The Effect of exchange rate volatility on international trade and debt sustainability in Kenya

Abstract

Exchange rate instability plays a pivotal role in shaping international commerce, influencing how nations approach cross‑border transactions and how trade and debt dynamics respond to shifts in the wider economy. This research undertook an empirical examination of the relationship between currency fluctuations and Kenya’s foreign trade between 1993 and 2023. Annual data were obtained from the Kenya National Bureau of Statistics and the Central Bank of Kenya, and the study applied econometric techniques, including regression analysis, Granger causality, and autoregressive distributed lag (ARDL) bounds testing to capture both immediate adjustments and long‑term linkages. The investigation was grounded in a quantitative design within a positive framework, ensuring objective measurement of macroeconomic forces that drive exchange rate movements and their subsequent impact on trade and debt outcomes. Three key insights emerged. Inflation as the dominant factor: Rising inflation was found to be the strongest contributor to exchange rate instability, with a highly significant positive effect, indicating that price increases intensify currency volatility. Interest rates and the current account deficit exerted weaker influences, though the current account balance showed signs of potential relevance. Trade effects: Exchange rate swings were shown to stimulate trade flows, with higher volumes recorded during periods of volatility. Yet this positive effect was tempered by the current account balance, which revealed a significant negative relationship, suggesting that trade imbalances reduce the benefits of currency movements. Debt sustainability: Exchange rate volatility itself did not significantly affect debt sustainability. Instead, fiscal discipline and structural economic factors played a more decisive role, as evidenced by the consistently significant constant term in the regression model. The findings carry important policy lessons. For trade, addressing structural deficits and improving export competitiveness remain essential, since exchange rate shifts alone cannot overcome persistent imbalances. On the monetary front, stabilizing prices is critical, given inflation’s central role in driving volatility. For debt management, the results highlight the need for sound fiscal strategies, careful debt structuring, and diversified financing approaches, rather than relying solely on exchange rate stability. In conclusion, the study recommends that Kenyan policymakers reinforce inflation‑targeting mechanisms, broaden the export base to reduce the current account gap, and incorporate hedging tools to mitigate currency risk in trade agreements. Furthermore, embedding exchange rate risk analysis into debt management practices will enhance resilience against external shocks.

Keywords: Exchange rate fluctuation, Determinants of exchange rate, GDP, Poverty, Per capita Income, Comparative Advantage, Imports, Exports, Dependency ratio and Exchange rate risk.