Understanding the dynamics of foreign reserve management: The central bank intervention policy and the exchange rate fundamentals

The aim of this study is to examine the behaviour of central banks in managing their foreign exchange reserves. This includes measuring the effects of macroeconomic fundamentals on intervention and the effectiveness of intervention in managing exchange rates. First, the paper focuses on measuring central bank reaction functions to assess the response of central banks to exchange rate volatility in both emerging (EE) and advanced economies (AE). Then, it proposes an alternative approach for the closest obtainable approximation for official intervention. Finally, the Propensity Score Matching (PSM) technique is applied to test whether the proposed foreign exchange intervention has causal effects on exchange rates. Results show that central banks in both EE and AE respond more aggressively to an exchange rate appreciation. Data from official foreign reserves provide enough evidence for detecting policy changes and reveal central bank intervention. The intervention model is improved once we include other central bank incentives such as sterilisation, trade balance and the growth of reserves in relation to the growth of output. PSM results show that the central bank interventions are meaningful, and they provide evidence of causal inference for the behaviour of exchange rates in EE.