Central bank intervention and exchange rate volatility in Pakistan : an analysis using GARCH-X model

Excessive exchange rate volatility has a deleterious effect on international financial flows, external trade, investment and output. Among others, these economic costs prompt the central bank in emerging countries to contain excessive exchange rate volatility through intervention in the foreign exchange market. This article investigates the effectiveness of State Bank of Pakistan's (SBP) daily foreign exchange intervention starting from 3 July 2000 to 31 December 2005 (1593 trading day observations). The method of Generalized Autoregressive Conditional Heteroscedasticity, with exogenous variables (GARCH-X), used in this article, shows that SBP's intervention operation is very effective as it not only affects the exchange rate levels but also reduces the exchange rate volatility. It is also found that the short-term interest rate and the size of the foreign exchange reserves held by SBP also affect the exchange rate level and its volatility. Increase in short-term interest rate and higher foreign exchange reserves are associated with appreciation of exchange rate levels and vice versa. In addition, higher foreign exchange reserves also reduce the exchange rate volatility. In sharp contrast to the no days-of-the-week effects on exchange rate level, the results show that there is some evidence of significant days-of-the-week effects of intervention on exchange rate volatility.