Impact of Bilateral Real Exchange Rate on Bilateral Trade Balance: Evidence from Pakistan and Its Major Trading Partners

This study investigates the impact of the bilateral real exchange rate on the bilateral trade balance of Pakistanwith its five major trading partners, namely the US, China, Saudi Arabia, Germany, and the UK. We utilize paneldata spanning from 1991 to 2018 for the six countries. We employ the fully modified OLS (FMOLS), and panelerror correction model (ECM) to explore the short-run as well as long-run dynamics of the relationships amongthe variables. Since the cointegration procedure requires the investigation of the order of integration of variables,we employ the panel unit root test to check the order of integration of variables. Before moving on to panel unitroot analysis, it is mandatory to check cross-sectional dependence. For this purpose, we employ a cross-sectionaldependence test designed by Pesaran (2004) which indicates the existence of cross-sectional dependence. Sincethe presence of cross-sectional dependence requires a second-generation test for panel unit root analysis,therefore, we employ the Fisher-ADF panel unit root test. The results of the test reveal that the trade balance isstationary at level, while bilateral real exchange rate, domestic real GDP, and foreign real GDP are first-orderintegrated. Further, the results of the FMOLS test reveal that both domestic real GDP and bilateral real exchangerate harm the bilateral trade balance of Pakistan, while foreign real income has a positive impact on it. Moreover,the results of panel ECM confirm the presence of a tendency of adjustment to the long-run equilibrium.