Policy Implication of Non-Sterilized and Sterilized Central Bank Intervention on Exchange Rate Volatility in Kenya

Abstract

Central bank of Kenya through the monetary policy is required to choose a policy mix that would ensure stable exchange rates by stemming out any excessive volatility in the exchange rate since volatility introduces uncertainty that negatively affects business decisions and plans. The increase in exchange rate volatility has negative effects on international trade and capital flows, thus having an adverse impact on domestic economy. Unpredictable changes in exchange rates may reduce international trade by increasing the risks of importing and exporting. Equally, by increasing the risk of investing in foreign assets, exchange rate volatility may retard the flow of capital between the countries. There has been a dilemma in policy making whether to intervene direct in the foreign exchange market or not and whether to sterilize the intervention or not. This study aimed at evaluating the policy implication of non-sterilized and sterilized intervention on exchange rate volatility in Kenya using GARCH (1, 1) model. Data for analysis included monthly time series data on US Dollar-Kenya shilling bilateral exchange rate, net foreign exchange intervention by central Bank, 91-day Treasury bill rates and inflation rate. The data for all the variables was purposively selected from January 1997 to June 2016 which makes a total of 233 months. The data was extracted from the Monthly Economic Reviews and surveys of the Central Bank of Kenya and Kenya National bureau of Statistics and also from database on their websites and analyzed using Eviews software. Non-sterilized intervention was found to be effective in reducing exchange rate volatility by individually using foreign exchange intervention and 91-day Treasury bill rate. However, Non- sterilized monetary policy intervention in the foreign exchange market was found to interfere with one or more of monetary policy other goals. The dilemma in non- sterilized central bank intervention results in central bank choosing to sterilize its interventions so as to cause a change in the exchange rate while at the same time leaving the money supply and hence interest rates unaffected. Therefore, policy makers should strive for a policy mix that will ensure stable exchange rates by stemming out any excessive volatility in the exchange rate to avoid further depreciation and fluctuation on exchange ra