Exchange Rate Dynamics and Trade Balance in Selected African Countries

Abstract

African countries have over the years experienced persistent current account deficits. The role of asymmetries in explaining the response of trade balance to exchange rate movement has not received adequate attention as linear models dominate extant empirical literature. In this paper, we examined the impact of exchange rate on the trade balance in five African countries using both linear and nonlinear autoregressive distributed lag models to analyze data for the period 1980–2018. The linear model revealed that the J-curve holds in Uganda in the short run, whereas evidence of long-run J-curve effect was found only in Algeria. However, the nonlinear analysis showed that the short-run J-curve holds for South Africa and Uganda whereas a long- run J-curve effect was found in Algeria and Uganda. The results make a case for modeling asymmetries as the nonlinear model performed relatively better. An important policy implication is the need to address structural imbalances in the economy to leverage on the exchange rate and trade policies to improve trade outcomes. under the CC BY-NC of foreign income. α 0 is a constant whereas α 1 – α 3 are parameters of the model, and ε t is the random error term. The J-curve hypothesis posits that an increase in the real effective exchange rate leads to an initial deterioration of the trade balance of a country but thereafter improves it when exports and imports adjust to price changes. An increase in real domestic income is expected to worsen the trade balance because the demand for imports increases, whereas an increase in foreign income improves the trade balance because it stimulates foreign demand for domestic products. The J-curve hypothesis incorporates time effects into the Marshall–Lerner condition, suggesting that the sum of trade elasticities may be below unity in the short run but greater than unity over the long run.