Exchange Rate And Balance Of Payments Adjustment In Sierra Leone, 1970-2005

In spite of series of exchange rate adjustments in the 1980s and the adoption of the managed floating exchange rate regime in 1990, Sierra Leone still experiences poor external sector performance. The nominal exchange rate has been depreciating since the 1980s without reflection on the real exchange rate and the balance of payments. Both the theoretical and empirical literature on the effects of the nominal exchange rate on the real exchange rate and, hence, the balance of payments, are inconclusive. Previous studies on Sierra Leone focused on the elasticity approach, ignoring the wide macroeconomic implications of changes in the exchange rate. This study therefore examined the role of the exchange rate in balance of payments adjustment in Sierra Leone. Based on the absorption approach to the balance of payments, a small open-economy macroeconomic model that incorporated the linkages among fiscal, monetary and exchange rate policies, and the balance of payments was constructed using annual data from 1970 to 2005. The empirical analysis was based on estimating the macroeconomic model using the three stage least squares, and counterfactual policy simulations. Using Ordinary Least Squares with moving average errors, an equilibrium real exchange rate model which was derived from the basic tradable and non-tradable goods framework was also estimated. Although increase in the nominal exchange rate was inflationary, it increased the real exchange rate, non-mineral export, aggregate export, output, absorption and import. Moreover, it decreased the trade balance and increased the overall balance of payments. The correlation coefficients between actual and simulated series ranged from 0.5 to 0.94, while the covariance proportions of the Theil's inequality coefficients ranged from 0.47 to 0.98. An 85 % increase in the nominal exchange rate increased the price level by 3.9 %, real exchange rate by 6.9 %, non mineral export by 117.1% and the balance of payments by 22.6% while it decreased the trade balance by 48.4%. Loose fiscal and monetary policies and trade restrictions reduced the potency of nominal exchange rate in attaining real exchange rate depreciation and improvement in the balance of payments of Sierra Leone. The estimated equilibrium real exchange rate model showed that an increase in investment appreciated the equilibrium real exchange rate, implying that investment took place more in the non-tradable goods sector than the tradable goods sector of Sierra Leone. Also, deterioration in-terms-of trade and trade restrictions appreciated the equilibrium real exchange rate. Nominal exchange rate depreciation leads to depreciation of the real exchange rate, and expansionary fiscal and monetary policies appreciate the real exchange rate. Although nominal exchange rate depreciation increases export and hence income, it raises import and therefore deteriorates the trade balance. It is, therefore, recommended that fiscal and monetary policies be coordinated such that tight monetary policy is given priority, as this enhances the benefit of nominal exchange rate depreciation. Also, bolstering domestic capacity for the production of import-competing goods is essential.