As a result, investors are unwilling to make investment in foreign financial assets. Firms are reluctant to engage in international trade. Moreover, the exchange rate fluctuation would spill over into the financial markets. In addition, when economic conditions change or when the market misinterprets economic signals, authorities use foreign exchange intervention to correct exchange rates, in order to avoid overshooting of either direction. Today, forex market intervention is largely used by the central banks of developing countries, and less so by developed countries.
Without a durable and independent impact on the nominal exchange rate, intervention is seen as having no lasting power to influence the real exchange rate and thus competitive conditions for the tradable sector. Large-scale intervention can undermine the stance of monetary policy. Developing countries, on the other hand, do sometimes intervene, presumably because they believe the instrument to be an effective tool in the circumstances and for the situations they face. 2015, the authors describe the common reasons central banks intervene. Based on a BIS survey, in foreign exchange markets “emerging market central banks” use the strategy of “leaning against the wind” “to limit exchange rate volatility and smooth the trend path of the exchange rate”.
In their 2005 meeting on foreign exchange market intervention, central bank governors had noted that, “Many central banks would argue that their main aim is to limit exchange rate volatility rather than to meet a specific target for the level of the exchange rate”. In the Cold War-era United States, under the Bretton Woods system of fixed exchange rates, intervention was used to help maintain the exchange rate within prescribed margins and was considered to be essential to a central bank’s toolkit. Quite unlike their experiences in the early 2000s, several countries that had at different times resisted appreciation pressures suddenly found themselves having to intervene against strong depreciation pressures. The sharp rise in the US long-term interest rate from May to August 2013 led to heavy pressures in currency markets.
Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing the exchange rate. Depending on whether it changes the monetary base or not, currency intervention could be distinguished between sterilized intervention and non-sterilized intervention, respectively. Sterilized intervention is a policy that attempts to influence the exchange rate without changing the monetary base. The procedure is a combination of two transactions. Non-sterilized intervention is a policy that alters the monetary base. Specifically, authorities affect the exchange rate through purchasing or selling foreign money or bonds with domestic currency.