1. Exchange rate and trade
balance in Ethiopia; j curve
effect
February 2013 1

2. Chapter One Introduction
1.1) Background of the study
Forex/Fx:how it
works???
Market for currency; biggest and 24 hrs in a day ,7 days in
complex one a week
Trading entirely on computer
The “bid” and “ask”
Traders, speculators involved
Euro/JPY,USD/CHF and
currency quotes; A” bid”
CAD/USD are popular and the price at w/c u can
common pairs sell and “ask” is a price u
Forex mkt(takes the notion of can buy
mkt in economic) is just
mechanism not a common place No commission charges;
….all trading done over brokers make profit Via
computer ask and bid quotes
2

3. Review of foreign
currency reserves
Certain figures in Africa
on forex Have got accumulated
recently from high export and
aid flows
Adequacy in reserve allow to
London mkt borrow and hedge against
largest(36%) instability in external capital
flows but there are forgone
Newyork(18%)Tokyo( costs from investment and
6%) social expenditure that could
be financed by these reserves
USD accounts 85% rather(Elhiraika andNdikumana;
euro 40% Yen 19% 2007)
3

4. Reserve accumulation seen as
a tool for maintaining low
exchange rates in order to Review of reserve in
promote trade Ethiopia
competitiveness: mercantilist Began depleting Sep 2007
motive (Aizenman and Lee By end of Nov 2008 it had
2005). reached a record low of just
one month of imports(result
in rationing(a temporary
strategy) foreign currency to
rebuild)
4

5. Certain figures on gross
foreign Reserves of of NBE
2.0 months of import of goods and non-factor
services(at end of 2008/09)
2.4 months of import(1.5 Billion USD) (On
June 2009)
2.2 months of import of goods and non-factor
services(on July 7, 2010)
5

6. Figures on Export and import
components in Ethiopia
Export 1980 Import 1980
Coffee(62%), leather and leather Capital goods(averaging
products(11%),oilseeds(3%) 34%),
Export 2008/09 Capital goods37%(1980-
Coffee(26%),leather and leather 1990) to 31%(2000-2009)
products(5%),Oilseeds(25%)
On export 2009/10
Consumer go0ds(29.5%)
Coffee(26%), Oilseeds(17%) Raw materials 3.1%(1980-
Gold (14%)and chat(10%), 1990) to 2.2%(2000-2009)
A shift in share of exports and a A shift of import sources from
shift in destination(south-south trade Europe to Asia(what a
w.r.t Asia and Africa) were dramatic import from china!!!)
observed(Tewodros Makonnen;
6
2012)

7. 1.2) Statement of the problem
Despite growth in export(mainly from the
agricultural sector) , magnitude of trade deficit
has increased(Birr 40,320.7 million in 2005 to
Birr 72,822.3 in 2009, with an average growth
rate of nearly 16%) .Due to the high cost and
dependency on imports and the slow growth of
exports (Samuel and Tarekegn; 2011)
Country’s industrial base failed to boost the
export of or to produce substitutes : in order to
narrow the ever widening trade deficit.
7

8. The country reported( in 2009) huge deficit even
on agricultural goods :where it has the potential
to narrow the gap such as Soya bean, wheat
flour, grain sorghum etc.
Does devaluation improve trade balance?
A surprise in devaluation of birr in August
31, 2010 from a value of 13.63 to the US dollar
to 16.35 as an effort to boost export;.
The move ,by itself, might not address the trade
problem
8

9. Certain points That Devaluation
Might Prove To Be
Disappointing
First, the trade balance will correct only if: the sum of
the import and export demand elasticities greater than
one
developing country context :believed to be low at least
in SR
Market structure :to dampen the impact of the
devaluation. A market for developing nations are
dominated by a few major international buyers who had
market power
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10. Because of this market structure, little benefit
for the Ethiopian producers (hence limit supply
response)
An excess or spare capacity must exist ready to
meet the demand
devaluation affects intermediate and capital
goods that are imported from abroad hence;
affecting domestic production in a negative way.
In the unlikely event that other trading partners
follow suit or take other retaliatory measures.
May trigger mini trade war involving
Ethiopia, its neighbors and her major trading
partners (Bienen et.al; 2010) 10

11. There is a doubt about enough available
domestically (Ethiopian) produced goods which
both domestic and foreign consumers wish to
buy(evidence ; the cause of inflation in 2008 and
thereafter is due to shortage of food items)
The times, how long will it take for both domestic
and foreign consumers to adjust their preferences
and switch towards Ethiopian-made goods matter
as well.
Others ; bring the theory of J-curve to play:
though devaluation deteriorate trade balance in SR
it could lead to positive result in LR
11

12. There is some support in theory for J Pattern but
again it is up to empirical evidence and that is why
the researcher is interested to support or reject
theory in Ethiopia.
The study will employ a time series econometrics on
data set available period 1974 – 2011.
Lulit Asefa has done impact of exchange rate on
trade balance (1992-2007).
This study will fill the gap(2008-2011) and will
also assess the trade balance pattern to the period
1974-1991
12

13. Hypothesis of the study
Previous research has tested the theory of J curve for
many developed and developing countries(little
attention at/to African countries)
Glenville Rawlins and John Praveen (1993) have done
on nineteen Sub-Sahara African countries(Burkina Faso,
Cameroon, Central African Republic, Côted'Ivoire,
Gabon, The Gambia, Ghana, Kenya, Madagascar,
Mauritius, Niger, Nigeria, Rwanda, Senegal, Sierra
Leone, Tanzania, Togo, Zaire, and Zambia).
13

14. Based on the analysis; in 17/19 countries:
devaluation improve trade balance though it is
not continuous. For only two of indicate J curve
but based on t-statistics only the J exist in
Tanzania
Mohsen Bahmani-Oskooee and Abera
Gelan(2012) had test J curve for nine African
countries ( Burundi, Egypt, Kenya, Mauritius,
Morocco, Nigeria, Sierra Leone, South Africa,
and Tanzania ).They were unable to find any
support for the J-Curve
Two reasons that the researcher don’t expect J
curve to hold in Ethiopia
14

15. A prominent professor of accountancy who has
published a number of professional articles on
sub-Saharan stated: The J curve has not been
observed in many African countries; hence there
is little reason to expect it in Ethiopia.
Some others said , the J-curve effect holds true
only if a country has a balanced BOP position at
the time of devaluation, which is not the case in
Ethiopia; Right?
15

16. Objectives of the study
General objective;
to examine the existence of j curve effect of
devaluation on trade balance
Specific objective:
To investigate the short run and long run
relationship between real exchange rate and trade
balance
To examine the pattern of trade balance during
in the two recent regimes; Derg and EPDRF
regimes 16

17. Scope and significance
1) Scope of the study
Idea scope: relationship between exchange rate, domestic income,
foreign income with trade balance;
Time scope :1974-2011 (the two regimes period)
Of course the area scope :is on multilateral trade balance in
Ethiopia
2) Significance of the study
Serve as a road map for policy makers on the short run
and long run relationship between exchange rate and
trade balance in Ethiopia on a particularly specified
period
it will contribute to the existing literature in the area.
17

18. Methodology of the study
Data type, data description and time series characteristic
logarithms
of trade balance (TB)
Real effective exchange rate(RER) and
domestic GDP and
World Industrial Production Index /US GDP
will be used as a proxy variable for foreign
income(Y*)
export and import values will be used for
calculating TB ratio measure 18

19. Model specification
In general: Three approaches for estimating j curve
Bahmani-Oskooee(1985) employed an aggregate data
Rose and Yellen(1989) used bilateral data
Bahmani-oskooee and Wang(2008) used sectoral data
However, the researcher will use only the first
approach of estimating J curve : employing an
aggregate trade data/ multilateral trade model.
19

20. Model used; a reduced form model employed by Rose and Yellen
(1989)and Bahmani-Oskooee (1991)
Model assumptions:
both exports and imports are imperfect substitutes for
domestically produced goods
the market clearing condition that equates the domestic
demand for imports to the foreign supply of exports.
the demand variables are represented only by current
income rather than permanent and transitory income.
homogeneity of the demand function is assumed, so that
the consumer does not suffer from money illusion -
demand will remain constant when doubling money
income and prices. 20

21. The standard "two-country" imperfect substitute model is as
follows
Domestic demand for import (Md), and the demand
for import by the rest of the world (M*d), are given
by equations (1) and (2):
Md F(Y,Pm,P)……………(1)
Md* F(Y*e,P*m,P*)………………………(2)
21

22. Where Y is domestic income,
PM the domestic currency price paid by domestic importers
and P denotes the overall domestic price level,
Y* represents foreign income,
e the exchange rate expressed as the domestic currency price
of foreign exchange,
P*M denotes the foreign currency price paid by domestic
importers and
P* the overall foreign price level.
In other words, the quantity demand is a function of the level
of money income in the importing region, the imported goods'
own price and the price of domestic substitutes.
22

23. From homogeneity assumption dividing the explanatory
variables on the right hand side by P.
23

24. the relative price of imports is equivalent to
the foreign currency price of foreign exports
adjusted for the exchange rate hence:
RPm eP*x/P=(EP*/P)(P*x/P)=(1/Q)RP*x ……….(5)
Where P*x is the foreign currency price of foreign exports
Q is the1)real exchange rate defined as the relative price of
domestic to foreign goods
{ i.e Q=P/(EP*)} and RP*x the relative price of foreign
exports to foreign produced goods
24

25. Substituting RPm from equation 5 in to equation 3 we
obtain
Md Md(RPx*/Q ,Y)…………………………..(6)
……….(2)
Similarly foreign country’s demand for imports
depends up on foreign income and domestic
relative export price;
M*d Md*(RPxQ ,Y*)…………………………..(7)
25

26. Domestic exports are foreign imports and vice versa
Xs= M*d X*s= Md ……………………..………………......(8)
……….(2)
trade balance TB as the following ratio
TB= Md / Xs = Md / M*d Md(RPx*/Q ,Y)/ Md*(RPxQ ,Y*) …………(9)
……….(2)
Assuming constant or stationary values of RPx and RPx* we
can write the above equation in general form:
TB=TB(Q,Y,Y*) ……………………….(10)
26

27. The log-linear functional form approximation is
Log TB t α β Log Yd, t γ LogYW, t λ Log REX t ε t (11)
Yd (Yw) is a measure of domestic (foreign) income, REX
is a measure of real effective exchange rate and ε is an error
term
Following Bahmani-Oskooee (1991) and others such
as Gligoric and Petrovic(2009 ) the researcher define
trade balance as the ratio of imports over exports
The ratio measure of is good for several and
important reasons
27

28. First, the main reason to use :regardless of
whether exports are less than import.
Especially good for the case in Ethiopia that
trade balance as a difference measure
between export and import takes almost in
all periods a negative value
Secondly, The ratio measure is not sensitive
to units of measurement in export and
imports (Bahmani-oskooee and Alse(1994))
28

29. Third , the form gives direct elasticities for
interpretation: additionally the use of ratio in log
gives the MLC exactly rather than approximately
(Onafowora 2003).
Fourth, the ratio is used to make the measure of
trade balance unit free (Bahmani-Oskooee, 1991).
Fifth it allows focusing on what proportion of
import is financed by exports.
29

30. Regarding with the expected sign of parameters used in the
model;
β and γ could be negative or positive.
Usually an increase in domestic income leads to higher
imports yielding a positive estimate for β.
However, if the increase in domestic income is due to an
increase in production of import substitute goods, imports
could actually decline yielding a negative β.
Higher in foreign income expected to boost domestic
export thus a positive effect on domestic trade balance
(Bahmani-Oskooee 1986).
• Finally, if a decrease in REX or depreciation has also an
ambiguous result until it is justified empirically
30

31. Equation (11) represents the long-run relationships. To test the J-Curve
phenomenon which is a short-run concept, we must incorporate the
short-run dynamics into the long-run model .Thus the following ARDL
representations
31

32. Where k lag length
Applying the familiar F test to determine joint significance of
lagged level variables as a test of cointegration, i.e., if 1- 4
are jointly significant, variables are said to be cointegrated.
The short-run effects of depreciation are inferred by the
estimates of K’s. Specifically, negative values for K’s. at
lower lags followed by positive values at higher lags will be
consistent with the J-Curve hypothesis in the case when
devaluation effect become negative at lower lags and positive
at higher lags.
The long-run effects are inferred by the estimate of 4
which is normalized on 1.
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33. Econometrics tools
The researcher will apply the following tools
Granger causality Method: determining whether one
time series is useful in forecasting the other
Unit root test :identifying the order of time series and
test stationarity of main variables
Cointegration Aalysis; explore the existence of long
run relationship: Johansen Cointegration test
(johansen1996) and Autoregressive distributed
lage(ARDL) approach of pesaran,shin and smith(2001)
will be respectively used if the variables have the same
order of integration
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34. Impulse response functions: to examine the J curve
pattern of the trade balance upon exchange rate shock.
Auto Regressive Distributive Lag Approach(ARDL)
ADRL allows
to estimate both the short run effects and long run
estimates
solves the problem of variable endogeniety
in small samples is superior (Narayan (2005)
works whether unit root exist or not. This method
does not require both variables to be integrated in
the same order.
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35. Graphical Methods And Summary Statistics
All the data are having a time series property
thus in order to show the relationship easier.
And graphical insights will be given on
stationary and non-stationary properties of
variables
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36. This is what I am
proposing !!!!!!
I Thank U
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