Effect of Foreign Direct Investment, Inflation, Real Exchange Rate and Transfer Payments on Trade Deficit in Kenya

Abstract

Across all the countries, the balance of trade has remained a key indicator of economic activities as it shows a country’s level of competitiveness in the world market. Previous studies have entrenched that Kenya needs to attest that trade remains the base upon which her development and industrialization strategy is secured to achieve Vision 2030. Economists are divided on whether a persistent trade deficit is good or bad for a developing country like Kenya. Contrary to most of the similar previous studies, the study included trade in services as well as some of the key factors affecting trade deficit such as inflation and transfer payments and sought to establish the nature and strength of their connection with the trade deficit in Kenya as well as their respective impulse response. The study sought to establish the effect of foreign direct investments (FDI), inflation, real exchange rate and transfer payments on trade deficit in Kenya. Specifically, the study sought to individually determine the effect of FDI, inflation, real exchange rate and transfer payments on trade deficit in Kenya. The study adapted a reduced form of the balance of trade model by hypothesizing that balance of trade is a function of FDI, inflation, real exchange rate and transfer payments. In order to gauge the elements and earnestness of synergy between the variables, the study embraced an ex post facto correlational research design. The study used time series data obtained from the World Bank ranging from the year 1978 which is the year from which Kenya has since experienced incessant aggregate trade deficit up to the year 2014 with annual frequency. The study also employed use of descriptive statistics, Cointegration, Vector Error Correction Model, Granger causality, impulse response function tests as well as a range of other diagnostics tests. The study established that in the long-run, only inflation and transfer payments have significant effects on trade deficit while real exchange rate has an insignificant effect with respective adjustment coefficients of 0.001, -0.060 and -0.028 and respective p-values of 0.49, 0.00 and 0.36. The study also established that FDI, inflation, real exchange rate and transfer payments all have insignificant short-run effects on trade deficit with respective adjustment coefficients of -2.669 , 0.002 , 0.097 and -0.116 and the respective p-values of 0.50, 0.74, 0.86 and 0.53. The study recommended that Kenya’s persistent trade deficit can be addressed in the long-run but at a cost to the economy in the form of reduced FDI in the long-run. The study concluded that trade deficit is not really bad for Kenya as measures that should reduce it actually reduce foreign direct investments which is really important for a growing economy like Kenya.