among marke paricipans. Saemens inerpreed as suggesing a weakening by EMEs of heir exchange rae policy s srong US dollar focus migh, in urn, be inerpreed as a signal ha relaive demand for global currencies is fundamenally changing, along wih he fuure course of he inernaional moneary sysem s naure. We es his hypohesis using daily exchange rae reurns of he US dollareuro, US dollar-yen and he nominal effecive exchange raes of he euro, US dollar and yen in he period We aemp o conrol for oher facors ha may influence he esimaions, in paricular saemens on exchange raes by G3 policymakers (US, euro area and Japan) as well as a broad se of macroeconomic news. The main finding of he paper is ha saemens on exchange raes and reserves by EME policy-makers exer a saisically significan and economically meaningful impac on he euro and on he yen vis-à-vis he US dollar. Overall, i is he euro ha is affeced he sronges. On average, an EME saemen poining a he possibiliy of loosening he US dollar peg or diversifying reserves leads o an appreciaion of 0.25% of he euro, and 0.15% of he yen agains he US dollar. In urn, he US dollar nominal effecive exchange rae depreciaes by an average 0.11% when such saemens occur. Wha seems sriking is ha he average effec of a saemen by Chinese or GCC officials on he euro or yen agains he US dollar is comparable in size o ha of euro area and Japanese officials. Of course i needs o be sressed ha he laer policy-makers generally communicae much more frequenly on exchange raes han he former. Bu, overall, he resul underlines ha financial markes pay very close aenion o saemens by hese EMEs, and ha his reflecs no only expecaions abou he susainabiliy of EMEs currency regimes, bu has a marked impac on he US dollar agains he yen and in paricular agains he euro. 8

10 I is of course difficul o gauge o wha exen he magniude of hese esimaes is economically relevan. Calculaing he cumulaed effec of EME saemens by year shows ha saemens by EME officials led o an appreciaion of he euro agains he US dollar by as much as 7 percenage poins in This indeed seems very subsanial. Neverheless, here is srong ime variaion in he effec of EME communicaion on major currencies. Few EME policy-makers alked openly abou reforming exchange rae regimes or diversifying reserves before 2003, so ha such communicaion had a relaively small overall relevance for he US dollar-euro exchange rae before Ineresingly, he effec of EMEs on global exchange rae configuraions also seems o have declined markedly in This migh reflec he much more cauious communicaion of EMEs, possibly due o he increased pressure on heir currency pegs from capial inflows and expecaions abou currency reform. We conduc various exensions and modificaions o check he robusness of he findings. Overall, he esimaes are quie similar across China, Russia and GCC counries. Neverheless, i is ineresing o noe ha, on a cumulaed basis, saemens by GCC officials seem o have had a somewha larger effec on he US dollar-euro han hose by Chinese or Russian auhoriies. The findings are also robus o alernaive classificaions of he saemens and heir underlying inenions. Moreover, we conrol for various macroeconomics news from he Unied Saes and he euro area, as well as saemens on exchange raes by G3 auhoriies. In all cases, he benchmark resuls are robus o hese exensions. As o he final par of he empirical analysis, we ry o gauge he channels hrough which EME saemens affec major currencies. One hypohesis ha is implici in he analysis above is ha saemens by EME auhoriies eiher rigger or confirm marke expecaions abou he likelihood of a change o he exchange rae regime or o reserve composiion. We find some evidence ha suggess ha his expecaions channel is indeed imporan as he effec of a given saemen is larger when also marke expecaions abou a fuure change in he domesic currency regime, as proxied from he spread beween non-deliverable forward and spo raes, increase. The findings of he paper have a number of policy implicaions. Firs, hey poin ou clearly ha imporan EMEs, such as China, Russia and he GCC economies, have a sysemaic and sizeable impac on global exchange rae configuraions. In paricular given he magniude of he reserves held by hese counries, any shif in marke expecaions ha one or several of hese counries could loosen heir close US dollar peg or diversify reserves affecs also he major currency pairs, and in paricular he euro. The resuls obviously do no conain any implicaions abou wha an opimal exchange rae regime choice is for hese economies. Bu he findings sugges ha policy-makers in hese economies are increasingly becoming aware of he impac of heir saemens on global financial markes. This underlines ha communicaion can be an imporan and effecive policy ool ha needs o be used wih cauion and wih a clear idea of wha i aims o achieve. The paper is relaed o various srands in he lieraure. I fis mos closely ino he rapidly growing lieraure on he role of communicaion in managing marke expecaions, no jus in he area of moneary policy, bu also of exchange raes 9

11 (Blinder e al., 2008). While here is ample evidence ha acual FX inervenions by moneary auhoriies influence currency values, here is also a growing area of he lieraure ha shows ha communicaion can be an effecive ool in guiding foreign exchange markes (Beine e al. 2006; Frazscher 2008a; Jansen and De Haan 2005, 2007; Dominguez and Panhaki 2007; Siklos and Bohl forhcoming). In fac here is evidence ha communicaion may o some exen and under some condiions be a subsiue o acual inervenions in ha i affecs markes quie independenly of he laer (Frazscher 2008c), and also ha credible communicaion overall enhances he effeciveness of acual inervenions (Eger 2007). The criical quesion is how communicaion can be successful in managing expecaions and hus influence exchange raes. The seminal work by Sarno and Taylor (2001) sresses he funcioning of a coordinaion channel, in which communicaion may no only provide new informaion o markes, bu in which i coordinaes marke beliefs and moves marke paricipans o ac in a coordinaed way. There is indeed evidence ha such a channel is a work for FX communicaion in he conex of major economies (Taylor 2004, Reiz and Taylor 2006, Frazscher 2008b). The paper is organised as follows. Secion 2 discusses in deail he consrucion of our daabase on communicaion by EME auhoriies, boh on FX regimes and on reserve diversificaion. Secion 3 hen gives he benchmark resuls and provides a number of exensions and robusness checks. Secion 4 summarises he findings and concludes wih a discussion of policy implicaions. 2. Daa and mehodology We aim o obain a lis of public saemens abou he domesic exchange rae regime and reserve diversificaion by relevan policy-makers in 18 emerging marke economies (China, 6 oher emerging Asian economies 1, 6 Gulf Cooperaion Council economies 2 and Russia), which include also four more oher EMEs, namely: Iraq, Iran, Norh Korea and Venezuela, which all have swiched, or signalled heir inenion o do so, par of heir inernaional ransacions (e.g. oil sales) or foreign reserves in euros. Our aim is o collec a lis of public saemens abou (i) he role of he US dollar in heir exchange rae regime and (ii) he composiion of heir foreign reserve asses ha is as comprehensive as possible. Moreover, as a conrol group we collec saemens abou exchange raes by he hree main currency economies, he US, he euro area and Japan. To ha end, we firs idenify he relevan policy-makers o include. As regards emerging marke economies, we collec saemens by cenral bank Governors in a sysemaic fashion, given ha cenral banks in hese economies are responsible for exchange rae policy and inervenions in foreign exchange markes. When available, however, we also collec saemens by Minisers of Finance and cenral bank Vice- Governors, alhough hese end o be less frequen. For China, we also have 1 These include Hong-Kong, India, Malaysia, Taiwan, Singapore and Souh Korea. 2 Bahrain, Kuwai, Oman, Qaar, Saudi Arabia and he Unied Arab Emiraes. 10

12 saemens by he Presiden of he People s Republic, he Premier and represenaives of he Sae Adminisraion of Foreign Exchange who have occasionally albei relaively rarely expressed public views on he renminbi and/or on he composiion of China s reserves. A lis of hose policy-makers broken down by naionaliy and insiuion is provided in Appendix I. Turning o our conrol group, i.e. G3 auhoriies, primarily saemens of he Treasury Secreary and of he Depuy Treasury Secreary are included for he Unied Saes, given ha exchange rae policy lies in he realm of he US Treasury Deparmen. 3 For he euro area, he European Union Treay specifies a close coordinaion beween he and he Eurogroup, which boh share he responsibiliy for official exchange rae communicaion. However, he alone is in charge of acual foreign exchange inervenions, wih is overarching aim remaining he mainenance of price sabiliy. Saemens are herefore exraced for he members of he Governing Council. Japan s exchange rae policy officially lies in he realm of he Minisry of Finance, alhough members of he Bank of Japan s Policy Board have ended o make regular saemens on he yen. Hence we collec saemens by boh he Miniser of Finance and he Governor of he Bank of Japan. Public saemens generally sem from hree sources: speeches, inerviews and public esimonies. In order o ensure ha hese public saemens were also available o marke paricipans in financial markes, one of he mos commonly used wire services, Reuers News, was chosen o exrac all news releases for he period 1 January 2000 o 31 December 2007, parly building on he daabase for he US, euro area and Japan in Frazscher (2008c). These releases were obained hrough Faciva. Reuers News has he advanage of being one of he mos comprehensive wire services, reporing on and disseminaing all major news in a imely fashion, usually wihin a shor imeframe afer a public announcemen. I is also among hose providers which receive greaes aenion among raders and invesors. This allows using daily daa o analyse he impac of saemens on exchange raes, aking exchange rae quoes a EST, i.e. closing prices of he New York markes. 4 In selecing he saemens, he search crieria for public saemens on he role of he US dollar in he exchange rae regime of emerging marke economies were: (a) he name or he ile of he policy-maker, (b) he word exchange rae or he name of he domesic currency and 3 Exending he analysis o oher officials, such as he Under Secrearies of he Treasury and of he Federal Reserve does no add many observaions. Federal Reserve officials have made remarkably few public saemens abou he US dollar. 4 Arguably an alernaive migh be o use inraday daa ogeher wih he ime samps corresponding o he saemens of our daabase. However, using inraday daa is no a feasible opion for improving our idenificaion scheme because he repors of Reuers News are he aricles summarising a paricular saemen by a policy-maker. These aricles may come as soon as 20 minues afer a paricular saemen, or hey become available several hours laer in he day. Hence we canno measure he highfrequency marke response of a saemen because no daa is available for he iniial snaps (i.e. realime reporing of headlines conaining a mos a few words, which may occur wihin seconds afer a saemen). 11

13 (c) he words sable or sabiliy or flexible or flexibiliy or dollar or peg. Likewise, he search crieria for saemens on he composiion of foreign exchange reserves were: (a) he name or he ile of he policy-maker, (b) he word reserves and (c) he words composiion or diversificaion or porfolio or rebalancing or dollar. were: Las, he search crieria used for he Unied Saes, he euro area and Japan (a) he name or he ile of he policy-maker and (b) he word exchange rae or he name of he domesic currency. Clearly, a crucial issue is how o classify he saemens in erms of boh conen and meaning. For emerging markes, saemens S are caegorised as eiher advocaing ha he reference o he US dollar in he exchange rae regime will be relaxed in order o le he domesic currency appreciae, or o le he domesic currency depreciae or ha he exchange rae regime will be mainained. e S US dollar reference is relaxed o appreciae US dollar reference is mainained US dollar reference is relaxed o depreciae Appendix II conains examples of saemens for each of hose caegories. We expec ha relaxing he US dollar reference o appreciae also conribues o an appreciaion of he euro or he yen vis-à-vis he US dollar hrough he porfolio balance channel (see e.g. Branson, 1977; Dominguez and Frankel, 1993; Greenspan, 2004). This relaxaion would indeed imply ha emerging marke economies reduce heir purchases of US dollar-denominaed securiies and, in urn, decrease demand for US dollars. Ulimaely, his would conribue o a depreciaion of he US dollar vis-àvis oher currencies, including he euro and he yen. A coordinaion channel migh also be a play (Sarno and Taylor, 2001), in which marke paricipans migh inerpre saemens by emerging economies suggesing a weakening of heir exchange rae policy s srong US dollar focus as a signal ha relaive demand for global currencies is fundamenally changing, along wih he fuure course of he inernaional moneary sysem s naure, which hus help coordinae invesor expecaions. Moreover, emerging marke saemens referring o he composiion of foreign exchange reserves are classified as eiher suggesing diversificaion away from he US 12

14 dollar, diversificaion ino he US dollar or ha he composiion of reserves is mainained: res S Diversificaion ou of he US dollar Reserve composiion is mainained Diversificaion ino he US dollar Appendix II conains examples of saemens for each of hose caegories. In he same vein, given ha a large if no dominan share of emerging marke reserves are denominaed in US dollars (see e.g., 2008), we expec saemens ha signal inenions o diversify across currencies and/or insrumens o conribue o an appreciaion of he euro or he yen vis-à-vis he US dollar. For he Unied Saes, he euro area and Japan, saemens IO are caegorised as eiher advocaing a sronger domesic currency ( srenghen ), a weaker domesic currency ( weaken ), or as being neural in he following way: G3 IO Inenion o srenghen he domesic currency Neural saemen Inenion o weaken he domesic currency The classificaion is a judgmenal one and clearly in some cases difficul o make. Three poins should be noed. Firs, he classificaion is done in a mechanical way, i.e. all saemens are classified based on heir language conen and no based on heir effec and imporance for asse prices. Second, he only saemens ha are no classified and lef ou from he daase are hose ha occurred on days of moneary policy meeings of he respecive cenral banks or in moneary policy esimonies o he respecive parliamens. I was also checked wheher exchange rae saemens ake place during release days of relevan macroeconomic daa. I is imporan o conrol for such evens because he news conen of moneary policy saemen or daa releases may have a dominan effec on hose days. Third, he advanage in using newswire services is ha inerpreaion of he saemens is provided by professionals who are aware of nuances and experienced in inerpreing hem. In his respec, small changes o sandard language may ofen occur inenionally o convey a message and have a large effec on financial markes. To accoun for his, we also use a dummy variable which equals 1 when a saemen deviaes from he predominan policy manra and 0 oherwise. Several addiional caveas should be borne in mind, however. A firs cavea is ha newswire repors may no reflec he rue inenion of policy-makers. Moreover, some public saemens may no be covered, or may o some exen conain Reuers inerpreaion. Hence he lis of saemens may no consiue a complee lis of 13

15 official communicaions bu only a lis of saemens as repored by Reuers. The objecive of our paper is o analyse he reacion of marke paricipans o policymakers communicaion. I herefore seems sensible o focus only on hose saemen ha acually become available o marke paricipans and, again, Reuers News is among hose providers ha receive greaes aenion among raders and invesors. Las, oher imporan saemens, such as hose by he G7, are no included as hey generally canno be aribued o a single counry s policy-makers alone and do no refer o an individual currency (see Frazscher 2008b for an empirical analysis of he marke impac of such saemens). Tables Table 1.1 provides a summary of he around 200 saemens by emerging marke auhoriies we found wih regard o he use of he US dollar as an anchor currency over January 2000-December The bulk of hese saemens (abou 75%) are from Chinese auhoriies 5 ; 19% are from Gulf Cooperaion Council auhoriies 6 and 6% from Russian auhoriies. 7 In erms of meaning and conen, abou wo-hirds of he saemens repea a manra ha he exchange rae regime will remain unchanged and are classified as neural. A quarer of he saemens are classified as conveying a message ha he reference o he US dollar in he exchange rae regime will be relaxed in order o le he domesic currency appreciae (e.g. when China swiched from a sric US dollar peg o a regime allowing for more exchange rae flexibiliy). A few saemens are classified as conveying a message ha he reference o he US dollar migh be relaxed o le he domesic currency depreciae (e.g. when uncerainies mouned in he wake of he Asian crisis as o wheher he Chinese renminbi migh be devalued). Saemens on he composiion of foreign reserve asses by emerging marke auhoriies are fewer (abou 70) han hose on he exchange rae regime and are summarised in Table 1.2. Less han one-fifh are from China (also in conras wih saemens on he exchange rae regime), wih he Governor of he People s Bank of China and represenaives from he Sae Adminisraion of Foreign Exchange being he main auhors. More han one-hird of he saemens are from oher emerging Asian economies (noably Souh Korea) and anoher hird by Gulf Cooperaion Council auhoriies. The remaining saemens are from Russian auhoriies. In erms of meaning and conen, he larges share (wo-hirds) of he saemens is classified as conveying a message ha diversificaion across currencies and/or insrumens is sough. One-fifh of he saemens ha repea a manra ha he composiion of foreign reserve asses will remain unchanged are classified as neural. A few saemens are classified as indicaing ha diversificaion ino US dollars is sough. Figures More han one-half of hese saemens are from he Presiden of he People s Bank of China. 6 More han one-half of hese saemens are from he Governor of he Cenral Bank of he Unied Arab Emiraes. 7 These saemens are exclusively from he Chairman or he Firs Depuy Chairman of he Cenral Bank of he Russian Federaion. 14

16 To furher give an inuiion of he daa, Figures 1.1 and 1.2 plo over ime he saemens by emerging marke officials relaing o he exchange rae regime ogeher wih he USD/EUR. Saemens by Chinese auhoriies are broadly spread over , bu hey were markedly more frequen in he afermah of he Asian crisis, when he debae abou a possible devaluaion of he renminbi mouned and afer 2004/5 wih he relaxaion of he US dollar peg and he adopion of a currency baske. Saemens by Gulf Cooperaion Council auhoriies have become increasingly frequen afer he revaluaion of he Kuwaii Dinar vis-à-vis he US dollar in May Likewise, saemens by Russian auhoriies have become increasingly frequen afer he inroducion of an exchange rae baske including he US dollar and he euro in February Figures 2.1, 2.2 and 2.3 plo over ime he saemens by emerging marke officials referring o he composiion of heir foreign reserve asses ogeher wih he USD/EUR. I is ineresing o noe ha saemens became significanly more frequen afer 2004, when he size of emerging marke reserve asses sared o grow considerably. 3. Empirical findings We now urn o he empirical analysis and he findings. We sar by oulining he benchmark resuls and discuss heir economic significance (secion 3.1) before esing heir robusness and presening various exensions and modificaions o he benchmark (secion 3.2). 3.1 Benchmark model and resuls As oulined in deail above, our primary ineres is in undersanding how saemens by EME officials affec major currencies, and in paricular he euro and he yen vis-à-vis he US dollar. Our saring poin is he microsrucure lieraure of FX markes, and more specifically he lieraure on announcemen effecs and asse prices (e.g. Andersen e al. 2003, Ehrmann and Frazscher 2005). This lieraure commonly models he exchange rae in a sandard asse-pricing framework, where he log exchange rae s is a funcion of he discouned value of privae secor expecaions abou fuure fundamenals f +i : s i 1 E ( f ) i0 (1) i wih as he public informaion available a ime, and as he discoun facor. Since our objecive is o undersand he effec of public saemens by policy-makers on exchange raes, we follow he announcemen lieraure and formulae a dynamic specificaion of he model. Such a dynamic specificaion of he model yields r i 1 E ( f ) E ( f i0 (2) i 1 i 1 ) wih r s s 1. The implicaion is ha wha drives exchange raes are changes o expecaions by marke paricipans abou relevan fuure fundamenals. Reserve 15

17 diversificaion and changes in he exchange rae regime of EMEs and oil exporing counries may precisely be such fundamenals, and he objecive of he paper is o es for heir empirical relevance for major currency configuraions. From his simple, sylized concepual framework, we derive our empirical model as r e e res res k k S S X (3) k wih r as daily exchange rae reurns over January 2000-December 2007, S e a [-1; 0; +1] indicaor variable for saemens on exchange rae regimes, S res a corresponding indicaor variable for communicaions on reserves, and X a vecor of conrols including saemens by G3 auhoriies and day-of-he-week effecs in he benchmark, and laer also macroeconomic news and oher conrols in he exended specificaions. Daily reurn daa exhibi srong heeroskedasiciy, which we correc for by using robus sandard errors. In one of he robusness ess discussed in secion 3.2, we also model exchange rae reurns using an EGARCH specificaion, i.e. in which we model boh he condiional mean and he condiional variance of exchange rae reurns. However, as our main ineres is in he condiional mean of currency reurns, esimaing he mean equaion via OLS wih robus sandard errors is sufficien for our purpose. Table 2 Table 2 shows he benchmark resuls when pooling all EME saemens, i.e. hose on exchange raes and on reserves, ino a single variable so ha S = S e + S res. There are wo main resuls worh emphasising. The firs one is ha saemens by EMEs maer, as hey clearly have a saisically significan effec on he euro and on he yen vis-à-vis he US dollar. On average, a saemen by EME officials moves he euro by 0.25% and he yen by 0.15% agains he US dollar. I is hard o gauge wheher hese effecs are sizeable. One possible inerpreaion for why he effecs on he euro are larger han on he yen is ha a larger share of reserve diversificaion may go ino euro denominaed asses han in yen denominaed asses, and marke paricipans may correcly anicipae his fac. One way o compare hem is wih corresponding saemens by officials of he US, he euro area and Japan. Models (1) and (3) of Table 2 indicae ha he effec of EME saemens are indeed comparable in magniude o hose of G3 officials, bar he US. 8 Models (2) and (4) use as conrols only he saemens by he main G3 policymakers in charge of exchange rae policy (he US Treasury Secreary, he 8 In fac, saemens by US auhorise are barely ever saisically significan. This is in line wih he lieraure, which explains he small or negligible effec of US saemens by he fac ha US policymakers end o repea heir sandard manra advocaing a srong dollar policy, hereby providing no new informaion o markes. Their saemens hus end o have a small effec, excep when US officials deviae from his manra (see e.g. Frazscher 2008c). 16

18 Presiden, and he Japanese Miniser of Finance). The poin esimaes of EME saemens basically remain unchanged, underlining heir robusness. An imporan poin o noe a his juncure concerns he permanence of he effecs of EME saemens. The conemporaneous effecs, as presened in Table 2, are meaningful for he relevance of such saemens only o he exen ha hey are lasing or permanen. Exending his model o a dynamic specificaion shows ha all of he effec of EME saemens on exchange raes akes place on he same day, while coefficiens for lagged effecs are always saisically insignifican. In line wih he findings of he microsrucure lieraure, his implies ha he conemporaneous effecs can indeed be inerpreed as he overall, lasing effecs of such evens. A second finding is ha he effec of EME saemens ends o be subsanially larger on he euro han on he yen. This is also confirmed when analysing he reacion of he hree G3 nominal effecive exchange raes in models (5)-(7) of Table 2. Ineresingly, he sronges reacion among he effecive exchange raes is for he US dollar, which depreciaes on average by around 0.11% in response o EME saemens abou relaxing heir link o he US currency. This seems quie a sizeable effec considering ha many EMEs coninue o have managed or fixed exchange raes agains he US dollar. Figures 3 4 A crucial issue is o wha exen hese esimaes are economically meaningful. In paricular, how much of he euro and yen movemens agains he US dollar can be explained by EMEs and heir inenions o loosen heir US dollar peg and diversify heir reserves ou of US dollars? To gauge his economic relevance, and given he poin on he lasing effec of such saemens as argued above, we cumulae he esimaed daily effecs of EMEs over a ime horizon of one year. Figure 3 shows hese cumulaed effecs by year, also disinguishing beween and comparing he overall impac of China wih ha of oil exporing counries (GCC counries plus Russia) and oher EMEs. The figure shows a sriking increase in he cumulaed effec of EMEs on he US dollar euro exchange rae since In fac, he larges overall effec was regisered in 2006, when saemens by all EMEs combined conribued o a 7 percenage poin (p.p.) appreciaion of he euro agains he US dollar. This compares o an acual appreciaion of he euro agains he US dollar by abou 10%, as indicaed by he black bars in he figure. 9 This suggess ha EME communicaion has indeed exered a sizeable overall effec on he euro exchange rae. Ineresingly, he cumulaed effec declined somewha in 2007, bu was sill abou 4 p.p. Wha explains hese ime variaions? Figure 4 shows he disribuion of EME saemens, and heir inclinaions, over ime. 9 A furher ineresing feaure of he figure is ha in 2006 he effec of GCC saemens was overall larger han hose of Chinese auhoriies. This does no necessarily mean ha he GCC economies are more imporan han he Chinese for global and G3 exchange rae configuraions. I only means ha he new informaion provided by GCC counries abou heir inenions regarding reserves and FX regimes may have been much larger han he new informaion provided by he Chinese, who had embarked on a seady and gradual process of RMB appreciaion vis-à-vis he US dollar in July

19 I sresses ha he frequency of EME saemens has coninuously increased over ime, reaching a peak in However, afer 2006 he conen of EME communicaion appears o have changed markedly, as EME policy-makers became increasingly neural in heir saemens, speaking much less frequenly abou abandoning heir US dollar peg or of diversifying reserves away from he US dollar, while sressing more ofen heir desire o mainain heir US dollar link. This migh reflec a much more cauious communicaion of EMEs, possibly due o he increased pressure on heir currency pegs from capial inflows and expecaions abou currency reform. 10 These figures illusrae he poency bu also he limiaions of our empirical approach. The fac ha EME policy-makers have sressed less frequenly heir desire o aler heir exchange rae regimes and reserve composiion could eiher mean ha heir preferences have changed, or i could imply ha hey sill have he same views bu have become more cauious in heir communicaion. If his second possibiliy is rue, we would be able o capure only a smaller share of he rue overall impac of EMEs regime changes and porfolio changes. As such, he cumulaed effecs shown in Figure 3 would herefore consiue a lower bound Exensions and robusness How robus are hese findings? There are many poenial caveas and limiaions o hese esimaes, and i is imperaive o gauge how sensiive he resuls when rying o address some of hese caveas. A firs cavea is ha many oher pieces of informaion become available and influence bilaeral currency values. I is obviously impossible o include all facors, bu we can ry o conrol for relevan US macroeconomic announcemens, which have been shown in he lieraure o exer a significan effec on major currencies agains he US dollar (e.g. Andersen e al. 2003). Table 3 shows he findings for wo such robusness checks. Models (1) and (3) for he bilaeral exchange raes, and (5)-(7) for he effecive ones, show he resuls wih hese macroeconomic news included and confirm ha he poin esimaes of EME saemens remain hardly changed. Moreover, he same holds when including also acual inervenions since 2000 by Japanese auhoriies (as in models (3) and (4) of Table 3) An alernaive explanaion which draws from recen marke commens on he possible exisence of a negaive correlaion beween US dollar movemens and oil prices since early 2008 migh be ha GCC economies refrain from making saemens ha could adversely impac he US dollar and hereby possibly reduce heir oil revenues. 11 We have also esed for ime variaions in he coefficien esimaes in he benchmark model. There indeed seems o be an overall increase in he poin esimae of EME saemens on he euro and he yen over ime. However, he magniude of his change is relaively modes, in paricular in laer years, so ha our preferred calculaions of he conribuions are based on consan parameer esimaes. 12 We also included lagged erms of he saemens o assess how persisen heir impac on major currencies is. As expeced, we find ha lags are saisically insignifican. This suggess ha he informaion conen of saemens is priced in by markes immediaely on he day hey occur, in line wih he efficien marke hypohesis. Thus we inerpre he conemporaneous effecs of he saemens as he permanen effecs. 18

20 A second issue is how robus he findings are o alernaive classificaions. For his purpose, we reclassify all neural saemens (i.e. S = 0) ino variables ha go agains he common policy manra. For insance, a saemen of a Japanese official which is neural bu comes in a period when he predominan policy sance is o weaken he yen as e.g. occurred in mos of would code, under he alernaive classificaion, as a deviaion from he common policy manra and hus as S = +1. Models (2) and (4) of Table 3 provide he esimaes, bu again show ha he main findings hold, alhough he poin esimaes are somewha smaller. Tables 3 7 As a furher exension, we nex spli EME saemens ino hose ha alk abou he exchange rae regime of he respecive counries and hose ha discuss reserve diversificaion. Table 4 shows his spli for all EMEs combined, while Tables 5-7 provide he corresponding esimaes individually for Chinese, GCC and Russian officials, respecively. Table 4 indicaes ha he effec of EME saemens is very similar when officials communicae abou he exchange rae regime or reserves. However, Tables 5-7 indicae ha here are some differences across counries. For China, i seems ha markes reac primarily o saemens abou he exchange rae regime, and no o hose abou reserve diversificaion. By conras, here is no sizeable difference across caegories of saemens for GCC counries or Russia. The lack of significance of Chinese saemens on reserves may parly sem from he fac ha Chinese officials hardly ever openly alk abou reserve diversificaion, and possibly ha marke paricipans expec his o be a less pressing issue han he fuure of China s domesic exchange rae regime, which has been he main focus of inernaional discussions hus far. Tables 8 9 We also es he impac of saemens by emerging Asian auhoriies oher han China, which mainly focus on reserve diversificaion, and find similar resuls for he dollar-euro (bu no saisically significan impac on he dollar-yen). Moreover, we esed he impac of saemens made by auhoriies of counries like Iraq, Iran, Norh Korea or Venezuela, which have swiched, or signalled heir inenion o do so, par of heir inernaional ransacions (e.g. oil sales) or foreign reserves in euros. We find ha hese saemens have no significan impac on eiher he currency pairs or he effecive exchange raes, cauiously suggesing ha markes may no reac o changes in currency focus driven by poliical consideraions, bu mainly o hose driven by economic ones. We nex urn o oher robusness checks. The firs one, shown in Table 8, is he quesion as o wheher EME communicaion affecs no only he level, bu also he condiional volailiy of he euro, he yen and he US dollar. Table 8 shows he esimaes from an EGARCH (1,1) model specificaion in which we es he effec of EME saemens also on he condiional variance of daily currency reurns. The findings are in line wih hose of he lieraure on foreign exchange communicaion in 19

21 ha EME saemens end o lower marke volailiy (e.g. Frazscher 2008c), suggesing ha such saemens are considered help reduce uncerainy and sele markes. As a furher robusness check, we also es he impac of emerging marke saemens on heir own domesic currencies. However, given ha hese currencies remain pegged or heavily managed, we use 1-year non-deliverable forward raes (NDFs) insead. 13 We find some evidence ha Chinese saemens also maer for is domesic currency NDF, bu no for he oher NDFs. However, giving a meaningful inerpreaion o such resuls is difficul given he igh managemen of hese currencies. A furher issue is he overall goodness-of-fi of our empirical model. How much of he daily euro, dollar and yen flucuaions can acually be explained by his model? Table 9 shows he R-squared of parial models in which he models are esimaed only for hose days when policy-makers in individual economies issued saemens, as compared o all days. For insance, focusing on he US dollar-euro shows ha EME saemens can explain abou 15% of he daily variaion of his currency pair on days when EME officials issued saemens. The explanaory power of differen groups and differen currencies varies. However, while such magniude of he R-squared may no sound very large, i sill appears quie sizeable given he overall volailiy of exchange raes (see e.g. Andersen e al. 2003). Tables As he final par, we would like o undersand beer he channels and he condiions under which EME communicaion influences major currency configuraions. One hypohesis is ha FX markes are more sensiive o new informaion when here is large uncerainy or when currency misalignmens are large. Disinguishing beween periods wih high versus low marke volailiy (relaive o he sample average for he corresponding 1-monh hisorical volailiy), he esimaes shown in Table 10 sugges ha EME communicaion has no a significanly larger effec in periods of high marke volailiy relaive o periods of low marke volailiy. However, disinguishing beween periods of large versus small misalignmens (defined here as periods when he exchange rae deviaes from is 5-year hisorical average), he esimaes show a larger effec on he US dollar euro exchange rae when currency misalignmens are large. Similarly, Table 11 indicaes ha he effec of EME saemens is larger when marke expecaions of an impending change in he respecive counries currency regime is perceived o be relaively likely, based on expecaions proxied by forward conracs. Indeed, ineracing saemens by emerging economies wih he expeced change in he Chinese renminbi relaive o he US dollar, proxied here by using he difference beween he 1-year NDFs and he spo rae, he impac of hese saemens is shown o be more han wice larger when markes expec he renminbi o appreciae. Conversely, we do no find ha he impac is larger when using NDFs for 13 Resuls are no shown here o save space bu are available from he auhors upon reques. 20

22 he currencies of he Gulf Cooperaion Council, perhaps because hese are less liquid insrumens wih more limied informaion conen on marke expecaions han renminbi NDFs. Sill, he resuls are somewha supporive of he expecaions channel, as he effec of a given saemen is larger when also marke expecaions abou a fuure change in he domesic currency regime of China increase. 4. Conclusions The empirical findings of he paper sugges ha saemens by sysemically imporan EMEs such as China, he GCC counries and Russia have a sizeable impac on major currency configuraions. In paricular, i appears ha i is in paricular he euro ha is highly sensiive o indicaions by EMEs o abandon heir close US dollar focus in heir exchange rae regime or in heir reserve managemen. The US dollar-yen exchange rae is also found o be sensiive o such saemens, bu significanly less so han he euro. In urn, he US dollar nominal effecive exchange rae ends o depreciae when such saemens occur. These findings are robus o a baery of exensions and alernaive specificaions of he model. Moreover, EMEs saemens abou heir inenion o move away from a close US dollar focus do no only exer a saisically significan bu also an economically meaningful impac on major currency configuraions. Cumulaing he effecs on an annual basis sugges ha since 2003/04, saemens by EME officials and ensuing marke expecaions conribued a subsanial share o he overall appreciaion of he euro agains he US dollar, and possibly as much as 7 percenage poins in 2006 alone. Ineresingly, he effec of EMEs on global exchange rae configuraions also seems o have declined markedly in This migh reflec he much more cauious communicaion of EMEs, possibly due o he increased pressure on heir currency pegs from capial inflows and expecaions abou currency reform. Many caveas and limiaions apply o our empirical approach, in paricular as he saemens we analyse may capure only a fracion of he rue effec of EME currency and reserve choices on global exchange rae configuraions. However, given heir rising imporance, i is inriguing and imporan o undersand how hese economies are affecing major currency configuraions. We have conduced a broad baery of exensions and modificaions o he benchmark model, and find ha overall he empirical findings appear robus. Overall, he srengh of he approach is a clean idenificaion of facors ha are specific o EMEs, which in urn allows us o gauge how a fuure shif away from he US dollar may aler he global seing and role of differen currencies, in paricular he US dollar, he euro and he yen. The findings of he paper have a number of policy implicaions. As a firs one, our empirical resuls clearly sress ha imporan EMEs, such as China, Russia and he GCC economies, have a sysemaic and sizeable impac on global exchange rae configuraions. In paricular given he magniude of he reserves held by hese counries, any shif in marke expecaions ha one or several of hese counries could loosen heir close US dollar focus or diversify reserves affecs also he major currency 21

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