Currency Market Intervention

In every big-bank currency trading room in major financial centers, there is a direct line to the open market trading desk of the central bank. When that line lights up, the whole dealing room erupts. That line is reserved for open market intervention by the central bank, and when it rings, it usually means only one thing: The central bank is intervening in the market.

Intervention refers to central banks buying or selling currencies in the open market to drive currency rates in a desired direction. Direct intervention in the market is usually taken only as a last resort. It also may be a stopgap measure to stabilize markets upset by extreme events, such as a terrorist attack or rumors of a financial institution’s failure. When it’s not necessitated by emergency circumstances, markets are generally aware of the increasing risks of intervention. 

Open market intervention is usually preceded by several less-blunt forms of official intervention. The idea from the governments’ point of view is to get as much bang for the buck as possible before committing real money. Remember, Central banks have limited firepower in relation to the overall market, so they have to pick their spots well. Sometimes, the government's objective is simply to slow a market move to restore financial market stability, and less drastic forms of intervention are not yet necessary. Some of the more subtle forms of intervention are

• Verbal intervention or jawboning: These are efforts by finance ministry or central bank officials to publicly suggest that current market directions are undesirable. Basically, it amounts to trying to talk up or talk down a particular currency’s value. For example, if the Japanese MOF is intent on preventing further JPY strength to protect its export sector, but the USD/JPY rate keeps moving lower, senior MOF officials may indicate that “excessive exchange rate movements are undesirable.” This message signals currency traders to reduce their USD selling/JPY buying or risk the potential consequences. If the market ignores the warning, the MOF may take it up a notch and indicate that it is “closely monitoring exchange rates,” which is language typically used before actual open market intervention.

• Checking rates: This is the central bank’s open market desk ringing in on the direct line to major currency banks’ trading desks. The traders don’t know if it’s going to be a real intervention or not, but they still react instinctively based on previously indicated preferences. Even rumors of a central bank checking rates are enough to trigger a significant market reaction.

In terms of actual open market intervention, there are several different forms it can take, all depending on which and how many central banks are participating. The more the merrier; better still, there’s strength in numbers.

• Unilateral intervention: This is intervention by a single central bank to buy or sell its own currency. Unilateral intervention is generally the least effective form of intervention, because the government perceived (usually correctly) to be acting alone and without the support of other major governments. Markets will typically revert to the earlier direction after the intervention has run its course to test the central bank’s resolve and to see if it’s intent on stopping the move or simply slowing it. The   MOF/BOJ intervention in 2003 and 2004 was unilateral intervention.

• Joint intervention: This is when two central banks intervene together to shift the direction of their shared currency pair. For example, if the ECB and the SNB are concerned about Swiss-franc weakness versus the euro, they may decide to intervene jointly to sell EUR/CHF. This is a clear sign to markets that the two governments are prepared to work together to alter the direction of that pair’s exchange rate.

• Concerted intervention: This is when multiple central banks join together to intervene in the market simultaneously. This is the most powerful and effective type of intervention, because it suggests unity of purpose by multiple governments. Concerted intervention is not done lightly by major central banks and markets don’t take it lightly either. It’s the equivalent of a sledgehammer to the head. Concerted intervention frequently results in major long-term trend changes.

In term of the impact of intervention, different governments are given different degrees of respect by the market. Due to the frequency of past interventions and constant threats of it, the Japanese tend to get the least respect. The BOE, the SNB, and the ECB are treated with considerably more respect by markets, with the ECB being the linchpin of credibility for the Eurozone. Finally, when the U.S. Treasury (via the Fed) intervenes, it’s considered a major event, and the market usually respects the intervention.

There is a difference between a central bank intervening for its own "account and a central bank intervening on behalf of another foreign central bank. For example, during the MOF/BOJ intervention campaign in 2003 and 2004, there were several instances where the U.S. Fed bought USD/JPY during the New York trading day. The first reaction was that the U.S. Treasury was joining in and supporting the intervention by the MOF/BOJ, and this amplified the effect of the intervention. But the U.S. Treasury later denied that it had ordered the intervention. What happened was that the BOJ asked the New York Fed to intervene on its behalf during the New York trading session. Central banks have standing agreements to act as each others’ representatives in their local markets. So even though the New York Fed bought dollars, it bought them for the B0J.

Does intervention work? That is a question that frequently comes up when central banks get involved. The simple answer is an unequivocal “Yes, but ….” Intervention is most effective when it’s backed by monetary policy moving in the same direction, such as expected higher interest rates to support a weak currency or easier monetary policy to weaken a strong one. Even then, interest rate changes are no guarantee that the intervention will be successful.

In the short run, the intervention may seem fruitless and counterproductive. This is especially-the case with unilateral intervention. The market typically rejects the unilateral intervention and reverts to pushing the market in the direction opposed by the intervention. This situation can go on for weeks and months or in the MOF/BOJ’s case in 2003 to 2004, years. When it’s a joint or concerted intervention, the results are usually more immediate and successful. 

Calling the shots on currencies

In the “Official CurrencyPolicies and Rhetoric: Currency policy or currency stance" I list a number of reasons why national governments are reluctant to get involved in trying to influence the value of their currencies. Chief among these are the size and extent of the global forex market and the need for nations to reach agreement on whether adjustments are even needed. One venue covers most of these bases and provides national governments with a collective voice to express their will on currencies: the G7. (We look at the G7 in greater detail in my January post )

If governments had their way, they would probably prefer to see fixed exchange rates replace floating rates and avoid the whole subject entirely, but that’s not a realistic option for the foreseeable future. Confronted with the realities of forex markets, most government currency officials go to great lengths to avoid discussing currency values out of fear that their comments will be misinterpreted and lead to sharp exchange rate shifts. That fear was born out of experience, and today's top currency officials are much more discreet than their predecessors just a few decades ago.

Responsibility for currency matters typically falls to the finance ministry or the central bank in the nations of the most heavily traded currencies. We will take a look at who has responsibility for setting and implementing currency policies in the five major currencies and what their major motivations are.

The United States

The Department of the Treasury has the legal mandate for all currency matters, from printing the notes and minting the coins to ensuring the soundness of the U.S. dollar in international markets. The secretary of the Treasury is the primary spokesman for the U.S. dollar. The deputy Treasury secretary for international affairs is the hands-on Treasury official responsible for day-to-day currency matters. 

When the Treasury secretary speaks on the value of the dollar, or any other currency for that matter, FX markets listen.

The Eurozone

The European Central Bank (ECB) is responsible for both monetary policy and currency matters under the agreement that created the single-currency Euro in 1999. The ECB’s central council is the primary decision-making body; it’s composed of the presidents of the central banks of the 12 participating nations, with the ECB president as the group's chief policy maker and spokesman.

When the ECB needs to intervene in the market, it can do so by itself, along with the central banks of the member states on its behalf.

However, individual European countries continue to exert influence over currency policy through their finance ministers, who had responsibility for currencies prior to the introduction of the euro and the creation of the ECB. The Eurozone finance ministers meet regularly as a group and frequently weigh in on forex market developments. There still appears to be great consideration given to the member states’ governments by markets with regard to currency values, with the two largest European economies - Germany and France - wielding the greatest influence. But consensus appears to be the key element in deciding if the euro is too strong or too weak, and a clear majority of member states needs to be on board in opposing market movements before the market will pay attention.

The ECB is primarily concerned with fighting inflation and seeks to achieve currency stability as a means of fostering long-term economic growth. Europe remains heavily export oriented, so extreme euro strength is the most likely risk factor for any future forex market interventions out of Europe.

Japan

The Ministry of Finance (MOP) is responsible for currency matters in Japan. The MOF is the most powerful government ministry in Japan and can wield more influence over economic affairs than even the Bank of Japan (BOD, the central bank. The primary day-to-day currency spokesman for the MOF is the vice minister for international affairs. It is not at all uncommon for the MOP to issue daily comments on the forex markets, particularly when volatility increases.

Japan's economy remains highly export oriented, and the value of the JPY is believed to be influenced by the MOF and kept artificially weak. Throughout the 1980s and early 1990s, artificial JPY weakness was a key trade issue between the United States and Japan. This issue keeps this JPY one of the most politically driven of the major currencies. To avoid accusations of official manipulation of currency rates, the MOP frequently uses proxies to do its bidding. The most common substitute is Kampo, the Japanese postal bank’s pension fund, which has assets well over $1 trillion. So even if the BOJ is not in the market, a Kampo-buying order or selling order for several billion dollars can accomplish the same objective.

Great Britain

The chancellor of the exchequer (treasury secretary or finance minister) is the individual responsible for the British pound’s fate. The governor of the Bank of England (BOE) also shares responsibility for the pound in a bit of a holdover arrangement from when the BOE became independent from the government in the late 1990s.

The chancellor/BOE generally stays out of currency matters and appears most concerned with the pound's exchange rate versus the euro, because the bulk of UK trade is conducted with the Eurozone. The story behind that dates back to 1992, when the British pound imploded and was forced to withdraw from the European Exchange Rate Mechanism (ERM), the predecessor arrangement leading up to the euro. So if you’re waiting for the chancellor or the governor to speak up on currency matters, don't hold your breath.

The United Kingdom is closely aligned with European economies and would be a candidate to join the Eurozone single currency, but nationalism runs deep when it comes to getting rid of the pound.

Switzerland

The Swiss National Bank (SNB) is charged with responsibility for the Swiss franc along with setting monetary policy. The SNB is most concerned with the Swiss franc’s exchange rate versus the euro, because nearly 80 percent of Swiss trade is conducted with Eurozone nations. The SNB has been known to speak up in opposition to CHF strength or weakness whenever the EUR/CHF exchange rate approaches extreme levels. Instead of engaging in open-market intervention, in the past the SNB has indicated that it may use interest rates to prevent excessive Swiss franc weakness, which is especially troublesome because it can import inflation and undermine SNB monetary policy.

Official Currency Policies and Rhetoric: Currency policy or currency stance?

After considering monetary policy and interest rates, the next biggest influences on currency values are government policies or official stances regarding the value of individual currencies. Some of the largest changes in currency values over the past 20 years have been brought on by official policies and multilateral agreements among the major industrialized economies. For instance, the Plaza Accord of 1985 stands out as a watershed in forex market history, ultimately resulting in a roughly 50 percent devaluation of the U.S. dollar over the course of the next two years.

National governments have a great deal at stake when it comes to the value of their currencies. After all, in a sense, a nation’s currency is the front door to its economy and financial markets. If the currency is viewed as unstable or too volatile, it’s tantamount to slamming the front door shut. And no major economy can afford to do that today.

Referring to official government thinking on currencies as a currency policy may be a mischaracterization. Instead, you may do better to think of it as a stance on particular currency values at a particular point in time.

Daily trading volumes in the forex market dwarf most national central bank currency reserve holdings. (Currency reserves are the accumulated stocks of international currencies held by central banks for use in market interventions and overall central bank reserve management.) Japan and China together have nearly $2 trillion in central bank currency reserves. That may seem like a lot to you and us, but average currency trading volume in the global forex market is over $2 trillion per day. This means that even if national governments wanted to routinely manage the value of their national currency, they would be hard-pressed to overcome market forces if they were at odds with the official policy.

To summarize why governments are generally reluctant to get involved in trying to influence currency values, it comes down to the following:

• They can’t because they’re too small. Forex markets are much bigger than any one nation’s foreign currency reserves.
• They can’t because of market structure. Forex markets operate outside national jurisdictions.
• They can’t agree on what to do. Currencies always have another country or countries on the other side of the pair. You may want your currency to weaken, but do others want their currencies to strengthen?
• They don’t want to meddle in the free market. Tampering with international capital flows is a recipe for economic disaster.

Generally speaking, then, governments prefer to refrain from getting involved in setting currency rates or trying to influence overall currency direction. They recognize that their power is extremely limited and that it must be used sparingly, and only when extreme circumstances demand action from the national government or collective action from several governments. Moreover, the global economic superpowers are believers in the power of free markets to best allocate capital and maximize long-run economic potential. It simply would not do for them to openly reject free-market policies by regularly seeking to influence currency rates. You have to practice what you preach, or you start losing your following. For governments, that translates to credibility and that’s a trait most governments seek to cultivate and protect.

But and this is a big but governments do seek to influence currency rates from time to time. And when they do, it’s usually a key long-term turning point in currency values.