Official Intervention, Reserve Accumulation and Exchange Rate Volatility

The Reserve Bank of India often claims that the official intervention in the foreign exchange market primarily aims at minimizing undue fluctuations in the exchange rate and this study is an attempt to explore the success story of such interventions. Although the stylized facts seem to indicate that maintaining adequate amount of official reserves help reduce the volatility, the marginal benefit of adding reserves in terms of containing excessive volatility declines as the level of reserve holding increases beyond certain threshold level. The evidence from a threshold vector autoregression model suggest that the response of exchange rate volatility is conditional upon the size of intervention and whether the level of reserve holdings is above or below certain threshold level. While the official purchase of foreign exchange reduces the variability of exchange rate, official sale seems to trigger volatility irrespective of whether reserve holding is above or below the threshold level. Further, a positive shock to absolute official sale (purchase) could reduce the pace of depreciation (appreciation) although it could not revert the direction of exchange rate. These evidences exemplify the fact that intervention cannot prevent exchange rate volatility from rising rather it can only moderate.