REAL EFFECTIVE EXCHANGE RATE OF INDIA:PATTERNS AND DETERMINANTS

INTERNATIONAL JOURNAL FOR RECENT TRENDS IN BUSINESS AND TOURISMVOLUME-1,ISSUE-4,2017,OCTOBER--LINCOLN UNIVERSITY COLLEGE , MALAYSIA

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REAL EFFECTIVE EXCHANGE RATE OF INDIA: PATTERNS AND DETERMINANTS

Debesh Bhowmik

Former Principal, International Institute for Development Studies, Kolkata, India

Corresponding Author Email: debeshbhowmik@rediffmail.com

ABSTRACT

In this paper, author endeavors to establish the patterns and trends of Real Effective Exchange Rate of India during 1970-2015 and tries to show the determinants of REER e.g., growth rate, current account deficit as percent of GDP, percent of openness, foreign direct investment inflows, and foreign exchange reserves excluding gold. The author used semi-log, double log linear and exponential model, autoregression, ARIMA, GARCH models for trends and volatility. Bai and Perron (2003) model was applied to show structural breaks and Hodrick and Prescott (1997 ) model was applied for smoothness of cyclical trend. Johansen (1988, 1991, 1996) models were used to fit co-integration test and vector error corrections. 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 percent per year which is insignificant at 5% level during 1970-2015 but it is exponentially declining at the rate of 0.2028 percent which is significant. AR(1) of REER is convergent, stationary and significant but AR(2) is convergent, non-stationary and insignificant. Even ARIMA(1,1,1) is non-stationary because AR(1) is stationary but MA(1) is non-stationary. 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). Its 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 non-stationary 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.

Keywords- Real Effective Exchange Rate, Stationary, Structural Breaks, Causality, Co-integration, Vector Error Correction

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 a 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 matters. According to Balassa-Samuelson effect, volatility of REER influences export competitiveness and productivity. In calculating REER based with export or trade weighted 36 countries, RBI did not consider productivity. Even, India has 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 is also related with monetary and fiscal policies as well.

(A) Objective of the study

This paper endeavors to study the behavioral 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 percent of GDP, openness of the economy, foreign direct investment inflows, foreign exchange reserves excluding gold and so on. The relations 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.

(B) Methodology and Data

Semi-log, and double-log regression models have been used for trends and relations and exponential model was used also for goodness of fit. AR(1), AR(2), ARIMA(1,1,1) and GARCH(1,1) models were applied to show autoregression, stationary and volatility analysis. Bai-Perron (2003) model was applied to find structural breaks. Granger  model(1969) was used to get causality. Hodrick-Prescott Filter model (1997) was used to find smoothness of cycles which allows to manage the exchange rate volatility. Johansen models (1988, 1991, 1996) were applied for cointegration and vector error correction analysis. Moreover, residual tests of VECM were also done for autocorrelation and normality. The data of REER, growth rate, current account deficit, openness, FDI inflows and foreign exchange reserves during 1970-2015 have been collected from RBI, World Bank and International Financial Statistics(IMF).

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