Foreign Capital Inflows and Real Exchange Rate Appreciation in Kenya: Revisiting the Dutch Disease Hypothesis

Abstract

Foreign capital inflows play an important role in Kenya’s macroeconomic performance, but their effects on the real exchange rate remain empirically mixed. This study examines the effects of personal remittances, official development assistance (ODA), foreign direct investment (FDI), and external debt on real exchange rate movements in Kenya, with particular emphasis on the Dutch Disease hypothesis, which suggests that large capital inflows may contribute to real exchange rate appreciation. The study uses annual time-series data for 1980–2024obtained from the World Bank and the Central Bank of Kenya. Stationarity was assessed using the ADF and Phillips-Perron tests, while the ARDL model was employed to estimate short-run and long-run relationships. The bounds test confirmed a long-run relationship among the variables, with an F-statistic of 7.522, exceeding the 5% upper critical bound of 4.799. In the long run, remittances had a positive and significant effect on the real exchange rate, increasing it by 1.82% following a 1% increase in inflows, while ODA had a negative and significant effect, reducing the real exchange rate by3.62%. FDI and external debt had positive but insignificant long-run effects. In the short run, remittances, FDI, and external debt generally exerted positive effects, while ODA had negative effects. The error correction term was negative and significant, indicating that 12.16% of short-run disequilibrium is corrected annually. The findings provide partial evidence of the Dutch Disease hypothesis, particularly through the appreciation associated with remittance inflows, and underscore the need for policies that promote the productive use of capital inflows, effective ODA utilisation, sustainable external debt management, and exchange rate stability.