Determinants of Current Account Deficit: Empirical Evidence from Ethiopia

Abstract

The main objective of this study is to empirically investigate the determinants of current account deficits in Ethiopia using annual time series data ranging from 1975 to 2016. To investigate the long run and short run relationship between current account deficit and its determinants, Autoregressive Distributed Lag (ARDL) model or bounds testing approach to co-integration and Error Correction Model (ECM) are applied respectively. The results of the Augmented Dickey Fuller (ADF) test indicate that the variables under consideration are a mixture of integrated of order zero and order one, that is, I(0) and I(1). Moreover, the result of bounds testing confirms the existence of stable long run relationship between current account balance and its determinants. The empirical result reveals that net foreign asset, real effective exchange rate, terms of trade and real GDP are found to have a negative impact on current account deficit, while government budget balance positively affected current account deficit in the long run. However, inflation is found to be insignificant both in the short run and in the long run. The ECM also shows that, real effective exchange rate, terms of trade and inflation have no significant effect on current account deficit in the short run. As a policy implication, it is recommended that employing appropriate policy mix along with devaluation, diversification and improving the quality of exports and implementation of efficient tax administration system are among the policy options that are supposed to alleviate the existing current account deficit.

Keywords: ARDL, Bounds testing, Current account deficit, ECM, Ethiopia

DOI: 10.7176/RJFA/11-17-06

Publication date:September 30^th 2020