The International Monetary Fund has cautioned that evidence of financial shocks in foreign exchange markets does not, by itself, warrant central bank intervention, stressing the need for policymakers to assess broader market conditions and the potential costs of such actions.

In a Staff Discussion Note titled Drivers of Exchange Rates in EMDEs: Implications for Foreign Exchange Intervention, the IMF proposed a framework to help policymakers distinguish exchange rate movements driven by macroeconomic fundamentals from those resulting from financial shocks and market amplification.

The note argues that while exchange rate flexibility generally helps economies adjust to changing conditions, market frictions can trigger destabilising currency movements even when domestic economic fundamentals remain sound.

The IMF’s framework draws on monthly macrofinancial data, theoretical models and evidence from real-world episodes to identify the factors driving exchange rate movements across emerging market and developing economies.

Applied to Brazil and Chile, the IMF’s analysis found that financial shocks account for about one-third of fluctuations in uncovered interest parity (UIP), on average.

The IMF said the finding suggests that most exchange rate movements are driven by forces that do not necessarily require policy intervention.

The organisation noted that financial shocks play a significantly larger role in driving UIP and exchange rate fluctuations than in influencing output and inflation.

According to the IMF, financial shocks account for about one-third of the variation in the UIP premium and roughly half of nominal exchange rate fluctuations, compared with less than 10 per cent of changes in macroeconomic indicators such as output and inflation.

“The financial shock plays a sizably more prevalent role in driving UIP and exchange rate fluctuations, as opposed to output and inflation. It accounts for approximately one-third of the variance of the UIP premium and about one-half of nominal exchange rate fluctuations. In contrast, it accounts for less than 10 percent of macroeconomic aggregates such as output and inflation,” the organisation noted.

However, the note cautions that financial frictions can magnify shocks and transmit their effects to the wider economy. It found that periods of heightened financial stress were linked to significant declines in output, highlighting the need to closely monitor indicators of market functioning when assessing exchange rate pressures.

The framework is designed to help policymakers assess exchange rate movements in real time and determine whether prevailing conditions may warrant intervention under the IMF’s Integrated Policy Framework (IPF).

The IMF cautioned that while identifying a financial shock may suggest a role for intervention, it is “neither necessary nor sufficient by itself to justify the use of FXI.”

The note added that foreign exchange intervention (FXI) may also be appropriate in other circumstances, including currency mismatches and unanchored inflation expectations, even in the absence of financial shocks.

Where intervention is being considered to stabilise exchange rate risk premia, the presence of a financial shock alone is not sufficient to justify action. Policymakers must also consider factors such as the adequacy of foreign exchange reserves and whether intervention would be more effective than alternative measures, including macroprudential policies.

The IMF noted that reserve adequacy varies significantly across countries, with some maintaining substantial buffers while others have limited capacity to absorb external shocks.

This, it said, underscores the need for a careful assessment of the potential costs and benefits before intervening in foreign exchange markets.

For countries operating under floating exchange rate regimes, the IMF said maintaining exchange rate flexibility remains essential for allowing economies to adjust to shocks and supporting macroeconomic stability.

The IMF’s findings come as Nigeria’s foreign exchange market undergoes changes, including renewed interest from foreign investors and an increase in the country’s external reserves.