Behaviour and Determinants of Real Effective Exchange Rate of India"

MBA Department of Vidyasagar University organised a two days International Seminar during 25-26 January,2017 on Recent Innovations in Management,Accounting Business and Entrepreneurship.
I have presented a paper on "Behaviour and Determinants of Real Effective Exchange Rate of India"The details of the paper is given below.

In this paper,author endeavours to establish the patterns and trends of Real Effective Exchange Rate of India during 1970-2015 and tries to show the determinants of REER eg,growth rate,current account deficit as per cent of GDP,per cent of openness, foreign direct investment inflows, and foreign exchange reserves excluding gold.The author used semi-log,double log linear and exponential model,autoregession,ARIMA ,GARCH models for trends and volatility.Bai-Perron (2003) model was applied to show structural breaks and Hodrick-Prescott (1997 ) model was applied for smoothness of cyclical trend.Johansen (1988, 1991, 1996) models were used to fit cointegration test and vector error correctons.Residual tests were done to verify autocorrelations, normality and impulse response functions were found to show stability and convergence.

                      The paper concludes that REER has been declining at the rate 0.4085 per cent per year which is insignificant at 5% level during 1970-2015 but it is exponentially declining at the rate of 0.2028 per cent which is significant.AR(1) of REER is convergent,stationary and significant but AR(2) is convergent ,nonstationary and insignificant.Even ARIMA(1,1,1) is nonstationary because AR(1) is stationary but MA(1) is nonstationary.GARCH(1,1) showed insignificant.Thus the series REER is highly volatile.This series contains five significant structural breaks in 1976,1986,1992,(downward)2004 and 2010(upward).It’s pattern is cyclical which was turned to smooth cycle.Trace statistic showed three cointegrating vectors and Max-Eigen Statistic showed two cointegrating vectors that verify cointegration in the order one.Vector Error Correction model is stable because all roots lie in the unit root circle but it is nonstationary because impulse response functions are diverging and error corrections are significant  only in degree of openness and FDI inflows in relating REER during 1970-2015 with one period lag.Residuals test of VECM confirmed non normality and autocorrelations.

         Only sound fiscal and monetary policy can control upward movement of REER so that significant relationships can be achieved with those selected determinants that would spur the growth of international trade.

Key words---Real Effective Exchange Rate, stationary,structural breaks, causality, cointegration,vector error correction

JEL-F15,F31,F32,F36,F43,O13,O24,O54

Behaviour and determinants of Real Effective Exchange Rate of India

I.Introduction

Real Effective Exchange Rate is an important tool in managing international trade and finance and macroeconomic stability in an open economy. It influenced export and import prices and trade volumes. Appreciation and depreciation of REER determined terms of trade, openness, foreign exchange reserves of an economy to at great extent.FDI inflows and current account balance are largely depend on the REER because in the liberalized and globalised world the adjustment in balance of payments is largely correlated with the movement of REER.The REER is closely related with the nominal and real rate by definition when it is trade weighted or export weighted with group of countries. Exchange rate policy whether it is nominal or real controls national inflation and influenced international inflation in which interest rate differential is the crucial and key variable. Today, under globalization REER is closely related with the growth rate also since volatility of REER is the barrier of high growth in which volume of trade affects. According to Balassa-Samuelson effect,volatility of REER influenced export competitiveness and productivity.In calculating REER based with export or trade weighted 36 countries,RBI did not consider productivity.Even,India have not long run data on REER,and NEER. However,India could not predict well the nature of capital account convertibility,the productivity changes and terms of trade changes in relating to REER. Therefore, the task before RBI is crucial because policy of exchange rate also related with monetary and fiscal policies as well.

II.Objective of the study

This paper endeavours to study the behavior patterns of REER and its determinants in India during 1970-2015 where the author assumed that the basic determinants of REER are growth rate,current account deficit as per cent of GDP,openness of the economy,foreign direct investment inflows,foreign exchange reserves excluding gold and so on .The relation were calculated through cointegration and vector error correction models.The policies of REER and limitations of the paper are also the aims of this study. 

VIII.Conclusion

REER of India during 1970-2015 is significantly decreasing exponentially at the rate of0.2028% per year.AR(2),ARIMA(1,1,1) are non stationary, GARCH(1,1) is exstremely volatile.REER has five structural breaks in 1976,1986,1992,2004 and 2010 ,it follows random walk, REER has bidirectional causality with growth rate,current account balance,FDI inflows but unidirectional causality with openness and foreign exchange reserves.

Johansen unrestricted cointegration rank test among REER ,growth rate,current account deficit,trade openness,FDI inflows and foreign exchange reserves assured that Trace Statistic contains three cointegrating equations and Max Eigen Statistic contains two cointegrating equations which determined they are cointegrated in the order one, All the estimated equations of VECM are not good fit except Δx_3t and Δx_4t where error correction processes are significant and even the changes of variables are not related with previous period significantly.

TOT,NEER are not included,model could be explained in pre reform and post reform period and in different exchange rate regime.It is necessary to reduce inflation,to rise foreign exchange reserves,to increase trade surplus and to rise productivity which will lower cost that may decrease price level and REER.

More the protection the less is the REER volatility,so avoid capital account liberalization. Again,the higher the foreign exchange reserves the lower is the commodity TOT shock to REER which tends to lower volatility of REER. RBI is trying to resist volatility of REER and formulates [i] to develop skill in dealing spot and foreward market,[ii] to compete with FED rate by reducing interest rate,[iii] to increase in outflow of port folio which will call for new exchange rate and monetary policy,[iv] to allow alternative exchange rate policy to check appreciation of REER which enhance capital inflows,[v] to monitor excessive exchange rate depreciation which follows loss of foreign exchange reserves during macro economic shocks ,[vi] thus Rajan said India needs macroeconomic stability.