Real exchange rate volatility and misalignment: effects on trade and investment in Kenya

Abstract

The real exchange rate (RER) has been recognized as an important price in international economics and finance. Misalignment of the RER has important implications on a country's international competitiveness. This is due to the effects of RER on the country's production of tradable goods and services. Additionally, it has influence on capital and financial flows. Similarly, RER volatility has important implications on a country's international trade and investment. It does so directly through creation of uncertainty and adjustment costs, and indirectly, through its effect on the structure of output and investment in the economy. This study sought to establish the effects of RER volatility and misalignment in Kenya on the country's international trade and investment over the period 1993-2003. Co-integration analysis based on a single equation approach was used to establish the equilibrium RER over the study period. The deviations of actual RER from the equilibrium RER path, which represent misalignment, were then calculated. The results from co-integration analysis showed that in the long run, Kenya's equilibrium RER is only affected by real variables, which may be categorized as either external or internal 'fundamentals'. The former fundamentals were terms of trade, and net capital and financial flows while the latter fundamentals were productivity growth and trade policy proxied by the degree of openness. The results of the short run dynamic model also showed that RER misalignment are policy-induced, with the main culprits being monetary and fiscal policies. In light of these results, it is recommended that Kenya should maintain its market determined exchange rate policy and implement a monetary policy aimed at confining inflation to levels that are at par or lower than those of Kenya's trading partners. It should also undertake further macroeconomic, institutional and structural reforms as well as export diversification in order to improve the country's international competitiveness. On the effect of RER volatility and misalignment on trade and investment, this study employed multivariate co-integration and error correction modeling technique to estimate three separate equations: namely; the export demand equation, the import demand equation and private investment demand equation, all of which had both the RER volatility and RER misalignments as explanatory variables. In the export demand function for Kenya, the results suggested that there exists one cointegrating vector for Kenya's real exports and its fundamentals. In line with theory, the results indicated that increases in the exchange-rate volatility exert a significant negative effect upon export demand in both the short and the long run. Similar results were also drawn in the import demand model. In the private investment demand function, the results showed that in the long run, the coefficient of RER volatility is negative and statistically significant. The main policy conclusions drawn from the results of the estimation of the trade equations is that Kenya's export demand and import demand are determined more by the exchange rate volatility than by changes in relative prices and other control variables. These findings have two policy implications. First, policy makers should concentrate their efforts on an export diversification strategy. Second, the government should follow a stable exchange rate policy. The major policy conclusions drawn from the results of the estimation of the private investment function is that RER volatility has a significant detrimental effect on private investment, suggesting that if private investment is to help reduce poverty, the policy makers should design an exchange rate policy that ensures that RER volatilities are minimized. Secondly, given the negative effects of external shocks, as reflected in the terms of trade, the Kenyan government needs to expand its production and export base in order to make its economy less vulnerable to these shocks.