There are many variables capable of impacting the Trade balance of a state. However, among all the many variables available, Real Effective Exchange Rate, Real Domestic Income and Foreign Direct Investment are variables most concerned by old research workers. There were many surveies done to find the relationship between the variables mentioned above. However, the findings of these surveies have given conflicting consequences.

2.2 Review of Relevant Theoretical Framework

Figure 2.1: Theoretical Model

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Real Effective

Exchange Rate

Balance of trade Real Domestic Income

Real foreign income

Adapted from Yusoff, M. B. ( 2009 ) . Bilateral Trade Balance, Exchange rate, and Income: Evidence from Malaysia. Global Economic, 9 ( 4 ) , 1-19.

The chart above showed the theoretical theoretical account is by Yusoff ( 2009 ) . This survey is to analyze the effects of Trade Balance on Real Effective Exchange Rate, Real Domestic Income and Real Foreign Income.

Figure 2.2: Research ‘s Model

Real Effective

Exchange rate

Balance of Trade Real Domestic Income

Foreign Direct Investment

Based on Yusoff ( 2009 ) theoretical account, we remodelling the theoretical account become Trade Balance as a map of Real Effective Exchange Rate, Real Domestic Income and Foreign Direct Investment.

2.3: Reappraisal of Theoretical Literature

2.3.1: Real Effective Exchange Rate

In the research of Yusoff ( 2007 ) , Rizaudin, Hussein and Muhd ( 2008 ) and Abdorreza, Chua and Behnaz ( 2011 ) , they found that Malaysia exhibited the J-curve consequence phenomenon. This means that the J-curve consequence will demo the worse of a state ‘s economic system for the first few old ages but will better in the coming old ages. In other words, the depreciation of Malayan ringgit will better the Trade Balance in the long tally. However, it is a good phenomenon to a state if they are holding a worse Trade Balance economic system.

Figure 2.3: The J-Curve


Deficit Time

Based on the J-curve theory, Real Effective Exchange Rate has a negative relationship with Trade Balance in short tally, however, positive relationship in long tally.

The 2nd theory for the consequence on Real Effective Exchange Rate is the Marshall- Lerner status ( Bahmani-Oskooee and Harvey, 2006 and Yusoff, 2007 ) . It is related to the proficient ground to explicate why a decrease in value of a state ‘s currency need non instantly develop its Trade Balance. The conditions stated that, for a currency depreciation to hold a positive impact in Trade Balance, the amount of monetary value snap of exports and imports in absolute value must be greater than one. It said that if the export monetary value goods are monetary value elastic, their measure demanded will increase more than the lessening in monetary value, and entire export gross will increase. Similarly, if goods imported are elastic, entire import outgo will diminish

In add-on, Lane and Ferretti ( 2002 ) have the consequence of negative relationship between Real Effective Exchange Rate and Balance of Trade. The increasing of Trade Balance will ensue of negative J-curve consequence. This may be due to the reactivity of import monetary value to interchange rate depreciation, every bit good as to the size of depreciation since foreign exporters can counterbalance monetary value additions merely to a certain grade. This non merely can better our state ‘s Trade Balance in the long tally, but besides can increase the fight in the international market. For case, in the research of Wong and Tang ( 2008 ) , Malaysia ‘s largest export industry ( semiconducting material ) are holding the impact on their export volume by the variable of REER on both short term and long term. Besides that, in Mazila ( 2008 ) research besides found that Malaysia ‘s major export includes electrical and electronic, palm oil, lumber dress and gum elastic besides have impact on exchange rate variableness neither in the fixed or drifting exchange rate periods.

Tiwari and Shabaz ( 2011 ) assume that a existent depreciation, which means an addition in the Real Effective Exchange Rate series, better the Trade Balance in a long tally ( positive relationship ) through monetary value effects- negative relationship between Trade Balance and Real Effective Exchange Rate. This is due to a lessening in Real Effective Exchange Rate leads to the cheapened of domestic goods to the foreign in existent term and this stimulates exports. On the other manus, foreign goods are more expensive therefore imports of domestic will be discouraged.

2.3.2. Real Domestic Income

Real Domestic Income has been used as the construct to stand for the magnitude of economic activities in a state. Yujiro ( 2001 ) said that Real Domestic Income is a typical flow variables, which aggregates assorted income earned on different yearss over the twelvemonth.

To our cognition, we know that if the family income is high, the import will be increased since affluent people will hold higher desire on foreign goods and services. If the production income is higher, export will be increased since the manufacturer will be capable of bring forthing more goods and services and pay for exporting fees. This theory is besides supported by Yujiro ( 2001 ) .

Income snap of Trade Balance is expected to be negative since increasing Domestic Real Income would excite more imports through an increasing domestic soaking up which ab initio deteriorates the Trade Balance. But as Doma & A ; ccedil ; ( 1993 ) provinces, when existent income additions, the production of import replacement goods may cut down the volume of imports, and in this instance the mark of existent income would be positive alternatively.

2.3.3 Foreign Direct Investment

Presents, Foreign Direct Investment ( FDI ) plays a important function in hiking the economic growing for developed and developing states. Athukorala, Prema and Menon ( 1996 ) said that the FDI has brought important returns to Malaysia chiefly because the general economic clime has been favorable for the internationalisation of production for a considerable period. Furthermore, Malaysia is now being hailed as the following Asiatic Newly Industrializing Country ( World Bank, 1993 ) . The function of FDI is frequently cited as the most of import contributory factor behind this success narrative.

Harmonizing to Mohammad ( 2010 ) , FDI shows positive impact on Balance of Trade as it may actuate the transnational corporation to bring forth import permutation domestically and it can cut down import and a positive impact on Balance of Trade as FDI flows additions.

Theoretically, there is positive relationship between FDI and Trade Balance in the long tally. The simulative positive effects of FDI on exports of the host state came from the extra capital, engineering, and managerial know-how the transnational corporations ( MNCs ) bring with them, along with entree to planetary, regional, and particularly home-country, markets ( Mencinger, 2007 ) .

However, Mencinger ( 2007 ) suggest that the initial influx of FDI tends to increase the host state ‘s imports in the short tally. In other word, the increase of imports will decline the trade balance in short tally. One ground that causes this is that FDI companies have high leanings to import capital and intermediate goods and services that are non readily available in the host state.

2.4 Review of Empirical Literature

2.4.1 Real Effective Exchange Rate

Among the treatment in the diary of Bahmani-Oskooee ( 2001 ) , Onafowora ( 2003 ) , Narayan and Narayan ( 2004 ) , Stucka ( 2004 ) , Nusrate ( 2008 ) , Heim and Bakija ( 2008 ) province that the Real Effective Exchange Rate is an of import variable that affects Trade Balance positively in Malaysia. If Real Effective Exchange Rate falls ( depreciate ) , it would diminish the demand for imports, in other words, increasing Trade Balance.

Harmonizing to Bahmani- Oskooee ( 2001 ) , he stated that devaluation or depreciation of REER can increase a state ‘s international fight. He said that devaluation additions export by doing exports cheaper, detering imports, therefore, bettering the Trade Balance. Furthermore, Nayaran and Nayaran ( 2004 ) states that the long-term snap of the trade ratio with regard to the REER is positive, connoting that a devaluation of the REER will take to a decrease in the ratio of imports to exports. In other word, import will be decreased as export remains unchanged. It can besides be said that REER has negative relationship with import. This consequence is in line with the consequence of Onafowora ( 2003 ) .

Besides that, Stucka ( 2004 ) states that as exchange rate falls, investing and trade shortages will besides diminish, which means that REER have positive consequence on Trade Balance. This research worker suggested that the snap of REER is more than one which shows that if the REER depreciates by one per centum point, the Balance of Trade will increase by 1.033 per centum points. Furthermore, Heim and Bakija ( 2008 ) show that if REER falls, it decreases the demand for imported consumer and investing goods and services. In short, REER falls, domestic investing besides falls, accordingly trade shortage decreases. Nevertheless, Nusrate ( 2008 ) defined that REER has significantly positive influence on Trade Balance in short and long tally.

On the other manus, Hailu ( 2010 ) states that negative relationship between REER and trade balance. By making the research in African states, Hailu ( 2010 ) used Least Square Dummy Variable Regression Method and found out that the negative coefficient of REER indicates that existent grasp of local currency leads to diminish in growing rate of import and export.

Besides, Boyd and Caporale ( 2011 ) found that REER is a weak exogenic variable, which means that Balance of Trade can be more improved by others variable such as Domestic Income. Besides that, in the survey of Rose ( 1990 ) , the research worker said that the non-structural technique indicates that a depreciation of the REER is non strongly associated with a important betterment in the Trade Balance. He added that REER has no statistically distinguishable impact on the many-sided trade balance without doing auxiliary premises. REER frequently shows either undistinguished or perverse impact on the Trade Balance and in this survey REER does non bespeak strong impact on Trade Balance.

Apart from that, Liew, Lim, Huzaimi ( 2000 ) said that REER can non be used entirely in pull offing the Trade Balances in Malaysia, therefore, policy shaper should see other variable such as Real Domestic and Foreign income every bit of import as REER.

In the surveies of Yusoff ( 2009 ) , he states that the exchange rate government did non hold any important impacts on the Trade Balance in the short-run. A depreciation of the Ringgit Malaysia will instantly deteriorate the Trade Balance. Besides that, he found that there is non-stationary relationship between REER and Trade Balance. REER depreciate improves the Malayan Balance of Trade in long tally, REER, Domestic and Foreign income have significantly positive mark to explicate the Trade Balance.

Besides that, research workers Duasa ( 2007 ) and Naseem, Tan and Hamizah ( 2009 ) besides proposed that REER do non hold a important consequence on the imports of developing states. Harmonizing to the research of and Duasa ( 2007 ) and Naseem, Tan and Hamizah ( 2009 ) , they stated that every goods and/or services in Malaysia are holding an uncomplete base on balls through. This means that non all the foreign goods and/or services are trade consequently with an exchange rate in the international market.

2.4.2 Real Domestic Income

Real Domestic Income is usually used for measuring the economic growing of a state over clip and comparing economic place with the remainder of the states ( Yujiro, 2011 ) .

Harmonizing to the survey of Dr. Muhammad ( 2010 ) , Liew, Lim and Hazaimi ( 2000 ) , Jarita ( 2007 ) , Rizaudin, Hussein and Muhd ( 2008 ) , Naseem, Tan and Hamizah ( 2009 ) , Abdorreza, Chua and Behnaz ( 2011 ) , they found that Real Domestic Income are closely related to interchange rate and therefore hold the relationship of impact in the state Trade Balance in long tally.

In footings of theory, Real Domestic Income should hold a positive relationship with the Trade Balance. In other words, as the Real Domestic Income additions, it encourages economic growing. This theory is in line with Dr. Gulzar ( 2011 ) research in which stated that an betterment in income will increase domestic nest eggs ; accordingly it can cut down the trade shortage.

However, some research workers get a consequence saying that the Real Domestic Income has negative consequence on Trade Balance. Duasa ( 2007 ) and Tiwari and Shabaz ( 2011 ) defined that Real Domestic Income are significantly negative impacting the Trade Balance. This consequence is consistent with Yusoff ( 2009 ) and Korap ( 2011 ) .

Duasa ( 2007 ) said that income has an of import function in finding the long tally behavior of the Malaysia Trade Balance as compared to interchange rate. This is because Malaysia ever sets the exchange rate within its mark zone with a series of controls and intercessions. However, in the research done by Tiwari and Shabaz ( 2011 ) in India, the research worker viewed that increasing in income will do citizen to purchase more imported goods as compared to domestic goods ; as a consequence, import will be more than export hence deteriorating Trade Balance in India. Furthermore, Yussof ( 2009 ) found that a rise in Real Domestic Income additions imports which tend to gnaw the Trade Balance by utilizing Johansen Cointegration Procedure.

However, Onafowora ( 2003 ) and Kamoto ( 2006 ) found that Real Domestic Income is positively and negatively related to Trade Balance. They explained that if the demands are driving force in finding the export and import, therefore there is a negative relationship between Trade Balance and Real Domestic Income. By contrast, the trade balance will hold a positive long tally relationship with Real Domestic Income if an addition in Real Domestic Income were due to the increasing productiveness or production of import replacement goods and supply is the driving force in finding exports and imports. This consequence is consistent with the consequence of Kimbugwe ( 2006 ) .

Apart from this, Narayan and Narayan ( 2004 ) states that there is a long tally relationship between the import and export, Foreign Income and Real Domestic Income, nevertheless, they found that Real Domestic Income is the most of import determiners of Fuji ‘s Trade Balance. On the other manus, Narayan ( 2004 ) examined the consequence on Real Domestic Income on the New Zealand ‘s Trade Balance and the consequence shows that there is no relationship between both of the variables.

Furthermore, Wong ( 2006 ) and Hailu ( 2010 ) said that there is no relationship between Trade Balance and Real Domestic Income. Wong stated that there is a long tally relationship between trade good footings of trade but non income term of trade in Malaysia. This is because he found that the addition in trade good term of trade will take to a lessening in trade in the long tally. Besides that, Hailu said that the unimportant income snap can be clarify by the fact that the population lives in poorness, income may non be extremely increased plenty to switch expenditure signifier domestically produced to imported goods and services.

2.4.3 Foreign Direct Investment

Foreign Direct Investment ( FDI ) is an investing straight into production in a state by a company located in another states, either by purchasing a company in the mark state or by spread outing operations of an bing concern in that state.

In the research done by Yusoff ( 2007 ) , this research worker found that FDI is of import in explicating the Trade Balance. Yusoff ( 2007 ) proved that FDI plays a practical function for employment coevals, engineerings bettering, extinguishing poorness every bit good as bettering societal public assistance particularly for developing states.

Furthermore, Aurangze and Anwar ( 2012 ) found that all independent variables of FDI has important impact on the Balance of Trade shortage, which is same consequence found by Ben & A ; aacute ; A?ek, Prokop and V & A ; iacute ; sek ( 2003 ) , they found that the chief drivers of the Czech international trade kineticss have been associated with alterations in factor gifts and influxs of FDI, other than that, they besides found the impact of REER grasp on trade was less significance compared to FDI.

Besides that, Wang and Wan ( 2008 ) and Korap ( 2011 ) besides found that Trade Balance is strongly improved due to an addition in net FDI influx, which means that there exists direct relationship between them. Harmonizing to the research done by Wang and Wan ( 2008 ) , they found that the coefficient of inflow FDI and Balance of Trade is positively important nevertheless the coefficient of outflow FDI is undistinguished in finding the Trade Balance, which have the same consequence found by Ben & A ; aacute ; A?ek, Prokop and V & A ; iacute ; sek ( 2003 ) . Wang and Wan ( 2008 ) used Akaike Information Criterion and Distributed lag theoretical account while Ben & A ; aacute ; A?ek etc used Normally Least Square method to find it.

However, the consequence is inconsistent with the findings of Athukoral ( 2003 ) . He found that FDI influxs do non exercise an independent influence on economic growing. In add-on, he besides obtained the consequence that the way of causing is non towards from FDI to Gross Domestic Product ( GDP ) growing but GDP growing to FDI.

However, Mencinger ( 2007 ) found that in short, FDI worsens Trade Balance in all NMS in short tally however FDI improved Balance of Trade in long tally. The consequence is changeless with Goh and Wong ( 2010 ) which is in FDI will better Trade Balance in long tally, but non in short tally. Goh and Wong ( 2010 ) found that there are strong grounds of a positive long tally relationship between Malaysia ‘s Outwards Foreign Direct Investment ( OFDI ) and the place state ‘s trade openness, which is same as what Mencinger ( 2007 ) found, but the lone different is that the consequence of this old research worker is non merely base on Malaysia informations.

By utilizing Granger Causality method, it shows a co-integration and causality relation between the FDI and import ( Dumitriu, Stefanescu and Nistor, 2010 ) . Since FDI has negative consequence on import, accordingly it will act upon on Trade Balance.

Besides that, Ghazali ( 2010 ) found that there is one-sided causality between Trade Balance and FDI. The co-integration trial done by Ghazali ( 2010 ) said that there is extremely degree of positive correlativity. The writer said that FDI inflow addition, domestic investing addition consequently, therefore ensuing in the economic growing.

However, in the research of Dr. Gulzar ( 2011 ) , he states that an betterment in the FDI can cut down the trade shortage, in other word, which is positive relationship between FDI and Trade Balance. He besides found out that even though there exists a positive relationship between those variables, FDI can besides has insignificantly influence on Trade Balance because of the political instability in some states. The unstable politic has resulted in the decreasing of influx of FDI, therefore net FDI will be negative.

Furthermore, in the survey of Wilamoski and Tinkle ( 2008 ) , they found that there are merely a little positive relationship between FDI and export, which is consistent with the consequence found by Mohammad ( 1999 ) .

On the other manus, there were some surveies done by research worker in which are non consistent with the theory that states there is positive relationship between FDI and Trade Balance. Yousaf, Nasir, Naqvi, Haoder and Bhutta ( 2011 ) concluded that there was a negative relationship between FDI and economic growing in their surveies. This means that a FDI addition, it will deteriorate the economic growing. They found out that the negative relationship exists is due to the deficiency of substructure and progress engineering in developing states. Omaniyi ( 2011 ) besides stated that FDI has a negative impact on Trade Balance in Nigeria. It may ensue in deficient FDI investing fund, exchange rate and political position.

Apart from this, in Kiran ( 2011 ) survey, the writer besides can non happen grounds of causality between FDI and Trade Balance in Turkey. The statistics done by this research worker shows no grounds in the consequence of Granger Causality trial and LM unit roots trial.

2.5 Methodology Review

First, this research will transport out the Augmented Dickey- Fuller ( ADF ) unit root trial to prove for stationary. ADF method is really good known and used by most of the old research workers such as Narayan ( 2004 ) , Yusoff ( 2007 ) and Ghazali ( 2010 ) . If the dependant variable and independent variables are non stationary, the consequence from Ordinary Least Square method will be specious.

This research will utilize Ordinary Least Square ( OLS ) method to find the important relationship of Real Effective Exchange Rate, Real Domestic Income and Foreign Direct Investment on Trade Balance. This method is besides used by old research workers such as Goh and Wong ( 2009 ) and Nayaran ( 2004 ) . OLS method will be used in this research due to its simpleness, cost free and is easier to understand.

2.6 Decision

In this chapter, this survey states the relationship between the balance of trade with its independent variables founded by old research workers. Apart from that, this research besides has to explicate the relationship between the trade balance exposures with its independent variables. By looking into the consequences gain from old research workers, there are contentions between different writers. This nevertheless generates good guidelines in this survey ‘s analysis because these old surveies are able to back up the result of this research analysis. In Chapter 3, this survey will be carry oning a methodological analysis which states the collection, processing and analysis of the informations.