The Behaviour of the Malawi Kwcha in a Liberalized Environment

The paper investigates some of the key factors that have influenced exchange rate movements since the foreign exchange market was liberalized in 1994. The paper adopts a general empirical specification of the exchange rate equation involving the interest rate and price differentials, as well as current account balance and net external flows to explain the exchange rate movements. In general, the empirical results indicate that increases in interest rates differential, has tended to attract, though insignificantly, private capital flows, leading to exchange rate appreciation. Deteriorations in current account, and reductions in net capital flows, on the other hand, are associated with depreciation of exchange rate. A rise in the price differential (widening gap between domestic and foreign prices) leads to exchange rate depreciation. Subject to the usual limitations of any econometric enquiry, the above results offer the following tentative conclusions. The insignificant impact of interest rate differential on attracting capital flows points to the need for government to address some structural bottlenecks. For instance, infrastructure services such road network and utilities (electricity and water supply) require improvement. Hence the current policy of lowering interest rates is therefore in line with maintaining a relatively depreciated currency. This implies that a demand for low interest rate regime must lead to a relatively weak Malawi kwacha internationally. On the other hand, changes in the current account balance have a bearing on the exchange rate market. Thus policies that influence exports and imports of goods and services also determine exchange rate movements. Likewise, prospects concerning donor funding influence the direction of market forces in determining the exchange rate movements. Therefore, government’s credibility regarding the use of external public funds and implementation of related reforms is important in as far as stability of the foreign exchange market and overall macroeconomic stability are concerned.