Central Banks Interventions in the New Millennia

The universe of foreign exchange has expanded dramatically since entering the new millennium and its future remains golden. Fresh from the pruning dictated by the introduction of the euro, the wave of banks mergers, and the emerging market crisis of 1998, currency trading benefited greatly from the equity crisis in the aftermath of overinvestment in tech stocks in the late 1990s and the Y2K brouhaha. Currencies were finally recognized as an asset class and funds and corporations were happy to incorporate them in their portfolios, particularly given the low costs of electronic trading. But the explosion in FX trading also enhanced macro risks that affected major participants' interests in specific economies. And that resuscitated the central banks, whose role had been continuously diminished since their days of glory in the 1980s. This brings us to the cases of three central banks: a G7 bank, a developed economy central bank and one from a premier emerging market.

But whether we are looking at the Bank of Japan, the Reserve Bank of New Zealand or the Brazilian Central Bank, the main questions are: why are these central banks intervening? Is it to fight back muscular and aggressive funds that unfairly bend the value of their currencies or to put the leash on the results of their own policies and decisions? And are they successful?

The Bank of Japan - the Group of Seven Representative

Central banks can no longer protect certain levels simply because they cannot compete any longer with the mighty CTAs, which can easily raise and trade billion dollars worth of yen. But that reality may not always ring true to some major central banks. In the most extreme example in currency trading, the Bank of Japan (BoJ) sold an unprecedented 32.9 trillion yen, which is equivalent to buying US$311 billion, in the fiscal year that ended March 31, 2004. The intervention was designed to stop the yen's revaluation to under 100 yen per dollar, after foreign investors bought record amounts of Japanese stocks. Figure 1 shows dollar/yen bottoming at 103.38 at the end of March 2004 and then embarking in a sustained recovery for a month and a half.

Figure 1. The Bank of Japan sold 32.9 trillion yen (US$311 billion) in the fiscal year ended March 31, 2004, to weaken its strong currency.

At the time, the demand for Japanese securities reflected the success of that economy. Ironically, the BoJ had to try to pour cold water over the success of its economy. And $311 billion could certainly buy a lot of water. In hindsight, the BoJ probably had no intention of putting that much money in that prolonged intervention. Nor did it hope to reverse the direction of the market. Central banks simply lack the ammunition, drive and motive to do that. The best they can hope for is to dampen volatility of the currency enough as to not trigger the aggressive momentum models that funds fondly use. But the BoJ managed to do just that and the dollar/yen stayed away from the 103.38 level for several months. It eventually bottomed in December 2004 at 101.67 and rallied for three years. March 2004 was also the last time the Japanese central bank overtly intervened in the currency markets. And nearly three years later, BoJ officials are actually talking the yen up!

The Reserve Bank of New Zealand - a Bank from the Developed Markets

The New Zealand dollar appreciated from 0.3898 against the U.S. dollar in October 2000 to 0.7642 by June 2007. In response to this staggering long-term uptrend, on June 11, 2007, the Reserve Bank of New Zealand (RBNZ) intervened to push down the value of the kiwi. That was the first intervention in the market since its currency was allowed to float 22 years earlier. The bank was rumored to have intervened again several days longer. Given its shock value, the NZD/USD quickly buckled from its high levels, but this didn't last long. In fact, it lasted only 2.5 days before the Kiwi resumed its powerful uptrend to reach new highs. See Figure 2. Clearly, the New Zealand dollar only managed to slow down the uptrend, but had a hard time slowing down the volatility.

Figure 2. The impact of the unprecedented Reserve Bank of New Zealand intervention to devalue of the kiwi lasted only 2.5 days.

Why? The country enjoys one of the highest interest rates among the developed economies and nearly everyone in the world wants a piece of the Kiwi, preferably while selling yen. While not perfect, New Zealand is fairly close to economic heaven. Its GDP accelerated 1 percent in the first quarter of 2007 from the fourth quarter of 2006, when the economy expanded 0.8 percent. That strength should continue despite higher interest rates that reached a record-high 8 percent. Unemployment is low and consumption is high - what's not to like? RBNZ's governor Alan Bollard argued that the intervention was necessary because the exchange rate was exceptional and unjustified in terms of economic fundamentals. But the high yield says otherwise. And so did investors, small and large.

Imagine you're a Japanese salary-man looking to enhance savings. Would you resign yourself to receiving a meager 0.5 percent rather than 8 percent in New Zealand? When you could make some money from the exchange rate as well? Now picture yourself as a leading investment entity trading currencies. Would you fold your long-term long position in NZD/JPY just because the RBNZ intervened a couple of times? Probably not.

The Brazilian Central Bank - a Bank from a Premiere Emerging Market

The Brazilian Central Bank's (BCB) has been very active in FX and has intervened heavily since the end of 2005, when government measures opened the capital and financial accounts. Foreign interests chased Brazilian high yields and the central bank was forced to balance the FX surplus in order to curb the excessive appreciation of the Brazilian real.

By May 2007, the BCB had accumulated a total of US$122.4 billion in international reserves, and by the end of the year the reserves could expand to US$180 billion. But how effective has the intervention been? Between the lowest low in May 2006 and the highest high in June 2007, the Brazilian real has already surged approximately 21 percent. See Figure 3.

Figure 3. The Brazilian real has already surged approximately 21 percent between the lowest low in May 2006 and the highest high in June 2007.

This means the intervention has been successful only in slowing down the appreciation of the local currency, rather than reverse its direction. What's in store for the real? Probably only good things. For the time being, the Brazilian banks regard the real as “theirs,” as most of then simply limit their FX activity to buying and selling USD/BRL. But the real is no longer a lonely emerging currency best left to local interests. It is now a thriving currency that is a pre-requisite to any sophisticated currency portfolio. This means two things: the real will become subject to more volatility reflecting economic developments and expectations; and Brazilian banks will have to quickly expand their horizon to pair their real against the euro and the yen, and reduce their exposure to the real in favor of non-real pairs. And slowly but surely the BCB will lose its control on the real.

Conclusion

Central banks generally abhor interventions. It is more common for central banks from emerging markets to intervene. The effectiveness of their success is random in the short to medium term, but improves in the long term. Single-handed interventions rarely fare well, even though the example of the Bank of Japan was successful. Central banks must be on the right side of the fundamentals to succeed. The RBNZ is not.

Cornelius Luca
Global Forex Trading
http://www.gftforex.com