Relationship between trade balance and exchange rate in India

Abstract

This study explores the relationship between exchange rate and trade balance in India. Theoretically, if domestic currency is weak compared to foreign currency it promotes exports as people would like to hold foreign currency and exports become cheaper comparatively, on the other hand if domestic currency is strong it will hurt exports and rather promote imports as they become relatively cheaper. This happens because of the stickiness in prices in short run. However in the long run prices adjust and the effect nullifies. India’s trade deficit has been rising from the period 1994-2012 with an average YoY growth of 31.3%, with a average growth in exports of 15.2% and that in imports by 18.23%. At the same time, the change in REER and NEER indices is -8.65% and -32.22% respectively. This study aims to establish if there exists in India any relationship between exchange rate and exports, imports and trade balance. In light of the recent trade performance reports, it is seen that the stress of external sector has grown persistently, suggesting the reason behind the consistently rising imports. The subdued performance of exports is said to be the reason behind the widening of the trade deficit from US$ 183.4 billion in 2011-12 to US$ 190.9 billion in 2012-13. This purpose of the study also includes the analysis of change in exchange rate on exports and the role played by the exports in causing the trade deficit.