Terms of trade, institutional quality and exchange rate volatility in the Economic Community of West Africa States (ECOWAS)

Abstract

The empirical literature on volatility in exchange rates and its impact on terms of trade is expanded upon in this study, considering the role of institutional quality. The research employs GARCH and PARDL techniques to analyse data on member countries of the Economic Community of West Africa States (ECOWAS), between 2000 and 2021. The findings revealed past volatility in exchange rates has a significant predictive power on current volatility. However, the relationship between inflation and exchange rates differs between non-francophone and francophone countries, with inflation acting as a positive driver in the former and a negative driver in the latter. The study also finds that most indicators of institutional quality, except regulatory quality, have a significant negative impact on exchange rate in the long run. Institutional quality, financial development, external debt, and debt services yield mixed results. Additionally, majority of variables in the interim are insignificant. The study highlights that the overall imbalance in terms of trade within the sub-region leads to currency destabilization and a subsequent reduction in aggregate GDP. In the short run, the impact of these variables is significant for oil-producing nonfrancophone countries, while oil-producing francophone countries do not experience significant impacts. Therefore, the study highlights on the urgency to implement appropriate fiscal control policy and focus on the dynamic patterns to ensure stability of the exchange rates. Also, strong institutions are needed in formulating effective policies to stabilise exchange rates. The study finally recommends that strategic value chain policies should be implemented.