WORKING PAPER SERIES COMMUNICATION AND EXCHANGE RATE POLICY NO. 363 / MAY by Marcel Fratzscher

Transcription

1 WORKING PAPER SERIES NO. 363 / MAY 004 COMMUNICATION AND EXCHANGE RATE POLICY by Marcel Frazscher

2 WORKING PAPER SERIES NO. 363 / MAY 004 COMMUNICATION AND EXCHANGE RATE POLICY by Marcel Frazscher In 004 all publicaions will carry a moif aken from he 00 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= I would like o hank Terhi Jokipii for excellen research assisance. Commens and suggesions from Gonzalo Camba-Mendez, Eore Dorrucci, Michael Ehrmann, Philipp Harmann, Peer Hördahl, Bernd Schnaz, Bernhard Winkler, he Ediorial Board and seminar paricipans a he European Cenral Bank are graefully acknowledged.the views expressed in his paper are hose of he auhor and do no necessarily reflec hose of he European Cenral Bank. Marcel.Frazscher@ecb.in; European Cenral Bank, Kaisersrasse 9, D Frankfur/Main. Germany. Tel.: Fax.:

3 European Cenral Bank, 004 Address Kaisersrasse Frankfur am Main, Germany Posal address Posfach Frankfur am Main, Germany Telephone Inerne hp:// Fax Telex 4 44 ecb d All righs reserved. Reproducion for educaional and noncommercial purposes is permied provided ha he source is acknowledged. 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:// ISSN (prin) ISSN (online)

4 CONTENTS Absrac 4 Non-echnical summary 5 Inroducion 7 Transmission channels and ime consisency of inervenions 9 3 The daa: Idenifying oral inervenions and acual inervenions 3. Idenificaion of oral inervenion policy 3. Acual foreign exchange inervenions 7 4 Benchmark model and resuls 9 4. Empirical mehodology and hypoheses 9 4. Benchmark resuls 5 Condiions for effeciveness 5 6 Conclusions 9 References 3 Tables 35 European Cenral Bank working paper series 39 3

5 Absrac This paper deals wih he very shor-erm influence of "oral inervenions" on he exchange rae of major currencies. The paper finds ha official communicaion, as repored by wire services, are effecive in influencing he dollar-euro and yen- dollar exchange raes in he desired direcion on inervenion days. Oral inervenions are found o be subsanially more effecive if hey deviae from he prevalen policy "manra". They also end o reduce marke volailiy whereas acual inervenions raise volailiy. A key resul of he paper is ha oral inervenions are effecive independenly from he sance and direcion of moneary policy as well as he occurrence of acual inervenions. This suggess ha oral inervenions migh consiue, on a shor-erm basis, an effecive and largely auonomous policy ool. JEL: E6; E58; F3. Keywords: communicaion; exchange rae; inervenion; policy; Unied Saes; euro area; Japan. 4

6 Non-echnical summary Exchange rae developmens in he presen floaing exchange rae sysem are an issue of grea sensiiviy where he inernaional co-operaion hrough he G7 and G3 plays a suble bu imporan role. In he long run, here is no doub ha he fundamenals of he economies concerned and he credibiliy of heir long-erm economic and moneary policy are decisive for exchange rae developmens. In he shor o medium run, here is lile doub ha he combinaion of policy acion, verbal communicaion and perhaps inervenion ha can excepionally be decided on he basis of a G7 consensus has had a significan influence over ime. This paper concenraes on he very shor-erm influence of communicaion or "oral inervenions" as perceived by he markes namely on he very day of he communicaion. I does no deal wih he longer-erm influence of communicaion, nor does i address he differences beween "oral inervenion" which is in line wih he saemens of he G7, "oral inervenion" which is he resul of a lack of verbal discipline, or pure "noise" in erms of communicaion. There is lile doub ha an imporan differeniaion could be observed over ime beween hese caegories of "oral inervenion". However, he purpose of he paper is o analyse he very shor-erm influence wihou discriminaing beween he various forms and complex naure of "oral inervenions". Overall, exchange rae policies in many economies have undergone a fundamenal change since he mid-990s. Moneary auhoriies in he Unied Saes and he euro area have shifed owards he use of official communicaion, i.e. public saemens o convey heir sance on exchange raes o he markes, while hey have basically abandoned acual inervenions, selling or purchasing foreign exchange only during wo episodes since 995. Only Japan has coninued and even increased acual inervenions and official communicaion in recen years. Despie his policy shif, i is sriking ha much of he lieraure on exchange rae policies has coninued o focus on acual inervenions. The objecive and inended conribuion of he paper is o help fill his gap by assessing he effeciveness of official communicaion for exchange raes, and o compare i o ha of acual inervenions. Following he lieraure, effeciveness is defined as he sysemaic change of he exchange rae level and volailiy in he desired direcion on inervenion days. I should be sressed ha effeciveness herefore does no necessarily enail ha inervenions are successful, i.e. ha hey reach he policymakers' ulimae objecive. 5

7 The cenral quesion of he paper is wheher he shif owards communicaion as he main policy ool has been an effecive one. A key resul is ha oral inervenions may consiue a largely auonomous policy ool in ha heir effeciveness does no depend on he presence of acual inervenions or paricular moneary policy condiions. One inerpreaion of his finding is ha oral inervenions influence financial markes no only by signalling fuure moneary policy decisions or acual inervenions, bu also by conveying privae informaion ha is relevan for he economy and for financial markes. The paper also finds ha foreign exchange inervenions are paricularly effecive when hey go agains he exising policy manra. This is especially he case for he Unied Saes, which has been paricularly seadfas in is pursui of a srong-dollar policy over he pas decade. Oral and acual inervenion policies are also found o be more effecive if hey are coordinaed across counries, if hey occur in periods of high marke volailiy and if hey go in he same direcion as pas exchange rae rends. Moreover, oral inervenions end o reduce exchange rae volailiy, whereas acual inervenions mosly increase volailiy. This reflecs and confirms he fundamenal difference beween hese wo ypes of inervenions. 6

8 Inroducion Exchange rae policies in many economies have undergone a fundamenal change since he mid-990s. Moneary auhoriies in he Unied Saes and he euro area have shifed owards he use of official communicaion, i.e. public saemens o convey heir sance on exchange raes o he markes, while hey have basically abandoned acual inervenions, selling or purchasing foreign exchange only during wo episodes since 995. Only Japan has coninued and even increased acual inervenions and official communicaion in recen years. Given his policy shif, i is sriking ha much of he lieraure on exchange rae policies has coninued o focus on acual inervenions. Communicaion policy has been acknowledged o play a seminal role in improving he effeciveness of policy and he economy's overall performance (e.g. Blinder 998, Bernanke 004). Neverheless, here has ye been no sysemaic aemp o assess he role of communicaion policies for exchange raes, while sill only few sudies have focused on communicaion and moneary policy. The objecive and inended conribuion of he paper is o help fill his gap by assessing he effeciveness of official communicaion for exchange raes, and o compare i o ha of acual inervenions. Following he lieraure, effeciveness is defined as he sysemaic change of he exchange rae level and volailiy in he desired direcion on inervenion days. I should be sressed ha effeciveness herefore does no necessarily enail ha inervenions are successful, i.e. ha hey reach he policy-makers' ulimae objecive. Official communicaion and acual inervenions share he same fundamenal characerisics in ha boh may follow an objecive, bu ha hey may also lead o undesired effecs as financial markes may speculae agains hem or misinerpre he auhoriies' inenions. To emphasise hese common feaures, he erms official communicaion and oral inervenions are herefore used inerchangeably hroughou he paper. I should also be sressed ha he objecive of he paper focuses narrowly on he echnical aspecs of he effecs of official communicaion and acual inervenions on exchange raes. Moreover, he paper does no deal wih he longer-erm influence of communicaion, nor does i address he differences beween "oral inervenion" which is in line wih he saemens of he G7, "oral inervenion" which is he resul of a lack of verbal discipline, or pure "noise" in erms of communicaion. The purpose of he paper is o analyse he very shor-erm influence wihou discriminaing beween he various forms and complex naure of "oral inervenions". Sarno and Taylor (00) and Edison (993) provide comprehensive surveys and assessmens of he lieraure on acual inervenions in he 980s and 990s. 7

9 The paper develops a novel daase, based on wire service releases of Reuers News obained from Faciva as he source, o measure and classify daily oral inervenions by policy-makers in he Unied Saes, he euro area and Japan. Using sric classificaion crieria, he saemens are ransformed ino an indicaor funcion, i.e. caegorised as advocaing a sronger currency, a weaker exchange rae, or as ambiguous. This daase, ogeher wih daa for official purchases and sales of foreign exchange, allows conducing a sysemaic comparison of oral inervenions and acual inervenion policies for he period The cenral quesion of he paper is wheher he shif owards communicaion as he main policy ool has been an effecive one. Using daily daa, he empirical resuls show evidence ha oral inervenions by he Unied Saes, he euro area/germany and Japan have indeed exered a significan effec on he daily yen-dollar and he dollar-euro exchange raes. The evidence indicaes ha (a) oral inervenions are subsanially more effecive if hey deviae from he prevalen policy manra; (b) hey have a smaller effec on he level of he exchange rae if hey aemp o lean agains he wind of he exchange rae rend; (c) inervenions are much more effecive in condiions of large marke uncerainy; and (d) if hey are coordinaed across counries. Acual inervenions are also found o be effecive in several cases, wih he resuls being in line wih hose generally found in he lieraure. In addiion o influencing he level of he exchange rae, a second poenial objecive of inervenion policies is o reduce marke volailiy, as for insance expressed by G7 policymakers in he 987 Louvre Accord. An imporan resul of he paper is ha oral inervenions end o reduce exchange rae volailiy, while acual inervenions mosly increase volailiy. 3 This resul emphasises he fundamenal difference of hese wo ypes of inervenions: oral inervenions generally aim o provide public informaion abou he desired direcion and/or level of he exchange rae, hereby ending o reduce uncerainy, whereas acual inervenions are mosly conduced in secre, hus ofen raising marke uncerainy. Wha policy lessons can be derived from he findings of he paper? In addiion o he porfolio balance channel for acual inervenions, analysed in deail by he seminal work of Dominguez and Frankel (993a,b), oral and acual inervenions influence he exchange rae hrough he signalling channel (Mussa 98). This channel enails ha inervenions influence asse prices by signalling o he markes eiher () privae informaion of he moneary While ime-series work based on daily or inra-daily models of exchange raes find mixed evidence, even sudy mehodologies generally find robus evidence for significan inervenion effecs (Humpage 999, Io 00, Faum and Huchison 003). 3 The finding ha acual inervenions increase volailiy is widely confirmed by he lieraure. See for insance Baillie and Oserberg (997). 8

10 auhoriies abou relevan economic fundamenals, () decisions abou fuure moneary policy, and/or (3) fuure inervenion policies. A key finding of he paper is ha oral inervenions have a significan effec on exchange raes also in periods when hey neiher are suppored by acual inervenions nor poin in he same direcion as moneary policy. This suggess ha oral inervenions are effecive parly because marke paricipans perceive hem o conain relevan informaion abou he sae of he economy. This evidence has imporan policy implicaions as i implies ha oral inervenions may consiue an effecive and largely auonomous policy ool. The paper is srucured as follows. Secion provides a brief background of he ransmission channels of inervenions and he lieraure on communicaion policies. Secion 3 oulines he mehodology for idenificaion and classificaion of oral inervenion policies and acual inervenions. The empirical mehodology and findings of he benchmark model are presened in secion 4. Secion 5 hen assesses under wha condiions oral and acual inervenions are effecive ools. Conclusions and a discussion of open quesions follow in secion 6. Transmission channels and ime consisency of inervenions How do acual and oral inervenions work? And how are hey used? In principle, he lieraure has focused on hree broad channels: he porfolio balance channel, he signalling channel and a co-ordinaion channel. In he porfolio balance channel, acual foreign exchange inervenions - boh when serilised and when non-serilised - aler he relaive supply of domesic and foreign financial asses. This induces a change in he price of hese asses, hereby affecing a change in he relaive value of he currencies involved. In heir seminal work, Dominguez and Frankel (993a, 993b) presen empirical evidence for some effeciveness of official inervenions hrough he porfolio balance channel for he 980s. However, he porfolio balance channel is likely o have become less relevan over ime. This may in par o be due o, firs, he rapid inegraion of global financial markes over he pas decade, which has made financial asses of differen counries beer subsiues, and second, he enormous increase in he size of foreign exchange marke volumes (Sarno and Taylor 00). Much of he lieraure has herefore focused on he role of he signalling channel. In his channel, oral communicaions or acual inervenions affec expecaions of invesors and asse prices by eiher signalling privae informaion of he moneary auhoriies abou relevan 9

11 economic fundamenals and/or revealing he auhoriies' inenions abou fuure policy. The erm signalling channel was coined by he influenial work of Mussa (98), who argues ha acual foreign exchange inervenion may indeed have influenced exchange raes hrough his channel in he 970s. More recenly, increased focus has been on he role of communicaion for moneary policy. Blinder (998) and Bernanke (004) argue ha successful communicaion is crucial for ensuring he effeciveness of moneary policy iself. A moneary auhoriy usually conrols only a single ineres rae, he overnigh rae, while i has only indirec influence over hose asse prices ha really maer for he economy, which are long-erm ineres raes, sock prices and exchange raes. These asse prices are highly dependen on marke expecaions and he credibiliy of he auhoriy. Communicaion is so crucial for he success of moneary policy precisely because i has an imporan influence on expecaions and credibiliy. However, Goodfriend (986) and Sein (989) show ha here is an inheren ime consisency problem in communicaion policies. The ime inconsisency consiss of he problem ha policy-makers may be able o achieve more efficien oucomes by providing false informaion o he public. This may lead o a sub-opimal oucome in ha markes may give oo lile weigh o informaion from he moneary auhoriies. Hence, he rade-off a moneary auhoriy faces is how o mainain credibiliy while providing effecive informaion o he markes. Sein (989) shows ha one soluion o he ime inconsisency is for he auhoriy o give imprecise announcemens abou is informaion and views. By conras, Viale (003) argues ha an alernaive soluion o his ime consisency problem is for he cenral bank o conduc acual foreign exchange inervenions. He argues ha his is an effecive soluion because an acual FX inervenion is mos ransparen and because i is poenially cosly, hereby ensuring he credibiliy of he auhoriy among marke paricipans. As o he hird channel, communicaion policies may affec asse prices via a co-ordinaion channel. This channel implies ha public saemens by moneary auhoriies funcion as a coordinaion device ha induces marke views o converge and move in a paricular direcion. Morris and Shin (00) and Amao, Morris and Shin (003) argue ha communicaion is a "double-edged" insrumen in ha i no only conveys informaion bu also serves as a focal poin for beliefs and expecaions. The danger, according o hese wo papers, is ha communicaion may be oo dominan by suppressing he formulaion of privae beliefs, which are in urn crucial informaion for he effecive implemenaion of moneary policy. The presence of a co-ordinaion channel in foreign exchange markes has also been suggesed by 0

12 Sarno and Taylor (00), alhough no empirical or heoreical work has been underaken so far o analyse his channel. Finally, here has been remarkably lile empirical work on he role and effeciveness of communicaion policies, wih wo noable excepions. Guhrie and Wrigh (000) for New Zealand and Kohn and Sack (003) for he Unied Saes provide an assessmen of he effeciveness of communicaion on moneary policy. Boh papers find ha communicaion can indeed be a raher effecive moneary policy insrumen in hese wo counries. While here has been work on he effecs of acual FX inervenions, no work so far has emerged ha analyses he role and he effeciveness of official communicaion for exchange raes. The objecive of his paper is o address his issue, providing an empirical analysis for he Unied Saes, he euro area and Japan. 3 The daa: Idenifying oral inervenions and acual inervenions 3. Idenificaion of oral inervenion policy Wha consiues an oral inervenion, and how can i be measured? The objecive of he idenificaion of oral inervenions is o obain as complee as possible a lis of public saemens abou he domesic exchange rae by relevan policy-makers in he Unied Saes, Germany/euro area and Japan. Oral inervenions may comprise hree ypes of saemens: 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 for exracing all news releases for he period January 990 o 30 June 003. 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. This allows using a daily frequency for he analysis of he effecs of oral inervenions on exchange raes, aking exchange rae quoes a 8.00 EST, i.e. closing prices of he New York markes. Several caveas of he daa should be underlined. In paricular, some public saemens may no be covered, or may o some exen conain Reuers' inerpreaion, and hence he lis of saemens may no consiue a complee lis of official communicaions bu only a lis of saemens as repored by Reuers. Moreover, oher saemens, such as G7 saemens, are no included if hey can generally no be aribued o a single counry's policy-makers alone and do no refer o an individual currency.

13 The search crieria used are (a) he name or he ile of he policy-maker, and (b) he word "exchange rae" or he name of he domesic currency. One issue is who he relevan policymakers are. For he Unied Saes, exchange rae policy lies in he realm of he Treasury Deparmen. Hence primarily saemens of he Treasury Secreary and he Depuy Treasury Secreary are included. Exending he analysis o oher officials, such as he Undersecrearies of he Treasury and of he Federal Reserve does no add many observaions. Federal Reserve officials have made remarkably few public saemens abou he dollar. For insance, Reuers News yields only 7 wire news aricles of saemens of Federal Reserve Chairman Greenspan abou he dollar over he enire period. 4 By conras, for Germany and he euro area, exchange rae policy has been de faco in he domain of he respecive cenral banks. For he euro area, he 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 he overarching aim being he mainenance of price sabiliy. Moreover, exchange rae communicaion is de faco mosly conduced by members of he Governing Council ( Monhly Bullein 00, page 59). Therefore all he saemens are exraced from Reuers News of he members of he Bundesbank Zenralbankra for he period 990 o 998, and of he Governing Council members since 999. Finally, 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 abou he exchange rae. Hence for Japan he daase of oral inervenions includes saemens of he senior officials of boh insiuions, i.e. he Finance Miniser and he Vice Finance Miniser for Inernaional Affairs as well as he Governor and he wo Depuy Governors of he Bank of Japan. 5 4 Mos of he saemens of Mr. Greenspan were supporive of a srong dollar. The only excepion was a repor on April 99 ha "chairman Alan Greenspan is concerned abou he dollar's recen srengh and believes i undermines chances of an economic recovery in he U.S." The dollar depreciaed by 0.9% agains he mark and by.5% agains he yen on ha day. 5 An ineresing noe relaes o he imporance aached by markes o Mr. Eisuke Sakakibara, Japan's Direcor General of he Inernaional Finance Bureau and Vice Finance Miniser in he second half of he 990s, who in media circles was ofen referred o as "Mr. Yen". His saemens abou exchange rae developmens almos always received close scruiny from financial markes. For insance, on June 999, Mr. Sakakibara saed in a press conference: " we do no wan a premaure srenghening of he yen." The yen fell by.7% agains he dollar on ha day. As anoher example, on April 998 Reuers quoes Mr. Sakakibara's reply o a quesion of reporers as: " excessive yen weakness has caused a rise in rade surplus in goods and services. In ha sense, i is no desirable." The yen appreciaed by 0.6% agains he dollar on ha day.

14 A crucial issue is how o classify he saemens in erms of heir conen and meaning. For his purpose, he saemens IO are caegorised as eiher advocaing a sronger domesic currency ("srenghen"), a lower exchange rae ("weaken"), or as being "ambiguous" in he following way: if " srenghening" oral saemen IO if " weakening" oral saemen 0 if " ambiguous" oral saemen This classificaion is a judgmenal one and clearly in some cases difficul o make. Table shows his classificaion of all he oral inervenions by he auhoriies since 990. Two imporan 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. Table : Oral FX inervenions (IO), A Germany / euro area Japan srenghen weaken ambiguous srenghen weaken ambiguous srenghen weaken ambiguous Number of inervenion days Sources: Reuers News, auhor's caegorisaion. While i proves relaively sraighforward o disinguish beween "srenghening" and "weakening" saemens, i is someimes no clear wheher or no o classify a saemen as "ambiguous". To quoe Rober Rubin (003), he Treasury Secreary beween January 995 and July 999: "I became very adep a simply repeaing he manra - excep in hose rare insances when we deliberaely used a sligh shading, always buil around commimen o a srong dollar, o convey a message. For example, my saying "a 3

15 srong dollar is in our naional ineres, and we have had a srong dollar for some ime now" creaed grea exciemen a a press briefing, as i was consrued o mean ha we wouldn' mind seeing he dollar remain srong bu sofen somewha. However, I would never give any explanaion for such a change beyond my prepared phraseology." The saemen by Mr. Rubin suggess ha small changes o he language abou exchange rae developmens are ofen done inenionally o "convey a message" and can have a large effec on financial markes. In his case, he classificaion scheme would have coded he menioned saemen as "ambiguous" alhough he inenion was o weaken he dollar. Given his difficuly o assign "ambiguous" saemens, wo oher classificaions are esed. The firs one implies dropping he ambiguous saemens from he daa, hus reaing hem jus as if hey had no occurred. The second and he preferred opion is o rea "ambiguous" saemens as deviaions from he predominan policy manra, as seems implici in Rubin's commen. Hence he alernaive classificaion is o rea "ambiguous" saemens as "weakening" oral inervenions for he Unied Saes and for Germany/he euro area, while classifying hem as "srenghening" inervenions for Japan in periods when i has advocaed a weaker yen. 6 This is he preferred opion I chose, and he empirical analysis below is based on his measure of oral inervenions. Figures -3 show he disribuion of he oral inervenions during he period January 990 hrough June 003, wih a circle indicaing an oral inervenion in favour of a sronger domesic currency, and a square for a weaker exchange rae. For he Unied Saes, i is sriking also from Table ha auhoriies almos never seem o have made saemens advocaing a weaker dollar, which sresses he persisence of a srong-dollar policy during mos of he period. An excepion o his rule may have exised in he early 990s, when oral inervenions are mosly ambiguous, favouring neiher a sronger nor a weaker dollar. 6 As will be discussed below, he only period when Japanese auhoriies expressed suppor for a sronger yen was in and briefly in lae 997/early 998. However, few ambiguous saemens occurred during ha period, and he empirical resuls proved robus o classifying differenly he ambiguous saemens in his period. 4

16 Figure : D/EUR exchange rae and oral inervenions D/EUR D srenghen D weaken Figure : D/EUR exchange rae and euro area / German oral inervenions D/EUR DEM-EUR srenghen DEM-EUR weaken Figure 3: JPY/D exchange rae and Japanese oral inervenions JPY/D JPY srenghen JPY weaken 5

17 There seem o have been a shif or a leas a confirmaion of a "srong-dollar policy" in he Unied Saes wih he Clinon Adminisraion in 993, and in paricular he appoinmen of Rober Rubin as Treasury Secreary in 995. An ineresing finding of he oral inervenions shown in Figure is ha oral inervenions in favour of a srong dollar coninued also in periods in which he dollar was already valued relaively highly, such as in early 998 and in paricular in 000 and 00 when he dollar peaked agains he euro. For Germany, auhoriies also mosly promoed a sronger mark, wih he excepion of when repeaed saemens were made favouring a weaker mark (Figure ). This finding seems sensible as he mark reached is peak agains he dollar in he firs half of 995. For he euro area, auhoriies have been supporing a srong euro quie persisenly since 999. Neverheless, hey seemed o have deviaed somewha from ha policy in early 999 afer he launch of he euro and in 003 afer he euro had risen significanly agains he dollar. This can be seen from he relaively larger number of ambiguous saemens abou he value of he euro during hose periods. Finally, Figure 3 suggess ha Japanese auhoriies shifed heir oral inervenion policy regime several imes in he 990s. In he early 990s when he yen flucuaed beween 0/30 and 60 o he dollar, mos oral inervenions favoured a sronger yen. Afer a significan appreciaion above 0 yen/ dollar in early 993, oral inervenions pushed for a weaker yen unil 996. When he yen depreciaed in 996 and 997, Japanese policy-makers seem o have made almos no saemens abou exchange rae policy. However, when he yen depreciaed beyond 30 and 40 yen/ dollar in 998, auhoriies again suppored a sronger yen. Afer a subsequen significan srenghening of he yen, policy-makers in Japan have been persisenly promoing a weaker yen since 999. In summary, wo cenral conclusions emerge. Firs, one can derive from oral inervenions disinc regimes of exchange rae policy in he G3. This suggess ha policy-makers have indeed had an exchange rae policy ha hey have communicaed o he markes. The second conclusion is ha here are disinc differences in exchange rae policies across he G3. The Unied Saes has very persisenly pursued a srong dollar policy, even during periods of a relaively high dollar. German and euro area auhoriies also followed a policy supporing srong domesic currencies, hough his pursui seems o have been somewha less adaman han ha of auhoriies. By conras, Japan's policy-makers shifed policy regimes several imes during he 990s, and since 999 have been advocaing a policy of a weaker yen. 6

18 3. Acual foreign exchange inervenions The analysis is exended o es also for he role and effeciveness of acual foreign exchange inervenions, i.e. acual purchases or sales of foreign exchange. The daa for he acual inervenions is publicly available from he respecive cenral banks, and includes boh he days when hey occurred as well as he amouns and currencies agains which hey ook place. Daa for he Unied Saes and Germany is available back o he early 980s and 970s, respecively. For Japan, acual inervenion daa sars in April 99. As Table shows, for Japan and Germany mos acual foreign exchange inervenions occurred agains he dollar, alhough here have been some insances in which Japanese auhoriies also inervened agains he mark or he euro. In 997, Japanese auhoriies bough Indonesian rupiah on a few occasions. Germany in some cases inervened in suppor of ERM currencies in he early 990s wih he ERM inervenions generally being much larger han hose vis-à-vis he dollar. For he Unied Saes, he Federal Reserve inervened boh agains he yen and he mark, someimes vis-à-vis boh currencies on he same day. The average daily inervenion amouns over he sample period were D 84 million for he Unied Saes, D.59 billion for Germany / he euro area, and D.55 billion for Japan. Figures 4-6 offer an insigh ino he iming and he direcion of he inervenions by he cenral banks since 990. The circles indicae when he respecive cenral bank sold foreign currencies in order o srenghen he domesic exchange rae, and he squares when i purchased foreign exchange. A sriking finding is ha he Federal Reserve and he Bundesbank basically sopped inervening in foreign exchange markes in 995 afer inervening ofen heavily and repeaedly in prior years. Afer 995, he Federal Reserve and he were only wice acive in foreign exchange markes. By conras, he Bank of Japan inervened frequenly in he markes, in paricular in , and again in recen years. In 003, he Bank of Japan bough foreign exchange a an order of magniude of 4. rillion yen or roughly D 78 billion. Overall, he ofen increased use of oral inervenions, as discussed above, coupled wih he almos complee cessaion of acual purchases and sales of foreign exchange in he markes indicaes ha here has been a regime shif in he conduc of exchange rae policies a leas in wo of he hree economies. 7

19 Figure 4: D/EUR exchange rae and acual inervenions D/EUR D srenghen D weaken Figure 5: D/EUR exchange rae and Euro area / German acual inervenions D/EUR DEM-EUR srenghen DEM-EUR weaken Figure 6: JPY/D exchange rae and Japanese acual inervenions JPY/D JPY srenghen JPY weaken 8

20 4 Benchmark model and resuls 4. Empirical mehodology and hypoheses The exchange rae is commonly modelled in a sandard asse-pricing framework, in which he log exchange rae s reflecs he discouned value of privae agens' expecaions abou fuure fundamenals f +i : s i E ( f ) i0 () i wih θ as he discoun facor and Ω he informaion se available o agens a ime. Wha an official inervenion I, eiher an acual inervenion or an oral inervenion, does is o add o he informaion se Ω. Through he porfolio balance channel, acual inervenions affec curren fundamenals f by alering he relaive supply of domesic and foreign asses, hus inducing a change in he price of hese asses and in he relaive value of he currencies involved (e.g. Dominguez and Frankel 993a,b). By conras, in he signalling channel, he effec of eiher acual or oral inervenions funcions by alering expeced fuure fundamenals f +i. As inervenions may eiher signal changes in fuure moneary policy m +i, or alernaively signal informaion of he moneary auhoriies abou oher relevan fundamenals g +i, he basic asse-pricing framework focusing on he effec of inervenions can hus be formulaed as s i E ( m, g, I ) i0 () i i Therefore, a es of he hypohesis ha official inervenions affec he exchange rae in essence implies esing ha s i i E ( m, g, I ) E ( m, g ) (3) i0 i i i0 i i or, in oher words, acual and oral inervenions a ime conain relevan informaion such ha i alers he exchange rae s. 9

21 To es his hypohesis, he empirical model for he effecs of acual inervenions IA and oral inervenions IO is formulaed as s D / EUR IA d d i i W, d IA IO IO (4a) s YEN / D JA IA JA JA d d i i W, d IA JA IO JA IO (4b) wih ε~(0,h ), s as he change in he log exchange rae of he dollar-euro or he yen- dollar, IA as he acual foreign exchange inervenions vis-à-vis he respecive currencies (in dollar billion) and IO he oral inervenions. 7 The model conrols for effecs of ineres rae differenials beween he Unied Saes vis-à-vis he euro area and Japan, respecively, o conrol for differences in moneary policies, and for day-of-he-week effecs W. 8 The daily exchange rae series exhibi non-normaliy, negaive skewness, excess kurosis and serial correlaion. The process of exchange rae changes is modelled in an exponenial GARCH (EGARCH) framework, following Nelson (99), o accoun for hese characerisics of he daa. Moreover, choosing an EGARCH specificaion implies ha no non-negaiviy consrains on he coefficiens of he condiional second momens need o be imposed. The condiional variance equaion of he EGARCH(,) 9 is hus modelled as 7 Including only conemporaneous effecs of inervenions and ineres raes differenials proved sufficien, while lagged values were generally no significan, hus confirming he efficiency of he foreign exchange marke in immediaely incorporaing inervenions on he same day. Also lagged exchange rae changes proved no significan. 8 Ineres raes are hree-monh money marke raes. For he day-of-he-week dummies, significan effecs were found in some cases only for he Monday and Friday dummies. The esimaes for he ineres rae differenials are mosly correcly signed, bu are no shown for space reasons. 9 Also EGARCH models wih higher-order lags were esed and showed ha he EGARCH (,) model is sufficien o address he non-normaliy of he daa. Moreover, using a sandard FIGARCH specificaion did no yield qualiaively differen resuls from he EGARCH(,) model employed here. Moreover, i has been argued by Beine, Bénassy-Quéré and Lecour (00) ha a fracionally inegraed GARCH (FIGARCH) model is a more appropriae way han a sandard GARCH (,) model o formulae he condiional variance. However, using a sandard FIGARCH specificaion did no yield qualiaively differen resuls from he EGARCH(,) model employed here. 0

22 log, h log, h, h IA IA IO, h IO,, d d W d (5a) log h, h, log JA IA JA h, IA JA IO JA, IO h,, d d W d (5b) where he condiional variances of he dollar-euro exchange rae (h, ) and he yen- dollar exchange rae (h, ) are expressed as a funcion of he pas variance (h - ) and innovaions (ε - ), he absolue values of oral inervenions IO and acual inervenions IA, as well as he day-of-he-week effecs W. The model is esimaed using he log likelihood esimaion funcion T L( ) ln( ) T ln H ' H wih H as he ime-varying condiional variance-covariance marix, φ he vecor of parameers of ineres and T he number of observaions. Table 3: Hypoheses of effeciveness of acual and oral inervenions dollar - euro condiional mean condiional variance Yen - dollar condiional mean condiional variance credible, 0, JA 0 JA, 0 JA, JA 0 signal I ,,,, no credible or, 0, JA 0 JA, 0 JA, JA 0 ambiguous signal I ,,,, Having formulaed he model, he hypoheses o be esed can be summarised as in Table 3. Firs, in an efficien marke seing, an acual inervenion o sell foreign exchange or an oral inervenion in suppor of he domesic currency ha is credible, i.e. when markes believe

23 ha i conveys rue and relevan signals abou economic fundamenals or fuure moneary policy, should lead o a corresponding appreciaion of he domesic currency. Second, a credible inervenion should help lower marke uncerainy and hence reduce exchange rae volailiy. And hird, an inervenion ha is no credible is expeced o have no significan effec on he level of he exchange rae while raising uncerainy and volailiy. 4. Benchmark resuls The saring poin of he empirical analysis is o esimae he model of equaions (4) - (5) over he full sample period Overall, Table 4 shows ha boh acual inervenions and oral inervenions have generally been effecive in influencing he level of he dollar - euro and yen - dollar exchange raes. All signs of hese effecs are as expeced, and as formulaed in Table 3. Table 4: Effeciveness of acual inervenions and oral inervenions, condiional mean equaion condiional variance equaion period: alernaive definiion alernaive definiion Jan Sep. 003 coef. sd.error coef. sd.error coef. sd.error coef. sd.error A. dollar - euro exchange rae oral inervenion IO -0.4 *** ** Ge/ oral inervenion IO GE/ 0.98 *** *** acual inervenion IA Ge/ acual inervenion IA GE/.536 *** ** *** *** 0.07 Ineres rae differenial LR es *** *** B. Yen - dollar exchange rae oral inervenion IO 0.49 *** ** Ja oral inervenion IO JA *** *** acual inervenion IA.87 *** ** *** *** 0.00 Ja acual inervenion IA JA *** * * Ineres rae differenial LR es *** *** Noes: ***,**,* indicae significance a he 99%, 95%, 90% levels, respecively. Alernaive definiion for IO is he one excluding "ambiguous" saemens, as explained in he ex,for IA i is an indicaor funcion + for purchases and - for sales of domesic currency. Ineres rae differenial for dollar - euro exchange rae is he difference of 3-monh money marke raes in he Unied Saes minus he one in he euro area, and correspndingly for he yen - dollar exchange rae. 3 LR es is es wheher model wih inervenion variables has a higher explanaory power han he model wihou inervenion variables. ***, **, * show significance of accepance of he LR es. As o oral inervenions, German / euro area inervenions, on average, lead o a 0.% change of he dollar - mark/euro exchange rae on he day of he saemen. The effecs of and Japanese oral inervenions are somewha smaller a around 0.5%, bu sill highly significan

24 saisically. These findings are robus o using he alernaive definiion of oral inervenions, which excludes he ambiguous policy saemens (columns 3 & 4, Table 4). As o acual inervenions, hese also mosly have a significan effec on exchange raes. However, he differences across economies are very subsanial. For insance, a D billion sale of foreign exchange by German / euro area auhoriies has been associaed wih a.5% appreciaion of he mark or euro, whereas acual inervenions seem o have had no significan effec on he dollar - mark / euro. By conras, he effec of acual inervenions on he yen - dollar has a magniude of.3%, while he effec of a Japanese D billion acual inervenion is subsanially smaller a %. These resuls for he yen- dollar are similar o hose found in Io (00) for a shorer ime period. A furher finding is ha acual inervenions have mosly increased he condiional variances of he exchange raes. By conras, oral inervenions have in mos cases decreased he volailiy of exchange raes, hough in he benchmark resuls presened here he poin esimaes are no saisically significan (columns 5 hrough 8, Table 4). The resul ha acual inervenions increase volailiy is confirmed by he evidence shown in he lieraure. 0 I is imperaive o sress an imporan poin here. This poin is ha an inervenion is defined o be "effecive" if i leads he exchange rae in he desired direcion on he day when i occurs. Effeciveness may herefore no necessarily imply ha an inervenion is "successful" in he sense ha (a) i alers he course of he exchange rae also in he medium- o long erm and (b) i achieves he ulimae long-run objecive of he policy-maker. For insance, an inervenion may be effecive in moving he currency in he desired direcion bu sill be unsuccessful in e.g. sabilising he exchange rae below or above a cerain level. The key poin is ha inervenion policies for wo reasons canno be assessed on he basis of how "successful" hey are. Firs, we usually do no know wha he precise objecive of he inervenion is. And second, we do no know wha he relevan couner-facual is, i.e. how he exchange rae would have evolved in he medium-erm if no inervenions had aken place. Wha one can aemp o measure is he permanence of he effec of he inervenion. Firs, lagged inervenions in model (4)-(5) are no significan, confirming ha financial markes are efficien in incorporaing informaion on he day when hey become available. Second, he model (4)-(5) was esed using lower-frequency daa of -day, -week, -week ec. inervals. I 0 See e.g. Baillie and Oserberg (997), which is consisen wih he work on dynamic effecs of FX inervenions, using marke microsrucure and order flow models ha analyse daa a differen ime 3

25 find ha he magniude of he poin esimaes for boh oral and acual inervenions are very similar for -day inervals and someimes also for -week inervals, bu ha hese esimaes become saisically insignifican when moving beyond -day or 3-day inervals. This is wha one would expec since markes coninuously price-in so many oher news ha his "noise" does no allow measuring he rue permanen effec of inervenions. Therefore, he only saisically valid inference one can make is abou he impac effec of inervenions, or wha I call effeciveness. Neverheless, wha maers for he success of an overall inervenion sraegy is also he frequency and, in case of acual inervenions, he magniude of inervenions, i.e. he cumulaed impac effecs. A compelling example is he small esimaed coefficien for Japanese acual inervenions on he yen- dollar exchange rae of This esimae suggess ha he Japanese auhoriies need o purchase abou D 7 billion o weaken he yen by %. Given ha he Bank of Japan purchased foreign exchange of roughly D 78 billion in 003, he esimaed coefficien suggess ha, ceeris paribus, Japanese inervenions in 003 moved he yen abou % lower agains he dollar. Alhough he rue effec of hese inervenions may have been differen since he effeciveness of inervenions varies depending on facors such as marke condiions, rends, co-ordinaion ec., a deailed analysis of which follows in he nex secion, he purpose of his example is o make he imporan poin ha oral and acual inervenion policies can indeed exer a sizeable influence on overall exchange rae developmens in he medium-erm. Several sensiiviy and robusness checks were conduced. Firs, various dynamic specificaions of model (4)-(5) were esed by including lags of pas inervenions as well as of pas exchange rae changes. None of hese lags are generally significan. Second, esing for ime effecs shows ha he effeciveness of oral inervenions generally rose slighly over he period , hough hese ime effecs are small and no saisically significan. Third, he effecs of oral inervenions by he "main" policy-makers - i.e. Treasury Secreary, Japan's Miniser of Finance, Bundesbank Presiden, Presiden - are mosly somewha larger, bu his difference is again usually no saisically significan. Fourh, here is also no compelling evidence for size effecs, i.e. ha large acual inervenions have a larger poin esimae han small inervenions. In summary, oral inervenions and acual inervenions have indeed been effecive in influencing exchange rae developmens. Oral inervenions are no only relaively effecive horizons (Peiers 997, Evans and Lyons 00, Dominguez 003) and he work on he relevance of macroeconomic news for exchange raes by Andersen, Bollerslev, Diebold and Vega (003). These resuls are no shown for reasons of breviy, bu are available from he auhor upon reques. 4

26 compared o acual inervenions, bu hey generally end o lower uncerainy and volailiy in he markes whereas acual inervenions have generally raised currency volailiy. 5 Condiions for effeciveness The lieraure on acual FX inervenions has shown ha moneary auhoriies frequenly pursue paricular sraegies wih heir inervenions. The quesion I urn o now is herefore when and under wha condiions foreign exchange inervenions are effecive. For his purpose, I exend he EGARCH model (4)-(5) in order o be able o es for alernaive hypoheses wihin he EGARCH model: s D / EUR ( IO ( IA D D H 0 H 0 ) d d i i W, d ) IO IA ( IO ( IA D D H 0 H 0 ) ) IO IA (6) log, h log, h, h IA D H 0 IA IA, D H 0 h,, IA (7) IO D H 0 IO IO D H 0 IO d d W d where he only exension o (4)-(5) is he inroducion of an ineracion erm wih a dummy DH0 o es for various hypoheses of ineres - e.g. wheher inervenions have a larger effec on he level or volailiy of he exchange rae in imes of high exchange rae deviaions from PPP (D H0 =). Hence he null hypoheses H 0 shown in he ables of he resuls are β + β = 0, γ + γ = 0 for he condiional mean equaion (6), and η + η = 0, χ + χ = 0 for he condiional variance equaion (7). The model for he yen- dollar exchange rae is formulaed analogously. A firs quesion is wheher inervenions are more or less effecive if hey deviae from he prevalen policy manra. The inuiion is as follows. For insance, a oral inervenion in suppor of a srong-dollar policy may have lile news conen in ha i provides lile or no new informaion o he markes. A saemen ha deviaes from he srong-dollar policy, however, may have a much larger effec if markes perceive i o quesion or even o aler he 5

27 exising policy sance. A similar argumen applies o Germany / he euro area which have mosly followed a srong-mark/euro policy. The issue is somewha more difficul for Japan, which has mosly followed a "weaker-yen" policy during he pas 4 years, hough here were some periods - from 990 o 99 and briefly in lae 997/early when Japanese auhoriies inervened in favour of a sronger yen, as discussed in secion above. For Japan, deviaions from he manra are herefore defined as inervenions o srenghen he yen, excep for and lae 997/early 998 when hese are inervenions o weaken i. Table 5: Deviaions from he exchange rae manra cond. mean eq. H 0 : deviaion H : no deviaion cond. variance eq. H 0 : deviaion H : no deviaion A. dollar - euro exchange rae oral inervenion IO Ge/ oral inervenion IO GE/ coef. sd.error sig. coef. sd.error sig. H 0 : -.6 *** *** H : H 0 : *** H : 0.97 ** acual inervenion IA Ge/ acual inervenion IA GE/ H 0 : *** H : *** H 0 :.75 *** *** H :.75 ** *** 0.83 B. Yen - dollar exchange rae oral inervenion IO Ja oral inervenion IO Ja H 0 : 0.87 *** H : H 0 : -0.7 ** H : *** *** 0.03 acual inervenion IA Ja acual inervenion IA Ja H 0 : *** *** H : *** 0.5 H 0 : -0. ** H : *** Noes: ***,**,* indicae significance a he 99%, 95%, 90% levels, respecively. + indicaes wheher coefficiens of H0 and H are significanly differen from each oher a he 90% level. For, Ge/: deviaions are negaive IO or IA, i.e. aiming a depreciaing he domesic currency. For Ja: deviaions are mosly posiive IO or IA, i.e. aiming a appreciaing he domesic currency. Table 5 reveals ha inervenions ha deviae from he manra have mosly a significanly larger effec on exchange raes. This effec is paricularly srong for he Unied Saes: A saemen ha fails o suppor a srong-dollar policy on average leads o a.% depreciaion of he dollar agains he euro and 0.9% depreciaion agains he yen. By conras, oral 6

28 inervenions in favour of he dollar have he correc sign bu do no have a saisically significan effec on he exchange rae. For Germany / he euro area and Japan a similar finding emerges in ha inervenions are more effecive if hey oppose he prevalen exchange rae manra. The differences in he effecs, however, are much smaller han hose for he Unied Saes. An oral inervenion opposie o he manra leads on average o a 0.38% change in he euro exchange rae and o a 0.% change in he Japanese yen. Moreover, deviaions from he exchange rae manra have a comparaively much bigger effec if hese deviaions are oral inervenions. This can be seen by comparing he size of he coefficiens of deviaions wih hose ha are in line wih he manra (called "no deviaion" in he able). As an order of magniude, for he an oral inervenion agains he manra has he same effec on he dollar exchange rae as a D. billion acual inervenion agains he euro and D.9 billion acual inervenion agains he yen. Overall, he resuls emphasise he remarkable effeciveness of oral inervenions if hey occur agains he prevalen policy sance. Second, he lieraure on acual FX inervenions has shown ha moneary auhoriies respond o exchange rae developmens, eiher focusing on achieving a paricular level, reducing deviaions from wha auhoriies believe are susainable levels or lowering volailiy. The lieraure finds ha many cenral banks aemp "leaning-agains-he-wind" inervenions in ha hey ry o reverse or a leas sop a paricular exchange rae rend ha is considered undesirable (Sarno and Taylor 00). The resuls wih regard o exchange rae developmens (Table 6) show ha leaning-againshe-wind inervenions are no effecive on he level, and moreover end o increase currency volailiy (model ). Excep for acual inervenions, here is also lile evidence ha inervenions are more effecive if hey occur when deviaions from PPP are large (model ). However, inervenions have ofen significanly larger effecs when previous exchange rae uncerainy has been relaively high (model 3). 3 The overall effecs of he differen inervenions are mosly quie similar across counries. Deviaions from PPP are deviaions from he average real exchange rae agains he dollar for he euro area and Japan, and a rade-weighed real exchange rae agains euro and yen for he Unied Saes. 3 Exchange rae volailiy is measured as he variance of he exchange raes during he pas wo weeks or one monh. An alernaive way o es for he hypohesis is o use a GARCH-in-mean ype of model, where he volailiies are h, and h, from he condiional variances are used direcly. The resuls, however, are robus o he differen definiions and ime windows. 7