What is currency intervention

What is currency intervention

The rate of any currency traded on the Forex market is a variable value. It is influenced by various market and non-market factors. Today we will supplement this information and talk about what currency intervention is.

Currency intervention is one of the instruments of the national bank

The term intervention is most often used when we are talking about the intervention of one or a group of states in the affairs of another state. This practice is not welcomed by the international community and is prohibited. But this prohibition does not apply to foreign exchange intervention. On the contrary, almost all national banks widely use its capabilities in their monetary policy. What kind of instrument is this?

Foreign exchange intervention is a financial transaction carried out by a national bank or government agency charged with financial regulation. The purpose of such intervention is to influence exchange rate movements of the national currency.

For those who are not very well versed in the intricacies of economic formulations, let us explain what currency intervention is in simple words.

In fact, this is an ordinary financial transaction, as a result of which currency, which is an official means of payment in the country, is bought or sold. In Russia, such a currency is the ruble, in the United States – the dollar, in Japan – the yen, and so on.

The state entrusts the function of conducting such financial transactions to its central bank, and in some cases to the Ministry of Finance. These institutions are authorized to carry out currency regulation and influence the exchange rate of the state’s domestic currency.

To increase this exchange rate, a certain amount of national currency is purchased on the market for the currency of a foreign country. Since the volume of these purchases is significant, a shortage of currency withdrawn from the market arises, and its exchange rate rises. Selling your country’s currency, on the contrary, leads to the market becoming saturated with this currency, which means its exchange rate decreases.

For what problems does currency intervention have the maximum effect?

Currency intervention can influence exchange rate movements of the national currency. This fact is undeniable. But in this regard, a reasonable question arises: what problems can be solved using this tool?

The purpose of currency regulation carried out using foreign exchange intervention is the following:

  • Maintaining the exchange rate within a certain price corridor. This approach to currency regulation is typical for countries with a fixed exchange rate.
  • Elimination of negative trends that the exchange rate may have on the development of the state’s economy.
  • Preventing significant deviations of the currency exchange rate from its equilibrium value. That is, the desire to ensure that the demand for currency and its supply are balanced.
  • Replenishment of the country’s gold and foreign exchange reserves, which is achieved as a result of the sale of national currency and the purchase of foreign currency.
  • Maintaining a level of liquidity of the national currency at which the volatility of its exchange rate will be minimal.

Who conducts currency interventions?

Typically, foreign exchange interventions are carried out by large banks, which are instructed by a national bank or body with appropriate powers to carry out a financial transaction. Such banks are authorized financial institutions to conduct foreign exchange interventions. They can carry out interventions:

  • On the interbank foreign exchange market.
  • On the Forex stock market.
  • On the commodity market.
  • On the currency exchange.

If the foreign exchange market cannot provide sufficient liquidity, then in this case foreign exchange interventions are carried out in the form of foreign exchange auctions.

The financial regulator independently selects a platform for conducting currency interventions. The Bank of Russia, for example, for such operations usually uses the trading platform of the Moscow Exchange, which, after merging with the MICEX, became the largest Russian exchange holding company. At the same time, it is necessary to pay attention to the fact that recently the currency intervention of the Central Bank of the Russian Federation has been carried out in a targeted manner; large-scale interventions have not been observed. This happened after the ruble exchange rate became floating.

Types of foreign exchange intervention

Depending on the methods of practical application, currency interventions are usually divided into types. The main types of intervention are the following:

  • Verbal. This type of intervention is inherently fictitious, since no actual purchase/sale of currency occurs. The country’s authorities declare their intention to make a one-time cash payment to purchase a large amount of currency, but at the same time they are holding a pause and are not entering the market. Typically, the foreign exchange market is sensitive to such information. This is what the bet is on. It is assumed that the majority of market participants will believe in the possibility of carrying out such a financial transaction and will follow the signal received, supporting the necessary trend in the development of the exchange rate of this currency.
  • Real intervention. Currency intervention of this type does not imply any provocative actions or statements on the part of the country’s central bank or high-ranking government officials. The purchase/sale operation of the national currency is carried out in reality, as evidenced by the report, which indicates the specific amount of the intervention made.
    Real mutual intervention. This is a joint, synchronously implemented agreement between the central banks of several countries, which undertake to simultaneously carry out foreign exchange intervention in their national market.

As practice shows, the effect of mutual intervention can be achieved more significantly than in the case of unilateral currency intervention. An example of such effectiveness was demonstrated by the agreement signed in 1985 in New York. The implementation of this agreement led to a drop in the value of the dollar by almost 50%.

  • Typically, the benefit from mutual intervention is received by the country participating in the monetary union. The relationship between the countries included in such a union makes it possible to build a unified approach to ensuring stabilization of the exchange rate relative to third countries.
  • Sterile and non-sterile intervention. Any central bank has obligations to creditors and issues cash. The totality of these financial resources constitutes the monetary base.

If a bank decides to buy national currency and spend foreign currency on it, then its gold and foreign exchange reserves decrease, as does the monetary base. The sale of national currency, on the contrary, leads to an increase in the gold and foreign exchange reserves and an increase in the monetary base. Therefore, it is generally accepted that foreign exchange intervention affecting the monetary base is unsterilized.

If a bank, while carrying out foreign exchange intervention, simultaneously carries out a financial operation on the domestic market, the result of which is the unchanged monetary base, then this will be considered a sterilized intervention.

Attitude of specialists to foreign exchange intervention

specialists working in the foreign exchange market believe that if the exchange rate is floating, then foreign exchange interventions lose their effectiveness. This point of view has the following justification:

  • In modern market conditions, it is not possible to determine the equilibrium exchange rate, despite the presence of a large number of methods for determining it.
  • Foreign exchange market volatility may be short-lived. Therefore, its presence should not always lead to the intervention of the national regulator in the operation of the foreign exchange market.
  • In practice, currency intervention does not always lead to the desired result. In some cases, its use may cause increased volatility, which is undesirable for any central bank.
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Currency basket

After the abolition of the gold standard, many countries began to look for ways to minimize currency risks. But, as practice has shown, the currency basket turned out to be the most reliable tool for ensuring the security of the national currency and controlling the dynamics of its exchange rate. We have not yet talked about this economic instrument. Therefore, today we will try to fill this gap and get acquainted with the currency basket, its contents and scope.

CURRENCY BASKET IS AN EFFECTIVE TOOL FOR ASSESSING THE VALUE OF CURRENCY

Before talking about the currency basket, you need to define what is meant by this term. In economic theory, it is generally accepted that a currency basket is an arbitrarily formed set of several names of foreign currencies, the weighted average value of which is used to determine the value of a government obligation (debt) or the value of the national monetary unit.

The volume of currency included in the basket is determined by its specific gravity, which may depend on the following indicators:

  • The value of the country’s gross domestic product and its share in the total gross product of the countries whose currencies form a specific currency basket.
  • The parts dealing with foreign exchange in all international settlements and foreign trade transactions.

What is a currency basket in simple words?

Let’s assume that a country that has issued its own currency wants to objectively assess its value. Moreover, most contracts and international obligations are invested in euros, American dollars and British pounds. Therefore, the state can set the price of a currency as the cost of a basket, which includes (in a certain proportion) euros, dollars and pounds. This will make it possible to obtain an objective estimated value of the national currency in all international payments.

Practical use of the currency basket

In modern conditions, the currency basket can be used:

  • Issuing countries in their monetary policy.
  • Large financial structures and organizations working in the field of international lending.
  • Enterprises and individuals to protect existing funds from negative exchange rate fluctuations.

Depending on the filling, the basket can be:

  • Multicurrency, which is filled with an unlimited number of different currencies.
  • Dual currency, formed from two types of currencies.
  • The multi-currency basket option is more common because it allows parties to take into account both their own risks and the risks of their trading partners. In addition, when forming a multi-currency basket, additional opportunities for earnings or hedging open up that currency traders and investors can take advantage of.

As for the concept of “dual-currency basket,” the most striking example is the currency basket of the Bank of Russia, which was used until 2014. It consisted of two currencies: the euro and the US dollar. A special feature of the functionality of this basket was that it made it possible to systematically monitor the dynamics of the ruble exchange rate. It was not a separate exchange rate to the dollar or euro that was taken into account, but a generalized indicator with the share of each foreign currency was calculated. The presence of such an indicator allowed the country’s monetary authorities to reasonably adjust the exchange rate of the national currency. Since 2014, the ruble exchange rate has become floating, and the Bank of the Russian Federation basket has lost its original value

Basket of currencies in the practice of international monetary relations

At the interstate level, the currency basket is also widely used. An example of its practical use is the Special Drawing Rights (SDR), developed by the IMF in 1969. This artificially created payment instrument is used only within the framework of the International Monetary Fund. It allows:

  • Regulate the balance of payments of IMF member countries.
  • Replenish reserves and pay off loans provided by the Monetary Fund.

The SDR basket consists of the currencies of five countries:

  • USA (dollar).
  • European Alliance (euro).
  • Japan (yen).
  • UK (pound).
  • China (yuan).

However, the cost of the entire basket is expressed in US dollars. The other components included in the basket are given continually adjusted weighting.

Another example of the use of a currency basket is the special European Currency Unit (ECU). It has all the characteristics of a basket of currencies and has been used in the European Union for:

Implementation of non-cash transactions between countries.

Regulation of parities of state currencies with the aim of creating a single European currency.

Once the euro has been issued, this currency can no longer be identified with the ECU, since the basket of currencies is created in the form of a portfolio of several different from the base one.

Currency basket and currency index

Traders working in financial markets often confuse the concept of a currency basket and a currency index. This is due to the fact that working with a basket of currencies is similar in content to portfolio investments (a trading operation with several assets to reduce the risk component associated with exchange rate fluctuations).

A basket can consist of a set of different currency pairs. It is not necessary to have a specific base currency.

If we are talking about indices, then they must demonstrate the general trend for a specific currency.

An example would be the dollar index. It shows the ratio of the value of the US currency to the value of a basket of major currencies. The code of such an index is purchased, which actually opens a long position in currency pairs where the dollar is the base currency and a short position in those pairs where the dollar is the quote currency. In this case, it is obvious that it is incorrect to talk about trading a basket.

Selling the dollar index would mean buying the basket of currencies included in the index. But this is only a special case, on the basis of which it is unacceptable to talk about the identity of the concepts “currency basket” and “currency index”.

Currency basket in the Forex market

When used skillfully, the currency basket provides great opportunities for traders trading on the Forex currency market. Having such a basket allows you to:

  • Diversify risks when making trade transactions. Working with one currency does not allow you to do this. When creating a basket of currencies and working with it, this opportunity appears.
  • Determine the weight of a particular asset and their impact on the dynamics of currencies forming a pair with it.
  • Group currency pairs whose behavioral characteristics are important. Such signs include the relationship between the price of petroleum products and the exchange rate, the correlation between currency pairs, etc.
  • Create an effective trading strategy that allows you to conduct transactions not with one asset, but with several. This achieves not only the profitability of currency trading, but also reduces the risk component.

From all that has been said, we can conclude that in conditions of instability of exchange rates of individual currencies, the presence of a currency basket is a necessity. At the state level, with its help it is possible to achieve a significant reduction in currency risks and validity in international payments. Regular traders can also take advantage of the benefits provided by currency baskets. By forming such a basket, they can significantly improve the quality of their trading in the financial markets.