Do large capital inflows hinder competitiveness? The Dutch disease in Ethiopia

This paper investigates whether large inflows of foreign aid and remittances have had a damaging impact on the Ethiopian real exchange rate (RER). We improve the current empirical literature by: (i) compiling a unique quarterly dataset to provide a larger sample size and enable the modelling of important intra-year dynamics - which should lead to better model specifications; (ii) providing a new empirical approach (Unobserved Components) to test the 'Dutch disease' hypothesis; and (iii) using several cointegration approaches to further test the robustness of our conclusions. Our results suggest that there are two main long-run determinants of the RER in Ethiopia: trade openness is found to be correlated with RER depreciations, while a positive shock to the terms of trade tends to appreciate the RER. Foreign aid is not found to have a statistically significant impact, while there is only weak evidence that remittances are associated with RER appreciations. The lack of empirical support for the Dutch disease hypothesis suggests that Ethiopia has been able to effectively manage large capital inflows, thus avoiding major episodes of macroeconomic instability. We believe that most African countries will therefore be able to absorb large inflows of foreign capital without damaging their external competitiveness.