Article

Asymmetric Exchange Rate Effects on Trade Flows in India

Niloufer Sohrabji

Department of Economics, Simmons University, 300 Fenway, Boston, MA 02115, USA; [email protected]

Abstract: This paper examines the role of exchange rate changes on India’s trade. The drivers of
exports and imports (income, exchange rate including sectoral differences, and exchange rate vari-
ability) are estimated for the short and long run including a structural break. Using annual data
from 1994 to 2022, the results of dynamic fixed effects estimation show that both exports and imports
are income-elastic in the short and long run, but income elasticity is far stronger for exports. More-
over, exports are responsive to the real effective exchange rate in the short run but not in the long
run, and the reverse is true for imports. Furthermore, exchange rates have asymmetric effects for
high-volume and primary sectors for exports and imports. The combined impacts show the ineffec-
tiveness of using currency depreciation to address trade imbalances.

Keywords: asymmetric exchange rate effects; dynamic fixed effects; India; rupee variability

JEL Classification: F14; F31; O24

1. Introduction
This paper investigates the role of the exchange rate in India’s trade. A depreciation
can help exports and hurt imports, thus improving the trade balance and vice versa for an
appreciation. This has led countries to pursue policies that depreciate or devalue the cur-
rency in an effort to improve trade balances.
Currency interventions by central banks are quite widespread in developing coun-
tries. In India, the Reserve Bank of India (RBI) has intervened in the currency market sev-
eral times over the last few decades. In some cases, the RBI has attempted to depreciate
Citation: Sohrabji, Niloufer. 2024.
the currency with the goal of improving trade balances, and in other cases, action has been
Asymmetric Exchange Rate Effects
undertaken to slow or reverse the decline in the rupee. However, there is no guarantee
on Trade Flows in India. Economies
that these interventions will successfully translate into the expected change in the cur-
12: 114. https://doi.org/10.3390/
rency. Moreover, a currency depreciation may not lead to an improved trade balance.
economies12050114
The relationship between exchange rates and trade has been widely studied in the
Academic Editor: Robert Czudaj literature, including in the case of India. Studies have separated exports and imports, ex-
Received: 1 March 2024 amined short-run and long-run effects, and focused on specific sectors. Through these
Revised: 15 April 2024 investigations, it is clear that the link between the exchange rate and trade is complex and
Accepted: 1 May 2024 needs further investigation.
Published: 9 May 2024 This paper focuses on India which is an important case study on this topic. The value
of the rupee has fluctuated greatly following the 1990–91 balance of payments crisis when
India moved to a managed float currency regime. Moreover, over the past few decades,
Copyright: © 2024 by the author. the country has suffered large trade deficits leading to a rupee depreciation policy by the
Licensee MDPI, Basel, Switzerland. RBI. Despite this, or perhaps because of this, the exchange rate has experienced consider-
This article is an open access article able volatility. Also, these changes in the currency have not always had the expected im-
distributed under the terms and pact on trade balances and this paper aims to understand why that is the case.
conditions of the Creative Commons The contribution of this paper is that it combines time effects and sectoral differences
Attribution (CC BY) license to provide a more complete picture of how the exchange rate affects India’s trade. Focus-
(https://creativecommons.org/license ing on the period after India switched to a managed float regime, this paper incorporates
s/by/4.0/). short-run and long-run effects to investigate how income and exchange rates affect

Economies 2024, 12, 114. https://doi.org/10.3390/economies12050114 www.mdpi.com/journal/economies

Economies 2024, 12, 114 2 of 13

exports and imports. The presence of a structural break can complicate the relationship,
so this paper tests for and incorporates a structural break in the estimation. Furthermore,
this study allows for sector-specific and sector-group exchange rate effects. Disaggregated
data of exports and imports from various sectors are used in the estimation which also
includes a grouping of high-volume sectors studied in the literature. Moreover, this paper
extends the investigation of sectoral differences by estimating how exchange rates impact
primary vs. manufacturing sector trade flows. Through this, this paper addresses the fol-
lowing questions: Does a change in the exchange rate have a bigger impact on exports or
imports? Are the effects different in the long –run and the short –run? Are some sectors
more responsive to exchange rate changes?
Using annual data from 1994 to 2022, this paper estimates the drivers of exports and
imports in 62 sectors across nine broad sector categories. Long–run and short–run effects
of income, exchange rate, and exchange rate volatility are estimated using dynamic fixed
effects. The estimation also includes sectoral groupings through interaction dummy vari-
ables. Results show that the exchange rate has an impact on exports only in the short run
and on imports only in the long run and there are differential effects for high-volume and
primary sectors. Overall, the results cast doubt on the effectiveness of using rupee depre-
ciations to improve trade balances.
This paper is organized as follows: Section 2 discusses the relevant literature which
is followed by a background on the rupee and India’s trade. Section 4 presents the frame-
work and sample used in this study. The results are analyzed in Section 5 and the last
section contains a conclusion.

2. The Related Literature

The literature examining the relationship between the exchange rate and trade is con-
siderable. Bahmani-Oskooee (2001) finds that a real exchange rate depreciation improved
trade balances for Algeria, Bahrain, Egypt, Jordan, Morocco, Tunisia, and Turkey in the
long run and Guechari (2012) showed the same for Algeria for both the total trade and
bilateral trade of the country with its major trading partners. Gomes and Paz (2005) and
Aziz (2012) show evidence for the J-curve effect in Brazil and Bangladesh, respectively.
Genc and Artar (2014) show that in the long run, the exchange rate impacts exports and
imports in developing countries. On the other hand, Onakoya et al. (2018) find no J-curve
effect for Nigeria.
Some studies have examined exports and imports separately. Younus and Chow-
dhury (2014) find that in Bangladesh, the real exchange rate affects trade in the short and
long run, while Alam (2010) finds no statistically significant impact of Bangladesh’s taka
on the country’s exports. Hassan et al. (2016) find that the real effective exchange rate
affects Bangladesh’s exports in the long run (not in the short run), while Younus and
Chowdhury (2014) find no relationship between trade and the real effective exchange rate
in Bangladesh.
Other studies extend this analysis to incorporate sectoral differences. For Turkish ag-
ricultural trade, Fidan (2006) finds that the relationship between the real effective ex-
change rate is stronger in the long run than the short run. Lanau (2017) finds that for Latin
American countries, depreciation helps high-export sectors more than low-export sectors.
Meanwhile, Bernardina (2004) finds that in the long run, real exchange rate appreciation
hurts non-oil exports in Russia while Mehare and Edriss (2013) find that exchange rate
variability hurts Ethiopia’s coffee exports in the short run only.
There have also been India-specific studies. Panda and Mohanty (2015) find that ex-
change rate volatility hurts Indian exports, as does Tripathi (2021), although the impact is
not statistically significant. Cheung and Sengupta (2013) show that rupee changes have a
bigger impact on firms with small export shares and Tripathi (2021) finds that the ex-
change rate has a bigger impact on manufacturing goods.
This paper builds on these studies and the previous literature by combining these
various drivers of exports and imports and analyzing them through the lens of time and
Economies 2024, 12, 114 3 of 13

sectoral differences. This study includes 62 sectors and includes both high-volume and
primary sector groupings. Also, in recognition that a structural break could affect the re-
lationship between trade and its drivers, this paper tests for, identifies, and incorporates
a structural break in the estimation.

3. Background
Prior to 1991, India was a closed economy with a fixed exchange rate. After the 1990-
1991 balance of payments crisis, India undertook a significant restructuring of the econ-
omy. Following a transition period, India moved to a managed float system in 1993. This
paper focuses on the period after that shift from 1994 to 2022, the last year for which there
is complete data.
The RBI has attempted to change the value of the rupee through direct and indirect
means. For example, direct intervention through the sale of foreign currency to increase
the demand for rupees is designed to appreciate the rupee while indirect intervention
through a cut in short-term interest rates reduces foreign demand for rupees and thus
lowers its value (depreciation).
These interventions can be costly. Attempts to appreciate the currency, for example,
can put pressure on foreign reserves (direct intervention) and can hurt investment and
growth (indirect intervention through an increase in interest rates). Moreover, there is a
concern that intervention increases dependency, where markets may be spooked if the
RBI did not intervene (Anand 2018).
Moreover, these interventions may not have the expected impact. Figures 1 and 2
show periods of direct and indirect intervention between 2018 and 2019.

Figure 1. Direct intervention in rupee market by the Reserve Bank of India. Notes: exchange rate is
measured on the left–hand–side axis and foreign reserves on the right–hand–side axis. A decrease
in foreign currency is used to purchase/increase demand for the rupee and thus increase its value
(an appreciation) and vice versa. A decrease (increase) in rupee–to–dollar rate indicates an appreci-
ation (depreciation) of the rupee. Data from CMIS, Database for Indian Economy (n.d.), Reserve
Bank of India (Bank for International Settlements n.d.). Author’s graph.
Economies 2024, 12, 114 4 of 13

Figure 2. Indirect intervention in rupee market by the Reserve Bank of India. Notes: Notes: exchange
rate is measured on the left-hand-side axis and foreign reserves on the right-hand-side axis. A de-
crease in short-term interest rate reduces demand for the rupee and thus lowers its value (depreci-
ation) and vice versa. A decrease (increase) in rupee–to–dollar rate indicates an appreciation (de-
preciation) of the rupee. Data from CMIS, Database for Indian Economy (n.d.), Reserve Bank of
India (Bank for International Settlements n.d.). Author’s graph.

As can be seen from the figures, there have been periods of effective intervention such
as during July–August 2019 when both direct and indirect intervention led to a deprecia-
tion of the currency. However, between January 2018 and October 2018, both direct and
indirect efforts failed in their efforts to appreciate the rupee.
A further consideration is the effectiveness of these interventions, meaning do ex-
change rate changes affect the trade balance as expected. Figure 3 shows that the changes
in the real effective exchange rate do not correlate neatly with the expected impact on the
trade balance. For example, while the rupee depreciated considerably between 2010 and
2013, this marked the period when the trade deficit rose to its highest at 6.5% and 6.7% of
GDP in 2011 and 2012. Also, when the rupee appreciated significantly between 2013 and
2016, the trade balance improved. Yet, as Veeramani (2008) notes for earlier episodes, this
does not indicate that the appreciation did not hurt exports. It is possible that without the
appreciation, there may have been an even greater improvement in the trade balance.
Economies 2024, 12, 114 5 of 13

Figure 3. India’s real effective exchange rate and trade balance. Notes: The real effective exchange
rate is measured on the left–hand–side axis and the trade balance on the right–hand–side axis. Data
for real effective exchange rate from Bank for International Settlements, Real Broad Effective Ex-
change Rate for India [RBINBIS], retrieved from FRED, Federal Reserve Bank of St. Louis
https://fred.stlouisfed.org/series/RBINBIS, 19 October 2023. Trade data from United Nations Statis-
tics Division (n.d.), UN COMTRADE. International Merchandise Trade Statistics. Available online
at http://comtrade.un.org/ (accessed on 5 February 2024). Author’s graph.

Why did rupee depreciations not improve trade deficits? The reason is that the rela-
tionship between the exchange rate changes and trade flows is much more nuanced, as
discussed earlier. The impact may differ for exports and imports over time and across
sectors. The methodology to examine the complex link between trade and exchange rates
is discussed in the next section.

4. Methods
4.1. Empirical Model
Following the literature, exports (ex) and imports (im) are separately estimated with
the real effective exchange rate (reer) and exchange rate variability (volatility) being in-
cluded in both cases. The export equation also includes the world real GDP (rgdppcw) and
the import equation includes domestic real GDP (rgdppcind). In addition, the differential
impact of the exchange rate based on sectoral differences (high vs. low volume and pri-
mary vs. manufacturing) are also included. The impact for both these sector groups are
captured through interactive terms between the exchange rate and dummy variable for
the sector group (exvol × reer or imvol × reer and prim × reer). Thus, the equations to be
estimated for exports and imports are as follows:
𝑒𝑒𝑒𝑒 = 𝑓𝑓(𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣, 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 × 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) (1)

𝑖𝑖𝑖𝑖 = 𝑓𝑓(𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣, 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 × 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) (2)

Economies 2024, 12, 114 6 of 13

The variables in the model are macroeconomic series with a time component which
have to be tested for non-stationarity prior to estimation. If the variables are stationary,
then Equations (1) and (2) can be estimated using OLS. If there are non-stationary varia-
bles, the next step is to test for cointegration. Evidence of cointegration requires use of an
error correction model which includes short- and long-run effects. The appropriate test
and method are based on whether there is a mix of I(0) and I(1) variables or if all variables
are non-stationary.
The error correction model for exports can be rewritten as follows:

∆ ln 𝑒𝑒𝑒𝑒𝑖𝑖𝑖𝑖 = 𝛼𝛼0 + 𝛽𝛽1 ∆ ln 𝑒𝑒𝑒𝑒𝑖𝑖𝑖𝑖−1 + 𝛽𝛽2 ∆ ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝛽𝛽3 ∆ ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝛽𝛽4 ∆ 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡−1 +
𝛽𝛽5 ∆ (𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝛽𝛽6 ∆ (𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝜇𝜇1 ln 𝑒𝑒𝑒𝑒𝑖𝑖𝑖𝑖−1 + 𝜇𝜇2 ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + (3)
𝜇𝜇3 ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝜇𝜇4 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡−1 + 𝜇𝜇5 (𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝜇𝜇6 (𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + λ 𝐸𝐸𝐸𝐸𝑡𝑡−1 + 𝑢𝑢𝑖𝑖𝑖𝑖
where ex = exports in current dollars, rgdppcw = world real GDP per capita in 2010 dollars,
reer = end-of-period real broad effective exchange rate index (2020 = 100), 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 is
calculated using the monthly standard deviation for each year (following Cheung and
Sengupta 2013). The dummy variables for sector groups are exvol which equals 1 when
exports in a specific sector exceed the average of the broad category of that particular sec-
tor and 0 otherwise and prim which equals 1 if a primary sector and 0 for manufacturing.
These group dummy variables are multiplied by the exchange rate to generate the inter-
active term that enables estimation of sector-group exchange rate impacts. EC is the error
correction term and ln = natural log. Short-run impacts are captured by 𝛽𝛽𝑖𝑖 and long-run
impacts by 𝜇𝜇𝑖𝑖 and error correction by λ.
As GDP per capita of India’s trade partner countries (rgdppcw) rises, their ability to
purchase goods increases, and thus Indian exports are expected to rise. An increase in the
real effective exchange rate (reer) or appreciation is expected to hurt exports as does vari-
ability of the exchange rate (volatility). The literature shows contradictory results for the
differential exchange rate effect on high-volume exports. Cheung and Sengupta (2013)
find that exchange rate appreciation effects are exacerbated for smaller export share sec-
tors, and thus a smaller impact is expected for larger sectors. On the other hand, Lanau
(2017) finds that exchange rate depreciation benefits high-volume exports more than low
volume exports. Thus, the sign for the differential effect for high-volume sectors (exvol) is
ambiguous. Based on Tripathi’s (2021) findings, the exchange rate is expected to have a
smaller impact on primary goods (prim).
Similarly, the error correction model for imports is given as:

∆ ln 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 = 𝛼𝛼0 + 𝛽𝛽1 ∆ ln 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖−1 + 𝛽𝛽2 ∆ ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝛽𝛽3 ∆ ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝛽𝛽4 ∆ 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡−1 +
𝛽𝛽5 ∆ (𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝛽𝛽6 ∆ (𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝜇𝜇1 ln 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖−1 + 𝜇𝜇2 ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + (4)
𝜇𝜇3 ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑡𝑡−1 + 𝜇𝜇4 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡−1 + 𝜇𝜇5 (𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + 𝜇𝜇6 (𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × ln 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)𝑡𝑡−1 + λ 𝐸𝐸𝐸𝐸𝑡𝑡−1 + 𝑢𝑢𝑖𝑖𝑖𝑖
where im = imports in current dollars, rgdppcind = India’s real GDP per capita in 2010 dol-
lars, imvol = 1 when imports in a specific sector exceed the average of the broad category
of that particular sector and 0 otherwise, and other variables are as defined earlier.
The impact India’s GDP per capita (rgdppcind) on imports is expected to be positive
because higher income increases demand for goods, including imports. As noted earlier,
an exchange rate (reer) appreciation is expected to raise imports and variability of ex-
change rate (volatility) will reduce imports. Similarly to exports, the differential exchange
rate impact on high-volume import sectors (imvol) is assumed to be ambiguous and lower
for primary goods (prim).

4.2. Data and Statistical Analysis

This is a pooled data estimation where the period of this study is from 1994 to 2022
using trade data from 62 sectors. Data for exports and imports from the 62 sectors (2-digit
Economies 2024, 12, 114 7 of 13

SITC) in nine broad categories are from UN Comtrade database (the complete list can be
found in Table 1).

Table 1. Sample sectors.

Code Description (Primary)

0 Food and live animals
00 Live animals other than animals of division 03
01 Meat and meat preparations
02 Dairy products and birds' eggs
03 Fish (not marine mammals), crustaceans, molluscs and aquatic invertebrates, and preparations thereof
04 Cereals and cereal preparations
05 Vegetables and fruit
06 Sugars, sugar preparations, and honey
07 Coffee, tea, cocoa, spices, and manufacturers thereof
08 Feeding stuff for animals (not including unmilled cereals)
09 Miscellaneous edible products and preparations
1 Beverages and tobacco
11 Beverages
12 Tobacco and tobacco manufacturers
2 Crude materials
21 Hides, skins and furskins, raw
22 Oil seeds and oleaginous fruits
23 Crude rubber (including synthetic and reclaimed)
24 Cork and wood
25 Pulp and waste paper
Textile fibers (other than wool tops and other combed wool) and their wastes (not manufactured into yarn
26
or fabric)
Crude fertilizers, other than those of division 56, and crude minerals (excluding coal, petroleum, and pre-
27
cious stones)
28 Metalliferous ores and metal scrap
29 Crude animal and vegetable materials, n.e.s.
3 Minerals and fuels
32 Coal, coke, and briquettes
33 Petroleum, petroleum products, and related materials
34 Gas, natural and manufactured
4 Animal and vegetable oils
41 Animal oils and fats
42 Fixed vegetable fats and oils, crude, refined, or fractionated
Animal or veg fats and oils, proc; waxes of animal or veg origin; inedible mix or prep of animal or veg fats
43
or oils, n.e.s.
Code Description (manufacturing)
5 Chemicals
51 Organic chemicals
52 Inorganic chemicals
53 Dying, tanning, and coloring materials
54 Medicinal and pharmaceutical products
55 Essential oils and resinoids and perfume materials; toilet, polishing, and cleansing prep
56 Fertilizers (other than those of group 272)
57 Plastics in primary forms
58 Plastics in non-primary forms
Economies 2024, 12, 114 8 of 13

59 Chemical materials and products, n.e.s.

6 Manufactured
61 Leather, leather manufactures, n.e.s., and dressed furskins
62 Rubber manufactures, n.e.s.
63 Cork and wood manufactures (excluding furniture)
64 Paper, paperboard, and articles of paper pulp, of paper, or of paperboard
65 Textile yarn, fabrics, made-up articles, n.e.s., and related products
66 Non-metallic mineral manufactures, n.e.s.
67 Iron and steel
68 Non-ferrous metals
69 Manufactures of metals, n.e.s.
7 Machinery and transport equipment
71 Power-generating machinery and equipment
72 Machinery specialized for particular industries
73 Metalworking machinery
74 General industrial machinery and equipment, n.e.s., and machine parts, n.e.s.
75 Office machines and automatic data-processing machines
76 Telecommunications and sound-recording and reproducing apparatus and equipment
77 Electric mach, app and appl, n.e.s., and electric parts
78 Road vehicles (including air-cushion vehicles)
79 Other transport equipment
8 Miscellaneous manufactured articles
81 Prefabricated buildings; sanitary, plumbing, heating, and lighting fixtures and fittings, n.e.s.
82 Furniture, and parts thereof; bedding, mattresses, mattress supports, cushions, etc.
83 Travel goods, handbags, and similar containers
84 Articles of apparel and clothing accessories
85 Footwear
87 Professional, scientific, and controlling instruments and apparatus, n.e.s.
88 Photographic apparatus, equipment, and supplies and optical goods, n.e.s.; watches and clocks
89 Miscellaneous manufactured articles, n.e.s.
Note: Data from United Nations Statistics Division (n.d.), UN COMTRADE. International Merchan-
dise Trade Statistics. Available online at http://comtrade.un.org/ (accessed on 5 February 2024).

To capture exchange rate and price effects, this paper uses the real broad effective
exchange rate which is calculated as price adjusted weighted bilateral exchange rates
sourced from the Bank of International Settlements and retrieved from the Federal Reserve
Economic Database. Real GDP capita for the world and for India in 2010 dollars is from
the World Bank (n.d.) database and retrieved from the Federal Reserve Economic Data-
base. For exvol and imvol, averages of exports and imports for each of the nine broad cate-
gories are calculated for each year and if the trade flow exceeds its average for that cate-
gory in that period it equals 1 which indicates a high-volume export or import sector and
0 otherwise. For prim, if the exports and imports are in a sector in categories 0–4 (primary
sectors) they are set equal to 1 and 0 if they are in categories 5–8 (see Table 1 for categories).
As noted earlier, the series are first tested for stationarity. The augmented Dickey–
Fuller test is used for variables without a panel component, real GDP, and real effective
exchange rate and the Im Pesaran Shin panel unit root test for those with a panel compo-
nent, exports, and imports. If there is a mix of I(0) and I(1) variables, ARDL bounds testing
and estimation can be used. If all variables are I(1), the equations are tested for cointegra-
tion using the Kao test. If there is evidence of cointegration, then the correct estimation
incorporating long-run and short-run effects must be determined. Two options are a
pooled mean group (PMG) estimation or a dynamic fixed effects (DFE) model. These tech-
niques include an error correction term which calculates the adjustment to equilibrium
and are estimated using xtpmg Stata code from Blackburne and Frank (2007). The
Economies 2024, 12, 114 9 of 13

appropriate method (PMG and DFE) is determined using the Hausman test. Test and es-
timation results are discussed in the following section.

5. Results
Prior to estimation, the variables were tested for multicollinearity. As expected, the
real effective exchange rate was correlated with the GDP variables. Neither variable can
be excluded because of its importance in explaining exports and imports, and thus the
estimation was conducted with no changes.
Test results are reported in Table 2. The augmented Dickey–Fuller and the Im Pesaran
Shin test results show that all series are non-stationary. Given that all variables are I(1),
cointegration tests were conducted using the Kao test and showed evidence of cointegra-
tion. The Hausman test showed that dynamic fixed effects is preferred over pooled mean
group estimation

Table 2. Preliminary test results.

Test p-Value or [t-statistic]

Stationarity test
lnexports 0.99
lnimports 0.99
lngdppcind [0.57]
lngdppcw [−0.46]
lnreer [−1.66]
reervolatility [−1.55]
Cointegration test
Exports 0.00 *
Imports 0.00 *
Hausman test
Exports 0.89
Imports 0.99
Notes: Table reports stationarity test, cointegration test, and Hausman test results. For stationarity
tests, either p-values or t-statistics (in square brackets) are reported. For series with a panel compo-
nent, stationarity is tested using the Im Pesaran Shin test assuming maximum lags = 2 and p-values
are reported. * indicates rejection of the null hypothesis at 5% level of significance. Rejection of the
null indicates that variables are stationary for at least some panels. For variables with no panel com-
ponent, the augmented Dickey–Fuller test is used assuming maximum lags = 2 and test statistics are
reported. Rejection of the null (if the test statistic in absolute value is greater than the critical test
statistic of −2.6540 at 1% level of significance) indicates that variables are stationary. Results show
that all series are nonstationary. For the Kao cointegration test, p-values are reported. * indicates
rejection of the null hypothesis and rejection of the null shows that there is cointegration. Results
show cointegration for both exports and imports. For the Hausman test, p-values are reported. *
indicates rejection of the null hypothesis, and rejection of null for the Hausman test indicates that
PMG is preferred over DFE. Results show that DFE is preferred for both exports and imports.

The presence of a structural break can affect the relationship between variables. Thus,
tests were conducted for structural breaks using xtbreak Stata code from Ditzen et al.
(2021). Test results showed evidence of a break point of 1999 for exports and 2000 for im-
ports. Thus, the two equations were revised to include a dummy variable for the period
after the break points labeled SBx and SBm for exports and imports, respectively. For ex-
ports, SBx = 1 for periods 2000 onward and 0 otherwise and SBm = 1 for periods 2001
onward and 0 otherwise. The estimation results are reported in Table 3.
Economies 2024, 12, 114 10 of 13

Table 3. Dynamic fixed effects results (DV = lnexports or lnimports).

Exports Imports
Variables Coeff [p-value] Coeff [p-value]
EC −0.26 * [0.00] −0.21 * [0.00]
SR
SBx 0.30 [0.00]
SBm 0.21 [0.00]
∆lngdppcw 6.38 * [0.00]
∆lngdppcind 2.78 * [0.00]
∆lnreer −0.81 * [0.04] 0.02 [0.47]
∆(exvol*lnreer) 0.09 * [0.00]
∆(imvol*lnreer) 0.12 * [0.00]
∆(prim*lnreer) −0.38 + [0.17] −0.35 + [0.17]
∆reervolatility −0.01 * [0.02] 0.003 * [0.04]
Constant −10.46 −3.93
LR
lngdppcw 4.74 * [0.00]
lngdppcind 1.30 * [0.00]
lnreer 1.05 [0.25] 4.10 * [0.02]
(exvol*lnreer) 0.13 * [0.00]
(imvol*lnreer) 0.21 * [0.00]
(prim*lnreer) −0.32 [0.41] −1.70 *** [0.14]
reervolatility −0.03 * [0.03] −0.02 ** [0.09]
n = 1798 (29 years from 1994 to 2022 and 62 sectors in nine categories described in Table 1)
Notes: Structural break points are identified using xtbreak code by Ditzen et al. (2021). Based on the
results, dummy variables were included in the two equations. Equations were estimated using
xtpmg Stata code by Blackburne and Frank (2007). The table reports coefficients and p–values for the
error correction terms and short– and long– run coefficients for export and import estimations. *, **,
and *** indicate variables are statistically significant at 5%, 10%, and 15% level of significance., re-
spectively. + indicates that while the variable is not statistically significant at typical levels of signif-
icance, it is important.

For exports, we find that the error correction term is −0.26 and statistically significant,
which indicates that 26% of the disequilibrium is corrected in the following period and
the speed of adjustment to equilibrium is about 4 years. The error correction term for im-
ports is −0.21 meaning that 21% of the disequilibrium is corrected in the following period
and a slower (than exports) speed of adjustment to equilibrium that is about five years.
The structural break points for both exports and imports are positive and statistically
significant. Results show that exports were approximately 0.30 percentage points higher
from 2000 compared with those from earlier periods and imports were 0.21 percentage
points higher from 2001 compared to those from earlier years. Both these shifts can be
traced back to the economic reforms of the 1990s that opened the country to trade. Higher
imports are a result of the reduction in tariffs that were part of these reforms and these
trade restrictions continued to decline in the 2000s. The push to boost exports in these
reforms also were successful with an increase in the 1990s and an even bigger jump in the
2000s. Chinoy and Jain (2019) highlight that a shift in the types of exports (from the more
traditional textiles to auto parts) is a reason for the significant rise in exports during that
period.
Both exports and imports are income-elastic, but there are differences in magnitude.
Real GDP per capita of the world has a positive and statistically significant impact on
Indian exports in the short and long run. For the long run, a 1% increase in the world’s
real GDP per capita is associated with about a 4.74% increase in exports. In the short run,
the impact is higher at 6.38%. The real GDP per capita of India has a positive and statisti-
cally significant impact on Indian imports in the short and long run. A 1% increase in
Economies 2024, 12, 114 11 of 13

India’s real GDP per capita is associated with a 1.30% increase in imports in the long run
and a 2.78% increase in the short run. For both exports and imports, income elasticity is
greater in the short run compared with in the long run and exports are considerably more
income-elastic than imports. According to these results, an equal increase in India’s GDP
per capita and world GDP per capita would lead to improvement in India’s trade bal-
ances.
The volatility of the exchange rate hurts exports in the long and short run, although
the impact is small (−0.01 in the short run and −0.03 in the long run). Imports are also
reduced by exchange rate volatility in the long run (−0.02); however, in the short run, there
is an unexpected small positive (0.003) and statistically significant impact on imports. A
likely explanation is that imports are inelastic in the short run and cannot be reduced even
in the face of some uncertainty.
For exports, the impact of the exchange rate is only statistically significant in the short
run, and thus only those results are discussed. For a 1% real effective exchange rate de-
preciation, exports rise by 0.81% in the short run. The differential coefficient for high-vol-
ume sectors is statistically significant and positive (0.09), while for primary sectors, the
differential coefficient is negative (−0.38) and important although not statistically signifi-
cant. These results indicate that a 1% decrease in reer leads to a 0.72% increase in high-
volume sector exports in the short run. The reduced impact is similar to Cheung and
Sengupta’s (2013) findings. Depending on the year, this affects between 19 and 26 sectors
or 31–41% of the sample. A 1% reer depreciation raises primary sector exports by 1.19% in
the short run, affecting 27 sectors or 44% of the sample. Thus, the positive impact of an
exchange rate depreciation is reduced in high-volume sectors but increased in primary
sectors.
For imports, exchange rate changes are only statistically significant in the long run.
A 1% real effective exchange rate depreciation lowers imports by 4.1%. The differential
coefficient for high-volume sectors is statistically significant and positive (0.21), while for
primary sectors it is negative (−1.70) and statistically significant. A 1% decrease in reer
leads to a bigger decline in high-volume imports at 4.22% (similar to Lanau 2017). This
impacts 16 and 24 sectors or 26–39% of the sample. Also, a 1% decrease in reer is associated
with a 2.4% decline in primary sector imports in the long run. For imports, sectoral differ-
ences work to raise the effect of an exchange rate depreciation for high-volume sectors
and reduce it for primary sectors.
Overall, the results show the importance of three inter-related effects in explaining
how income and exchange rates impact trade: the necessity of separating of exports and
imports, the role of time, and the importance of sectoral differences. The statistically sig-
nificant structural break period shows that both trade flows have been on an increasing
trajectory since the early 2000s, although, as Chinoy and Jain (2019) note, growth rates for
both have declined in recent years due to de-globalization and India’s demonetization.
Time also enters the analysis through short- and long-run estimation which reveal im-
portant differences. The impact of income (world and domestic) is stronger in the short
run compared with in the long run for both exports and imports. In both periods, exports
have a stronger income elasticity.
In the short run, exports (all exports as well as high-volume and primary sectors)
increase due to a depreciation, while results for imports are not statistically significant. In
the long run, exports are not affected by the exchange rate, while imports for all cases are
highly responsive to the exchange rate (although the impact on primary sectors is sub-
stantially lower). Thus, these results show that an exchange rate depreciation can improve
the trade balance in both the short and long run by raising exports and lowering imports
in the two periods, respectively. This conclusion is dependent on the structure (sector
types) of trade flows and on the changes in India’s and world income.
The following section offers concluding remarks.
Economies 2024, 12, 114 12 of 13

6. Conclusions
Exports and imports are estimated by incorporating structural breaks and including
long- and short-run effects. The latter is important because it shows that income and ex-
change rate effects vary for exports and imports. Sectoral differences add another layer of
nuance to exchange rate effects on trade flows.
The results show that while both exports and imports in India have been on an up-
ward trajectory since the early 2000s, income and exchange rates play an important role
in trade. Given that exports are more income-elastic than imports, this indicates that equal
rates of GDP growth in India and in the world could lead to an improvement in trade
balances in both the short and long run (assuming no other effects). Over the sample pe-
riod, an average growth rate in India of 4.68% was more than three times that of the
world’s real GDP growth of 1.35% (World Bank database), suggesting that for reasonable
GDP growth rates, the trade balance will worsen.
Exchange rates affect trade in two ways: through changes and variability. As ex-
pected, exchange rate variability hurts both exports (in the short and long run) and im-
ports (in the long run only), but the effect is small. There is an unexpected positive (alt-
hough minimal) impact on imports in the short run which is likely related to the inability
of imports to adjust to fluctuations in the short run.
There are asymmetric exchange rate effects on trade flows. While exports and im-
ports are expected to respond to exchange rate changes differently (depreciation increases
exports and reduces imports), the results show that these effects are only seen in the short
run for exports and only in the long run for imports. In the short run, a depreciation will
help exports for all sectors and even more for primary sectors, but the improvement will
be smaller for high-volume sectors. In the long run, following a depreciation, imports will
fall substantially for all sectors and even more for high-volume sectors, but much less for
primary sectors. Thus, if exports are primarily dominated by high-volume sectors, a de-
preciation would lead to a smaller improvement in the trade balance in the short run, and
if they are dominated by primary goods, the improvement would be greater. In the long
run, if imports are mostly dominated by high-volume sectors, depreciation would lead to
a substantial improvement in the trade balance and would be considerably smaller than
if primary-sector goods dominated imports.
During the various interventions by the RBI in the foreign exchange rate market, pro-
moting exports and addressing trade imbalances have been an important consideration.
While the results provide an argument for using rupee depreciation to improve trade bal-
ances, the asymmetry in the responses of exports and imports across time and sectors
shows the limits to that strategy. It is also important to emphasize the importance of in-
come effects, notably domestic income effects, on imports. The strong effect of India’s GDP
per capita on imports in both the short and long run coupled with high growth rates in
India will continue to worsen trade balances irrespective of rupee depreciations. Given
that currency interventions are costly and can lead to volatility which hurts exports, de-
preciation is not an effective policy in addressing trade imbalances.

Funding: Simmons University Undergraduate Faculty Student Collaborative grant (UGFSC 2021-
2022)
Informed Consent Statement: Not applicable.
Data Availability Statement: All data is publicly available from sources listed in the paper.
Conflicts of Interest: The author declares no conflict of interest.

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