The Dynamics of the Exchange Rate and Bilateral Trade Balances: Evidence from Kenya using Nonlinear ARDL Approach

Abstract

This study examines the effect of exchange rates on Kenya’s trade balances with principal trading partners in the period 1975-2013. The analysis confirms the asymmetric effect of the exchange rate on Kenya’s trade balance with her trading partners; establishing the presence of asymmetries in the short run as well as in the long run. Estimations from the NARDL model indicate that Kenya’s trade balances with trading partners respond more to exchange rate movements when the currency is depreciating and less when the currency is appreciating. It is found that depreciations mainly exert adverse effects on Kenya’s trade balance with trading partners in the long run, a finding supported by previous studies which indicated low price elasticities in trade. Policy wise, it would be counterproductive to pursue a policy of depreciating the currency in the face of deteriorating trade balance as such a move would most likely compound the external imbalance.