FX Intervention Watch

Currency intervention occurs when one central bank or more buys (or sells) a currency in the foreign exchange market in order to raise (or lower) its value.

Why Intervene ?

Intervention usually happens when a nation’s currency is undergoing excessive downward or upward pressure from market players—usually speculators.

A significant decline in the value of a currency has the following drawbacks:

1. Raises the price of imported goods and services and triggers inflation. This will push the central bank to raise interest rates, which will likely hurt asset markets and economic growth. This could also lead to additional losses in the currency. Case in point: Euro movements in summer-fall 2000
2. A nation with a large current account deficit (buys more goods and services than it sells from abroad) that is dependent upon foreign inflows of capital may undergo a dangerous slowdown in the financing of its deficit, which will require rising interest rates to maintain the value of the currency and, could risk serious repercussions on growth. Case: US
3. Pushes up the exchange rate of the nation’s trading partners and drive up the price of their exports in the global market place. This will also trigger serious economic slowdown, especially for export-dependent countries. Case: Currencies of Southeast Asian nation’s rose in 1997 as they were pegged to the appreciating dollar.

Looking at the other side of the coin, central banks also intervene to stem excessive appreciation of their currency, which makes exports less attractive and weighs on the balance of payments.

Means and Forms of intervention

Foreign exchange intervention takes several shapes and forms. Here are the most common.

1. Verbal Intervention: This occurs when officials from the Ministry of Finance (Treasury), central bank or other politicians “talk up” (or "talk down") a currency. This is either done by threatening to commit real intervention (actual buying/selling of currency), or simply by indicating that the currency is undervalued or overvalued. This is the cheapest and simplest form of intervention because it does not involve the use of foreign exchange reserves. Nonetheless, its simplicity doesn’t always make it effective. Yet, a nation whose central bank is known to intervene more frequently and effectively than others are, is usually more effective in verbal intervention.
2. Operational Intervention: This is the actual buying or selling of a currency by a nation’s central bank, usually on behalf of the Finance Ministry.
3. Concerted Intervention: This happens when several nations collaborate in driving up or down a certain currency using their own reserves. Its success is dependent upon its breadth (number of countries involved) and depth (dollar size of intervention).
   
   Note: Concerted intervention could also be verbal when officials from several nations unite in expressing their concern over a continuously falling/rising currency.
4. Sterilized Intervention: When a central bank sterilizes its interventions, it offsets these actions in its monetary policy practices (open market operations or interest rate targets). When the Fed sold dollars for euros in order to push up the currency on September 22, 2000, it intended to offset that action by draining sufficient liquidity from the US money market to maintain monetary policy intact and the cost of money unchanged. If the Fed hadn’t sterilized the intervention by draining liquidity into the system, it would have let extra flows, which would have expansive impact on monetary policy and render market interest rates cheaper. Thus, the role of the Fed’s action in selling dollars for euros may have successfully propped the euro for some time, but the impact in the money market remained sterilized.
   Central banks usually sterilize their interventions so as not to compromise their domestic monetary policies for the sake of pushing up (down) a certain currency. FX interventions only go unsterilized (or partially sterilized) when action in the currency market is in line with monetary and foreign exchange policies.
   This occurred in the great intervention of the “Plaza Accord” in September 1985 when G7 collaborated to stem the excessive rise of the dollar by buying their currencies and selling the greenback. The action eventually proved to be successful because it was accompanied by supporting monetary policies. Japan raised its short-term interest rates by 200 bps after that weekend, and the 3-month euroyen rate soared to 8.25%, making Japanese deposits more attractive than their US counterpart. Another example of unsterilized intervention was in February 1987 at the “Louvre Accord” when the G7 joined forces to stop the plunge of the dollar. On that occasion, the Federal Reserve engaged in a series of monetary tightening, pushing up rates by 300 bps to as high as 9.25% in September.

Impact on Currency Markets

Before listing the determinants of a successful FX intervention, it is important to define “success”. Thus, a central bank that spends about $5 billion (medium-size) and manages to raise lift its currency by about 2% against the major currencies over the next 30 minutes is said to be successful. And even if the currency ends up paring its gains over the next two trading sessions, its ability to move the market in the first place gives it some kind of respect the next time it “threatens” to step in.

1. Size Matters: The magnitude of the intervention is usually proportional to the resulting move of the currency. Central banks equipped with a substantial chest of foreign exchange armory (usually denominated in dollars), are those that command most respect in FX interventions. As of Q3 2000, the three central banks with the highest amount of FX reserves are: the Bank of Japan ($340 billion); European Central bank ($260 billion) and the Bank of China ($150 billion).
2. Timing: Successful FX interventions thrive on timing. The more surprising the intervention, the more likely market players are caught off-guard from a large inflow of orders. In contrast, when intervention is largely anticipated, the shock is better absorbed.
3. Momentum: In order for the “timing” element to work best, intervention is more ideally implemented when the currency is already moving in the intended direction of the intervention. The large volume of the FX market ($1.5 trillion per day) dwarfs any intervention order of $3-5 billion. So central banks should try to avoid intervening against the market trend and wait for more favorable currents. This is usually done through verbal posturing, which sets the general tone for a more fruitful action.
4. Sterilization occurs when central banks engage in monetary policy measures to offset their Forex action. Unsterilized interventions are more likely to trigger a lasting change in the currency because they are not diluted by the central bank's actions in the money markets.

Will the ECB Intervene Again?

On September 22, 2000, the ECB finally launched its first intervention in history, in order to shore up its ailing currency. Most notable about that intervention was the joined action by the central banks of the US, Canada, Japan, Germany and France. The timing was perfect in that the euro buying was unexpectedly triggered prior to that weekend’s G7 meeting (instead of after the meeting). The intervention was also effective because it included the US, and that it was launched on the back of an already rising euro (momentum effect).

Additional intervention by the ECB to shore up its currency cannot be ruled out. The uncertainty, however, lies in the style of intervention. Thus, it is unlikely at this point for the Federal Reserve, to engage in any more euro buying, especially after the US Administration reiterated its strong dollar policy--a view well supported by the Fed--. If the US did intervene again, it’s likely to trigger mixed signals into the market regarding its dollar policy, which could provoke an ugly sell-off in the greenback and in US assets.

Who Else?

This leaves out the central banks of Japan, the UK and the Eurozone as those most likely expected to engage in subsequent FX actions. The Bank of England could always do with selling the pound against the euro, since British industry would profit from cheaper British goods destined to the Eurozone, which accounts for over 60% of UK exports.

The Bank of Japan’s massive war chest of FX reserves and its successful track record in sustaining yen stability in the markets, will make it a likely candidate in intervening and preventing the yen from surging beyond the 90-yen level against the euro.

Implications on Your Trading

• During times such as these, FX traders are advised to take extra care when submitting orders and selecting stop-losses.
• It is not advisable to trade against the currents of intervention. A single sell order by a central bank for instance, could trigger a series of stop-loss orders by players that will exacerbate the selling and create gapping in the market. If you insist on trading against the market, then your stop-loss orders must be somewhat closer to your positions than at normal market conditions.
• Such care must always be exercised during times of intervention. Now that the ECB has demonstrated it is ready to act to support the euro, shorting the currency has become more of a risky venture than before.
• Be aware of levels of support. It is near these points (usually below them) at which central banks step in to lift currencies.

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