The impact of exchange rate volatility on export and FDI inflows: The case of Ethiopia

Background of the Problem: After the communist junta fell in 1991 and the new leadership assumed power, the Ethiopian government had taken successive steps to revitalize the entire economy, by designing and implementing new reform programs. As part of the new reform programs, the government adapted a managed floating exchange rate system and started rigorously devaluating its currency against the U.S. dollar and other major internationally currencies.;Although the purpose of the new exchange rate system and subsequent devaluations was to increase international export and attract foreign direct investment, scholars, anti-reformists and the public in general, have been raising a number of issues regarding to these reforms and their intended objectives.;Problem Statement: With the adoption of a managed floating exchange rate system, and decade's long currency devaluation, Ethiopia must constantly investigate the effects of these reforms on its macroeconomic indicators. The threat of volatility, which is the very nature of floating exchange rates, and the successive devaluations since the new reform program began, necessitates the need for a thorough and continuous evaluation of the impact of the devaluation program as well as the performance of the exchange rate system in general.;Research Objective: Therefore, the main objective of this research paper is to assess the behavior of the country's exchange rate system in general, and to examine the long-run impact of exchange rate volatility on the country's macroeconomic variables, including export trade and foreign direct investment (FDI) inflows, in particular.;Data and Methodology: This research paper employed monthly data series for the export demand model and yearly data series for the FDI Inward model. The data series for both models ranges from 1994 -- 2014. In regard to the methodology, this paper used Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model to capture the volatility of both nominal and real exchange rates, while it adopted Autoregressive Distributed Lags (ARDL), or Bounds test model to estimate the long-run casual relationship that may exist between the variables of both models described above.;Research Findings: The overall investigations of this paper show the long-standing devaluation policy of the country has been counterproductive to its international export, while it has been a motivational tool for attracting foreign capital (investment) from the external world. It shows bilateral real exchange rates have a significant long-run negative impact on the volume of the country's export, while they have a significant long-run positive impact on the flow of capital (investment) into the country.;In contrast, the findings of this paper show that the volatility of bilateral real exchange rates does not have a significant long-run impact (effect) on the volume of the country's international export as well as capital (investment) inflows. It indicates the volatility series has a significant long-run inverse relationship with the volume of the country's real export. However, the magnitude (effect size) of the relationship is not statistically significant to bring any kind of long-run negative impact (effect) on the volume of the country's export within critical values of 1-10%. Similarly, the evidence shows it has neither a significant long-run relationship nor long-run impact (effect) with/on the flow of capital (investment) within critical levels of 1-10%.