Asymmetric exchange rate pass-through and the j-curve: evidence from Sri Lanka's trade balance

The study empirically evaluates the effectiveness of exchange rate flexibility in facilitating Sri Lanka’s external adjustment. Using monthly data from January 2003 to December 2024, the analysis employs both the linear Autoregressive Distributed Lag (ARDL) and Nonlinear Autoregressive Distributed Lag (NARDL) frameworks, focusing on the aggregate trade balance and the separate export and import channels. The NARDL model identifies a long-run asymmetric relationship between exchange rate fluctuations and the import-export ratio (M/X), defined as imports relative to exports, where a decline in the ratio indicates an improvement in external balance. The results show that currency depreciation reduces the import-export ratio, implying an improvement in external balance, while appreciation remains statistically insignificant, providing no evidence of a symmetric J-curve pattern. The observed asymmetry reflects export inertia (hysteresis) and asymmetric import responses associated with Sri Lanka's structural dependence on imported goods. The potential gains from appreciation are absorbed by foreign suppliers through asymmetric pricing-to-market behaviour (foreign suppliers adjusting prices differently for currency appreciations versus depreciations). Higher demand for foreign goods worsens the trade balance because exports rely heavily on imported inputs. Taken together, the results suggest that exchange-rate adjustments alone may be insufficient to correct Sri Lanka’s trade disequilibrium. Policymakers should implement measures to reduce import dependency, strengthen backward linkages by supporting local suppliers, and diversify exports.