1992 Exchange Rate Policy of the Central Bank of Russia
7.3 Evaluating Central Bank Interventions: The Criteria
In order to assess the success of central bank activity in the exchange market some criterion should be clearly defined. In Milton Friedman's work (1953) on floating exchange rate, the so-called 'profitability criterion' is defined in the following way:
"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."
This idea can be demonstrated with the help of the simple diagram presented in Figure 7.1. Time is depicted along the X-axis. Under the assumption of a uniform spread of the interventions over the periods in question, this axis may be interpreted also as a quantity axis (t, q). The vertical axis depicts the exchange rate (p).
During the period shown in the left part of the diagram, the national currency is considered to be 'too heavy'. The central bank buys dollars, for example, and these purchases push the exchange rate to the level showed on the diagram in the form of a flatter curve. The area A (vertical lines) may be interpreted as the amount of the domestic currency spent to support the dollar. The shaded area, C, depicts the profit made by buying dollars below the reference (long term equilibrium) level
Xo.
In the right half of the diagram, the situation has been reversed. The domestic currency undershoots. This results in official dollar sales, and the amount of national currency purchased is shown by area B (horizontal lines). The shaded area, D, reflects the profit made by selling dollars above the equilibrium level. As long as area B is larger than area A, the official agency finishes with profit in terms of the national currency. This is an example of stabilizing and profitable
Exchange Rate Policy in Russia 125
P
Actual exchange rate Xo
Figure 7.1 Interventions and Exchange Rates
intervention. However, some serious problems with the practical applicability of this criterion are shown in Mayer and Taguchi (1983). In short, these are:
1. Under specific conditions, unprofitable intervention may have a stabilizing effect. For example, it may be the case when the official agency intervenes in the right direction, but excessively.
2. In order to obtain meaningful results some kind of equilibrium level (level X, in our diagram) should be used as a benchmark. The attempt to assess results (the reference point being the actual exchange rate differing from this level) may produce the same problem as discussed above: the case of unprofitable but stabilizing intervention. This problem may be avoided if the intervention is closed, or in other words, when the amounts of foreign currency sold and purchased during the period is equal.
3. The assessment of results of interventions may become ambiguous when the equilibrium level is not static, but is subject to some kind of a trend. Once again, unprofitable intervention may have a stabilizing effect. Moreover, the assessment would depend on what has taken place first: sales or purchases of the foreign currency. By incorporating the implicit assumption of the interest rate differential, an amendment of the criterion would give results only under the specific set of circumstances, when
A. Kovalev
"...the nominal interest differential is equal to the path of the equilibrium exchange rate. Conversely, it can be seen, that if the interest differential is no longer equal to the exchange rate trend
...
commercial profits or losses will still be measured correctly, but they can no longer serve as a reliable indicator of the stabilizing impact of official intervention"(Mayer and Taguchi, 1983, p. 16-17).
Generally speaking, if judged on the basis of the profitability criterion, the stabilizing interventions would be rejected in most cases. In this sense, the criterion is definitely negatively-biased. Mayer and Taguchi advised to drop the profitability criterion and substitute it with the more direct approach disregarding interest rate differentials; thus, shifting from the use of the profitability criterion to another method. This should allow measuring whether the interventions, which occurred at a particular point in time, tended to push the actual exchange rate to the then prevailing equilibrium level, or not. The most important advantages of the alternatively suggested criterion are: (i) the opportunity to disregard interest rate differentials, and (ii) the possibility to avoid a dependence of the whole computation on the single (equilibrium) exchange rate level. The latter is even more significant as it facilitates the consideration of shifts in the trend of the equilibrium exchange rate. However, a serious difficulty with this approach lies in the search for the equilibrium rate. Mayer and Taguchi suggested to use some long-term moving average of the actual exchange rate as its proxy.
This paper is based on the method elaborated by Mayer and Taguchi in spite of its shortcomings admitted by the authors themselves. There are some additional limitations concerning the use of this method with respect to the particular case of the CBR's interventions. The choice of a moving average for the actual exchange rate can be only arbitrary with respect to the number of points taken into consideration when the equilibrium exchange rate is computed. The less points considered, the less likely the result would look like any kind of equilibrium rate.
However, increasing the number of points raises a further problem. The more time between points, the earlier the influence on the level of the equilibrium rate. This feature may be disturbing when breaks in trends are under consideration.
Consequently, weighted averages should be used, but even this would not clear the method of negative or positive bias (which depends on the general direction of the trend).
Another problem is linked to the actual practice of interventions made by the CBR. These are taking place during the sessions of the MICEX in Moscow (also at St. Petersburg Currency Exchange during the second half of 1992).[4] Currency exchanges in Russia work in the following way. Member banks of the particular exchange (approximately 90 banks are members of the MICEX) bid at each session under the directions given by their clients during the period preceding the session.
Exchange Rate Policy in Russia 127 The aggregate data on supply and demand is at the CBR's disposal before the session. However, the banks may withdraw some of their bids during the sessions.
As a result, the starting supply and demand bears the influence of the longer-term trends and expectations of the economic agents. However, interventionist policy seriously depends on interaction of supply and demand during each session.
It follows, that the results of the study may be only approximate, either with respect to the actual way of using the Mayer and Taguchi method, or with respect to any cross-country, or cross-time comparisons.