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ANNEX: Determinants of India’s Long-Run Equilibrium Real Effective Exchange Rate
25. This annex describes a model of India’s long-run equilibrium REER based on annual data for 1979/80–1997/98, and examines the issue of misalignment of the rupee from an econometric point of view.
Prepared by Dimitri Tzanninis.
The Balassa-Samuelson effect describes the process by which higher productivity growth in the tradable than in the nontradable goods sector (relative to partner countries) leads to wage and price increases in the nontradable goods sector, and to a real appreciation of the currency.
India’s fiscal year starts April 1.
However, it is difficult to detect any Balassa–Samuelson effects during the 1980s due to the overvaluation of the currency and the prevailing price and trade controls.
The effective import-weighted tariff rate has been lowered from 87 percent in 1990/91 to about 30 percent in 1997/98.
It is reasonable to view the REER in March 1993 as consistent with a stable equilibrium in the external position. The unification of exchange rates set the rupee at a competitive and sustainable level from the point of view of movements in both domestic prices and the external current account; since then, the net flow of foreign assets and the external debt have followed sustainable paths.
Countries with bilateral competitive weights below one percent are excluded from the calculations of effective exchange rates in the INS. For a description of the methodology and the data used to compute the effective exchange rate indices in the INS, see Desruelle and Zanello (1997).
The term “CPI-based REER” is used to reflect the use of consumer prices for partner countries in the calculation of the REER. For India, however, rather than the CPI, the wholesale price index (WPI) is used in the INS calculations because it is the widest and most timely price indicator.
The RBI also uses the WPI for India in its calculations of a CPI-based REER. See Reserve Bank of India (1993).
There has been a gradual increase in the share of Asian countries in India’s exports in recent years. The share of all Asian countries in India’s exports increased from 24 percent in 1990/91 to 29 percent in 1996/97, with the trend broadly continuing in 1997/98 despite declining exports to the countries primarily affected by the financial crisis. In 1997/98, exports to the subset of Southeast and East Asian countries accounted for about 20 percent of India’s exports, while imports from those countries accounted for about 15 percent of total imports.
The cumulative weights of the countries of the European Union in the RBI’s REER index are 13.9 percentage points lower than their cumulative weights in the INS. Moreover, the weight of the U.S. is 3 percentage points higher than its weight in the INS.
The effect is more pronounced in the mid-1980s and early 1990s, when more drastic changes in India’s trade and exchange regimes took place. Such an effect is more likely to be important when examining countries at different levels of development, such as India and its major trading partners (the G-7 countries). The existence of the Balassa-Samuelson effect is tested directly in section D.
The measurement of the extent of misalignment is complicated by the fact that the “equilibrium” REER is an unobservable variable. In this chapter, misalignment is defined as the deviation (in percent) of the actual REER from its estimated equilibrium level. In interpreting the results, it is worthwhile noting that the notion of equilibrium used is a statistical one rather than one that would be consistent with macroeconomic balance as defined by economic theory.
The HP filter is a generalization of the trend-stationary hypothesis used in the literature on real exchange rates. Although the HP filter is devoid of theoretical underpinnings and gives excessive weight to the most recent observations (the end-period problem), it is often used because of its computational simplicity. To avoid the end-period problem, actual data for the REER through June 1998 were used but the results were truncated at end-March 1998.
See Agénor and Hoffmaister (1996), and Clark and MacDonald (1998) for the application of HP filters to estimate the extend of misalignment of REERs. Chinn (1998) used a simplified version of the trend-stationary hypothesis by employing a linear deterministic trend to calculate equilibrium REERs.
See Beveridge and Nelson (1981). Several studies have used this method mainly to compute the extent of misalignment of REERs. See, for example, Agénor and Hoffmaister (1996), and Calvo et al (1995). Patel and Srivastava (1998) used this method to compute the correlation between the temporary component of India’s REER and cyclical impulses such as inflation.
While keeping in mind the inherent imprecision of econometric estimates, the somewhat higher degree of misalignment found with this method apparently captures the aggregation effect of annual data, which are unable to identify turning points within a year. By the other two methods employed to measure the degree of misalignment, the overvaluation of the rupee in the first half of 1997/98 had, to a significant extent, been corrected by end-March 1998.
The estimated overvaluation (1–3 percent by all three methods used) in 1997/98 is not large relative to past deviations of the REER from its equilibrium. Historically, misalignments of the rupee have tended to correct themselves within two years.
Using annual data for India, Patel and Srivastava (1998) were also unable to establish a long-run link between fiscal policy (deficit-to-GDP ratio) and the REER.
For example, net portfolio and foreign direct investment inflows—which have accounted for the bulk of capital inflows in recent years—amounted to 1.2 percent of GDP in 1997/98, substantially lower than most Asian economies.
Srinivasan estimated the elasticity of India’s exports with respect to the REER in the range of (−0.304, −0.278) in the short run and (−0.537, −0.493) in the long run.
Reliable data on the extent of quantitative restrictions on imports as well as on other nontariff barriers are not available for the full sample period.
Capital inflows rather than a real interest rate differential was chosen as a fundamental determinant of India’s REER. This choice was dictated by the fact that India maintained a relatively closed capital account for most of the period under examination that did not allow the prevailing high interest rate differential to manifest itself in large-scale capital inflows.
Available data on sectoral productivity do not extend beyond 1993/94.
Preliminary regressions did not find evidence of fiscal variables (government consumption to GDP, and government investment to GDP) belonging to the long-run relationship. While this result may be consistent with fiscal policy having only a short-run effect on the REER, it may also indicate that the variables used were poor proxies for testing the hypothesis that government expenditure is relatively concentrated on nontraded goods.
A common cointegrating relationship could not be obtained when the capital inflows variable was included. By contrast, Patel and Srivastava (1998) were able to obtain such a relationship for India, but they did not elaborate on how the capital inflows variable was defined.
Estimation and testing were carried out in PcFiml. The small sample size (19 annual observations) was sufficient for the Johansen procedure to be conclusive despite the loss of degrees of freedom due to the lag structure of the estimated system. Given that the fewer the degrees of freedom the harder it is to reject the null hypothesis of no cointegrating relationship, the reported results are thus relatively powerful.
It is unclear to what extent the large misalignment of the rupee in 1991/92 and 1992/93 (around 13 percent) reflects actual misalignment or a statistical error in the standard econometric sense (that is, the combined effect of temporary and random factors). This period coincides with a sharp depreciation of the rupee in nominal terms that might have overshot the long-run equilibrium rate.