Currency intervention

Currency intervention, also known as exchange rate intervention or foreign exchange market intervention, is the purchase or the sale of the currency on the exchange market by the fiscal authority or the monetary authority, in order to influence the value of the domestic currency.

Purposes

There are many reasons for the authority to intervene the foreign exchange market.

Some general consensuses are related to adjusting the volatility or changing the level of the exchange rate. First, governments always prefer to stabilize the exchange rate’s oscillation, because excessive short-term volatility erodes the market confidence and affects both the financial market and the real goods market. When there is an 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 the international trade. Moreover, the exchange rate fluctuation would spill over into the 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 changes or when the market misinterprets economic signals, authorities use the foreign exchange intervention to correct exchange rates, in order to avoid overshooting of either direction.

Moreover, in recent years, another possible reason for intervention, profitability, has been brought forward. Some literature has presented significant profits from intervention (Sweeney 1997). Although few governments confess that profitability is a motivation for intervention, some monetary authorities admit that it is a useful gauge of their success in convincing the public for currency intervention.

Types

Currency intervention could be classified into different categories according to its characteristics.

Sterilization

Depending on whether it changes the monetary base or not, currency intervention could be distinguished between sterilized intervention and nonsterilized intervention.

Nonsterilized intervention

Nonsterilized 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, aim 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.

Central bank purchase of foreign-currency bonds

Central bank balance sheet
Assets	Liabilities
Foreign-currency bonds (+1)	Monetary Base (+1)

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 nonsterilized intervention by buying (selling) foreign currency bonds using domestic currency that it issues. Then the central bank “sterilizes” the effects on the monetary base by selling (buying) a corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase (decrease) 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, and vice versa.

For example, desiring to decrease the exchange rate/price of domestic currency without changing the monetary base, authorities purchase foreign-currency bonds, the same action as in the last section. After this action, in order to keep the monetary base, governments conduct a new transaction, selling an equal amount of domestic-currency bonds, so that the total money supply is back to the original level.

Central bank purchase of foreign-currency bonds

Central bank balance sheet
Assets	Liabilities
Foreign-currency bonds (+1)	Monetary base (+1)

Central bank sale of home-currency bonds

Central bank balance sheet
Assets	Liabilities
Domestic-currency bonds (-1)	Monetary base (-1)

Net effect of a sterilized foreign-exchange purchase

Central bank balance sheet
Assets	Liabilities
Foreign-currency bonds (+1) Domestic-currency bonds (-1)	Monetary base (—)

Spot and forward markets intervention

According to the time used to settle the transaction, currency intervention could be labeled as spot market intervention and forward market intervention.

Spot market intervention

Spot market transaction is an agreement to buy or sell currency at the current exchange rate. The delivery time is usually two days or less.

Forward market intervention

Forward market transaction is an agreement to buy or sell currencies for settlement at least three days later, at predetermined exchange rates. The forward market transaction has the advantage of not requiring immediate cash outlay and is often used to reduce the exchange rate risk. If a central bank expects that the need for intervention will be short-lived and reversed in the future, then a forward market intervention may be conducted discreetly - with no observable effect on foreign exchange reserves. A point worth mentioning, the economic effects of forward market intervention are fully equivalent with the net effect of a sterilized intervention.

Currency swap

Both the spot and forward markets may be used simultaneously. A transaction in which a currency is bought in the spot market and simultaneously sold in the forward market is known as a currency swap.

Direct and indirect intervention

Direct intervention

Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing exchange rate.

Indirect intervention

Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capital controls (taxes or restrictions on international transactions in assets), and exchange controls (the restriction of trade in currencies, Neely 1999). Those policies may lead to inefficiencies or reduce market confidence, but can be used as an emergency damage control.

Effectiveness

Nonsterilization 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 (Mussa 1981).

The Portfolio Balance Channel

In the portfolio balance approach, domestic and foreign bonds are not perfect substitutes. Agents balance their portfolios among domestic money and bonds, and foreign currency and bonds. Whenever aggregate economic condition changes, agents adjust their portfolios to a new equilibrium, based on a variety of considerations, i.e. wealth, tastes, expectation, and etc.. Thus, these actions to balance portfolios will influence exchange rates.

The Expectations or Signaling Channel

Even if domestic and foreign assets are perfect substitutability of each other, sterilized intervention is still effective. According to the signaling channel theory, agents may view exchange rate intervention as a signal about the future stance of policy. Then the change of expectation will affect the current level of the exchange rate.

Examples

Swiss Franc

As the late-2000s global financial crisis hit Switzerland, the Swiss franc appreciated, “owing to a flight to safety and to the repayment of Swiss franc liabilities funding carry trades in high yielding currencies”. On March 12, 2009, the Swiss National Bank (SNB) announced that it intended to buy foreign exchange to prevent the Swiss franc from any further appreciation. Affected by the SNB purchase of Euros and US dollars, Swiss franc weakened from 1.48 against the euro to 1.52 in a single day. At the end of 2009, the currency risk seemed to be solved; the SNB changed its attitude to preventing substantial appreciation. Unfortunately, the Swiss franc began to appreciate again. Thus, the SNB stepped in one more time and intervened at a rate of more than CHF 30 billion per month. By the end of June 17, 2010, when the SNB announced the end of intervening, it had purchased an equivalent of USD 179 billion of Euros and US dollars, amounting to 33% of Swiss GDP. Furthermore, in September 2011, the SNB influenced the foreign exchange market again, and set a minimum exchange rate target of SFr 1.2 to the Euro.

Japanese Yen

From 1989 to 2003, the Japanese economy was suffering from a long deflationary period. On June 2003, over a 15 month period, the Japanese central bank intervened in the YEN/USD currency markets by creating over 35 trillion Yen of currency ("printing" money). This currency was then used to buy 320 billion U.S. dollars, which were in turn invested into U.S. treasuries. This increased the supply of yen, weakening the yen against the dollar, improving exports and lifting Japan out of a deflationary period. At the same time, the U.S. was lifted out of the 2001-2003 recession with the ability to keep interest rates low, despite growing trade and government deficits.

Chinese Yuan

When a consumer in the U.S. buys a Chinese product, Chinese manufacturers are paid in US dollars. These U.S. dollars are then deposited in a U.S. bank account. At this point, the Chinese exporter needs to convert dollars into yuan. Through its commercial bank it sells the U.S. dollars to the Chinese central bank, the People's Bank of China. Since the trade between the United States and China does not balance, there is a shortage of yuan and a surplus of U.S. dollars in the Chinese central bank (therefore the Yuan must be 'created'). The usual remedy to this situation used in international trade would be for the Chinese central bank to sell its dollars on international currency markets and buy yuan in exchange, resulting in a self-correcting system: the U.S. dollar weakens and the Chinese yuan strengthens, until equilibrium is restored and the trade gap closes.

However, in order to avoid this situation (which would decrease Chinese exports), the Chinese central bank chooses a different solution: it slows the appreciation of the Yuan, or in some cases effectively pegs the CNY against the USD. The central bank net buys USD, then sterilizes the excess dollar flows by buying dollar-denominated assets, such as U.S. treasuries. This has the effect of keeping the excess dollars out of the currency exchange markets, where they would cause a correction in the exchange rates. Thus, the Chinese central bank manipulates the exchange rates by creating yuan and buying U.S. debt. This "printing" of Chinese Yuan by the central bank is not without consequence, however, since in excess (if yuan are created faster than domestic economic output) it would eventually lead to inflation, causing consumer prices to rise.

United States and the Great Depression

During the 1920s, the U.S. government "sterilized" gold in-flows from Europe used to purchase products, in an effort to prevent the U.S. dollar from strengthening and hurting the export economy. This set the stage for the Great Depression, as it caused the money supply of gold in Europe to shrink (deflation).

See also

• Mercantilism
• Open market operation
• Sterilization (economics)
• Foreign exchange market