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Investigating the Causes of Persistent Trade Deficit: A Study based on Marshal-Lerner Frame Work.

Byline: Muhammad Tariq and Yasmeen Amber Khuhro and Ranjeet Kumar

The focus of this paper is to investigate the causes of persistent Deficit in Pakistan's Balance of Trade. The study considers one of the significant factor i.c. Currency. The study investigates the Marshal-Lerner (M-L) conditions to study the cause and effect between Currency and Trade Balance by applying OLS estimation Technique. The study concludes that Currency Depreciation can benefit only in case of Trade with China because the M-L factor (e + e) is greater than 1. The currency Depreciation has positive effect on Balance of Trade. However Trade with Sri Lanka in case of Currency Depreciation may be made favorable since total of elasticity is close to 1. More efforts than FTA are required to avail gain in Trade with Sri Lanka. The Trade with India and Japan may have adverse effect on the Balance of Trade in case of currency depreciation sine M-L factor is less than 1. The Trading of items with inelastic demand might be probable reason for adverse trade (in case of Currency depreciation) with Japan and disturbed and irregular pattern of Trade with India might be the strong reason for unfavorable Trade outcome with India. It is suggested that best way to improve Trade Balance is adding Trade items such as technological or innovative products and adding more items with more elastic demand. Accompanied with it the concept of J-Curve theory should be added in Trade Policy by sustaining and increasing domestic production capacity to that describes the favorable outcome in trade after currency depreciation may be obtained in long run only if home country's production is not only sustained but also it is improved. It may be made by resolving the energy crisis and motivating the local Industries for more production with Government support for export across borders.

Keywords. Marshal-Lerner condition Co-integrating Vector Currency Depreciation.

Introduction

The role of Trade is highly crucial in economic development of an economy.

The Agricultural as well as Industrial Development may be channelized on the bases of Trade Policy. The Investment and employment may be directed and increased due to Foreign Trade. The efficiency of local producers may be boasted due to competition with foreign producers. Consumers can enjoy more choices especially in terms of availability variety and price due to cross border Trade. Foreign Policy of Pakistan (since 1950s) has been focusing on growth in Trade. Friendship with an economy is mainly due to Trade relations.. Pakistan is member of WTO. The most recent Trade Policy (2012-2015) focuses on regional trade and it emphasizes on institutional work for export promotion. Pakistan's efforts for Regional Trade include; Free Trade Agreements (FTA) with many countries such as: Pakistan-China FTA (July 1 2007) Pakistan- Sri Lanka FTA (August 2002) and multilateral agreement with South Asian countries SAFTA (July 12006) and SAARC. Pakistan' Trade promotion efforts may be seen via attainment of Generalized Scheme of Preferences (GSP) whereby most of export of Textile and leather may be made at zero tariff and many other items at preferential rate.

However despite of significant Trade efforts and Foreign Policy measures the Balance of Trade has been in deficit since 1950 till to date. Another economic aspect to avail favorable Terms of Trade as proposed by Marshall (1923) was by depreciating currency. Currency depreciation causes export relatively cheaper and hence export may increase both in quantity as well as in amount on the other side the import shall become relatively expensive and hence the import shall decrease both in quantity as well as in amount consequently the Balance of Trade shall get improved Marshal (2003). Practically this theory did not work for developing countries such as Pakistan. Currency of Pakistan has continuously been depreciating especially after 1970s still the Balance of Trade is in deficit.

Lerner (1944) extended Marshal's work and proposed that currency depreciation could only benefit if the elasticity of export demanded (Ex) and that of elasticity of import demanded (Em) is comparatively elastic. As long as the sum of Ex and Em is greater than One (1) then the currency depreciation will cause favorable improvement in Balance of Trade (Lerner 1944).

Problem StatementPakistan has been suffering Economic Dilemma that Balance of Trade is in Deficit despite of continuous Depreciation in its Currency. Marshal (1923) focused on link of currency on Trade. The Study of Marshal (1923) suggested that depreciation in currency causes favorable improvement in Trade. Apparently such condition is not working in Pakistan. This paper shall investigate the claim of Lerner (1944) for Pakistan and shall find out whether the real cause for adverse Balance of Trade is that demand for exported goods and imported goods is inelastic.

Research HypothesisH1: Exchange Rate (Pakistan to its Trading Partner) has negative impact on Export to Trading Partner.

H2: Exchange Rate (Pakistan to its Trading Partner) has negative effect on Import from Trading Partner.

The study takes into account Pakistan's four major Asian Trading Partners: China Japan Sri Lanka and India. The above both Hypotheses shall be tested individually for each country.

Literature ReviewAbundant literature is available on the subject of Trade. This article provides literature and findings of few authors providing relevant concept and technical analysis. Raza Larik and Tariq (2013) analyzed the effect of currency on the trade balances in South Asia using Marshal- Lerner Model and J- curve that affirmed that depreciation of money is one of the root cause to make exports inexpensive and imports become high- priced commodities. The cross sectional data accessible from South Asian nations was analyzed by multiple regression and the research make forecast on devaluation of money its causes and its repercussions. Each country was separately made subject to analysis and the results substantiate Marshal- Lerner model focusing that Balance of trade cannot be progressed by Depreciation of money.

Pandey (2013) has practically verified the Marshal Lerner Model in relevance to India's external trade. The results points out that devaluation of the exchange rates bring about advancement in trade balance. Furthermore multivariate co-integration approach was used to estimate the equilibrium of imports and exports.

Bahmani-Oskooee and Cheema (2009) have used quarterly data of real exchange rates export-import ratio and relative (US) income for the time period examined the Marshall- Lerner Condition for Kenyan Economy make use of Long- range dependence fractional integration and co-integration methods based absolutely on integer degrees of differentiation. The results designate that a definite co-integrating connection lies in between balance of payments real exchange rate and relative income and in the long run the conditions of ML satisfies whereas the concurrence point is comparatively steady. This further entails that reasonable devaluation of Kenyan shilling have steady impact on balance of payments with high interest rates through the current account.Chinn (2004) concluded that receptiveness of trade flows to exchange rates and income changes is refocused with great concentration after chronic expanding of US trade deficit. He estimated import and export equations over a particular period across 1990s when there was a new boom in Economy and depreciation in dollar prices. The results designate a low receptiveness of imports to exchange rate fluctuations and reduction of income elasticity irregularity. The grouping of low price elasticity of imports with current amount of trade deficit means that any fall in trade deficit will essentially go along with large exchange rates and income trend modification.

The strongest and the most frequent work on M-L condition have been made by Bahmani-Oskooee. Oskooee (1998) was first to take up long run method i.e. Co-integration Technique to approximate the trade elasticity in developing nations around the globe. Under the hypothesis of The Marshall-Lerner condition if the aggregate import and export demand become less than or equal to one in the long run the trade balance must get better. In the majority cases the result certainly disclose that trade elasticity are considerable enough to sustain devaluation as successful strategy to prosper Trade Balance. Bahmani-Oskooee and Kara (2005) have employed ARDL co-integration methods that does not require pre- testing for unit route and assess the Income and Price elasticities of28 countries. He further emphasized that with the preface of new inference methodologies old theories obtain a transformed concentration and one amongst them is Trade Elasticity. The result suggests that Price Elasticity in most occurrences support the conclusion that Real Depreciation progress trade balance.

Rose (1990) examined the influence of exchange rate on the trade balance in the emergent nations. The Non- Structured procedure points out that depreciation of Real Exchange rate is weakly correlated with noteworthy enhancement in the trade balance.

Bahmani0Oskooee and Wang (2006) concluded that there is a significant difference in effects of currency depreciation in the short run against long run. The J- phenomenon is observed in short run hence the trade balance decline and development comes after a span of time. Previous studies that were conducted in this regard using cumulative trade data in China had diverse results. Undeniably most of them ended up that real depreciation have no impact on trade balance in the long run. The authors have separated data in categories used time series modeling and hypothesized the real trade balance model in China and its 13 business and trade partner countries. It showed that real depreciation of currency has positive impact on her trade balance.

MethodThe data for Export import and exchange rate has been taken from Handbook of Statistics on Pakistan Economy 2010". The data for 2011 to 2013 has been taken from Economic Survey of Pakistan". As already discussed this research paper investigates the Trade outcome with four major Asian countries which are: China Japan Sri Lanka and India.

Research Model DevelopedElasticity of Demand for Export may be given as:Equation

Bahmani-Oskooee and Niroomand F. (1998) and Raza Larik and Tariq (2013) has estimated similar model via OLS.

The expected sign for elasticity of demand for export (based on equation (1) is Minus (-) and the expected sign for elasticity of demand for import (based on equation (2) is positive (+) (Boyd Caporale andSmith 2001).

ResultsThe OLS provides best estimates only if Gaussian Assumptions are satisfied. Before proceeding to the final estimates for the betas (elasticity) the model developed for export and import for each country was tested for at least 6 Gaussian Assumptions. The Normality was tested via Shapiro-Wilk. The Homoscedasticity was investigated via Breusch-Pagan-Godfrey. The autocorrelation was determined by the test value of Durbin Watson. The presence of multicollinearity was determined by the test value of VIF. The model specification was investigated via Ramsey RESET Test. The detail of test results has been provided in following tables 1 to table 4.

Table1: Results Related to satisfaction of Gaussian Assumptions for Pakistan to

China

No.###Assumption###Test###Values###Result

###The regression model is

1###Shapiro-Wilk###Sig: 0.175###Accepted

###linear in the parameters

###Breusch-Pagan-

2 Homoscedasticity###P : 0.2512###Accepted

###Godfrey

3 No autocorrelation###Dubin-Watson###D-W: 1.723###Accepted

4 No perfect multicollinearity VIF###All values less than 5 Accepted

###The regression model is###Ramsey RESET

5###P: 0.142###Accepted

###correctly specified###Test

###ANNOVA###ANNOVA###sig 0.00###Significant

Table2: Results Related to satisfaction of Gaussian Assumptions for Pakistan to Sri Lanka

No.###Assumption###Test###Values###Result

###The regression model is

1###Shapiro-Wilk###Sig: 0.085###Accepted

###linear in the parameters

###Breusch-Pagan-

2 Homoscedasticity###P : 0.075###Accepted

###Godfrey

3 No autocorrelation###Dubin-Watson###D-W: 1.821###Accepted

4 No perfect multicollinearity###VIF###All values less than 5 Accepted

###The regression model is###Ramsey RESET

5###P: 0.120###Accepted

###correctly specified###Test

###ANNOVA###ANNOVA###sig 0.02###Significant

Table3: Results Related to satisfication of Gaussian Assumptions for Pakistan to India

No.###Assumption###Test###Values###Result

###The regression model is

1###Shapiro-Wilk###Sig: 0.0510###Accepted

###linear in the parameters

###Breusch-Pagan-

2 Homoscedasticity###P : 0.637###Accepted

###Godfrey

3 No autocorrelation###Dubin-Watson###D-W: 1.920###Accepted

4 No perfect multicollinearity VIF###All values less than 10 Accepted

###The regression model is Ramsey RESET

5###P: 0.631###Accepted

###correctly specified###Test

###ANNOVA###ANNOVA###sig 0.00###Significant

Table4: Results Related to satisfication of Gaussian Assumptions for Pakistan to Japan

No.###Assumption###Test###Values###Result

###The regression model is

1###Shapiro-Wilk###Sig: 0.095###Accepted

###linear in the parameters

###Breusch-Pagan-

2 Homoscedasticity###P : 0.307###Accepted

###Godfrey

3 No autocorrelation###Dubin-Watson###D-W:1.850###Accepted

4 No perfect multicollinearity###VIF###All values less than 10 Accepted

###The regression model is###Ramsey RESET

5###P: 0.4979###Accepted

###correctly specified###Test

###ANNOVA###ANNOVA###sig 0.00###Significant

Table 5: Elasticity for Export and Import

###Elasticity of Demand for###Elasticity of Demand for

Country

###Export (Ep)###Import (Mp)

###Beta###sig Value###Beta###sig Value

China###-0.818###0###0.321###0.001

Sri Lanka###-0.641###0.001###0.228###0.043

India###0.235###0.034###0.321###0.001

Japan###-0.0982###0.021###0.213###0.043

The sig values as shown in Table 5 for all four betas for export and for all betas for import is less than 0.05 suggesting that Betas are significant. Table 5 suggests that first Hypothesis (H1) is accepted for all China Sri Lanka and Japan because their Betas are Negative indicating that exchange rate and export has inverse relation i.e. decrease in exchange rate (currency depreciation) shall cause increase in export and vice versa. However H1 is rejected for India since its Beta is positive showing that Exchange rate and export has positive relation. The second hypothesis (H2) is accepted for all four countries since Betas are positive showing positive relation of Exchange Rate with Import. It means increase in decrease in exchange rate (currency depreciation) shall cause decrease in Import.

Investigating the Marshal-Lerner ConditionThe summation of elasticity of demand for export Ex and Import Mp in absolute terms is provided in Table 5. The elasticity is added if signs are same as expected i.e. negative for Ex and positive for Ep. The elasticity shall be subtracted if signs are opposite to as expected as in case of India in table 5.

Table 6 : M-L Condition

###M-L Condition###Effect on BoT due to currency

Country

###(Ex+Em)###depreciation

China###1.139###Favorable

Sri Lanka###0.869###Adverse

India###0.086###Adverse

Japan###0.3112###Adverse

ConclusionCurrency Depreciation can benefit only in case of Trade with China (since eX + eM greater than 1). The friendship as well as Trade relation has flourished since the inception till today. The Trade between neighboring countries has been flourished to $12b and in the upcoming period it is expected to reach at $15b by the end of 2014. The currency Depreciation has positive effect on Balance of Trade. However Trade with Sri Lanka in case of Currency Depreciation may be made favorable since total of elasticity is close to 1. The Trade relation between Sri Lanka has improved mainly due to Free Trade Agreement between both countries Abeyratne (2012) however more efforts are required to improve the Trade. The Trade with India and Japan can adversely affect the Balance of Trade in case of currency depreciation. The Trading of items with inelastic demand might be probable reason for adverse trade (in case of Currency depreciation) with Japan.

Pakistan's Major import from Japan consists of automobile auto spare parts and that of electric equipment (less elastic demand) and Pakistan's Major Export to Japan consists of Thread and some other Textile Products (more elastic) the amount of import is larger than that of Export. Therefore Pakistan's Trade Account with Japan has been remained in deficit (Chaudhary and Abe 2000). The major Trade with India is comprised of sugar gems fruits fish and onyx (Taneja 2006). The nature of demand of Trade item is less elastic and the disturbed and irregular pattern of Trade might be the strong reason for unfavorable Trade outcome for both countries.

RecommendationsIt is suggested that best way to improve Trade Balance is adding Trade items such as technological or innovative products and adding more items with more elastic demand. Accompanied with it the concept of J-Curve theory should be added in Trade Policy that describes that the favorable outcome in trade after currency depreciation may be obtained in long run only if home country's production is not only sustained but also it is improved. It may be made by resolving the energy crisis and motivating the local Industries for more and production with Government support for export across borders.

ReferencesAbeyratne S. (2012). Sri Lanka's Free Trade Agreements with India and Pakistan: Are They Leading Bilateral Trade Beyond Normalcy. Lahore Journal of Economics 17.

Bahmani-Oskooee M. (1998). Cointegration approach to estimate the long-run trade elasticities in LDCs. International Economic Journal 12(3) 89-96.

Bahmani-Oskooee M. and Cheema J. (2009). Short-run and long-run effects of currency depreciation on the bilateral trade balance between Pakistan and her major trading partners. Journal of Economic Development 34(1) 19-46.

Bahmani-Oskooee M. and Kara O. (2005). Income and price elasticities of trade: some new estimates. The International Trade Journal 19(2) 165-178.

Bahmani-Oskooee M. and Kara O. (2005). Income and price elasticities of trade: some new estimates. The International Trade Journal 19(2) 165-178.

Bahmani-Oskooee M. and Niroomand F. (1998). Long-run price elasticities and the MarshallLerner condition revisited. Economics Letters 61(1) 101-109.

Bahmani0Oskooee M. and Wang Y. (2006). The J curve: China versus her trading partners. Bulletin of Economic Research 58(4) 323-343.

Boyd D. Caporale G. M. and Smith R. (2001). Real exchange rate effects on the balance of trade: cointegration and the MarshallLerner condition. International Journal of Finance and Economics 6(3) 187-200.

Boyd D. Caporale G. M. and Smith R. (2001). Real exchange rate effects on the balance of trade: cointegration and the MarshallLerner condition. International Journal of Finance and Economics 6(3) 187-200.

Chaudhary M. A. and Abe K. (2000). Pakistan Japan and Asean Trade Relations And Economic Development (A Comparative Analysis). Pakistan Economic and Social Review 193-214.

Chinn M. D. (2004). Incomes Exchange Rates and the US Trade Deficit Once Again. International Finance 7(3) 451-469.

Lerner A.P. (1944). The Economics of Control: Principles of Welfare Economics.

New York: The MacMillian Company. Marshal A. (2003). Money Credit and Commerce. Prometheus Books Publishers. Marshall A. (1923). Money Credit and Commerce. London: MacMillian and Co. Ltd. Pandey R. (2013). Trade Elasticities and the Marshal Lerner Condition for India. Global Journal of Management and Business Studies 3(4) 423-428.

Raza A. Larik A. and Tariq M. (2013) Effects of Currency Depreciation on Trade Balances of Developing Economies: A Comprehensive Study on South Asian Countries.

Rose A. K. (1990). Exchange rates and the trade balance: some evidence from developing countries. Economics Letters 34(3) 271-275.

Taneja N. (2006). India-Pakistan Trade. Working Paper 182. New Delhi: Indian Council for Research on International Economic Relations.
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Publication:Journal of Business Strategies (Karachi)
Geographic Code:9PAKI
Date:Jun 30, 2014
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