Exchange rate changes, price level and the income effects on trade balance in South Africa

This paper examines the long-run and short-run effects of the exchange rate changes on the net trade balance in South Africa and compares the effects to those induced by the foreign and domestic price and income effects. Using annual data from 1970 to 2019 and the autoregressive distributed lags bounds testing approach, evidence shows that the long-run elasticities of the exchange rate on the net trade balance are bigger than the short-run impacts. In both the short run and long run, the impact of domestic income on the net trade balance is the biggest followed by consumer prices and then last is the nominal effective exchange rate. The long-run impact of the domestic income is nearly double that of the exchange rate. This shows that domestic income has a bigger effect on the net trade balance than both the price levels and the exchange rate effects. These results imply that policymakers designing the exchange rate policy should complement this with an appropriate industrial policy which emphasises the value of import-substituting industries to eliminate the net trade deterioration. At the same time, the design of the inflation targeting framework matters. Hence, there is a need to pursue import-substitution strategies to strengthen the domestic industrial base with all the associated multiplier effects throughout the economy and this contributes to the reduction of the worsening trade deficits.