Exchange Rate Misalignment in Rwanda. Does Export Diversification Matter?

Abstract

Export diversification is a key instrument that helps developing economies to hedge against price volatility and
external shocks. Export diversification helps to reduce macroeconomic volatility, notably exchange rate misalignment
by alleviating and stabilizing export revenue and domestic output. The main objective of this paper is to estimate the
equilibrium fundamental exchange rate misalignment and investigate the role of export diversification in reducing real
exchange rate misalignment in Rwanda. We employ quarterly data, covering the period 2000Q1-2022Q4. Building on the
behavioral equilibrium exchange rate (BEER) Approach, we estimate the relationship between the real effective exchange
rate and economic fundamentals using single equation cointegration-based techniques, particularly the dynamic ordinary
least squares (DOLS) model. To derive the level of REER misalignment, the estimated equilibrium real exchange rate
results are used, along with the Hodrick-Prescott filter to obtain sustainable levels of REER and decompose REER into
their permanent and cyclical components. The main results indicate that the real effective exchange rate is in line with
the economic fundamentals. Alternating episodes of undervaluation and overvaluation are identified. The obtained level
of REER is not too high, and the identified episodes of undervaluation and overvaluation are not persistent to cause loss
of competitiveness in the external sector. We also estimated the link between real exchange rate misalignment taken
in absolute values and export diversification. The results point to the fact that export diversification reduces exchange
rate misalignment in Rwanda. Accordingly, we recommend implementing policies to diversify Rwanda’s export base.
Greater diversification of exports would make Rwanda less vulnerable to exogenous shocks and more protected against
the risks of short-term devaluation.