Central bank FX interventions are actions taken by central banks aiming to devalue or strengthen their local currencies against foreign currencies. To achieve this, the banks can issue verbal announcements or take hands-on action, such as buying or selling specific foreign currencies. In order to counteract any negative effects on the local economy, part of the action would typically also institute measures to adjust the amount of local currency flowing through an economy.
What is the rationale for central bank intervention?
Intervention is usually triggered when the actions of market participants, mainly speculators or traders, exert a selloff of a country’s currency. Central banks are then forced to swing into action to avert the potential diverse effects of such pressures on the economy.
One of the possible outcomes of excessive speculation against a local currency is the depreciation or harmful level of strengthening of the local currency against foreign currencies. When that happens, it can result in the following consequences:
- The cost of importation can rise significantly, which can lead to a spike in the rate of inflation. This can even grow into hyperinflation if the country is a net importer. When that happens, central banks often raise interest rates, which can reduce economic activity and further hurt the economy. In the end, the affected currency may depreciate further.
- If the country depends significantly on foreign inflows, it may find it expensive to finance its deficits if its current account is negative. If the central bank reacts by raising interest rates, it might trigger a slowdown in economic output, leading to a contraction of the economy.
- If the local currency strengthens excessively against foreign currencies, the country’s exports may become expensive. This may render them uncompetitive in the international market, and the economy will feel the effects back home. Under such circumstances, most central banks add to the FX reserves by injecting the local currency.
From the measures outlined above, it can be argued that central banks are often forced to manipulate the exchange rate on purpose in order to benefit their home countries.
Types of intervention
- Jawboning: This is purely verbal action, in which a central bank states that it may take action if the value of the local currency depreciates or rises to a level that would be disadvantageous to the economy. It is more lip service than actual action. As long as the central bank is prepared to step in, traders will work to restore the currency’s value to a more reasonable level.
- Operational involvement: This is perhaps the most common interpretation of what a central bank action entails. In this case, the regulator is forced to swing into action by injecting or withdrawing a specific foreign currency. Market reaction will depend on the scale of the bank’s transactions.
- Concerted intervention: Such measures involve hands-on operational action, combined with jawboning; it is most successful when several central banks express the same worries about exchange rates. Increasing the jawboning efforts of several central banks increases the likelihood of an operational intervention to move the exchange rate towards the trajectory wanted by those central banks.
- Sterilized intervention: This is usually carried out through the involvement of the bank in open market operations (OMO). Sterilization of the local currency is achieved through the sale of government securities with short-term maturity. This is done to sweep up surplus liquidity from the economy.
Effects on FX markets
For a central bank to consider its measures as successful, it will be based on many factors. For instance, if an action achieves even the smallest percentage movement in the value of a currency within an hour of a medium-sized buy or sale, it can be counted as a great success.
Whatever happens in future trading sessions, the central bank’s demonstrated ability to impact markets earns it some respect, which will make any future “threats” of intervention more impactful.
- The magnitude: Currency movements are directly related to the size of the action taken. Central banks with large US dollar reserves typically command the most respect when it comes to FX interventions.
- Timing: Timing is critical for effective FX action. It is more likely that market participants will be taken off guard by a significant flood of orders if the intervention is more startling. Shock can be better absorbed and impact reduced when it is widely expected.
- Momentum: For the “timing” aspect to be most effective, interventions are most effectively delivered when the currency has already begun to move in the direction of the anticipated outcome.
Considering the sheer size of the global forex market (about $6 trillion), engaging in direct confrontation with the market momentum may not always be a good idea. Consequently, central banks typically strive to stay out of the market’s way, preferring to wait for better currents.
Using verbal action like jawboning might help establish the tone for more effective moves once it really gets underway.
Consequences for traders
Foreign exchange traders should exercise extra caution when placing orders and employing stop losses during central bank involvements.
Trading against the flow of action is a bad idea. For example, a single sell order from a central bank could set off a cascade of stop-loss orders from market participants, further escalating the selling and resulting in market gaps.
The regulators’ interventions in the FX market are one of the primary approaches to protecting the local currency’s value. The institutions can achieve their targets by either buying or selling either local or foreign currencies.
Alternatively, they can intervene verbally by expressing the intention to take action and leaving it to traders to take care of the rest. In some instances, however, a hybrid of actions is needed. FX traders need to understand these dynamics to avoid being hurt by such activities.