Effect of selected macroeconomic variables on the volatility of foreign exchange in Kenya

Abstract

The volatility in the real exchange rate often results in major changes within the global economy and other macro-economic factors within an economy. The Kenyan shilling enjoyed a period of relative stability between October 1999 to December 2005 but later, the shilling experienced some fluctuation in the real exchange rate appreciating by 30 % to the US Dollar in the period between 2006 and 2013. The study established the effect of selected macroeconomic variables on the volatility of foreign exchange in Kenya from 1999 to 2018. The study had four-fold objectives; to establish the effect of interest rate on foreign exchange volatility in Kenya; to examine the influence of foreign direct investments on foreign exchange volatility in Kenya; to establish the effect of inflation rate on foreign exchange volatility in Kenya; and to determine the effect of the balance of payments on foreign exchange volatility in Kenya. The study was underpinned by the theories of comparative advantage and purchasing power parity. The theory of comparative advantage hypothesis that nations stand to benefit from comparative production cost advantages drawn from specialization and are transformed into absolute money price advantages. Money is a neutral and function as a means of exchange in facilitating international trade. The study adopted an explanatory research design and used documentary analysis to collect secondary data from the published annual reports from the Kenya National Bureau of Statistics (KNBS) and the Central Bank of Kenya spanning twenty years from 1999 to 2018. The data collected included the monthly data on the real exchange rate, interest rates, core inflation rates, inflows and outflows of the balance of payments and foreign direct investments. Once the data had been collected, the data were organized and analysed using descriptive and inferential statistics. The study used a graphical presentation to present the elementary information on the trends of the study variable. The results from the GARCH models indicated that volatility is associated with the balance of payments, interest rate and inflation rates while the foreign direct investments had no influence. The long-run models from the VECM models show that volatility in the foreign exchange rate responds faster to previous period volatility at 35.22%(χ2 = 38.249, p<0.05), inflation rate at 29.55%(χ2 = 29.355, p<0.05), interest rate at 27.37%(χ2 = 26.373, p<0.05) and balance of payment at 22.53%(χ2 = 20.255, p<0.05) but not the FDI at 9.16% (χ2 = 7.059, p>0.05). Based on the findings, the study rejected the null hypotheses that inflation rate, interest rate and balance of payment have no influence on the volatility of the foreign exchange in Kenya and concluded that the selected macro-economic variables (the interest rate, the inflation rate and balance of payments) significantly influenced the foreign exchange rate in Kenya. The findings showed that the selected macroeconomic variables impacted on the stability of the exchange rate in Kenya. The study recommends that the government seeks way to stabilize the local currency against fluctuations by pursuing initiatives that will attract foreign exchange inflows such as encouraging exports and import substitution aimed at reducing trade deficits while pursuing monetary policy regimes that stabilize inflation and interest rates.