Does a J-Curve Effect Exist in Nepal-India Trade?

Abstract

Nepal is facing a persistent negative trade balance with India. One of the ways a nation can improve its trade balance is by imposing or raising tariffs on its import. An import tariff raises the price of imports, lowers its domestic demand, and ultimately lowers its import, which leads to an improvement in the country’s trade balance in the long run. However, consumers take time to change their habit or find a substitute in response to a price rise, a tariff led price increase of imports only increases the import bills, thereby, worsens the nation’s trade balance in the short run. Thus, the short-run deterioration and the long-run improvement of trade balance following the imposition of an import tariff produce a J-curve phenomenon. This study tests the presence of a J-curve effect, if any, on Nepal-India trade.

Our study defines BOT as a dependent variable and measures it as Nepal’s export to India minus Nepal’s import from India. Our independent variables include RRGDP (ratio of real GDP) measured as Nepal’s real GDP divided by India’s real GDP, and RP (relative price) measured as the ratio of Nepal’s consumer price index to India’s consumer price index. We estimate an unrestricted vector autoregressive model (VAR). The coefficient of the variables