# **5.2     The impact of devaluation on the trade balance**<sup>**7**</sup>

This section empirically addresses the question of whether a real exchange rate depreciation will improve the balance of trade in Ethiopia (Haile, 2015a). The analysis is based on annual data for Ethiopia covering the period 1980-2013 and employs multi-equation time-series approach. A real devaluation could improve the balance of trade via increasing exports and discouraging imports. Currency depreciation should positively impact on exports of the country because they are more competitively priced than identical products from other countries, all else being equal. There is, however, no clear-cut theoretical relationship between movements in the exchange rate and the trade balance. The reason for this is that exports may not strongly respond to exchange rate changes while the value of imports may not significantly decline as the country now pays higher price for a given quantity of imports. This is nonetheless an empirical issue and should be settled based on thorough empirical analysis.

There are some preconditions that should be fulfilled for the benefits of a real devaluation to materialize. In particular, the well-known Marshall-Lerner (ML) condition must hold for a devaluation of the birr to improve the trade balance position of the country. The ML condition states that an exchange rate devaluation (or depreciation) will have favorable impacts on the balance of trade only if the responses of export and import demand to the devaluation-induced price changes are sufficiently strong. Technically speaking, the sum of export and import demand elasticities should be greater than one in absolute value. A real depreciation would lead to an increase in the quantity of exports and a decline in the quantity of imports, and thus have a net positive impact on the trade balance. Specifically, a depreciation renders the cost of foreign goods higher relative to the cost of domestic goods, which instigates foreign consumers to buy more of the country’s exports and domestic consumers to buy fewer imported goods, thereby resulting in a positive quantity effect on the balance of trade. However, there is an offsetting cost effect stemming from a rise in the cost of imports. Therefore, the net impact depends on whether the quantity effect or the cost effect dominates. If the quantity effect outweighs the cost effect, the ML condition is satisfied.

**Table 1. Effects of RER Undervaluation on Export and Real Output Growth in Ethiopia**

|**Dependent**|**∆ln(real exports)**|**∆ln(real GDP)**|
|---|---|---|
|**Variable**|**(1)**|**(2)**|
|ln(Initial Real Exports)|–0.203**<br>(0.076)||
|ln(Initial Real GDP)||–0.104**<br>(0.044)|
|Undervaluation|**0.523****<br>(0.233)|**0.226*****<br>(0.064)|
|Constant|1.674***<br>(0.577)|0.807**<br>(0.307)|
|R-squared|0.151|0.340|

Note: Newey-West HAC Standard Errors in parenthesis. ***, **, * indicate statistical significance at the one, five, and ten percent, respectively. Source: Nguyen (2014).

In particular, the empirical analysis asks whether the ML condition holds for Ethiopia and whether a devaluation causes significant trade balance deterioration in the short-term. Note that even if devaluation is effective in improving the trade balance in the long-term, it may worsen it in the shortterm as trade in goods may tend to be inelastic while import prices increase in the immediate aftermath of a change in an exchange rate. Some previous studies find that it may take time to change

> 7See Annex III for more technical details on this section.

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