Assessing the Impact of Great Recession on India’s Trade in Gravity Model Framework

Date01 November 2018
Published date01 November 2018
AuthorRaj Rajesh
Subject MatterArticles
Assessing the Impact of
Great Recession on
India’s Trade in Gravity
Model Framework
Raj Rajesh1
This study examines the efficacy of trade channel in the transmission of recent
Great Recession impulses to the Indian economy. To investigate the impact
of Great Recession on India’s trade, gravity model of trade was estimated by
regressing trade flows on size of economies, level of economic development,
geographical distance and dummies for common border, landlocked country,
islands, colonial history, common language, etc. For the same, quarterly data with
respect to 11 advanced nations (namely, Austria, Australia, Canada, Denmark,
Japan, Korea, New Zealand, Sweden, Switzerland, the United Kingdom and
the USA) and nine emerging market economies (EMEs), including the BRICS
nations (namely, Brazil, Russia, Indian, China, South Africa; Indonesia, Mexico,
Saudi Arabia and Turkey) for the period from 2001q1 to 2013q4 were con-
sidered. Estimations suggest that Great Recession had an adverse impact on
India’s bilateral import volume and total trade volume after a lag of three quar-
ters. Findings validate that trade channel acted as a conduit for transmission of
Great Recession impulses to the Indian economy. This suggests that as the Indian
economy becomes progressively more integrated with the global economy, con-
tainment of potential adverse shocks emanating from trade sector would call for
more pro-active policies. Lessons from the Indian economy could be useful for
other similar EMEs.
JEL Classification: F14, G01
Trade, gravity model, Great Recession, panel data, India
Foreign Trade Review
53(4) 239–270
©2018 Indian Institute of
Foreign Trade
SAGE Publications
DOI: 10.1177/0015732518797174
1 Internal Debt Management Department, Reserve Bank of India, Mumbai, India.
Corresponding author:
Raj Rajesh, Internal Debt Management Department, Central Ofce Building, Reserve Bank of India,
Mumbai 400001, India.
240 Foreign Trade Review 53(4)
The world has become more globalised than ever. A series of economic crises that
occurred since the 1990s (such as the Mexican crisis, 1994; East Asian crisis,
1997–1998; Brazilian crisis, 1999 and the Great Recession) have evidenced that
crisis can get transmitted from a country (where it originated) to other countries
through designated transmission channels. Main channels for transmission of cri-
sis impulses across borders include finance channel, trade channel and confidence
channel (Mohanty, 2010; RBI, 2010). Finance channel operates through the finan-
cial markets wherein a country’s equity, foreign exchange and money markets get
affected in the aftermath of a crisis event elsewhere. Trade channel adversely
impacts the merchandise sector and decline in imports and exports moderates or
slows down domestic economic activity as production and investment activities
get hampered on account of sluggish external demand. The confidence channel
operates through the financial markets, wherein across the board decline in busi-
ness and consumer confidences undermines resource mobilization activities of
firms through the financial market and thereby adversely affect production and
investment activities.
During the Great Recession, all these transmission channels operated in India;
albeit their strength varied, and the finance channel was more dominant as com-
pared to trade channel (RBI, 2010). In the present analysis, however, only the
trade channel has been analysed for understanding the adverse impact of the Great
Recession on the Indian economy. This has been done for the sake of making it a
study focused only on trade.
Though there is an abundant literature on trade and growth linkages, little
attention has been paid to the issue as to whether, and to what extent, crisis shocks
influence bilateral trade flows of a country. This has significant policy implica-
tions as trade flows affect growth and thereby economic welfare of an economy.
Furthermore, a broader understanding of how the shocks affect trade flows could
help policy makers in designing counter-cyclical policies in a better way. Against
this premise, this study examines whether the trade channel acted as a conduit for
transmission of Great Recession impulses to the Indian economy by analysing
bilateral trade flows of the Indian economy with select economies, both the
advanced economies (AEs) and the emerging market economies (EMEs).
The present analysis has a number of distinctive features differentiating it from
earlier studies. First, this study is based on high-frequency (quarterly) data, which
present a more realistic assessment of the impact of crisis. Second, the analysis is
undertaken in a panel gravity model framework, covering bilateral trade flows,
which has theoretical foundations. Third, none of the studies, so far have exam-
ined how the Great Recession had affected trade, export and import of the Indian
economy using bilateral level trade flows data.
The remainder of the study is organised as follows: the next section discusses
select literature in this area. The third section analyses the impact of Great
Recession on components of aggregate demand in India. The fourth section covers
data sources and empirical estimation. Concluding observations of the study are
set in the final section.
Rajesh 241
Literature Survey
Trade openness could possibly cause the business cycle of an open economy co-
move with its trading partners either in the same or opposite direction depending
upon the nature of trading relations. This suggests that trade sector could act as a
conduit for transmission of international crisis from one country to another, if
there are trade linkages between them. However, given the ambiguous impact of
trade openness on business cycles correlation, there is a clear divide amongst the
experts on the issue whether trade linkages act as a conduit for transmission of
crisis impulses. Some consider that international trade linkages do act as a conduit
for transmission of crisis from one country to another (Eichengreen, 1999). Akin
(2006) attached importance to trade linkages as medium of transmission of crises,
but contended that trade channel gets overshadowed by other transmission mech-
anisms. On the contrary, Mason (1998) and Harrigan (2000) contended that trade
linkages do not play any role in the transmission of international crisis, citing the
fact that in the past crises, namely, Mexican crisis, Asian crisis and Russian crisis,
trade sector did not act as a conduit for international transmission of crisis.
A few studies relating to the Indian economy have also dwelt on the issue
whether trade sector acted as a conduit for transmission of international crises to
the Indian economy. These studies have covered the role of trade in transmission
of crisis with respect to the Great Recession (Fidrmuc & Korhonen, 2010;
Mohanty, 2010; RBI, 2010).
Fidrmuc and Korhonen (2010) analysed the transmission of global financial
crisis to business cycles in China and India using quarterly GDP data from 1993
to 2008. They reported that trade intensity between the OECD economies and
India had a significant effect on the correlation of their GDP cycles at business
cycle frequencies.
Mohanty (2010) undertook analysis of the impact of the Great Recession on
the Indian economy since the second half of 2008–2009 over three distinct
phases. He found that despite sound fundamentals and no direct exposure to the
sub-prime assets, Indian economy got affected by global financial crisis through
all the channels—trade, finance and confidence channels—reflecting increasing
globalization of the Indian economy than what is apparent in terms of tradi-
tional indicators.
RBI (2010) observed that global financial crisis got transmitted to the Indian
economy through three channels, namely, finance, trade and confidence channels.
Using VAR framework, it found that finance channel had a more dominant role in
transmitting the effects of global developments to Indian economy. Analysing the
quarterly data from 1996 to 2009 in VAR framework, it reported that about 50 per
cent of variation in GDP in India was explained by financial variables, while exports
of goods and services explained only about 9 per cent of output variation.
Notwithstanding the above-mentioned studies, none of the studies, so far, have
examined the impact of Great Recession on trade, export and import of the Indian
economy using bilateral level trade data in gravity model framework (which is
premised on theory). Against this premise, this study seeks to bridge this gap in

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