Ever since China’s accession into the WTO, India has been running a trade deficit with it. This trend has only been rising in the last few years. While this imbalance could be accounted for by a variety of factors, economists’ understanding of the relation between trade and exchange rates, by far, had been largely influenced by the Mundell-Fleming model. The key underlying assumption of this paradigm is that countries transact with each other on the bilateral exchange rate which means it is the bilateral exchange rate that will have an impact on the bilateral trade flows.

However, in the past few years, the work done by a group of economists (chief among whom has been Gita Gopinath, the current IMF Chief Economist) has challenged this paradigm and put forth an alternative, the Dominant Currency Paradigm (DCP). Contrary to the assumption of the Mundell-Fleming model, it has been empirically observed that countries trade heavily with the US Dollar than any other currency on the planet. For instance, 86 percent of India’s trade is invoiced in Dollars.

As a consequence, a key prediction of the DCP is that bilateral imports are not influenced by the bilateral exchange rate but more so by the dollar exchange rate. In this story we look at how Indian Imports from China are interlinked with the Dollar/INR exchange rate. For this purpose, we take a look at monthly data from January 2011 up to October 2020.

Theory, in any framework, tells us that higher the exchange rate makes imports costlier and thus must lead to a reduction of imports (the depreciation in DCP is the depreciation vis-à-vis the dominant currency). It is also understood from the Marshall-Lerner condition that for a depreciation to be effective on the trade surplus, the sum of import and export elasticities must be greater than 1. Barring these results, we focus on the key movements between the INR/USD exchange rate and the Indian imports.

What we find is a bit surprising. Indian imports from China are significantly and positively correlated with the dollar exchange rate. In other words, a depreciation has been accompanied by a rise in imports. The correlation coefficient stands at 0.4348 with a p-value of 0.0000. In (Gopinath et.al., 2020) an estimation of exchange rate elasticities resulted in a significant value of -0.131 on imports. So, in comparison with the estimated model, this finding is a bit out of place.

There have been episodes where a depreciation has seen a fall in imports as was the case during the COVID pandemic but it cannot entirely be attributed to the exchange rate depreciation. A negative force of limited international mobility was involved. All in all, this result is nonetheless surprising. What remains to be accounted is the other factors that could influence trade.