Introduction
This paper focuses on the methods and tactics of foreign exchange market intervention with an
emphasis on how the tactics of intervention can depend on intervention objectives and the
environment. The paper highlights the main features of the survey responses provided by emerging
market central banks on questions of the methods and tactics of intervention. Links are drawn to other
information about methods and tactics of foreign exchange market intervention.
King (2003), amongst others, makes the point that different objectives should involve different
intervention methods and tactics. Yet there is a considerable degree of consistency in the actual
choice of mechanics across the emerging market group covered by the BIS survey undertaken for this
meeting. This consistency appears not only within the emerging market group, but extends also to
developed countries.
1
Specifically, spot transactions predominate; they are conducted with those
counterparties that operate in the deepest part of the market; and at times when the market is most
liquid. And where other intervention techniques are used, such as auctions of option contracts, by
design the central bank is also operating where the market is thickest.
Given the need to select methods and tactics to maximise the effectiveness of intervention, at one
level it is perhaps surprising that most central banks choose to transact at a time and place where their
relative size is minimised. At another level, however, the choice to operate in the thickest part of the
market reflects the importance that central banks attach to avoiding volatility and to maintaining
credibility.
The main area where different approaches and different attitudes are evident relates to the visibility of
intervention operations. This issue is given special attention.
As background, at the outset the channels through which intervention is thought to influence the
exchange rate are discussed. Subsequently, choice of markets in which intervention takes place, the
preferred degree of visibility of intervention, and the choice of instrument and transaction method are
addressed in turn. Finally, some thoughts are offered on intervention size, frequency and timing. It is
perhaps around these issues that the general preference for plain vanilla operations becomes most
apparent.
Methods and tactics: some background considerations
Foreign exchange market intervention involves trying to change the value that market participants put
on a particular currency. How to do this is not immediately clear, particularly as the foreign exchange
market is far from homogeneous.
High-frequency, high-pressure foreign exchange trading by market-making professionals is the part of
the market most actively reported. In this market, prices seem able to be disturbed by even quite
inconsequential pieces of news with little evidence of fundamental determinants working to establish
an equilibrium value.
For cross-border investors with medium- to long-term investment horizons, on the other hand, the
immediate and near-term pressure of order flows on market-makers’ open positions is almost
irrelevant. What matters is the likely accumulation of such foreign exchange flows over the investment
horizon. With this focus, economic fundamentals are likely to be more relevant.
2
Even so, the
short-term relationship between economic fundamentals and exchange rates is notoriously imprecise;
simply extrapolating recent trends might be better (or less bad) than attempting to predict such
developments from analysis of fundamentals. Some investors with medium-term horizons might thus
turn to auto-regressive and “technical” prediction methods, which are certainly cheaper than
fundamentals analysis in terms of time and effort. Order flow information might also be useful for
cost-effective insights into the interaction between fundamentals and exchange rate behaviour.
However, order flow information is most readily available to market participants least able or willing to
use it - the institutions engaged in clearing customer orders. Such institutions typically operate with
tight limits on net open foreign exchange exposures. In general, firms specialising as market-makers
seek to make their income from “clipping the ticket” (crossing the bid-ask spread and generating fee
income) and do not commit enough risk capital to provide for large speculative positions to be taken.
The vast numerical majority of participants in the market, however, are firms engaged in commerce
across currency boundaries, or financing their business in international capital markets, or investing in
assets denominated in different currencies. They relate to the market as price-takers. Over time, their
willingness to use those currencies will depend on the profitability of their cross-currency business,
and change with variations in that profitability. It is through this mechanism that economic
fundamentals of competitiveness and macrobalance will eventually shape exchange rate trends. It is
these forces that fundamental investors are trying to anticipate.
Finally, at least some of these agents just discussed will be attempting to second-guess the interests
and behaviour of the others, adding to the complexity of the exchange rate determination process.
Against that complex background, central banks must choose operational methods that effectively
influence this heterogeneous group’s collective valuation of the currency. Economic theorists have
attempted to identify the channels through which central bank actions might influence such valuations.
emphasis on how the tactics of intervention can depend on intervention objectives and the
environment. The paper highlights the main features of the survey responses provided by emerging
market central banks on questions of the methods and tactics of intervention. Links are drawn to other
King (2003), amongst others, makes the point that different objectives should involve different
intervention methods and tactics. Yet there is a considerable degree of consistency in the actual
choice of mechanics across the emerging market group covered by the BIS survey undertaken for this
meeting. This consistency appears not only within the emerging market group, but extends also to
developed countries.
1
Specifically, spot transactions predominate; they are conducted with those
counterparties that operate in the deepest part of the market; and at times when the market is most
liquid. And where other intervention techniques are used, such as auctions of option contracts, by
design the central bank is also operating where the market is thickest.
Given the need to select methods and tactics to maximise the effectiveness of intervention, at one
level it is perhaps surprising that most central banks choose to transact at a time and place where their
relative size is minimised. At another level, however, the choice to operate in the thickest part of the
market reflects the importance that central banks attach to avoiding volatility and to maintaining
credibility.
The main area where different approaches and different attitudes are evident relates to the visibility of
intervention operations. This issue is given special attention.
As background, at the outset the channels through which intervention is thought to influence the
exchange rate are discussed. Subsequently, choice of markets in which intervention takes place, the
preferred degree of visibility of intervention, and the choice of instrument and transaction method are
addressed in turn. Finally, some thoughts are offered on intervention size, frequency and timing. It is
perhaps around these issues that the general preference for plain vanilla operations becomes most
apparent.
Methods and tactics: some background considerations
Foreign exchange market intervention involves trying to change the value that market participants put
on a particular currency. How to do this is not immediately clear, particularly as the foreign exchange
market is far from homogeneous.
High-frequency, high-pressure foreign exchange trading by market-making professionals is the part of
the market most actively reported. In this market, prices seem able to be disturbed by even quite
inconsequential pieces of news with little evidence of fundamental determinants working to establish
an equilibrium value.
For cross-border investors with medium- to long-term investment horizons, on the other hand, the
immediate and near-term pressure of order flows on market-makers’ open positions is almost
irrelevant. What matters is the likely accumulation of such foreign exchange flows over the investment
horizon. With this focus, economic fundamentals are likely to be more relevant.
2
Even so, the
short-term relationship between economic fundamentals and exchange rates is notoriously imprecise;
simply extrapolating recent trends might be better (or less bad) than attempting to predict such
developments from analysis of fundamentals. Some investors with medium-term horizons might thus
turn to auto-regressive and “technical” prediction methods, which are certainly cheaper than
fundamentals analysis in terms of time and effort. Order flow information might also be useful for
cost-effective insights into the interaction between fundamentals and exchange rate behaviour.
However, order flow information is most readily available to market participants least able or willing to
use it - the institutions engaged in clearing customer orders. Such institutions typically operate with
tight limits on net open foreign exchange exposures. In general, firms specialising as market-makers
seek to make their income from “clipping the ticket” (crossing the bid-ask spread and generating fee
income) and do not commit enough risk capital to provide for large speculative positions to be taken.
The vast numerical majority of participants in the market, however, are firms engaged in commerce
across currency boundaries, or financing their business in international capital markets, or investing in
assets denominated in different currencies. They relate to the market as price-takers. Over time, their
willingness to use those currencies will depend on the profitability of their cross-currency business,
and change with variations in that profitability. It is through this mechanism that economic
fundamentals of competitiveness and macrobalance will eventually shape exchange rate trends. It is
these forces that fundamental investors are trying to anticipate.
Finally, at least some of these agents just discussed will be attempting to second-guess the interests
and behaviour of the others, adding to the complexity of the exchange rate determination process.
Against that complex background, central banks must choose operational methods that effectively
influence this heterogeneous group’s collective valuation of the currency. Economic theorists have
attempted to identify the channels through which central bank actions might influence such valuations.
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