The Causal Relationship Between the Flow of Domestic Credit and Changes in Net Foreign Reserves in Lesotho (1980-2000)

Abstract

The management of external balance has been the major problem of most of the non-oil less developing countries in the last three decades. The empirical literature on this subject has shown that. the major cause of balance of payments disequilibrium in the LDCs was the adverse developments in the international economy which included the deterioration in the terms of trade associated with OPEC oil price hikes and high interest rates, increased protectionism and recession in the developed world. However, the IMF has been of the view that overly expansionary domestic demand policies that created excess demand for imports have been the common cause of payments deficits. This has led to its recommendation of the monetary approach to balance of payments in the LDCs. This study tests the applicability of the monetary approach to balance of payments in Lesotho by concentrating on the casual relationship between the flow of domestic credit and changes in net foreign reserves. The results show that there was a unidirectional causality between the flow of domestic credit and changes in net foreign reserves in the 1980-2000 period, running from net domestic credit to reserves. The findings are in support of the monetary approach to balance of payments. It therefore follows that given a stable demand for money in Lesotho, the balance of payments disequilibrium can be corrected, at least partly, by appropriate financial programming and monetary targeting.