How can a country’s economy be pushed towards growth? There are many ways to achieve it: increasing investment attractiveness, introducing innovations, easing the tax burden for small and medium-sized businesses, etc. But it happens that these measures are not enough, then the central bank comes to the rescue. By interventions, the Central Bank strengthens or weakens the exchange rate of the national currency, which can stimulate economic processes.
Central banks may be able to weaken a currency by selling their own reserves on the market. They can also strengthen it by buying more and selling their own currency. Sterilization happens when authorities offset the purchase of foreign currencies or securities by selling domestic ones, therefore dropping its own money supply. Central banks use sterilization as a way to insulate or protect their economies against any negative impact from things like currency appreciation or inflation—both of which can reduce a country’s place in export competitiveness in the global market.
It is also used to control exchange rate volatility, maintain liquidity in the foreign exchange market, oppose the import or export of capital, and accumulate central bank reserves in a particular currency.
Foreign exchange intervention can be carried out both on the domestic and on the world market. In this case, the operation is carried out not by one central bank, but by a number of regulators and treasuries from different countries in accordance with their agreement among themselves on a single monetary policy in relation to third countries.
Sterilized vs Unsterilized Intervention:
Direct foreign exchange intervention is usually defined as foreign exchange transactions conducted by a monetary authority and aimed at changing the exchange rate. Depending on whether it changes the monetary base, foreign exchange intervention can be divided into unsterilized intervention and sterilized intervention, respectively.
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 intervenes unsterilized by buying (selling) foreign currency bonds for the national currency it issues. The central bank then “sterilizes” the impact on the monetary base by selling (buying) an appropriate amount of local currency denominated bonds to absorb the initial increase (decrease) in the national currency. The net effect of these two transactions is the same as when exchanging bonds in domestic currency for bonds in foreign currency without changing the money supply. In sterilization, any purchase of foreign currency is accompanied by an equivalent sale of domestic bonds. For example, wishing to reduce the exchange rate, expressed as the price of the national currency, without changing the monetary base, the monetary authority buys bonds in foreign currency, the same action as in the previous section. After this action, in order to keep the monetary base unchanged, the monetary authority makes a new transaction, selling an equal number of bonds in local currency, so that the total money supply returns to its original level.
Non-sterilized Intervention is a policy that changes the monetary base. Specifically, the authorities influence the exchange rate by buying or selling foreign money or bonds for local currency. For example, in order to lower the exchange rate / price of the national currency, the authorities may buy bonds in foreign currency. During this transaction, the additional supply of the local currency will result in a decrease in the price of the local currency, and the additional demand for foreign currency will lead to an increase in the price of the foreign currency. As a result, the exchange rate falls.
Intervention Mechanisms
Increase Rate
The Central Bank begins a large-scale sale of foreign currency and the same massive purchase of national currency. Due to this, the level of demand for the currency of one’s country increases in the world market, and as you know, an increase in demand gives rise to an increase in the exchange rate.
Decrease Rate
The Central Bank purchases foreign currency while simultaneously “throwing” the national currency onto the market. As a result, demand exceeds supply, and the rate of domestic money decreases.
Types of Interventions
By the nature of the actions, there are three types of foreign exchange interventions:
- Direct intervention is an open action by the central bank that notifies market participants in advance. The regulator informs in advance about when the intervention will take place, in what direction (buying or selling foreign currency), and in what volume. In this case, traders, investors, and the real sector of the economy can prepare for the upcoming increase or weakening of the exchange rate.
- Indirect Intervention is carried out not directly by the Central Bank itself, but by commercial banks on the orders of the Central Bank. For traders who make money on the difference in exchange rates, this type of intervention is the most undesirable, as it becomes more difficult to predict price fluctuations. When inexplicable jumps in the exchange rate begin, a panic can begin in the market, due to which a large number of traders are at a loss, and only large investors who have insider information from sources close to the Central Bank can benefit from this.
- Verbal Intervention is not an intervention in the literal sense of the word, but only statements by the chairman of the central bank about the need to conduct such an intervention in order to influence market sentiment. The effect of this is temporary, since if the statements of the head of the Central Bank are not further supported by actions, then the exchange rate returns to its previous values. By the way, the US Federal Reserve and the European Central Bank quite often use verbal intervention. If you trade on Forex with pairs with USD and EUR, then pay special attention to the statements of the chairmen and representatives of these financial regulators.
Final Words:
Typically, central banks proactively and publicly announce their plans for foreign exchange interventions. Keeping track of such news is extremely important for traders, as a position open against such a major player in the foreign exchange market as the main regulator can lead to disastrous financial consequences.
When trading on the Forex market, follow the statements and actions of the leaders of major world central banks. When an intervention is made, compare its direction with the direction of the current trend for the currency pair, which this intervention should affect. For example, if an uptrend is developing for the GBP / USD pair, and the Bank of England has made a large purchase of the dollar for the pounds, then the central bank wants to weaken the pound. In this case, there is a high probability of a trend reversal – at least to the nearest support level. And if the bank bought pounds for US dollars, it would support the uptrend, and you can make transactions in this direction.
We hope this article made ‘’Currency intervention’’ clear for you. Wishing a good and profitable week to our readers!
