What is a Currency Intervention?

A Look at Central Bank Interventions in the Forex Market

Currency
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Currency interventions - or forex interventions - occur when a central bank purchases or sells the country's own currency in the foreign exchange market in order to influence its value. The practice is relatively new in terms of monetary policy, but has already been used by a number of countries including Japan, Switzerland and China to control currency valuations.

For the most part, currency interventions are designed to keep the value of a domestic currency lower relative to foreign currencies.

Higher currency valuations cause exports to be less competitive, since the price of products are then higher when purchased in a foreign currency. As a result, a lower currency valuation can help improve exports and drive economic growth.

In this article, we will take a look at various currency interventions throughout history, how they're accomplished, and their effectiveness.

Currency Interventions throughout History

The first instance of currency intervention was arguably in the U.S. during the Great Depression when the government sterilized gold imports from Europe by selling U.S. dollars in order to maintain the gold standard at the time. But, currency interventions as we know it today didn't really begin until much more recently after globalization influenced economics.

China is probably the most popular example of currency intervention. With an export-driven economy, the country wanted to ensure that the Chinese yuan didn't appreciate in value against the U.S. dollar, since the U.S. was its biggest importer.

The country sold yuan in order to purchase U.S. dollar denominated assets like Treasuries and maintained a peg in value to the dollar.

More recently, the Bank of Japan (BOJ) and the Swiss National Bank (SNB) have intervened in the currency markets in order to protect their currencies from excessive appreciation.

Since the two countries are considered safe-havens for investors, the yen and franc appreciated during times of economic turmoil, which prompted the central banks to intervene in the market.

Common Methods for Currency Intervention

Currency interventions are generally characterized as either sterilized or non-sterilized transactions, depending on whether it changes the monetary base. Both methods involve buying and selling foreign currencies - or bonds denominated in those currencies - to either increase or decrease the value of their currency in the global foreign exchange market.

Sterilized transactions are designed to influence exchange rates without changing the monetary base by buying or selling foreign currency denominated bonds while simultaneously buying and selling domestic currency bonds to offset the amount. Non-sterilized transactions involve simply buying or selling foreign currency bonds with domestic currency without the offsetting transaction.

Central banks can also opt to directly intervene in the currency markets through spot and forward market transactions. These transactions involve directly purchasing foreign currency with domestic currency or vice versa, with delivery times of a few days to several weeks.

The goal in these transactions is to affect currency values in the very near-term.

Effectiveness of Currency Interventions

The effectiveness of currency interventions, particularly those conducted in the spot foreign exchange market, remains questionable. Most economists agree that long-term non-sterilized currency interventions are effective at influencing exchange rates by affecting the monetary base. But, sterilized transactions appear to have very little effect over the long-term.

Spot and forward market transactions have also been questionable. For instance, the Bank of Japan has embarked on such interventions several times throughout the 1990s and 2000s, but forex traders have always responded by pushing the yen higher down the road. There is therefore somewhat of a moral hazard in constantly being willing to defend a certain level.

Key Takeaway Points

  • Currency interventions consist of buying or selling domestic currency and/or foreign currency bonds in the global forex market.
  • Most currency interventions are conducted to contain excessive appreciation of a domestic currency, which can hurt the manufacturing and export sectors.
  • Currency interventions can take place using a number of different strategies, but their effectiveness remains questionable for the most part.