Foreign Exchange Intervention

What Is Foreign Exchange Intervention?

A foreign exchange intervention is a monetary policy tool that involves a central bank taking 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

When a central bank increases the money supply through its various means of doing so, it must be careful to minimize unintended effects such as runaway inflation. The success of foreign exchange intervention depends on how the central bank sterilizes the impact of its interventions, as well as general macroeconomic policies set by the government.

Two difficulties that central banks face are determining the timing and amount of intervention, as 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 the ever-changing market conditions require that a fair amount of research and understanding be in place 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.

Why Intervene?

Foreign exchange intervention comes in two flavors. Firstly, a central bank or government may assess that its currency has slowly become out of sync with the country's economy and is having adverse effects on it. 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.

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 other 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, without prior warning, the Switzerland central bank released the minimum exchange rate. This had highly negative consequences to some businesses, but, generally, the Swiss economy has been unfazed by the intervention.

Intervention can also be a short-term reaction to a certain event. A one-off event may cause a countries currency to move 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 in its currency against the Euro, the Swiss franc plummeted by as much as 25 percent. The SNB intervened in the short term to stop the Franc from falling further and curb 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 stability. 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.