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Sukumar Nandi Indian Institute of Management Lucknow

Exchange Rate Regime in India
• • • Fixed Exchange rate regime : 1954 – 1966 1966 – 1971 Post Bretton Woods Era :  $ 1 = Rs. 4.76  $ 1 = Rs. 7.50

!973 0nwards  Flexible exchange rate regime, and rupee was linked with a basket of currencies

• • • •

Rigid system of exchange control…. Foreign Exchange Regulation Act, 1973 Effects:: a) Hawala Transactions [ arbitrage on gold prices – India and Middle East ] b) Black market exchange rate

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Continued…
• A near stagnant exports and increasing imports made the capital account balancing item depending on external loans, that was not very reassuring  the result had been a precarious position of international reserves GOI tried to manage this situation with tight control on the use of foreign exchange The license permit raj in domestic markets had its spill over in external sector with results of --- (i) huge black market of foreign exchange , and (ii) capital flight The paradigm change from 1990 brought fundamental change in the exchange rate regime in India
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• •

• •

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INR Movement

Rupees per US dollar

50 45 40 35 30
Apr-93 Apr-94 Apr-95 Apr-98 Apr-99 Apr-01 Apr-04 Apr-96 Apr-97 Apr-00 Apr-02 Apr-03 Apr-05

115 105 95 85 75

Rupees per US dollar

REER

NEER

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Index (1993-94=100)

Exchange Rate

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Official and Black Market Exchange Rates of Indian Rupee 1954 – 1990 [ The black market premium being linked to gold prices difference/ hawala premium]

Rs/ USD

35 25
Black market Rate

15 5
1954 1966 1971 Official Rate 1990

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INR Movement in 2007

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Issue
• Every country while seeking equilibrium in open economy situation faces the impossible trinity: Independence of monetary policy, fixed exchange rate policy and free capital mobility. A country can have any of the two at a time, and the third is to be sacrificed… this is the choice. Given the fact that international capital mobility is now facts of life, a country’s choice is now restricted to either fixed exchange rate regime or monetary policy independence. Since the latter is very important, a country is to adapt a flexible exchange rate regime. In that attempt a country may monitor the movement of real exchange rate and use the latter as a target.

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Model
• There are different models for the determination of equilibrium real exchange rate( RER) in an economy. RER depends on the macroeconomic fundamentals of an open economy apart from policies of the government.
Here we will follow the model as developed by Edwards in his JDE ( 1988) paper
[ The choice is influenced by the fact that this approach takes into account the whole mapping of macroeconomic fundamentals of the economy along with government policies in an equilibrium setting]

• • •

Let us consider a small open economy with a dual exchange rate regime ___ a fixed exchange rate for goods and a flexible exchange rate for assets. There are three goods ___ exports, imports and non-traded goods. The non-traded goods are produced and consumed domestically. Exports are produced in the country and consumed abroad (importing countries). Imports are produced abroad and consumed in the country. Therefore, domestic consumers and producers are concerned with the relative prices of imports and exports.

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Real Exchange Rate
• Since exchange rate is the link between the price levels of two countries, it is the real value of money that determines the competitiveness of a country’s exports. This leads us to the concept of real exchange rate( RER). Real exchange rate is defined as the nominal exchange rate multiplied by the ratio of the price of traded commodities to the price of non-traded commodities, or

s= E * ( CPI T / CPI ( 1)

NT

)

......

Since prices of traded commodities are related to the world prices only, the wholesale price index of the United States of America ( WPI*) is taken as a proxy. Again, the prices of non-traded commodities is approximated by the domestic consumer price index or CPI. So the equation of RER is s= E* ( WPI* / CPI) ………
9

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RER
• • • • • Thus the relative price of import is Wm = Pm / Pn ,

And the relative price of exports similarly will be Wx = Px / Pn

• • •

Here Px , Pm and Pn are respectively domestic prices of exports (X), imports (M) and non-traded goods (N). The price of imports includes tariffs that make the domestic price of the imported goods. Suppose Wm* is the relative price of imports domestically that excludes tariff. Real exchange rate ( RER and denoted by s) as defined in the beginning is a weighted average of the two relative prices, i.e., ……… ( 3) s= a Wm* + ( 1 – a ) Wx ……

04/02/08 Real Exchange 0< a < 1) , S Nandi • where a is a positive fraction ( Rate Targeting __and Wi ’s are relative10

prices as defined above.

RER
• The real exchange rate can also be rewritten in terms of the world prices of exports and imports ( denoted by asterix * ), the domestic price of non-traded goods and the nominal exchange rate E, or, • s= [ b Pm* + ( 1 – b ) Px* ] E / Pn ……….. (4) The world prices of exports and imports are exogenously given. Exports are assumed to be the numeraire, so RER is affected by the ratio of the price of imports to that of exports, and this is the inverse of the terms of trade. Again RER is also influenced by the price of non-traded goods and these are determined in the market of non-traded goods
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.
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Non-Traded goods
• In a country demand for non-traded goods is determined by assets of people, government consumption of non-traded goods, and the relative price of imports, the latter is the ratio of the domestic price of imports to the price of non-traded goods • The price of non-traded goods is thus a function of real assets A, world import price Pm* that does not include tariffs, rates of tariffs tr, and government consumption of non-traded goods GC. Thus the function of the price of non-traded goods is • • Pn = f ( A, Pm* , tr, GC ) ……….. ( 5) + + + +
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Continued…
• Thus in Edward model RER in equilibrium is determined by some macroeconomic fundamentals of the economy like tariffs, terms of trade, composition of government consumption, capital flows and technical progress, or,
RER ( s*) = f ( tariff rate, terms of trade, government consumption of non-traded goods, official capital flows, technical progress ) ……………. ( 6)

Edwards also considers the effects of government policies at different levels that cause deviations of RER from its equilibrium level. The policies considered are monetary policy, fiscal policy and exchange rate policy
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Continued…
• s(t)= a0 + a1 tr + a2 tot + a3 GCON + a4 cflows + a5 tech + a6 fp + a7 mp + a8 ep • …………… (7) • Where the macro fundamentals that determine the equilibrium RER like tariff rate, terms of trade, government consumption of non-traded goods, official capital flows and technical progress are denoted by tr, tot, GCON, cflows and tech respectively apart from three policies fp, mp and ep as defined above. • The proxies for the policy variables are constructed following the recommendations of Edwards ( 1988b). • Fiscal policy is approximated by the ratio of fiscal deficits to high power money with a lag as developing countries often use a policy of which isReal Exchange Rate Targeting __ S Nandi money creation to finance budget deficit

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.

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Continued…
• • Monetary policy is approximated by the growth of domestic credit. The latter includes claims on the central government, state government, local institutions and non-monetary financial institutions. Again exchange rate policy is approximated by the changes in the nominal exchange rate, that may result through direct intervention by the government in foreign exchange market ( fixed rate regime ) , or indirect intervention when apex bank intervenes in floating rate system.

• We now have the equation of estimation after incorporating the proxy variables as follows: • s(t)= a0 + a1open + a2 tot + a3 GCON + a4 cflows + a5 GW + a6 fp + a7 mp + a8 ep + u • …………. (8)

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Description of the Variables with proxy

Ta le1: D scrip ionof V ria le b e t a b Variable s(t) open tot GCON cflow s GW fp m p ep Description Real exchange rate Degree of openness Term of trade s Governm consum ent ption of nontraded goods Official capital flow s Rate of grow th fiscal policy m onetary policy Exchange rate policy ratio of total trade to GDP ratio of US W to CPI of India PI ratio of governm consum ent ption to GDP ratio of capital flow to GDP s log difference of GDP Ratio of fiscal deficit to high pow m er oney log difference of dom estic credit log difference of nom inal exchange rate Proxy if any

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Data
• The period of the study is 1990 – 2006 as the liberalization of the economy in 1990 led to a much flexible policy in the exchange rate. The apex bank became serious about the stability of the real exchange rate. The annual data are collected from International Finance Statistics, Year Book_ different issues Since the variables show the existence of unit root of order one, first differences of the variables have been used so that they become stationary.

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Estimation

Table 2: Estimation_ Dependent variable: Real Exchange Rate

• •

s(t) = - 0.7517 – 7.353 tot + 14.43 GCON + 6.35 cflow – 23.34 GW + 20.489 open ( - 1.425) (-1.044) ( 0.227) ( 2.77) (-2.027) ( 1.028)
– 65.87 fp – 1.79 mp + 10.657 ep + e ( -1.536) ( -0.28) ( 5.365) R-squared 0.9079 1.6145 Adjusted R-square 0.8028 n= 16 Sample:: 1991 2006 D-W statistic F-statistic 8.634

– – – – –

– 04/02/08 Value in parentheses are respective t- statistic Nandi coefficients Real Exchange Rate Targeting __ S of the

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Nominal, Exact and Real exchange rates of rupee: 1980 – 1993

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Real Exchange rate and its predicted value from the model

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RER and predicted value from model without the policy variables

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REER of Japan, USA and Euro area
Real Effective Exchange Rate for Industrial Economies
150 140

(1997 January - June = 100)

Japan
130 120 110 100 90

USA

Euro Area

80 1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1 2006M1 Euro Japan United States

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REER of Some Countries [ REER is the weighted average of RER of
countries and weights are the percentage of trade with the partner countries]

Real Effective Exchange Rate for Some Countries
180 160 140 120 100 80
Latin America

Index Number (1990 = 100)

ECA

China
East Asia

India
60 1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1 2006M1 LAC EA7 China India ECA

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Ratio of Exchange rate and Interest Rate Volatility [ data: Int. Fin. Statistics]

60 50 40 30

South East Asian Countries
India

S. Korea 20 10 0 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Hong Kong Korea Malaysia Singapore Thailand China India

China

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References


Edwards, S. , Exchange Rate Misalignment in Developing countries, ( 1988a), Baltimore: Johns Hopkins University Press. Edwards, S (1988b) Real and monetary Determination of Real Exchange Rate Behavior. Journal of Development Economics, 29, 311-341. Devereux, M B, Real Exchange Rates and Macroeconomics: Evidence and Theory, Canadian Journal of Economics, 30, 1997, 773- 808 Isard, P., Exchange Rate Economics, NY, Camb. Univ. Press, 1995.

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