Exchange Rates and Merchandise Trade in Liberalised India

Suranjali Tandon

• Publisher: Routledge India
• Year: 2019
• Print ISBN: 9780367431990
• eBook ISBN: 9781000020236
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book examines the linkages between exchange rates and India's merchandise trade since the 1990s. It looks at India's trade in the post-liberalisation period through its two main components: commodities and trading partners, and provides a bird's eye view through aggregate analyses accompanied by a historical narrative of the evolution of trade and exchange rate dynamics. Presenting a comprehensive analysis of bilateral and product-specific trade, the book explores the impact of exchange rate on labour intensive sectors and charts out major development. It also offers compelling evidence to suggest that if some commodities are identified as integral to India's export plans, then the impact of exchange rate must be weighed by the Reserve Bank of India (RBI) prior to a market intervention.

This timely volume will be of interest to scholars and researchers of economics, business and finance, development studies, trade, business, and industry as well as practitioners, think-tanks, and policy makers.

Chapter 1
Introduction

Episodes of sharp exchange rate depreciation reignite interest in its possible economic ramifications. During such times, the central bank, in an economy with a managed float, is confronted with the difficult choice either to intervene to stall such depreciation or to resort to inaction. The decision to intervene is based on a variety of macroeconomic considerations. However, one consideration that often gets cited to discourage the central bank from stepping in is that depreciation could make the country’s exports relatively competitive as well as render imports dearer. The change in prices denominated in foreign currency would in turn correct the imbalance in the trade account. Those familiar with the empirical literature on the subject know that such assumed causation or adjustment may vary circumstantially. The lack of agreement on the direction of impact is rooted in theory, where two schools of thought – Keynesians and monetarists – offer alternate explanations of the processes of adjustment that ensue following a depreciation.

Within the Keynesian theoretical tradition, two main explanations are provided for the processes of adjustment: the elasticities approach and the absorption approach. As per the elasticities approach, depreciation of the domestic currency must result in higher export proceeds¹ and lower imports if the demand and supply elasticities permit. The condition when such an impact will be realised is formally called the Marshall-Lerner Condition.² This condition, put simply, requires that when currency depreciates, a country that does not hold a dominant position in the global market must have an elasticity of exports and imports that together exceed one, for the trade balance to improve. Even when the elasticities are such as to lead to a positive response of the trade balance to exchange rate depreciation, pre-contracted trade along with invoicing of trade in foreign currency may delay such a response. Such lagged improvement in the trade balance is referred to as the J-curve effect. That is, a temporary worsening of the trade deficit is followed by an improvement.

The other Keynesian approach – which is known as the absorption approach – looks at the balance of payments as a reflection of the macroeconomic aggregates in the economy. In this case, the impact of the exchange rate is to affect absorption (expenditure) differently from income: so depreciation improves the balance of trade to the extent that expenditure, which is consumption plus investment, increases less than income. Here, imports are seen as a function of the level of income.

These approaches assume that a nominal depreciation results in a real devaluation as well, even if not to the same extent. The real exchange rate is the nominal exchange rate expressed in domestic currency unit deflated by the ratio of domestic to foreign prices. Thus, for the Keynesian process of adjustment to take place, the relative prices would have to remain unchanged.

By contrast, monetarists argue that changes in the nominal exchange rate result in changes in domestic prices such that there is no change in the real exchange rate, and therefore nominal devaluation has no impact on trade. The purchasing power parity hypothesis posits a positive (45-degree line) relationship between the exchange rate and the domestic price level. This occurs because individuals demand more of the currency with the higher purchasing power, so domestic price change results in nominal depreciation. Similarly, nominal exchange rate depreciation results in an increase in domestic prices to the point that there is no change in the real exchange rate. Most monetarist theorists now accept this as a long-run tendency and accept that some short-run effects of nominal exchange rates on the trade balance may occur.

The above discussion provides the theoretical grounding. However, as is often observed, the question of whether exchange rate movements can impact the merchandise trade does not have a simple answer. In 2014, I undertook a statistical analysis of the exports and imports of 16 major trading countries – Austria, Brazil, China, Denmark, France, Germany, Italy, Japan, Malaysia, Mexico, the Philippines, Norway, the Netherlands, Singapore, Switzerland, and the United Kingdom (UK), for the period 1980–2010. The estimated results show that for countries such as China, Brazil, Malaysia, the Philippines, and Mexico, exchange rate depreciation led to an improvement in the trade balance. As for the countries in the Euro Zone, the response of the exchange rate is not symmetric across member countries. For France and Italy, an improvement is observed in trade deficit with depreciation, whereas the obverse is observed for the rest. Without further detail, the evidence provided here makes clear that there are no clear-cut responses. Work by other authors, specifically focussing on India, does not present a clear answer to this question. Motivated by these results observed in my earlier work, and by those for India – which, until I began this study, were largely restricted to the pre-liberalisation era – I chose to examine the question specifically in the context of post liberalisation.

Other than the dearth of systematic study on the subject, developments in the India economy were an even more compelling reason to pursue the theme of research. In 2013, the Indian rupee depreciated sharply. Responding to such sharp depreciation, experts and policy makers presented different views. A few suggested that the exchange rate depreciation could encourage exports. The fact that this was being conjectured, and no evidence was available to conclude, created the need to examine this in the Indian context. In trying to unravel the dynamics underlying such an observed relationship, a series of evidence was found and is presented in this book to explain why and when the exchange rate changes are expected to influence merchandise trade.

The book begins by introducing the reader to market for exchange rates. The whole process of adjustment – beginning from the source of the observed exchange rate movements, to price changes, and finally the response of the trade account – must be understood prior to interpreting the statistical results. Further, to say why we see the results we do, it is important to have a reasonable understanding of the structure of trade and the principal drivers of this trade. This book, therefore, begins by providing a broad overview of India’s external account followed by the first set of econometric results to show the exchange rate–trade relationship for the overall economy. The exploration of these results opened up a new dimension for examination. It was not unknown, in the case of India, that the exchange rate could elicit different responses for trade in different commodities. However, this evidence was not systematically presented in a single document, neither was there any attempt to rationalise the impact observed for the overalls using commodity composition. Building on the preliminary findings that the exchange rate will have a certain kind of impact depending on the structure of the trade, and the underlying regulatory and market dynamics, this book provides detailed evidence for top items exported and imported by India (Chapter 3), then proceeds to analyse bilateral trade (Chapter 4).

Therefore, within the broad theme – whether exchange rate changes affect merchandise trade – the book asks if there are patterns that explain the evident impact or the lack thereof. While doing so, the various forces at play, such as government intervention, international agreements, and regulatory sanctions, are documented. The details, though seemingly a digression, in Chapters 2 and 3 are veritable to the principal question being addressed.

The analysis carried out in each chapter is for the period after liberalisation. However, I must caution the reader that these may not be consistent across chapters. This is because the data available to present a cogent argument, using price and quantity information, are taken from alternative sources. The information available across such sources of information is for different time periods presented herein. The positive outcome of this exercise is that despite the disparate time periods selected across different analyses, the results remain consistent. That is, the results remain unchanged even if the time period varies for the disaggregate analysis based on commodity and country.

Going back to the important question: should the Central Bank intervene at all, and would letting exchange rates be bring about the desired change? The results presented here allow policy makers to reflect the different kinds of changes that are set in motion once the exchange rate appreciates or depreciates sharply. In fact, at the end of this book, we may be able to say whether the exchange rate remains a tool that the government can employ to influence exports and imports.

Notes

1 Except for the perverse cases where the demand for exports is completely inelastic.

2

$$\left(\frac{{ϵ}_x\left({\eta }_x-1\right)}{{ϵ}_x+{\eta }_x}+\frac{{\eta }_m\left({ϵ}_m+1\right)}{{ϵ}_m+{\eta }_m}\right)>0$$

Where ε_x and ε_m denote the elasticity of supply of exports and imports respectively, and, η_m and η_x are the elasticity of demand for exports and imports respectively.

Chapter 2
Exchange rate movements and trade patterns in India

Introduction

Occasions of sharp exchange rate depreciation tend to revive the unresolved debate on whether such depreciation can augment a country’s exports. The evidence for different countries does little to resolve this debate. It is seen that movements in exchange rates have differing impacts on the trade balances of different countries (Tandon, 2014). For this precise purpose, this book presents systematic evidence for India in the period post liberalisation. The observed causalities derive their explanation from history and the structure of economic activity.

As is known, the exchange rate system in India has evolved from a fixed pegged to the pound sterling in the 1970s to the present managed float. The conduct of monetary policy varies across regimes. In the case of a fixed exchange rate, there is an explicit commitment to a peg whereas a liberalised or floating exchange rate restricts the intervention by the Central Bank, if it intervenes at all, to extra-ordinary circumstances. Theoretically, the merit of the floating exchange rate is that it allows an economy to pursue an independent monetary policy. The floating exchange rate system also redistributes the burden of adjustment from the domestic economy to the external account in the circumstance of a crisis. However, the reduced burden of adjustment on the domestic economy comes at the expense of increased volatility. India has observed several episodes of pronounced volatility and sharp current account imbalances.

The theory of purchasing power parity suggests that movements in the nominal exchange rate are accompanied by adjustments in domestic prices so as to keep the real exchange rate unchanged. However, there is evidence that suggests the contrar...

Table of contents

• Cover
• Half Title
• Series Page
• Title
• Copyright
• Dedication
• Contents
• List of figures and tables
• Preface and acknowledgements
• 1 Introduction
• 2 Exchange rate movements and trade patterns in India
• 3 Commodity-wise trade and impact of the exchange rate
• 4 Bilateral trade and exchange rates
• 5 Conclusion
• Postscript: the world we are in now
• Index