Exchange rate volatility and its effect on macroeconomic management in Rwanda
Prepared by Wilberforce NUWAGIRA
July 2014
The views expressed in this Working Paper are those of the author and do not necessarily represent those of COMESA. Working Papers describe research in progress by the author and are published to elicit comments and to further debate.
Abstract
In this study, we investigate exchange rate volatility and its impact on macroeconomic management in Rwanda. To establish the empirical relationship between exchange rate volatility and its impact on macroeconomic management, we build our analysis on quarterly data spanning the period 2000Q1-2013Q4 and different quantitative techniques are employed; we utilize structural vector autoregressive model (SVAR), Vector error correction model (VECM), Granger causality, generalized conditional autoregressive model (GARCH) and threshold autoregressive model (TAR). The econometric analysis starts with testing the stochastic properties of data and we find most variables integrated of order I (1) save for lnexp and lnexchrate_vol. Accordingly the paper proceeds by measuring the exchange rate volatility using GARCH model and on the basis of exchange rate volatility and other variables specified in the model we Estimate SVAR model and vector error correction models and the main empirical result indicate that exchange rate volatility has a negative impact on Rwanda’s exports .Other variables like gross domestic product, investment, current account balance and CPI inflation are insignificant to exchange rate shocks but emerge correctly signed. The study further confirms that there is a threshold level (4.33) beyond which exchange rate becomes disruptive. In the view of these findings a number of policy implications emerge which are also discussed in the present analysis.
Key words: Exchange rate volatility, GARCH, SVAR, VECM, Granger causality and TAR
I. Introduction
The real exchange rate is one of the key economic indicators of the economy’s international competitiveness, and therefore has a strong influence on a country’s macroeconomic management particularly foreign trade developments. Many developing economies have experienced high real exchange rate volatility and this translates into high degree of uncertainty for the two main monetary policy objectives that policymakers often seek to achieve: price stability and economic growth.
Exchange rate volatility[1] is a central theme in the debate on the performance of exchange rate regimes. The consequences of this volatility for economic activities have always been a major concern for policy makers. After World War II, the Bretton Woods agreements created the International Monetary Fund and set up a world-wide system of fixed exchange rates. One objective of this system was to foster international exchanges of goods and services.
In 1973, the Bretton Woods system was abandoned and many countries allowed their exchange rates to float. The consequence was an increase in exchange rate volatility thus, the debate on the optimal management of exchange rates attracted renewed attention and indeed experience shows that the relationship between exchange rate volatility and macroeconomic developments have been extensively studied in both theoretical and empirical studies.
Researchers for instance, clarida (1999) argue that the demise of the Bretton Woods exchange rate system has led to significant fluctuations in both real and nominal exchange rates. The liberalization of capital flows and the associated intensification of cross border financial transactions appears to have exacerbated the volatility of exchange rates. Indeed a study by Flood and Rose (1999) indicate that exchange rate volatility can have negative effect on international trade particularly exports. The impact of global economy on developing countries like Rwanda is significantly driven by swings among the currencies of major economic powers-the overvaluation of the exchange rate undermines non-resource exports and has adverse implications for growth.
Exchange rate assessment is a crucial element in evaluating Rwanda’s international competitiveness and thus its macroeconomic performance and sustainability of its policies and therefore has assumed a prominent place in economic development strategies as a measure of export competitiveness.
Despite Rwanda’s impressive growth rates and its ability to maintain the stability of her currency, her economy is still characterized by both internal and external macroeconomic disequilibria, alongside low savings and investment rates. In addition, her exports are mainly composed of traditional commodities like coffee, tea and minerals whose prices are subject to fluctuations on the international market. This has prompted the government of Rwanda to undertake reforms aimed at revamping the economy.
Since 1995, Rwanda has undergone a process of far-reaching economic and financial reforms featuring particularly in trade and exchange rates. However, empirical evidence reveals that there is a widespread presumption that volatility on the exchange rates of developing countries is one of the main sources of economic instability around the world.
For Rwanda like any other developing country adhering to floating exchange rate, exchange rate volatility is inescapable fact of life. It is not in itself a bad thing since exchange rate movements are part of the adjustment mechanism through which economies react and readjust to new sets of information and economic shocks nonetheless some argue that exchange rates are too volatile given the underlying economic fundamentals and create significant management problems for the financial institutions, businesses and economic policy makers. In the light of recent macroeconomic developments in Rwanda, it becomes quite important to examine the effects of exchange rate volatility on the economy.
Despite vast literature on the effects of exchange rate volatility on macroeconomic management, little has been done to assess the impact of exchange rate volatility on macroeconomic management citing Rwanda’s case. This study attempts to fill this gap by exploring the impact of exchange rate volatility on macroeconomic management in Rwanda.
Secondly, the studies that dealt with the exchange rate volatility and its effect on macroeconomic management have yielded mixed results. This prompts the need to attempt to shed light on this issue by providing empirical estimates on exchange rate volatility on macroeconomic management whose results would give an idea for policy makers about the level of real exchange rate volatility and serve as a basis for policy oriented recommendations related to the modeling and the choice of exchange rate regime.
The objective of this study is to investigate the exchange rate volatility and its effect on macroeconomic management in Rwanda, establish the extent beyond which exchange rate becomes disruptive and give the appropriate macroeconomic policy to minimize the volatility of exchange rates and their impact on Rwanda’s macroeconomic management.
The rest of this paper is structured as follows. Section 1 entails introduction, motivation of the study, objectives and scope of the study. Section 2 includes overview of Rwandan economy as relates to exchange rate volatility and macroeconomic management, section 3 includes both theoretical and empirical literature as relates to the study section 4 describes the methodology to be followed, and section 5 reports empirical results and section 6 presents discussion of results, conclusion and recommendations.
II.Overview of exchange rate and macroeconomic management in Rwanda
As an open low income country, Rwanda considers exchange rate as a key macroeconomic policy instrument that ensures export promotion and economic growth. The main goal of Rwanda’s exchange rate policy is to provide a conducive environment that promotes exchange rate stability and support the government’s objective of accomplishing export-led growth.
In view of the above, the exchange rate policy in Rwanda is analyzed in two distinct periods; the first period reflects a system of fixed exchange rate and the second period, a more flexible exchange rate system.
During the fixed exchange rate system, foreign currencies of the banking system were held by the central bank, it was the sole institution authorized to carry out exchange transactions. The exchange rate was initially pegged to the Belgian franc, then to the American dollar and finally to the special drawing rights (SDR). Its value did not reflect economic reality due to lack of exchange rate flexibility (Himili, 2000). During this period, the exchange rate seemed to be overestimated; causing the rising of effective prices of Rwandan exports and loss of competitiveness on the international market. However, many reforms of exchange rate system were undertaken since 1990 to correct the overvaluation of FRW and improve external competitiveness.
The statutory order n° SP 1 of 3rd March 1995 organizing the foreign exchange market instituted a flexible system of exchange of RFW. To avoid the risks related to the flexible exchange system, the central bank has chosen a more flexible exchange rate policy of FRW with nominal anchor, which links the level of exchange rate to the fundamentals of the economy. The reform of the exchange rate system began with the launch of the structural adjustment programs (SAP) in 1990. Residents were authorized to hold accounts in foreign currencies in commercial banks since 1990, while in 1995, the flexible exchange rate system was introduced and new exchange control regulations were put in place. The main features of these new regulations are: full liberalization of current and capital account operations, determination of the exchange rate by the market, introduction of foreign exchange bureaus, authorization of foreign direct investment in Rwanda and the transfer of returns on investment abroad.
Other measures were taken later to supplement these exchange control regulations for instance the right granted to exporters to own and use their foreign currency export proceeds and authorization given to residents to withdraw money from their foreign currency accounts without providing any justification. For some operations, however, prior approval from the BNR was maintained; this concerned invisible operations (medical care, tourist trips, etc.) for which the purchase of foreign currency was subject to ceilings and capital transfers abroad that were not related to current operations
The objective of this flexible system is approaching as much as possible the exchange rate equilibrium level; to stabilize prices and support growth. Under this system, BNR intervenes on foreign market to smoothen the volatility of exchange rate using its reference rate as the average of interbank exchange rate and the BNR intervention rate.
Fig 1: Bilateral nominal exchange rate of RWF (1980-2013)
Source: BNR, Monetary policy and Research Department
Figure 1 clearly shows that Rwanda’s bilateral nominal exchange rate generally appreciated due to rigidity in exchange rate during the period 1980-1990s and it started depreciating from 1995 with the advent of financial liberalization that led to exchange rate flexibility which reflects changes in economic fundamentals. Up to now minor fluctuations prevail but the trend shows that exchange rate has remained relatively stable. However, being driven by market forces, the exchange rate has been under relative pressure since 2012 emanating from a swift increase in foreign exchange demand on the account of increased demand for imports.
The Rwandan currency depreciated by 4.9% against the US dollar in 2013 against a depreciation of 6.71% registered in 2000. RWF also depreciated by 2.0% and 11.3% against the Great Britain Pound sterling and euro respectively compared to 4.20 and 1.01 in 2000
Similarly, in the context of EAC, the RWF depreciated against Kenyan shillings and Tanzanian shillings by 2.6% and 3.0%, while appreciated against Ugandan shillings and Burundian franc by 0.1% and 3.5% respectively. From the above trends, it is clear that since 2012, RWF has faced persistent swings however, BNR through its policies and measures including effective communication and market displine has managed to ensure stability of Rwandan currency.
Figure 2: Development of REER in Rwanda
Source: BNR, Monetary Policy and Research Department
The figure below depict the trends of the three time series of REER obtained by using different weights from imports ( REERm), exports ( REERx) and total trade ( REERt).
A closer look at the figure above shows that since 2005 the real effective exchange rate has been appreciating but a sharp real appreciation is observed in 2008 mainly due to the appreciation of the nominal value of the RWF against the currencies of major trading partners. The RWF appreciated by 1.9% against the Kenyan shillings, 5.6% versus the Burundi franc, 0.01% against US dollar,7.4% compared to the British Pound and by 13.6% against the South African Rand. On the other hand, the appreciation of the real effective exchange rate in 2008 was due to high inflation in Rwanda during this period compared to prices in the major trading partners. Indeed inflation rate was 22.4% in Rwanda, 16.3% in Kenya, 14.2% in Uganda, 13.5% in Tanzania, 1.6% in Euro Area, 3.1% in United Kingdom and 0.1% in the US. However, we observe moderate REER depreciation since 2012 up to present but RWF remains quite stable as moderate bilateral depreciation against USD, GBP and EURO during this period is insulated by an increase in relative prices given that domestic inflation has increased in relation to foreign inflation and the slowing pace of nominal exchange rate depreciation.
Table 1: EAC currencies depreciation against USD (2008 – 2013)
Year / USD/RWF / USD/KES / USD/UGX / USD/TZS / USD/BIF2008 / 2.64% / 21.98% / 16.50% / 15.37% / -0.04%
2009 / 2.26% / -2.46% / -3.47% / 0.53% / 8.92%
2010 / 4.06% / 6.51% / 21.41% / 10.47% / -0.58%
2011 / 1.63% / 3.66% / 5.75% / 7.88% / 3.94%
2012 / 4.51% / 1.06% / 7.25% / -0.20% / 18.09%
2013 / 6.12% / 0.76% / -4.98% / -0.04% / 1.13%
6 Years Average / 3.54% / 5.25% / 7.08% / 5.67% / 5.24%
Source: BNR, Financial Markets Department
The stability of RWF has been mainly attributed to good performance of external trade coupled with the increased inflows from Budget support. Regarding external trade, the Rwandan export sector continues to register good performance on the account of impressive performance of formal exports whose value stood at USD 573 million in 2013, representing an annual increase of 18.7%, while the volume increased by 6.8%. In the same period, formal imports free on board(FOB) slightly increased by 2.2% in value amounting to USD 2247.4 million and by 4.3% in volume. As a result, the trade deficit reduced from USD 1276.6 million recorded in 2012 to USD 1224.9 million in 2013 and Import cost insurance freight (CIF) cover by exports increased to 25.4% against 22.9% recorded in 2012. Including informal cross border trade, exports covered 30% of imports from 27.7% in 2012.
As a consequence, in 2013 the overall balance of payments recovered from a deficit of USD 205.5 million recorded in 2012 to a surplus of USD 223.4 million and the BNR’s intervention on domestic foreign exchange market declined from USD 455 million sold in 2012 to USD 322 sold in 2013. However, during the last two years the Rwandan franc recorded upward trend depreciation due to an increase in imports of goods, especially the capital and intermediate goods to finance the 8.6% and 8.0% GDP growth rate that the country has recorded in 2011 and 2012 respectively.