Budget Deficit Financing and Exchange Rate Volatility in Kenya
Kirui, Benard Kipyegon
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This study was motivated by over a quarter of a century of exchange rate volatility, the persistent problem of budget deficit in Kenya, and the importance of the two in the economy, which explains their inclusions in the convergence criteria for the East Africa Community. Exchange rate volatility exposes the participants of international markets to the risk of loss and thus disturbs the optimal allocation of resources. Despite effort made by past studies to explain exchange rate volatility, there exists controversy in their findings, with a counterargument being provided for each assertion. This study attempted to improve on the modelling of volatility in exchange rate in order to best explain its movement. This was done by analysing the effects of using the financing composition of budget deficit instead of budget deficit in modelling of exchange rate volatility. Thereafter, the model that provided the best fit and forecast were applied to determine the effects of budget deficit financing and macroeconomic fundamentals on exchange rate volatility under different exchange rate regimes. Monthly data spanning the period 1973:01 to 2005:12 for the following variables: exchange rate volatility, interest rate differential, inflation rate differential, domestic nominal interest rate, money supply differential, net foreign assets and productivity differential were used to achieve these objectives. The study tested for structural breaks and aggregation of variables problem then applied the VAR estimation technique to the model which offered the best fit. VAR results were used to explain the effects of macroeconomic fundamentals on exchange rate volatility. The results of impulse response functions and variance decomposition revealed that shocks to productivity differential, inflation rate differential, and to a lesser extent, the interest rate differential and the net foreign asset are the main drivers of exchange rate volatility in Kenya. The analysis of the results revealed a stronger medium- to long-term causality linkage from macroeconomic volatility to exchange rate volatility than the other way around. This was evidenced by bidirectional causalities between productivity differential, inflation rate differential, and to a lesser extent, the interest rate differential on one hand and exchange rate volatility on the other. The net domestic financing of budget deficit had positive effect, while the net foreign financing of budget deficit had negative effect. The study concluded that there is no aggregation problem in budget deficit. However, the model with the financing composition of budget deficit provided the best fit and the macroeconomic fundamentals successfully explained exchange rate volatility.