Foreign Exchange Intervention Definition, Strategies, Goals

What Is Foreign Exchange Intervention?

A foreign exchange intervention is a monetary policy tool which a central bank uses to take an active, participatory role in influencing the monetary funds transfer rate of the national currency, usually with its own reserves or its own authority to generate the currency.

Central banks, especially those in developing countries, intervene in the foreign exchange market in order to build reserves for themselves or provide them to the country's banks. Their aim is often to stabilize the exchange rate.

Understanding Foreign Exchange Intervention

The success of a foreign exchange intervention depends on how the central bank sterilizes the impact of its interventions, as well as on general macroeconomic policies set by the government.

Two difficulties that central banks face are in determining, one, the timing and, two, the amount of intervention. This is often a judgment call rather than a cold, hard fact.

The amount of reserves, the type of economic trouble facing the country, and ever-changing market conditions require that a fair amount of research and understanding be achieved before determining how to take a productive course of action.

In some cases, a corrective intervention may have to be taken shortly after the first attempt.

Purpose of Interventions

Foreign exchange interventions can be made for two main reasons: to increase exports and to rein in volatility.

A Currency Is Out of Sync With the Economy

Firstly, a central bank or government may assess that its currency has slowly become out of sync with the country's economy and is affecting it adversely.

For example, countries that are heavily reliant on exports may find that their currency is too strong for other countries to afford the goods they produce. They may intervene to keep the currency in line with the currencies of the countries which import their goods.

Example

The Swiss National Bank (SNB) took this kind of action from September 2011 to January 2015. The SNB set a minimum exchange rate between the Swiss franc and the euro. This kept the Swiss franc from strengthening beyond an acceptable level for European importers of Swiss goods.

This approach was successful for three and half years, after which the SNB determined that it had to let the Swiss franc float freely. Suddenly, and without prior warning, the Switzerland central bank released the minimum exchange rate. This had highly negative consequences for some businesses, but, generally, the Swiss economy was unfazed by the intervention.

Liquidity and Stabilization Are Needed

Intervention can also be a short-term reaction to a certain event. Such an event may cause a country's currency to move dramatically in one direction in a very short space of time. Central banks will intervene with the sole purpose of providing liquidity and reducing volatility.

After the SNB lifted the floor for its currency against the Euro, the Swiss franc jumped by an estimated 30%. SNB intervention in the short term stopped the Franc from falling and curbed the volatility.

Risks of Foreign Exchange Intervention

Foreign exchange interventions can be risky because they can undermine a central bank's credibility if it fails to maintain the stability of its country's currency.

Defending the national currency from speculation was a precipitating cause of the 1994 currency crisis in Mexico, and was a leading factor in the Asian financial crisis of 1997.

The Bottom Line

A foreign exchange intervention is an action taken by a central bank usually to control exchange rate volatility. This stability is achieved by buying or selling a currency in the foreign exchange market.

Countries may intervene as well to weaken their currencies relative to those of other countries in an effort to make the prices for their exports more attractive to international buyers.