Different Approaches to Forex Intervention
I got the idea for this article after recently sitting through several bouts of forex intervention by the Swiss National Bank, which has used different tactics to discourage appreciation of the Swiss Franc. Central bank intervention may be a new event for those who have recently entered the forex market. An understanding of the different forms intervention can take and the effectiveness of each is useful for those trading in the currency market.
I got the idea for this article after recently sitting through several bouts of forex intervention by the Swiss National Bank, which has used different tactics to discourage appreciation of the Swiss Franc. Central bank intervention in the forex market may be new for those forex traders who have recently entered the forex market. An understanding of the different forms intervention can take and the effectiveness of each is useful for those trading in the currency market.
Forex intervention has been going on for as long as I can remember although there is not one set of rules that central banks follow. Rather, forex intervention can be employed in a variety of methods, each having a different level of effectiveness. The recent forex interventions by the Swiss National bank to prevent the CHF from appreciating sparked the idea to write an articleon this subject.
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 currency intervention is sterilized, the central bank neutralizes the impact 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.
Some central banks may disguise their actions by using 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.
What types of forex intervention tend to be more 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. Forex intervention tends to be more effective when other actions are taken in concert, 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 a harder task for a central bank, acting unilaterally, 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 is often referred to 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. the Swiss National Bank (SNB) switched tactics in its recent forex interventions 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.
Central bank intervention to manage a currency's range and limit its movements seems to have become more of a factor as the global reserve managers looks to diversify reserves. Intervention by the Russian central bank, which 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. selling USD) to prevent its currency from appreciating, it needs selling 45% of the USD it just accumulated and buy EUROS to maintain the 55/45 ration in its currency basket. Alternatively, when the central bank intervenes by selling USD/RUB (i.e. selling USD), it then needs to buy dollars and sell EUROS to maintain the 55/45 ratio for its currency basket. This was a factor ion 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 according. 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 give some insights into forex intervention.
Copyright (c) 2009 Jay Meisler
