The effects of overvalued exchange rates on the export competitiveness of less developed countries: Evidence from the Communaute Financiere Africane (CFA)

From 1948 to the 1980s, the monetary arrangement of the CFA zone enforced monetary stability and openness which led to more direct investments and a strong regional currency. But from the late 1980s to early 1990s the problem of the currency being overvalued became a concern because of the economic and development crisis which plagued the region. Highly overvalued exchange rates and restrictive trade policies are blamed for undermining the competitiveness of exports, shrinking the export sector, reducing employment and government revenues and slowing down economic growth.;This study hypothesizes that the real exchange rate is a major determinant of the export competitiveness of the CFA zone. An overvalued real exchange rate signals resource movements from the export sector to the production of domestic goods. This reduces the profitability and the ability of exporters to compete in international markets. Falling exports create a foreign exchange gap and reduce access to much needed imports of capital and intermediate goods necessary for development and growth. Since the real exchange rate is a strategic variable for determining the competitiveness of the CFA zone, it is important that policy makers be made aware of its macroeconomic determinants and the impact of overvaluation on exports to facilitate sustainable management decisions.;The study uses instrumental variables and two-stage least square estimation techniques suitable for panel data to analyze eleven CFA zone countries from 1980–2004. A fixed-effects regression model is employed to investigate the determinants of real exchanges rate across the sample of countries. An investigation of the impact of real exchange rate (RER) overvaluation on the performance of disaggregated exports is also conducted. The null hypothesis that aid inflow, terms of trade, domestic credit and investments do not influence RER movements was rejected as the results show a highly significant relationship between these variables. The RER effects of the recent CFA parity switch to the euro in 1999 was of great interest in this analysis. The results indicate that this policy change has not been favorable to the zone as it has contributed to the appreciation of the real exchange rate.;An analysis of the magnitude of overvaluation of the CFA franc using the traditional purchasing power parity method (PPP) and a model based method validates the gross misalignment in the early 1990s. The degree of misalignment is higher with the model based approach compared with the PPP method. The 2003–2004 period shows that 91 percent (model based method) and 63 percent (PPP method) of the CFA zone RER are overvalued.;On the export performance effects of RER overvaluation, the empirical analyses do show that the effects of RER overvaluation on export performance depend on the sector. The results find no evidence that overvaluation negatively affects the manufacturing sector. However, overvalued exchange rates do have an adverse effect on the agricultural sector and on aggregated exports. This confirmation requires that the central banks of the zone have to diligently monitor the fluctuations in the macroeconomic variables that cause the RER to appreciate and encourage the respective governments to institute policies that stabilize the RER.