Dynamic relationship between exchange rate and trade balance

Abstract

The volatility of exchange rates affects the country’s export-import positions and the financial condition of organizations in the real and financial sectors. Also, it has an impact on the country’s macroeconomic stability. This study analyses the dynamic relationship between exchange rates and the trade balance in five North African countries: Algeria, Tunisia, Morocco, Libya, and Mauritania. A panel autoregressive distributional-lag model (PANEL ARDL) was chosen to analyze the long-term relationship and short-term dynamics between the studied indicators. 1990-2019 was chosen as the research period. The selected variables (exchange rate level net trade balance) were tested for stationarity, and a cointegration test was performed. Three-panel dynamic models were built into the work: pooled mean group (PMG), mean group (MG), and dynamic fixed effects (DFE). The study demonstrates a long-term inverse relationship between the exchange rate level and the net trade balance for all analyzed North African countries. In particular, an increase in the exchange rate by 1 USD leads to a decrease in the trade balance deficit by 46.4 million USD for all analyzed countries together. It is found that the countries of North Africa need about three years on average to return to the equilibrium state caused by significant crises from 1990 to 2019. Individual countries (Algeria, Libya and Mauritania) have mechanisms to rebalance after approximately two and nine months, two and three months and a year and a half, respectively. However, Morocco and Tunisia do not have such mechanisms, which means that any external shock will weaken the equilibrium relationship between the analyzed variables in these two countries. To protect the trade balance from potential shocks and ensure the stability of the exchange rate, the countries of North Africa need to implement fundamental reforms in the monetary, financial and trade policies of these countries. It includes reducing imports, especially consumer goods that can be produced domestically, encouraging foreign investment and providing incentives to attract foreign capital as additional support for foreign exchange reserves.