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J-Curve Relationship between Balance of Trade and Exchange Rate in Pakistan.

Byline: Muhammad Abubakar Awan , Sherbaz Khan and Shair Sultan Mughal

This study encompasses and covers the economic phenomena of J-curve derived from the concept of martial-learner condition (1944, 1948) which explains the concept of inverse relationship between the two economic variables, foreign exchange and balance of trade. However this study looks into the possibilities of a beneficial negative relationship between these two.

Historically conventional wisdom states that a depreciation in the value of a particular local currency deteriorates the countries balance of trade initially in the short term, but improves gradually and eventually in the long run due to an increase in economic activities and decrease in the value of exports. Many researchers have questioned the existence of this phenomena supported by empirical data and many have found the existence of this relationship. This research has focused on the evidence of the existence of these phenomena in Pakistan's import, export (balance of Trade) and foreign exchange.

Key words: J-curve, Martial-Learner Condition, Balance of Trade, Foreign Exchange.

Introduction

J-curve is a phenomena which has been derived partially from the studies of Alfred Marshall and Abba Lerner, which gives it its name Marshall-Lerner condition in the situation where the balance of trade of a country is zero then elasticity in supply are never ending then an exchange rate decrease in value can initiate a surplus surge in the balance of payments of that country.

The theory, in essence states that initially when a country's currency devaluates the balance of trade for that country will decline in the immediate scenario, that is in the short-term but it will increase as the dynamics of elasticity settle in. Devaluation means that more people will buy good and products of your country as they are cheaper now than before, it also means that you will have a competitive edge over other countries dealing in the same goods as you can provide them at a lower rate than those countries.

This will increase the economic activity and in essence increase your exports. This will give you a J-curve shape if you plot it in a time-series graph as initial figures will be declining but as economic activity increases it will move upwards, forming a J-curve in the process.

Advantages of J-curve

The benefits yielded by the use of J-curve vary across many aspects of modern study which includes economics, finance, medicine and even politics and the effects of revolution on our countries long-term stability. J-curve also explains the changing dynamics of closed economies in communist countries when they change to democratic governments if J-curve was not there it would be hard and almost impossible to measure the short-term as well as the long-term effects of such transition on the economy of a country.

J-curve also helps top realize varying risks in business and multi-nationals by identifying the effects of any long-term business decision it also measures the political risk and its effects on the economy. The J-curve also helps to realize the positive side effect of a seemingly negative occurrence in an economy if J-curve's didn't exist we couldn't have possibly identified this positive outcome through a negative incident and blindly think of it as a bad sign. For example countries currency devaluation is seemingly negative and a bad sign for an economy but the J-curve helps us to find that this devaluation actually is beneficial in the long-run as the country's exports increase and economic activity is, as a result, increased.

Foreign exchange

Foreign exchange has a great impact on the GDP and its true and real value the value of any currency is derived from the laws of demand a supply the more a currency is demanded by buyers, which includes tourist buying the local currency to spend while on vacation, multinationals which buy local currency in huge amounts to invest in a new country and new business venture, importers who buy a countries local currency to pay off their payments in return for the goods they have purchased or investors who buy and sell currencies to make and benefit from arbitrage profits.

A countries currency can be pegged to any other countries currency so as to give an idea of the fluctuation and the universal standing of that currency. Currency can be fixed by the government, which usually is the case in closed economies or is floated freely on the mercy of demand and supply, which usually is the case in open and free economies which are developed.

Any particular currency is judged by the forces in market which are based on factors of tourism, geo-political situation and investment scenario along with trade.

Aim of the Research

The aim of this research is to find a relationship between the two economic variables foreign exchange and balance of trade.

Statement of the Problem

"Is there negative co-relation or a positive co-relation between the balance of trade and foreign exchange of Pakistan?" The research wants to analyze the effects of foreign exchange on the trade balance of Pakistan. As developing economy Pakistan's economic variables and dynamics are not fully developed and this acts as a barrier for economic progress. These economic indicators should be assessed and tested so that in the future, people can build on these findings to create a better solution and economic policy to strengthen the economy.

Hypotheses

H1 = Exchange rate has a significant impact on balance of trade

H2 = There is a negative correlation between Exchange rate and Balance of Trade

According to Atiq-ur-Rehman (2012) exchange rate is a tool through which economists and researchers try to manage the balance of trade of a country. Now, the import and export are commonly sensitive to fluctuations in the value of the local currency. In other words import and export are elastic. In Pakistan the effect of the devaluation of currency has little or no impact on the balance of trade.

Normally if the import and export are elastic a decrease in the value of currency means that the balance of trade will increase and record a surplus, as balance of trade has an inverse relation with the value of currency. But, in Pakistan this impact is not visible or attainable as the import and export are not elastic or sensitive to currency value fluctuation. In this case the devaluation of currency will only cause a highly inflated value of imports and an increase in the external debt of Pakistan.

The decrease in value of a currency translates into increased domestically produced good's consumption as goods from abroad and imported become more expensive than they already were due to the extra burden of a decreased value in the currency. People demand more of the domestic goods as they are cheaper and affordable. This phenomena increases economic activity and balance of trade surplus is expected.

The goods traded offered services are improved as a result of decrease in the real value of money and increase in the real price.

Further Atiq-ur-rehman (2012) explained that many and every statistical tools were used to find the relation between these two variables; balance of trade and real exchange, and were not able to find any relation between the two.

The negative flipside of J-curve as highlighted by the Marshall-Lerner condition is that the J-curve comes into effect when and if the import and export of a country are elastic enough to sustain the effect and change in one variable and transfer it to the other. In Pakistan the absence of a relation between these two variables is due to the same reason as our import and export are not elastic enough.

Pakistan's main exports are sports good, leather etc. Now these items which constitute a major chuck of our exports are facing challenges from the international community not sue to the exchange rate but due to other issues as child labor etc. So countries are not buying and furthermore Pakistan is faced by energy crisis which has damaged production to a large extent. That is the reason why our exports are also not responding to the fluctuations in exchange rate and giving us the benefits of J-curve effect.

Another study conducted by Elif Akbostanci (2002) suggests that a particular pattern can be seen in the balance of trade fluctuations due to varying exchange rates, where the balance of trade dips low initially as an immediate reaction to the changes in exchange rates but gradually rises upwards due to increased economic activity and exports due to the lower exchange rate of the currency where people buy more of the local goods and internationally goods are more demanded as it becomes cheaper.

Furthermore Elif stated that after conduction tests on both long-term equilibrium and short-term dynamics exposed an S-curve rather than a J-curve in the short-term dynamics which recorded the behavior of trade balance in reaction to changes in the exchange rates.The reason Elif Akbostanci (2002) said economist give behind the logic and dynamics of J-curve which states an initial worsening of balance of trade in the short-term and improvement in the long run comes from the fact that when a 'real' depreciation of the currency occurs the value of imports increase only.

This is due to the fact that import and export bills and orders are made many months in advance, so the value of exports does not change but the bill-value of import rise as the currency depreciates making imports more in absolute value then exports causing an inflated import value in the beginning. Afterwards in the long run the exports increase due to heavy buying by other countries of cheap goods and cut in imports due to expensive goods help increase the balance of trade towards surplus and give us a tilted J-curve shape.

Shirvani and Wilbratte (1997), Elif (2002) and Liu, Fan, Shek (2006) also found similar results to Henran (1999) which gave proof of a J-curve relation existence between the two economic variables, exchange rate and balance of trade. Onafowora (2003) identified a substantial existence of a relation between the three Asiatic countries of Indonesia, Thailand and Malaysia. Moreover this relationship was found in the bilateral trading between the mentioned countries as well as Japan and United States.

Rose (1991), significantly went in the opposite direction and stated that there was no significant relation among the five OECD countries. In addition she said that there was no significant relation between the two economic variables of exchange rate and balance of trade. This supported the conclusion that a decrease in the value of the currency would not improve the balance of trade in the long- run but would rather keep deteriorating.

Hatemi and Irandoust (2005), utilizes the cointegration method of testing. Results obtained were failed to comply with the marshal-Lerner condition. This was probably due to the inelasticity of Sweden's balance of trade to the fluctuations in the real exchange rate.

Wilson and Kua (2001), similarly conducted out tests which again directed towards the fact that there was significant relation between the two-way trade balance of the United States and Singapore on exchange rate.

Method

The study is looking into the socio-economic phenomenon of the J-curve and find out what are the causes of it. Moreover the phenomenon of the J-curve has not been clearly defined as many researchers have found its evidence and many have questioned it. This study also looking at the two variables to figure out why it is so. This demands the use of explanatory research (Quantitative) method.

J-curve relation is determined on long-term, as the balance of trade improves due to the depreciation of the currency in the long run. Hence, we employ time series analysis for this research.

The data was collected for two variables balance of trade and exchange rate from the last 10 years. Both, balance of trade and exchange rate data was obtained from State Bank of Pakistan's Historical archive database.

Results and Discussion

Table 1 Model Summary

###Adjusted###Std. Error of the

###Model###R###R Square

###R Square###Estimate

###1###.651a###.423###.419###398.06513

a. Predictors: (Constant), Exchange Rate

Table 1 shows the linear relationship between the variables under study. The R-value of 0.651 shows that there is a 65% correlation between the independent and dependent variable. The R square value shows the variability in the dependent variable which is explained by the variation in the independent variable. The R- square value of 0.423 shows that a variation of one (1) unit in the independent variable causes a variation of 0.423 in the dependent variable.

Table 2 ANOVA b

###Model###Sum of Squares###df###Mean Square###F###Sig.

1 Regression###17207277.350###1###17207277.350###108.594###.000a

###Residual###23451465.983###148###158455.851

###Total###40658743.333###149

a. Predictors: (Constant), Exchange Rate b. Dependent Variable: Balance of trade

Table 2 shows the significance of the model. The Sig. value of 0.00 is very less than 0.05 showing that the study is significant. Keeping this in mind we fail to reject our null hypothesis.

Table 3 Coefficientsa

###Unstandardized###Standardized

###Coefficients###Coefficients

###Model###B###Std. Error###Beta###t###Sig.

1 (Constant)###1111.800###176.454###6.301###.000

###Exchange Rate###-25.754###2.471###-.651###-10.421###.000

a. Dependent Variable: Balance of trade

Table 3 shows the individual sig and t value of the variables under study. The exchange rate has a sig. value of 0.00 which is very less than 0.05 showing that the exchange rate has a significant impact on the dependent variable, Balance of trade. Additionally the t value shows a value of -10.421 showing that the impact is significant and inverse. Keeping these values in mind it can be concluded that exchange rate has a significant and inverse impact on the balance of trade.

Figure 1

In figure 1 P.P Plot clearly shows that the residuals are normally distributed.

Figure 2

In figure 2 Histograms are used as tools to find out if the data is normally distributed. We generated a histogram, using SPSS, from our data. The Histogram shows that the data is more or less normally distributed.

Table 4 Correlations

###Exchange Rate###Balance of trade

Exchange Rate###Pearson Correlation###1###-0.651

###Sig. (2-tailed)###.000

###N###150###150

Balance of trade###Pearson Correlation###-0.651###1

###Sig. (2-tailed)###.000

###N###150###150

Correlation is significant at the 0.01 level (2-tailed).

Table 4 shows the correlation between the dependent and independent variable. A correlation of -0.651 exists between the two variables showing an inverse correlation with a magnitude of 0.651.This correlation is also statistically significant because the Sig. (significant0 value is 0.00 which is less than 0.05. Keeping this in mind it can be concluded that if one variable increases, the other decreases with a magnitude of 65%.

Data Analysis

1. Statistically the two variables, exchange rate and the Balance of Trade are negatively correlated with each other with a negative value of -0.651

2. The results are significant as the sig value is .000 which is less than 0.05 and within the specified 95% confidence level

3. We significantly to reject Null Hypothesis.

Discussion

The initial supporting evidence presented is the matrix for correlation (also known as the correlation of matrix) for the economic variables of import, export, exchange rate and the balance of trade. The component used to construct the matrix is the growth rate (percentage change in each variable's growth).As the difference in all of these variables is constant and stagnant, the results of the correlation testing is purposeful.

The matrix of correlation that we applied here gives us results that present the fact that there is an existence of an inverse or negative relationship between the two economic variables, balance of trade and the exchange rate. This means clearly that the fluctuations in the exchange rate due to any means will lead to a positive increase in the balance of trade figures. If, for instance the currency depreciates due to exchange rate dynamics it will cause the balance of trade to increase.

However we can see that the currency depreciation is further destroying and disintegrating the balance of trade but this can be explained by two factors as to why it is deteriorating the balance of trade.

(a) As is consistent with all J-curve theories that a decrease in currency's value will cause a proportionate increase in the balance of trade in the long run. But however in the immediate scenario or short-term the J-curve phenomena states that the balance of trade will decrease as a result initially due to the decrease in value of exports and increase in the value of imports but gradually and eventually this will rise upward due to increased economic activity. So we can assume that this might be one of the reasons we see a deterioration in the balance of trade even when the currency is depreciating.

(b) The import and exports of the country are not sensitive to changes in the exchange rate, meaning that they are inelastic and any change in the exchange rate is not causing any sort of effect other than negative and decrease in value of the balance of trade.

The ineffectiveness of J-curve is explained by so-called Marshal-Lerner condition. The Marshal Lerner condition states that both imports and exports should be elastic enough in order to improve the trade balance. If the imports are inelastic, the devaluation of local currency will cause an increase in the import bill.

Furthermore we can say that if the imports of a country are not sensitive and responsive to changes in the exchange rate, meaning if the imports are in elastic then a decrease or depreciation the currency will lead only to an inflated imports bill.

Similarly if the exports of a country is not responsive and elastic then a depreciation in the value of currency will mean only a decrease in the value of exported products and goods and it will create a worse scenario then what we were trying to overcome. Meaning the cure will become more hazardous than the disease itself.

This assumption can be further supported by the date and the facts of the components in Pakistani imports and the nature of those imports. Major imports of Pakistan include Machinery, Petroleum, Fertilizers, Chemicals and medicines which are all inelastic in demand due to their nature. As a result the currency depreciation only increase the value of these imports items and their bills.

Conclusions

The primary objective of this study is to find an estimated form of reduced balance of trade model to suggest and establish the empirical authentication of J- curve's existence. The effect of the depreciation of Pakistan Rupee on the balance of trade is examined using aggregate data. From the statistical testing conducted it is concluded that Exchange rate and Balance of Trade are negatively correlated. Thus, we significantly reject the null hypothesis. Our findings are statistically significant.

These results are in similarity with the results of Mr. Ateeq-ur- Rehman's Exchange Rate, J-Curve Amd Debt Burden of Pakistan. His empiric finding stated that there is a negative relation which is statistically significant. He concluded that depreciation in the value of currency increased external debt only. Thus the negative relation is not yielding desired effects. Similarly this research also supports the same perspective that although negatively related they fail to yield positive results. The evidence of the existence of J-curve is found but the long-term effects of the depreciation of Pak Rupee, which is supposed to be favorable, is not favorable.

Recommendation Based on the findings and this research report it is clear that the Pakistan's Balance of Trade is not improving as a result of the currency's depreciation and only the value of imports is increasing along with the external debt. So it is suggested that the State Bank of Pakistan should not depreciate the currency through monetary or fiscal policies as a tool and variable to subsequently increase trade balance because it will not yield the desired result.

Limitations

The major hindrance and limitation during the research was that the data acquired to test and observe the J-curve relation was aggregate. The research could face the problem of aggregate bias. As Thorbecke, (2006) stated that the trade direction of any country is quite sensitive to fluctuations of changes in income and the general prices. Keeping that in mind disaggregated data is more suitable as it is constant with the empirical literature involving the trade which is multilateral.

References

Ahmad, J. and Yang, J. (2004). Estimation of the J-curve in China. Economics Series East West Center's working papers.

Akbostanci, E. (2002). Dynamics of the trade balance: the Turkish J-curve. Economic research center working papers in economics, 0105.

Chinn, M. and J. Frankel (1991). Are exchange rate expectations biased? Test for a cointegration rank test statistics, Oxford Bulletin of Economics and Statistics, 54, 461-472.

Hameed, A. and Kanwal, S. (2009). Existence of a J-curve: The case of Pakistan, Journal of Economic Cooperation and Development, 30 (2).

Hatemi, J.A. and Irandoust, M. (2005). Bilateral Trade Elasticties: Sweden Versus Her Major Trading Partners. Retrieved from www.arpejournal.com/ APREvolume3number2/Hatemi-J-Irandoust.pdf. reterived on: 22 October, 2013.

Hernan, R. C. (1999). Testing the short-and-long run exchange rate effects on trade balance: The case of Colombia, reterieved from: http://www.banrep.gov.co/docum/ttp/borral120.pdf, reterieved on: 23rd October 2013.

Liew, K.S., Lim, K.P. and Hussain, H. (2003). Exchange rate and trade balance relationship: The experience of ASEAN countries. EconWPA, International Trade with number 0307003.

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Moffett, M.H. (1989). The J-curve revisited: an empirical examination for the United States. Journal of International Money and Finance, 8, 425-444.

Rehman, A. (2012). Impact of model specification decisions on unit root tests, International Econometric Review, 3 (2), 22-33.

Rose, A.K. (1991). The role of exchange rates in a popular model of international trade, Does the Marshall Lerner condition hold. Journal of International Economics, 30, 301-316.

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Thorbecke, W. (2006). The effect of exchange rate changes on trade in East Asia. RIETI Discussion Paper Series 05-E-009.

Backus, D.K., Kehoe P.J. and Kydland F.E. (1994). Dynamics of the trade balance and the terms of trade: the J-curve, American Economic Review, 84 (1), 84-103.

Muhammad Abubakar Awan , Sherbaz Khan and Shair Sultan Mughal Greenwich University mabawan@hotmail.com
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Publication:Journal of Business Strategies (Karachi)
Article Type:Report
Geographic Code:9PAKI
Date:Dec 31, 2013
Words:3772
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