Economies the world over have become increasingly interdependent. While closer
ties among nations has been partly driven by the rise in the movement of labour,
services and capital- with the latter amid barriers to complete mobility-across
national borders, it is trade in goods that is arguably at the core of economic
relations among independent states (Bahmani-Oskooee and
Brooks, 1999). The potential gains from commodity exchange have been well
documented in the classic theories of international trade which emphasize, among
other things, the benefits that accrue from comparative advantage and specialization
(Krugman and Obstfeld, 2001).
Concerted efforts by nations at establishing both bilateral trade links and
subsequent formation of regional trading blocs, such as NAFTA, MERCOSUR, SADC,
GCC among others, are the upshot of this widely held view on the gains from
trade. The West African Monetary Zone was formally launched in December 2000
with the key objective of promoting trade among The Gambia, Ghana, Guinea, Nigeria
and Sierra Leone. However, considerable challenges arise especially in terms
of macroeconomic policy stance within countries and the requisite coordination
across them. For instance, the influence of policymakers on the exchange rate
may stir their interest towards gaining deeper insight into how the deployment
of that influence would affect crucial external sector aggregates in particular
the trade balance (Himarios, 1985; Gupta-Kapoor
and Ramakrishnan, 1999; Lal and Lowinger, 2001).
Since the Bretton Woods Accord collapsed in 1973, many countries have gravitated
towards floating exchange rates with heightened interests on the effects of
devaluation on the trade balance in both developed and developing economies
(Artus, 1975; Spitaller, 1980;
Krugman and Baldwin, 1987; Bahmani-Oskooee
and Alse, 1994; Marwah and Klein, 1996; Hacker
and Abdulnasser, 2003; Nadenichek, 2006). The sequence
of events in the traditional argument is that currency depreciation first leads
to deterioration in the trade balance before improvements become obvious. This
response pattern mimics the letter J hence the label J-curve phenomenon. The
evidence is however not as clear-cut as the theory appears to imply. Infact,
the vast empirical literature on the J-curve is inundated with conflicting outcomes
which have been attributed to the multiplicity of samples, models and methods
that were used in the analyses.
Although investigation on the exchange rate-trade balance nexus has a long
history in economics, it is the extension to capture this relationship in a
time series though multi-country trading bloc context that distinguishes the
present attempt. More specifically, an interesting attempt is made to unearth
answers to key questions such as; Is there a J-curve effect in the WAMZ countries?
If yes, it becomes pertinent to know the response pattern since a delayed J-curve
(Rosensweig and Koch, 1988; Moffett,
1989) signifies a more prolonged worsening of the trade balance while the
absence of this effect has a different policy implication altogether. Thus,
the novelty value of this study cannot be over-emphasized. First, we consider
the J-curve effect in WAMZ which, to the best of our knowledge, is a pioneer
attempt at explicitly querying the trade balance effects of exchange rate policies
in WAMZ countries. Also, using quarterly data from 4 countries (Rose
and Yellen, 1989; Rose, 1991; Shirvani
and Wibratte, 1997; Wilson, 2001) over the period
1980-2005 we employ the Autoregressive Distributed Lag (ARDL) approach to cointegration
which has been demonstrated to outperform competing cointegration approaches
in small samples (Pesaran et al., 2001).
Finally, since the WAMZ is still a nascent bloc, we opine that relevant policy lessons can be gleaned with a view to improving the lot of member countries.
EXCHANGE RATE AND THE TRADE BALANCE: A LITERATURE SUMMARY
The theory and empirical evidence: Theoretically, currency depreciation
influences the trade balance via two important channels. The volume effect,
due implicitly to more expensive imports, raises the export volume while the
volume of import declines resulting in an increase in the trade balance. A countervailing
import value effect moves the trade balance in the opposite direction (Krugman
and Obstfeld, 2001; Hacker and Abdulnasser, 2003).
Hence, the net effect on the trade balance depends on which effect dominates.
These adjustments take place over time hence a J-shaped time path of the trade
balance results from depreciation. The claim in the orthodox J-curve theory
is that, at the outset, the import value effect outweighs the volume effect
since prices are assumed to respond faster than export and import quantities
to exchange rate movements. Many explanations of this slow adjustment mechanism
have been proffered. First, the market players might not immediately observe
changes in competitive conditions and the rules of the game (recognition lag).
Second, since many contracts have been designed using the old exchange rate
establishing new business orders may not be instantaneous (decision lag). Third,
delivery of old orders and difficulties with regard the acquisition of new capital
may take a while (delivery and replacement lags). Finally, suppliers need to
be convinced that the changes in market conditions are large enough and expected
to be persistent before the option value to waiting, as against expansion, becomes
less attractive (production lag) (Junz and Rhomberg, 1973).
In sum, therefore, following an initial decline in the trade balance a strengthening
volume effect leads to an improvement-J-curve- in response to devaluation.
In contrast, the empirical literature appears far from reaching a concensus
on the existence or otherwise of the J-curve phenomenon. Several studies have
investigated the trade balance effects of devaluation but regardless of the
samples, number of countries, model specification and estimation techniques
employed in the analysis, this effect seems, at the best, ambiguous. Miles
(1979) failed to find evidence of the J-curve using annual data from 14
developed countries. Sundararajan and Bhole (1988) found
similar result for India. More recently, the studies of Demeulemeester
and Rochat (1995), Shirvani and Wilbratte (1997)
and Wilson (2001) seem to reinforce this no J- curve
stance. On the contrary, devaluation lead to an improvement in the trade balance
of ninety per cent of the countries in the sample used by Himarios
In a subsequent study, Himarios (1989) found support
for the J-curve in a sample of 15 developing countries. In contrast, mixed results
are reported by Bahmani-Oskooee (1985). He finds that
of the four developing countries under study, the conventional J-curve pattern
is admissible only with the Thailand data. Bahmani-Oskooee
and Alse (1994) employed the Engle and Granger (1987)
cointegration method on data from 41 countries and found that the effect of
currency depreciation on the trade balance was positive for Brazil, Costa Rica
and Turkey (supporting the J-curve phenomenon) with a negative effect in the
case of Ireland. For the remaining 37 countries, this effect was found to be
nil. Yiheyis (2006) examined the impact of exchange
rate policy on external sector performance using a sample of 20 African countries.
The result shows that the contemporaneous effect of nominal devaluation is negative
and hence provides support for the J-curve. Hence, the empirical evidence, needless
to say, is inconclusive.
Model specification: The trade balance is conventionally measured as
the total value of exports less total value of imports. We, however, use the
ratio of exports to imports values in this study. The merit of this choice is
that the unit of measurement becomes unimportant and the constructed variable
can be conveniently interpreted as nominal or real trade balance (Bahmani-Oskooee
and Brooks, 1999; Gupta-Kapoor and Ramakrishnan, 1999;
Lal and Lowinger, 2001). The Real Effective Exchange
Rate (REER) is used since it is not unusual for countries to have multiple trading
Thus, there is a possibility that a countrys currency may be appreciating
with respect to some partners while depreciating against others. The reer, which
is a trade weighted measure, aptly captures this notion. While the Gross Domestic
Product (GDP) of individual countries is used as our measure of domestic income,
we employ a single measure of world income in all four models. This was done
on two grounds. First, the countries involved are small and thus are expected
to respond to global developments and not vice-versa. Also, the WAMZ, when fully
established, is expected to continue trading with the rest of the world and
developments in economic activities in industrial countries should continue
to be important. Therefore, following the received wisdom on the J-curve hypothesis,
the model we specify for all countries in our sample is:
||The trade balance
||Index of world income
||the gross domestic product
||Real effective exchange rate
From the theory, an increase in the world income is hypothesized to lead to
a surge in the exports and hence the trade balance, of WAMZ countries. This
suggests that the volume of exports to trading partners should increase as a
consequence of higher purchasing power in these foreign economies. Therefore,
an estimate of a1 is expected to be positive. In a similar vein,
the volume of imports from trading partners ought to rise with an increase in
the real income of WAMZ countries. Hence, an estimate of a2 is expected
to be negative. There is however some ambiguity with respect to the estimate
of a3. The argument here is that with a real depreciation, that is
a fall in real effective exchange rate, increased competitiveness results in
more exports and less imports via the volume effect. The import value effect
however pulls in the opposite direction since a higher reer means each unit
of import becomes more valuable. This latter effect would tend to worsen the
trade balance which naturally rises when the volume effect is dominant.
Turning now to investigating the responsiveness of the trade balance to changes
in the real effective exchange rate, a deeper understanding entails thorough
examination of the dynamic adjustment of the trade balance model specified above.
Hence, in this study we deploy the Unrestricted Error Correction Model (UECM)
which is in the spirit of the Autoregressive Distributed Lag (ARDL) model proposed
by Pesaran et al. (2001). Pesaran
et al. (2001) proposed an (ARDL) bounds testing approach to examining
the existence of cointegration relationship among variables. Compared to other
cointegration procedures, such as Engle and Granger (1987)
and Johansen and Juselius (1990), the bounds testing
approach appears to have gained popularity in recent times due to the following
reasons: Both long-and short run parameters of the specified model can be estimated
simultaneously. Again, the approach is applicable irrespective of the order
of integration whether the variables under consideration are purely I (0), purely
I (1) or fractionally integrated. Finally, this approach is more appropriate
for small samples. The ARDL specification of the trade balance model estimated
for each country is:
The first step in the (ARDL) bounds testing procedure is to first estimate equation (2) by Ordinary Least Square method and then conduct an F-test for the joint significance of the coefficients of the lagged level of the variables with the aim of testing for the existence of long run relationship among the variables in the model.
For Eq. 2:
Consequently, the computed F-statistic is then compared to the non-standard
critical bounds values reported by Pesaran et al.
(2001). There are a number of possibilities which are considered in turn.
If the computed F-statistic exceeds the critical upper bounds value, then the
null hypothesis of no cointegration is rejected. If the computed F-statistic
falls below the critical lower bounds value, then the null hypothesis of no
cointegration is not rejected. But when the computed F-statistic falls between
the critical lower and upper bounds values, then the knowledge of integration
of the variables under consideration is required, or else, no conclusion can
be reached about cointegration status.
Data definition and study scope: With the aim of investigating the trade
balance effects of devaluation in the WAMZ, this study shall employ quarterly
data covering the period from 1980Q1 to 2007Q4 for The Gambia, Ghana, Nigeria
and Sierra Leone. The variables employed in this study include: Trade balance,
real effective exchange rates, world income and domestic income. All variables
are sourced from International Financial Statistics and expressed in their natural
We use quarterly data spanning the period 1980Q1 to 2007Q4 sourced primarily from the International Monetary Funds International Financial Statistics CD-ROM 2007. Since the data are chiefly available at annual frequency, we follow the store and fetch procedure for changing data frequency from annual to quarterly in E-views. Due to the unavailability of data over most of the sample period Guinea had to be dropped in our investigation. Details on variable names, construction and definition are provided in Appendix.
The unit root test results, reported in Table 1, show that domestic income, the real effective exchange rate, world income and the trade balance are all stationary on differencing once. This suggests a need to examine the existence or otherwise of some pattern of long-run association among these variables. It has been argued, in the time-series literature, that there is a possibility that some linear combination of non- stationary variables may be mean-reverting.
With a view to examining this cointegrating relationship we deploy the bounds
testing approach (Table 2) (Pesaran et
al., 2001). From the results, cointegration is found for all countries
but Sierra Leone. Hence, we resort to the Engle-Granger technique with a view
to ascertaining if there are joint movements of these variables in the case
of Sierra Leone. It is clear from Table 2 that cointegration
exists among the variables of the model.
Our overarching objective in this study is to investigate the existence of the J-Curve effect for the WAMZ countries. Thus, considerable emphasis is placed on interpreting the signs of the real effective exchange rate coefficients in all the individual country models. Following a real devaluation, an initial worsening of a countrys real trade balance followed by an improvement would suffice to confirm J-Curve effects. We return to this issue only after the domestic and foreign income variables are queried with regard their consistency with a priori expectations.
The results in Table 3 show that foreign income has the expected
positive sign and is significant in all countries. This outcome fits the view
that demand is the key driving force with respect to imports and exports (Onofowora,
2003). In a similar vein and in line with the demand as driver
view, domestic income is negatively and significantly related to the trade balance
in Ghana. In The Gambia and Nigeria, however, domestic income appears to be
positively associated with the trade balance. A plausible explanation is that
increased productivity leads to domestic output outstripping domestic consumption
hence requiring higher exports to dispose of some of this surplus.
|| Augmented dickey-fuller unit root test reslults
|The critical values for the model with a drift term at the
1, 5 and 10% levels of significance are -4.059, -3.458 and -3.155 in that
order. For the model which includes a drift and trend, the corresponding
critical values are -3.501,-2.893 and -2.583 in that order
|| The bounds (Cointegration) test
|The asymptotic critical value bounds are obtained from Table
C1 (iii) case III: Unrestricted intercept and no trend (Pesaran
et al., 2001). For k = 3, the lower bound I (0) = 3.23 and upper
bound I (1) = 4.35 at 5% significance level. The lag structure was selected
based on the Akaike Information Criterion. *** (**) Denotes the rejection
of the null hypothesis at 1 (5%) significance level
This is essentially a supply-side argument which is not only consistent with
the potential effects from productivity improvements but also in line with the
notion of substantial increase in the production of import-competing goods (Rose,
1990; Wilson, 2001).
We return now to the crux of the study. The standard view, ubiquitous in the
literature, is that the signs of the coefficients on the real effective exchange
rate should switch from an initial negative (say at lower lags) to an eventual
positive (at relatively higher lags) for the J-Curve effects to be confirmed.
Interestingly, we find such evidence only in the case of Nigeria. This coefficient
which is negative (-0.098) four quarters following real devaluation turns positive
(0.329) after an additional four quarters. The converse is found for The Gambia
and Ghana where initial improvements in the trade balance in response to real
devaluation is followed by deteriorations in later periods. In these cases,
devaluation seems to embody some degree of risk with regard external sector
performance. This good news- bad news cycle appears to occur at
lower lags for The Gambia compared to Ghana. The speed of adjustment to the
steady state after any disequilibrium is thus higher in the case of the former
as about 30% of any distortion is corrected in the next quarter. This is about
6% age points higher than in Ghana.
|| Parsimonious real trade balance model results for the WAMZ
|***(**) and * represent significance at the 1 (5) and 10%
levels in that order. The t-values are given in parenthesis
All real effective exchange rate dynamics appear to provide little or no useful information for trade balance movements in Sierra Leone. This lack of evidence of a J-Curve pattern is, however, not unusual in the literature on the subject matter. In sum, therefore, we find evidence in favour of the J-Curve pattern only in one case. Some kind of inverted-J is found in the case of The Gambia and Ghana while no clear pattern emerges for Sierra Leone.
An attempt was made in this study to query the existence or otherwise of a J-Curve, that is an initial deterioration and later improvement in the trade balance following a depreciation of the exchange rate, in four WAMZ countries: namely The Gambia, Ghana, Nigeria and Sierra Leone. We use quarterly data and a relatively recent approach to cointegration in capturing the impact of devaluation on the trade balance.
Our results indicate that cointegration exists among the trade balance, foreign income, the real effective exchange rate and domestic income in all countries. More importantly, for these countries the pattern of the short-run dynamics varies markedly across countries. Thus, our results seem to support the J-Curve pattern only in the case of Nigeria with Sierra Leone displaying the obverse.
What should be of interest to policymakers in these countries is whether the potential gains from regional economic integration are more than offset by disparities that may emanate from the emergence of potential winners and losers from such agreement. The differential impact, of this policy of real depreciation, across countries implies that appropriate and better policy coordination among these countries is necessary for ease of collective action and hence sustenance of the trading bloc. Such policies should engender incentives that are compatible with the growth and developmental objectives of member states.
||Real effective exchange rate and the trade balance in WAMZ
|| Variable definitions
|The four WAMZ countries included in our analysis are The Gambia,
Ghana, Nigeria and Sierra Leone