The effect of real effective exchange rate volatility on Uganda's trade balance

Abstract

The purpose of this study was to investigate the effect of Real Effective Exchange Rate (REER) volatility on Uganda’s trade balance. Since the adoption of the flexible exchange rate system in 1993, Uganda has experienced rising deficits over the years which could be arising from the real effective exchange rate volatility. As a result, the continued deficit in trade balance may erode the country’s competitiveness and hamper economic growth and the attainment of the country’s growth rate target of over 8.2 percent per annum as envisaged in the vision 2040. The study employs time series econometric techniques including GARCH model, ARDL and other standard diagnostics to estimate the relationship between REER volatility and the trade balance. The results of the ARDL revealed a negative relationship between the trade balance and the volatility of the real effective exchange rate in the short run and a positive though insignificant relationship in the long run. The Impulse Response Function results show evidence of the J-Curve on Uganda’s trade balance, a sign that depreciation of the real effective exchange rate initially deteriorates the trade balance and finally improves it in the long run. Also the results on the REER indicate that the Marshal-Lerner Condition holds for Uganda’s case. From the findings, the study recommends that policies such as developing a well-developed hedging facility like forward markets and institutions that protect exporters against exchange rate risk in the short run should be geared towards reducing volatility of the real effective exchange rate with the aim of improving Uganda’s trade balance.