An Analysis of Exchange Rate Volatility and Trade in Mauritius

*Polodoo. V.
Mphil/Phd Candidate
Faculty of Law & Management,
University of Mauritius
Reduit
Email: polodoov@rocketmail.com
Seetanah.B,
Faculty of Law & Management,
University of Mauritius
Reduit
Email: b.seetanah@uom.ac.mu
Sanassee. R.V
Faculty of Law & Management,
University of Mauritius
Reduit
Email: rvsan@uom.ac.mu

Brooks. C
ICMA Centre,
University of Reading, U.K
Email: c.brooks@icmacentre.ac.uk

ABSTRACT
This paper gives an analysis of the impact of exchange rate volatility on manufacturing trade flows
in Mauritius. The econometric analysis employs yearly data for the period spanning 1980-2011 and
two measures of exchange rate volatility, viz, the Z-score and the EGARCH are used. When using
the Z-score, it is found that exchange volatility does not affect real manufacturing exports.
However, exchange rate volatility is found to be significantly affecting real manufacturing imports.
Also, the Vector Autoregression estimates suggest that exchange rate volatility has not been a
determining factor influencing real manufacturing imports.
Keywords: Manufacturing trade, EGARCH, Z-Score, VECM, VAR, Causality.
*For correspondences and reprints
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1.0.

Introduction

Subsequent to the floating of the US dollar in 1973, liberalization of capital flows and the
associated exponential growth of cross-border financial transactions during the last three decades,
important volatility and uncertainty has been seen in exchange rates (Arize, 1998). Academicians,
policy makers, researchers and economists have always raised eyebrows with regards to the
potential impact of exchange rate volatility on trade. The recent currency crisis emanating from the
Europe and the ensuing economic instability as well as economic crises in the past in various
countries due to exchange rate volatilities such as that of the Asian crisis, the peso crisis among
others substantiate that tribulations in the foreign exchange market have some sort of domino effect
and can spread their tentacles to the entire economy and fuel large-scale crises. Therefore, from a
macroeconomic viewpoint, a stable and sound exchange rate helps to resist financial turmoil and
helps to bring stability and preserve employment in an economy.
Taking into account the recent volatility in world known currencies and given that Small Island
Developing States like Mauritius rely heavily on manufacturing trade for its survival, this paper
analyses the impact of exchange rate volatility on manufacturing trade for Mauritius.
An analysis of exchange rate movements on trade to Mauritius is deemed pertinent as the latter has
recently experienced negative shocks in its terms of trade owing to the phasing out of the MultiFiber Agreement in 2004, cuts in sugar price under the Lome Convention by the European Union in
2006 and skyrocketing world oil and commodity prices. The phasing out of the Africa Growth and
Opportunity Act also had some severe repercussions, which means that Mauritius has been
gradually losing its comparative advantage in textiles from low cost producing economies of the
like of the Vietnam and Bangladesh. Furthermore, the manufacturing sector has been hardly hit
with the closure of several firms, more specifically, in the textile sector. Moreover, the Mauritian
trade has always been vulnerable to real exchange rate variability, notably during the last few years
on account of a depreciating euro but exchange rate risk hedging facilities are virtually nonexistent.
Although hedging facilities are available, they are considered as expensive for small exporting
firms. As a result, exporters bear the consequences of unexpected changes in the exchange rates.
Even though the effect of exchange rate movements has pertinent policy implications, attempts to
analyse these issues in developing countries and more specifically Small Island Developing States
like Mauritius are scarce. Moreover, the study employs a Vector Autoregression framework to take
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into account the dynamism and endogeneity aspect of the relationship between trade and exchange
rate volatility. It is noteworthy that most studies pertaining to exchange rate volatility and trade
employ are inconclusive on account of the sensitiveness to the choices of sample period,
econometric modelling, problems regarding proxies for exchange rate volatility as well as countries
in panel data sets. This study is conducted using time series econometrics so as to provide a fresh
insight as regards the impact of exchange rate volatility on manufacturing trade flows.
The paper is organised as follows: Section 2 reviews existing literature on trade and exchange rate
volatility; Section 3 gives the situational analysis regarding trade and exchange rates in Mauritius;
Section 4 specifies the model and provides the data source; section 5 explains the methodology
employed; section 6 analyses the results from econometric estimation and finally section 7
concludes the paper.

2.0. Review of Literature

Since the floating of the US dollar in 1973, several theories have been developed to explain the
channel through which exchange rate volatility affects trade. The theories propounded have been
broadly classified into two channels. The first one concerns channels through which only exchange
rate influence trade- the partial equilibrium theory- to put it in the words of Ct (1994). Here, the
impact of exchange rate volatility on trade is explained and dependent on the following: the risk
profile of exporters, the presence/absence of hedging, the market structure, costs and pertinence of
hysteresis in trade, alterations of production volume and export destination, assuming that the only
variable that influence trade is the exchange rate. A second channel, more technically known as the
general equilibrium theory Ct (1994) explains the channel through which exchange rate volatility
impacts on trade by combining all the probable factors that might influence trade. All the channels
through which exchange rate volatility influences trade in goods are discussed below. Partial
equilibrium theories ignore the availability of nonlinear hedges (options and portfolio of options)
or takes the prices of hedge instruments (or some of the determinants of these prices) as given,
Sercu and Uppal (1995, pg 5). In the same vein, Clark et al (2004) criticise the partial theories and
aver that most of these theories assume that revenues are convex and assumes that demand and cash
flow functions as given. The partial models, according to them, ignore the dynamism pertaining to
the link between exchange rate volatility and trade and ignore the fact that changes in the macro
economy may affect exchange rate and hence influence demand or cash flow function.

Because of the limitations of the partial equilibrium theories, neo classical trade models employ
general equilibrium approach to explain the channel through which exchange rate volatility affects
trade. Yet, according to Sercu and Uppal (1995), the main problem with the neo classical models is
the assumption that Commodity Price Parity (CPP) holds for all goods and at all times. General
equilibrium models, however, allow for deviations from CPP and changes in real exchange rates.
General equilibrium models demonstrate that factors that influence exchange rates may also result
in changes in other macroeconomic variables, substantiating why partial equilibrium models are
flawed in some respects, ignoring the effect of changes in other macroeconomic variables in
explaining the link between exchange rate volatility and trade. According to Chit et al (2008),
general equilibrium models are founded on the New Open Economy Macroeconomics that
combines the impact of the market structure or trade, inflexibilities and intertemporal decision
making. It is postulated by Sercy and Uppal (1995), Clark et al (2004), Chit et al (2008) among
others that the general equilibrium framework endogenises exchange rate volatility such that a
better insight as regards the link between exchange rate volatility and trade can be gained as it
includes the impact on other macroeconomic variables to explain the link between exchange rate
volatility and trade. It is a question of what causes exchange rate to be volatile that explains the link
between exchange rate and trade. For example, a fall in shipping costs might result in a fall in
exchange rate volatility, a situation which might improve trade volume. Similarly, higher shipping
costs might result in an increase in exchange rate volatility, a situation which might depress trade
volume. Similarly, for an economy with imperfectly tradable good, shocks to risks associated with
output results in increased exchange rate volatility which increases the projected trade volume as
economic agents respond by trading more given the uncertainty. Also, if the degree of segmentation
between the commodity markets (traded internationally) falls, expected trade increases leading to a
fall in exchange rate volatility.
So far, we have looked at the impact of exchange rate volatility on trade. Most of the theories
discussed so far take exchange rate volatility as an exogenous variable and disregards the impact of
trade on exchange rate volatility. However, the general equilibrium models make it possible to
endogenise exchange rate volatility and consider the impact of trade on exchange rate volatility.
Rodriguez (1980) explains in a general equilibrium portfolio balance of rational expectations, the
part that trade flows play in determining exchange rates. The author postulates that the current and
the future time path of the exchange rate is influenced essentially by trade flows. Rodriguez (1980)
further postulates that at any point in time, the difference between spot exchange rate and its long
4

run intrinsic value is comparative to the present value of the normalised trade balance. The
conclusion is centred on the absorption approach to trade balance but the causality runs from trade
balance to exchange rates.
The foregoing theories explain the impact of trade balance /volume on exchange rate. However,
Ortega and di Giovanni (2005) demonstrate through a simple Ricardian trade model that exchange
rate volatility increases with trade costs such that there exists a negative link between exchange rate
volatility and trade volume.
Review of empirical evidences
Studies regarding the impact of exchange rate volatility on manufacturing trade are provided by
Campa and Goldberg (1993), Samson et al (2003), Aguirre et al (2007), Hayakawa and Fukunari
(2008) among others. For instance, Campa and Goldberg (1993) examined the impact of exchange
rate volatility on US manufacturing sector trade using annual sectoral data for the period 1972 to
1986. The authors employ real exchange rate and two measures of exchange rate volatility in their
study; the coefficient of variation and the standard deviation of the first differences of the logarithm
of exchange rate over the twelve previous quarters. The authors employ a panel investment
equation and apply in the first instance Two Stage Least Squares to take into account endogeneity
problems. The equation is also regressed with fixed effects and for robustness purposes, GMM is
applied. The empirical findings reveal that for the period 1972 to 1983, exchange rate volatility led
to a fall in investment in the manufacturing sector and hence trade. However, for the period 1984 to
1986, there was an increase in investment in the manufacturing sector and hence trade.
Sekkat and Varoudakis (2002) investigated the impact of exchange rate on manufactured exports in
North Africa using an export demand function having as independent variables; real exchange rate,
volatility of exchange rate as measured by ARCH, trade liberalisation and other determinants of
exports. The authors find a negative significant effect of exchange rate volatility on manufactured
exports in North Africa. However, empirical results using export demand functions are mixed.
Further, Samson et al (2003) examined the impact of exchange rate volatility on manufacturing
trade for South Africa using annual data for the period 1990-2002. The authors employ both
nominal and real exchange rate, the standard deviation of changes in exchange rates both for one
and three years and a structural demand and supply model in their study. To account for

endogeneity, the authors employ instrumental variables approach and find no significant effect of
exchange rate volatility on the manufacturing trade for South Africa.
Moreover, Aguirre et al (2007) examined the impact of exchange rate volatility on manufactured
exports in Brazil using quarterly data for the period 1986 to 2002. Two general measures of
volatility are employed; the standard deviation of real effective exchange rate and the GARCH
model. The empirical findings reveal that when the standard deviation is used, there is a significant
dampening effect on Brazilian manufactured exports. However, when the GARCH model is
employed, no statistically significant effect is found.
Besides, Hayakawa and Fukunari (2008) examined the impact of exchange rate volatility on
international trade in East Asia using bilateral trade data for 60 countries for a period spanning from
1992 to 2005. They employ a gravity function having real GDP, geographical distance, language,
adjacency, real exchange rates, colony and tariffs as the main independent variables and standard
deviation of the first difference of the monthly natural logarithm of bilateral real exchange rate for
five years. The empirical findings reveal the following. In the first place, exchange rate volatility
depresses trade within Asia much more acutely than in other areas. In addition, the larger impact is
on intermediate goods which are deemed to take a significant portion of trade in East Asia in
relation to other types of goods. Moreover, the impact of volatility is much more pronounced than
tariffs but less pronounced than distance related costs in East Asia.

3.0. The Link between exchange rates and trade.

The link between manufacturing exports as well as manufacturing imports and the main countries
currencies are depicted in the diagrams below. From the diagram, ME is manufacturing exports, MI
is manufacturing imports, EURO is the euro currency, GBP is pound sterling, USD is United States
dollar, RENMINBI yuan, Chinese currency and INR is Indian rupee. As explained earlier, prior to
2005, the euro, GBP and USD had a general appreciating trend vis--vis the MUR and after 2005,
they all depreciated slightly. Increased manufacturing exports led to appreciating euro, GBP and
USD prior to the year 2005 although Mauritian main export markets remained to be Europe over
the period considered. However, despite the fact that manufacturing exports kept on increasing after
a fall in the 2000-2005 period, the euro, GBP and USD depreciated vis--vis the MUR. The
movement of the currencies is mostly explained by factors other than trade. The renminbi and INR

as mentioned earlier, appreciated vis--vis the MUR after 1995 despite mounting manufacturing
exports.
Figure 3.1. Relationship between manufacturing exports (ME), imports (MI) and exchange
rates (MUR. Million)
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
1970

1975

1980

1985

1990
ME

1995

2000

2005

2010

2005

2010

MI

70
60
50
40
30
20
10
0
1970

1975

1980

1985

EURO
RENMINBI

1990

1995

2000

GBP
INR

USD

Source:Drawn from Eviews 7

As far as manufacturing imports are concerned, it continuously grew over the period considered. It
is pertinent to note that increased manufacturing imports which accelerated as from the mid-1990s
led to appreciating INR and renminbi as Mauritius started to diversify its import sources and
ultimately China and India became Mauritius main trading partners.
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As regards the exchange rate of the rupee, starting from a parity of USD1=MUR.5.29 in 1968, it
reached USD1=MUR.31.01 as of end of 2012. The USD continued to appreciate in the 1980s and
was being traded at an average rate of MUR.14.83/USD. The depreciation of the rupee in that
period is explained mostly by growing current account deficits as the Mauritian economy started to
industrialise and adopted and export led growth strategy which meant that a lot of machineries and
equipment need to be imported. However, consequent upon the liberalization of the capital account
in July 1994, the appreciation of the USD accelerated. From a parity of MUR.18.44 in 1995, it
reached MUR.30.45 in the year 2011, chiefly on account of record growth rates experienced by the
USA leading to an overheated US economy, which mandated raising interest rates. In spite of the
subprime crisis from the US starting in 2007, the rupee depreciated up to the year 2011on account
of skyrocketing world oil prices, imported food price inflation and revitalized buybacks to relieve
Greeces troubles.
Generally, over the period 1968 to 2011, the MUR depreciated against the GBP. From an average
rate of MUR.12.703/GBP in 1968, the GBP was being traded at an average rate of
MUR.45.33/GBP as of end of year 2011 The GBP continued to appreciate significantly in the early
2000s to reach an average all time high of MUR.66.95/GBP in the year 2006. A reversal of the
trend was noted after 2006, where the GBP started to depreciate against the MUR. The MUR was
being traded at an average rate of MUR45.33/GBP by the end of 2011. A fall in Mauritian imports
from the UK also contributed to the depreciation of the GBP vis--vis the MUR.
Europe is also a major trading partner for Mauritius. The euro was introduced in the year 2000.
Due to unavailability of data for euro prior to the year 2000 and given that the Mauritian economy
is deemed to be euro-centric as regards its export markets, the ECU is used as a proxy for the euro
prior to the year 2000. An analysis of the currency vis--vis the MUR for the period 1968 to 2011
reveals that the euro appreciated remarkably from a parity of 5.56 MUR/EUR in 1968 to reach a
high of MUR.43.27/EUR in 2007, after which it depreciated on an average basis. In the early
2000s, the appreciating trend of the euro vis--vis may be explained by international factors, viz,
problems regarding the Corporate Accounting scandal in the USA, cuts in rate of interest in USA as
the US economy got overheated. In the late 2000s, however, the rupee gained a lot vis--vis the
euro on the back of a slowdown of the European economy caused principally by the subprime crisis
emanating from the USA. Also, the sovereign debt crisis also weakened the euro against the major
world currencies. However, the euro started to appreciate slightly in the year 2012 as the Bank of
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Mauritius started to intervene frequently in the foreign exchange market to prevent the euro from
further depreciation and to stabilize exporters revenue
Generally, the INR has slightly depreciated against the MUR since independence from a par value
of MUR.0.74/INR in 1968 to MUR.0.553/INR in the year 2011. After 1995, the INR reversed its
trend and started to appreciate as the Indian government gave its automatic approval of foreign
direct investment in many sectors. The appreciation of the INR in the late 2000s may also be
explained by increased Mauritian imports from India as India became the leading import partner for
the island.
China has emerged as the second leading import source for Mauritius after India over the recent
years. Generally, the renminbi appreciated against the MUR from 1968 to 2011. In the 2000s, given
the rise of China as an economic superpower and that it became the second largest source of
Mauritian imports, the renminbi appreciated significantly against the MUR. It was trading at an
average exchange rate of MUR.3.41/RMB in the year 2000 and appreciated to MUR.4.58/RMB in
the year 2011.

4.0. Model Specification.

In order to analyse the impact of exchange rate on trade in manufacturing goods, it is pertinent to
note that there are several factors apart from exchange rate volatility which influence imports and
exports and that these factors are accounted for as per existing economic theory. As elucidated in
the empirical literature, various types of trade models have been employed in the literature, viz,
export equations, import equations, import and export equations and trade balance equations. Given
that the gist of the study is to investigate the impact of exchange rate volatility on trade, the import
and export equations will be employed. The latter have been widely employed by Siregar and Rajan
(2002), Marquez and Schindler (2006), Garcia-Herrero and Koivu (2007), Lee and Kim (2010),
Huchet-Bourdon and Korinek (2012) among others. However, so far, no studies have been
conducted for Mauritius using this model, albeit recent studies in Africa include Rey (2006),
Kiptui (2007), Sekantsi (2010), Olayungbo et al (2011) among others.

4.1. The Import and Export Equation

Taking all the different factors that influence exchange rate volatility and as employed by Siregar
and Rajan (2002), Marquez and Schindler (2006), Garcia-Herrero and Koivu (2007), Lee and Kim
9

(2010) Huchet-Bourdon and Korinek (2012) among others, the export and import equations may be
modelled as follows:

X t 11 21Yt foreign 31 EER t 41VOL t 51 X t 1 1t

(4.1.1)

M t 12 22 Yt local 32 EER t 42 VOL t 52 M t 1 2 t

(4.1.2)
From equations 4.1.1 and 4.12,
Xt is the natural logarithm of volume of manufacturing exports
Mt is the natural logarithm of the volume of manufacturing imports
Yt foreign
Yt local

is the natural logarithm of foreign real income(GDP) to world GDP;

is the natural logarithm of real GDP for the local economy;

EERt is the effective exchange rate

and VOLt is real exchange rate volatility.

21 and 22 are Income elasticities of exports and imports respectively

31 and 32 are the Price elasticities of exports and imports respectively

Logarithmic transformations to the above functions are deemed pertinent as according to HuchetBourdon and Korinek (2012), such transformation enables both exports and imports to respond
proportionately to changes in the factors mentioned. It is also mentioned by Siregar and Rajan
(2002) that logarithmic transformation of the export and import functions helps to prevent the issue
of radical decreases in elasticities.

The authors postulate that for a small open economy, it is

important to include lagged terms for the dependent variables as independent variables in order to
account for partial adjustment behaviour. Hence lagged exports and imports are included in
logarithmic forms in the equations.
The equations 4.1.1 and 4.1.2 will be used for estimating the impact of exchange rate volatility on
Manufacturing trade for Mauritius.
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4.1.2. Definition of the Variables

(a) Exports and Imports
As far as exports and imports are concerned, volumes rather than values are used. In other words,
real exports and imports figures are employed. Siregar and Rajan (2002) stresses the importance of
using real exports as against values as regards trade figures. They reported that value comparisons
are sometimes biased due to price factors. Similar statements were made by Learner and Stern
(1970). . Following Yao and Zhang (2003), Clark et al (2004) Klaassen (2004) and Chit (2008) the
real export for Mauritius is measured as:

Xt

VEX ti

USDEF

(4.1.3)

Where X t is the volume of exports / real exports for Mauritius to country i.

VEX ti is the value of exports to country i converted in US dollar and

USDEF is the US GDP deflator.

Similarly, real import for Mauritius is calculated as

Mt

VIM ti

USDEF

(4.1.4)

Where M t is the volume of imports / real imports for Mauritius from country i.
VIM ti is the value of imports from country i converted in US dollar and

USDEF is the US GDP deflator.

The data for value of exports is obtained from the Central Statistical Office, various issues of the
annual reports Bank of Mauritius (BoM) and the World Bank database for US GDP deflator.
Exchange rate data is obtained from the various issues of the annual reports of the

BoM,

www.oanda.com and www.fxtop.com.

11

(b) Income
Income as a variable has been used widely by almost all authors in the literature. Income is deemed
to be positively related to both real exports and real imports. Foreign Income is measured by
foreign GDP and domestic income is measured by domestic GDP. A higher level of income from a
trading partner means that the demand for domestic produced goods increases. In other words, a
rise in the GDP of Mauritian trading partner tends to increase Mauritian real exports.
On the other hand, higher domestic income means higher standard of living and for small island
economies like Mauritius, having high propensity to import, real imports would rise. In other
words, an increase in domestic GDP is positively related to Mauritian real imports.
The data for GDP for both Mauritius and the trading partners is taken in US dollar from World
Bank database.
(c) Effective Exchange Rate.
An effective exchange rate, sometimes referred to as trade weighted exchange rate, pertains to an
index of a countrys currency vis--vis a basket of other currencies, usually of its trading partners.
The currencies in the basket are weighted according to the proportion of trade with that country. In
the literature, there are two types of effective exchange rates used: Nominal Effective Exchange
Rate (NEER) and Real Effective Exchange Rate (REER). Whilst some authors employ either
NEER (for example Dell Ariccia (1998), De Grauwe and Schnabl (2004), Kandilov (2007) and
Schnabl (2007) among others) or REER (for example Arize et al (2000), Marquez and Schindler
(2006), Sheldon et al (2011) among others), others like Samson et al (2003) employed both the
measures to analyse the impact of exchange rate volatility on trade flows.
The NEER is the weighted mean of the nominal exchange rate of the domestic currency, without
reflecting changes in the domestic prices vis--vis the domestic countrys main trading partners.
The NEER has, however, been criticised on various fronts. For instance, it does not reflect changes
in the purchasing power of a countrys currency nor does it show changes in a countrys trade
competitiveness. As such, to take into account changes in competitiveness and purchasing power,
the REER is mostly used in the literature. The REER thus accounts for changes in purchasing

12

power and competitiveness. In other words, the REER refers to weighted average of a countrys
real exchange rate vis--vis its main trading partners currencies and is calculated as follows:

REER

ei t * Pi t
W
1 it P
dt

(4.1.5)

From equation 4.1.5,

ei t

is the bilateral exchange rates expressed in nominal terms

Pi t is the trading partner is index of retail prices

Pdt is the domestic economys index of retail prices and

n

Wit is the proportion of trade of the domestic economy with country i. Note that

W =1.
i

Wit is calculated as follows:

Xi Mi

Wit n
n

X1 M i
1
1

(4.1.6)

From equation 4.1.6,

M i is the import of Mauritius for country i

X i is the export of Mauritius to country i
n

is total imports from all trading partners

is total exports to all trading partners.

The main reason for employing index of retail prices for Pit and Pdt is that data for either producer
price index nor wholesale price index are not available for the whole sample period. We expect the
price elasticity of exports for Mauritius to be negative given that fierce competition prevails on the
13

world market for Mauritian manufactured trade. However, the degree of price elasticities will
differ. REER is being employed to immune ourselves from misleading inferences pertaining to the
evolution of Mauritius extent of competitiveness and to take into account the dynamic nature of
trade patterns between Mauritius and its trading partners.

(d) Volatility

There is a plethora of models developed to date. Here also, some studies employ only one measure
whilst others employ more than one measure.For the purpose of this study the E-GARCH and Zscore are employed.
The Z-score measure is a measure combines movements in exchange rate around a constant level as
well as around a steady depreciation/appreciation rate. GARCH (Generalised Conditional
Heteroskedasticity) was developed by Bollerslev in 1986. According to Chit et al (2008), in these
models, exchange rate volatility is calculated by taking the variance of exchange rate as a linear
function of the expected squares of the lagged value of the error term from an auxiliary regression
determining the mean. Chit et al (2008, pg 100). EGARCH (exponential generalized
autoregressive conditional heteroscedasticity) which has certain advantages over the simple
GARCH model. In the literature, the EGARCH allows for asymmetries and there is no violation of
the non-negativity condition.

4.1.3. Data Sources

Data for the above variables were obtained from the Bank of Mauritius annual reports, Central
Statistical Office, World Bank database, International Monetary Fund, International Financial
Statistics, www.oanda.com and www.fxtop.com. The data starts from 1980 to end 2011 due to
unavailability of data for some variables. The data are then converted into natural logarithm to
process into time series. As such, the coefficients are merely elasticities. The following table
gives a summary of the variables and their sources.
14

5.0

Analysis of Results

In order to assess the impact of exchange rate volatility on manufacturing trade for Mauritius, time
series econometrics is employed. We initially test for stationarity using the Augmented DickeyFuller test and the Phillips Perron test. The tests confirmed that our data series are stationary only
in its first difference (ie I(1)). To test for cointegration, the Johansen cointegration technique is
subsequently employed.
To check for the presence of heteroskedasticity in the residuals, the study checks for the ARCH
effects of the residuals, two different methodologies are applied. Firstly, graphs for the residuals.
Second, the t-statistic as well as the p values are used. As a rule of thumb, when investigating the
graph and it is found that low periods of volatility is followed by another low periods of volatility
or high periods of volatility is followed by another high periods of volatility, ARCH effects is
present. As far as p-value is concerned, ARCH effects is present if p values are less than 5% (0.05).
The tests above substantiated the presence of ARCH effects.
As a measure of volatility of exchange rate, there is a plethora of ARCH models to choose from.
Hence, a choice has to be made between GARCH, EGARCH, PARCH and Component ARCH
(1,1) bases on Akaike Information Criteria (AIC) and Shwarz Information Criteria (SIC). The
ARCH family with lower absolute value of AIC and SIC is preferred. EGARCH is preferred as it
has the lowest AIC and SIC for all equations with AICs of,-1.704396 and 2.1543 respectively and
SICs of 1.433107 and 2.0764 respectively for the real manufacturing export and real manufacturing
import equations.
Once having verified for ARCH effects and chosen EGARCH from the family of GARCH, now
proceed with the regression techniques to be applied. In fact, studies in the 1970s and 1980s such
as Hooper and Kohlhagen (1978), Caballero and Corbo (1989) among others conducted to
investigate the impact of exchange rate volatility on trade were inconclusive, spurious and
inefficient on account of the employment of plain Ordinary Least Squares in their estimations and
failed to test for unit root and the order of integration of the regression variables. Following recent
development in time series econometrics, some authors such as Arize et al (2000), Cheong (2004),
Rey (2006) among others, aver that international trade variables are not stationary in nature and
those previous studies examining the impact of exchange rate volatility on trade neglect to examine
15

the integration order of the variables. In view thereof, to address these time series issues, the
authors employ cointegration and error correction models to capture stationarity and cointegration
of the variables. In the presence of cointegration, it is understood that there is a long run
equilibrium relationship between them. As a result, Vector Error Correction Model (VECM), is
applied with a view to appraise the short run properties of the series. On the other hand, if no
cointegration is found, VECM is not resorted to, but rather VAR methodology is used. VAR
methodology is considered better than ordinary least squares and instrumental variables approach as
it does capture stochastic trends and does not require instrumental variables. It is also considered to
be a better method to separate long run and short run properties of a time series data set and lend
itself to the dynamic nature of the variables by treating all variables endogenous as a priori, albeit
restrictions as well as exogeneity of some of the variables may be imposed. VAR methodologies
also produce better forecasts and subjective factors are not required by the VAR models like the
Instrumental variables approach.
It is important to note that volatility is estimated in the first stage and same is used as a regressor in
the equations. The latter is expected to have an errors-in variable problem.
5.1. Vector Error Correction Estimates- Z Score as Measure of Volatility
5.1.1. Real Manufacturing Export (RME) Model
Given the presence of cointegration, Vector Error Correction methods are applied to the Real
Manufacturing equation.The VECM estimates for RME equation when Z score is used as a
measure of volatility are provided in Table 1:

16

Table 1: Vector Error Correction Estimates with Z-Score as Measure of Volatility

Estimation Methods-Ordinary Least Squares
Independent Variables
Coefficient P value
Standard
t-statistic
Error
D(Real

Manufacturing

Equation)

-0.701073

0.064

0.248942

-2.816208

170.003

0.0019

52.5967

3.232198

-0.688597

0.038

0.316108

-2.178358

First Differenced REER

D(Foreign Income Equation)
First Difference Foreign Income
First Difference REER
Adjusted R-Square

0.478411

R-Square

0.683321

Source: Eviews 7.1

The above table reports only the coefficients deemed to be significant regarding the VECM
estimates. The insignificant coefficients are not reported here for expositional ease.
From table 1, put of the error correction terms, only the first differenced of REER, and of foreign
income are significant with p-values of 0.064, 0.019 and 0.0328 respectively. However the third
difference of REER is not considered significant despite having a p-value of less than 0.05 as it has
a positive and large coefficient (170.003), contrary to what econometric theory suggests. The
significance of the lagged REER implies that REER adjusts very fast (70%) to equilibrium state of
RME. It is noted that the lagged values of foreign income significantly influence real
manufacturing exports, which means that foreign income increases, real manufacturing exports
increase in the next periods and vice. The Mauritian manufacturing exports is indeed very
dependent on income of foreigners. Falling incomes due to the European crisis in recent years have
had a dampening effect on our manufacturing exports.
As expected the first difference of REER is significant in explaining changes in real manufacturing
exports with a negative coefficient of -0.70173 when the equation of real manufacturing exports
with z score is used as a measure of volatility. The result is consistent with the findings of Campa
17

and Goldberg (1993), Sekkat and Varoudakis (2002), Clark et al (2004), Aguirre et al (2007) but is
not in conformity with Samson et al (2003), This means that there is a negative link between the
real price of rupee and manufacturing exports as expected. In other words, the result shows that a
real depreciation of the rupee helps to boost manufacturing exports while a real appreciation
adversely affects exports. It also means that Mauritian exporters are adversely affected in terms of
export earnings in case of swings in real exchange rates as they are unable immune themselves
from the adverse movements in real exchange rates for simple reason that hedging is deemed to be
costly. This has always been the case in Mauritius. For example, presently, the textile sector is
surviving thanks only to the large established players. Small players are having much difficulty to
operate owing to frequent swings in the exchange rate. Moreover, a real depreciation of the
Mauritian rupee makes imports dearer and raises the cost of production of firms in the
manufacturing firms, which rely heavily on imports of their raw materials. As a result of increased
cost of production, competitiveness is eroded on the world markets characterized by fierce
competition from emerging players from China, Pakistan, Sri Lanka, India, Brazil and other Asian
economies. Thus, a real depreciation of the rupee adversely impact on Mauritian manufacturing
exports.

18

5.1.2. Real Manufacturing Import (RMI) Model

Both Trace and Maximum eigen value for cointegration result in one cointegrating equation. The
VECM estimates for the RMI equation with Z-Score as a measure of volatility are provided below:
Table 2: Vector Error Correction Estimates with Z-Score as Measure of Volatility
Estimation Methods-Ordinary Least Squares
Independent Variable
D (Real Manufacturing Import
Equation)
First Differenced(Real Manufacturing
Imports)

Coefficient

Std. Error

t-Statistic

Prob.

-0.138264

0.042674

-3.240009

0.0018

Second Differenced(Domestic Income)

0.047769

0.011408

4.187143

0.0001

Third Differenced(REER)

-0.033969

0.009938

-3.418225

0.001

Third Differenced(Volatity Z-Score))

0.045544

0.014831

3.070962

0.003

0.521673

0.251834

2.071497

0.0417

Second Differenced Real Manufacturing

Imports

-4.743137

2.366611

-2.00419

0.0486

Second Differenced(Volatity Z-Score))

-0.405053

0.194618

-2.081267

0.0408

Third Differenced(Volatity Z-Score))

-0.45244

0.195285

-2.31682

0.0232

D(Domestic Income Equation

Second Differenced(Domestic Income

D(Volatility Equation)

R-squared
Adj. R-squared
Source: Eviews 7.1

0.645717
0.477899

19

From Table 2, the coefficients of the error correction terms are depicted by D(MRI) and is
significant with a p-value of 0.0018 and a coefficient of -0.138264, suggesting that the independent
variables adjust moderately (13.8%) towards long run equilibrium values of RMI. The second
difference of domestic income the third difference of REER the third difference of volatility, are
also significant coefficients from the estimates with p values of 0.001, 0.001 and 0.003
respectively. It is also noted that the second difference of real manufacturing imports significantly
influence exchange rate volatility as evidenced by a p-value of 0.0486. The results are consistent
with the findings of Siregar and Rajan (2002), Marquez and Schindler (2006), Hayakawa and
Fukunari (2008) and Huchet-Bourdon and Korinek (2012) but not consistent with the findings of
Samson et al (2003). The positive coefficient of domestic income (0.047769) means that an
increase in domestic income encourages more consumption and more import given that Mauritius
has a high propensity to import. It also means that higher income encourages more investment and
capital goods not produced locally have to be purchased from foreign countries. Further, as
expected, the real effective exchange rate coefficient is negative (-0.033969) implying a negative
impact of real exchange rate on imports. The latter means that real exchange rate changes raised the
cost of imports for Mauritius, which has an export led growth strategy and relies heavily on primary
inputs and an adverse movement in real exchange rate, had a dampening effect on imports. Last,
but not least, as expected, higher exchange rate volatility increases imports as Mauritian importers
find their cost of imports increase and become risk averse. This is explained by the fact that that
agreement regarding exchange rate at the time of trade contract is done much earlier than payments,
which are made upon delivery. Hence, Mauritian importers cannot predict future rates accordingly,
creating a profit uncertainty environment thereby reducing their imports with time.

20

5.2. Vector Error Correction Estimates- EGARCH as Measure of Volatility

5.2.1 Real Manufacturing Export (RME) Model
The Trace test results show 3 cointegrating equations. The VECM estimates for the RME equation
with EGARCH as a measure of volatility are provided below.
Table 3:Vector Error Correction Estimates with EGARCH as Measure of Volatility
Estimation Methods-Ordinary Least Squares
Real Manufacturing Exports
Independent Variable
D(Real Manufacturing Exports
Equation)
Third Differenced(REER)

Coefficient

0.857483

Std. Error t-Statistic

0.419412

Prob.

2.044486

0.0448

D(Foreign Income Equation)

First Differenced(Real
Manufacturing Exports)

-0.003719

0.001655 -2.246812

0.0279

First Differenced(Foreign Income

-1.206151

0.410337 -2.939415

0.0045

Third Differenced(Foreign Income

1.46369

0.65192

2.2452

0.028

Third Differenced(REER)

0.006747

0.002629

2.565951

0.0125

R-squared
Adj. R-squared
Source: Eviews 7.1

0.607509
0.353544

21

The adjusted R-squared stands at 35.35% of the parsimonious equation, which is considered
acceptable. From equations 4.158 to 4.1.61, only the first difference of real manufacturing exports
and the first difference of foreign income are significant with p-values of 0.0279 and 0.0045 and
coefficients of -0.03719 and -1.206151 respectively suggesting that real manufacturing exports
adjusts very slowly to long run equilibrium value of foreign income (0.3%) and lagged foreign
income adjusts very fast to equilibrium (120%). The significance of the second difference of REER
means that it accounts for 85.75% of real manufacturing exports. The significance of the second
difference of exchange rate volatility means that it accounts for 0.67% of foreign income and the
significance of the second difference of real manufacturing exports means that it accounts for about
0.0018% of exchange rate volatility.
5.2.2. Real Manufacturing Import (RME) Model- VAR Estimates
Given that no cointegration is found in the real manufacturing import equation when EGARCH is
used as a measure of volatility, the model is estimated using an unrestricted VAR model. The
Vector Autoregression Estimates (lag length 1) for the Real Manufacturing equation with
EGARCH as exchange rate volatility measure is provided in the following table:

22

Table 4: Vector Autoregression Estimates

Sample (adjusted): 1981 2011
Included observations: 31 after adjustments
Standard errors in ( ) & t-statistics in [ ]
MRI
MRI(-1)

0.953237
-0.0905
[ 10.5328]

0.442353
-1.49443
[ 0.29600]

0.665355
-1.30691
[ 0.50910]

DY(-1)

0.003025

0.886434

0.159282

-0.00723
[ 0.41853]

-0.11935
[ 7.42730]

-0.10437
[ 1.52609]

0.008517
-0.01241

-0.05025
-0.20489

0.219201
-0.17918

EGARCH
0.0000658
-0.000069
[-0.95602]
0.0000073
7
0.0000055
[-1.34144]
0.0000043
1
0.0000094

[ 0.68643]
127.1796

[-0.24526]
890.7892

[ 1.22335]
1338.628

[ 0.45630]
0.810056

-81.124
[ 1.56772]
0.017196
-0.06638
[ 0.25905]

-1339.58
[ 0.66498]
-0.422986
-1.09614
[-0.38589]

-1171.49
[ 1.14267]
-0.601511
-0.9586
[-0.62749]

-0.0617
[ 13.1287]
0.0000567
-0.00005
[ 1.12273]

REER(-1)

EGARCH(-1)

DY

REER

D(MRI)
0.835053

D(DY)
0.706992

D(REER)
0.153837

D(EGAR
CH)
0.908964

Adj. Rsquared
0.809676
Source: Eviews 7.1 Output

0.661914

0.023659

0.894959

R-squared

Table 4 depicts the VAR estimates for the real manufacturing import with EGARCH as a measure
of exchange rate volatility. In order to know the significance of the estimates, it is very important to
order the system by variable and then estimate the equations so obtained to obtain the p-values.
When the system is ordered by variable, the estimates for the p-values are as follows:

23

Table 5: Vector Autoregression Estimates with EGARCH as Measure of Volatility

Real Manufacturing Imports
Independent
Variable

Coefficient

Std. Error

t-Statistic

Prob.

First
Differenced(Real
Manufacturing
Imports)

0.976252

0.116292

8.394808

0.0000

First
Differenced(Domestic
Income)

0.842061

0.114375

7.362274

0.0000

0.732252

0.095098

7.699952

0.0000

D(Domestic Income
Equation)
D(Volatility
Equation)
First Differenced
Volatility
R-squared

0.835053

Adj. R-squared
Source: Eviews 7.1

0.809676

From Table 5, the first difference of manufacturing imports and first difference domestic income
and are significant with a p-values of 0.000 each and coefficients of 0.976252 and 0.842061
respectively,, suggesting that the independent variables adjust quite rapidly towards long run
equilibrium values of RMI..
5.3. Granger Causality/Block Exogeneity Wald Tests Results
Having analysed the long run relationship between the variables, this section confines itself to
analysing possible causality between the variables. Using Z-Score as a measure of volatility, as far
as the results for real manufacturing export equation is concerned,(RME), there is no evidence of
bidirectional causality. However, causality runs from FY to MRE, from REER to FY and from
REER, FY and VOL simultaneously to FY as the Block Exogeneity Wald test p values stand at
0.0288, 0.0188 and 0.0343 respectively.
24

The results for the real manufacturing import equation shows unidirectional causality for the RMI
equation as causality runs only from DY to RMI, from REER to RMI and from VOL to RMI as
shown as p values of 0.0001, 0.0024 and 0.0085. All the variables taken together also granger-cause
RMI as evidenced by a p-value of 0.0000.
When EGARCH is used as a measure of volatility no causality is found the RME and RMI
equations given that all the p values are greater than 0.05

6.0. Summary, Implications and Recommendations.

This paper gives an analysis of the impact of exchange rate volatility manufacturing trade flows in
Mauritius. The econometric analysis employs yearly data for the period spanning 1980-2011 and two
measures of exchange rate volatility, viz, the Z-score and the EGARCH are used. When using the Zscore, it is found that exchange volatility does not affect real manufacturing exports. However,
exchange rate volatility is found to be significantly affecting real manufacturing imports. When the
EGARCH is used, the Vector Autoregression estimates suggest that exchange rate volatility has not
been a determining factor influencing real manufacturing imports.
The findings of the paper are intended to have important implications for the Mauritian
manufacturing sector. In the first instance, it means that the Mauritian manufacturing sector is
adversely affected in terms of earnings in case of high swings in real exchange rates. It may also
mean that frequent swings in the MUR might bring uncertainty on the part of foreign buyers such
that in the long run, they might contemplate to switch to cheaper markets, which means that given
the elasticity of the foreign demand for manufactured goods, Mauritian manufacturers cannot
increase their prices and hence suffer in terms of earnings. The results also mean that hedging
facilities are not so much in place to immune manufacturers in Mauritius from frequent swings in
real exchange rates. This is due to high costs associated with such transactions and acute
competition facing the Mauritian manufacturing sector. As far as real manufacturing imports are
concerned, the results confirm that Mauritius has a very high propensity to import as evidenced by
the significance of domestic income with respect to real manufacturing imports. Movements in real
exchange rates as well as volatility are also significant in explaining real manufacturing imports
which means that Mauritius should try to bring strategies to promote import substitution, albeit at a
lower cost. This shall also help to reduce our current account deficits given that a large proportion
of our manufacturing imports are meant for production as Mauritius practices an export led growth
strategy. The results also warrant an analysis of the constraints facing the Mauritian export sector as
25

well as the level of imports as well as what informed decision policy makers should make to
address the problems facing our international trade sector. Further, it can also be a case for
exporters who can argue their case to Government by lobbying for an export-friendly
macroeconomic environment and assist them to plan their export activities more effectively.
I believe it is high time for the Mauritian authorities and exporters to start thinking about payment
in dollar for our exports. We pay most of our imports in dollar, yet we receive payment for most of
our imports in euro. This is a situation which requires some attention among authorities. In
essence, Asian countries such as Hong-Kong, India, Pakistan, Bangladesh, China etc exporting to
Europe are paid in dollar when claiming payment from France or Great Britain.. However, it is
important to note that while using the dollar as a single currency for our imports and exports would
be very practical, this policy would not eliminate the risks of currency fluctuation, for the dollar is
also prone to high level of depreciation.
On the regional scene, it is also high time for the regional bodies like the SADC, COMESA and the
African Union to start thinking about a regional currency pegged to a major world currency to
immune members from frequent fluctuations in the exchange rates and thus stabilize export
revenues for their export operators. Moreover, in order to boost export performance and reduce
costs, it is suggested that the existing stimulus package be continued and a special stimulus package
for the manufacturing sector sectors be put in place to smooth them out of their financial difficulties
they might face in the light of adverse movements of the rupee. As regards the appreciating USD
which is another burden for imports of raw materials, it would be appropriate that import
substitution strategies are in place such that investors may be encouraged to produce the imported
raw materials in Mauritius at lower cost.
Further, the results also suggest a diversification of both of our export products and markets. We
note that manufacturing exports for Mauritius, are concentrated in Europe. Bilateral and regional
agreements should be intensified with a view to diversify our markets further.
Besides, to boost export performance in the manufacturing sector, constraints facing our exporters
should be reduced to a desirable level. For example, lower electricity charges, export processing
efficiency in terms of reduced time for processing exports and lower rates of interest through the
stimulus package. It is believed that these additional measures will give the export operators some
breathing space in the light of external shocks facing their enterprises.
26

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