Central Bank Intervention

A central bank intervention takes place when a central bank purchases (or sells) its currency in the foreign exchange market to increase (or decrease) its value relative to another currency.

Why do central banks intervene?
Interventions typically occur when a country's currency faces excessive upward or downward pressure from market participants, often speculators.

A significant drop in a currency's value can lead to several disadvantages:

• It increases the cost of imported goods and services, leading to inflation. This may compel the central bank to raise interest rates, which could negatively impact asset markets and economic growth, potentially resulting in further currency losses.
• A country with a substantial current account deficit (importing more goods and services than it exports) that relies on foreign capital inflows may experience a dangerous slowdown in financing its deficit. This situation may necessitate raising interest rates to sustain the currency's value, risking severe consequences for growth.
• It elevates the exchange rate of the nation’s trading partners, making their exports more expensive in the global market. This can trigger significant economic slowdowns, particularly for countries dependent on exports.

Central banks often buy foreign currency and sell local currency when the local currency appreciates to a level that makes domestic exports more costly for foreign markets. Thus, central banks intentionally adjust the exchange rate to support the local economy.

Foreign exchange intervention can take various forms. Here are the most common types:

• Verbal Intervention: Also known as “jawboning,” this occurs when central bank officials “talk up” (or “talk down”) a currency. This can involve threatening actual intervention (buying/selling currency) or simply suggesting that the currency is undervalued or overvalued. This is the least expensive and simplest form of intervention, as it does not require the use of foreign currency reserves. However, its simplicity does not always guarantee effectiveness.
• Operational Intervention: This refers to the actual buying or selling of a currency by a central bank.
• Concerted Intervention: This occurs when multiple nations coordinate to influence a currency's value using their foreign currency reserves. Its success depends on the number of countries involved and the total amount of intervention. Concerted intervention can also be verbal, with officials from several nations expressing concern over a currency's continuous rise or fall.
• Sterilized Intervention: When a central bank sterilizes its interventions, it offsets these actions through open market operations. For example, selling a currency can be sterilized by selling short-term securities to absorb excess funds created by the intervention. Currency interventions are only unsterilized (or partially sterilized) when they align with monetary and foreign exchange policies.

This was evident in the concerted interventions of the “Plaza Accord” in September 1985, when G7 nations collaborated to curb the excessive rise of the dollar by buying their currencies and selling the greenback. This action proved successful due to accompanying supportive monetary policies. Japan raised its short-term interest rates by 200 basis points after that weekend, and the 3-month euroyen rate surged to 8.25%, making Japanese deposits more appealing than their U.S. counterparts.

Another instance of unsterilized intervention occurred in February 1987 during the “Louvre Accord,” when the G7 united to halt the decline of the U.S. dollar. On this occasion, the Federal Reserve implemented a series of monetary tightening measures, raising rates by 300 basis points to as high as 9.25% in September.

Before discussing the factors that contribute to a successful FX intervention, it is essential to define “success.” A central bank that spends approximately $5 billion (a medium-sized intervention) and manages to increase the value of its currency by about 2% against major currencies within the next 30 minutes is considered successful. Even if the currency subsequently loses its gains over the next two trading sessions, the central bank's demonstrated ability to influence the market initially earns it respect for future interventions.

Size Matters: The scale of the intervention is generally proportional to the resulting currency movement. Central banks with substantial foreign currency reserves (typically held in dollars outside the U.S.) command the most respect in FX interventions. As of Q3 2003, the three central banks with the highest FX reserves were: the Bank of Japan ($550 billion), the Bank of China ($346 billion), and the European Central Bank ($330 billion).

Timing: Successful FX interventions rely heavily on timing. The more unexpected the intervention, the more likely market players are to be caught off-guard by a sudden influx of orders. Conversely, when an intervention is anticipated, the market can better absorb the shock, resulting in a diminished impact.

Momentum: For the timing element to be most effective, intervention should ideally occur when the currency is already moving in the desired direction. The vast volume of the FX market ($1.2 trillion per day) dwarfs any intervention order of $3-5 billion. Therefore, central banks typically avoid intervening against market trends, preferring to wait for more favorable conditions. This may involve verbal posturing (jawboning) to set the stage for a more effective intervention.

Sterilization: Central banks that align their monetary policy measures with their FX actions (unsterilized intervention) are more likely to achieve a favorable and lasting change in the currency's value.

During central bank interventions, currency traders should exercise caution when placing orders and consider their stop-loss levels carefully. It is generally unwise to trade against the direction of the intervention. For example, a single sell order from a central bank could trigger a cascade of stop-loss orders from other traders, exacerbating the selling pressure and creating market gaps.

If you choose to trade against the market, your stop-loss orders should be set closer to your positions than usual. Additionally, be mindful of support levels, as central banks often intervene near these points (typically just below them) to bolster currencies.

For more information, explore the major central banks 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
• The People’s Bank of China