The Effect of Exchange Rate Movement on
Trade Balance in Ethiopia
Presented by Lencho,MPP/IP,
The University of Tokyo

Introduction
The effectiveness of exchange rate
depreciation in improving the trade balance
has long been an issue of considerable
interest to economists and policy makers.
Especially, since the break down of theBretton Woods Accord in 1973, and theadvent of floating exchange rates, there has
been renewed interest on the effect ofdevaluation on the trade balance of bothdeveloped and developing countries.

Objective setting
To briefly look at exchange rate regimes anddevelopments in Ethiopia.
Briefly investigate the structures and trendsof import and export situation in Ethiopia.
To empirically investigate the short run andlong run impact of change in exchange rate
on Ethiopian trade balance.
To make conclusions , policy implications andrecommendations.

Import--Export structure
ImportExternal trade

ExportConcentration
problems

Sectoral(agriculture)
Commodityconcentration(coffee)

Geographic : to and from
North America and Europe

importCapital goods
Consumption
goodsExport – Import structure
Export-Coffee-Hidesand skins-Chat-Gold

ExportImportImport-Fuel-Semi-finishedgoods-Oil seeds-Capital goods-Raw materials-Flower- Consumergoods-Liveanimals-Others

Methodology cont’dLn(TB)= β0 + β1Ln(REERI)+ β2Ln(RGDP)+β3 Ln(MS)+ β4 Ln(TOT)+ β5Ln(RWGDP)+ β6Ln(RGE)+ β7(DDRT)+ β8 (DPC) +Ui -----------(ii)Where Ln is natural logarithm, TB is trade balance inEthiopia, RGDP is real gross domestic product a proxy forreal domestic national income, DDRT is dummy drought orlack of rainfall that takes the value of one for the years ofdrought zero otherwise, MS is domestic money supply,
RWGDP is real world gross domestic product a proxy for real
income of Ethiopia's major trading partners, RGE is real
government expenditure, TOT is external terms of trade,
REERI is real effective exchange rate index, DPC is dummy
policy change which takes value zero (0) for the period pre
1992/93 reform and one (1) for the period then after, and Ui
is the random error term.

Hypothesis Testing
The variable of interest in our study is the realeffective multilateral exchange rate (REERI) andset the hypothesis to be tested in the following
manner.
H0: β1 = 0 (real effective exchange rate
depreciation policy does not have an impact inimproving trade balance in Ethiopia)
Ha : β1 > 0( depreciation is expected toimprove the trade balance and hence enhances
the country’s competitiveness.)

Long run Estimation Results using
OLS
Variables
Cons.

Coefficients
9.235863

Std. Error
9.267340

t-Statistic
0.996603

Prob.
0.3285

LNTOT

0.382464

0.155087

2.4661270.0209LNRGE ( un expected sign)

0.302723

0.197170

1.535342

0.1373LNRGDP-1.797966

1.109507-1.620509

0.1177

LNREERI

0.830719

0.4031012.060822

0.0499LNMS-0.167423

0.457369-0.366057

0.7174LNWGDP

0.027501

0.441595

0.0622770.9508DPC

0.025851

0.328765

0.078632

0.9380DDRT-0.001476

0.145815-0.010123

0.9920R-squared

0.858646
0.813412

Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood

0.209529
1.097555
10.12177

Theeffectofeachvaria
blesonTB

Adj R2 :Mean dependent var-0.822238

S.D. dependent var

0.485067

suggest s agood fitnessAkaike info criterionof the model Schwarz criterion
F-statistic-0.065987
0.338050
18.98255

Sta
tist
ical
significanceof
thevariables

Short run Dynamics con’d
TB = 0.16 + (0.80)REERI +(0.41)REERI(-2) + (0.03)REERI(-3) +(0.32)TOT + (-1.22) RGDP

(2.01)(3.44)(2.08)(0.15)(2.64)+(-2.08)(-1.55) MS(-1) + (-0.90)ECM(-1)(-2.59)(-4.92)
Where, D refers to first difference.
Diagnostics
R2 =0.76 R2 adjusted =0.72 F-statistic =11.43 (0.000000)

DW=2.17

ARCH=0.272078 [0.606194] AR=1.125631[0.344155] RESET=0.004707 [0.945950]
JB=1.204001[0.547715]

Short run Dynamics con’d
The coefficient of the one period lagged value ofthe error from the co integration regression(error correction mechanism-ECM (-1)) is
negative and is less than one in absolute value as
it should be.
The coefficient is expectedly negative and isaround -0.90 suggesting that trade balance
disequilibrium adjusts by about 90 percent
towards its long run equilibrium in each year.

Conclusion
In the long run , trade balance is significantly
influenced by exchange rate depreciation. An
empirical result shows that a 10 % depreciationin exchange rate would result in 8.3%
improvement in trade balance in Ethiopia.
Hence, there is positive relationship between thereal exchange rate depreciation and tradebalance.
In the short run, trade balance is explained by
REER an d lagged other explanatory variables.

Conclusion con’dGenerally, the existence of persistent tradebalance deficit is fundamentally structural innature because Ethiopia's imports are
essential/necessity in nature that they are
price inelastic and therefore cannot simply be
discouraged or easily substituted while
exports are highly concentrated on
agricultural primary commodities that arevery sensitive to whether condition and priceshocks.

Policy implication
The policy implication is that real exchange
rate depreciation improves the international
competitiveness of Ethiopia thereby reducing
its deficit in trade balance and consequently
the balance of payment deficit in the longrun.

Recommendations
To make and keep the country competitive, keeping
track of international exchange rate and pricedevelopments and adjustment of the real exchange
rate accordingly is crucial.
As complimentary policy instrument to real exchange
rate depreciation, compatible policies such as tightmonetary and fiscal policies should be implemented(maintained if they prevail) timely and sequential to
avoid the possible depletion of the competitive
advantage obtained by real exchange rate
depreciation due to rise in domestic prices. In doingso, coordination of these policies is important forfailure to do so will be costly.

Thank you!