Academic journal article Indian Journal of Economics and Business

Exchange Rates, Free Trade Agreement and Bilateral Trade Balances of Sri Lanka

Academic journal article Indian Journal of Economics and Business

Exchange Rates, Free Trade Agreement and Bilateral Trade Balances of Sri Lanka

Article excerpt

This paper examines the short run and long run effects of real exchange rate changes and Free Rate Agreement (FTA) on the real trade balance of Sri Lanka with major trade partners. India and Japan are major sources of Sri Lankan imports and USA is major export destination. Results show that there is a clear J-curve effect and also Marshall-Lerner condition holds. The FTA with India has decreased the real bilateral trade balance of Sri Lanka. This focus on the bilateral trade balance relationships with major trade partners should be useful for policy makers in Sri Lanka.


The exchange rate is an important policy variable that influences trade flows, capital flows, inflation, international reserves, and remittances. Many empirical analyses examine how exchange rate changes affect the trade balance of developing and developed countries. There is still considerable disagreement regarding the effectiveness of currency devaluation as a tool for increasing the balance of trade. Many Asian countries encountered crisis in 1997 due to poor choice and implementation of this policy. However, there is no consensus in the theoretical or empirical literature about any unique effect of the exchange rate volatility on macroeconomic indicators.

Immediately after independence in 1948, Sri Lanka adopted a highly regulated financial, fiscal, and industrial policy along with inward-oriented import substituting trade and overvalued exchange rate system. The resulting economic growth was not satisfactory. Thus, in order to achieve a high and sustained economic growth and rapid development, Since 1977, most of the trade and industrial policies have aimed at higher growth in the export sector. International competitiveness, faster growth of export-oriented industries, tariff rationalization, access to bigger markets, encouraging imports of intermediate capital goods were the main objectives of the exchange rate and trade policies of government. The trade deficit widened as the import bill increased under the influence of the government's development program and defense expenditure.

Since the independence in 1948, Sri Lanka has gone through different exchange rate regime from fixed exchange rate to floating exchange rate regime. These changes had different effects on nominal, real effective exchange rate and trade balance and balance of payments over the years. The Sri Lanka Rupee was pegged to sterling pounds under the Bretton Woods system in 1948. After it was pegged to the dollar in 1971 it started to depreciate with the dollar. In a major reform in November 1977, multiple exchange-rates were introduced. Then, the rupee depreciated further relative to United States dollar. Sri Lanka introduced floating exchange rate system in August 1990.

Western countries were the major export destinations and Asian countries were the major import suppliers. The USA and U.K are Sri Lanka's major export destination. India and Japan are major sources of Sri Lankan imports. The composition of exports demonstrated the continuing dominance of industrial exports followed by agricultural and mineral exports. USA and EU are the major destinations for the export of textiles and garments. Establishment of Free Trade Arrangements (FTA) between India and Sri Lanka has accelerated the development of national economies, promoting mutually beneficial bilateral trade and strengthening intra-regional economic cooperation.

Being a small open economy, the continuously improving liberal economic environment and the greater freedom in trade, investment and payments have benefited Sri Lanka in maintaining its growth momentum and in strengthening the ability to face recurrent external shocks during the last three decades. Sri Lanka remained firmly committed to the multilateral trading system, being a founder member of the World Trade Organisation (WTO).

The aim of this paper is to examine whether there is a difference in the short run and long run relationships between the real exchange rate and the real trade balance with different trade partners and whether the Marshall- Lerner (ML) conditions holds and also to estimate the impact of Free Trade Agreement (FTA) with India on bilateral trade balance of Sri Lanka. …

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