Rupee voltility, twin deficits and exchange rate policy


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Rupee voltility, twin deficits and exchange rate policy

  1. 1. Rupee Volatility, Twin Deficits and Balance of Payments avadhoot nadkarni University of Mumbai 1
  2. 2. Outline• Effect of exchange rate volatility on trade• Long run versus short run volatility• India’s Exchange rate policy: Constancy of REER• Equilibrium real exchange rate in medium term• Twin deficit problem and BOP• Financing of imports• Diversification of exports 2
  3. 3. Broad Conclusions• The real exchange rate is in equilibrium from the medium to long run point of view• The BOP trends indicate problems in financing the import demand that would be necessary for and is generated by growth. K inflows become important• The export basket is not yet as diversified as one would expect from the hype about our growth and external sector experience. 3
  4. 4. Exchange Rate Volatility• Exchange rate volatility is expected to decrease international trade due to uncertainty of domestic currency receipts• Export margins especially for Heckscher-Ohlin goods (labor-intensive and bulk goods in the context of developing country exports) are thin• Hedging in forward markets involves additional costs 4
  5. 5. Exchange Rate Volatility• Studies show that measure of exchange rate volatility (e.g. standard deviation) enter a regression equation explaining trade with a significant estimated negative coefficient confirming the adverse effects of volatility on trade.• This effect is over and above the standard effect of exchange rate on trade, i.e., a depreciated domestic currency in real terms increases trade. 5
  6. 6. Volatility in the Indian Context• Volatility can be either in the short run or in the long run. The standard deviation of the exchange rate of a currency steadily depreciating in the long run could be as high as (or even higher than) that of a currency volatile in the short run around a steady long run level.• Moreover the volatility can be measured either in nominal terms or in real terms. 6
  7. 7. Volatility in the Indian Context• The bilateral nominal exchange rates of the rupee w.r.t. major currencies exhibits greater volatility than the real effective exchange rate (REER).• In a situation of generalized floating, it is the EER which is more relevant; and in particular the inflation adjusted EER, i.e., REER• The Indian Exchange Rate Policy has effectively been to hold the REER constant over the long run 7
  8. 8. Exchange Rate Policy 1• India follows a managed floating exchange rate regime• The avowed exchange rate policy of the RBI is that the rate is basically determined by the market, but since the market-determined rate tends to be volatile, the RBI manages the rate to avoid excess volatility in the market• This implicitly means that the RBI does not influence the level of the rate
  9. 9. Exchange Rate Policy 2• Yet the Real Effective Exchange Rate of the rupee has been relatively stable over the entire period• It can be said that volatility is being avoided not only in the short run, but also in the long run!• Apparently, the nominal rate is being managed to maintain the real rate in the face of higher domestic inflation compared to the trading partners
  10. 10. 120.00100.00 NEER vs. REER (36 Countries) 80.00 60.00 NEER-36 REER-36 40.00 20.00 0.00
  11. 11. NEER & REER (1993-94 to 2004-05)110.00105.00100.00 95.00 REER 90.00 NEER 85.00 80.00 75.00 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 11
  12. 12. NEER & REER (2005-06 to 2011-12) 120.00 100.00 80.00 60.00 REER 40.00 NEER 20.00 0.00 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 12
  13. 13. Exchange Rate Policy in the Short Run• There have been periods of spurts in capital inflows when the exchange rate appreciation is allowed within limits even at the cost of sacrificing potential build-up of reserves that could be useful in defending the rate when it tends to depreciate. So also depreciation within limits is allowed at times. But overall the REER has been maintained constant 13
  14. 14. Relevant Concept of Real Exchange Rate in the Medium to Long Run• The relevant concept of RER is not the one associated with Px/Pm in a Keynesian model but Pt/Pn as in a Dependent economy model• Mechanisms of BOP adjustment through exchange rate changes differ in the two models• Unemployed resources brought into use in one model and resource transfers across sectors in the other. 14
  15. 15. Real Exchange Rate• From the medium to long run point of view of profitability of the tradable goods sector, the current real exchange rate (proxy: REER) seems to be the equilibrium rate.• The huge current account deficit in the short to medium term is then explained by the twin- deficit problem via the Absorption approach 15
  16. 16. Absorption Approach and the Twin Deficits• Y = C + I + G + (X – M) = A + B• B=Y–A• X – M = (S – I) + (T – G)• M – X = (I – S) + (G – T)• The 5.6 per cent CAD is explained ex post by the large fiscal deficit in the economy which spills over into the CAD creating the BOP problem in the economy. 16
  17. 17. BOP Problem in the Economy• Analyzed by examining the trends in the quarterly RBI BOP data for the period 2000-01 Q1 to 2011-12 Q4 from the Handbook of Statistics and RBI Bulletin August 2012.• All values normalized by imports as financing of imports is the constraint 17
  18. 18. 0.00 20.00 40.00 80.00 100.00 120.00 60.00 1950-51 1953-54 1956-57 1959-60 1962-63 1965-66 1968-69 1971-72 1974-75 1977-78 X/IM 1980-81 1983-84 1986-87 1989-90 1992-93 1995-96 1998-99 2001-02 2004-05 Percentage of Imports covered by 2007-08 Exports (Annual Data from 1950-51)18 2010-11
  19. 19. Per Cent of Imports covered by Exports (Five Year Periods)100 90 80 70 60 50 40 30 20 10 0 1971-75 1956-60 1986-90 2001-05 2010-11 19
  20. 20. 0.00 10.00 30.00 40.00 50.00 60.00 70.00 80.00 100.00 20.00 90.00 2000-01:Q1 2000-01:Q3 2001-02:Q1 2001-02:Q3 2002-03:Q1 2002-03:Q3 2003-04:Q1 2003-04:Q3 2004-05:Q1 2004-05:Q3 2005-06:Q1 2005-06:Q3 2006-07:Q1 2006-07:Q3 2007-08:Q1 2007-08:Q3 2008-09:Q1 Exports (Qtly Data) 2008-09:Q3 2009-10:Q1 2009-10:Q3 2010-11:Q1 2010-11:Q3 Percentage of Imports covered by 2011-12:Q1 2011-12:Q320
  21. 21. -5.00 0.00 10.00 15.00 20.00 25.00 5.00 2000-01:Q1 2000-01:Q3 2001-02:Q1 2001-02:Q3 2002-03:Q1 2002-03:Q3 2003-04:Q1 2003-04:Q3 2004-05:Q1 2004-05:Q3 2005-06:Q1 2005-06:Q3 2006-07:Q1 2006-07:Q3 2007-08:Q1 2007-08:Q3 2008-09:Q1 2008-09:Q3 2009-10:Q1 2009-10:Q3 2010-11:Q1 2010-11:Q3 2011-12:Q1 Financing of Imports by Services 2011-12:Q321
  22. 22. 0.00 5.00 10.00 20.00 25.00 30.00 35.00 40.00 15.00 2000-01:Q1 2000-01:Q3 2001-02:Q1 2001-02:Q3 2002-03:Q1 2002-03:Q3 2003-04:Q1 2003-04:Q3 2004-05:Q1 2004-05:Q3 2005-06:Q1 2005-06:Q3 2006-07:Q1 2006-07:Q3 2007-08:Q1 2007-08:Q3 2008-09:Q1 2008-09:Q3 2009-10:Q1 2009-10:Q3 2010-11:Q1 2010-11:Q3 2011-12:Q1 Financing of Imports by Transfers 2011-12:Q322
  23. 23. 0.00 -16.00 -12.00 -10.00 -8.00 -6.00 -4.00 -2.00 -14.00 2000-01:Q1 2001-02:Q1 2002-03:Q1 2003-04:Q1 2004-05:Q1 2005-06:Q1 2006-07:Q1 Income/M 2007-08:Q1 2008-09:Q1 2009-10:Q1 2010-11:Q1 2011-12:Q1 “Financing” of Imports by Income Income/M23
  24. 24. 10.00 15.00 20.00 25.00 30.00 0.00 5.00 -10.00 -5.00 2000-01:Q1 2000-01:Q2 2000-01:Q3 2000-01:Q4 2001-02:Q1 2001-02:Q2 2001-02:Q3 2001-02:Q4 2002-03:Q1 2002-03:Q2 2002-03:Q3 2002-03:Q4 2003-04:Q1 2003-04:Q2 2003-04:Q3 2003-04:Q4 2004-05:Q1 2004-05:Q2 2004-05:Q3 2004-05:Q4 2005-06:Q1 2005-06:Q2 2005-06:Q3 2005-06:Q4 2006-07:Q1 2006-07:Q2 2006-07:Q3 2006-07:Q4 2007-08:Q1 Investment 2007-08:Q2 2007-08:Q3 2007-08:Q4 2008-09:Q1 2008-09:Q2 2008-09:Q3 2008-09:Q4 2009-10:Q1 2009-10:Q2 2009-10:Q3 2009-10:Q4 2010-11:Q1 2010-11:Q2 2010-11:Q3 Financing of Imports by Foreign 2010-11:Q4 2011-12:Q1 2011-12:Q2 2011-12:Q324 2011-12:Q4
  25. 25. 0.00 10.00 20.00 30.00 40.00 -30.00 -20.00 -10.00 2000-01:Q1 2001-02:Q1 2002-03:Q1 2003-04:Q1 2004-05:Q1 2005-06:Q1 2006-07:Q1 2007-08:Q1 2008-09:Q1 2009-10:Q1 2010-11:Q1 Financing of Imports by Loans 2011-12:Q125
  26. 26. 10.00 15.00 20.00 25.00 30.00 0.00 5.00 -20.00 -15.00 -10.00 -5.00 2000-01:Q1 2001-02:Q1 2002-03:Q1 2003-04:Q1 2004-05:Q1 2005-06:Q1 2006-07:Q1 2007-08:Q1 Capital 2008-09:Q1 2009-10:Q1 2010-11:Q1 2011-12:Q1 Financing of Imports by Banking Banking K/M26
  27. 27. 10.00 30.00 20.00 40.00 0.00 -30.00 -10.00 -20.00 2000-01:Q1 2001-02:Q1 2002-03:Q1 2003-04:Q1 2004-05:Q1 2005-06:Q1 2006-07:Q1 2007-08:Q1 Imports 2008-09:Q1 2009-10:Q1 2010-11:Q1 2011-12:Q1 Current Account Normalised by CurAc/M27
  28. 28. Financing of Imports over the Three PeriodsPeriod Exports Services Transfers Income Foreign I Loans Banking K2001-04 81.01 6.70 26.17 -6.81 11.35 -0.96 6.312005-08 67.67 14.54 16.42 -3.49 11.30 10.67 2.382009-12 62.35 13.80 14.75 -3.04 9.26 4.44 0.88Period Current Account Normalised by Imports2001-04 7.072005-08 -4.862009-12 -12.14 28
  29. 29. Export Diversification Problem• Analyzed through UN Comtrade data at 5-digit level (SITC Rev 3) for two biennia 1993-1994 and 2005-2006.• Ref: ‘Diversification of India’s Exports in the Post Reforms Period’ by A. Nadkarni and F. Desai, March 2012, Department of Economics, University of Mumbai 29
  30. 30. Commodity Classes (SITC Rev 3: 5 digit level)• Primary products• Resource-based products (RB1, RB2)• Low technology products (LT1, LT2)• Medium technology products (MT1, MT2,MT3)• High technology products (HT1, HT2) 30
  31. 31. Primary & Resource-based Exports• More than 40 per cent of our total exports are still clocked in the primary and resource-based category, though, within these two categories at the lower end, we are clearly vacating the lowest rung of the product category, viz., primary product exports, and shifting to resource-based products. 31
  32. 32. Low Technology Exports• Low technology exports still clock about 35 per cent of our total exports. The small observed decline of about three percentage points in the low technology category is due to a decline in the LT1 category. The LT2 category has actually increased in importance. The two low technology groups are now about equally important in the export basket. 32
  33. 33. Primary, Resource-based & Low Technology Products• It follows that the share of resource-based and low technology exports together is still as high as three-fourths of the total. 33
  34. 34. Medium & High Technology Products• The importance of medium and high technology products in the export basket increased from about 14 per cent to 24 per cent over the period and is thus still less than one-fourth of the total. Within these groups, though, the importance MT3 has increased more than that of MT1 or MT2 and that of HT2 is increased more than that of HT1. 34
  35. 35. Shifts within LT, MT & HT• It is interesting to note that though the rightward shift has not been substantial in terms of broad commodity classes, within these classes there is a shift in relative from the lower to the higher classes, i.e., a shift to LT2 from LT1, to MT3 from MT1 and MT2, and to HT2 from HT1. 35
  36. 36. Country Categories Developing Developed Africa (5) - America (3) America Asia (4) Asia Oceania Oceania - Europe Transition Economies 36
  37. 37. Geographical Concentration• The geographical concentration of our exports in terms of broader regions has actually increased. Exports to the top three importing regions, viz., Developing Asia, Developed Europe and Developed America have actually increased from 81 per cent of the total in 1993/1994 to 83 per cent of the total in 2005/2006.• Between these three groups, however, there has been a shift from Developed Europe to Developing Asia, though Developed America has been able to maintain its share at one-fifth of the total. The share of Developed Asia (which includes Japan) has more than halved from 8.48 per cent to 3.79 per cent. 37
  38. 38. Geographical Distribution• Even in terms of geographical distribution of exports, as in the case of commodity composition, the shifts within the broader regions are interesting. Thus, within Developing Africa, the shift is from East to West Africa. Within Developing Asia too, the importance of West Asia has increased in relation to that of the other sub-regions like south-east Asia. The share of West Asia in total exports increased from around 10 per cent to 15 per cent of the total. 38
  39. 39. Look East Policy• The ‘Look East’ policy can be said to have succeeded in broader terms in shifting our exports from the developed west to developing countries in general, though not necessarily to the developing east in particular. 39
  40. 40. Country-Commodity Intersection I• On the intersection of commodity composition and geographical distribution, the top two product classes exported to the major regions covering more than 85 per cent of our exports have remained unchanged between the two periods: – Resource-based and low technology products, in that order, to developing Asia, – Low technology and resource-based products to developed America and developed Europe, – Resource based and primary products to developed Asia.• Resource-based products dominate in each of the major regions, either as the most or next most important commodity export. 40
  41. 41. Country-Commodity Intersection II• Similarly, the top two destinations of any major commodity class have also remained unchanged between the two periods. The major destination for most of the commodity classes is developing Asia and the second major one is developed Europe.• One exception is low technology exports wherein the positions are reversed – developed Europe is the major destination and developing Asia comes next in both the periods.• The other exception is resource-based products where developed America, and not developed Europe, is the second important destination.• Developing Asia is, however, becoming even more dominating in two of the four commodity classes it leads in, viz., primary products and resource-based products, whereas developed Europe is reducing its lead over Developing Asia as a market for Indian exports of low technology products. 41
  42. 42. Country-Commodity Intersection III• Our exports to the developed world markets of America, Europe and Oceania still consist largely of low technology exports. 42
  43. 43. New Commodities• About 8.5 per cent of the commodities exported in 2005/ 2006 were new in the sense that they did not exist in the export basket in 1993/1994.• About 70 per cent of these were primary or resource-based. Only about 20 percent were in the medium and high technology category.• In terms of value however, nearly 40 per cent of the new exports were in the medium technology category and close to 30 per cent in the low technology class, though the exports in the high-technology class were less than 3 per cent. The value of new exports in the primary and resource-based class was less than 30 per cent.• The discordance between the distribution of the number of new commodities in different classes and of their values clearly points to our failure in increasing exports in the high unit value medium and high technology classes. 43
  44. 44. New Commodities: GeographicalDistribution & Commodity Intersection• Close to 60 per cent of our new exports went to developing Asia. Developed America took in only about 5 per cent, though developed Europe absorbed nearly one fourth.• Close to 50 per cent of the new exports to developing Asia were in the medium technology category. New exports to developed Europe were much more diversified. More than one-fifth of the new exports to developed America were in the high technology category. 44
  45. 45. Thank You 45