Macro-economic determinants of Kenya’s trade Balance

Abstract

Trade balance is a critical component of a country’s current account balance and the balance of payment at large. Over the years, Kenya has experienced trade balance deficit with threats of slowing down the pace of economic growth and development. Despite implementation of various interventions such as import substitution strategies in 1960’s, export promotion and liberalization policies of 1990’s, there are still persistent imbalances and deterioration in trade balance, which is a serious problem for the country. Existing literature show that macroeconomic factors explain trade balance. However, there exists limited literature regarding the effect of macroeconomic variables on Kenya’s trade balance. Thus, the purpose of the study was to investigate macroeconomic factors determining balance of trade in Kenya. Specifically, the study sought to: determine the effects of terms of trade, trade openness, real exchange rate, economic growth, inflation, and foreign direct investment on Kenya’s balance of trade. The study was guided by elasticity, absorption, monetary and imperfect substitute theories. The study employed correlation research design to establish direction of the relationship between trade balance and its determinants. The study used annual secondary data for a period of 54 year (1963-2016). This data was collected from various sources which include: World Bank database, Kenya National Bureau of Statistics and the Central Bank of Kenya. To achieve the objectives, Vector Error Correction Model (VECM) was employed. First, the study performed stationarity test using Augmented Dicky Fuller test. The test at level revealed that all the variables under investigation had unit roots. The variables were transformed through differentiation and tested again. All the variables were now stationary. In addition, Johansen co-integration test was performed to predict the existence of long-term relationship. This test was positive (trace statistics for all equations were greater than critical values at 5% level) implying, existence of a long run relationship in the series. This confirmation meant that the study had to employ VECM as opposed to Vector Autoregressive mode (VAR). Findings of the study indicate that terms of trade, and trade openness have a positive and significant effect on trade balance (10437, P-value 0.028 <0.05) and (36739.4, p-value 0.000 < 0.05) respectively. Similarly, foreign direct investment, and economic growth variables have a significant, and positive effect on trade balance (295.0472, p-value 0.034<0.05), and 6767, p-value 0.046<0.05) respectively. On the other hand, the study reveals that real exchange has a negative and significance effect on trade balance (-211.5063, p-value 0.046). The study concludes that, terms of trade, trade openness, foreign direct investment, real exchange rate and gross domestic product have a significant and a positive long-term effect on trade balance in Kenya. On the other hand, real exchange rate has a negative significant and a long-term effect on the balance of trade. Based on these findings, the study recommends that the government should create a conducive business environment to encourage foreign direct investment, exports and economic growth. In addition, the government should employ sound monetary and fiscal policies to stabilize exchange rates.