Real Effective Exchange Rate Volatility and Its Impact on Foreign Direct Investment in Kenya

Abstract

A country’s real effective exchange rate (REER) is an important determinant of the growth of cross-border trading and it serves as a measure of its international competitiveness. Studies that have focused on the relationship between REER volatility and FDI inflow have generated mixed results, thus, there is lack of clear-cut conclusion on the relationship. This study assessed the REER volatility and determined its impact on foreign direct investment in Kenya for the period 1972 – 2015. The study was guided by the Dornbusch over- shooting model and adopted correlation Research Design. It relied on secondary data. To overcome methodological deficiencies that could arise from using measures of unconditional volatility, the study focused on Generalized Autoregressive Conditional Heteroskedasticity (GARCH) technique which is a superior measure of uncertainty.  Vector Error Correction Model (VECM) was used to establish the relationship between REER volatility and foreign direct investment. Augmented Dickey-Fuller and Phillip-Perron approaches were used to test for the presence of unit roots. The test for volatility conducted using the GARCH model showed that there is persistent volatility in the Kenyan shilling real effective exchange rate with that of the trading partner currencies for the period under consideration and the results of the VAR and VECM indicate a negative and significant impact of real effective exchange rate volatility on foreign direct investment in Kenya. Findings of this study will add value to the Dornbusch over- shooting model, production flexibility and risk aversion theories and partial and general equilibrium theories and will further help in the formulation of fiscal and monetary policies to address macro-economic shocks associated with REER shocks in the Kenyan economy.