Rupee Movements and India’s Trade Balance: Exploring the Existence of a J-Curve

According to conventional wisdom, depreciation of a currency should lead to a reduction in imports and give a boost to exports, thereby improving the country’s trade balance. However, the improvement in trade balance may not be immediate. There has been considerable evidence to suggest that there is a lag between the devaluation of a currency and its impact on the trade balance, with an initial worsening of the trade deficit before an improvement. This scenario occurs when imports are priced in foreign currency and exports are priced in domestic currency; prices are sluggish and there are contracts still in place that have been finalised at the earlier exchange rates which prevent quantities from adjusting.1 In this case the only effect of the currency depreciation is to raise the domestic price of imports, hence worsening the trade balance. Over time, as contracts are renegotiated, quantities can start adjusting in response to the exchange rate change. Assuming prices still remain sluggish, currency depreciation should give the country a price competitiveness boost while making foreign goods relatively more expensive compared to import substitutes, thereby improving the trade balance following the initial deterioration. Assuming the elasticity of exports and imports (in absolute terms) is “sufficiently large,” the trade balance should improve compared to its starting point prior to the initial valuation effect-induced deterioration.2