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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.
[email protected]
Jin-sang, Lee
Specialist Professor, Duksung Women’s University, Seoul, South Korea.
[email protected]
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.
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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 inelastic, and the reduced price of
export goods abroad would lead to only a small increase in quantity sold. Hence, the total amount
of exports may be reduced. Furthermore, the impact of the devaluation may require some time to
adjust in the real economy. In the short run, the demand for export goods in foreign markets may
be inelastic, but as time goes on, the demand for goods become price elastic in the long run, and
hence bring greater impact to the export sector. Secondly, the state of the global economy could
affect the export sector. When the global economy is in recession, depreciation may not bring
much impact on the demand for export goods abroad and vice versa. With these uncertain
consequences of devaluation, this study attempts to analyze the effects of devaluation on trade
balances among 14 Asian economies between 1990 and 2012. The first group consists of 14
countries including large economies with some export driven relatively small economies.2 For the
second group of countries, we excluded relatively small economies and used 8 countries.3
Figure 1 shows that the annual average trade balance of 14 Asian economies since 1990.
China, Korea Republic, Indonesia, Malaysia and Singapore experienced trade surplus while
countries such as Bangladesh, India, Pakistan, Philippines, Sri Lanka, Vietnam, Thailand and
2
This group of countries includes China, South Korea, Hong Kong China, Vietnam, Philippines,
Indonesia, Singapore, Burnei, Malaysia, Thailand, Sri Lanka, Bangladesh, India and Pakistan
3
The second group includes China, South Korea, Hong Kong China, Vietnam, Singapore, India,
Malaysia, Indonesia and Malaysia.
International Journal of Global Business, 7 (1), 59-76, June 2014 62
Hong Kong China were experiencing huge trade deficits regardless of currency depreciation in
their respective countries. Hong Kong China has a large share of income originated from trade
brokerage which caused trade deficit in the current account whereas surplus in the capital account.
This is possible with the openness of the Hong Kong economy that stimulates the free movement
of portfolio investment from developed economies.
Figure 1. The Average Trade Balance of Asian Economies (1990-2012) in Millions of US $
100000
82409
80000
60000
40000
17471
20000
11021
16675
11815
3222
0
-4228
-20000
-6929 -7177
-2669 -1376 -4627
-17640
-40000
-43052
-60000
Source: UNCTAD Hand Book of Statistics, 2013
After the Chinese government started open door policy in the later part of 1970s, China was
focusing on the promotion of manufacturing export goods and also encouraged foreign direct
investment. The Chinese yuan has been kept relatively low relative to foreign hard currencies
though there were pressures of appreciation from other countries notably the USA. Consequently,
China has been experiencing trade surplus for a considerable time period. India, on the other hand,
has been experiencing trade deficit for more than a couple of decades. The value of Indian rupee
International Journal of Global Business, 7 (1), 59-76, June 2014 63
has been fluctuating and devaluation could not bring sufficient impact to the export sector. This is
because the Indian economy is heavily dependent upon imported energy and industrial goods.
Moreover, Indian export products are not competitive and the price inelastic in foreign markets.
Other countries such as Indonesia, Malaysia and Burnei are largely focused on primary export and
limited demand for imports. Korea is one of the most successful economies driven by the export
sector. The country achieved technology progress and focused on exporting industrial products
that are very competitive in external markets. The exchange rate of Korea is very sensitive in
foreign markets. Though Korea imports almost all industrial raw materials and energy, the country
has been experienced elastic demand for export goods abroad. Other countries are experiencing
export promotion, but with limited export commodities which are rather focused on labor intensive
and lower technology production. These products are less price elastic compared with more
sophisticated consumer goods in foreign markets.
Other than currency devaluation, this study also investigates the effects of other factors that
may cause changes in trade surplus from one country to another country. The remainder of the
paper is organized as follows. Section II provides theoretical background of the impact of
devaluation. Section III brings model specification, estimation methods and data sources. Section
IV presents the results of empirical analysis and main findings and section V brings concluding
remarks.
Theoretical Background
The classical approach of devaluation could remedy trade deficit that entails domestic expenditure
as imported goods tend to become more expensive than domestic products, and domestic products
will be cheaper in abroad. Hence, these shifts contribute to reduce the domestic absorption and
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hence could ease trade deficit. Accordingly, it is expected that devaluation would lead to improve
in trade balance in the long-run (Agbola 2004, Rawlins and Praveen, 2000; Musila and Newark,
2003; Bahmani-Oskoee and Ratha, 2004). Another theory of devaluation states that trade balance
has been also rooted in a particular solution of the BRM condition, known as the Marshall-Lerner
condition (Marshall, 1923; Lerner, 1944; Bahmani-Oskooee and Niroomand, 1998). This
condition states that devaluation brings a positive effect on trade when the sum of the demand
elasticities for exports and imports must exceed unity. More specifically, the Marshal-Lerner
Condition assumes that if εx and εm denote the elasticities of export and import respectively, then
we reach to the following prepositions:
a. If εx + εm > 1, the devaluation of home currency would improve trade balance.
b. If εx + εm = 1, the devaluation of home currency will make no difference to the trade
balance.
c. If εx + εm < 1, , the devaluation of home currency will deteriorate the trade balance.
Similarly, empirical studies such as Junz and Rhomberg (1973) shows that devaluation may cause
a negative impact on trade balance in the short run but improve in the long run; that is, the trade
balance followed a time path which looked like the letter “J”. Nguyen(1993) and BahmaniOskoeee and Xu(2013) also proved that depreciation brings adverse effect on trade balance in the
short run. The main explanation for the J-curve would be exchange rate could adjust
instantaneously, but there is a time lag as consumers and producers need to adjust to changes in
demand for and supply of goods.4
4
However, Rose and Yellen(1989) examined that the J-curve was not statistically significant in the case
of the USA.
International Journal of Global Business, 7 (1), 59-76, June 2014 65
In the import sector, depreciation could raise the domestic price of imported goods. This will
bring consumers substitute imported goods into domestic products. However, this substitution is
relied on the availability of similar domestically produced goods as well as the time period
subsequent to the depreciation (Edwards and Willcox, 2003). For that circumstance, many
developing economies are tending to import intermediate goods such as oil and capital goods.
These economies are lacking a wide range of substitutes for imported products implying a highly
inelastic import demand function. Even if substitutes are available, “lags in recognition of the
changed situation, in the decision to change real variables, in delivery time, in the replacement of
inventories and materials, and in production” give rise to an inelastic demand curve in the short
run (Magee, 1973). In these results, devaluation raises the price level of import goods that may
persist even in the long run.
In the export side, as we mentioned earlier, devaluation lowers the price of export goods
abroad. The depreciation is passed on to foreign consumers in the form of lower foreign currency
prices of exports (their imports) depends on the elasticities of export supply and demand. This
leads to the Marshall-Lerner condition which states that devaluation is only viable when the sum
of price elasticities of exports and imports (in absolute value) is greater than unity. This implies
that if export goods are price elastic in foreign markets, their quantity demanded will increase
proportionately more than the decrease in price, and total export revenue will increase. Similarly,
if import goods are price elastic, total import expenditure will decrease. In both cases trade balance
will be improved. Empirically, it has been found that trade in goods tends to be inelastic in the
short term, and it takes time to change consuming patterns and trade contracts (Bahmani-Oskoee
and Ratha, 2004). This condition will be fulfilled in the short run when import and export demand
curves are inelastic. However, in the long run, the volume of exports may start to rise because their
International Journal of Global Business, 7 (1), 59-76, June 2014 66
export goods would be competitive in foreign markets, and also domestic consumers may switch
to domestic goods rather than import ones. Eventually, the trade balance will improve and bring
positive impact to the real economy. If there is a currency appreciation, with the same reason it
can induce an inverted J-curve. In fact, it is obvious that following devaluation, the volume of
imports and exports may remain largely unchanged due in part to pre-existing trade contract that
have to be honored. Moreover, in the short run, demand for expensive import goods and supply of
export goods remain price inelastic. This is due to time lags in the consumer's choice for acceptable
and cheaper alternatives.
The notion that devaluation stimulates exports and curtails import is not always acceptable
in all circumstances. For instance, Abeysinghe and Yeok (1998) empirically investigated the
impact of currency appreciation on exports in the case of Singapore, and found that with the
presence of high level of import and exports are not adversely affected by currency appreciation.
Accordingly, Singapore is a particularly interesting case study as the country has been
experiencing sustained export growth despite of appreciation. With these different consequences
of devaluation, opponents of the classical view are not optimistic about the effect of currency
devaluation to improve trade balance. In fact, most of the structuralists argue that nominal
devaluation leads to contractionary demand for output. Thus, devaluation may bring an ambiguous
effect on trade balance at least in the short-run. Consequently, policy makers in developing
countries find difficulty to decide the types of exchange rate regime.
Model Specification, Estimation Methods and Data Sources
Apart from the exchange rate regime, there are many other factors that would affect trade balance.
For instance, the degree of openness of the economy could be related to foreign trade. It is also
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sensitive in the flow of foreign capital and hence affect the balance of payment with capital account
like what is happening in Hong Kong China. The level of industrial development of the country
will also matter to the export sector. If a country has advanced industrial structure, there is a
tendency of higher level of elasticity of demand for export commodities abroad. Hence, it would
be closely related to the country’s level of manufacturing capacity. There are some other factors
that would affect trade balance such as inflation, lending interest rate, the population size and
physical infrastructure of the country as these will have paramount effect on trade. Figure 2
summarizes a theoretical model for the effects of devaluation and other control variables on trade
balance.
Figure 2. Theoretical Model for the Effects of “Devaluation” and Other Control Variables
on Trade Balance
Exchange Rate (+)
Income Per Capita (+/-)
Trade Balance
Manufacturing Export/Total
Merchandise Export (+)
Inflation (-)
Lending Interest Rate (-)
Degree of Openness (+)
Population Size
(+)
Physical
Infrastructure
(+)
Model Specification and Estimation Methods
Based on earlier empirical studies and theoretical explanations, the effect of currency devaluation
and other control variables on trade balance (TB) in a given economy can be specified as flows:
TBit=β0+β1CDit+β2 Openit +β3 IPCit+Zit +εit
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Where; TB refers to trade balance, CD refers to devaluation, Open refers the openness, IPC refers
to income per capita which captures the level of development of the country, Zit represents the set
of other control variables including physical infrastructure, etc., as mentioned in Table 2; i indexes
the country under study, t denotes the year, and εit is the idiosyncratic errors. Thus, the model
takes both the cross-section dimension and the time-series dimensions into consideration.
In doing so, test for heteroscedasticity was conducted using the Breusch-Pagan test and the nullhypothesis of homoscedasticity was rejected at 1% significance level, implying there is strong
evidence of heteroskedasticity in which the error variance is not constant and needs to be corrected
using robust standard errors. Likewise, the test for serial correlation for the error terms was
conducted using Wooldridge test for autocorrelation in panel data and the result yields a p-value
of 0.5761, that implies there is no evidence of serial correlation (first order autocorrelation) and
hence the error terms are not correlated.
Apparently, a specification test has been conducted to determine which estimation methods
would be more appropriate for this study. According to Gujarati (2003), there is a formal test that
will help to choose between the fixed effect model (FEM) and the random effect model (REM).
Accordingly, Hausman (1978) test has been conducted and the null hypothesis was not rejected.
Hence, the REM is much appropriate for this study. In addition to the REM, this study also used
the feasible general least square (FGLS) with corrected heteroscedasticity standard errors so as to
check the consistency of the results. In fact, heteroscedastic models are usually fitted with the
FGLS regression since the estimates assume that the disturbances are heteroscedastic. In line with
this, the variables, their expected effects on trade balance, and data sources are shown in Table 1.
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Table 1. Variables, Their Expected Signs and Data Sources
Variable
Indicator
Trade Balance
Trade Balance in Million USD$
+/-
Data Sources
UNCTAD Hand
Book of Statistics
Exchange Rate
Official exchange rate of each
+
WDI
country’s currency against USD$
Income Per Capita
Income Per Capita (PPP)
+
WDI
MEX/TME
Ratio of MEX/TMEX
+
WDI
Inflation
Index (Based on CPI)
+
WDI
Lending Interest Rate
Lending Interest rate
+
WDI
Population Size (log)
Number of Population
+
WDI
Degree of Openness
Trade/GDP
+
WDI
Physical Infrastructure
Telephone/100 people
+
WDI
Empirical Results and Main Findings
Results from the Whole Sample
The empirical results using the REM and the FGLS estimation methods with heteroscedasticity
corrected standard errors are presented in Table 2. Accordingly, the empirical results revealed that
the effect of currency devaluation on trade balance in selected Asian economies was found to be
statistically insignificant. In other words, no evidence was found for devaluation to boost trade
balance. 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 imported inputs. When trade volumes do not respond to exchange-rate changes,
the trade balance moves in the “wrong” direction and as a result, devaluation makes the country’s
trade deficits even worse at least in the short term. Moreover, it is obvious that most of the Asian
International Journal of Global Business, 7 (1), 59-76, June 2014 70
economies import resources such as industrial raw materials and energy. In addition, most of those
countries are highly dependent on exporting manufactured goods mainly intermediate and capital
goods, and input materials for industrial needs.
Table 2. Regression Results Using RE and FGLS for the Whole Sample
Dependent Variable: Trade Balance
Explanatory Variables
Exchange Rate
Income Per Capita
MEX/TME
Inflation
Lending Interest Rate
Population Size (log)
Degree of Openness
Physical Infrastructure
Constant
Number of Observations
Number of Groups
Time periods
RE
.0903
(.1589)
. 1376***
(.0437)
.7932***
(.2116)
-.4031*
(.2169)
-.9986*
(.5735)
.2945
(11.986)
.3312***
(.0788)
.2039***
(.0353)
-.7252.22
(916.1)
322
14
23
FGLS
.0371
(.1102)
.7194***
(.0494)
.9242***
(.1796)
-.3624***
(.1354)
-.2763***
(.0425)
.9807***
(.0992)
.5591***
(.0664)
.1901***
(.0430)
-8246.7
(776.8)
322
14
23
Apart from China and India, most of emerging Asian economies countries are small in size, and
there is no guarantee that trade balance can be improved via devaluation. This empirical study
using both the REM and the FGLS estimation methods have found other control variables such as
the country’s level of development captured by the real GDP/capita of each country, the extent
how that country is dependent on manufacturing exports, degree of openness, and physical
infrastructure to positively and significantly influence trade balance in a given country. For
International Journal of Global Business, 7 (1), 59-76, June 2014 71
instance, the positive and significant effect of openness on trade balance is highly expected since
openness to trade can enhance productivity by enabling more efficient allocation of resources. It
also provide greater opportunities to achieve economies of scale. In other words, as Dobre (2008)
noted, openness to trade can play an important role in raising the long-run sustainable rate of
productivity growth in the economy. Likewise, better infrastructure is expected to decrease the
cost of doing business in the country and consequently boosts exports as well as reducing cost of
imported goods. The significant effect of the ratio of manufacturing export to total merchandise
trade implies that manufactured products still have price elasticity of demand and if it is
accompanied by devaluation, it can enhance trade surplus, whereas agricultural and primary
exporting countries experienced price inelastic.
In addition, this study reveals inflation and high lending interest rates might have negative
impact on trade balance. This is due to the fact that a high rate of inflation is generally harmful to
economic growth and trade balance in particular. This is due to the cost of borrowing which lowers
the rate of capital investment. Furthermore, a high lending interest rate may discourage potential
entrepreneurs from undertaking production and export activities as it increases the cost of capital.
Results from the Sub-Sample
The next attempt is excluding relatively small and non-stable economies from the first group. We
excluded Bangladesh, Sri Lanka, Pakistan, Brunei, Philippines, and Vietnam and reexamined the
effects of devaluation on trade balance for the remaining 8 Asian economies including China,
Hong Kong, India, Indonesia, Malaysia, Korea and Singapore between 1990 and 2012. We found
that devaluation has a strong positive effect to improve trade balance (Table 3). This is due to the
fact that those relatively bigger and stable economies and they produce competitive export goods
International Journal of Global Business, 7 (1), 59-76, June 2014 72
countries like Korea, Singapore, India and China who are producing high-tech products like
computer and software, pharmaceutical and medical equipment, advanced ICT products and
scientific equipment. These products are price elastic and demand will increase more than the
decrease in price, and export revenue will increase. Similarly, these countries are also in a better
position to produce substitute goods for domestic consumption if imported goods become
expensive as a result of devaluation. Accordingly, devaluation improved trade balance in selected
emerging 8 Asian economies.
The empirical evidence of the sub-sample analysis in Table 3 confirms those variables such
as the level of development measured in GDP/capita, the ratio of manufactured products,
population size which captures the size of the domestic market, and found that devaluation
enhances trade balance. The study found that there is a strong evidence that inflation and high
lending interest rate may negatively affect trade balance, as they increase the cost of capital.
Table 3. Regression Results Using RE and FGLS for the Sub-Sample
Dependent Variable: Trade Balance
Explanatory Variables
RE
FGLS
Exchange Rate
.8532***
(.2282)
. 7118**
(.3728)
.1401***
(.0529)
-.1155
(.0864)
-.1853*
(.1047)
.2213***
(.0830)
.3115*
(.1897)
.1907*
(.1058)
-.4426***
(.1724)
-.8194
(3.7535)
..1893*
(.0986)
.3459***
(.1516)
.4353*
(.2377)
.2082***
(.0375)
.5439**
(.2429)
.3431**
(.1501)
Income Per Capita
MEX/TME
Inflation
Lending Interest Rate
Population Size (log)
Degree of Openness
Physical Infrastructure
International Journal of Global Business, 7 (1), 59-76, June 2014 73
Constant
Number of observations
Number of groups
Time Periods
-.2324.6
(893.4)
184
8
23
-1847.4
(328.6)
184
8
23
Concluding Remarks
Devaluation works through its “expenditure switching and expenditure reducing effect”.
Expenditure switching works through changes in relative price of exportable and non-exportable.
Devaluation is expected to increase the price of exportable relative to that of non-tradable there by
shifting aggregate supply to the tradable and aggregate demand to non-tradable. Therefore, export
earnings would increase and improve current account and the balance of payment. In addition to
the shift in production from domestic goods (non-tradable) to tradable, the shift also occurs from
import to import substitution (Guitian, 1982). Although the classical economic theory prescribes
that devaluation improves trade balance, empirical evidences show that the outcome can be
ambiguous or inclusive. Accordingly, the Marshal-Lerner condition proposes that the ultimate
outcome of currency devaluation depends on the nation’s price elasticities of demand for exports
and imports.
This study attempted to analyze the effects of devaluation among 14 emerging Asian
economies between 1990 and 2012. There was no strong evidence showing devaluation brings
positive impacts on trade balance. From Table 1, it was evident that most Asian countries were
experiencing trade deficit from time to time. Imports continued to grow more than exports after
devaluation. This is because of the very strong demand for imported necessities and inelastic
foreign demand for most of the exports mainly from those relatively small Asian economies. This
implies that with relatively inelastic demand for exports and imports, devaluation has little or no
effect in changing trade balance.
International Journal of Global Business, 7 (1), 59-76, June 2014 74
To further discussion, we attempted to exclude those relatively small and unstable Asian
economies such as Pakistan, Bangladesh, Sri Lanka, Brunei, Vietnam and Philippines from the
sample, and we analyzed the effects of devaluation on trade balance for 8 relatively bigger and
stable economies. This group includes Korea, China, India, Hong Kong, Singapore, Malaysia,
Indonesia and Thailand. With this group of countries, it was confirmed that devaluation
significantly contributed to trade balance. The rationale behind the positive impact of devlauation
might have been because of their relatively large and stable Asian economies with strong
competitive manufacturing sector. This is very difference from those who are focusing on
exporting agricultural and primary products, and imports intermediate and capital goods. In
addition to devaluation, this study also found strong evidence for other variables such as the level
of development measured in GDP/capita, the ratio of manufactured products, population for the
market size, that influence trade balance. Likewise, the study found a strong evidence for inflation
and high lending interest rate to negative affect on trade balance.
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