Financial liberalization and exchange rate volatility: evidence from South Africa

Abstract

This paper investigated the impact of financial liberalization on the South African exchange rate, known as the rand estimated through Autoregressive Distributed Lag (ARDL) model. The focus of the paper includes the determination of cointegration relationship amongst balance of payments, interest rate, inflation and financial liberalization represented through the liberalization indices developed by Abiad from 1973 to 2005. The preliminary steps to estimating the mentioned ARDL included detecting any prevalence of unit roots in the variables through the augmented Dickey-Fuller (ADF), Kwiatkowski, Phillips, Schmidt and Shin (KPSS) and Phillips-Perron (PP) tests. The estimated coefficients were also tested for their significance using the Wald tests and also underwent stability tests using the cumulative sum of residuals (CUSUM) and the cumulative sum of squared residuals (CUSUMSQ). The results from all the tests conducted indicated the presence of unit roots with some variable and their return to stationarity after the first order differencing. The ARDL estimates indicated the existence of long-run cointegrating relationship amongst the variables exchange rate, balance of payments, inflation, interest rate, gross domestic product and financial liberalization.