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Forex Intervention - Beware But Does it Work?
I wrote an article several years ago (see below) and it is still relevant today as the Bank of Japan has taken a step back into the currency wars with a threat of intervention. As I have said many times, I learned a long time ago not to count on central banks to bail out your position. The carnage following the Swiss National Bank’s decision to abandon its support of the EURCHF 1.20 peg last year should serve as a warning to anyone counting on central bank intervention. With that said, the threat of intervention (otherwise called verbal intervention) is often a better deterrent than the actual act as no one wants to get caught in the first salvo.
Those new to the market probably know little about intervention, the different forms it can take and the different impact it can have. I didn’t mention verbal intervention in this article and while it has always been a weapon, it seems to be one central banks like to employ as markets in general have become ever more sensitive to news headlines.
Forex Intervention – Does It Work? (Global-View.com, July 3, 2009)
Types of Intervention
1) Intervention can take the form of being unilateral (i.e. one central acting alone) or coordinated (i.e. various central banks acting in concert).
2) The results of the intervention (i.e. buying or selling a currency) can be sterilized or left un-sterilized. When a central bank sterilizes intervention, it offsets the impact of buying or selling its currency through intervention by adding or draining reserves from its domestic money market. When intervention is left un-sterilized, the central bank allows the full impact of such actions to either increase or reduce the supply of liquidity.
3) The central bank may look for the shock effect by being visible in its forex intervention. This may see the central bank surprise the market and come in via an electronic platform, which gets flashed across wore services. This often sees a sharp reaction in the market but the more times employed, the less impact it tends to have.
4) Other central banks may use surrogates to buy or sell its currency. In this way it can disguise its actions and keep the market guessing. Some call this stealth intervention. There is speculation that the Japan’s MOF (Ministry of Finance) and Bank of Japan employ this tactic but only insiders know whether this is true and if so, to what extent it is used.
5) Those countries with managed currency regimes have become a factor in intervention. In these cases, the central bank uses the proceeds from forex intervention to adjust its currency reserve basket to maintain the ratio of dollars and other currencies. Central banks often use this tactic to keep its currency from appreciating although it can work on both sides.
Which types of intervention tend to be most effective?
As a rule, it is easier for a central bank to intervene to slow the appreciation of its currency than to support a falling currency. Intervention tends to be more effective when accompanied by other measures, such as an increase/decrease in interest rates to make a currency more/less attractive.
Coordinated forex intervention is generally more effective than unilateral intervention in the currency market. The most notable example is the 1986 Plaza Accord, where the G-7 countries agreed to work together to drive down an overvalued USD. It is more difficult for a country, acting alone, to intervene effectively.
Un-sterilized intervention is more effective than sterilized intervention. Traders look to see if central banks sterilize intervention and allow interventions to increase or decrease (as the case may be) the supply of its currency. Most interventions tend to be sterilized as central banks take offsetting measures to limit the impact on domestic monetary conditions.
The more predictable a central bank is in its interventions, the less the impact each time employed. This may be referred to as the law of diminishing returns as the market gets used to it and adjusts its strategies accordingly. The initial reaction to a surprise intervention tends to have the greatest impact. Traders also look to see whether the central bank intervenes at lower/higher levels or gets aggressive by continuing to buy/sell at higher/lower levels. The latter tends to see the most impact but runs a risk as once the central bank steps back, the market tends to reverse some of the earlier moves.
Stealth intervention is more of a gray area. The market only suspects intervention when a central bank uses surrogates to intervene and a lot depends on how much it wants to keep the market guessing. During recent interventions by the Swiss National Bank (SNB), it switched tactics and apparently started placing orders through the BIS (Bank for International Settlements). This fueled speculation that the SNB was behind the BIS bids for EUR/USD and USD/CHF but it was never confirmed. The Bank of Japan and Ministry of Finance tend to be more secretive but the market suspects they have been employing stealth intervention for years. One reason may be that they did not want to be accused of trying to engineer an undervalued currency. Given Japan’s dependence on exports, there is suspicion that it tries to limit the JPY upside to help its exporters through stealth intervention, thereby avoiding any criticism from other trading partner countries.
Adjusting the currency basket
Central bank intervention to manage a currency’s range and limit its movements seems to have become more of a factor as global reserve managers look to diversify reserves. An example of this is the Russian central bank, which tends to be active intervening in USD/RUB. In the past, most reserves were held in USD. This has changed as countries look to diversify. Let’s say the Russian currency reserves basket is comprised of 55% in US dollars (USD) and 45% in EUROS. When it intervenes by buying USD/RUB (i.e. buying USD) to prevent its currency from appreciating, it s to sell 45% of the USD it just accumulated and buy EUROS to maintain the 55/45 ratio in its currency basket. On the other hand, when it intervenes by selling USD/RUB (i.e. selling USD), it then needs to buy dollars and sell EUROS to maintain the 55/45 ratio. This was a factor in the forex market last year in the EUR/USD sharp rise when the dollar was in a broad downtrend and the USD/RUB was falling. The Russian central bank intervened on a daily basis by buying USD and conversion of some of the proceeds to EUROS helped fuel the EUR/USD rise. It was then a factor the other way, pressuring EUR/USD lower later that year and into 2009 during the global financial crisis when the USD/RUB was under sharp upward pressure and the central bank had to sell USD to defend its weakening currency.
So when you see that a central bank intervenes, you have to explore further to assess its potential impact and adjust your strategies accordingly. Is it unilateral or coordinated? Are there any additional measures taken to support the intervention? How visible is the central bank intervention? Is there stealth intervention going on? What is the impact on major currencies from intervention to maintain a managed float? These just scratch the surface but gives some insights into forex intervention.
Jay Meisler, co-founder
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