Bilateral J-curve between Sri Lanka and its major trading partners

Wtk Perera

doi:10.4038/ss.v39i1.3154

Abstract

It is widely believed that the short run effect of exchange rate depreciation on trade balance is different from the long run. In the short run, first, the trade balance deteriorates before resulting in an improvement, suggesting a J-curve pattern. Most of the empirical studies have employed aggregate trade data, while recent studies have used bilateral trade data. These studies are mostly between industrial countries, a few developing countries, but none so far for Sri Lanka. Hence, in this study, the impact of real depreciation of Sri Lankan Rupee (SLR) on the trade balance in the short run and the long run has been examined, employing bilateral trade data between Sri Lanka and its six major trading partners using the autoregressive distributed lagged (ARDL) model. The results reveal that the trade balance between Sri Lanka and its trading partners does not support the J-curve phenomenon, and also it does not have any specific pattern in response to depreciation of real exchange rate. DOI: http://dx.doi.org/10.4038/ss.v39i1.3154 <em>Staff Studies</em> Vol.39(1&2) 2009 pp.69-85

Highlights

Exchange rate devaluation is one of the important policy tools that can be adopted in open macroeconomics to improve a country’s competitiveness as well as the trade balance
It is not necessary to check for the unit roots to confirm the validity of the results, the Augmented Dickey Fuller (ADF) unit root test was carried out and the results are reported in Appendix A
This reveals that each variable is non-stationary at their levels, and they are stationary at their first difference, at 10 per cent significance level

Summary

Introduction

Exchange rate devaluation is one of the important policy tools that can be adopted in open macroeconomics to improve a country’s competitiveness as well as the trade balance. According to the Marshall-Lerner condition, currency devaluation may succeed in improving the trade balance in the long-run, if the sum of export and import elasticities. Currency devaluation encourages exports and discourages imports This is expected to improve the trade balance. It is widely believed that currency depreciation worsens the trade balance in the short-run, but improves it in the long-run. As this represents the shape of the letter J, Magee (1973) named this the ‘J-curve phenomenon’. Sri Lanka has continuously recorded a trade deficit, which has worsened over the period (Chart 1) This deficit is mainly due to high oil prices and the increased demand for imports. As a consequence, Sri Lanka which specializes in the production of primary commodities suffers the difficulties in the trade balance

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Results

Conclusion