Foreign Exchange Intervention

What is a 'Foreign Exchange Intervention'

A foreign exchange intervention is a monetary policy tool in which a central bank takes an active participatory role in influencing the monetary funds transfer rate of the national currency. Central banks, especially those in developing countries, intervene in the foreign exchange market in order to build reserves, stabilize the exchange rate and to correct misalignments.

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.

BREAKING DOWN 'Foreign Exchange Intervention'

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 make taking the best course of action difficult.

Why Intervene?

Foreign exchange intervention comes in two parts. Firstly, a central bank or government may assess that its currency has slowly become out of kilter with its economy and is having adverse affects on it. For example, countries that are heavily reliant on exports and are dealing with a currency that is appreciating may intervene. By weakening its currency it is making the products it exports more competitive on the global market. During the oil crisis in 2015, many Middle Eastern countries that peg their currency to the U.S. dollar devalued it because as the price of oil plunged it was receiving fewer receipts. Remember oil prices are denominated in U.S. dollars. 

Secondly, intervention can be a short-term reactionary to a certain event. Often, times 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 Swiss National Bank (SNB) lifted the floor in its currency against the euro the Swiss franc plummeted by as much as 25 percent, which saw the SNB intervene to stop it falling further and to curb the volatility. 

Risks

Foreign exchange interventions can be risky in that 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.