Discussion Paper No.170 of 2014 on Real Exchange Rate Volatility and Exports in Kenya: 2005-2012

Abstract

The real exchange rate is an important factor in international trade because exports react to real exchange rate movements with respect to the characteristics of the importing and exporting countries. Real exchange rate volatility, therefore, increases uncertainty of profits on contracts denominated in foreign currency, subsequently dampening trade and economic growth. This study investigated how real exchange rate volatility affects export of key Kenyan commodities to the European Union and United Kingdom, namely: tea, coffee and horticulture. The presence of real exchange rate volatility was determined using the GAR CH model. A bounds testing and autoregressive distributed lag model was used to establish the presence of a long run relationship between real exchange rate volatility and commodity exports. Findings reveal that real exchange rate volatility affected tea exports to the UK and horticulture exports to the European Union. Foreign income played an important role in explaining tea and coffee exports to the UK and EU, respectively. It is recommended that greater value addition be done to tea and coffee exports to ensure that their demand increases with increase in foreign incomes.