The purpose of this paper is to find the impact of devaluation on trade balance in Pakistan in both long and short run using bound testing approach to Cointegration and Error Correction Mechanism (ECM). The result shows that devaluation is effective in improving trade balance and there is a cointegrated relationship between the real effective exchange rate and trade balance in the long run.

Kashif RASHID

Muhammad ASIF

English

Research Papers in Economics

Page 16  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
Impact of Devaluation on Trade Balance in 
Pakistan 
 
 
Muhammad ASIF, Lecturer 
Management Sciences Department 
CIIT, Abbottabad, Pakistan  
E-mail: m_asif[at]ciit[dot]net[dot]pk 
 
Kashif RASHID 
 
 
Abstract:  The purpose of this paper is to find the impact of devaluation 
on trade balance in Pakistan in both long and short run using 
bound testing approach to Cointegration and Error Correction 
Mechanism  (ECM).  The  result  shows  that  devaluation  is 
effective  in  improving  trade  balance  and  there  is  a 
cointegrated  relationship  between  the  real  effective 
exchange rate and trade balance in the long run. 
Keywords: REER, Devaluation, Trade Balance, Cointegration, Pakistan. 
 
 
Introduction 
  Devaluation is undertaken as a mean of correcting a deficit in trade 
balance  and  the  balance  of  payments.  It  raises  the  domestic  price  of 
imports and reduces the foreign price of exports. According to Alse and 
Oskooee  (1995),  it  is  common  to  find  arguments  for  and  against 
devaluation but the issue is to find the effects of devaluation in terms of 
trade, as devaluation lowers the prices of exports and raises the prices of Page 17  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
imports.  Some  economists  believe  that  the  necessary  and  sufficient 
condition for an improvement in the trade balance is a combination of a 
sufficiently large price elasticity of demand and a sufficiently small price 
elasticity  of  supply  (Brahmasrene  and  Jiranyakul,  2002).  Thanh  and 
Kalirajin (2006) find that devaluation can be implemented to encourage 
the exports and to improve the trade balance and also to reduce the real 
exchange  rate  appreciation  in  short  run.  Narayan  (2006)  finds  that  in 
short  and  long  run,  a  real  devaluation  of  currency  improves  the  trade 
balance.  Oskooee  (1998)  finds  that  devaluation  improves  the  trade 
balance  in  the  less  developed  country.  Cooper  (1971)  proves  that 
devaluation  improve  the  trade  balance,  while  studying  the  impact  of 
devaluation  in  19  developing  countries  including  Pakistan.  Halicioglu 
(2008)  suggests  that  there  is  a  long  run  relationship  between  real 
effective  exchange  rates  and  the  trade  balance  using  bound  testing 
cointigration  approach,  if  the  trade  balance  is  used  as  a  dependent 
variable. Upadhayaya (1999) finds the long run effects of devaluation in 
six Asian countries including Pakistan. He suggests that devaluation has a 
long run contractionarey effect in Pakistan. 
  Pakistan  has  been  facing  the  problem  of  trade  deficit  since  its 
creation  in  1947.  To  improve  the  trade  balance,  Pakistan  had 
experienced a series of devaluation in different periods of time from 1955 
to  up  till  now.  After  1982  the  country  is  experiencing  a  continuous 
devaluation in the rupee against dollar (Zaiby, 2009). The government 
and policy makers of Pakistan tried different exchange rate policies. To 
strengthen  the  balance  of  trade  and  balance  of  payments  (BOP)  and 
keeping in view this frequent appreciation of dollar against other major 
currencies, Pakistan adopted the managed floating exchange rate system 
in January 1982. The exchange rate observed much larger devaluation in 
nominal terms as there is a higher  level of inflation in Pakistan in the 
beginning of 1990’s compared to other major trading partners. In July 
2000, State Bank of Pakistan moved away from managed exchange rate 
to floating exchange rate regime. There was a sharp nominal depreciation Page 18  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
of  18.5  percent  during  fiscal  year  2001,  which  showed  the  market 
overvaluation  during  fiscal  year  1999  and  2000  (Hyder  and  Mehboob, 
2005). 
  There  are  several  empirical  evidences  found  for  developing 
countries  including  Pakistan.  In  previous  studies,  attempts  have  been 
made  to  investigate  the  j-curve  phenomenon  in  Pakistan.  Due  to  the 
advent of new econometric techniques it is expected to find better results 
for future policy making. Therefore, objective of this study is to find the 
impact of devaluation on trade balance in Pakistan in longer run using 
Auto Regressive Distributed Lag (ARDL) approach. 
 
Data and Methodology 
The  annual  data  over  the  period  from  1981  to  2008  is  used  to 
estimate the ARDL equation. The data set was extracted from the annual 
reports of the State Bank of Pakistan. The real effective exchange rates 
from 1981 to 2005 were gathered from the study of Hyder and Mehboob 
(2005). The real effective exchange rate (REER) is a key macro economic 
relative price, which plays  an important role in the broad allocation of 
resources in production and spending behavior in the economy. The real 
effective exchange rate (REER), as a measure of competitiveness, also 
determines and influences the performance of export sector. 
 The impact of real effective exchange rate on trade balance can be 
analyzed  through  Auto  Regressive  Distributed  Lag  (ARDL)  model.  The 
same  model  is  used  to  study  the  long  run  and  short  run  relationship 
among the variables. 
The model can be written in the log linear form as: 
                (1) 
() TB f REER Page 19  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
            (2) 
where the trade balance (TB), is the ratio of exports to imports and 
REER is the logarithm of the real effective exchange rate. According to j-
curve phenomenon, an increase in real effective exchange rate initially 
reduces  the  demand  for  the  home  country’s  export  but  increases  its 
demand for imports. As a result, the balance of trade worsens initially but 
it will improve after a while as export and import volumes adjust to price 
changes. 
The impact of exchange rate changes is unpredictable, i.e.  could 
be  positive  or  negative.  If  there  is  a  real  devaluation  of  domestic 
currency i.e. RER increases, then the increased competitiveness in prices 
for domestic country should result in exporting more and importing less. 
However, the higher RER also increases the value of each unit of import, 
which would tend to diminish the trade balance. In the short run there 
prevails an “import value effect”, whereas the “volume effect” dominates 
in the longer run. 
To investigate the cointegrated relationship between trade balance 
and exchange rate, several economometric methods were implemented. 
A  recent  single  cointegration  approach,  known  as  Auto  regressive 
Distributed  Lag  (ARDL)  of  Pesaran  et  al.  (2001),  has  become  popular 
amongst the researchers. The ARDL approach to test the existence of a 
long  run  relationship  between  the  variables  in  levels  is  applicable 
irrespective  of  whether  the  underlying  regressors  are  purely  I(0)  i.e. 
integrated  at  level  or  I(1)  i.e.  integrated  at  first  order.  According  to 
Narayan  (2004),  the  small  sample  properties  of  the  bounds  testing 
approach are far superior to that of multivariate cointegration. 
 
 
01 ln( ) ln( )tt TB REER      
1 Page 20  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
An ARDL representation of equation 1 is as under: 
 (3) 
Once  a  long  run  relationship  has  been  established,  using  an 
appropriate  lag  selection  criterion,  the  second  stage  of  ARDL 
cointegration procedure is to perform a parameter stability test for the 
selected  ARDL  representation  of  the  Error  Correction  Model  (ECM).  A 
general equation of ECM of ARDL equation is as follows: 
    (4) 
Where  λ  is  the  speed  of  adjustment  parameter  and  EC  are  the 
residuals  that  are  obtained  from  the  estimated  cointegration  model. 
Furthermore, Δ is the first difference operator. The F test is used to find 
out whether a long-run relationship exists between the variables through 
testing the significance of the lagged levels of the variables. When a long
-run relationship exists between the variables, the computed F statistic 
exceeds the upper bounds of the critical value (Halicioglu, 2008). 
 
Empirical Evidences  
The results of ARDL   equation  are  reported  in  Table  1.  The 
results show that there is a lack of relationship between the real effective 
exchange rate and trade balance in the short run. On the contrary, we 
have found a valid relationship between these variables in the long run. 
The  short  and  long  run  elasticities  are  0.45  and  1.14  respectively 
calculated  as  and are  shown  in  Table  5.  The  results  show  that 
46%  of  the  trade  balance  is  explained  by  the  REER,  which  shows  the 
goodness of fit. The Durbin Watson value is 1.9 which is approximately 
equal to the benchmark of lack of autocorrelation in the model. The value 
0 1 2 3 1 4 1 ln( ) ln( ) ln( ) ln( ) ln( ) t j t j j t j t t t TB REER TB REER TB                    
0 1 2 ln( ) ln( ) ln( ) t j t j j t j t j t TB REER TB EC                 
1
2


3
4

Page 21  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
of  Wald  F-statistic  is  5.15  as  reported  in  Table  3,  is  greater  than  the 
upper  critical  bound  value  at  1  %  level  of  significance  of  Pesaran  as 
shown  in  Table  4.  This  suggests  that  there  exists  a  cointegrated 
relationship  between  the  REER  and  the  trade  balance.  The  results  of 
equation 2 are reported in Table 2. The results suggest that one percent 
devaluation will improve the trade balance by 64 percent. 
 
Table 1— Estimated Results of ARDL equation 
 
Table 2— Estimated Results of OLS 
 
Table 3 — Wald Test 
Variables  Coefficients  Probability 
Constant  -3.4921  0.0000 
D(LNTB(-1))  -0.8318  0.0065 
D(LNREER(-1))  -0.3706  0.4302 
LNTB(-1)  0.6825  0.0009 
LNREER(-1)  0.7977  0.0000 
MA(2)  -0.9947  0.0000 
R-squared = 0.456  Durbin-Watson stat = 1.92  Prob(F-statistic) = 0.023 
Variable  Coefficient  Probability 
Constant  2.629553  0.0000 
LNREER  -0.640917  0.0000 
R-squared = 
0.575112 
F-statistic =35.19253  Probability = 0.000003 
Test Statistic  Value  Probability 
F-statistic  5.159628  0.0210 
Chi-square  10.31926  0.0057 Page 22  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
From these results, it is obvious that there is a long run relationship 
amongst  the  variables  because  its  F-statistic  is  higher  than  the  upper 
bound critical values, 5.06 at 1 percent level of Pesaran.  This implies 
that the null hypothesis of no cointegration among the variables cannot 
be accepted. Bounds test for cointegration analysis is presented below in 
Table 4. 
 
Table 4— Bounds Test for Cointegration Analysis Based on Equation 
Note:  Computed  F-statistic:  5.61  (Significant  at  0.01  marginal 
values). Critical Values are cited from Pesaran et al. (2001) 
 
Table 5— Short and Long Run Elasticities Calculated from Table 1 
 
 
 
 
 
 
Critical value  Lower Bound Value  Upper Bound Value 
1%  3.74  5.06 
5%  2.86  4.01 
10%  2.45  3.52 
Short Run Elasticities  Long Run Elasticities 
 
1
2


 
3
4


0.45  1.14 Page 23  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
Table 6 — ECM Results 
 
The ECM results indicate that the ECM term (λ) has a negative sign 
and its value lies between 0 and 1, hence showing the convergence of 
the model and implying that about 49 % adjustments take place every 
year.  In  the  short  run,  the  results  are  significant  at  fourth  lag  which 
indicates that 1 % decrease in REER leads to a 1.2 % increase in the 
trade balance. 
 
Conclusions   
In this study, an attempt is made to find the impact of devaluation 
on  trade  balance  and  balance  of  payments.  We  use  the  real  effective 
exchange  rates  (REER)  as  a  proxy  for  devaluation.  In  this  study,  the 
analysis is made on annual data ranging from 1981 to 2008. ARDL model 
is used for studying the long run relationship among the variables. The 
trade balance (TB) was used as the dependent variable for this study. 
The  coefficient  of  REER  is  significant,  which  shows  that  devaluation  is 
effective  in  improving  the  trade  balance.  Based  on  the  findings  of  the 
Variables  Coefficients  Probability 
Constant  0.0005  0.9900 
D(LNTB(-1))  -0.0370  0.8711 
D(LNREER(-1))  -0.3611  0.3805 
D(LNREER(-2))  -0.3419  0.5952 
D(LNREER(-3)  0.7469  0.1771 
D(LNREER(-4)  -1.1981  0.0185 
D(LNREER(-5)  0.4287  0.3173 
λ  -0.4945  0.0369 
R-squared = 0.7105  Durbin-Watson stat = 2.1  Prob(F-statistic) = 0.0858 Page 24  Oeconomics of Knowledge, Volume 3, Issue 3, 3Q, Summer 2011 
 
study,  it  is  suggested  to  increase  the  trade  balance,  increase  exports 
volume and introduce import quotas and seriously consider devaluation in 
trade policy. 
 
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Impact of Devaluation on Trade Balance in Pakistan

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Impact of Devaluation on Trade Balance in Pakistan

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