Real Exchange Rate Changes and the Trade Balance: The Evidence from Pakistan

Abstract

This study uses quarterly data from July 1980 to June 2006 to explore the relationship between changes in real exchange rate and the trade balance of Pakistan. Applying the Auto Regressive Distributed Lag (ARDL) approach to cointegration, we examine the existence of a possible long-run relationship. We find the following: (1) a long-run relationship between the series exists, and (2) the coefficient of elasticity is negative and statistically significant, which does not support for the J-relation.

Given this, the policymakers should take a conservative approach in using currency devaluation to cure the fundamental disequilibrium in the balance of payments. It is likely that such policy may not produce the desired outcome—i.e., the trade balance may not improve.

Keywords:

• devaluation
• trade balance
• cointegration
• Pakistan

ACKNOWLEDGMENTS

The authors gratefully acknowledge the professional comments of the two reviewers. The article has been revised substantially to address their valuable suggestions. Any remaining errors are those of the authors alone.

Notes

¹ The Bretton Woods system made it obligatory for each country to adopt a monetary policy that would maintain the exchange rate of its currency within a fixed value, with a ±1% variation in terms of gold, and allowed the IMF to bridge temporary trade imbalances. This set the stage for the fixed exchange rate regime. On August 15, 1971, President Nixon unilaterally terminated the convertibility of the dollar to gold. At that point the US$ became the basis for global reserve currency for the member states and also provided the sole backing to currency.

² Covered 22 less developed countries.

³ The theory of the S-curve states that the trade balance initially declines after depreciation followed by a trade balance improvement, i.e., the typical J-curve effect. However, after several quarters when the trade balance improvement reaches its limits it then starts to deteriorate again.

⁴ They excluded the United States, a major trading partner of Australia. For the United States, real depreciation of the Australian dollar neither had short- nor any long-run effects on the trade balance between the two partners.

⁵ The condition for currency devaluation to succeed, the sum of price elasticity of exports and imports |e| > 1

⁶ Sinha (2001) also found validation of M-L condition for India, Japan, the Philippines, and Thailand but not for Sri Lanka.

⁷ Bahmani-Oskooee (1998) could not found evidence on existence of Marshal-Learner condition in Pakistan.

⁸ Bahmani-Ooskooee and Cheema (2009) found China and the UAE are effected by the depreciation in the Pak-rupee.

⁹ This is the Central Bank of Pakistan and we got the data from various issues.

¹⁰ Covered 22 less developed countries

¹¹ In a recent paper Shahbaz et al. (2011) found positive but insignificant impact of income on trade balance of Pakistan. This is the reason we excluded income variables from the model.

¹² Parity is defined as PKR/ USD.

¹³ In case-III (unrestricted intercept and no trend), critical values for lower and upper bounds (3.725, 5.163), (4.133, 5.260), and (2.843, 3.920) are obtained from Narayan (2005, pp. 1988) at 1%, 5%, & 10% level of significance with lag 5, 2, & 3.