A central bank intervention occurs when a central bank buys (or sells) its currency in the foreign exchange market in order to raise (or lower) its value against another currency.
Why do central banks 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:
- It 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.
- 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 raising interest rates to maintain the value of the currency and could risk serious repercussions on growth.
- It pushes up the exchange rate of the nation’s trading partners and drives up the price of their exports in the global market place. This will also trigger a serious economic slowdown, especially for export-dependent countries.
Central banks will often buy foreign currency and sell local currency if the local currency appreciates to a level that renders domestic exports more expensive to foreign nations.
Therefore, central banks purposely alter the exchange rate to benefit the local economy.
Means and Forms of Central Bank Intervention
Foreign exchange intervention takes several shapes and forms. Here are the most common:
|TYPES OF INTERVENTION||DIRECT OR INDIRECT|
|Concerted Intervention||Direct and indirect|
- Verbal Intervention. Also known as “jawboning”. This occurs when officials from the central bank “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 currency reserves. Nonetheless, its simplicity doesn’t always imply effectiveness. A nation whose central bank is known to intervene more frequently and effectively than other nations is usually more effective in a verbal intervention.
- Operational Intervention. This is the actual buying or selling of a currency by a nation’s central bank.
- Concerted Intervention. This happens when several nations coordinate in driving up or down a certain currency using their own foreign currency reserves. Its success is dependent upon its breadth (number of countries involved) and depth (total amount of the intervention). Concerted intervention could also be verbal when officials from several nations unite in expressing their concern over a continuously falling/rising currency.
- Sterilized Intervention. When a central bank sterilizes its interventions, it offsets these actions through open market operations. Selling a currency can be sterilized when the central bank sells short-term securities to drain back the excess funds in circulation as a result of the intervention.
Currency 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 concerted interventions 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 an unsterilized intervention was in February 1987 at the “Louvre Accord” when the G7 joined forces to stop the plunge of the U.S. 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 forex intervention, it is important to define “success”.
A central bank that spends about $5 billion (medium-size) on intervention and manages to raise/lift the value of its currency by about 2% against the major currencies over the next 30 minutes is said to be successful.
Even if the currency ends up losing its gains over the next two trading sessions, the proven ability of that central bank to move the market in the first place gives it some kind of respect for the next time it “threatens” to step in.
- Size Matters. The magnitude of the intervention is usually proportional to the resulting movement of the currency. Central banks equipped with substantial foreign currency reserves (usually denominated in dollars outside the US) are those that command the most respect in forex interventions. As of Q3 2003, the three central banks with the highest amount of forex reserves were: the Bank of Japan ($550 billion); the Bank of China ($346 billion), and European Central Bank ($330 billion).
- Timing. Successful forex interventions depend on timing. The more surprising the intervention, the more likely it is that market players are caught off-guard by a large inflow of orders. In contrast, when intervention is largely anticipated, the shock is better absorbed and the impact is less.
- 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 forex market ($1.2 trillion per day) dwarfs any intervention order of $3-5 billion. So central banks usually try to avoid intervening against the market trend, preferring to wait for more favorable currents. This may be done through verbal posturing (jawboning), which sets the general tone for a more fruitful action when the actual intervention begins.
- Sterilization. Central banks engaging in monetary policy measures in line with their forex actions (unsterilized intervention) are more likely to trigger a more favorable and lasting change in the currency.
Implications for Traders
- During central bank interventions, currency 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 gaps 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.
- Be aware of levels of support. It is near these points (usually below them) at which central banks step in to lift currencies.
Read more about the major central banks from around the world:
- The European Central Bank
- The Bank of Japan
- The Bank of England
- The Swiss National Bank
- The Federal Reserve System
- The Reserve Bank of Australia
- The Reserve Bank of New Zealand
- The Bank of Canada
- Central Bank of Kenya
- People’s Bank of China
Vincent Nyagaka is a Professional Trader, Analyst &. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Checkout Vincent’s Professional Trading Course here.