Real exchange rate misalignment and economic growth in East African least developed countries

Abstract

The behavior of real exchange rate remained an important policy concern for small open economies as its poor management adversely affects their economy with substantial welfare losses. This study examined the main drivers of real effective exchange rate (REER) misalignment and its effect on the economic growth of East African least developed countries (LDCs). The study applied Pooled Mean Group (PMG) and dynamic OLS estimators for panel and ARDL Bound testing for time series data over the period 1980–2019. The panel results revealed that the REER of LDCs were significantly misaligned for the study period. The REER appreciates for an improved terms of trade and net foreign asset position, while it depreciates for an increased trade openness and broad money supply in the long-run. The panel results also confirmed that the GDP per capita would improve for an increase in real investment and human capital, while it decline for an increase in openness, net foreign aid inflows and REER misalignment in the long-run. The ARDL bound testing results generally support the panel estimation results. In the short-run, the REER misalignment would impede growth of Ethiopia while it promotes growth of Kenya. Thus, the central banks and policy makers of East African LDCs should initiate a consistent macroeconomic policies and regulatory frameworks focusing on the main drivers of equilibrium REER to correct currency misalignment and to support their promising economic growth.