Relative responses of trade in goods and services to currency devaluation: Evidence from Ethiopia

Abstract

Lack of hard currency is one of the key growth barriers in emerging countries, as imports vastly outstrip exports. In response, governments in these countries usually undertake a variety of policy packages, including the devaluation of the domestic currency. Despite these efforts, there have been no discernible adjustments to foreign balance. This study examines whether the response to devaluation differs significantly between the goods and services trade in Ethiopia. We estimate the long- and short-run elasticities of the disaggregated trade indicators using an autoregressive distributed lag (ARDL) and error correction mechanisms. The empirical results confirm a significant difference between the goods and service sectors in terms of their responses to the devaluation policy in the long and short run. The estimated long-run elasticities of devaluation are only statistically significant for service imports and trade balances with negative signs. The remaining sectors did not show any significant relationships. In addition, we obtain meaningful short-run elasticities for service imports, goods exports, and total exports, all of which have a negative sign. Domestic inflation accounted for a large portion of the short-run import dynamics, output growth, and FDI, which contributed significantly to long-term export performance. The current study reveals that the government should not rely exclusively on the devaluation policy to bridge its external imbalances, and should see alternative and more effective policy mixes to alter the demand and supply sides of foreign trade.