On the causes and effect of exchange rate volatility on economic growth: Evidence from Ghana

After the collapse of the Bretton Woods system of fixed exchange rates in the 1970s a number of countries adopted a flexible system. In Ghana, the advent of the Financial Sector Adjustment Programme (FINSAP) – a component of the Economic Recovery Programme (ERP) – introduced major reforms in the financial sector including the jettison of the fixed exchange rates in favour of the free floating regime in the 1980s. Among others, this transition was done under the premise that flexible exchange rates would curb the boom–and–bust syndrome as well as turn the country towards a trajectory of growth with the growth–enhancing effect emanating from the exchange rate pass–through on consumer prices, terms of trade, trade volumes and investments.

However, the Ghanaian Cedi (GH¢) has depreciated against major currencies especially the US Dollar (US$), albeit, not monotonically since the adoption of the flexible exchange rate regime, recording a modicum of stability between 2002 and 2007. Most recently, the Cedi has been very volatile. For instance, at the beginning of January, 2014, a US$ was exchanged for GH¢2.21 and by the end of September, 2014, the Cedi–Dollar exchange rate stood at GH¢3.20 – denoting about 44.65% depreciation. Arguably, this level of depreciation contributed to a rise in consumer price inflation which stood at 17% in December, 2014 from 13.8% in January, 2014. GDP growth which stood at 15.0% in 2011 dropped to 8.8% in 2012 and further to 7.6% in 2013. In fact, provisional GDP growth rate for 2014 is estimated at 6.9% down from a revised initial target of 7.1%.

While anecdotally the volatility of exchange rate has been linked to macroeconomic instability, very little attempt has been made to examine the factors behind it and the impact it has for both internal and external stability. Moreover, the discussions surrounding the fluctuations in Ghana’s exchange rate are only gleaned from public discourses on the economy with very little empirical and theoretical backing. Understanding the key drivers of exchange rate volatility and the channels of manifestation is an empirical matter and this study examines the causes of exchange rate volatility and its impact on growth performance with the view to informing policy towards maintaining stable currency (especially under inflation targeting), public debt management and steady economic growth.

Methodologically, this study employs the generalised autoregressive conditional heteroskedasticity (GARCH) model to estimate the volatility of exchange rate. To understand the short– and long–run causes of volatility, the study uses the vector error correction model (VECM). A quadratic term of exchange rate volatility is included to account for possible non–linearities in the growth–volatility nexus. And finally, a generalised method of moments (GMM) is used to estimate the growth equations in order to control for endogeneity and simultaneity problems resulting from the lag dependence. To yield consistent estimates, instrumental variables and a battery of robustness and stability tests are employed.

The expected outcomes can be summarised under two broad headings: academic literature and public policy and practice. In the former, the study provides a comprehensive pioneering work on the causes of exchange rate volatility, non–linearities and pass–through effects of volatility on Ghana’s economic growth and its ramifications for poverty reduction and global competitiveness. For the latter, and for countries hoping to form a monetary union, it is imperative to know the major sources of exchange rate volatility so as to prescribe workable policy response. Thus, the relevance of this study is self–evident and serves as a powerful tool for demonstrating the practicality of conducting effective monetary policy in Ghana and several other developing countries also grappling with high exchange rate volatility amidst sluggish growth rates.