Central Bank Digital Currency

Central Bank Intervention

When a central bank sells or buys its currency in foreign exchange market to Increase or decrease its value against another currency then a central bank intervention occurs.


Why do central banks intervene?


When a national currency experiences an huge decrease or increase from the market player then intervention occurs usually.
Here are some major demerits of the devaluation of a currency:

  • Due to intervention, the prices of the imported goods go high and inflation occurs as result. Finally, the central bank increases the interest rates which directly affect the economic growth and asset markets. Additional loss in the currency also occurs due to intervention.

  • A nation having a large current account deficiency and depends upon the foreign inflows of the capital can experience a huge downfall to finance its deficit which needs to increase the interest rate for stabilize the currency which can affect the economy growth.

  • The intervention drives trading partner’s exchange rate and their export prices are increased in international market. This can also affect the economy negatively, especially for those countries which are dependent on exports.

  • Central banks will often buy foreign currency and sell local currency if the local currency appreciates to a level that renders domestic exports more expensive to foreign nations.

  • So, central banks alter the exchange rate to benefit the local economy.


Means and Forms of Intervention


Foreign exchange intervention takes several shapes and forms. Here are the most common:


TYPES OF INTERVENTION

DIRECT OR INDIRECT

Verbal Intervention

Indirect

Operational Intervention

Direct

Concerted Intervention

Direct and indirect

Sterilized Intervention

Direct

  • Verbal Intervention.  When officials from the central bank “talk up” (or “talk down”) a currency is called a verbal intervention. It is also called “jawboning”. This is the cheapest and simplest form of intervention because it does not involve the use of foreign currency reserves. It may be carried out to make real intervention (actual buying/selling of currency), or simply by indicating that the currency is undervalued or overvalued. A nation whose central bank intervenes more frequently and effectively than other nations is usually more effective in verbal intervention.

  • Operational Intervention. This is the actual buying or selling of a currency by a nation’s central bank.

  • Concerted Intervention. When several nations coordinate in driving up or down a certain currency using their own foreign currency reserves then Concerted Intervention occurs. The success of it depends upon its breadth/number of countries involved in it and depth (total amount of the intervention). Concerted intervention may also be verbal when officials from several nations unite in expressing their concern over a continuously falling/rising currency.

  • Sterilized Intervention. When a central bank sterilizes its interventions, it offsets these actions through open market operations. Selling a currency can be sterilized when the central bank sells short-term securities to drain back the excess funds in circulation as a result of the intervention.

Currency interventions can be unsterilized only (or partially sterilized) when action in the currency market is in line with monetary and foreign exchange policies.
This was in the wake of the Plaza Accord joint intervention in September 1985, when the G7 bought its own currencies and sold greenbacks to help stem the tide of dollar appreciation.
The move was ultimately successful because it was accompanied by support for monetary policy. Japan raised its short-term interest rate by 200 bps this weekend, and the 3-month euro rate rose to 8.25%, making Japanese deposits more attractive than their US counterparts.
Another example of non-sterile intervention was in the "Lower Accord" in February 1987 when the G7 joined forces to stem the decline of the US dollar.
On this occasion, the Federal Reserve engaged in a series of monetary tightening, raising rates from 300 bps to 9.25% in September.


Impact on Currency Markets


Before listing the determinants of a successful FX intervention, it is important to define “success”.
A central bank that spends about 5 billion (medium) on intervention and manages to raise / lift its currency by about 2% against major currencies in the next 30 minutes is said to be successful.
Even if the currency loses its profits in the next two trading sessions, the central bank's proven ability to move the market in the first place gives it a kind of respect to "threaten" to take the next step.

  • Size Matters. The intensity of the intervention is usually proportional to the movement of the currency. Central banks equipped with foreign exchange reserves (usually counted in dollars outside the United States) are the ones that are most respected in FX interventions. As of Q3 2003, there were three central banks with the largest amount of FX reserves: Bank of Japan ($ 550 billion); Bank of China ($ 346 billion), and European Central Bank ($ 330 billion).

  • Timing. Successful FX interventions depend on time. The more surprising the intervention, the more likely it is that market players will become insecure with the large influx of orders. Conversely, when the intervention is largely expected, the shock is better absorbed and the effect is less.

  • Momentum. For the "timing" factor to work best, the intervention is more ideally applied when the currency is already moving in the desired direction of the intervention. The huge volume of the FX market ($ 1.2 trillion per day) sows any intervening order of -5 3-5 billion. Therefore, central banks generally try to avoid interference against market trends, and prefer to wait for a more favorable current. This can be done through oral positioning, which sets the general tone for more effective action when the actual intervention begins.

  • Sterilization Central banks that adopt monetary policy measures in line with their (non-sterile intervention) are more likely to trigger a more favorable and lasting currency exchange.


Implications for Traders


  • Currency traders are advised to take extra precautions when placing orders and choosing stop losses, during central bank intervention.

  • It is not advisable to trade against the currents of intervention. A single sell order by a central bank, for instance, could trigger a series of stop-loss orders by players that will exacerbate the selling and create gaps in the market.

  • If you insist on trading against the market, then your stop-loss orders must be somewhat closer to your positions than at normal market conditions.

  • Be aware of levels of support. It is near these points (usually below them) at which central banks step in to lift currencies.

 

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