The impact of currency depreciation and trade liberralzation on trade balance of Sri Lanka

Abstract

This study examines the impact of trade liberalization and currency depreciation on the trade balance of Sri Lanka. Using the bounds testing ARDL approach for co-integration, which is more suitable for small finite sample cases, we found that there was a long run co-integrating relationship between the trade balance and its determinants; particularly the Trade Openness and Real Exchange Rate. Our findings suggest that 1% increase in trade openness leads to 0.48% deterioration, while 1 % depreciation of local currency leads to 0.45% improvement in the Trade Balance Ratio of Sri Lanka given all else remaining unchanged. These findings solve the fundamental dilemma, why Sri Lanka’s Trade Balance continued to deteriorate; despite of substantial currency devaluations/depreciations allowed during past five decades. Our findings conclude that a more powerful negative impact arising from trade openness fully offset the positive impact arising from currency depreciation; thereby leading the Trade Balance into deficit, eventually in the long run. Accordingly, we found trade liberalization and devaluation are counter-cyclical as policy tools.