Effect of the Exchange Rate on the Trade Balance: Evidence from Selected Sub-Saharan African Countries

Abstract

International trade has enormous impact on a country’s economic growth and development as a whole. Governments in every part of the globe pursue various economic policies aimed at improving trade and enhancing economic development. The trade balance is a major indicator in determining a country’s trade performance on the international market. An improved trade balance will improve a country’s current account balance and GDP as a whole and vice versa. Unfortunately, most of the economies in Sub-Saharan Africa (SSA) have persistently been recording a trade deficit. This continuous deterioration of the current account balance is a reflection of the persistent trade deficit in the region as whole. Thus, this can jeopardize the growth and development process of these economies. A strong export sector is therefore necessary in order to keep the trade balance in a better position as has been the anchor of the economies of East Asia. Although, a focus on technological advancement, innovation and investment are some of the long term measures to build a strong export sector to remedy the situation, the exchange rate has been cited as one of the most commonly used short term mitigating policies to curtail a falling trade balance. Especially for developing countries, it has been assumed that exchange rate depreciation is an appropriate macroeconomic fundamental to support the export sector (Vitale, 2003). A lot of the empirical works in this area of research are time series analysis, therefore this research employs a panel analysis of sixteen Sub-Saharan African countries with more recent data to find out if there exists any relationship between the exchange rate and the trade balance. Specifically, the focus of the study is to find out if the exchange rate can be used as a policy tool in remedying the persisting trade deficit in Sub-Saharan African countries. The study adopted the standard trade balance framework as the empirical model. Again, the traditional FE and RE models were used to estimate the empirical model using robust standard errors to control for the presence of heteroscedasticity and autocorrelation. However, the presence of endogeneity in the model ultimately informed the use of the System GMM which has the ability to overcome this problem. The empirical results confirmed the assertion by most economic theory and empirical works alike. That is, although there exist a negative relationship between exchange rate and trade balance in the current year, the trade balance tend to improve following an exchange rate depreciation in the second year. Thus, the outcome of the study was found to be consistent with the J-curve hypothesis. Nonetheless, all the other variables were found to adversely affect the trade balance. Particularly, contrary to economic theory and most empirical works, the foreign income was found to negatively impact the trade balance at all lag levels. It is therefore recommended that, if the exchange rate would be used as a measure to remedy the problem of the persistent trade deficit, it must be accompanied by some macroeconomic fundamentals to control the effect of exchange rate pass throughs and frequent depreciation of currencies in these countries.