Dynamics of India-China Trade Relations : Testing for the Validity of Marshall-Lerner Condition and J-Curve Hypothesis

Recent devaluation of Chinese yuan has threatened the stability of global financial system and has invited unwarranted currency war. China is India's largest goods trading partner and India has a whopping trade deficit (US$49 bn in FY15) with China on account of rising imports and dismal exports. The recent devaluation of yuan (around 4% in two days, August 11-12, 2015) would make Chinese exports more competitive than that of India, which in turn would have a negative impact on India's exports. Depreciation of Indian rupee by virtue of its global integration though has nullified the devaluation effect of yuan, but the growing trade deficit of India with China is still a concern. This study aims to provide empirical insights on whether real depreciation of Indian rupee is an effective way of improving the trade deficit with China. Using annual data from World Bank and UN Comtrade from 1987 to 2014, the paper validates Marshall-Lerner condition and J-Curve effect for India. Bounds test to cointegration approach based on Autoregressive Distributed Lag (ARDL) model and error correction of ARDL model are employed in the study. The bounds test result shows evidence of long-run relationship between trade balance, domestic income, foreign income and real exchange rate. Moreover, the estimated long-run ARDL model rejects the validity of Marshall-Lerner condition for Indian economy. Finally, short-term dynamics obtained from the estimation of error correction model show that there is no J-curve effect for India. Hence, depreciation of rupee is not expected to yield the desired result in correcting the trade deficit with China