Determinants of real effective exchange rate fluctuations in Kenya

Abstract

Economic growth in any country is important as it has a significant role in the standards of living of the people. Exchange rates play an important role in economic growth especially through foreign trade. Exchange rates in Kenya have been experiencing fluctuations since the transition of the fixed exchange rate regime of the 1960s to the crawling peg of the 1970s to 1980s and lately the floating exchange rate of the 1990s to date leading to the country losing its nominal anchor on the global market and thus its exports became less competitive. The exchange rate has oscillated between Kshs. 7.142 in 1960s to Kshs. 102.35 per unit US dollar in 2015. The magnitude of exchange rate fluctuations in most developing economies has attracted the interest of many scholars including economists and policy makers. These scholars have however differed on the determinants of real effective exchange rate. The purpose of this study therefore was to examine the determinants of real effective exchange rate fluctuations in Kenya. The specific objectives for the study were; to examine the relationship between money supply and real effective exchange rate fluctuations in Kenya, to evaluate the relationship between external debt on real effective exchange rate fluctuations in Kenya, to determine the relationship between trade balance and real effective exchange rate fluctuations in Kenya and to examine the relationship between inflation real effective exchange rate fluctuations in Kenya. The study was anchored on the balance of payments theory of exchange rate determination; which focuses on the balance of payments in the sense of demand and supply of foreign exchange in the market. The study used annual time series data for the period 1972-2015; during this period Kenya adopted the crawling exchange rate from the initial fixed exchange rate regime and that Kenya experienced the highest depreciation in its currency. The study used correlational study design to establish the relationship between the real effective exchange rate fluctuations and money supply, external debt, trade balance and inflation. Hypotheses were tested at 5% level of significance. The study employed cointegration and ECM to test both the long run and short run dynamics between the dependent and independent variables respectively. Coefficient of determination( ) was to determine the goodness of fit, it established a 75.84% of the variations in real exchange rate fluctuations are explained by the independent variables and therefore the model was a good fit. From the ECM results, the vector of real effective exchange rate fluctuations in Kenya is error correcting at -11.4179 thus real effective exchange rate fluctuations in Kenya adjust to short run shocks caused by money supply, external debt, trade balance and inflation though not significantly. The study concluded that there exists a positive significant relationship between money supply, trade balance, inflation rate and real effective exchange rate fluctuations in Kenya. However, external debt has a negative but significant relationship with real effective exchange rate fluctuations in Kenya. A deficit trade balance leads to depreciation of the shilling by 0.2951. An increase in money supply also leads to depreciation in the Kenyan shilling by 7.1363 same to an increasing inflation rate (0.1678). An increasing debt burden depreciates the Kenyan shilling by 2.4061. These results are in conformity with the balance of payments theory of exchange rate determination. The study recommends that policy makers should formulate sound credit control policies to control money supply, export promoting policies should be to make the local products globally competitive, inflation rate should be maintained within the set limits and the government should reduce debt burden as much as possible.