Exchange Rate and Trade Balance

Topics: International trade, Supply and demand, Export Pages: 18 (4839 words) Published: November 2, 2014
International Journal of Global Business, 7 (1), 59-76, June 2014 59

Examining the Effects of Currency Depreciation on Trade Balance in Selected Asian Economies
Alemu, Aye Mengistu
Assistant Professor, SolBridge International School of Business, Daejeon, South Korea. ayem2011@solbridge.ac.kr
Jin-sang, Lee
Specialist Professor, Duksung Women’s University, Seoul, South Korea. jinslee0209@duksung.ac.kr

Abstract
The aim of this study is to investigate how depreciation could affect the export sector in selected Asian countries. Theoretically, depreciation will bring positive impact on trade balance. However, it is only possible when the sum of the elasticities of demand for export commodities and demand for import goods is greater than unity. Accordingly, this study found no evidence for the effect of depreciation to improve trade balance of about 14 Asian economies. This was perhaps due to the fact that exports did not respond as expected, mainly due to a decline in terms of trade for primary commodities and manufactured products or due to heavy dependence on import goods which may be more expensive in the local currency. As a second approach, we attempted to narrow down the number of countries understudy into 8 countries that are relatively bigger, industrialized and stable, and in this case we found that depreciation improved trade balance.

Keywords: devaluation, trade balance, export, Marshall-Lerner condition, J-curve effect

International Journal of Global Business, 7 (1), 59-76, June 2014 60

Introduction
Theoretically, depreciation of a local currency is good for the export sector, ceteris paribus, it would increase competitiveness of export goods in foreign markets. On the other hand, it would cause higher level of import price. The higher import price could bring inflationary pressure especially those who import a lot of industrial needs, energy resources and consumer goods. Hence, the overall economic impact of depreciation will not be easy to conclude. Many Asian economies are heavily engaged in imported energy resources like oil and gas, natural resources, and many economies are focusing on export promotion. Therefore, it is worthwhile to look at the consequences of devaluation.

The exchange rate in a given economy often plays a prominent role than the interest rate in the transmission mechanism of monetary policy (Vitale, 2003). Especially for developing countries, it has been assumed that depreciation is an appropriate macroeconomic fundamental to support the export sector.1 In these regards, higher exports and lower imports will increase the trade surplus of a country and also increases the aggregate demand (AD) and it is likely to allow higher level of the real GDP. This implies that there are two elements to be noted on devaluation and the impact of trade balance. Firstly, we suppose that a country has export potential, and depreciation has the price elastic for export goods in foreign markets. Secondly, we also assume that depreciation is supported by sound macroeconomic fundamentals and can maintain competitiveness in foreign markets i.e. the economy has capacity to produce more output for export.

1

Depreciation with the floating exchange rate system and devaluation in a fixed exchange rate system mean a fall in the value of the domestic currency against foreign hard currencies.

International Journal of Global Business, 7 (1), 59-76, June 2014 61

Although economic theory suggests the above scenarios with respect to the impact of devaluation on trade balance and economic growth, the results from empirical research is inconclusive and even sometimes devaluation would bring negative impact on trade balance. Some studies show that there should be a set of necessary conditions on the size of import demand, export demand and supply elasticities of devaluation. This can be interpreted from two different aspects. Firstly, the elasticity of demand for exports and imports is price...

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