Official intervention in the exchange markets: stabilising or destabilising
BIS Economic Papers No 6
Disappointment with exchange rate behaviour has resulted, even under the floating rate system, in continuing, and in some cases heavy, intervention by the national authorities in the exchange markets. It is the aim of this study to throw some light on whether this official exchange-market involvement has tended to exert a stabilising influence, or whether it was itself a factor in the large and erratic exchange rate fluctuations which have been an outstanding feature of the international monetary scene over the past ten years.
In order to arrive at an overall judgement of the official role in the exchange markets it is necessary to adopt a formal criterion with the help of which the stabilising or destabilising nature of intervention operations can be evaluated. One such yardstick, which in the past has commanded fairly broad support in academic, official and private thinking on the subject, is the profit criterion. The classic formulation of this criterion can be found in Milton Friedman's well-known essay on floating exchange rates:
"In any event, it would do little harm for a government agency to speculate in the exchange market provided it held to the objective of smoothing out temporary fluctuations and not interfering with fundamental adjustments. And there should be a simple criterion of success - whether the agency makes or loses money."
In a more recent study, the profit criterion is applied empirically in order to gage the impact that official intervention may have exerted in the 1970s in the case of a number of currencies. The results of this study are not very complimentary to the official role in the exchange market and seem to suggest that intervention was primarily of a destabilising nature.
In Section II of the present paper it is, however, argued that, except under very special circumstances, the profitability criterion cannot be employed an any meaningful sense as ain indicator of the stabilising effect of official intervention. Instead, a number of alternative criteria are suggested which circumvent some of the basic difficulties inherent in the profit criterion. Although these alternative criteria, too, suffer from certain conceptual and practical weaknesses, they nevertheless, particularly if used in combination with each other, convey a more realistic impression of the type of influence exerted by official intervention than the naive profit criterion.
Subsequently, in Section III, these alternative criteria are used to evaluate the influence exerted by official intervention in the period from 1974 to mid-1982 on the dollar exchange rate of three key floating currencies, namely, the Deutsche Mark, the Japanese yen and the pound sterling. Unlike the findings made using the profit criterion, the results of this analysis strongly indicate that official intervention in the case of these three currencies was predominantly of the stabilising kind. The paper does not claim that these results are wholly conclusive or that this kind of standardised analysis can act as a full substitute for an in-depth appraisal of each individual intervention episode. Nevertheless, these findings would appear to put the burden of proof on those who argue that the official role in the exchange markets has been primarily unhelpful and will continue to be so in the future.
Both the profit criterion and the criteria adopted in this essay inevitably suffer from one basic shortcoming: they can at best tell whether official intervention was in the right direction, but they can provide no information on the extent to which intervention was successful in actually influencing exchange rate movements. On the contrary, to the extent that the intervention was fully successful in ironing out unwanted exchange rate movements, neither the profit criterion nor the criteria used here would be generally applicable. Conversely, if intervention was ineffective, and failed to exert a significant influence on exchange rate movements, both the profit criterion (under the specialised conditions where it is applicable) and the criteria used here would perform best, but would be irrelevant, since in that case official intervention would be meaningless from a macroeconomic point of view.
The use of these criteria is therefore based on the implicit assumption that official intervention has had an impact on exchange rate movements, but only a limited one. The limited nature of this impact appears to be emphatically confirmed by the circumstance that exchange rate fluctuations have remained very large despite official intervention; unfortunately, this same circumstance might seem to suggest that official intervention, insofar as it was in the right direction, was largely ineffective. In order to refute this suggestion, Section I of this study sets out why the authors believe that in the present world of pronounced uncertainties well-timed official intervention can be influential and has an important role to play. Because of space limitations, the argument in this first section is presented in a highly condensed and somewhat dogmatic form. Nevertheless, it stresses the fluid and psychic nature of the exchange markets - each situation is in a way unique - with the intention also of cautioning the reader about regarding the formalised approach adopted in the main body of the study as being of unqualified validity.