The effect of foreign Aid on trade balance in Rwanda
Habakurama, Iradukunda Gallican
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Rwandais seen as a good macroeconomicperformerand has achievedhigh rate of growth and macroeconomicstability.Due to the low level of saving,capital inflowwas necessary to keep the economybuoyant.The inflowof capitalwas not only importantfor investment and job creation but also used for capital imports. Production is not satisfying as the country's imports continue to exceed the exports. The trade gap keeps expanding and necessitatesmore foreign aid inflow. Increase in foreign aid strengthens domestic currency in the short run. As result of appreciation of domestic currency, it is expected that imports will increase and exports decrease in the short run and the country will experience trade balance deficit. It is also expected in the long run that foreign aid increases the income of population which increase the imports and domestic currency is expected to depreciate. This makes the imports expensive and exports cheaper, therefore trade balance improvement in the long run due to the fact that domestic currency depreciates and capital imports are producing substitute and competitive goods. However the situation is controversialin Rwanda, the more foreign aid inflow, the more trade balance deteriorates while the domestic currency continuously depreciates. The study intended to determine the effects of foreign aid on trade balance in Rwanda and specific objectives of the study were to determine the effect of foreign aid on trade balance in Rwanda, to determine the effect of exchange rate on trade balance in Rwanda and also to determine the causal relationship between foreign aid and trade balance in Rwanda. The study used time series data spanning from 1982 to 2012 and descriptive and econometric analysis were carried out based on Vector Autoregressive (VAR). Cointegration and causality tests were used to test the relationship exist between foreign aid and trade balance. Vector error correction model (VECM) was applied to determine the speed of adjustment from the short run to the long run economic equilibrium. The study revealed that there is a negative effect of foreign aid on trade balance in Rwanda and a positive effect of exchange rate on trade balance in Rwanda. The study also denoted that there is a bi-directional causality between foreign aid and trade balance in Rwanda and a long run relationship between trade balance, Exchange rate and Foreign aid. The test for VECM presented that the speed of adjustment from short run to the long run equilibrium was faster at 1.43 or 143 percent. It is advised that the republic of Rwanda should implement import substitution policy in order to reduce the quantity of imports which widens the trade balance deficit for many years. Export promotion policy should be important in order to gain enough foreign earnings instead of relying on uncertain foreign aid. To achieve these GoR should be wisely prepared to tear down all trade barriers Rwandan exports faced on global market. It is expected that the study is useful to the macroeconomic policymakers of government of Rwanda towards the effects of foreign aid on trade balance in Rwanda.