Central Bank Intervention and Inflation Targeting in Emerging Markets: Lessons from the Experience of Colombia

Policymakers in many emerging markets are attempting to resist currency appreciation by intervening actively in currency markets, typically through the accumulation of international reserves. At the same time, many of these same countries have adopted inflation-targeting regimes to anchor inflation expectations, most often using short-term interest rates as their main operating target. Thus, limiting currency appreciation—while at the same time controlling inflation—is posing a policy dilemma for many emerging market countries. As such, identifying the effectiveness of intervention, and the circumstances under which it can be a useful policy tool, are key questions for economic policy today.

As of April 2008, nine out of thirteen Latin American and Asian emerging market economies intervened in foreign exchange markets. Widespread central bank intervention seems to reflect the predominant view among policymakers that intervention is a useful policy tool to influence real exchange rates. Indeed, according to a 2005 study of the Bank of International Settlements, 85 percent of those policymakers interviewed characterized their interventions as being effective most of the time. However, while an extensive literature on intervention exists for advanced economies, much less is known about the effectiveness of foreign exchange intervention as an independent policy tool in emerging markets.

In a recent paper , I add to this literature by examining Colombia’s experience with central bank foreign exchange intervention under an inflation targeting regime, between 2004 and 2007. During most of this period, the Central Bank of Colombia (Banco de la República, henceforth BdR) engaged in large-scale, discretionary purchases of foreign exchange to resist appreciation of the domestic currency, making it an interesting case study for assessing the efficacy of such efforts. The paper focuses on two central questions: (1) How effective was BdR’s intervention in stemming domestic currency appreciation in Colombia? (2) What constraints—if any—did the inflation-targeting regime pose on the BdR’s ability to influence the currency?

A major hurdle for doing research in emerging market economies has been the lack of official, high frequency data on central bank intervention operations (because of valuation changes, the magnitude of intervention operations cannot be inferred simply from changes in reserves). Moreover, it is often not possible to know, a priori, whether the authorities accumulate international reserves with the intent of affecting the exchange rate or for other reasons, such as self-insuring against external financial shocks.

In this study, I use a new data set that includes official statistics on daily foreign exchange intervention by the BdR. A key advantage of the intervention data used in this study is that it accurately reflects discretionary purchases of dollars made with the explicit intention to depreciate the value of the domestic currency vis-à-vis the U.S. dollar. As constructed, this data set excludes changes in reserves for reasons other than—and not related to—influencing the level of the exchange rate. This allows a cleaner identification of the impact of central bank intervention on the exchange rate.

Besides the availability of a novel dataset, Colombia offers an ideal case to study the effects of central bank intervention in foreign exchange rate markets and derive policy lessons, for at least three reasons. First, Colombia has faced strong exchange rate appreciation pressures. Between December 2006 and May 2007, for example, Colombia ranked as the country with the highest nominal domestic currency appreciation in the world—both vis-à-vis the U.S. dollar and in nominal effective terms. Second, the period under study is punctuated by frequent, and at times large, discretionary purchases of foreign exchange to resist domestic currency appreciation. Figure 1 below shows the two distinct episodes of discretionary intervention in the foreign exchange rate market analyzed in the study: the first period, spanning from September 2004 to March 2006, and a more recent period from January 2007 to April 2007. During these periods of intervention, BdR activity took place on almost 70 percent of business days and the scale of official intervention was significant relative to the daily turnover in the market, reaching 50 percent on some days.


Colombia is also an interesting case study because the two periods of discretionary intervention considered here are associated with two very different stances of monetary policy. The first period was characterized by constant or falling interest rates and a loosening of monetary policy. The second discretionary intervention episode, in turn, was marked by a tightening of monetary policy and an increase in nominal interest rates to reduce inflationary pressures in an overheating economy (see Figure 2 below). This provides an ideal setting to analyze the interplay between monetary policy and exchange rate policy decisions under inflation-targeting regimes. In particular, the Colombian case provides an opportunity to test the hypothesis that discretionary intervention to stem domestic currency appreciation is more effective when there is consistency between monetary and exchange rate policy goals.


This paper’s results suggest that the effects of BdR intervention varied sharply across the two periods. During the first period of discretionary intervention (September 2004–March 2006), BdR foreign currency purchases had a statistically significant, positive impact on the exchange rate level, i.e., intervention led to a more depreciated exchange rate. However, while discretionary intervention was successful in moderating the appreciation trend, the effect of BdR’s foreign currency purchases on daily exchange rate movements was economically small and short-lived. As such, substantial amounts of sterilized intervention were required to have a quantitatively important impact on exchange rate dynamics.

During the second period (January–April 2007), however, BdR intervention did not influence the level of the exchange rate, even in the short term. In practice, intervention operations aimed at depreciating the currency were dwarfed by offsetting increases in domestic interest rates and the market’s reaction to higher-than-expected inflation announcements—both of which tended to appreciate the currency. Thus, during this period, sterilized intervention did not provide an independent channel for monetary policy.

The results suggest that coherence between intervention policy and inflation objectives was a critical factor in determining the success of discretionary intervention. During the first intervention episode, no contradiction existed between monetary and exchange rate policies. Purchases of international reserves were made in the context of decreasing policy rates and an economy operating below potential capacity. Because macroeconomic objectives were well aligned, foreign currency purchases credibly signaled an easing of monetary policy and the BdR was able to stem appreciation pressures without undermining its ability to meet the inflation target (see Figure 3). Thus, Colombia’s experience between 2004 and 2006 indicates that an inflation-targeting regime can be credible and effective even though the exchange rate regime is not an entirely clean float.


During the second period, however, tension existed between monetary and exchange rate policy goals. The BdR was torn between a concern for price stability in an overheating economy, on the one hand, and concern over the rapid pace of appreciation of the exchange rate, on the other. The BdR sought simultaneously to maintain price stability by raising interest rates, and preserve competitiveness by resisting currency appreciation. Rising interest rate had the consequence of attracting more capital inflows, thereby exacerbating appreciation pressures. At the same time, resisting currency appreciation (which typically feeds into lower domestic prices of imported goods) worked at cross-purposes with the goal of containing inflation.

In this environment, markets perceived the BdR as pursuing two mutually inconsistent—and ultimately unsustainable—goals. Using estimates on the domestic currency’s response to unexpectedly high inflation announcements, I show that markets expected monetary policy to remain firmly committed to the goal of reducing inflation—even if that meant increasing interest rates and, thereby, undoing intervention efforts. Foreign investors, realizing that the central bank would eventually focus on taming inflation (and eventually let the exchange rate appreciate), took unprecedented amounts of leveraged bets against the central bank (and the dollar) in the derivatives market—thereby limiting the effectiveness of intervention. Paradoxically, then, the BdR’s perceived strong commitment to inflation actually undermined its ability to influence the exchange rate.

These results have important implications for policy design. The Colombian case suggests that successful intervention to stem domestic currency appreciation may be particularly difficult for an inflation targeter at advanced stages of the business cycle. The commitment to an inflation target limits the scope for lowering interest rates, and low upward exchange rate flexibility provides incentives for carry trade and leveraged bets on the currency through derivatives markets. Thus, while a government committed to reducing the value of its currency has, in theory, a large supply of “ammunition” (i.e., printing money to buy reserves), the inflation objective can in practice become a binding constraint that puts a limit to the amount of foreign reserves that a central bank can accumulate.

More generally, Colombia’s experience provides useful policy lessons for other emerging markets facing the challenge of resisting domestic currency appreciation while at the same time controlling inflation. The analysis yields three key results. First, discretionary intervention can only be successful when there is no conflict between exchange rate and inflation objectives. In particular, central bank’s discretionary intervention to resist currency appreciation is likely to be effective when the economy is operating below full capacity and thus monetary easing is consistent with meeting the inflation target.

Second, the case of Colombia highlights the practical limits to sterilization of reserve accumulation when the macroeconomic cycle calls for tightening monetary policy. Much of the literature emphasizes that the high costs of sterilization is what ultimately limits intervention efforts. Yet, the actual constraint faced by policymakers in Colombia in offsetting the monetary consequences of intervention was not given by the quasi-fiscal costs of intervention, but rather by the central bank’s net creditor position vis-à-vis the financial system. A net creditor position is regarded as more desirable for reasons of monetary control: in practice, a central bank is better positioned to move short-term interest rates to its desired level if the monetary authority is a net lender of liquidity to the financial sector. With the BdR undertaking large-scale intervention in the first months of 2007, the BdR quickly reduced its stock of treasury bills and, by mid-march 2007, reversed its position from being a net creditor, to being a net debtor to the financial system (see Figure 4 below). This made it more difficult to control inter-bank rates. This is evident in the behavior of policy and inter-bank interest rates in Figure 4. While the average inter-bank rate tracked very closely the reference rate until the end of March 2007, the inter-bank interest rate drifted below and away from the BdR’s lending rate after that. This stifled the primary transmission channel of monetary policy and layed the groundwork for the demise of intervention efforts a month later.

image008_11.gif Third, when one-sided, protracted discretionary intervention is perceived as unsustainable, inflation targeting regimes may be vulnerable to speculative attacks against the central bank—but attacks that appreciate the currency. Such attacks may occur in the derivatives market rather than in the spot market, as speculators leverage massive bets on appreciation of the domestic currency. Predicting that sterilization efforts would become unsustainable, offshore entities speculated heavily on a real exchange rate appreciation by building-up large long-positions in pesos through the onshore forward market. The turnover value in peso forwards bought by off-shores to local banks increased more than three times between end-2006 to its peak in March 2007 (see Figure 5 below). The size and speed of execution of this leveraged market positions substantially reduced the ability of the central bank to influence exchange rate market conditions by buying international reserves. In summary, with financial systems in emerging markets growing in depth and sophistication, inconsistencies in monetary policy objectives are eventually arbitraged in the derivatives markets, thereby limiting the effectiveness of intervention.

image010_07.gif Additional research on the effects of intervention would be useful. Better data availability (especially at daily frequencies) and continued research into the motives, strategies, and channels for conducting foreign exchange market operations intervention in emerging markets countries could help provide more guidance on the appropriateness and effectiveness of intervention strategies.

6 Responses to "Central Bank Intervention and Inflation Targeting in Emerging Markets: Lessons from the Experience of Colombia"

  1. Vitoria Saddi   April 24, 2008 at 12:53 pm

    You say that the sterilization works with decreasing interest rates. I thought that the impacts of sterilized interventions on exchange rates would have to be zero or small. Why is then sterilization works with decreasing interest rates?Thanks for the great piece.

  2. Robert Fay   April 24, 2008 at 12:54 pm

    If the ability of authorities to resist the attack is not determined by the level of reserves then it depends on what?

  3. Anonymous   April 24, 2008 at 5:15 pm

    Thank you for the great piece. Have you thought about the opposite case, what if the central bank wants to smooth the depreciation of the currency? If I recall correctly, the central bank of Colombia signaled in 2003 that they managed to smooth the depreciation of the currency given the amount of RIN they sold… What I think is that, although this helped, this was not the main driver.Given the constraints you mention about the data, would be good to analyze the case of Peru. The central bank has accelerated its intervention in the FX market and publishes daily data on this. The interesting difference with Colombia is that they manage a more succesful mechanism of sterilization.Thank you.

  4. bsetser   April 26, 2008 at 6:35 pm

    Thanks, Dr. Kamil, for a most interesting post. I want to read your paper carefully. Two questions though:a) You write:"During the second period (January–April 2007), however, BdR intervention did not influence the level of the exchange rate, even in the short term. In practice, intervention operations aimed at depreciating the currency were dwarfed by offsetting increases in domestic interest rates and the market’s reaction to higher-than-expected inflation announcements—both of which tended to appreciate the currency."I am a bit surprised by your conclusion that the operation did not influence the level of the exchange rate, as it seems possible that the exchange rate might have appreciated more in the absence of BdR intervention. Certainly for a country like China that would be the case — i.e. the outcome of central bank buying can be a slower pace of appreciation than would otherwise be the case rather than a depreciation. I can see an argument that this doesn’t work over time — especially if domestic interest rates are high — as the central justs slows the move to a more appreciated state and thus creates more opportunities to profit from the move. But over shorter time periods, it still might hold the exchange rate at a lower level than otherwise would be the case.b) Who took the other side of the currency forwards (I.e. who bet on a depreciation?). I think there is some data from the BdR indicating that its net forward position increased, which would suggest that it was intervening both in the spot and forward market. Perhaps the impact of the BdR’s intervention in the forward market is examined in the paper (Which i have yet to read)? Or perhaps my sense that the BdR intevened heavily there as well is off …

  5. Herman Kamil   April 29, 2008 at 9:12 am

    Dear Vitoria, Mr. Fay, M. Setser and Guest:Thanks for your comments and feedback. Below I respond briefly to each of your posts, in the order they appeared.Victoria: Thanks for your comments. Given everything else constant, a decrease in interest rates would lead to a more depreciated currency. Changes in the monetary supply would naturally affect the exchange rate, so it would not be surprising to find that un-sterilized intervention is effective in depreciating the currency. The goal of the paper is to test whether sterilized intervention has an independent effect on the exchange rate, once we control for movements in the nominal interest rate.In broad terms, sterilized intervention was effective during the first period because the Central Bank was seen as conducting mutually consistent – and ultimately sustainable — exchange rate and interest rate policies. That is, the Central Bank was both lowering interest rates (which in itself leads to a more depreciated currency) and at the same buying foreign currency to depreciate the domestic currency.Given the reduced-form nature of the estimation used in the paper, however, the framework can only identify the average response of exchange rate returns to intervention operations. It does not, however, identify the channels through which intervention may have affected exchange rates.Robert Fray: You are right, in the sense that I am only looking at the Central Bank’s attempt to resist domestic currency appreciation. Indeed, since floating in 1999, the Central Bank has only use discretionary (i.e., outright) intervention in the spot market to resist appreciation pressures. As you point out, the Central Bank in 2003 attempted to smooth pressures for depreciation, but in that case they used foreign exchange options, which is a very different instrument of intervention. I have not looked at the effectiveness of intervention through options (either “volatility options” or options to accumulate or drawdown reserves). Anonymous: I fully agree that Peru would be an ideal case to study the effect of discretionary intervention to resist currency appreciation. It shows many resemblances to the Colombian case. It would be also useful to see how their different strategies for sterilization may have affected the effectiveness of intervention. Thanks for your feedback.Brad Setser: Thanks for your comments. On your questions:a) When conducting policy evaluation, is always crucial to account for the counterfactual—i.e., what the exchange rate movement would have been if intervention had not occurred, in days when the authorities did in fact intervene. As you mention, simultaneous observation of foreign exchange purchases and domestic currency appreciation cannot be interpreted as evidence that intervention was ineffective. For instance, in the absence of intervention, the exchange rate might have followed a more appreciated path. I identify the effect of intervention on the rate of change of the exchange rate (not its level), as the model should be estimated in first differences. I include as an additional explanatory variable one that captures the amount of foreign currency purchases, once the effects of all other determinants have been taking care of. The coefficient on the intervention variable can be interpreted as answering the following question: “How much more appreciated, in daily percent, would the currency had been if Central Bank had not intervened, in days when in fact it did?”. I find robust evidence that this coefficient is not significantly different from zero. Instead, the results of the model points to the theoretically sensible finding that high and increasing interest rate differentials, positive domestic inflation surprises and improvements in sovereign creditworthiness (as represented by decreases in the EMBI spread) were key factors driving the appreciation of the peso during this period.b) Regarding who took the other side of the currency forwards (i.e. who bet on a depreciation?). This is an interesting question. The simple answer is the Central Bank. But note that the Central Bank did not intervene in the forward markets (only in the spot market). So the way the Central bank ended up taking the long US$ risk was through an indirect channel, as the local banks giving the bid to the off-shores created a synthetic peso hedge. Due to prudential reasons and/or risk aversion, domestic banks giving the bid to foreign speculators could balance their short peso position by taking off-setting contracts (real o synthetic) with other counterparties. Yet, since the banking system as a whole attempted to do the same, the ultimate counterparty was the BdR, as it was the only market participant willing to take the long U.S. dollar risk.Herman

  6. Eduardo   March 18, 2009 at 12:22 pm

    Dear Herman: first of all, congratulations for your article. I would like to know if you consider that there are the technical conditions to implement the inflation targeting system in Uruguay.Kind regards,Eduardo PiaggioMontevideo – Uruguay