Currency intervention
Currency intervention, also known as foreign exchange market intervention or currency manipulation, is a monetary policy operation. It occurs when a government or central bank buys or sells foreign currency in exchange for its own domestic currency, generally with the intention of influencing the exchange rate and trade policy.
Policymakers may intervene in foreign exchange markets in order to advance a variety of economic objectives: controlling inflation, maintaining competitiveness, or maintaining financial stability. The precise objectives are likely to depend on the stage of a country's development, the degree of financial market development and international integration, and the country's overall vulnerability to shocks, among other factors.
The most complete type of currency intervention is the imposition of a fixed exchange rate with respect to some other currency or to a weighted average of some other currencies.
Purposes
There are many reasons a country's monetary and/or fiscal authority may want to intervene in the foreign exchange market. Central banks generally agree that the primary objective of foreign exchange market intervention is to manage the volatility and/or influence the level of the exchange rate. Governments prefer to stabilize the exchange rate because excessive short-term volatility erodes market confidence and affects both the financial market and the real goods market.When there is inordinate instability, exchange rate uncertainty generates extra costs and reduces profits for firms. As a result, investors are unwilling to make investment in foreign financial assets. Firms are reluctant to engage in international trade. Moreover, the exchange rate fluctuation would spill over into the other financial markets. If the exchange rate volatility increases the risk of holding domestic assets, then prices of these assets would also become more volatile. The increased volatility of financial markets would threaten the stability of the financial system and make monetary policy goals more difficult to attain. Therefore, authorities conduct currency intervention.
In addition, when economic conditions change or when the market misinterprets economic signals, authorities use foreign exchange intervention to correct exchange rates, in order to avoid overshooting of either direction. Anna Schwartz contended that the central bank can cause the sudden collapse of speculative excess, and that it can limit growth by constricting the money supply.
Today, forex market intervention is largely used by the central banks of developing countries, and less so by developed countries. There are a few reasons most developed countries no longer actively intervene:
- Research and experience suggest that the instrument is only effective if seen as foreshadowing interest rate or other policy adjustments. Without a durable and independent impact on the nominal exchange rate, intervention is seen as having no lasting power to influence the real exchange rate and thus competitive conditions for the tradable sector.
- Large-scale intervention can undermine the stance of monetary policy.
In a Bank for International Settlements paper published in 2015, the authors describe the common reasons central banks intervene. Based on a BIS survey, in foreign exchange markets "emerging market central banks" use the strategy of "leaning against the wind" "to limit exchange rate volatility and smooth the trend path of the exchange rate". In their 2005 meeting on foreign exchange market intervention, central bank governors had noted that, "Many central banks would argue that their main aim is to limit exchange rate volatility rather than to meet a specific target for the level of the exchange rate". Other reasons cited were to "slow the rate of change of the exchange rate", "dampen exchange rate volatility", "supply liquidity to the forex market", or "influence the level of foreign reserves".
Historical context
In the Cold War-era United States, under the Bretton Woods system of fixed exchange rates, intervention was used to help maintain the exchange rate within prescribed margins and was considered to be essential to a central bank's toolkit. The dissolution of the Bretton Woods system between 1968 and 1973 was largely due to President Richard Nixon's "temporary" suspension of the dollar's convertibility to gold in 1971, after the dollar struggled throughout the late 1960s in light of large increases in the price of gold. An attempt to revive the fixed exchange rates failed, and by March 1973 the major currencies began to float against each other.Since the end of the traditional Bretton Woods system, IMF members have been free to choose any form of exchange arrangement they wish, such as: allowing the currency to float freely, pegging it to another currency or a basket of currencies, adopting the currency of another country, participating in a currency bloc, or forming part of a monetary union.
The end of the traditional Bretton Woods system in the early 1970s led to widespread but not universal currency management.
From 2008 through 2013, central banks in emerging market economies had to "re-examine their foreign exchange market intervention strategies" because of "huge swings in capital flows to and from EMEs.
Direct intervention
Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing the exchange rate. Depending on whether it changes the monetary base or not, currency intervention can be distinguished between non-sterilized intervention and sterilized intervention, respectively.Sterilized intervention
Sterilized intervention is a policy that attempts to influence the exchange rate without changing the monetary base. The procedure is a combination of two transactions. First, the central bank conducts a non-sterilized intervention by buying foreign currency bonds using domestic currency that it issues. Then the central bank "sterilizes" the effects on the monetary base by selling a corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase of the domestic currency. The net effect of the two operations is the same as a swap of domestic-currency bonds for foreign-currency bonds with no change in the money supply. With sterilization, any purchase of foreign exchange is accompanied by an equal-valued sale of domestic bonds.For example, desiring to decrease the exchange rate, expressed as the price of domestic currency, without changing the monetary base, the monetary authority purchases foreign-currency bonds, the same action as in the last section. After this action, in order to keep the monetary base unchanged, the monetary authority conducts a new transaction, selling an equal amount of domestic-currency bonds, so that the total money supply is back to the original level.
Non-sterilized intervention
Non-sterilized intervention is a policy that alters the monetary base. Specifically, authorities affect the exchange rate through purchasing or selling foreign money or bonds with domestic currency.For example, aiming at decreasing the exchange rate/price of the domestic currency, authorities could purchase foreign currency bonds. During this transaction, extra supply of domestic currency will drag down domestic currency price, and extra demand of foreign currency will push up foreign currency price. As a result, the exchange rate drops.
Indirect intervention
Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capital controls, and exchange controls. Those policies may lead to inefficiencies or reduce market confidence, or in the case of exchange controls may lead to the creation of a black market, but can be used as an emergency damage control.Effectiveness
The largest empirical study on effectiveness shows success around 80% when it comes to managing volatility of a currency. A meta-analysis based on 300 different estimations on the effectiveness of the practice show that, on average, a $1 billion dollar purchase depreciates domestic currency in 1%.Non-sterilization intervention
In general, there is a consensus in the profession that non-sterilized intervention is effective. Similarly to the monetary policy, nonsterilized intervention influences the exchange rate by inducing changes in the stock of the monetary base, which, in turn, induces changes in broader monetary aggregates, interest rates, market expectations and ultimately the exchange rate. As we have shown in the previous example, the purchase of foreign-currency bonds leads to the increase of home-currency money supply and thus a decrease of the exchange rate.Sterilization intervention
On the other hand, the effectiveness of sterilized intervention is more controversial and ambiguous. By definition, the sterilized intervention has little or no effect on domestic interest rates, since the level of the money supply has remained constant. However, according to some literature, sterilized intervention can influence the exchange rate through two channels: the portfolio balance channel and the expectations or signaling channel.;The portfolio balance channel
;The expectations or signaling channel