VoxEU Column International Finance

Foreign-exchange intervention and the fundamental trilemma of international finance: Notes for currency wars

The so-called trilemma of international finance maintains that a country cannot simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows. At best, only two of the three are feasible. This column argues that despite their best efforts, countries are set to learn this lesson again and again.

In the mid-1990s, many of the large developed countries ended their activist approach to foreign-exchange-market intervention. Yet while these operations faded, they never disappeared. The Great Recession recently piqued interest in them, as exchange-rate volatility increased and threats of currency wars were heard (see Neely 2011). Still, then, the key question remains: Do sterilised interventions allow countries a way around the fundamental trilemma of international finance by providing them with a means of systematically affecting exchange rates independent of their monetary policies? Japan, Switzerland, and China provide some lessons on that score. In recent research (Bordo et al. 2012a), we demonstrate that despite differences across these three countries in their degree of exchange-rate flexibility and their extent of sterilisation the fundamental trilemma holds.

The fundamental trilemma of international finance maintains that a country cannot simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows (Feenstra and Taylor 2008). At best, only two of the three are feasible.

American economists find Japan’s experience with sterilised foreign-exchange intervention particularly interesting because of institutional similarities between the two countries. The central banks in both cases conduct their monetary policies independent of the fiscal authorities, but the fiscal authorities in Japan and the US call the shots with respect to intervention. Moreover, Japan’s experience with sterilised foreign-exchange intervention has been broadly similar to the US experience. Between 1991 and 2004, when the Japanese Ministry of Finance intervened most actively, Japanese purchases and sales of US dollars demonstrated little correspondence with same-day yen depreciations or appreciations, but they were often associated with more moderate movements of the yen-dollar exchange rate (see Chaboud and Humpage 2005, Bordo, et al. 2012b). In general, like earlier US operations, Japanese interventions were more of a hit-or-miss proposition than a sure bet. Since March, the Ministry of Finance has intervened on only four occasions, but many observers anticipate further operations.

As documented in Bordo, et al. (2010), the US stopped its activist intervention policy in part because of serious doubts about its effectiveness, but mostly because the Federal Open Market Committee (FOMC) complained that the operations interfered with US monetary policy. Even though the Federal Reserve routinely sterilised all US interventions, the transactions were often at odds with the thrust of monetary policy, and the FOMC feared that intervention created uncertainty about the System’s commitment to price stability at a critical time. Sterilised intervention not only did not solve the trilemma in the US, but threatened to damage monetary policy credibility.

In contrast, most Japanese interventions since 1991 have consisted of dollar purchases during a period of slow economic growth, frequent bouts of deflation, and policy rates near the zero bound (see McCallum 2003). They, therefore, seem broadly consistent with the desired thrust of Japanese monetary policy and undoubtedly have not damaged the Bank of Japan’s credibility. Still, the potential for sterilised intervention to create uncertainty about monetary policy remains a key reason why central banks in major developed countries avoid its use. The Bank of Japan may someday encounter the same problem.

Switzerland offers a second modern example of the fundamental trilemma of international finance. Prior to the recent international financial crisis, the Swiss National Bank had not intervened in the foreign exchange market since August 1995, but as world economic conditions deteriorated and as a sharply appreciating Swiss franc dulled the trade-goods sector’s competitive edge, the bank undertook foreign-exchange operations to affect the value of the Swiss franc. Although the Swiss National Bank has a strong history of monetary and price targeting, the Bank has deviated from those targets when financial inflows produced severe franc appreciations (Rich 2000).

Switzerland has recently undertaken both sterilised and non-sterilised interventions. The former had no obvious lasting effects on the Swiss franc-euro exchange rate. The latter seemed successful, but posed a threat to price stability.

Figure 1. Change in the Swiss Monetary Base

Note: Six-month change; exchange rate is at end of period

Source: Swiss National Bank/Federal Reserve Board

In March 2008, the Swiss National Bank eased monetary policy in response to expectations of deflation, deteriorating economic conditions, financial-market distress, and a Swiss franc appreciation that resulted from the global financial crisis. In conjunction with this action, the Bank aggressively bought euros in the foreign-exchange market in 2009. Throughout March and April 2009, the Swiss National Bank did not seem to sterilise its substantial foreign-exchange purchases; the Swiss monetary base rose by more than the value of foreign assets on the Bank’s books. In response, the Swiss franc depreciated. By April 2009, however, the Swiss monetary base had more than doubled from a year earlier, and the Bank – now concerned about latent inflation – began to sterilise the liquidity resulting from its huge interventions. The Swiss interventions continued through June 2010, but the Swiss monetary base either grew by less than the Swiss National Bank’s holdings of foreign assets, or the monetary base actually declined. The Bank was clearly sterilising the operations, and the franc appreciated by nearly 10% between April 2009 and June 2010. On balance, from May 2010 to August 2011, the Swiss monetary base contracted and the franc appreciated, reaching an historic high on a real trade-weighted basis.

In early August 2011, the Swiss National Bank announced a series of new measures to inject liquidity into financial markets with the objective of stemming the Swiss franc’s appreciation. The operations included foreign-exchange swaps in which the Bank sold francs spot and repurchased them forward. The franc depreciated sharply, but undertook a stunning reversal late in the month. The Swiss National Bank then announced that it was prepared to buy foreign exchange in unlimited quantities to maintain a floor of SF 1.20 vis-à-vis the euro. The Bank’s holdings of foreign exchange increased substantially, but the Swiss monetary base increased by even more. Since September, the Swiss National Bank has maintained an exchange-rate floor, by giving up control of its monetary base in conformity to the fundamental trilemma.

No country’s exchange-rate practices have incited as much controversy as China’s have generated. US policymakers in particular have accused China of artificially undervaluing the renminbi relative to the dollar in order to achieve a trade advantage. Whatever trade advantage China might obtain from undervaluing the renminbi, however, should be transitory. China’s control over its nominal exchange rate does not extend to its real exchange rate, and the latter – not the former – matters for trade. Price level pressures emanating primarily from China’s exchange-rate practices must eventually induce a real renminbi appreciation. This process, which almost seems a corollary of the fundamental trilemma, appears to be occurring.

Figure 2. Sterilisation of Reserve Flows in China

Source: International Monetary Fund/International Financial Statistics

Over the past 17 years, China’s exchange-rate regime has shifted back and forth between a peg against the dollar and a tightly controlled renminbi appreciation. Since 1995, the renminbi has appreciated approximately 28% against the dollar on a nominal basis. Still, as that country’s huge build up of foreign-exchange reserves attests, China has consistently undervalued the renminbi vis-à-vis the dollar. Between mid-1995 and December 2011, China’s official foreign-exchange reserves rose from $250 billion to $3.2 trillion (equivalent). Most of this official reserve accumulation took place after 2001, with important monetary consequences.

Prior to 2003, the Chinese monetary base increased modestly relative to the country’s rapid growth rate. The disparity was such that China often experienced deflation, and the renminbi depreciated against the dollar on a real basis. In 2003, however, the situation changed. Reserve accumulation picked up, as did China’s monetary base and its inflation rate. Since then China’s accumulation of foreign-exchange reserves has been especially heavy. To limit the inflation consequences of its exchange-rate policies, the People’s Bank started selling sterilisation bonds to local commercial banks. From 2004 through 2009, the People’s Bank offset 41% of its reserve accumulation, but the monetary base continued to grow sharply. In addition, the People’s Bank increased reserve requirements on banks 19 times from 6% to 17.5% over these years.

Despite these sterilisation operations, China’s monetary base generally grew substantially faster after 2002 than it did before that date. In 2010 and 2011, the monetary base outpaced reserve growth by a substantial margin. Although the People’s Bank of China increased reserve requirements, China experienced a sharp run up in its inflation rate and a continued real renminbi appreciation.

China may undervalue its nominal exchange rate, but it cannot control its real exchange rate. In late 2011, on the heels of a 25 percent cumulative real renminbi appreciation against the dollar, China’s foreign-exchange reserves began to fall. China’s current-account surplus has also been narrowing. While it is still too early to tell, the real appreciation may be restoring nominal equilibrium. China’s experience may illustrate adjustment under a peg and the inability of sterilisation to offer a way around the fundamental trilemma.

To be sure, sterilised foreign-exchange intervention can sometimes affect exchange-rate movements, but sterilised intervention does not provide central banks with a mechanism for systematically altering exchange rates independent of their monetary policies. Attempts to stabilise or undervalue exchange rates necessarily weaken a country’s control of its monetary policy and ultimately leave the real exchange rate unaffected.


Bordo, MD, OF Humpage and, AJ Schwartz (2012a), “Epilogue: Foreign Exchange Market Operations in the Twentieth Century”, NBER Working Paper w17984.

Bordo, MD, OF Humpage, and AJ Schwartz (2012b), “The Federal Reserve as an Informed Foreign Exchange Trader: 1973 – 1995”, International Journal of Central Banking, 8(1):127-160.

Bordo, MD, OF Humpage, and AJ Schwartz (2010), “US Foreign Exchange Market Interventions during the Volcker-Greenspan Era”, NBER Working Paper w16345.

Chaboud, AP and OF Humpage (2005), “An Assessment of the Impact of Japanese Foreign Exchange Intervention: 1991-2004”, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, #824.

Feenstra, RC and AM Taylor (2008), International Economics, Worth Publishers.

McCallum, BT (2003), “Japanese Monetary Policy, 1991-2001”, Federal Reserve Bank of Richmond Economic Quarterly, 89(1):1-31.

Neely, CJ (2011), “A Foreign Intervention in an Era of Restraint”, Federal Reserve Bank of St. Louis Review, 93(5):302-324.

Rich, G (2000), “Monetary Policy without Central Bank Money: A Swiss Perspective”, International Finance, 3(3):439-469.

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