Exchange rate volatility in LDCs: some findings from the Ghanaian, Mozambican and Tanzanian markets

In the post Bretton Woods era, the volatile nature of exchange rates has been the focus of many researchers. Although some previous studies suggest that variations in an exchange rate has the potential to affect a country’s economic performance, LDC’s (Less Developed Countries’) have received less attention compared to industrialized or developed economies. In this thesis we analyse thenature of exchange rate behaviour in three LDCs: Ghana, Mozambique and Tanzania. These countries have gone through comparable policy engagements with the IMF, have followed similar floating exchange rate regimes since early 1990s and currently all adhere to the IMF convention of free current account convertibility and transfer (Ghana and Tanzania accepted Article VIII of IMF “Articles of Agreement” in 1994. Mozambique began floating in 1992 under theSAP reforms of IMF; Article IV consultation was completed in 2009 and acceptance of Article VIII seems imminent).The main content of the thesis can be summarised as follows.I. We examine whether exchange rate behaviour in these three countries areinfluenced by similar factors. In order to justify the applicability of a number of volatility modelling techniques, we also examine the data to find if they exhibit the empirical regularities found in other exchange rate/financial markets such as volatility clustering, non-linearity, non-normality and asymmetry. Our results suggest that exchange rate behaviour in these countries is generally influenced by similar factors. In particular, we find that the series exhibit the empirical regularities found in other exchangerate/financial markets, justifying the application of the ARCH methodology which we use to estimate the volatility of exchange rate in these countries.We however observed that the ARCH family of models does not always produce the best fit. For instance, volatility forecasts generated by an Exponentially Weighted Moving Average (EWMA) model based on theRiskMetricsTM estimation technique produces the best fit for the daily Ghanaian exchange rate series under consideration compared to volatilityforecasts from our estimated ARCH family of models.II. We explore the causal relationship between exchange rate depreciation and uncertainty/volatility using the VAR toolkit. Our main motivation for this study is to analyse whether the changes in the levels of exchange rate as a result of appreciation or depreciation in an underlying currency changes the level of exchange rate uncertainty (volatility). Further, we also analyse the reverse causal relationship; whether increasing uncertainty feeds back into the exchange rate market. We find a bi-directional Granger causalrelationship between the level of exchange rate and uncertainty in the foreign exchange markets. Despite adopting similar macro-policies since the mid 1980s and early 1990s, uncertainty in the Tanzanian exchange rate as a response to changes in the level of exchange rate takes a shorter length of time to dissipate. We attribute this to the macroeconomic policies undertaken by Tanzanian policymakers which have ensured price and currency stability.The reverse causality reflects the effectiveness of the Tanzanian macro-policies and the confidence in them; we observed that intervention reduces uncertainty in the Tanzanian exchange rate, whereas for Ghana and Mozambique, macro-policies intending to mitigate undesired exchange rate changes rather create further uncertainty in their exchange rate markets. For all three LDCs under consideration, we observed that effects of shocks to exchange rate from innovations in uncertainty for each country is fleeting III. We investigate the relationship between exchange rate volatility and economic performance (via trade) for each of these countries and some of their biggest trade partners. Exchange rate volatility resulting from a depreciating underlying currency of trade can potentially affect the economic performance of a country. Using a gravity model augmented with variables that are deemed to influence earnings from trade, we observe that earnings from trade are not significantly affected by exchange rate volatility. We conjecture that in periods of uncertainty, traders increase the volume of trade to compensate for the ill effects of currency volatility.