An Analysis On The Effect Of External Public Debt On Exchange Rate Volatility In Kenya

Abstract

Kenya has faced a rising trend in external public debt and experienced changes in exchange rates in the past decades. The changes in exchange rate have been seen to exhibit an appreciating and volatile trend which is detrimental to an economy as it affects economic growth. This study empirically investigated the effects of external public debt on real effective exchange rate (REER) volatility under the complete float regime for period 1993 to 2013 using quarterly data. REER index was constructed using US Dollar and British Sterling Pound. The REER volatility was measured using the standard deviation of the second order of the moving average. A linear model was developed and exchange rate volatility was regressed against inflation, interest rates, and GDP growth rate, money supply to GDP ratio and external debt to GDP ratio using Ordinary Least Square technique. The results showed that external debt to GDP ratio had negative and significant effect on REER volatility while interest rates had positive and significant effect. Inflation, GDP growth rate and money supply to GDP ratio were found not to have any significant effect. High and unsustainable external public debt was evidenced to lead to high REER volatility in Kenya. Monetary authorities should ensure debt sustainability indicators such as external debt to GDP ratio are at low levels and pursue strategies that reduce excessive accumulation of external public debt.