TESTING MARSHALL-LERNER CONDITION IN SUB-SAHARAN AFRICA
ABSTACT
In this study we test the Marshall-Lerner (ML) condition for six sub-Saharan African economies, Nigeria, Zambia, South Africa, Kenya, Cameroon and Sierra Leone. In particular, we use annual data on the log-linearity of real effective exchange rates, exports, imports, real gross domestic product of the sub-Saharan countries, balance of trade and real gross domestic product of the world, for the time period 1980– 2013, and employ techniques of vector error correction model. Specifically, we use dynamic ordinary least square and Johansen cointegration methods to estimate the elasticities coefficients of the ML model and to test for long-run correlationship. The results indicate that there exists a long run cointegrating relationship linking the balance of trade to the real effective exchange rate, real gross domestic product of the sub-Saharan countries, exports, imports and real gross domestic product of the world, and that the ML condition is satisfied in the long run for five out of six sampled sub-Saharan economies, the odd economy been south Africa which violate the ML condition both in the short and long run period. Although the convergence process is relatively slow. They also imply that a moderate depreciation of their currencies may have a stabilizing influence on the balance of payments through the current account without the need for high interest rates.   
Keywords: Marshall-Lerner condition, vector error correction model, Johansen cointegration
TABLE OF CONTENTS
CHAPTER ONE: INTRODUCTION
Background to the Study                    
Statement of Problem                    
Objective of Study            
1.4     Research Hypothesis        
1.5     Scope of Study                
1.6     Significance of the Study                
CHAPTER TWO: LITERATURE REVIEW
2.1     Introduction                        
2.2     Definition of Exchange Rate        
2.3    Types of Exchange Rate                
2.3.1    Nominal Exchange Rate            
2.3.2    Real Exchange Rate                    
2.3.3    Bilateral Exchange Rate                
2.3.4    Multilateral Exchange Rate                
2.4     Importance of Exchange Rate            
Determinant of Exchange Rate            
Definition of Trade Balance                
Real Effective Exchange Rate (REER)            
The Impact of Exchange Rate Movement on
Trade Balance                        
The Different Approaches to the Relationship
Between Exchange Rate Changes and Trade Balance                        
The Elasticity Approach                    
2.9.2   The Absorption Approach                
2.9.3. The Monetary Approach                
The Marshall- Lerner Condition                
Mathematical Derivation of Marshall- Lerner Condition                            
2.12     Africa in the World Economy                
2.13     Empirical Literature                
CHAPTER THREE: METHODOLOGY
3.1     Introduction                        
3.2     Model Specification for Sub-Sahara African Countries                    
CHAPTER FOUR: PRESENTATION, ANALYSIS OF DATA AND DISCUSSION OF RESULTS
4.1     Discussion Of Findings Of Sub Sahara Africa As
 An Entity                        
4.1.1 Descriptive Statistics                    
4.2    Test for Stationarity and Co-Integration Test    
4.2.1    Test for Stationarity                
4.2.2     Johansen Co-integration Test        
4.3     Country Specific Impact Assessments        
4.3.1 Short Run Preliminary Analysis        
4.4    Test for Stationarity and Co-integration Test    
4.4.1 Test for Stationarity                
4.4.2     Johansen Co-integration Test                
4.5     Short Run Preliminary Analysis    
4.6 Test for Stationarity and Co-Integration Test        
4.6.1 Test for Stationarity                    
4.6.2     Johansen Co-integration Test            
4.7    Test for Stationarity and Co-Integration Test        
4.7.1 Test for Stationarity                
4.7.2     Johansen Co-integration Test                
4.8     Short Run Preliminary Analysis        
4.8.1     Test for Stationarity                
4.8.2 Johansen Co-integration Test                
4.9    Short Run Preliminary Analysis            
4.9.1 Test for Stationarity                
4.9.2 Johansen Co-integration Test            
4.10     Short Run Preliminary Analysis            
4.10.1 Test for Stationarity                
4.10.2 Johansen Co-integration Test                
CHAPTER FIVE: CONCLUSIONS AND RECOMMENDATIONS
5.1    Conclusion                        
5.2    Recommendations                
Bibliography                        
Appendix                            
CHAPTER ONE
1.1     BACKGROUND TO THE STUDY
Most countries in Africa rely on the rest of the world and the level of their interdependence has increased in last three decades (OECD, 2011). Domestic market is small to support large scale demand, hence depends on imports from other countries to supply a part of domestic consumption. On the other hand, there is a huge amount of commodities Africans produce and export (mainly primary product such as crude oil, Agricultural products mostly cash crops) to the other countries. This fact makes Black race economy defenseless to any adverse changes in other economies. One of the most important factors which influence international trade development is exchange rates.
  The relationship between the trade balance and terms of trade or the trade balance and the real exchange rate continues to be of substantial interest in trade literature and by policy makers. There are three distinct method of explaining the link between the trade balance and real exchange rate or terms of trade that includes testing the Marshall-Lerner condition, the J-Curve, and the S-Curve.
   The Marshall-Lerner condition is an indirect method of assessing the effectiveness of devaluation in improving the trade balance. The Marshall-Lerner condition states that, for a currency devaluation to have a positive impact on trade balance, the sum of price elasticity of exports (in absolute value) must be greater than one. As a devaluation of the exchange rate means a reduction in the price of exports, quantity demanded for these will increase. At the same time, price of imports will rise and their quantity demanded will diminish. The net effect on the trade balance will depend on price elasticity. If goods exported are elastic to price, their quantity demanded will increase proportionately more than the decrease in price, and total export revenue will increase. Similarly, if goods imported are elastic, total import expenditure will decrease. Both will improve the trade balance. What this mean is that a depreciation (or devaluation) of the domestic currency may stimulate economic activity through an initial increase in the price of foreign goods relative to home goods: by increasing the global competitiveness of domestic industries it diverts spending from the former to the latter (Kandil and Mirazaie, 2005).They aver that following a real depreciation volumes of exports and imports would not change much as the export and import contracts are usually made several months in advance. But the real depreciation will make the predetermined level of imports to cost more in domestic currency units, thus value of imports rise where the value of exports do not change much, which will worsen the trade balance immediately after the real depreciation. However as time passes by, both producers and consumers will be more responsive and quantities start to adjust to the change in relative price of domestic goods and hence trade balance start to improve. The response of the trade balance through time then forms the famous J shape. The assumption to the above discussion is that in the short-run elasticity’s are sufficiently low and in the long-run elasticity’s are sufficiently high, or in the long-run Marshall- Lerner condition holds.
       Historical data gathered for developed and developing countries have shown that devaluation may cause a negative effect on the trade balance in the short run but an improvement in the long run. This is known as the J-curve phenomenon. More clearly the J-curve describes the post devaluation time path of the trade balance.   The main explanation for this J-curve has been that, while exchange rates adjust instantaneously, there is lag in the time consumers and producers take to adjust to changes in relative prices (Junz and Rhomberg, 1973; Magee, 1973; Meade, 1988). The time lag comes about, because of the time needed for recognition, decision, delivery, replacement, and production (Junz and Rhomberg, 1973).
The J-curve is a time path showing the response of a country’s trade balance to exchange rate changes. This response consists of two parts, namely, the price effect and the quantity effect. The price effect is due to relative price or the change in the terms of trade where as the quantity effect relates to a change in the volume of real good and services. The initial effect of depreciation on the trade balance is “perverse” if import value increases by more than the increase in export value. In the long-run, however, the trade balance will improve when import and export volumes adjust to the higher (lower) import (export) prices.
      Another approach to investigating the short-run response of the trade balance to movements in the exchange rate (i.e., the S-curve concept) introduced by Backus, Kehoe and Kydland (1994). Rather than engaging in regression analysis, he took a look at the cross-correlation between the trade balance and the terms of trade or the real exchange rate. In their study, they found that the cross-correlation function between current terms of trade and future values of the trade balance is positive, but between current terms of trade and past values of the trade balance it is negative. The S-curve is also tested for 30 developing countries by Senhadji (1998), again using aggregate trade data. The cross-correlation between the terms of trade and trade balance was S-shaped in majority of cases - as the lag changes from -3 to +3 years, the underlying correlation first decreases, and then increases before declining again; the contemporaneous correlation is negative. We suspect aggregation bias may have played a role in cases where the support was weak or missing, e.g., Chile, Senegal, Tunisia, Yugoslavia (Bahmani-Oskooee and Ratha, 2009).
1.2     STATEMENT OF PROBLEM
It has often been argued that import and export price elasticity’s tend to be price inelastic for developing and least developing countries (LDCs). The reasons are quite simple. Developing countries and LDC's primarily import the consumer and capital goods required to sustain economic growth. On the other hand, they typically export primary commodities and raw materials whose prices have recently declined sharply due to the availability of substitutes, making their exports noncompetitive.
One of the most common ways of measuring sustainability in external balance is analysis of trade balance. This is acknowledged in the Fifth National Development Plan (FNDP) where growth in trade is to be promoted by reducing barriers to trade, maintaining a competitive exchange rate and money supply among other things. Most African governments substantially depend on revenue from trade through various taxes in order to finance development programs. Chronic deficits in trade balance are an indicator of unhealthy external position that may lead to build up of foreign debt as the continent relies heavily on external borrowing to finance essential imports.
It was argued that the opening up of the domestic economy to trade and liberalization of foreign exchange market would help correct relative international prices of traded goods and restore trade balance through adjustments to export and import patterns. The change in the exchange rate would induce changes in relative prices between domestic and imported goods. By this domestically produced goods would be more competitive and foreign produced goods less competitive. As a result, consumption of locally produced goods would increase, while consumption of foreign produced goods reduces. Also the trade balance would improve following depreciation of local currency. This mechanism of restoring trade equilibrium is valid if there is sufficient passing through effect of exchange rate changes on the volume of imports and exports.
    It is expected that depreciation and liberalization of the exchange rate would promote faster growth in exports relative to imports. However, despite some improvements in the external balance situation, their position still remains precarious. For example, according to the UNDP in its 2007 report on Zambia’s debt strategies made the observation that, “to date, however, Zambian international trade performance and profile has largely designated the country as a net importer.”
There are concerns that the region may continue facing trade balance deficits if it continues relying on a narrow base of primary export commodities with low world price and income elasticity’s. It is also argued that the structure of imports is not sufficiently responsive to changes in relative prices, since the makeup is mainly of essential goods such as oil, manufactured goods and equipment which have few or no domestic substitutes. These factors make the country more vulnerable to external economic shocks.
On the whole, the recent fall in oil prices have exposed the secret of African country especially Nigeria on their high level of dependence on revenue generated from this sector which have resulted to reoccurring budget deficits over the years. In addition, improper structures of policy on how to cope with macro economic variables especially inflation couple with lack of diversification pose as impediment in taking the advantage of devaluation.
        Empirical literature on various countries being examined (i.e. mostly on the basis of bilateral trade and various technique use in estimation) which support Marshall- lerner such as Hernan Rincon (1999), Hatemi-J and Irandoust (2003), Yol and Baharumshah (2007) etc , while some end as invalid such as Narayan (2004), Hatemi and Irandoust’s (2005) etc and others ending  inconclusive. This result has clearly shown that the socio-economic setting of each nation is an ever changing one differs from each other and such changes may not be neglected in the operation of Marshall- leaner condition, sometimes they may be working at the opposite ends with the objectives of the learner's condition. Therefore, we can conclude that ‘each country demonstrates different response path to changes in the relative prices and the exchange rate’ (Bahmani-Oskooee, 2008). I intend to answer the questions at hand which are:
1. Is exchange rates related to trade balance?
2. Do exchange rates have a short and long term effect on trade balance in Sub- Saharan Africa?
1.3     OBJECTIVE OF STUDY
Our major focus is to test Marshall-Lerner condition in Sub-Saharan Africa in which the following will be empirically examine:
1. The relationship between exchange rates and trade balance.
2. The effects of exchange rates and trade balance in National economic performance of Sub- Saharan Africa.
1.4     RESEARCH HYPOTHESIS
1. Exchange rates have significant inverse relationship with trade balance in import dependent nations.
 2. Exchange rates and trade balance in Sub- Saharan Africa has significant positive relationship with Gross Domestic Product (GDP)
1.5     SCOPE OF STUDY
The purpose of this study is to test Marshall-leaner condition in some Sub-Saharan African for the period 1980- 2013.
A traditional trade balance model will be estimated with two equations, for exports and imports, using the Johansen approach and a Vector Error Correction Model (VECM). Preliminary unit-root tests will be performed, and the results will be presented. The co-integration equations will present the long-run relationship between exports, imports, and the exchange rate. It is expected, for the Marshall-Lerner condition to hold, that the sum of export and import elasticity’s from these two equations will exceed 1.
1.6     SIGNIFICANCE OF THE STUDY.
Trade elasticity’s have major macro-economic policy implications for any country. The major determinants of international trade are the gross domestic product (GDP) of a country, the foreign GDP, the price of export and import, the foreign price and the exchange rate. Since shifts in the trade balances are regarded widely as a function of changes in exchange rates, the relationship between trade and these determinants are examined by a robust model of the export and import demand functions (Haynes, Hutchison &Mikesell, 1996).
Exchange rates are especially important for many developing economies where trade flows continue to drive balance of payments accounts due to the low development of capital markets. In addition, exchange rate behavior, whether determined by exogenous or endogenous shocks or by policy, has been a common, yet controversial, policy issue in most of those countries. Economic authorities in developing countries have repeatedly resorted to nominal devaluations as a means to correct external imbalances and/or misalignments of real exchange rates, to increase competitiveness, to increase revenues, to be a key element of adjustment programs, and/or to respond to pressures from interest groups (exporters, bureaucracy, etc.). The decision to devalue has been taken many times even if the devaluation might cause inflationary spirals, domestic market distortions, disruptive effects on growth, and undesirable redistributive effects.
    A depreciation (or devaluation) of the domestic currency may stimulate economic growth through an initial increase in the price of foreign product relative to home goods: by increasing the global competitiveness of local industries it diverts spending from the former to the latter.
    Case studies on several African countries such as Zambia and Nigeria seem to support empirically the existence of a J-curve. However, no studies have been carried out yet to test the Marshall-Lerner condition in some countries like Cote d’Ivoire, Equatorial Guinea, Sudanetc which represents an interesting case.