Exchange rate volatility and macroeconomic stability in Sierra Leone: using EGARCH and Markov switching regression

This study investigates the core drivers of exchange rate volatility and macroeconomic stability in Sierra Leone, a fragile, post-conflict economy exposed to severe external and internal macroeconomic shocks for the period 2000–2020 with data sourced from World Bank Development Indicators (WDI) and Bank of Sierra Leone. We develop a micro-founded model of currency substitution and use a dual methodological approach that combines both the baseline Exponential GARCH model and the Markov-Switching Regression (MSR) to capture the asymmetric effects, regime-dependent and persistent nature of exchange rate volatility over the study period. Findings from the study demonstrate that currency substitution emerges as a persistent and significant determinant of currency depreciation in Sierra Leone. This finding is consistent across all the model estimations, confirming the destabilizing role of dollarization in undermining monetary stability. A key finding emerges from the MSR analysis: the effect of interest rate differentials is profoundly asymmetric across the two regimes. An increase in the domestic interest rate during the stability period significantly supports currency appreciation. In contrast, during the high volatility regime associated with the crisis period, raising domestic interest rates has a destabilizing effect; instead of currency appreciation, it leads to currency depreciation. Further findings confirm strong evidence of a structural break in the model as revealed by the Chow structural breakpoint test. This further demonstrates that the Ebola crisis significantly triggered a shift in the exchange rate volatility in Sierra Leone. From these findings, the study suggested crucial policies worthy of attracting foreign investments.