WSJ BLOG/Real Time Economics: Currency Intervention: A Primer

17/08/2011 19:24

(This story has been posted on The Wall Street Journal Online's Real Time Economics blog at


By Vincent Cignarella

As central banks around the world try their hand at currency intervention, here's a quick primer on what types of interventions there are, and how successful they can be.

The hard truth: Whether unilateral or coordinated, with or without monetary or fiscal-policy measures, they almost never work well. At best, currency intervention arrests a currency's movement but doesn't reverse it (the 1985 Plaza Agreement was seen as successful, but it really just enhanced a trend that was already starting).

Here are a few examples of actual interventions, listed broadly in order, from weakest-to-strongest.

Direct Buying or Selling:

The simplest way a country can intervene is to directly buy or sell one's currency in the spot market without the help of other countries. The most-recent example was the Bank of Japan on August 4, unilaterally selling yen against the dollar to defend its own currency. The bank reportedly purchased $50 billion against the yen, driving the dollar-yen exchange rate above Y80 from Y76.97 -- it closed that day at Y78.80.

It didn't work. The dollar-yen rate is back at 76.50 today, just 25 pips off its all-time low. The market's overlying demand for the safe-haven yen outweighed the BOJ's actions.

Coordinated Buying or Selling:

Coordinated buying or selling of a currency is similar, in theory, to unilateral buying or selling. The key difference is that there's more firepower because there are several central banks working together.

The most-often cited example is the Plaza Accord, where the then-G-5 sold U.S. dollars in a bid to weaken the currency to reduce the U.S. current-account deficit and, more importantly, lift the U.S. economy out of recession. It worked brilliantly, but there's a catch-the dollar was already trending lower, so it really only enhanced a movement instead of starting a new one.

More recently, the Bank of Japan acted with the G-7 in March to weaken the yen. Immediately before the intervention, the currency was at 76.25 against the dollar, and it closed the day at 78.89. It was a temporary success, with the dollar-yen rate soaring as high as 85.48 in early April. Alas, the move only held water for 20 days, with the yen eventually falling to where it is now.

Monetary Policy:

A more-complicated, yet somewhat more-effective way of intervening is to go through the trouble of altering monetary policy. A monetary authority can raise short-term interest rates dramatically to make selling its currency so prohibitively expensive to finance that speculators will back away from it.

The most-infamous version of this was a 1979 Franco-German led initiative, in which the European Monetary System (EMS) was established among European countries in order to stabilize exchange rates and allow Europe to be more globally competitive. Germany started hiking rates in 1989 after German reunification, forcing other nations to hike in order to keep pace.

The problem was, market participants knew that the U.K.'s economy was too weak to keep hiking rates, so speculators started aggressively selling British pounds for Deutschemarks. This is when George Soros made his famous $10 billion bet against the pound.

The Bank of England tried buying sterling in foreign-exchange markets to support the pound, and on what later became known as Black Wednesday, the bank raised its rates from 10-12% to try defending the currency. But speculators smelled blood and kept piling on, and that evening the Chancellor said Britain would leave the exchange-rate mechanism and the pound collapsed.

Fiscal Policy:

A tax to weaken a country's own currency can actually work relatively well. Brazil is going down this path now, most-recently raising the IOF tax on local derivatives denominated in dollars in order to stop currency gains. Brazil's government increased the tax on dollar-short, Brazil real-long positions larger than $10 million.

The combination of this move, along with buying dollars daily on the spot market, has slowed down the real's wild appreciation. The currency hasn't tried testing the government's latest move, but traders should stay on-guard-the odds of this form of intervention lasting long-term aren't high.

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August 17, 2011 14:24 ET (18:24 GMT)

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