Re-assessing Rwanda’s Exchange Rate and External Sector Competitiveness

Abstract

This paper re-assesses Rwanda’s real exchange rate and external sector competitiveness using three complementary
approaches proposed by the IMF’s consultative group on exchange rate issues (CGER). We use quarterly data, covering
the period 2000Q1-2020Q4 and 5-year period medium term projections. In terms of estimation strategy, we employ a
triangulation of methods, including ordinary least squares (OLS) to estimate current account determination model and
the estimation of trade semi-elasticities and for the reduced form equilibrium exchange rate (ERER) model, particularly
the behavioral equilibrium exchange rate (BEER) model, we use dynamic ordinary least squares (DOLS) along with its
complementary estimators such as fully modified ordinary least squares (FMOLS) and Canonical cointegration regression
(CCR) as robustness checks. For the external sustainability (ES) model, we rely on trade elasticities obtained from the
first model together with a few assumptions relating to economy’s potential growth rate and inflation rate. The results
indicate that the current account and the RER are influenced by economic fundamentals. The estimated exchange rate
misalignment levels from the three approaches point to the same direction. The current research obtains an average
exchange rate gap for the three models of 13.4 percent, implying that Rwandan currency is overvalued in real effective
terms by 13.4 percent, pointing to adverse effects on the external competitiveness. The important policy implications
arising out of these empirical findings include maintaining exchange rate flexibility to cushion adverse external shocks,
but also effective monitoring of exchange rate developments remains vital to avoid higher levels of volatility which could
lead to poor performance of the country’s tradable sector.