Currency intervention refers to the buying or selling of currency by a country’s central bank in order to influence exchange rates. With trillions of dollars worth of currency traded on the forex market daily, intervention can have a significant impact on currency valuations and is an important concept for forex traders to understand. This comprehensive guide will provide an in-depth look at currency intervention, including key aspects such as:
What is Currency Intervention?
Currency intervention occurs when a country’s government or central bank buys or sells its own currency in the forex market to raise or lower the value of its currency. It is a monetary policy tool used by central banks to stabilize or re-align the value of their domestic currency by countering disruptive short-term movements.
The main objectives of currency intervention are:
- Influencing exchange rates to make exports more competitive and stimulate economic growth. For example, lowering currency value makes exports cheaper.
- Countering disorderly market conditions like excessive volatility. Intervention helps restore stability.
- Building up foreign exchange reserves of that currency. This reserves provide confidence in the currency.
- Reducing large trade deficits by discouraging imports and boosting exports.
- Redirecting large capital inflows that may destabilize the economy. Intervention helps absorb surplus liquidity.
How Does Currency Intervention Work?
There are two main types of intervention:
1. Buying Domestic Currency
This refers to a central bank buying its own currency using foreign exchange reserves. It causes an increased demand for the currency, boosting its value. For example, the US Fed buying USD using its Euro reserves.
2. Selling Domestic Currency
This refers to the central bank selling its own currency onto the forex market. The increased supply depresses the value of the currency. For example, the Bank of Japan selling JPY for USD reserves.
By buying or selling domestic currency in large quantities, the central bank aims to shift exchange rates and stabilize currency movements. Direct intervention is highly effective due to the scale and resources central banks possess.
What are the Policy Tools for Intervention?
Central banks have several policy tools and methods available to intervene in forex markets:
Open Market Operations
This involves buying or selling government bonds to influence money supply and interest rates. Buying bonds supplies currency, lowering interest rates. Selling bonds removes currency, increasing rates. This impacts currency valuations.
Currency Swaps
Central banks use swap agreements with commercial banks to manage liquidity and exchange rates. This helps maintain stability in currency markets.
Verbal Intervention
Verbal statements by central banks hinting at intervention can impact forex activity. Even the threat of intervention is often enough to direct currency valuations.
Coordinated Intervention
Central banks sometimes intervene collectively in a coordinated manner. This increases effectiveness due to combined reserves. For example, G7 central banks intervening to support the USD.
Quantitative Easing (QE)
QE is the process of creating new central bank reserves to buy securities like government bonds. This flood of cash into the system aims to lower interest rates and boost asset prices & economic growth. But it also weakens the domestic currency.
What are the Motives Behind Intervention?
Some of the key motives and situations that prompt central banks to intervene in forex markets include:
- Smoothing volatility – Tempering excess volatility and large swings in currency prices. This provides stability and confidence.
- Re-aligning valuations – Pushing misaligned exchange rates back to desired levels based on economic fundamentals.
- Building currency reserves – Boosting stockpiles of foreign exchange as a reserve asset and buffer against crisis.
- Supporting trade objectives – Influencing exchange rates to boost exports and growth or to reduce large trade deficits.
- Preventing currency rises – Capping currency appreciations that hurt exports. This includes ‘currency wars’ between nations competing for trade.
- Avoiding destabilizing capital flows – Restricting large hot-money inflows or outflows that disrupt the economy.
What are Some Famous Examples of Intervention?
Some notable historical examples of forex intervention include:
- 1985 Plaza Accord – Collective intervention by G5 central banks to depreciate the US dollar.
- 1992 Soros breaks the Bank of England – Soros’ massive short selling forced the BoE to abandon GBP peg to Deutsche Mark.
- 1995 US reverses JPY rise – Mass-buying of JPY by the US reversed excessive Yen strength harming Japanese economy.
- 1998 Hong Kong counters speculative attack – Heavy intervention by Hong Kong Monetary Authority to protect Hong Kong dollar peg during Asian financial crisis.
- Post 2008 crisis intervention – Coordinated central bank action to provide USD liquidity and stabilize markets.
- 2011 Swiss franc peg – Swiss National Bank pegs CHF at 1.20 to Euro to protect exporters from excessive Franc strength.
- 2015 China’s surprise Yuan devaluation – PBOC lowered Yuan by nearly 2% in a surprise move to boost exports and growth.
What are the Arguments For and Against Intervention?
Currency intervention has been praised by some and criticized by others. Key arguments include:
For:
- Can quickly restore orderly markets during crisis periods
- Helps counter damaging volatility and stabilize economic growth
- Levels the playing field in international trade
- Can build valuable currency reserves as a buffer
Against:
- Artificially influences free market pricing and efficient allocation of capital
- Discourages hedging by exchange rate protection
- Drains resources from other uses to buy foreign currencies
- Subject to political pressures rather than policy effectiveness
Overall, modest intervention to calm excessive volatility may be viewed as positive. But critics argue it should be limited to crisis situations only.
How Can Forex Traders Position Around Intervention?
Traders can employ certain strategies to navigate currency intervention:
- Follow intervention news: Closely track reports, statements and activity hints of possible intervention.
- Consider impact on currency pairs: Determine how intervention in one currency might affect its pair valuations.
- Watch for reversals: Intervention often sparks mean-reversion as prices swing back post-intervention.
- Utilize options for intervention risk: Hedge exposure using long-dated options contracts.
- Factor in increased volatility: Intervention may spark above-average whipsaws and choppy price action.
- Focus on intervention targets: Intervention often targets specific exchange rates based on policy motives.
- Beware the fading effect: Intervention impact may diminish over time as markets reassert.
- Watch escalation risks: Intervention may spark a ‘currency war’ of retaliation from other nations.
Conclusion
Currency intervention is an important monetary policy option for central banks to maintain orderly forex markets. During periods of market turmoil or exchange rate misalignments, direct intervention in forex can provide stability and direction. However, critics argue it distorts free market pricing.
For traders, being aware of intervention risks and responding with appropriate strategies is key to navigating these currency market events. Following central bank communications, anticipating motives and targets, and using options or other hedges can help manage the impact of intervention-driven volatility.