American Journal of Business, Economics and Management

2015; 3(1): 14-18

Published online January 20, 2015 (http://www.openscienceonline.com/journal/ajbem)

Exchange rate and determinants of balance of trade,

its impact on balance of payment
Amna Nazeer1, *, Khuram Shafi2, Zahra Idrees2, Liu Hua2
1
Schools of Statistics and Mathematics, HuaZhong University of Science and Technology, Wuhan, China
2
School of Management, HuaZhong University of Science and Technology, Wuhan, China

Email address
[email protected] (A. Nazeer)

To cite this article

Amna Nazeer, Khuram Shafi, Zahra Idrees, Liu Hua. Exchange Rate and Determinants of Balance of Trade, Its Impact on Balance of
Payment. American Journal of Business, Economics and Management. Vol. 3, No. 1, 2015, pp. 14-18.

Abstract
An endogenous search for the relationship between exchange rate and determinants of balance of trade and its impact on
balance of payment is made. Exchange rate is affected by certain factors like balance of trade and balance of payment. Balance
of trade is measured using different factors like exports, imports, capital goods, consumption level, oil prices and political
uncertainty. This study is not yet been conducted in Pakistan and we have done this research to evaluate the impact of different
factors on exchange rate. Exchange rates help a country while making imports and exports and balance of trade tells about the
imports and exports of that country during any particular time period. The paper looks at how the exchange rate is affected by
the balance of trade of a country and also explores the relationship between exchange rate and balance of payments. Balance
of payment is taken as dependent variable in this paper. Both balance of trade and balance of payment affects the exchange rate
and similarly manufacturing growth rate is also affected through variation in exchange rate. The results have shown that there
is significant relationship between exchange rate and balance of trade and balance of payment. Both balance of trade and
balance of payment have strong relationship with exchange rate.
Keywords
Exchange Rate, Balance of Trade, Balance of Payment

payments for country assets (capital inflows). All payments to

1. Introduction foreigners are entered in the “Payments” column with a minus
A country’s balance of payments (BOP) account keeps track sign (-) to reflect that they are debits because they result in
of both its payment to and its receipts from other country. The flows of funds to other countries. Payments include country
BOP is a bookkeeping system for recording all payments that purchases of foreign products such as machinery and cars
have a direct bearing on the movement of funds between a (imports), country travel abroad (services), income earn by
nation (private sector and government) and foreign countries. foreigners from investments in the country (investment
The BOP account uses a standard double-entry bookkeeping income), foreign aid and gifts and pensions paid to foreigners
system much like to keep a record of payments and receipts. (unilateral transfers), and country payments for foreign assets
All transactions involving payments from foreigners to (capital outflows). Along with BOP, balance of trade (BOT)
country are entered in the “Receipts” column with a plus sign and exchange rates are amongst the most important factors
(+) to reflect that they are credits; that is, they result in a flow that play a vital role in examining the economic equilibrium of
of funds to county. Receipts include foreign purchases of a country. Mostly trade oriented factors affect exchange rate
country products such as computers and wheat (exports), and devalued exchange rate lower the purchasing power of
purchases from foreign tourists (services), income earn from that nation. BOP also has a strong relationship with the
country investment abroad (investment income), foreign gifts exchange rate.
and pensions paid to country (unilateral transfers), and foreign In Pakistan it is important for the investors to invest from
the debt to increase the investment in the country. When the
 American Journal of Business, Economics and Management 2015; 3(1): 14-18 15

investment increases in the country, imports of that country weathering a financial crisis attract fewer FDI inflows if they
decreases and exports tends to increase that mean a country’s sign IMF agreements. A second argument is that countries
capital account increases and the current account decreases. may sign IMF agreements because of the austerity conditions
Debt is important to increase the investment in the country, the associated with IMF programs [8]. In his 1970 analysis of the
production as well as exports will also increase that will world monetary crises, Harry Johnson spoke of the liquidity
reduce the balance of payment through the exports of the problem as re-emerging in the late 1960s because of the
product. In the long run internal or external deficits have inadequacy of the IMF provisions 'to provide for growth of
negative impact on the economic growth of the country. It will international liquidity at a rate adequate to meet the needs of
increase the future investment in the country’s economic the expanding world economy [9]. Rose estimate the effect of
growth. It has two impacts on the debt and growth. First it is sovereign debt renegotiation on international trade.
the burden of debt on the economy and second is debt is the Sovereigns may fear the trade consequences of default;
neutral for the economy. Pakistan’s external debt reached an because creditors deter default, or because trade finance dries
unprecedented level during the 1990s. Growth in external debt up. Those developing countries which are exposed to the trade
include inept use of borrowed resources in the form of liberalization policies have experienced rise in exports and
wasteful government spending, and financing of current imports but imports rose more than exports and hence
expenditure, and investing in low priority development imbalance the BOT and BOP [10]. Positive and significant
projects, and poor implementation of foreign aided projects. long-run relationship exists among the exchange rate and
Because of an injudicious utilization of foreign loans, debt balance of payment [11, 12]. Exports need to be higher for a
carrying capacity of the country weakened due to reduction in balanced economic scenario for Pakistan. Economic
real revenues and exports, leading ultimately to increase real phenomena that restrict the positive flow of exports require a
cost of government borrowing, both domestic and foreign. revision because exchange rate depreciations cannot improve
the BOP situation solely [13].
2. Literature Review
3. Variable Explanation
The exchange rate directly affects policy making of a nation
regarding the trade balance of a country with the rest of the Balance of Trade: In Pakistan balance of trade is in deficit
global and policy formulation [1]. The government has been constantly, Pakistan is basically an agricultural country and
concerning on increasing exports and improving the balance 70% population rely on agriculture directly or indirectly.
of payments for the last few years; result seem to be exactly Balance of trade also affected by many other economic
the opposite of the declared target: the gap between exports factors.
and imports has widened [2]. Rising oil prices and the import Manufacturing Growth Rate: The second source of export
of machinery have severely troubled the balance of trade as of Pakistan is manufacturing growth rate that is textile
the trade deficit reached $3.5 billion in just nine month [3]. industry and sports industry. Many Multi-National Companies
Purchasing Power parity does not hold as a long run (MNCs); operate in Pakistan that are also source of exports but
equilibrium relation, it is an empirical test on Australia’s long MNCs; long term effect is go beyond opposite to balance of
run real exchange rate [4]. A monetary expansion causes long trade.
run depreciation because it is an increase in the supply of the Exports: The exports of goods play an imperative role in the
currency, and an increase in expected inflation causes long run economic development of a country and signify one of the
depreciation because it decreases the demand for the currency most important sources of foreign exchange income. Exports
[5]. Short and long-run neutrality results if wealth consists not only ease the pressure on the balance of payments but also
only of foreign original level. However, if interest earnings on create employment opportunities. They can increase
foreign securities dominate the trade balance in the expression intra-industry trade, help the country to integrate in the world
for the exchange rate; monetary expansion leads to an economy and reduce the impact of external shocks on the
appreciation of the exchange rate [6]. The real exchange rate domestic economy increases in the volume of exports always
may be an important variable through which terms of trade support the current account balance. However, this increase
shocks are transmitted to the current account. Debt service on must be greater than the volume of imports. If the volume of
amortization and interest account reaches and exceeds the exports increases at the same proportion or less than imports
annual amount of a constant gross outflow of new capital. then this increase in the exports will not support the current
Foreign investment does not give rise to any problems account balance.
intrinsically different from those created by domestic Imports: Imports of a country depend upon the domestic
investment, public or private [7]. Distinct arguments link IMF production capacity. If the local producers are unable to
programs to either higher or lower levels of FDI inflows. IMF produce enough to satisfy the domestic demand, then
programs may prescribe economic reform packages that are increased imports are required to fill this gap. High volume of
conducive to multinational investors, leading to higher levels imports as well as concentration of imports on capital products
of economic stability and strong macroeconomic performance. are some of the main causes for current account deficit.
Countries in economic crisis that urn to the IMF for supporting Capital goods: In the economic realm, "capital goods" is a
habit their ability to attract multinational investors, countries specialized term which refers to real objects owned by
16 Amna Nazeer et al.: Exchange Rate and Determinants of Balance of Trade, Its Impact on Balance of Payment

individuals, organizations, or governments to be used in the following regression equation.

production of other goods or commodities. Capital goods
include factories, machinery, tools, equipment, and various Exchange rate = β0 + β1 (Exports) - β2 (Imports) - β3 (Capital
goods) - β4 (industrial growth) - β6 (Consumption level) + β7
buildings which are used to produce other products for
(Oil prices) + error (1)
consumption. The growth in capital goods industry in Pakistan
has more merits and it would be a reflective of business The coefficient of each variable in the left hand side
confidence on the dynamic economic performance. The State generally called independent variable, measures the impact of
Bank in its annual report for the year 2007-08 said that in that respective variable on the right hand variable known as
Pakistan, the correlation of GDP growth was highest with dependent variable assuming the impact of every other
capital goods manufacturing compared with the production of variable held constant. To have valid results the error term is
intermediate and consumer goods. assumed to be distributed normally with zero mean and
Consumption Level: Total consumption is the factor that constant variance.
has a negative sign, points out that an increase in the With the help of literature, we concluded that BOP and
consumption level will decrease country’s exchange rate and exchange rate has significant relationship with each other.
fall in the consumption will enhance the exchange rate. Role of government is very significant in making advantage
Therefore it is hypothesized that consumption of the country from this variation with the help of devising country favorable
has a negative relationship with exchange rate. policies for boosting exports and reducing imports helps in
Oil Prices: Oil prices have a significant contribution in the their trade reforms, and eventually constructs a strong positive
country exchange rate. It will affect both positively and impact on BOP. The mathematical relationship among
negatively on the current account balance. Therefore it is exchange rate and BOP is provided in equation 2.
hypothesized that Oil prices has a relationship with exchange
rate of the country. BOP = β0 + β1 (exchange rate) + error (2)
Exchange rate: The exchange rates (also known as the
Slope coefficient of exchange rate measures its impact on
foreign-exchange rate, forex rate or FX rate) between two
BOP and the error term is assumed to be normally distributed
currencies specify how much one currency is worth in terms of
with zero mean and constant variance.
the other. It is the value of a foreign nation’s currency in terms
Data of defined variables is collected on annual basis for
of the home nation’s currency. The exchange rate of Pakistan
Pakistan. The data of exchange rate (ER) and BOP is collected
as compared to other currencies fluctuated with the passage of
from International Financial Statistics (IFS). The data for
time due to different political, economical and other factors.
imports (IM), exports (EX), capital goods (CG) and industrial
Balance of Payments: In economics, the balance of
growth (IG) are taken from World Data Bank indicators.
payments (or BOP) measures the payments that flow between
Furthermore, Oil prices (OP) (US $ per barrel) are taken from
any individual country and all other countries. It is used to
OANDA forex. All the data are collected in same measuring
summarize all international economic transactions for that
unit as billion United States dollars.
country during a specific time period, usually a year. The BOP
is determined by the country's exports and imports of goods,
services, and financial capital, as well as financial transfers. It
reflects all payments and liabilities to foreigners (debits) and
all payments and obligations received from foreigners
(credits). Balance of payments is one of the major indicators
of a country's status in international trade, with net capital
outflow.

4. Methodology
Theoretical framework of this study in the form of a flow
chart is given in figure 1.
Objective of research can be achieved with the help of
econometric technique which is used to test the existence of a
long run association among the time series of data. In detail Figure 1. Theoretical Framework
review of literature of exchange rate relationship, the BOT
has significant positive relationship and economic growth i.e. 5. Data Analysis
industrial growth, capital goods and consumption level has
strong negative relationship and oil prices has The regression equation explained through equation 1 is
positive/negative relationship with exchange rate as its sign estimated using the most common statistical method; the
depends upon oil production at national level and its import ordinary least square method and the estimated results are
from other countries. A general form of linear relationship of provided in table 1.
exchange rate with defined variables is presented in the
 American Journal of Business, Economics and Management 2015; 3(1): 14-18 17

Table 1. Result of Linear regression of Model-1 balance of trade and balance of payment. Export, import,
Variable Coefficients t-value p-value
capital goods, consumption level, oil prices and political
uncertainty are used for measuring the impact on exchange
constant 12.55 1.01 0.334
rate. Exchange rates help a country while making import and
EX 0.010842 3.34 0.007
export. Balance of trade of a country tells about the imports
IM -0.005869 -2.35 0.038
and exports of a country during any particular time period.
CG 0.001212 1.08 0.304
This study had tried to reveal the relationship between the
OP 0.002600 0.39 0.704 exchange rate and balance of trade and balance of payment.
CL -0.001030 -0.61 0.552 The results showed that there is 89.6% strong and significant
IG -0.0000598 -1.08 0.302 relationship between exchange rate and balance of trade,
R-Sq(adj) = 83.9% R-Sq = 89.6% export, import, capital goods, consumption level, oil prices
and political uncertainty. The study also supports the past
The estimated regression equation is given below. findings for Pakistan that a rise in exports is needed in order to
ER = 12.6 + 0.0108 EX - 0.00587 IM+ 0.00121 CG + 0.00260 attain economic balance and assure the economic growth of
OP- 0.0 0103 CL -0.000060 IG the country. The results have also shown that statistically there
is significant relationship between exchange rate and balance
It is quite clear from the values of the regression coefficient of payment. The hypothesis of strong and positive relationship
R2= 0.89 and adjusted R2= 0.839 that equation 1 well capture between the growth rate, BOT and BOP remains valid in the
the relationship among the exchange rate and its under study case of Pakistan and these factors affect the exchange rate.
determinants. From the results it can be inferred that 1 billion
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