Foreign Exchange Intervention and Exchange Rate Volatility in Zambia

Abstract

The study analyzes the impact of central bank intervention on the volatility of the exchange rate in Zambia during the period of 1996–2013. The empirical findings reveal a statistically weak negative impact of intervention on exchange rate volatility, suggesting that other policy instruments are required to augment foreign exchange interventions in dampening volatility in the exchange rate.

Key words:

• exchange rate volatility
• intervention

ACKNOWLEDGMENTS

The author thanks his employer for all the support during this endeavor. The study benefited from comments at the AERC conferences by resource persons and fellow researchers as well as colleagues at the Bank of Zambia. Incisive comments from an anonymous reviewer greatly improved the quality of this work. The views expressed in this paper do not in any way represent the official position of the Bank of Zambia. The author remains responsible for all errors and omissions.

Notes

The foreign exchange in Zambia has traditionally been supplied by the copper mining sector (mostly by the now privatized ZCCM), which accounted for about 90% of total foreign exchange earnings. Up until 1984, all Zambian exporters surrendered foreign exchange earnings to the BoZ, which in turn allocated to the market through an administrative arrangement. In 1984, noncopper exporters (i.e.,. nontraditional) were allowed to retain 50% of their export earnings. In 1992, nontraditional exporters were allowed 100% foreign exchange earnings retention. However, in April 1996, the ZCCM foreign exchange retention scheme was abolished. This meant that ZCCM could now trade foreign exchange directly in the interbank foreign exchange market. The retention scheme refers to the requirement by law at that time for ZCCM to surrender some of the total foreign exchange earnings to the BoZ and retain the other amount for its own operational use.

All interventions undertaken by BoZ were preannounced to the market and the market was informed of the change in the frequency of BoZ intervention.

The exchange rate is defined as kwacha per U.S. dollar such that an increase (positive) in the kwacha–U.S. dollar signifies a depreciation while a decrease (negative) in the kwacha–U.S. dollar implies an appreciation.

It is noteworthy that Eqs. 2 and 3 do not control for factors that could potentially affect exchange rate volatility as alluded to in Eq. 1. However, available literature on Zambia indicates money supply, inflation, foreign exchange reserves, interest rates, terms of trade, openness, and real output as some factors underlying the kwacha exchange rate volatility (see Chipili, 2010).

Data gaps make the distribution of intervention to be concentrated around zero (“zero-inflated process”) such that the relationship between intervention and its determinants is nonlinear and the distribution of errors from regressions that include absolute intervention data may not be normal as per ordinary least squares assumption, especially in small samples.