Bilateral J-curve between India and her trading partners

Abstract

India, a land of over one billion people and one of the newly emerging industrial powers in the world, is going through a slow but steady metamorphism. For centuries, India has played a major role in the international trade. It was not uncommon to see her ships carrying silk and spices across the Arabian seas and bringing back machine-made textile. Invasions of India first by Mughals and latter by the British through the East India Company were all trade oriented. India’s presence in the world trade is relatively small at this time but is gaining momentum. After independence in 1947, India for a brief period experimented with socialism. The Five Year plans were mainly focused towards building infrastructure and development of small-scale agriculture based industries. The industrial development even though extremely important for growth, played a secondary role. The foreign investment was encouraged but only in the selected sectors of the economy. However, threat of nationalization, a large bureaucracy, corruption, lack of understanding of the Indian business practices and the requirement that a major share holder must be an Indian national, discouraged foreign capital investment in India. During 1991-1992, India adopted a policy of trade liberalization. To attract foreign capital and to encourage Non-resident Indians to invest in their home country, Government of India established a separate unit within the Home Ministry whose main function was to expedite processing of applications. India also relaxed the requirement that a major partner be an Indian national. India provided export subsidies to the exporters in terms of cash as well as foreign exchange so that they could import machines and raw materials. Exports responded to the trade liberalization and increased from 44 041 crores of rupees in 1991–1992 to 141 603 crores in 1998–1999 where one crore is equivalent to ten million. In US dollar terms at a current exchange rate of 42.48 rupees per dollar, this translates to an increase from $10.37 billion to $33.34 billion over eight years. India also anticipates that through a major increase in the information technology, mainly software industry, her exports will increase to 90 billion by 2005. The trade liberalization has been accompanied by changes in the monetary policies. The inflation rate has been reduced from about 12% to 9% per year, the interest rates have declined from 14% to 10% and the exchange rate has been allowed to respond to market forces. As a result from 1991–1992 to 1998–1999, the rupee has declined from 19.62 rupees per dollar to 42.48 rupees per dollar. By December 2000 rupee had further devalued to 46.25 per dollar with a hope that it will further boost India’s exports and improve her trade balance. However, the impact of currency depreciation on the trade balance is not instantaneous. Indeed, there is ample evidence in the literature that after currency depreciation, the trade balance worsens in the short-run before improving in the long-run. Since this pattern of movement of the trade balance over time resembles the letter J, Magee (1973) labelled it the J-curve phenomenon. Magee argued that after devaluation, contracts that are in transit at old exchange rates dominate the short-run response of the trade balance. Over time, new contracts at new prices begin to exert their favourable impact. At this stage, elasticities may increase leading to an eventual improvement in the trade balance. Of course, the delayed response could also be due to lags in the process of increasing the production of exportables. Junz and Rhomberg (1973) have identified five lags, namely, recognition lags, decision lags, delivery lags, replacement lags and production lags. Only after the realization of these lags, the trade balance could improve. Early studies that tried to investigate the impact of currency depreciation on the trade balance relied upon estimating the Marshall-Lerner condition. The condition