Empirical Analysis of the Trade Balance and its Determinants in Sri Lanka

Abstract

Every economy has experienced an expansion in international trade in recent years, and some developing countries frequently experience persistent trade deficits. The investigation of the short-term and long-term relationships between trade balance and its macroeconomic determinants is the main goal of this study. In particular, the study explores the impact of the real exchange rate, foreign direct investment, inflation, budget deficit, private consumption, real money supply, and gross domestic product on the trade balance. For this purpose, the paper employed an autoregressive distributed lag (ARDL) bounds test co-integration model that covered the period from 1980 to 2020. The data were mainly gathered from the annual reports of the Central Bank of Sri Lanka, the World Development Indicators, and the UNCTAD database. The findings show a co-integration between the trade balance and selected macroeconomic variables. The study found that real exchange rate and foreign direct investment have a statistically significant and positive association with trade balance, indicating these two determinants will improve the trade balance in the long run. The real exchange rate balances the trade deficit following currency devaluation through expansion in real exports and collapse in real imports. The real exchange rate, however, is insignificant, with positive signs in the short run indicating that Sri Lanka has no J-curve effect. Further, the results demonstrate that in the long run, the budget deficit, private consumption expenditure, and real money supply have a negative impact on the trade balance. However, there is no evidence that inflation and trade balance are related over the short and long term. The results of this analysis suggest that the government should focus on exchange rate policy, followed by monetary and fiscal policies, in order to improve Sri Lanka's trade balance.