Impact of Exchange Rate Changes on the Trade Balance of India: An Asymmetric Nonlinear Cointegration Approach
| Date | 01 February 2021 |
| DOI | 10.1177/0015732520961328 |
| Published date | 01 February 2021 |
| Subject Matter | Articles |
Impact of Exchange
Rate Changes on the
Trade Balance of India:
An Asymmetric Non-
linear Cointegration
Approach
Sajad Ahmad Bhat1 and Javed Ahmad Bhat1
Abstract
Applying an asymmetric model, the study reported no evidence of J-curve
phenomenon in case of India. In the short-run currency appreciation deteriorates
the trade balance and currency depreciation improves it. In the long-run, again the
similar response is observed, however, only the impact of currency depreciation
is statistically significant. Increase in domestic demand deteriorates the trade
balance by a greater magnitude than improvement is observed due to the decline
in domestic demand conditions. Finally, foreign demand hike improves the trade
balance relatively by a higher magnitude; however, the impact of a foreign demand
decline is statistically insignificant.
JEL Codes: F4, F41, F42
Keywords
Trade balance, exchange rate, domestic demand, foreign demand, asymmetry
Article
1 School of Economics, University of Hyderabad, Telangana, India.
Corresponding author:
Javed Ahmad Bhat, School of Economics, University of Hyderabad, Telangana 500046, India.
E-mail: apjavaid.jn@gmail.com
Foreign Trade Review
56(1) 71–88, 2021
© 2020 Indian Institute of
Foreign Trade
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DOI: 10.1177/0015732520961328
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72 Foreign Trade Review 56(1)
Introduction
The impact of exchange rate changes on the macroeconomic dynamics of an
economy has long been recognised as a matter of concern. However, substantial
emphasis on the issue has evolved considerably with the advent of the generalised
floating era. The gyrations of exchange rate have effects on imports and exports
of a country and as such leave an impact on its trade balance. The standard theo-
retical contours presume that a domestic currency depreciation/devaluation would
make the exports cheaper and imports more expensive and thereby improves the
trade balance of the country whose currency depreciates. However, if the imports
are priced in foreign currency and exports are priced in domestic currency, certain
rigidities prevent the improvement of trade balance immediately following a cur-
rency depreciation. Because at the time of depreciation, while the previous pur-
chase orders or contracts for import and export quantities remain unchanged, the
price changes have an instantaneous effect. As a result, value of export earnings
fall and import payments rise and thereby depreciation worsens the trade balance
in the immediate period. However, once quantity and price adjustments are made
in the long-run, an improvement in the trade balance is observed.1 This temporary
deterioration of a country’s trade balance followed by an improvement due to a
domestic currency depreciation is popularly known in the literature as the ‘J-curve’
effect.2
The possible influence of currency depreciation or devaluation on the trade
balance of an economy is usually scrutinised through the Marshal-Lerner (M-L)
condition.3 However, scholars (Warner & Kreinin, 1983) have unanimously docu-
mented that the M-L condition is easily satisfied; hence, the devaluation or depre-
ciation will improve the trade balance of an economy in the long run. Subsequently,
instead of measuring the demand-price elasticities, some studies have established
a direct link between the exchange rate changes and the trade balance by employ-
ing various measures of latter like ratio of import value to export value and exports
less imports.
With the econometric advancements, scholars went a step further to examine
whether there exists any long-run cointegration relationship between the two vari-
ables. For instance, Bahmani-Oskooee (1991) using conventional cointegration
approach documented the evidence of long-run relationship between the trade
balance and real effective exchange rate (REER). Subsequently, new and improved
approaches of cointegration were applied; however, the evidence reported is
largely inconclusive. Some studies like Bahmani-Oskooee (2001), Singh (2002),
Aziz (2008) and Sun and Chiu (2010) found a positive relationship. Some others
(Hatemi & Irandoust, 2005; Liew et al., 2000; Rose, 1990; Wilson & Tat, 2001)
report the evidence of neutrality. Liew et al. (2000) maintained that the impact of
exchange rate on the trade balance is exaggerated and that it is actually the real
exchange rate and not the nominal one which affects the trade balance. However,
Bahmani-Oskooee (2001) asserted that real exchange rate does not change on its
own; it is basically the initial change in nominal exchange rate that causes a shift
or change in real exchange rate.4 In addition, Tandon (2014) analysed the relation-
ship between trade balance and real exchange rate and Korkmaz and Bilman
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