Factors Influencing Real Exchange Rate and Export Sector Performance in Kenya

Abstract

In December 2004 to December 2007, the Kenya shilling real exchange rate appreciated by 30.0 % representing a major deviation from its past levels. Appreciation of the shilling real exchange rate has attracted public attention recently, especially from exporters and importers who have argued that the weakening shilling is eroding their competitiveness. This study was guided by the following objectives; to investigate the effects of foreign aid inflow on real exchange rate and export volumes in Kenya. It was hypothesized that foreign aid inflows to Kenya do not result in real exchange rate appreciations, and that exports do not respond positively to foreign aid inflows. The data comprised of annual time series data for Kenya over the sample period 1960 to 2010. The sources of data included World Bank world tables, Organization of Economic Co-operation and Development, Central Bank of Kenya and Kenya National Bureau of Statistics. The study adopted Error Correction Model, because of its ability to induce flexibility by combining the short run dynamic and long run equilibrium model in a unified system. Inferential statistics were applied using Micro fit and PC Give (ox-metrics); unit root, co integration and granger causality tests were done prior to estimation. The study found that, foreign aid inflow lead to real exchange rate appreciation in Kenya. This was depicted by the significance of aid in the long run co-integrated equilibrium results. Foreign aid inflows also had a positive impact on export volumes as shown by the significance of aid in the export performance model estimation. The results of short-run parsimonious real exchange rate model revealed that real exchange rate is influenced by domestic factors such as government expenditure, technological progress and commercial policy stance. External factors proxied by terms of trade also tend to play a critical role as they lead to real exchange rate depreciation this was shown by the positive co-efficient of terms of trade in the long run co-integrated equilibrium results. The study concluded that for foreign aid to be an effective investment, policy management need to focus on ensuring the prevalence of sound macroeconomic fundamentals, liberalizing trade, focusing on export-led growth strategy and promotion of tourism industry in Kenya. KEY WORDS: Real Exchange Rates, Aid, Exports Sector Performance.