Effect of Exchange Rate Misalignment on Bilateral Trade between Kenya and European Union

Abstract

The exchange rate is an important variable in international trade due to the expectations that trade reacts to its movements and therefore determines a country’s international competitiveness. Prudent management of trade and exchange rate policies have been associated with faster growth in developing countries. In order to orient the economy outwards, Kenya has pursued various measures from 1990s to 2000s. Despite these export oriented efforts, Kenya’s trade has remained skewed towards imports and a widening trade deficit which seems to follow the weakening of the Kenya shilling. The main policy dilemma is therefore how imports accelerated in an environment of unhindered European union market access, and hence the motivation of this study. The key objective of this study was to investigate the effect of exchange rate misalignment on Kenya’s bilateral trade with the European Union. Secondary data was used on variables considered instrumental in influencing trade between Kenya and EU for the period between 2000 and 2016. Data was collected from Kenya National Bureau of Statistics, Central Bank of Kenya, EuroSTAT and IMF financial statistics. The study adopted a dynamic modelling approach since exchange rate and trade are affected by previous as well as present values. The study results show that the real exchange rate is driven by the economic fundamentals and in terms of misalignment the exchange rate is overvalued to maximum of 5.9 percent and undervalued up to 5.2 percent. The estimated misalignment has a negative effect on imports but positive statistically insignificant for exports. Finally, the exchange rate has a positive effect on trade balance. The results of this study suggest that the monetary authority should ensure the exchange rate remains stable and within the 6 percent range while monitoring all the underlying determinants. Coupled with this, hedging instruments should be made available and affordable.