THE IMPACT OF EXCHANGE RATE CHANGES ON TRADE BALANCE

(SRI LANKAN EXPERIENCE 1977-2010)

A Research Proposal

Submitted in Partial Fulfillment of the Requirements of the

BACHELOR OF ARTSSPECIAL DEGREE IN ECONOMICS

2011/12

Department of Economics & StatisticsFaculty of Arts

University of PeradeniyaSri Lanka

Name of Supervisor: Mr. S.Sivarajasingham

Student Registration number: A / 07 / 268 Date: 16 / 03 / 2012Name: H.M.A.T.Koswaththa.

Signature of Head of the Department: Date:

Table of Contents

1. INTRODUCTION..............................................................................................................1

1.1. Background of The Study............................................................................................1

1.2. Behaviour of The Variables.........................................................................................3

2. LITERATURE REVIEW...................................................................................................4

2.1. Empirical Studies in Sri Lanka....................................................................................4

2.2. Empirical Studies in Other Countries..........................................................................5

2.3. Research Gap.............................................................................................................10

3. PROPOSED RESEARCH...............................................................................................11

3.1. Research Problem......................................................................................................11

3.2. Hypothesis.................................................................................................................12

3.3. Objectives of the Study.............................................................................................12

3.4. Importance of the Study............................................................................................13

4. METHODOLOGY...........................................................................................................14

4.1. Main Variables..........................................................................................................14

4.2. Frequency, Source of Data and Study Period............................................................16

4.4. The Model.................................................................................................................17

4.5. Econometric Tools.....................................................................................................18

REFERENCES.........................................................................................................................20

APPENDICES..........................................................................................................................22

1. INTRODUCTION

This fragment provides an initiation to the research problem and gives a distinctive

impression to the behavior of the exchange rate and the trade balance.

1.1. BACKGROUND OF THE STUDY

It is proposed to launch this study to investigate the exchange rate* behavior on trade

balance in Sri Lanka by using its 10 major trading partners. These partner countries are

selected by calculating the trade share. They are; USA, India, UK, Singapore, Japan,

Germany, Hong Kong, Iran, China and Saudi Arabia. Considering these countries the

effective exchange rates are calculated.

The exchange rate is one of the most important policy variables, which determines the

trade flows, capital flows, inflation, international reserve and remittance of an economy.

Exchange rate is the value of one currency in terms of another currency. The exchange

rate fluctuations can be seen in the floating exchange rate regimes and managed floating

exchange rate regimes. Sri Lanka is experienced depreciation except few years. The

factors which are affecting to the exchange rate movements are relative interest rate,

relative inflation level, relative income levels and etc. If we consider the Sri Lankan

situation at the independence a fixed exchange rate regime was operated linked to the

Sterling Pound. And Since 1950s the exchange rate was fixed. The direct regulations

were imposed on foreign trade by the socialist government in 1970-977. And the trade

liberalization in 1997 leads the country to follow a flexible exchange rate system. The

rupee has continuously depreciated except the years 2005, 2008 and 2010.

The dependent variable, trade balance** can be defined as the difference between

exports and the imports. This is also known as the Net Exports (NX). This trade balance

is a component of the Balance of Payments of a country.

*Exchange Rate: value of one currency in terms of another currency. **Trade Balance: The difference between the monetary values of exports and imports.

There are two major accounts in the Balance of Payments*. Those are Current Account**

and the Capital Account. The Trade Balance will be the first quarter of the current

account and it only records the exports and the imports. The trade balance can be

negative, positive or zero. Negative trade balance is occurred, when the imports exceed

the exports. And when the exports are greater than the imports there will be a trade

surplus. Trade Balance will be balanced when the exports are exactly equal to the

imports. In Sri Lanka, after 1977 the deficit was grown and it was filled by heavy

borrowings. It is said that the Sri Lanka’s Balance of trade in a Chronic deficit all over the

period.

The relationship between these variables is generally measured using the behavior of

the Real Exchange Rate (RER) in terms of bi-lateral trade and Real Effective Exchange

Rate (REER) in multi-lateral trade and the impact is measured by some specific analytical

tools. Although there are number of other criterion used to measure the impact of

exchange rate on trade balance, to fill the research gap, it is proposed to use mainly the

Granger Causality Test in this research.

As a specific objective of this study it is proposed to investigate the validity of

Marshal-Learner Condition in Sri Lanka. According to the M-L condition, A depreciation

of a country’s currency will improve the current account balance if the sum of the price

elasticity of domestic and foreign demands for imports is larger than unity.

(Ie + Xe) >1

Ie Import Elasticity

Xe Export Elasticity

*Balance of payments: are the accounts which record foreign transactions systematically. **Current Account: shows all the flows that directly affect the national income.

1.2. BEHAVIOR OF THE VARIABLES

Behavior of the main variables over 33 years (1977-2010) reflected by the below graphs.

The Exchange Rate Behavior of Sri Lanka’s major trading partners against LKR

1 4 7 10 13 16 19 22 25 28 310

10

20

30

40

50

60

70

80

90

100

USAIND RSJAPANUKSINGAPOREGERMANYHONGKONGIRANCHINASAUDHI ARABIA

Sri Lanka’s Trade Balance Behavior

1 4 7 10 13 16 19 22 25 28 31 34

-10000

-5000

0

5000

10000

15000

20000

EXPORTSIMPORTSTrade Balance

According to the literature there is a considerable relationship between these two

variables in Sri Lanka. Depreciation has been instrumental in making a favorable impact

on the trade balance (Wijesinghe 1988). And also Silva & Zen (1998) found that the

exchange rate policy after 1977 has improved the trade balance but has failed to stimulate

real output at least in the short run. These things are widely discussed under the literature

review.

2. LITERATURE REVIEW.

2.1. EMPIRICAL STUDIES IN SRI LANKA.

According to De Silva D.G. and Zen Zhu (1998), the changes in Sri Lanka’s

Trade Balance affected by changes in the exchange rate since 1977. This study has

shown that it is impossible to detect any positive effect on GDP in Sri Lanka due to

currency depreciation*. The study period was 1977-1997.VAR Analysis has been used to

identify shocks and fully control important external shocks that affect economic

performance. There were two exogenous variables used as Government Expenditure and

Foreign Direct Investment. And endogenous variables were GDP, Trade Balance,

Nominal Interest Rate and CPI. The Co integration model was estimated, which

comprised of four endogenous variables (GDP, Trade Balance, CPI, Real Exchange

Rate). Then by adding one variable at a time, the study re estimated the model and

investigates the effects of exchange rate on Trade Balance and GDP. And also allowed

for determination of the stability of the results.

Wijesinghe D.S.(1988) has found that the Nominal Exchange Rate changes has

caused improvements in Sri Lankan Trade Balance in most of the years (study period

1971-1985). And the improvements were largely contributed by the depreciation of the

Sri Lankan rupee. The Trade Balance effect of real exchange rate changes had not been so

impressive due to the high rates of inflation which prevailed in Sri Lanka in most of the

years. The effect of the unfavorable price changes on export earnings were moderated or

more than compensated for by the depreciation of the Sri Lankan rupee which induced

increased in the export volume. In the case of real exchange rate changes, the price of

imports recorded increases in most of the years. The movements of the index of nominal

effective exchange rate computed with the trade balance objective closely reflected the

effect of exchange rate changes on Sri Lanka’s trade balance. He has calculated Effective

Exchange Rates by using the variables, exports, imports etc.

Further, W.T.K.Perera (2009) has done this study to find the impact of real

depreciation of SLR on the trade balance in the short run and the long run (1970-2008),

employing bilateral trade data between Sri Lanka and its six major trading partners. There

was no specific pattern for the trade balance between Sri Lanka and its trading partners in

response to the change in real exchange rate, and none of the cases supported the J-curve

phenomenon. In the long run, only in the cases of India and Singapore has there been a

positive and significant impact on trade balance with the depreciation of the SLR. This

study emphasized that Sri Lanka has to take action to improve its income from exports

and reduce the expenditure on imports to overcome the problem in the trade deficit. The

study also revealed that both domestic and trading partners’ real incomes were important

determinants of Sri Lanka’s trade balance.

2.2. EMPIRICAL STUDIES IN OTHER COUNTRIES

Nusrate Aziz (2008) have done the Bangladesh study for 1972-2005 study period.

Mainly he has found that the Real Exchange rate has a positive effect on Balance of Trade

in in Bangladesh in the long run. Both the Engle-Granger and the Johansen test confirmed

the presence of a long run co integrating relationship among the variables of interest in

the study. The study also suggested that the real exchange rate has a significant impact on

balance of trade of Bangladesh both in the short-run and long-run. The Granger causality

test proved the causal relation between exchange rate and balance of trade of Bangladesh.

The IRF also supported the above mentioned positive impact of real effective exchange

rate on balance of trade in the long run. The study clearly indicated that real depreciations

of exchange rate have been positively associated with improvement of balance of trade. In

the first step the long-run equilibrium relation among the variables has been estimated. In

the second step, they tested the order of integration of residuals using ADF statistic.

The study done by Ng Yuen-Ling (2008) attempted to identify the relationship

between the real exchange rate and trade balance in Malaysia from year 1955 to 2006.

This study used Unit Root Tests, Co integration techniques, Engle-Granger test, Vector

Error Correction Model (VECM), and impulse response analyses. The main findings of

this paper were: (i) long run relationship exists between trade balance and exchange rate.

Other important variables that determine trade balance such as domestic income showed a

long run positive relationship between trade balances, and foreign income shows a long

run negative relationship (ii) the real exchange rate was an important variable to the trade

balance, and devaluation will improve trade balance in the long run, thus consistent with

Marshall-Lerner condition (iii) the results indicate no J-curve effect in Malaysia case. In

this research, the results supported the empirical validity of the Marshall-Lerner condition

through VECM, indicating that depreciation has improved the trade balance.

Pavle Petrovic (2009) has found that exchange rate depreciation in Serbia

improved trade balance in the long run (2001-2007), while giving rise to a J-curve effect

in the short run. Both Johansen’s and autoregressive distributed lag approach were

respectively used giving similar long-run estimates showing that real depreciation

improved trade balance. Corresponding error correction models as well as impulse

response functions indicated that, following currency depreciation, trade balance first

deteriorated before it later improves, exhibiting the J-curve pattern. The main findings of

the paper were that a real exchange rate depreciation has a significant positive long run

impact on the trade balance in Serbia, and that in the short run trade balance first

deteriorated before it later improves. The corresponding error correction models (ECM)

of trade balance captured its short run movements and indicated the existence of the J-

curve effect.

The Japanese study is done by Shao Zaiwei (2008) and identified the major

economic factors that influenced the bilateral trade balance between Japan and the US.

Differing from conventional elasticities approach, one more variable the net foreign assets

were added in the Vector Auto regression estimation using quarterly data from 1980: I to

2006: IV. The Johansen and Juselius result indicated three long-run relationships among

five macro variables: trade balance, domestic income, foreign income, net foreign assets

and real exchange rate. Short run adjustment parameters were identified as coefficients of

the error correction terms. The main finding of this paper was that taking the valuation

effect of the net foreign asset position into account, the final effect of the exchange rate

changes on trade balance was undetermined. Although appreciation could reduce trade

surplus in the short run, in a longer horizon, there was no stable relationship. Besides

that, Granger causality procedure is carried out to investigate the causal relationship and

directions of causality between the variables. Finally, Impulse Response Analysis and

Variance Decomposition procedure are performed to provide more insight into short run

interaction between trade balance and those endogenous variables in the system.

Suleiman Monammad (2010) done this study and identified the depreciation of

domestic currency lead to unexpected falls in eport earnings in Pakistan. The study

examined validity of the Marshall Lerner condition in Pakistan data (1970-2008) by using

impulse response function which fulfills the J- curve idea. To evaluate long run

association among the variables by employing Johansson Co integration test. The end

consequence of test showed that there was a long run relationship among the variables at

vector two. The finding of this research paper showed that real depreciation of exchange

rate has positively impact on balance of trade. So the depreciation is in favor of Pakistan’s

export.

Tihomir Stucka (2004) done his research for 1994-2002 and used a reduced-form

model approach was used to estimate the trade balance response to permanent domestic

currency depreciation in Croatia. For this purpose, long-run and short-run effects were

estimated, using three modeling methods along with two real effective exchange rate

measures. Evidence of the J-curve was also found. This attempted to estimate the impact

of a permanent exchange rate depreciation on the merchandise trade balance employing a

reduced form model. The model was estimated using three methods - the ARDL "delta"

approach developed by Pesaran, Shin, and Smith (1996). This study found evidence of the

J-curve effect in Croatia. The increase of the trade balance deficit as a consequence of the

J-curve effect is estimated to be between 2.0 percent and 3.3 percent. The empirical

results were consistent with the exception of one model. Overall, intuitively it seemed

unlikely that a permanent nominal depreciation of the domestic currency embodied in an

asymmetric intervention policy a pegged exchange rate regime would have a net

favorable effect on the entire economy, taking into account potential negative side effects.

Further Quio, H., (2005) did his study for East Asian Economies for the time

period of 1978-2004, to identify the post impact of a discrete exchange rate change and its

implications for net trade balance. He emphasized the difference between dollar debtor

and dollar creditor countries and concluded that even though currency devaluation may

improve the trade balance of a debtor country, appreciation may or may not reduce the

surplus of a creditor country. It was therefore inappropriate to follow the elasticity models

to use exchange rate to adjust trade balance predictably when the wealth effect,

investment effect and indirect investment effect (in East Asia) were all considered. His

model attested that such a move may not induce a reduction in the trade surplus.

Sekantsi. L.(2008), empirically examined the impact of real exchange rate

volatility on trade in the context of South Africa’s exports to the U.S. for the South

Africa’s floating period January 1995-February 2007. In measuring real exchange rate

volatility, this study utilized GARCH. After establishing the existence of cointegration

among the variables involved in our two-country export model, he estimated long-run

coefficients by means of ARDL bounds testing procedure proposed by Pesaran, et al.

(2001). His results indicated that real exchange rate volatility exerts a significant and

negative impact on South Africa’s exports to the U.S. Therefore, stable and competitive

exchange rate and sound macroeconomic fundamentals were required in order to improve

international competitiveness and greater penetration of South African exports to

international markets.

Monacelli,T., & Perotti,R.,(2006) employed structural VAR techniques to

estimate, for a series of OECD countries. They have found that in all countries a rise in

government spending induces a real exchange rate depreciation and a trade balance

deficit. In the US, however, the effect on the trade balance is small. They have shown

how recent empirical evidence that points to a decline in the trade deficit after a budget

deficit shock can be traced to an alternative method to recover the fiscal shocks. Second,

in all countries private consumption rose in response to a government spending shock,

and therefore co-moves positively with the real exchange rate.

2.3. RESEARCH GAP

De Silva D.G. and Zen Zhu (1998), has not speculated the causal relationship between

the exchange rate and the trade balance. And his study stands for 1977-1997. No studies

were conducted to fill this time gap (1997-2010). Wijesinghe D.S.(1988) analyzed his

findings by calcualating the Effective Exchange Rates, but has not used any of the

econometric tools for the analysis. And his study flows for the period 1971-1985. Silva

has filled his time gap by 12 years (1985-1997). But no studies have been done to fill the

remaining 13 years. W.T.K.Perera (2009) has found the impact of real depreciation of

SLR on the trade balance in the short run and the long run by using its 6 major trading

partners. And he has employed mainly the J curve phenomenon. In this study it is

proposed to add 4 more major trading partners (Singapore, Iran, China and Saudi Arabia)

and more econometric tools are proposed to use.

The geographical gap can be taken from the empirical studies in the other

countries, and also throughout the literature there is no study has done for the causal

impact of exchange rate on trade balance except the Malaysian case. Other than that the

trade balance behavior due to the external shocks is not investigated for the Sri Lankan

case.

Considering these gaps, it is proposed to fill them by employing the Granger

Causality test and the Impulse Response Function. And the other econometric tools will

be applied for the performance of the study. As a result of these applications, the time gap

will be instinctively filled.

3. PROPOSED RESEARCH

3.1. RESEARCH PROBLEM

Based on the research gap which is identified by the literature, it is proposed to

investigate whether the exchange rate has a significant impact on trade balance in Sri

Lanka. Then the fundamental research problem will be;

Do the Exchange Rate changes affect the trade balance effectively?

Two macroeconomic variables are used in this research, namely Exchange Rate and

Balance of Trade. And the literature proves that there is a significant impact of exchange

rate on trade balance in Sri Lanka.

The exchange rate policy after 1977 has improved the trade balance, but has failed to

stimulate real output at least in the short run (Silva D. & Zhen Z. 1998).Depreciation has

been instrumental in making a favorable impact on the trade balance during the study

period except for the years 1971, 1979,1985 (Wijesinghe D.S. 1988).

Therefore, it is investigated that the exchange rate affects the balance of trade in Sri

Lanka. But there were no studies done to fill the time gap after 1997. Furthermore the

causal impact is not found. Then this study is done to fill these gaps by mainly using the

Granger Causality Test, Impulse Response Function and the other econometric tools.

In addition to the above fundamental research problem, it is proposed to identify the

existence of Marshal-Learner Condition by elasticity approach. Other than that the

existence of J curve phenomenon has to be identified.

3.2. HYPOTHESIS

Impact of exchange rate changes on trade balance.

H0: Exchange Rate Changes do not affect the Trade balance.

H1: Exchange Rate depreciation improves the trade balance.

Existence of Marshal Learner Condition in Sri Lanka.

H0: Depreciation will not improve the trade balance even though the condition is

hold.

H1: Depreciation will improve the current account if the sum of the price elasticity

of domestic and foreign demands for imports is larger than unity.

3.3. OBJECTIVES

Main Objective

To investigate the impact of exchange rate changes on trade balance in Sri

Lanka.

Specific Objectives

To analyze the time series properties of the variables used in this study.

To understand the behavior of the variables in Sri Lanka.

To analyze the short run and long run effect of exchange rate changes on the

trade.

To investigate the existence of Marshal Learner condition in Sri Lanka.

To identify the J curve phenomenon in Sri Lanka.

To suggest the policy implications.

3.4. IMPORTANCE OF THE STUDY.

The LKR is continuously depreciated all over the study period except some years. It is

expected that this would improve the trade balance, reduce inflation, and increase the rate

of output. The importance of this study lies in the evaluation of currency devaluation as a

long-term developmental policy in Sri Lanka that can serve as a model for other country

studies. The Central Bank uses devaluation as a policy tool for economic growth.

Therefore if there is such a relationship found, it can be mainly beneficial for two parties.

Those are;

i. Policy Makers

The Trade Balance is the dependent variable. It is a component of the Balance of

Payments. Therefore Balance of Payments can significantly influence the country’s GDP.

The GDP will determine the health of an economy. Then if a relationship found between

the trade balance and exchange rate, it can be manage in policy making.

ii. Exporters

When the exchange rate is devaluated, the domestic currency will be weaker against the

foreign currency. And the local exporters are benefited. And If there is such a relationship

is investigated, it can be positively applied to the predictions of these exporters.

4. METHODOLOGY

This fragment concise the main variables, the frequency of data, the source of data study

period, and the econometric methods.

4.1. MAIN VARIABLES

Several variables are used in the calculations. Namely, exports, imports, trade share,

consumer price index, GDP, GDP deflator, Nominal Exchange Rate, Real Exchange Rate,

Nominal Effective Exchange Rate and Real Effective Exchange Rate.

I. Exports and Imports

These are the basic variables in this study. All the calculations are based on exports and

imports. Exports are used to calculate the Export Share and the Export Share is used in

calculating Effective Exchange Rates. Imports are used to calculate the Import share and

it is used to calculate the Effective Exchange Rates.

II. Trade share

X= Exports

M= Imports

i = Major trading partners

Using this equation the major 10 trading partners are found. Those are;

USA, India, Japan, UK, Singapore, Germany, Hong Kong, Iran, China and Saudi Arabia.

III. Consumer Price Index(CPI)

Consumer Price Index is used to convert the nominal terms into the real terms. In this

research two basic real terms are calculated. Those are the Real Exchange Rate and the

Real Effective Exchange Rate. To do these calculations the Consumer Price Index will be

used.

IV. Nominal Exchange Rate

The nominal exchange rate is used to calculate the other RER, NEER & REER. It

includes the inflationary impact.

V. Real Exchange Rate

Trade Share =(X+M ) i

total (X+M )d

The RER between two currencies is the product of the nominal exchange rate. It is

calculated by using the Nominal Exchange Rate.

VI. Nominal Effective Exchange Rate (NEER)

The Nominal Effective Exchange Rate measures the average change of a country’s

exchange rate against all other currencies.

R= Exchange Rate ( major trading partners)

W= Trade Share

VII. Real Effective Exchange Rate (REER).

The Real Effective Exchange Rate adjusts NEER by appropriate foreign price level and

deflates by the Sri Lankan price level.

Pdi= Domestic CPI

Pfi= Foreign CPI

R = Exchange Rate

NEER=∏j=1

m

r1j

W j

REER=∏j=1

m

(r PdiPfij

)wi

4.2. FREQUENCY AND SOURCE OF DATA

Data come from the Central Bank (CBSL) Annual Reports, IMF Publications and

Econstat data of the World Bank. All the data are in US Dollar Billions. The

study employed 33 annual observations (1977-2010) of Sri Lanka and

the annual data is used because quarterly data of some relevant

variables are not available.

4.3. STUDY PERIOD

The study period is 1977-2010, Because the Exchange rate and the trade balance become

substantial with the trade liberalization in 1977.

4.4. THE MODEL

This study attempts to develop a similar model applied by Aziz N.

(2008) for Bangladesh, that the trade balance is a function of real

exchange rate and the domestic and foreign real income. A log-linear

specification of the model can be stated as follows:

lnTB = β0 + β1 lnREER + β2 lnY+ β3 lnY*+ ui

Where, lnTB, lnX, lnM imply logarithm of balance of trade (lnX-lnM),

exports and imports at time respectively. lnREER, InY, In Y* are

logarithm of real effective exchange rate, Real GDP and world real

industrial production index (proxy of trade partners income).

4.5. ECONOMETRIC TOOLS

I. Granger Causality Method

The Granger causality test is a statistical hypothesis test for determining whether one time

series is useful in forecasting another. There is an interpretation of a set of tests as

revealing something about causality. To identify the causal impact of exchange rate on

Balance of Trade, the Granger Causality Test can be applied.

II. Impulse Response Functions (IRF)

This can be used to measure the trade balance behavior due to the external shocks. This

represents the reactions of the variables to shocks hitting the system. And this test is

tested to identify the trade balance behavior due to the external shocks. An impulse

response refers to the reaction of any dynamic system in response to some external

change (Lin, 2006). It is an essential tool in this empirical causal analysis.

III. Graphical methods and summary statistics

The variables can be described by the graphical methods and summary statistics. There

are various variables are used in this research. And all the data is having the time series

property. There is a pattern of observed time series data. When the pattern is identified,

the interpretation can be done. The graphical methods and Summary statistics can be used

to show this relationship in a visible and understandable manner. So it can be used in

analyzing the results of this research.

IV. Vector Auto Regression

This can be used to check the linear interdependencies among multiple time series and

can be used in structural models with simultaneous equations.

V. Unit Root Test

To identify the order of time series properties of this study unit root test is proposed to

employ. To test the stationary of the time series this is basically used. If one or both of the

series are non-stationary, the standard OLS approach will produce a spurious regression,

thus rendering standard testing techniques invalid (Fuei, 2007).

VI. Johansen’s Cointegration Method

This is a non stationary method. This study employs Johansen’s Cointegration method to

investigate both long-run and short-run relationship between the Exchange rate and the

trade balance.

VII. Autoregressive Distributed Lag Model (ARDL Model)

This study also employs ARDL model to investigate the long-run relationship Exchange

Rate and Trade Balance. This method does not require both variables to be non-stationary

at the same level or integrated in the same order.

VIII. Error Correction Model

An error correction model is a dynamical system with the characteristics that the

deviation of the current state from its long-run relationship will be fed into its short-run

dynamics. A rough long-run relationship can be determined by the cointegration vector,

and then this relationship can be utilized to develop a refined dynamic model.

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XIV. WWW. Wikipedia .com.

APPENDICES

Some of the data which have been collected by this time are attached in this section.