An investigation of the effects of Kenya’s external debt on exchange rate fluctuations

Abstract

The exchange rates in Kenya have been rising over the years and so has been the external debt. This trend was the subject of this study why an investigation was performed on whether exchange rates are influenced by external debt stocks. Empirical studies have shown contradicting results with the direction of the relationship also being a subject of some studies. Lack of studies on the same in Kenya provided a motivation for the current study. The objective of this study was therefore to assess empirically the effect of Kenya’s external debt on exchange rate fluctuations. A correlation design was selected for the study. The population and subsequent sample size was 360 data points covering a period of 40 years from 1971 – 2010 with 9 variables under study. The dependent variable was exchange rate while the independent variable was external debt. Control variables used were GDP, interest rate, inflation rate, terms of trade, net foreign assets and government expenditure. Secondary data was collected from the World Bank website, the CBK website and from the Kenya National Bureau of Statistics. SPSS was used to analyse data using descriptive statistics, correlation and regression analysis. The study found that there was a general upward trend in both external debt and exchange rate fluctuations. The model accounted for 95.3% of the variance exchange rates. The F statistic (79.082) was significant at 5% level. Further, the study revealed that external debt, interest rate, and net foreign assets had a positive and significant effect on exchange rate. On the other hand, inflation and FDI inflows had negative and significant v effects on exchange rates. External debt accounted for 63% of the foreign exchange volatility. The study therefore concludes that Kenya’s external debt positively and significantly affects her exchange rate fluctuations and this is consistent with theory and research on the same. The study recommends that decisions on controlling exchange rates must take into account factors which are beyond the control the Central Bank of Kenya such as external debt, net foreign assets, and FDI inflows. The Central Bank of Kenya and the Treasury must therefore work together to tame exchange rate volatility. There is need to replicate this study to a large sample size especially in Africa and to test more factors in the model other than the ones tested in this study.