Exchange Rates Volatility in Developing Countries

Effects of Exchange Rates Volatility in Developing Countries

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Effects of Exchange Rates Volatility in Developing Countries

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Effects of Exchange Rates Volatility in Developing Countries

Introduction

Exchange rates reflect the value that a country’s currency exchanges to a foreign currency. In an ideal world, the exchange rates can be predicted easily. Therefore, they do not affect the international trade of a country. The imports and exports of a country comprise of its activities in the international market. Imports are products that a country’s citizens, government, and businesses from other countries.

On the other hand, exports are products that a country’s citizens, businesses, and government sell to other countries. The exchange rate volatility is unpredictable changes in exchange rates.

Developing countries face numerous challenges such as the negative balance of payments, high inflation, declining growth rates, public debts, interest rates, speculations, and deficits in their current account. Such negative implications on their economies have resulted in low standards of living and underutilization of their resources.

They have also led to the fluctuation of exchange rates in the developing countries (De Grauwe & Grimaldi, 2018). Exchange rates can be used to analyze the economic stability of a country. Stable developing countries have stable or controlled exchange rates. Volatile exchange rates affect countries’ imports and exports.

Risk-averse traders reduce their trading activities to reduce the magnitude of their losses. It also affects the magnitude of trade as the return on investments is uncertain. The volatility of exchange rates encourages local trade thus reducing the amounts of imports.

Apart from exchange rates, other factors affect international trade. One of them is foreign currency reserves. A country needs to have enough foreign currency reserves. That promotes international trade. Inflation rates also affect international trade. When a country is experiencing inflation, the general prices of its goods increase.

That reduces a country’s exports as they are expensive in the international market. It also increases the value of imports and vice versa. International trade is also affected by market forces. The demand and supply of certain goods and services determine whether imports or exports will decrease or increase.

Another factor affecting international trade is trade policies. A country may use trade policies to influence the value of imports and exports in a country. Some trade policies such as export subsidies and trade restrictions on imports are commonly used to protect a country’s products.

Such policies aim at increasing the value of exports and decreasing the value of imports. The prices of oil can also affect international trade in a country. Most developing countries import oil from other countries.

Therefore, when the price of oil is high, the value of imports increases. That affects imports negatively. When the price of oil is low, the value of imports reduces thus the imports to a country increase (examples).

Developing adopt exchange rate regimes depending on their need. There are two exchange rate regimes. In the fixed exchange rate regime, the government determines how its currency will be exchanged. In the floating exchange rate regime, exchange rates are determined by forces in the forex market (Catterall, 2017).

Research question

1. Is international trade of a developing country affected by exchange rates volatility? If so, how do the two relate?
2. Is international trade affected by the real exchange rates of developing countries?
3. Determine the magnitude of the effects of exchange rate volatility on exports and imports of a developing country.
4. Determine differences between the long-run and short impacts of exchange rates volatility on exports and imports.
5. Evaluate the direction of the effects of exchange rate volatility on imports and exports.

Aim of the research

By the end of the research project, the research should have fulfilled its aims. The aims of this research are:

1. The research aims at identifying how exchange rates affect the international trade of developing countries. This research will identify the magnitude by which the exchange rate volatility affect imports and exports.
2. The research also aims at unveiling how the volatility of exchange rates affect the imports and exports of a country. It will show whether imports or exports are affected positively or negatively.
3. This study will also identify how imports and exports are affected differently by exchange rates volatility.

Objectives of the research

The objective of the research will be to investigate how exchange rate volatility affects international trade in developing countries.

Specific objectives

1. The study will be unveiling how the international trade in developing countries is affected by changes in exchange rates
2. The study will analyze how international trade is affected by real exchange rate levels.

Comment :Ths is important. Is it real exchange rate or the nominal exchange rate that is important? What does the theory say? What have others looked at? ????

1. The study will determine the direction of the effects of exchange volatility on imports and exports.
2. The study will differentiate the long-run and short-run effects of exchange volatility rates on exports and imports.

Literature review

Most countries in the world are coming up with policies that will help them embrace the new era of globalization. Such policies will help to control macroeconomic tools such as exchange rates. This chapter will present an analysis of empirical and theoretical literature on the changes in exchange rates.

Theoretical Literature

The effects of fluctuations in exchange rates have been explained by different theories. They are the traditional, risk portfolio, and political economy theories.

The traditional theory

This school of thought uses the degree of risk to analyze the effects of fluctuating exchange rates on exports and imports. According to Hook and Boon (2017), risk-averse, risk-neutral, and risk lovers are affected differently.

For risk-neutral people, their trade activities are not affected by fluctuations in exchange rates. For risk-averse people, they turn to trade in the domestic market to avoid suffering losses. For risk lovers, their trading activities depend on the magnitudes of risks.

Most of them continue trading speculating that they might earn increased returns. Risk-averse companies increase the prices when selling using foreign currencies to minimize the impacts of the risk. According to this school of thought, exports reduces as a result of exchange risk volatility.

Comment : I think generally we expected people and institutions to be risk averse please commnet on this ???.

Risk-portfolio school of thought

According to this school of thought, firms should diversify their portfolios. This school of thought associates exchange rates volatility to increased returns. Therefore, exchange rate volatility encourages risk-neutral companies to increase their participation in international trade to earn higher profits.

According to this school of thought, companies increase the number of their exports if exchange rate volatility creates a higher income effect and reduces exports if exchange rate volatility results in a higher substitution effect. However, this theory does not model firms’ responses to risks.

Political economy theory

According to Tretvoll (2018), this theory explains that fluctuations in exchange rates lead to reduced trade. This resulted from policies that governments come up with to protect the local market. A government may come up with numerous trade policies. Some of such policies are subsidizing exports.

That reduces the costs of producing goods. Therefore, the exporters can continue exporting their goods with a reduced risk of loss. The government can also enforce trade barriers such as increasing the import tariffs to restrict imports. That protects the local market from increased competition and other negative impacts such as flooding.

Empirical Literature

Positive effects

According to Tatliyer and Yigit (2016), fluctuations in the real exchange rate led to an increase in exports. It induces exporters to export their products so that they may gain more profits. The effects of exchange rate volatility lead to devaluation of a country’s currency.

That leads to increased FDI, exports, and imports. That was observed to happen when the fluctuations in the exchange rate led to the depreciation of a country’s currency. A weaker currency promoted exports as they were more expensive in the international market. Imports became more expensive in the local market thus the value of imports reduced.

However, the effects of fluctuations in exchange rate depend on whether they make a currency strong or weak. That is a factor that cannot be controlled when conducting research.

Taşseven et al. (2019) studied the short-run and long-run determinants of the trade balance in Turkey. He used data from 1974 to 2017. In the research, he found that in the long-run, there was a positive correlation between the trade balance in Turkey and the real exchange rate. In his study, he revealed that real exchange rate elasticities were positive thus resulting in devaluation in the long -run. That lead to an increase in international trade.

Negative effects

Nisthar and Mustafa (2019), studied the relationship between the effects of fluctuating exchange rates in 13 countries. They found out that exchange rate volatility affects exports and imports.

According to their study, appreciation of currency led to a negative balance of payments thus resulting in countries enforcing exchange rate controls and trade barriers to protect the economy and vice versa. Exchange rate volatility also makes the decision-making process difficult because of the uncertainties. Thus, it reduces international trade.

Augustin and Song (2018) investigated the risk associated with exchange rates and the equilibrium quantities and prices in international trade among developing countries. According to the research, increased exchange rate risks reduced the revenues and incentives from the exports.

Therefore, exchange rate risks affected the value of exports negatively. The study also revealed higher risks in exchange rates created a lot of uncertainty in the trade. Economic agents were unable to predict the trends in international trades thus companies and countries could not project the value of their trade.

Ambiguous effects

Some studies show the absence of consistency in the relationship between fluctuating exchange rates and imports and exports in developing countries. Asteriou and Pılbeam (2016) agree that the effects of exchange rate volatility are ambiguous. That depends on the assumptions used as exchange rates are responsive to time.

The prices of goods and services are affected by the party taking the risk. In the case of an importer, fluctuations in exchange rates reduce the prices and demand if they take the risk. In case an exporter takes the risk, the prices are expected to increase due to the risk premium charged.

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Methods

The research will use secondary data. The data used will be obtained from yahoo finance, world data atlas, World Bank database, and international monetary fund database. I will use data from the last ten years. That will enable the research to use the most recent data.

That will ensure that the research considers the current conditions in the international market. I will use the data on exports and imports and the data on exchange rates.

I will use a log-linear regression model to determine the effects of exchange rate volatility on imports and exports in developing countries. When carrying out the regression analysis, the variables used will be the real exchange rate, the value of imports, the value of exports, the ratio of imports to exports (terms of trade), domestic national income, foreign national income, prices of oil and the real exchange rate volatility.

I will use correlation analysis to measure the direction and the magnitude of the relationship between exchange rate volatility and imports and exports. To estimate the long-run relationship between exchange rate volatility and exports and imports, I will use the cointegration analysis.

Effects of Exchange Rates Volatility in Developing Countries

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