The effect of exchange rates on economic growth in Ethiopia

TABLE OF CONTENTS

Declaration

Acknowledgment

List of Tables

List of Figures

Acronyms

Abstract

CHAPTER ONE: INTRODUCTION
1.1. Background of the Study
1.2. Statement of the Problem
1.3 Objective of the Study
1.4 Basic Research Questions
1.5 Hypothesis
1.6 Significance of the Study
1.7 Scope and Limitation of the Study
1.8 Organization of the study

CHAPTER TWO: LITERATURE REVIEW
2.1 Brief discussion of exchange rate in Ethiop
2.1.1 Definition
2.1.2 Exchange rate policy in Ethiopia
2.1.3 Exchange rates and economic growth in Ethiopia
2.1.4 Real and nominal effective exchange rates
2.2 Theoretical literature review
2.2.1 The traditional views of Exchange rate
2.2.2 The structuralist views of Exchange rate
2.2.3 The Balassa-Samuelson Hypothesis
2.2.4 The export-led growth hypothesis
2.3 Empirical literature review

CHAPTER THREE: DATA AND METHODOLOGY
3.1 Introduction
3.2 Research Design
3.3 Data type and sources
3.4 Method of data analysis
3.5 Model specification
3.6 Unit root tests
3.7 Johansen cointagration test and VECM
3.8 Impulse response and variance decomposition analysis
3.9 Diagnostic checks

CHAPTER FOUR: EMPIRICAL ANALYSIS AND DISCUSSION
4.1 Introduction
4.2 Descriptive data analysis
4.2.1 Real effective exchange rate and economic growth
4.3 Tests of the time series data
4.3.1 Stationarity tests
4.4 Test for cointegration
4.5 Determination of optimal lag length
4.6Estimation results and interpretation
4.6.1Vector Error Correction Model
4.7 Diagnostic tests on the residuals of VECM
4.8 Impulse response and variance decomposition analysis

CHAPTERFIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
5.1 Summary of the Findings and Conclusions
5.2 Policy implications

References Appendices

DEDICATION

To Mahder Tadesse my wife, Who Has helped me reach here.

ACKNOWLEDGMENT

Words are powerless to express my praise and adoration to the Almighty God and Saint Mary, for their love, comfort, kindness, blessing and mercy.

I would like to express my heartfelt gratitude and respect to my advisor Gemoraw Adinew, who had put all his efforts to get the best out of my work. The accomplishment of this study would be impossible without his irreplaceable advice, support and encouragement.

My special thanks and appreciation goes to my father, mother and brothers for their unreserved love and encouragement to finish this thesis.

Last but not least, I would like to thank all workers in the Ministry of Finance and Economic Development, National Bank of Ethiopia and Central Statistics Agency who had provided me with all the necessary data and information during my visit to their offices.

LIST OF TABLES

Table 3.1: Expected sign of the independent variables

Table 4.1: Summary statistics

Table 4.2: Correlation matrix between the independent variable

Table 4.3: Variance Inflation factors of a Full model

Table 4.4 Stationarity results of the Augmented Dickey-Fuller test

Table 4.5 Stationarity results of the Phillips-Perron test

Table 4.6: Testing for co-integration in Johansen-Juselius procedure

Table 4.7: VAR Lag Order Selection Criteria

Table 4.8: Results of the long run co-integration equation

Table 4.9: Short Run Error correction model results

Table 4.10: Variance decomposition of RGDP

LIST OF FIGURES

Figure 2.1: Gradual ETB depreciation continues ETB/USD

Figure 4.1: Trend of real effective exchange rates and Real GDP in percentage

Figure 4.2: Trends in real effective exchange rates and nominal effective exchange rates

ACRONYMS

Abbildung in dieser Leseprobe nicht enthalten

ABSTRACT

This study attempts to investigate the effect of exchange rates on economic growth in Ethiopia using annual time series data spanning from 1985/86 to 2014/15. The explanatory variables in this study were real effective exchange rate, government final consumption expenditure, gross fixed capital formation, broad money supply and trade openness. The multilateral real exchange rates is used to measure real exchange rates. Results from Vector Error Correction Model revealed that real effective exchange rates, broad money supply and trade openness have a positive long run effect on economic growth, while government final consumption have a negative long run effect on the economic growth of Ethiopia. From the regression results, it was noted that undervaluation of the currency is contractionary in the long run and neutral in the short- run. As such, the effect of exchange rates on economic growth works through the supply channel. It is the reflection of various economic and policy shocks, mainly a strategy shifts, of the government. Based on the findings of this study, the researcher recommended that since the Ethiopian output is dominated by primary agricultural products and it is insensitive for the change in exchange rate. Government intervention is needed to balance the adverse effect of exchange rate movements until the economy well transformed from agricultural lead economy to industrial lead economy and becomes less dependent on imported raw materials.

CHAPER ONE

1. INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Countries have the same consensus on the possible effect of exchange rates on economic growth until the end of 1970s. There appears a consensus view on the fact that exchange rate devaluation or depreciation could boost domestic production through stimulating the net export component. This is possible because devaluation increases international competitiveness of domestic industries which leads to the diversion of spending from foreign goods to domestic goods. Up to this period, devaluation has expansionary effect on output. It would improve trade balance, alleviate balance of payment deficits, and accordingly expand output and employment (Acar, 2000).

Since 1992, Ethiopia, under the support and guidance of the IMF and the World Bank has undergone liberalization and enhanced Structural Adjustment Programs (SAPs) to restrain internal and external imbalances of the economy. One of the basic tasks of the new policy regime is to increasingly open the economy to foreign competition with a view of benefiting the economy from expanded markets. To this end, the government uses different tools such as: devaluation of the ETB and step-by-step liberalization of the foreign exchange market (Haile,1999).

In the recent period, devaluation has become the basic macroeconomic policy issue in most less developed countries. The effect is contractionary or expansionary depending on the structure of the economy. During the structural adjustment program, the International Monetary Fund (IMF) and World Bank (WB) suggested for developing countries to devalue their currency for the development of domestic firms. Devaluation increases the demand for domestic product and protects infant firms form outside competition (Genye, 2010). Krugman T. (1978) examine the negative effect of currency devaluation on output in developing countries which has used devaluation as a policy strategy. However, many researchers like Eichengreen, (2008), Mbaye, (2012), Acar (2000), Schweicker, Thiele and Wiebelt, (2006), Ngandu and Gebreselasie, (2006), Medina-Smith (2001), Schweicker et al., (2006) and Araujo and Soares (2011) found different results on the effects of currency devaluation on output in less developed countries.

1.2 STATEMENT OF THE PROBLEM

Even though ambiguous results were observed on the possible effect of devaluation, developing countries have actively used devaluation as a policy instrument. This study investigates the long run and short run effects of currency devaluation on real output growth in Ethiopia for two reasons. First, the country has short story of using exchange rate adjustments as a policy tools to promote external competitiveness. Since 1992, Ethiopia devalued its currency where the ETB exchange rate is adjusted continuously rather than discretely, as it was previously the case. Second, Ethiopia is heavily dependent on agricultural products and imported intermediate goods that would have contractionary effect on output. Despite the large number of studies on the effect of exchange rateson economic growth, they generally considered channels of exchange rates while the growth implications of currency adjustments are generally overlooked.The responses of productions andexports of the countries are highly heterogeneous depending on their characteristics such as export orientation, import dependency and liability of dollarization. The empirical evidence on the effects of currency adjustments on output is mixed and consequently government development approaches, where the manufacturing industry and its sub-sectors are being the main engine of economic growth, are the best possible option to guide policy directions of Ethiopia. This study, therefore, attempted to fill this research gap.

1.3 OBJECTIVE OF THE STUDY

The general objective of this study is to analyze the effect of exchange rates on economic growth in Ethiopia spanning from 1985/86 to 2014/15.

The specific objectives of the study will be as follows:

- To provide a review of the trends in exchange ratesand economic growth of Ethiopia over the period 1985/86-2014/15.
- To analyzethe short run and long run effect of exchange rates on economic growth in Ethiopia during the period 1985/86-2014/15.

1.4 BASIC RESEARCH QUESTIONS

- What look like the trend of exchange rates and economic growth in Ethiopia?
- Does exchange rates have a long run effect on economic growth in Ethiopia?

1.5 HYPOTHESIS

H0: Exchange rates do have a long run effect on economic growth in Ethiopia.

H1: Exchange rates do not have a long run effect on economic growth in Ethiopia.

1.6 SIGNIFICANCE OF THE STUDY

The issue of nominal devaluations attracts so much attention in Ethiopia, discussions surrounding it mainly focus on inflation and are generally without any reference to overall economic activity. This generates a lack of attention to the role of exchange rate management for promoting economic growth and maintaining the external competitiveness. It is on this basis that this study adds value to the relevant macro policy discourse more effectively by carrying out an empirical investigation of the effects of exchange rate changes on economic growth based on the government development approaches. Even though the study focuses on Ethiopia, the results from this study can hopefully be used when evaluating the growth effects of exchange rates in other developing countries.

1.7 SCOPE AND LIMITATION OF THE STUDY

The study analyzes the effect of exchange rates on economic growth in Ethiopia. To achieve this objective, the period range from 1985/86 to2014/15 is chosen. This period is chosen based on two reasons the first is the official exchange rate was first announced in 1992 and the other is Ethiopia’s heavily dependence on imported intermediate goods that would have contractionary effect on output.However, the effect of exchange rate changes on production and international trade dynamics vary with technology intensity and product complexity of the country. This study did not take in to consideration because I thought that it is insignificant in the context of Ethiopia.Another limitation of this study concerns data on the Ethiopian economy because it lacks consistency. Different data sources give different data for the same variable. To maintain accuracy and consistency, the study use data from Ministry of Finance and Economic Development, Central Statistics Agency and National Bank of Ethiopia which are more harmonized. The objectivity of the economy which is obsessed by factors like political and rules of law (property right) are not addressed here and might be consider other limitations of this study.

1.8 THE ORGANIZATION OF THE STUDY

This paper is organized as follows: Chapter I provides the introduction to the study; Chapter II reviews both the theoretical and empirical literature pertaining to the relationship between the exchange rates and economic growth; Chapter III presents a discussion on the research methodology; Chapter IVpresents both the descriptive and econometric results and the interpretation of the results; finally Chapter VI provides a summaryof main findings, conclusions based on the findings along with their policy implications.

CHAPER TWO

2. LITERATURE REVIEW

2.1. BRIEF DISCUSSION ON EXCHANGE RATE IN ETHIOPIA

2.1.1. DEFINITION

Exchange rate is a rate at which one country's currency is exchanged for the other currency. As cited by Fentahun (2011) from Pilbeam (1998), exchange rate can be expressed in two ways. These are domestic currency per unit of foreign currency and foreign currency units in terms of domestic currency. In this study data's taken from NBE, exchange rate is defined in terms of domestic currency per unit of foreign currency.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2.1: Gradual ETB depreciation continues (ETB/USD)

Source: National Bank of Ethiopia, Standard Chartered Research

Despite depreciation pressure across the region, the Ethiopian birr (ETB) has been depreciated only gradually.

2.1.2. EXCHANGE RATE POLICY IN ETHIOPIA

The Ethiopian legal affectionate currency was issued and the official exchange rate of this currency with US dollar was created on July 23, 1945. The name was initially Ethiopian dollar with the gold content 0.357690 gram corresponding to US$ of 0.4025 or an official rate of 2.48 ETB/USD. The gold content was almost constant up to the collapse of Britton woods system and devaluation of US dollar. After 1976 the name of the Ethiopian currency changed in to Ethiopian birr and the exchange rate of birr with dollar was remained fixed during Derg regimes (Fentahun, 2011).

Therefore, the Ethiopian currency has been pegged to the US dollar at the rate of 2.07 birr per US dollar until the huge devaluation in October 1992. This fixed official exchange rate was left unaltered for two decades despite the floating of the major world currencies including US dollar. As a result the birr became overvalued in terms of US dollar as well as many other foreign currencies. "From May 1993 up to the unification of the official and the public sale exchange rates on July 25, 1995, the exchange rate was partly determined by the government decree (applicable to the official rate) and partly by quasi-market forces (applicable to the auction rate) as represented by fortnightly auctions"(Derrese, 2001).

The National Bank of Ethiopia (central bank), follows a managed floating exchange rate regime where the local currency Birr is pegged to the US Dollar. Accordingly, drastic movements in the nominal exchange rate are not expected. The Birr continued to depreciate but at a very slow rate and it reached 21.5073/US$ at the end of 2015. This gradual depreciation is in line with the goal to enhance competitiveness of Ethiopian exports and attract FDI. The primary task of exchange rate policy in Ethiopia is promoting export and minimizing the adverse effect of exchange rate instability. The objective is limiting the gap between effective exchange rate indicating that the overvaluation of the birr has substantially been reduced and the parallel market exchange rate has declined significantly (Zerayehu, 2006).

2.1.3. EXCHANGE RATES AND ECONOMIC GROWTH IN ETHIOPIA

After the devaluation in 1992 the exchange rate is changed from fixed to managed floatingexchange rate in order to control overvaluation through a gradual depreciation of domestic currency every year. The gap between the unofficial and official rate also decreased compared to the period when the exchange rate was fixed. However during the fiscal year 2007/08 the rate of depreciation against other foreign currencies increased compared to the previous years. In the 2009/10 and September 2010/2011 the Ethiopian Birr was devalued to 23.7% and 16.5% respectively against the US dollar. This huge devaluation was expected to “decrease overvaluation and increase competiveness” (IMF, 2010; MOFED, 2009).

The increase in depreciation rate was expected to encourage the export sector. The higher increase in export rate, the better the rate of growth of the economy. The export of goods and services was 11% of the GDP in 2009 and yet the trade balance is negative. The world financial crisis where the major importing countries decreased their import quota might have a negative role in the decrease of the export as well as low growth since export is one part of the GDP (NBE, 2010).

The level of real exchange rate is important on economic growth as it determines the value of imports and exports of a country. Walters and De Beer (1999) explain that a country’s exchange rate is an important determinant of the growth of its cross-border trading and it serves as a measure of its international competitiveness.

2.1.4. REAL AND NOMINAL EFFECTIVE EXCHANGE RATES

Nominal effective exchange rate and real effective exchange rate are commonly used as an indicator of external price competitiveness. NEER is a weighted average of bilateral nominal exchange rates of national currency against a basket of major foreign currencies. At the same time, conceptually, REER is defined as a weighted average of a country’s currency against a basket of other major trading partners currency adjusted for the inflation. The foreign currencies weights in the basket are calculated based on the trade balance of Ethiopia. In total, the currencies of 16 major trading partners(Djibouti, Kenya, Sudan, U.A.R, France, Germany, Italy, Netherlands, U.K., Russia, Yugoslavia, U.S.A., China, P.Rep., Japan, and Saudi Arabia) are included in the calculation of nominal and real effective exchange rates (NBE,2014).

Abbildung in dieser Leseprobe nicht enthalten

Where, n-number of countries (currencies) from the basket; Abbildung in dieser Leseprobe nicht enthalten-exchange rate of the national currency against the currency of the country i; Abbildung in dieser Leseprobe nicht enthalten-exchange rate of the national currency against the currency of the country i during the base period; Abbildung in dieser Leseprobe nicht enthalten- country’s weight of the currency.

Abbildung in dieser Leseprobe nicht enthalten

Where, n- number of countries (currencies) from the basket; Abbildung in dieser Leseprobe nicht enthalten-exchange rate of the national currency against the currency of the country i; Abbildung in dieser Leseprobe nicht enthalten-exchange rate of the national currency against the currency of the country i; during the base period, Abbildung in dieser Leseprobe nicht enthalten-country’s weight of the currency in the basket;Abbildung in dieser Leseprobe nicht enthalten-inflation rate in the country i; Abbildung in dieser Leseprobe nicht enthalten-inflation rate in Ethiopia.

2.2 THEORETICAL LITERATURE REVIEW

This section examines theories that deal with exchange rates. The theories discussed in this section include the traditional views of exchange rates, the Structuralist or modern views of exchange rates, the Balassa- Samuelson Hypothesis and export led hypothesis.

2.2.1THE TRADITIONAL VIEW OF EXCHANGE RATES

This view holds that devaluation have expansionary effects on economic growth. This is popularly known as the traditional view. This approach holds that devaluation of a currency will cause local goods to be cheaper abroad and this will increase their demand, leading to an increase in exports (Salvatore, 2005). The view that devaluation has expansionary effects on output is evident in that devaluation of the currency improves trade balance, alleviates balance of payments difficulties and accordingly expands output and employment (Acar, 2000). The case for devaluation is that when a country devalue its currency, it enhances the cost competitiveness of its exports which are a component gross domestic product.

The traditional approach to exchange rates assumes that exchange rates affect economic growth through two main channels; the Total Factor Productivity growth channel and the Capital accumulation channel.

I. THE TOTAL FACTOR PRODUCTIVITY GROWTH CHANNEL

The Total Factor Productivity growth channel holds that currency depreciation shifts the output composition of a country from the production of non-traded goods to traded goods. The link from output composition to growth is through economy-wide productivity improvements, generated by the production of some types of traded goods (exported manufactured goods) through mechanisms such as technology and skill transfers associated with learning by doing that is external to the firm (Montiel and Serven, 2008). This shift to the production of traded goods and improvements technology results in an increase in investments locally, exports and ultimately economic growth.

The Total Factor Productivity growth channel places the structure of domestic production at the core of the argument (Eichengreen, 2008). A depreciated real exchange rate, equivalent to an increase in the price of tradables relative to non tradables, improves the profitability of the tradable sector. As production moves from the non tradables to the tradable sector characterized by higher (marginal social) productivity levels the overall productivity in the economy increases. Such economy-wide productivity improvement ultimately fosters growth (Mbaye, 2012). Acar (2000) explains that currency devaluation switches demand from imports to domestically produced goods by increasing the relative prices of imports. Export industries on the other hand become more competitive in international markets by stimulating domestic production of traded goods and inducing domestic industries to use more domestic inputs.

Dabla-Norris and Floerkemeier (2005) are of the view that changes in exchange rates have an effect on aggregate demand through improvements in international competitiveness as well as net exports.

In other words, when the rand weakens against other currencies, local people opt for domestic goods thus improving economic performance of the manufacturing sector. At the same time the country exports more and imports less resulting in favourable net exports. Ngandu and Gebreselasie (2006) further explain that increased exports, through the multiplier effect, are expected to increase aggregate demand, and ultimately domestic production and employment.

Given that depreciation tends to be inflationary, it is argued that the increase in the overall price level leads to the lowering of the real wage, which leads to more hiring and increased production, assuming that there is unemployment in the economy.

The criticism leveled against the Total Factor Productivity growth channel is that it does not give clear-cut ways in which it operates except for the learning by doing assumption. Also it lacks empirical support; Mbaye (2012) for instance argues that there is no empirical investigation on the TFP transmission channel of the effect of real exchange rate undervaluation on growth.

II. CAPITAL ACCUMULATION GROWTH CHANNEL

The capital accumulation approach is a view that holds that exchange rates affect economic growth through their effect on savings. This approach claims that real exchange rate undervaluation enhances growth through an increase in the capital stock of the economy as a whole (Mbaye, 2012). A backdrop for this view is that a depreciated real exchange rate has a tendency to increase the domestic saving rate. Higher saving rates induced by depreciation stimulate growth by increasing the rate of capital accumulation.

According to Montiel and Serven (2008) while there is no consensus on the precise channels through which this effect is generated, an increasingly common view in policy circles points to saving as the channel of transmission, with the claim that a depreciated real exchange rate raises the domestic saving rate, which in turn stimulates growth by increasing the rate of capital accumulation. The capital accumulation channel holds that there are two sources of capital accumulation. Mbaye (2012) explains that in the first mechanism, the capital accumulation operates exclusively in the tradable goods sector whose share in GDP increases while in the second, the stock of capital in the economy increases through the expansion of overall savings and investment.

The relationship between a depreciated real exchange rate and the saving rate arises because a depreciated real exchange rate tends to shift aggregate demand away from traded to non-traded goods, requiring an increase in the real interest rate to maintain internal balance (Montiel and Serven, 2008). The increase in interest rates constrains aggregate demand in part by raising the domestic saving rate. Thus from this perspective, causation runs from the real exchange rate through the real interest rate to the saving rate which in turn increases economic growth. Dooley, et al. (2004) argue that high saving rates in many Asian countries, including China, are at least in part the result of the pursuit of such an exchange rate policy (depreciated currency) in their export driven strategies.

In understanding the capital accumulation channel of exchange rates, it is important to note that there are two conceptual links in the causal chain that underlies the capital accumulation channel. The first being the real exchange rate to the saving rate, and second, from the saving rate to growth (Montiel and Serven, 2008). The second link of saving and economic growth is familiar and has long been an underpinning of mainstream growth process. The first link of exchange rates and savings, however, is controversial both theoretically and empirically. Montiel and Serven (2008) further argue that if the real exchange rate is adopted as a policy target, an improvement in a country’s current account balance resulting from depreciation, increases the country’s saving rate relative to its rate of investment.

A more depreciated real exchange rate can also result in higher saving through a different channel (Levy-Yeyati and Sturzenegger, 2007). Thus, a more depreciated real exchange rate will result in firms paying lower wages in real terms. Lower wages in turn reduce costs of production, inducing firms to invest more. Consequently, firms increase their savings to finance their additional investment, which ultimately raises the aggregate savings. The validity of the capital accumulation channel is subject to debate, for instance, Bernanke (2005) argues that causation runs from a high saving rate to a depreciated exchange rate not the other way round. The rationale behind this reasoning is that, a high saving rate tends to depress domestic demand. In order to sustain internal balance, countries maintain a depreciated real exchange rate. If this view is correct, an empirical correlation between exchange rates and savings cannot be interpreted as the capital accumulation channel at work. Even if the causation runs in the correct direction from exchange rates to savings, the second link of savings to growth might not result because the same high real interest rate that induces a higher domestic saving rate would also tend to discourage domestic investment. Montiel and Serven (2008) believe that the existence of a link between the real exchange rate and the saving rate, as well as the interpretation of that link if it exists is questionable.

The traditional approach poses a challenge when it comes mostly to less economically developed countries which rely mostly on imported capital goods and infrastructure. In as much as devaluation of the currency makes exports cheaper for external buyers, imports in contrast become dearer for local buyers. Local firms which rely on imported capital goods pass the extra cost to customers in terms of high prices thus leading to inflation. Failure to consider this challenge in part resulted in the formulation of the Structuralist approach to exchange rates. Acar (2000) explains that consensus on the view that devaluation leads to output expansion was broken at the end of the 1970s. An alternative line of approach emerged, which raised the possibility that depreciation could be contractionary, especially in developing countries. This approach is referred to as the Structuralist approach.

2.2.2 THE STRUCTURALIST VIEWS OF EXCHANGE RATES

Contrary to the traditional approach, this view argues that currency depreciation might have a contractionary effect on output and employment, especially for less economically developed countries. This approach shows how currency depreciation might cause a reduction in output.

Depreciation of the currency can cause a contractionary effect on output in many ways, but the increase in the price of imports it causes is an important issue and requires much attention. Depreciation increases the cost of imports in particular, and the cost of domestic production in general, through imported inputs Acar, 2000). If the costs of inputs rise, it is possible that they may be a rise in the cost of production and firms will pass this on to their prices. This is because, firms can only get rid of an increase in the cost of production by increasing their prices. This increases the general price level. Acar (2000) notes that “decreasing imports in this context imply insufficient inputs necessary for production. Eventually, because of the lack of enough inputs and increasing costs, production will slow down, leading to a contraction in total supply”. In this case, depreciation would be contractionary in that it causes a slowdown or decrease in the growth rate of output in the economy. Channels through which depreciation may create negative effects on aggregate demand are:

I. REDUCTION IN REAL WEALTH OR REAL BALANCES

As a result of depreciation, prices of traded goods increase relative to non-traded goods. This leads to an increase in the general price level. As prices rise, real money balances (M/P) decline (Acar, 2000). The larger the share of traded goods in the consumption, the more severe the increase in general price level and decrease in real money supply. As real money balances go down, expenditures also fall. Ngandu and Gebreselasie (2006) state that in order to restore real balances a fall in expenditure is needed thereby lowering consumption demand and providing an offsetting contractionary effect on output. The lowering of consumption also implies that the increase in import prices of final consumer goods will diffuse to the consumer price index.

II. NEW INVESTMENT CONSTRAINED BY RISING PRICES OF IMPORTED MACHINERY

A depreciating currency more often than not limits investment of capital and equipment which are usually imported in the case of less economically developed countries. As discussed above, after a depreciation of the Birr, imported goods become expensive and exported goods cheaper. Acar (2000) asserts that this channel seems to be applicable to most developing countries.

Developing countries during the growth phase import much of the capital goods and infrastructure abroad and the expenditure is too high when the currency is weaker. Depreciation on the contrary, may stimulate domestic capital and equipment industries if supported by right policies.

III. THE TIME LAG IN INDUCING NEW TRADED GOODS MAY BE TOO LONG

Traditional exports of developing countries frequently lie in sectors that offer unattractive demand prospects and limited inter-sectoral linkages, such as agriculture and minerals. This means that there may be limited potential for expansion in existing industries (Schweicker, Thiele and Wiebelt, 2006). Currency depreciation might not stimulate investment into new non- traditional exports, except it is generated through foreign direct investment.

IV. INCREASED DEBT AND DEBT SERVICE PAYMENTS IN LOCAL CURRENCY

One of the critical factors that play a role in macro-economic difficulties of less economically developed countries is the existence of a large amount of accumulated external debt stock and the interest burden on it (Caves et al. 1996). For a country that has accumulated external loans denominated in foreign currency, a devaluated local currency means that in real terms the country and businesses pay more than the real worth of the debt, thus influencing the country’s debt servicing capacity. When the currency is depreciating, it is hard for Ethiopians and the government to pay their debts denominated in external strong currencies.

V. WAGE INDEXATION BASED ON FOREIGN AND DOMESTIC PRICE LEVELS

Increased prices for tradables caused by depreciation may lead labour to demand higher wages, which could produce adverse supply effects. Ngandu and Gebreselasie, (2006) agree that the possibility of an inflationary impact of depreciation might lead labour to demand higher wages. If wages are flexible they will adjust to the new prices following the depreciation. Similarly, if there exists a wage indexation mechanism, which automatically increases nominal wages in proportion to price changes, then production costs will increase through higher wages (Acar, 2000). An increase in wages contributes to higher input costs causing a reduction in production, causing output to contract. This might not apply to the Ethiopian context because of high unemployment levels and wage rigidities.

VI. IMPORT COST CHANNEL

Acar (2000) contends that currency depreciation usually takes place when countries have a foreign trade deficit and related external balance difficulties. The opinion holds mostly for developing countries that usually run unfavorable trade balances. The effect of currency depreciation on aggregate demand for a country that has a trade deficit is negative. Following the depreciation, given that imports exceed exports, price increases of traded goods reduce the home country’s real income and raise the real income of the outside world, since foreign exchange payments (import costs) exceed foreign exchange receipts (export revenues).Schweicker et al.

(2006) explain that within the home country the value of foreign savings goes up, aggregate demand goes down, and imports fall along with it. The larger the initial deficit, the greater the contractionary outcome.

The Structuralist approach to exchange rates in a nutshell is a view that holds that exchange rates depreciations can be contractionary. This approach explains that the contractionary effect is due mainly to an increase in price levels through a number of channels. Given this approach, a policy to depreciate the currency can end up contradicting macro policies that seek to stabilize the macro-economy through a reduction in inflation.

2.2.3 BALASSA-SAMUELSON HYPOTHESIS

The Balassa-Samuelson Hypothesis follows the work of Balassa and Samuelson of 1964 who gave a theoretical explanation of the long run trends in the real exchange rates (RER). According to Solanes and Flores (2009) the basis of the Balassa-Samuelson Hypothesis is that there is a positive correlation between the relative economic growth and real exchange rate. It is therefore anticipated that fast-growing countries usually experience real exchange rate appreciations as opposed to slow-growing countries. This theory is in contrast with the commonly held view that depreciation enhances economic growth. It has been subjected to numerous empirical tests5 and found to be relevant in some counties, for example Japan and Korea.

The Balassa-Samuelson Hypothesis is based on the following assumptions: a) there are two sectors in the economy that produce tradable and non-tradable goods, respectively, with the same production function; b) the prices of tradable goods and the interest rate are determined in the world market; c) Purchasing Power Parity holds in the tradable sector; d) labour is perfectly mobile across sectors inside the country, but less mobile between countries; e) wages are led by developments in the tradable sectors, and then translated to the non-tradable sector (wage equalisation across sectors). Given the above assumptions the Balassa-Samuelson Hypothesis is such that:

1. The differentials in productivity growth rates between the tradable goods and non- tradable goods sectors cause relative price changes.
2. The ratio of non-tradable prices to tradable prices is higher in a fast growing country.
3. The ratio of tradable prices across countries remains constant.
4. A combination of 2 and 3 causes a real exchange rate appreciation.

The productivity differential between the tradable and non-tradable sectors is the main determinant of real exchange rates (MacDonald, 2000). Since improvements in the tradable sector productivity are normally linked to economic growth, a correlation between relative economic development and the real exchange rate is also postulated. Thus, it is expected that countries growing faster will tend to experience real exchange rate appreciations with respect to other, slowly growing economies (Solanes and Flores, 2009). This postulation challenges the notion that fast growing countries run depreciated currencies.

The Balassa-Samuelson Hypothesis though applicable in some instances is not in others. It usually suits fast growing countries than slow growing countries. According to Ito et al. (1999), the Balassa-Samuelson Hypothesis may not be applicable when the economy has just come out of being the primary goods exporter or planned economy even if the economy is growing fast.

2.2.4 EXPORT-LED GROWTH HYPOTHESIS

The export-led growth hypothesis postulates that export expansion is a key factor in promoting long-run economic growth. According to Medina-Smith (2001) the export-led growth hypothesis (ELGH) postulates that export expansion is one of the main determinants of growth. This view holds that countries do not only grow by increasing the amounts of labour and capital within the economy, but also by expanding exports. Advocates of export led growth hypothesis argue that exports can perform as an “engine of growth” (Schweicker et al., 2006). Araujo and Soares (2011) contend that stronger exposure to international competition by higher exports is considered to increase the pressure on the export industries to keep costs low and provide incentives for the introduction of technological change. In this vein the growth of exports is seen to have a stimulating influence on productivity of the economy as a whole via externalities of exports on other sectors.

Many industrial economies according to Garnaut et al. (1995) have come to recognize that reliance on world markets, a strategy known as outward looking, gives much greater scope for economic growth than reliance on domestic markets. Outward looking countries, instead of only relying on local markets, can enjoy extended markets abroad which help improve the balance of trade and ultimately exports. James et al. (1989) reckons that the success of the East Asian countries in the 1970s is a result of their adoption of export led growth. James, et al. (1989) further argues that the remarkable growth and industrialization first of Japan, and then of Hong Kong, Taiwan and the Asian tigers (Singapore and Korea) challenged the negativity regarding the applicability of export led growth strategy to other less developed countries.

Agosin (1999) is of the opinion that exports can be a catalyst for income growth, as a component of aggregate demand. The rationale behind this reasoning is that in a small open economy, demand for products is not sustainable in domestic markets to stimulate economic growth. Export markets, in contrast, are almost limitless and hence do not involve growth restrictions on the demand side. Kubo (2011) argued that exporting is beneficial as it enables related firms to avail of certain benefits, such as the enhancement of efficient resource allocation, exploitation of economies of scale, foreign technological knowledge through learning-by-doing and technological innovation stimulated by exposing foreign-market competition.

Palley (2011) believes that export-led growth generates a win–win outcome for developing and industrialized economies. Both the exporter and importer benefit from the global application of the principle of comparative advantage. This is so because export oriented strategies discourage the use of trade barriers and encourage free trade that will at the end benefit the countries involved. Free trade, on the other hand, comes with its own evils, for instance, it can cause an import boom and defeat the same purpose of export growth that countries need to achieve. If unregulated, free trade can lead to dumping whereby countries export poor quality products at cheap prices.

The export-led growth hypothesis is not without its own critiques. One such critique according to Palley (2011) is that in a Keynesian world of demand shortage, trade can reduce domestic demand, leading to reduced output, employment, and national welfare. In the Keynesian world, export subsidies are not a gift but may instead steal demand and employment.

The other criticism leveled against the export-led growth is that it disturbs free trade. Usually exporting countries devalue their currencies to make exports cheaper and reduce imports. This strategy invokes retaliation by other countries which may lead to exchange rate wars, were countries involved devalue their currencies. Also classical economists believe that any employment induced by depreciation is at worst temporary because monetary effects are neutral.

Classical economists’ standpoint is that money is neutral hence inflation caused by depreciation will not affect the real side of the economy (employment, economic growth and output).

2.3 EMPIRICAL LITERATURE REVIEW

A lot of researchers examined the effect of real exchange rate on economic growth using different methods and countries. They came to different conclusions depending on the country, method and time of study. This section presents the various studies done, the methods used, the countries of research and the results obtained.

I. EMPIRICAL LITERATURE FROM DEVELOPING COUNTRIES

Tarawalie (2010) employed econometric techniques using quarterly data to find the relationship between real effective exchange rates and economic growth in Sierra Leone. He also used a bivariate Granger causality test as part of the methodology to examine the causal relationship between the real exchange rate and economic growth. The empirical results suggest that the real effective exchange rate correlates positively with economic growth, with a statistically significant coefficient. These results which show a positive correlation between real effective exchange rate and economic growth are supported by the Balassa-Samuelson hypothesis.

Ndlela (2011) investigated implications of Real Exchange Rate Misalignment in developing countries with particular reference to growth performance in Zimbabwe. The study followed ARDL (autoregressive distributed lag) approach to the co-integration method. The main advantage of the ARDL method is that it can be applied irrespective of whether the variables are I(0), I(1) or fractionally integrated. The main findings show that exchange rate misalignment exerts a negative and highly statistically significant impact on growth. Also the findings support the notion that real exchange rate overvaluation was a key fundamental in the post-2000 economic growth contraction in Zimbabwe. In turn, Masunda (2011) investigated the impact of real exchange rate misalignment on sectoral output in Zimbabwe. To achieve this, the feasible generalized least squares panel data techniques using data for the period between 1980 and 2003 from a sample of Zimbabwean sectors that include agriculture, manufacturing and mining sectors was employed. The study indicated that real exchange rate misalignment is harmful to sectoral output. The findings of the study were that undervaluation negatively affects the sectoral output while exchange rate overvaluation negatively and significantly affects sectoral output.

McPherson et al. (2000) studied the direct and indirect relationship between the real and nominal exchange rates and GDP growth in Kenya for the period 1970 to 1996. A number of approaches that include the following: single equation regressions, a system of simultaneous equations, and a VAR model test and co-integration techniques were used. The results of the study showed no evidence of a statistically significant strong direct relationship between changes in the exchange rates and GDP growth, rather growth responds to fiscal, monetary policy and foreign aid. The results of this study are not supported by the theories reviewed in this chapter.

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