Impact of Exchange Rate on Trade Balance of India: Evidence from Threshold Cointegration with Asymmetric Error Correction Approach

Published date01 May 2024
DOIhttp://doi.org/10.1177/00157325231158855
AuthorLingaraj Mallick,Smruti Ranjan Behera,Mita Bhattacharya
Date01 May 2024
Subject MatterOriginal Articles
Impact of Exchange
Rate on Trade Balance
of India: Evidence from
Threshold Cointegration
with Asymmetric Error
Correction Approach
Lingaraj Mallick1, Smruti Ranjan Behera2
and Mita Bhattacharya3
Abstract
In this research, we investigate the dynamic relationship between the trade bal-
ance and exchange rate in the case of India using threshold cointegration and an
asymmetric error-correction model. Empirical results validate that the long-run
dynamic relationship between the trade balance and exchange rates is asymmetric.
In the short run, the trade balance responds only due to positive deviations in
the exchange rate. In contrast, in the exchange rate model, the exchange rate
reacts only due to negative deviations in the trade balance. In addition, the results
exhibit that the adjustment following variation in the exchange rate seems higher
than the adjustment in the trade balance in the short run. Besides, the results
indicate that the speed of adjustment due to the positive and negative shocks
differs in the trade balance and the exchange rate models. Further, the uni-
directional Granger causality result suggests that the trade balance substantially
affects the exchange rate. However, the Granger causality effect of the exchange
rate on the trade balance seems minimal. Finally, our results validate the impact
of momentum equilibrium adjustment path asymmetric effects between the trade
Original Article
Foreign Trade Review
59(2) 279–308, 2024
© 2023 Indian Institute of
Foreign Trade
Article reuse guidelines:
in.sagepub.com/journals-permissions-india
DOI: 10.1177/00157325231158855
journals.sagepub.com/home/ftr
1 Department of Economics, Maulana Azad National Urdu University, Hyderabad, Telangana, India
2 Department of Humanities and Social Sciences, Indian Institute of Technology Ropar, Rupnagar,
Punjab, India
3 Department of Economics, Monash Business School, Caulfield, Victoria, Australia
Corresponding author:
Smruti Ranjan Behera, Department of Humanities and Social Sciences, Indian Institute of
Technology Ropar, Rupnagar, Punjab 140001, India.
E-mail: Smruti.ranjan@iitrpr.ac.in
280 Foreign Trade Review 59(2)
balance and exchange rate, indicating that the adjustment path is asymmetric in
the long run. Therefore, policy planners in India should consider the asymmetric
adjustment between these two drivers to overcome trade balance discrepancies
in the short and long run.
JEL Codes: F40, F41, C22, C32, C12
Keywords
Trade balance, exchange rate, non-linear threshold cointegration, asymmetric
error-correction, causality
Introduction
The relationship between the trade balance and the exchange rate has stirred much
interest, particularly in the oating exchange rate era. Exchange-rate movements
continually aect imports and exports, directly impacting the trade balance of any
economy. International trade theory denes domestic currency depreciation (or
devaluation) as directly aecting a country’s trade balance. Moreover, it is expect-
ed that improvements to the trade balance do not immediately change at the time
of currency depreciation, which indicates that the exports and imports of previous
years have long-term consequences for and cumulative impacts on the current
trade balance (Arize et al., 2017). Therefore, any exchange-rate volatility has an
immediate and cumulative eect on the trade balance (Dogru et al., 2019; Martin,
2016). The current account imbalance and its adverse impact on the exchange rate
are serious concerns for a developing economy like India. Since the devastating
global nancial crisis (GFC) in 2008, there has been an emphasis on evaluating
current account decits (CADs) and their associated negative consequences for
most developed and developing economies (Behera, 2015a, 2015b, 2016).
Some scholars claim that the CAD significantly contributes to global financial
crises (Blanchard & Milesi-Ferretti, 2009; Caballero et al., 2008; Obstfeld &
Rogoff, 2009; Portes, 2009). The high and unsustainable CAD threatens a grow-
ing economy and can surmount efforts towards debt insolvency in the long run
(Behera, 2017). A high and persistent CAD occurs due to several factors in an
open economy model. These can trigger unwarranted impacts on the balance of
payments (BOPs) of a country. One significant factor contributing to the deterio-
ration of the CAD is exchange-rate fluctuation. Therefore, exchange-rate dynam-
ics and their effect on the BOPs are vital issues to any emerging economy.
The pioneering Marshall–Learner (M–L) stability condition is usually applica-
ble when measuring the effects of currency depreciation or devaluation on the
trade balance of a country.1
The M–L conditions require the estimation of export and demand models
(Arize et al., 2017). Analysing export demand is tedious as it requires a proxy of
world income, world export prices and effective exchange rates for all trading
partners. However, some studies have employed this approach (Arize, 1990;
Warner & Kreinin, 1983). For instance, Arize (1990) used the export and demand

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