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1. INTRODUCTION This fragment provides an initiation to the research problem and gives a distinctive impression to the behavior of the exchange rate and the trade balance. 1.1. BACKGROUND OF THE STUDY It is proposed to launch this study to investigate the exchange rate* behavior on trade balance in Sri Lanka by using its 10 major trading partners. These partner countries are selected by calculating the trade share. They are; USA, India, UK, Singapore, Japan, Germany, Hong Kong, Iran, China and Saudi Arabia. Considering these countries the effective exchange rates are calculated. The exchange rate is one of the most important policy variables, which determines the trade flows, capital flows, inflation, international reserve and remittance of an economy. Exchange rate is the value of one currency in terms of another currency. The exchange rate fluctuations can be seen in the floating exchange rate regimes and managed floating exchange rate regimes. Sri Lanka is experienced depreciation except few years. The factors which are affecting to the exchange rate movements are relative interest rate, relative inflation level, relative income levels and etc. If we consider the Sri Lankan situation at the independence a fixed exchange rate regime was operated linked to the Sterling Pound. And Since 1950s the exchange rate was fixed. The direct regulations were imposed on foreign trade by the socialist government in 1970-977. And the trade liberalization in 1997 leads the country to follow a flexible exchange rate system. The rupee has continuously depreciated except the years 2005, 2008 and 2010. The dependent variable, trade balance** can be defined as the difference between exports and the imports. This is also known as the Net Exports (NX). This trade balance is a component of the Balance of Payments of a country.
*Exchange Rate: value of one currency in terms of another currency. **Trade Balance: The difference between the monetary values of exports and imports.

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There are two major accounts in the Balance of Payments*. Those are Current Account** and the Capital Account. The Trade Balance will be the first quarter of the current account and it only records the exports and the imports. The trade balance can be negative, positive or zero. Negative trade balance is occurred, when the imports exceed the exports. And when the exports are greater than the imports there will be a trade surplus. Trade Balance will be balanced when the exports are exactly equal to the imports. In Sri Lanka, after 1977 the deficit was grown and it was filled by heavy borrowings. It is said that the Sri Lankas Balance of trade in a Chronic deficit all over the period. The relationship between these variables is generally measured using the behavior of the Real Exchange Rate (RER) in terms of bi-lateral trade and Real Effective Exchange Rate (REER) in multi-lateral trade and the impact is measured by some specific analytical tools. Although there are number of other criterion used to measure the impact of exchange rate on trade balance, to fill the research gap, it is proposed to use mainly the Granger Causality Test in this research. As a specific objective of this study it is proposed to investigate the validity of MarshalLearner Condition in Sri Lanka. According to the M-L condition, A depreciation of a countrys currency will improve the current account balance if the sum of the price elasticity of domestic and foreign demands for imports is larger than unity.

(Ie + Xe) >1

Ie Xe Import Elasticity Export Elasticity

*Balance of payments: are the accounts which record foreign transactions systematically. **Current Account: shows all the flows that directly affect the national income.

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1.2. BEHAVIOR OF THE VARIABLES Behavior of the main variables over 33 years (1977-2010) reflected by the below graphs. The Exchange Rate Behavior of Sri Lankas major trading partners against LKR
100 90 80 70 60 50 40 30 20 10 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 USA IND RS JAPAN UK SINGAPORE GERMANY HONGKONG IRAN CHINA SAUDHI ARABIA

Sri Lankas Trade Balance Behavior

20000 15000 10000 EXPORTS 5000 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 -5000 -10000 IMPORTS Trade Balance

According to the literature there is a considerable relationship between these two variables in Sri Lanka. Depreciation has been instrumental in making a favorable impact on the trade balance (Wijesinghe 1988). And also Silva & Zen (1998) found that the exchange rate policy after 1977 has improved the trade balance but has failed to stimulate real output at least in the short run. These things are widely discussed under the literature review.

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2. LITERATURE REVIEW. 2.1. EMPIRICAL STUDIES IN SRI LANKA. According to De Silva D.G. and Zen Zhu (1998), the changes in Sri Lankas Trade Balance affected by changes in the exchange rate since 1977. This study has shown that it is impossible to detect any positive effect on GDP in Sri Lanka due to currency depreciation*. The study period was 1977-1997.VAR Analysis has been used to identify shocks and fully control important external shocks that affect economic performance. There were two exogenous variables used as Government Expenditure and Foreign Direct Investment. And endogenous variables were GDP, Trade Balance, Nominal Interest Rate and CPI. The Co integration model was estimated, which comprised of four endogenous variables (GDP, Trade Balance, CPI, Real Exchange Rate). Then by adding one variable at a time, the study re estimated the model and investigates the effects of exchange rate on Trade Balance and GDP. And also allowed for determination of the stability of the results. Wijesinghe D.S.(1988) has found that the Nominal Exchange Rate changes has caused improvements in Sri Lankan Trade Balance in most of the years (study period 19711985). And the improvements were largely contributed by the depreciation of the Sri Lankan rupee. The Trade Balance effect of real exchange rate changes had not been so impressive due to the high rates of inflation which prevailed in Sri Lanka in most of the years. The effect of the unfavorable price changes on export earnings were moderated or more than compensated for by the depreciation of the Sri Lankan rupee which induced increased in the export volume. In the case of real exchange rate changes, the price of imports recorded increases in most of the years. The movements of the index of nominal effective exchange rate computed with the trade balance objective closely reflected the effect of exchange rate changes on Sri Lankas trade balance. He has calculated Effective Exchange Rates by using the variables, exports, imports etc.

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Further, W.T.K.Perera (2009) has done this study to find the impact of real depreciation of SLR on the trade balance in the short run and the long run (1970-2008), employing bilateral trade data between Sri Lanka and its six major trading partners. There was no specific pattern for the trade balance between Sri Lanka and its trading partners in response to the change in real exchange rate, and none of the cases supported the J-curve phenomenon. In the long run, only in the cases of India and Singapore has there been a positive and significant impact on trade balance with the depreciation of the SLR. This study emphasized that Sri Lanka has to take action to improve its income from exports and reduce the expenditure on imports to overcome the problem in the trade deficit. The study also revealed that both domestic and trading partners real incomes were important determinants of Sri Lankas trade balance.

2.2. EMPIRICAL STUDIES IN OTHER COUNTRIES Nusrate Aziz (2008) have done the Bangladesh study for 1972-2005 study period. Mainly he has found that the Real Exchange rate has a positive effect on Balance of Trade in in Bangladesh in the long run. Both the Engle-Granger and the Johansen test confirmed the presence of a long run co integrating relationship among the variables of interest in the study. The study also suggested that the real exchange rate has a significant impact on balance of trade of Bangladesh both in the short-run and long-run. The Granger causality test proved the causal relation between exchange rate and balance of trade of Bangladesh. The IRF also supported the above mentioned positive impact of real effective exchange rate on balance of trade in the long run. The study clearly indicated that real depreciations of exchange rate have been positively associated with improvement of balance of trade. In the first step the long-run equilibrium relation among the variables has been estimated. In the second step, they tested the order of integration of residuals using ADF statistic.

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The study done by Ng Yuen-Ling (2008) attempted to identify the relationship between the real exchange rate and trade balance in Malaysia from year 1955 to 2006. This study used Unit Root Tests, Co integration techniques, Engle-Granger test, Vector Error Correction Model (VECM), and impulse response analyses. The main findings of this paper were: (i) long run relationship exists between trade balance and exchange rate. Other important variables that determine trade balance such as domestic income showed a long run positive relationship between trade balances, and foreign income shows a long run negative relationship (ii) the real exchange rate was an important variable to the trade balance, and devaluation will improve trade balance in the long run, thus consistent with Marshall-Lerner condition (iii) the results indicate no J-curve effect in Malaysia case. In this research, the results supported the empirical validity of the Marshall-Lerner condition through VECM, indicating that depreciation has improved the trade balance.

Pavle Petrovic (2009) has found that exchange rate depreciation in Serbia improved trade balance in the long run (2001-2007), while giving rise to a J-curve effect in the short run. Both Johansens and autoregressive distributed lag approach were respectively used giving similar long-run estimates showing that real depreciation improved trade balance. Corresponding error correction models as well as impulse response functions indicated that, following currency depreciation, trade balance first deteriorated before it later improves, exhibiting the J-curve pattern. The main findings of the paper were that a real exchange rate depreciation has a significant positive long run impact on the trade balance in Serbia, and that in the short run trade balance first deteriorated before it later improves. The corresponding error correction models (ECM) of trade balance captured its short run movements and indicated the existence of the J-curve effect.

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The Japanese study is done by Shao Zaiwei (2008) and identified the major economic factors that influenced the bilateral trade balance between Japan and the US. Differing from conventional elasticities approach, one more variable the net foreign assets were added in the Vector Auto regression estimation using quarterly data from 1980: I to 2006: IV. The Johansen and Juselius result indicated three long-run relationships among five macro variables: trade balance, domestic income, foreign income, net foreign assets and real exchange rate. Short run adjustment parameters were identified as coefficients of the error correction terms. The main finding of this paper was that taking the valuation effect of the net foreign asset position into account, the final effect of the exchange rate changes on trade balance was undetermined. Although appreciation could reduce trade surplus in the short run, in a longer horizon, there was no stable relationship. Besides that, Granger causality

procedure is carried out to investigate the causal relationship and directions of causality between the variables. Finally, Impulse Response Analysis and Variance Decomposition procedure are performed to provide more insight into short run interaction between trade balance and those endogenous variables in the system.

Suleiman Monammad (2010) done this study and identified the depreciation of domestic currency lead to unexpected falls in eport earnings in Pakistan. The study examined validity of the Marshall Lerner condition in Pakistan data (1970-2008) by using impulse response function which fulfills the J- curve idea. To evaluate long run association among the variables by employing Johansson Co integration test. The end consequence of test showed that there was a long run relationship among the variables at vector two. The finding of this research paper showed that real depreciation of exchange rate has positively impact on balance of trade. So the depreciation is in favor of Pakistans export.

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Tihomir Stucka (2004) done his research for 1994-2002 and used a reduced-form model approach was used to estimate the trade balance response to permanent domestic currency depreciation in Croatia. For this purpose, long-run and short-run effects were estimated, using three modeling methods along with two real effective exchange rate measures. Evidence of the J-curve was also found. This attempted to estimate the impact of a permanent exchange rate depreciation on the merchandise trade balance employing a reduced form model. The model was estimated using three methods - the ARDL "delta" approach developed by Pesaran, Shin, and Smith (1996). This study found evidence of the J-curve effect in Croatia. The increase of the trade balance deficit as a consequence of the J-curve effect is estimated to be between 2.0 percent and 3.3 percent. The empirical results were consistent with the exception of one model. Overall, intuitively it seemed unlikely that a permanent nominal depreciation of the domestic currency embodied in an asymmetric intervention policy a pegged exchange rate regime would have a net favorable effect on the entire economy, taking into account potential negative side effects.

Further Quio, H., (2005) did his study for East Asian Economies for the time period of 1978-2004, to identify the post impact of a discrete exchange rate change and its implications for net trade balance. He emphasized the difference between dollar debtor and dollar creditor countries and concluded that even though currency devaluation may improve the trade balance of a debtor country, appreciation may or may not reduce the surplus of a creditor country. It was therefore inappropriate to follow the elasticity models to use exchange rate to adjust trade balance predictably when the wealth effect, investment effect and indirect investment effect (in East Asia) were all considered. His model attested that such a move may not induce a reduction in the trade surplus.

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Sekantsi. L.(2008), empirically examined the impact of real exchange rate volatility on trade in the context of South Africas exports to the U.S. for the South Africas floating period January 1995-February 2007. In measuring real exchange rate volatility, this study utilized GARCH. After establishing the existence of cointegration among the variables involved in our two-country export model, he estimated long-run coefficients by means of ARDL bounds testing procedure proposed by Pesaran, et al.(2001). His results indicated that real exchange rate volatility exerts a significant and negative impact on South Africas exports to the U.S. Therefore, stable and competitive exchange rate and sound macroeconomic fundamentals were required in order to improve international

competitiveness and greater penetration of South African exports to international markets.

Monacelli,T., & Perotti,R.,(2006) employed structural VAR techniques to estimate, for a series of OECD countries. They have found that in all countries a rise in government spending induces a real exchange rate depreciation and a trade balance deficit. In the US, however, the effect on the trade balance is small. They have shown how recent empirical evidence that points to a decline in the trade deficit after a budget deficit shock can be traced to an alternative method to recover the fiscal shocks. Second, in all countries private consumption rose in response to a government spending shock, and therefore co-moves positively with the real exchange rate.

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2.3. RESEARCH GAP De Silva D.G. and Zen Zhu (1998), has not speculated the causal relationship between the exchange rate and the trade balance. And his study stands for 1977-1997. No studies were conducted to fill this time gap (1997-2010). Wijesinghe D.S.(1988) analyzed his findings by calcualating the Effective Exchange Rates, but has not used any of the econometric tools for the analysis. And his study flows for the period 1971-1985. Silva has filled his time gap by 12 years (1985-1997). But no studies have been done to fill the remaining 13 years. W.T.K.Perera (2009) has found the impact of real depreciation of SLR on the trade balance in the short run and the long run by using its 6 major trading partners. And he has employed mainly the J curve phenomenon. In this study it is proposed to add 4 more major trading partners (Singapore, Iran, China and Saudi Arabia) and more econometric tools are proposed to use. The geographical gap can be taken from the empirical studies in the other countries, and also throughout the literature there is no study has done for the causal impact of exchange rate on trade balance except the Malaysian case. Other than that the trade balance behavior due to the external shocks is not investigated for the Sri Lankan case.

Considering these gaps, it is proposed to fill them by employing the Granger Causality test and the Impulse Response Function. And the other econometric tools will be applied for the performance of the study. As a result of these applications, the time gap will be instinctively filled.

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3. PROPOSED RESEARCH

3.1. RESEARCH PROBLEM Based on the research gap which is identified by the literature, it is proposed to investigate whether the exchange rate has a significant impact on trade balance in Sri Lanka. Then the fundamental research problem will be; Do the Exchange Rate changes affect the trade balance effectively? Two macroeconomic variables are used in this research, namely Exchange Rate and Balance of Trade. And the literature proves that there is a significant impact of exchange rate on trade balance in Sri Lanka. The exchange rate policy after 1977 has improved the trade balance, but has failed to stimulate real output at least in the short run (Silva D. & Zhen Z. 1998).Depreciation has been instrumental in making a favorable impact on the trade balance during the study period except for the years 1971, 1979,1985 (Wijesinghe D.S. 1988). Therefore, it is investigated that the exchange rate affects the balance of trade in Sri Lanka. But there were no studies done to fill the time gap after 1997. Furthermore the causal impact is not found. Then this study is done to fill these gaps by mainly using the Granger Causality Test, Impulse Response Function and the other econometric tools. In addition to the above fundamental research problem, it is proposed to identify the existence of Marshal-Learner Condition by elasticity approach. Other than that the existence of J curve phenomenon has to be identified.

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3.2. HYPOTHESIS Impact of exchange rate changes on trade balance. H0: Exchange Rate Changes do not affect the Trade balance. H1: Exchange Rate depreciation improves the trade balance. Existence of Marshal Learner Condition in Sri Lanka. H0: Depreciation will not improve the trade balance even though the condition is hold. H1: Depreciation will improve the current account if the sum of the price elasticity of domestic and foreign demands for imports is larger than unity.

3.3. OBJECTIVES Main Objective To investigate the impact of exchange rate changes on trade balance in Sri Lanka.

Specific Objectives To analyze the time series properties of the variables used in this study. To understand the behavior of the variables in Sri Lanka. To analyze the short run and long run effect of exchange rate changes on the trade. To investigate the existence of Marshal Learner condition in Sri Lanka. To identify the J curve phenomenon in Sri Lanka. To suggest the policy implications.

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3.4. IMPORTANCE OF THE STUDY. The LKR is continuously depreciated all over the study period except some years. It is expected that this would improve the trade balance, reduce inflation, and increase the rate of output. The importance of this study lies in the evaluation of currency devaluation as a longterm developmental policy in Sri Lanka that can serve as a model for other country studies. The Central Bank uses devaluation as a policy tool for economic growth. Therefore if there is such a relationship found, it can be mainly beneficial for two parties. Those are; i. Policy Makers

The Trade Balance is the dependent variable. It is a component of the Balance of Payments. Therefore Balance of Payments can significantly influence the countrys GDP. The GDP will determine the health of an economy. Then if a relationship found between the trade balance and exchange rate, it can be manage in policy making. ii. Exporters

When the exchange rate is devaluated, the domestic currency will be weaker against the foreign currency. And the local exporters are benefited. And If there is such a relationship is investigated, it can be positively applied to the predictions of these exporters.

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4. METHODOLOGY This fragment concise the main variables, the frequency of data, the source of data study period, and the econometric methods. 4.1. MAIN VARIABLES Several variables are used in the calculations. Namely, exports, imports, trade share, consumer price index, GDP, GDP deflator, Nominal Exchange Rate, Real Exchange Rate, Nominal Effective Exchange Rate and Real Effective Exchange Rate. I. Exports and Imports

These are the basic variables in this study. All the calculations are based on exports and imports. Exports are used to calculate the Export Share and the Export Share is used in calculating Effective Exchange Rates. Imports are used to calculate the Import share and it is used to calculate the Effective Exchange Rates.

II. Trade share Trade Share

X= Exports M= Imports i = Major trading partners Using this equation the major 10 trading partners are found. Those are; USA, India, Japan, UK, Singapore, Germany, Hong Kong, Iran, China and Saudi Arabia.

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III. Consumer Price Index(CPI) Consumer Price Index is used to convert the nominal terms into the real terms. In this research two basic real terms are calculated. Those are the Real Exchange Rate and the Real Effective Exchange Rate. To do these calculations the Consumer Price Index will be used. IV. Nominal Exchange Rate The nominal exchange rate is used to calculate the other RER, NEER & REER. It includes the inflationary impact. V. Real Exchange Rate The RER between two currencies is the product of the nominal exchange rate. It is calculated by using the Nominal Exchange Rate.

VI. Nominal Effective Exchange Rate (NEER) The Nominal Effective Exchange Rate measures the average change of a countrys exchange rate against all other currencies.

R= W=

Exchange Rate ( major trading partners) Trade Share

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VII.

Real Effective Exchange Rate (REER).

The Real Effective Exchange Rate adjusts NEER by appropriate foreign price level and deflates by the Sri Lankan price level. Pdi= Domestic CPI Foreign CPI Exchange Rate

Pfi= R=

4.2. FREQUENCY AND SOURCE OF DATA Data come from the Central Bank (CBSL) Annual Reports, IMF Publications and Econstat data of the World Bank. All the data are in US Dollar Billions. The study employed 33 annual observations (1977-2010) of Sri Lanka and the annual data is used because quarterly data of some relevant variables are not available.

4.3. STUDY PERIOD The study period is 1977-2010, Because the Exchange rate and the trade balance become substantial with the trade liberalization in 1977.

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4.4. THE MODEL

This study attempts to develop a similar model applied by Aziz N.(2008) for Bangladesh, that the trade balance is a function of real exchange rate and the domestic and foreign real income. A log-linear specification of the model can be stated as follows:

lnTB = 0 + 1 lnREER + 2 lnY+ 3 lnY*+ ui

Where, lnTB, lnX, lnM imply logarithm of balance of trade (lnX-lnM), exports and imports at time respectively. lnREER, InY, In Y* are logarithm of real effective exchange rate, Real GDP and world real industrial production index (proxy of trade partners income).

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4.5. ECONOMETRIC TOOLS I. Granger Causality Method The Granger causality test is a statistical hypothesis test for determining whether one time series is useful in forecasting another. There is an interpretation of a set of tests as revealing something about causality. To identify the causal impact of exchange rate on Balance of Trade, the Granger Causality Test can be applied. II. Impulse Response Functions (IRF) This can be used to measure the trade balance behavior due to the external shocks. This represents the reactions of the variables to shocks hitting the system. And this test is tested to identify the trade balance behavior due to the external shocks. An impulse response refers to the reaction of any dynamic system in response to some external change (Lin, 2006). It is an essential tool in this empirical causal analysis. III. Graphical methods and summary statistics The variables can be described by the graphical methods and summary statistics. There are various variables are used in this research. And all the data is having the time series property. There is a pattern of observed time series data. When the pattern is identified, the interpretation can be done. The graphical methods and Summary statistics can be used to show this relationship in a visible and understandable manner. So it can be used in analyzing the results of this research.

IV. Vector Auto Regression

This can be used to check the linear interdependencies among multiple time series and can be used in structural models with simultaneous equations.

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V. Unit Root Test To identify the order of time series properties of this study unit root test is proposed to employ. To test the stationary of the time series this is basically used. If one or both of the series are non-stationary, the standard OLS approach will produce a spurious regression, thus rendering standard testing techniques invalid (Fuei, 2007). VI. Johansens Cointegration Method This is a non stationary method. This study employs Johansens Cointegration method to investigate both long-run and short-run relationship between the Exchange rate and the trade balance. VII. Autoregressive Distributed Lag Model (ARDL Model)

This study also employs ARDL model to investigate the long-run relationship Exchange Rate and Trade Balance. This method does not require both variables to be non-stationary at the same level or integrated in the same order. VIII. Error Correction Model

An error correction model is a dynamical system with the characteristics that the deviation of the current state from its long-run relationship will be fed into its short-run dynamics. A rough long-run relationship can be determined by the cointegration vector, and then this relationship can be utilized to develop a refined dynamic model.

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REFERENCES I. Rose, A. K., (1991), The role of exchange rate in a popular model of international trade: Does the Marshall-Lerner condition hold? Journal of International Economics, 30, 301-316. II. Santos-Paulina, A. U. (October, 2002), Trade Liberalization and Export Performance in Selected Developing Countries, Journal of Development Studies, 39:1, 140-164. III. Weerasekara, Y.M, (1992), Nominal and Real Effective Exchange Rates for the SEACEN Countries: The South East Asian Central Banks (SEACEN). IV. De Silva, D.K, (1998), Sri Lankas Experiment with Devaluation: The International Trade Journal, Volume 16, No.04. V. Wijesinghe, D.S.,(1988), Effective Exchange Rate Changes and their Impact on the Trade Balance: SEACEN Research and Trainig Unit, Kuala Laumpur. VI. Aziz, N.,(2008),The Role of Exchange Rate in Trade Balance: Empirics from Bangladesh, C22,F31. VII. Qioy, H., (2005), Exchange Rates and The Trade Balances Under the Dollar Standards: Stanford Center for International Development, Working Paper 05. VIII. Shao,Z.,(2008), Exchange Rate Changes and Trade Balance; An Empirical Study of the Case of Japan, Dissertation and Theses collection, Singapore Mangement University. IX. Ling,N.Y.,(2008), Real Exchange Rate and Trade Balance Relationship: International Journal of Business and Management, Vol.3.,No8.

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X. XI.

Pavle, P.,(2009),Exchange Rate and Trade Balance: Panoeconomics, 2010,1,pp23-41. Mohammad, S.D., The Role of Exchange Rate Changes on Trade Balance: Emperical from Pakistan, European Journal of Social Sciences, Vol.14, no.1, 2010.

XII.

Sekansti, L.,(2008), The Impact of Real Exchange Rate Volatility on South African Exports to the United States: National University of Lesotho, JEL Classification: F10, F31.

XIII.

Monacelli,T., & Perotti,R.,(2006),Fiscal Policy, the Trade Balance, and the Real Exchange Rate: Implications for International Risk Sharing.

XIV.

WWW. Wikipedia.com.

APPENDICES Some of the data which have been collected by this time are attached in this section.