International Journal of Economics, Commerce and Research (IJECR) ISSN 2250-0006 Vol.

2, Issue 4 Dec 2012 9-16 TJPRC Pvt. Ltd.,

EXCHANGE RATE BEHAVIOUR AND MANAGEMENT IN INDIA: ISSUES AND EMPIRICS

ASWINI KUMAR MISHRA1 & RAHUL YADAV2
1

Asst. Professor,Bits, Pilani-K.K.Birla Goa Campus, Goa,India

2

Msc.(Hons.),Bits, Pilani-K.K.Birla Goa Campus, Goa,India

ABSTRACT
Drawing from the strand of literature, this paper attempts to find some stylized facts about the rupee-dollar exchange rates (ER) based on Hooper-Morton model by relating it with five very important macroeconomic variables namely; Money Supply (MS), Real Inflation Rate (RIR), Real Output (Y), Inflation Rate (IR) and Trade Balance (TB) for both domestic and foreign economy. The findings based on Vector Autoregressive (VAR) model confirm most of the stylized facts such that RIR and MS have prominent effects on ER. But, the interesting thing obtained here is that IR does not directly affect ER. There is an indirect causal relationship between IR and ER with intermediate changes in RIR i.e. any change is IR will lead to change in RIR which in turn changes ER. The dependency of ER on Y is also obtained from the present study. These findings can be very useful for determining Indian exchange rate (ER) taking into account the policy instruments at the RBIs disposal and domestic as well as foreign monetary conditions.

KEY WORDS: Exchange Rate, Vector Autoregressive (VAR) Model, Policy Instruments INTRODUCTION
The exchange rate is a key financial variable that affects decisions made by all economic agents in the developed as well as developing world. Exchange rate fluctuations affect the value of international investment portfolios, competitiveness of exports and imports, value of international reserves, currency value and the cost to tourists in terms of the value of their currency. E.g., trade is like a fulcrum in the inter-country interactions. It not only has an economic significance of reducing the cost of the world and increasing overall profits but also political significance where it becomes an integral part of negotiations between countries. The purchasing power of a country determines the ease of buying goods and merchandise from the world for that country and it is determined by the currency value or exchange rate. Another example can be of Domestic Investment which is also highly dependent on the exchange rate volatility because of high exchange rate risk at the time of volatility. Movements in exchange rates thus have important implications for the economys business cycle, trade and capital flows and are therefore crucial for understanding financial developments and changes in economic policy. India has been operating on a managed floating exchange rate regime from March 1993, marking the start of an era of a market determined exchange rate regime of the rupee with provision for timely intervention by the central bank. Indias exchange rate policy has evolved overtime in line with the global situation and as a consequence to domestic developments. 1991-92 represents a major break in policy when India harped on reform measures following the balance of payments crisis and shifted to a market determined exchange rate system. As has been the experience with the exchange rate regimes the world over, the Reserve Bank of India (RBI) as the central bank of the country has been actively participating in the market dynamics with a view to signaling its stance and maintaining orderly conditions in the foreign exchange market. These include careful monitoring and management of exchange rates with flexibility, no fixed target or a

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Aswini Kumar Mishra &Rahul Yadav

preannounced target or a band and ability to intervene, if and when necessary. Hence, this position demands an efficient way of determining and regulating the exchange rate by changing the policy instruments that RBI has under its control. This shows that exchange rate management is one of the most important issues in the scheme of running a country. This study attempts to develop a model for the rupee-dollar exchange rate taking into account the monetary model that include variables which are used by the central bank for intervention. The focus is on the exchange rate of the Indian rupee vis--vis the US dollar, i.e., the Re/$ rate. Apart from introduction, section 2 deals with the review of the existing literature about the studies that have been done in relation to exchange rate determination and section 3 deals with the methodology part which tells us about the approach used and the data sources to implement those approaches. Section 4 gives the results found from the applied approaches and Section 5 concludes the study with some policy implications of the results obtained earlier. Theoretical and Empirical Literature The objective of managing a variable or policy instrument comes with the responsibility not affecting the stability of other variables vis--vis change in the policy variable. So, to manage exchange rate in a definite way, we should be sure about the inter-relationships between exchange rate and other major economic variables. So, we should prioritize exchange rate determination over any other data like history of exchange rate or present issues which exchange rate management should address. In the international finance literature, various theoretical models are available to analyze exchange rate determination and its behavior. Most of the studies on exchange rate models prior to the 1970s were based on the fixed price assumption. With the advent of the floating exchange rate regime amongst major industrialized countries in the early 1970s, an important advance was made with the development of the monetary approach to exchange rate determination. The dominant model was the flexible-price monetary model that has been analyzed in many early studies like Vitek (2005), Nwafor (2006), Molodtsova and Papell, (2007). The sticky price or overshooting model by Dornbusch(1976) is also tested amongst others by Alquist and Chinn (2008) and Zita and Gupta (2007).Frankel (1979) argued that a drawback of the Dornbusch formulation of the sticky-price monetary model was that it did not allow a role for differences in secular rates of inflation. He develops a model that emphasizes the role of expectation and rapid adjustment in capital markets. The innovation is that it combines the assumption of sticky prices with that of flexible prices with the assumption that there are secular rates of inflation. This yields the real interest differential model. Hooper and Morton (1982) extend the sticky price formulation by incorporating changes in the long-run real exchange rate. The change in the long-run exchange rate is assumed to be correlated with unanticipated shocks to the trade balance. They therefore introduce the trade balance in the exchange rate determination equation. A domestic (foreign) trade balance surplus (deficit) indicates an appreciation (depreciation) of the exchange rate. The portfolio balance model also developed alongside, which allowed for imperfect substitutability between domestic and foreign assets and considered wealth effects of current account imbalances. With liberalization and development of foreign exchange and assets markets, variables such as capital flows, volatility in capital flows and forward premium have also became important in determining exchange rates. There are also models that include micro structure of the underlying markets. But the above mentioned models are rejected because of the unavailability of the private information i.e., wealth of economic agents. Agents in the foreign exchange market have access to private information about fundamentals or liquidity, which is reflected in the buying/selling transactions they undertake, that are termed as order flows (Medeiros, 2005; Bjonnes and Rime, 2003). Microstructure theory evolved in order to capture the micro level

Exchange Rate Behaviour and Management in India: Issues and Empirics

11

dynamics in the foreign exchange market (Evans and Lyons, 2001, 2005, 2007). Another variable that is important in determining exchange rates is central bank intervention in the foreign exchange market. But again the restricting factor for this approach is data unavailability. Non-linear models have also been considered in the literature. Sarno (2003), Altaville and Grauwe (2006) are some of the recent studies that have used non-linear models of the exchange rate. The above mentioned were the models that were introduced, but these were also used in many papers to find some empirical results. Frenkel (1976) suggests that PPP holds in the long-run but not in short-run because of price stickiness in goods market. Recent studies by Johnson (1990), Kong (2000), Lothian and Mc Carthy (2001), Kleijn and Dijk (2001) and Bahrumshah, Sen and Ping (2003), also find that PPP is a long-run phenomenon. Reitz (2002) studied the performance of PPP during periods of central bank intervention and found that PPP is not strengthened during intervention. On the other hand, many other studies like Jacobson, Lyhagen, Larsson and Nessen (2002), Cheung, Chinn and Pascual (2004) find that PPP is not a common phenomenon even in the long-run. Early studies which modeled exchange rates using the flexible pricemonetary model such as Frenkel (1976), Bilson (1978), Hodrick (1978),Putnam and Woodbury (1980), and Dornbusch (1980) support theperformance of the flexible price monetary model in modelling andforecasting exchange rates. Subsequent studies by Frankel (1979), Driskilland Sheffrin (1981) and Taylor (1995), however, fail to support the performance of the flexible price monetary model and real interest differential model in terms of explaining the exchange rate behaviour. Empirical studies on the sticky price version of the monetary model show mixed results and suggest weak performance in explaining exchange rate movements. On one hand, studies like Driskill (1981) show that the sticky price monetary model explains exchange rates well, while studies such as Backus (1984) show that the sticky price monetary model fails to explain the exchange rate behaviour. Dornbusch (1990) also analyzed the relationships between exchange rate and other macroeconomic variables. Data and Methodology The objective of this study is to find the relationship between exchange rate and other monetary variables like money supply, output, real interest rate, inflation rate and trade balance. The best model which gives us all interrelationships is Hooper Morton model. But our objective is not only to find how other monetary variables affect exchange rate but also how exchange rate affects rest of the variables. Hence, this study employs Vector Autoregressive (VAR) model over the Portfolio equation to estimate the exchange rate with respect to euro instead of dollar (Re/$). The choice of US Dollar is because USD is the most demanded currency and all the exchange rates are determined in terms of USD. The analysis for any other country can be done on the same lines. The Hooper-Morton is as follows:-

(et et* ) = + ( mt mt* ) + ( y t y t* ) + (it it* ) + ( t t* ) + (t t t t* ) + t

Where, (* denotes values for foreign or base country)

et mt yt it

= = = = = =

Exchange Rate at time t Money Supply at time t Output at time t Real interest Rate at time t Inflation Rate at time t Trade Balance at time t

t
tt

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Aswini Kumar Mishra &Rahul Yadav

The economic indicators used as variables and the data sources ate mentioned in the table below. Variables used in the present study Macroeconomic indicators (India/US) Or (Domestic/Foreign) Data Source Official exchange rate (LCU per US$, period average) World Bank (WDI Database) 1978-2010 Money and quasi money (M2) as % of GDP World Bank (WDI Database) 1978-2010 Real interest rate (%) GDP (current US$) Inflation, consumer prices (annual %) World Bank (WDI Database) 1978-2010 Trade (% of GDP)

et / et*

m t / m t*

it / it*

y t / y t*

t / t*

t t / t t*

Period

World Bank (WDI Database) 1978-2010

World Bank (WDI Database) 1978-2010

World Bank (WDI Database) 1978-2010

*WDI refers to World Development Indicators. After obtaining the data mentioned in the table above, we can use it in our methodology. The main objective is to find the inter-relationships which can be obtained by applying VAR model. Although VAR model can be applied on nonstationary series as well, but results obtained will have less accuracy. So, test for stationarity are performed before applying VAR. If all the series are found to non-stationary, then co-integration test is performed to check for co-integrating series. After the above mentioned tests, the VAR or VECM (if series are found to be co-integrated) model can be applied on the modified (if required) series. The lag length for the VAR model is fixed to be 2. It is so because the lag length of 2 suffices for almost all the series.Although lag length calculations can be done by using models like Akaike Criteria, but they are just increasing the calculations without a significant increase in accuracy. Finally, the VAR model isapplied to analyze the relationship between exchange rate and other variables to meet the objective of the study. The results are given in the section below.

RESULTS
Augmented Dickey Fuller (ADF) test is applied to each of the seven series to test for stationarity. The analysis is done at 5% level which amounts to the t value of -3.60. If the series t value is less than magnitude of 3.60, then the series is non-stationary otherwise it is stationary. The t (= tau) statistic value is given in the table below. ADF Test t value

et
-0.639

( mt mt* )
0.054

(it it* )
-3.13

( yt yt* )
0.494

( t t* )
-2.77

(t t t t* )
-2.39

As we can see from the t values of the table, all the t values are less negative than -3.60. It implies that the Null hypothesis is accepted and all the series are non-stationary. The unit root test summary is given in the table below. Order Integration T value (India) I(1) I(1) I(1) I(1) I(1) I(1) of

et

( mt mt* )

(it it* )

( yt yt* )

( t t* )

(t t t t* )

Engle Granger test is applied is for checking the co-integrating relationship between exchange rate and all other independent variables of the model. The thing to be pointed out is that all the variables mentioned here are in log terms not absolute terms. The t (=tau) values are given in the table below. The t critical value for the EG test at 5% level is 2.43.

Exchange Rate Behaviour and Management in India: Issues and Empirics

13

Cointegrating w.r.t t value

et

( mt mt* )
-2.526

(it it* )
0.4188

( yt yt* )
-5.218

( t t* ) (t t t t* )
2.004 -0.3874

residuals

-2.03865

The above mentioned series are co-integrating if: 1. The unit-root hypothesis is not rejected for the individual variables. 2. The unit-root hypothesis is rejected for the residuals. But from the table we can infer that 1. 2. The unit root hypothesis is rejected for (it it ) , ( t t ) and (t t t t ) .
* * *

The unit root Hypothesis is not rejected for residuals.

Hence, we can say that no co-integrating relationships exist in the above regression. Since there is no co-integration in the regression and all the series are stationary of order 1. Therefore, we can apply VAR on the first differences of the variables to get better results. VAR on original series will give spurious results because of non-stationarity at order 0. Applying VAR model on the above series with lag length of 2, we got some results which are shown in the table below. Dependent variable

det
0.0071 0.1940 0.0364 5.2840 -1.8644 -0.3955

d ( mt mt* )
-0.3806 0.7832 0.7794 4.9501 -4.0482 0.9695

d ( yt yt* )
0.0431 -0.6266 -0.6999 -2.4784 0.4365 -1.2563

d ( t t* )
-0.0082 0.0174 0.0140 -0.3758 0.1388 0.0136

d (it it* )
0.4303 0.0446 0.0481 0.4278 -0.4939 0.0374

d (t t t t* )
-0.0165 0.2161 0.2931 2.023 0.2211 0.2877

det
d ( m t m t* )

d ( yt yt* )
d ( t t* ) d (it it* ) d (t t t t* )

This matrix or table has dependent variables as rows and all the independent variables as columns. The value of the independent variables is of the first lag which is quite significant as compared to higher lags. Since the first difference of the series is taken, the second order lag value becomes negligible after applying VAR. From the above table, we can infer the following:1. Real interest rate has a significant positive effect on the exchange rate. If currency value is increased by some external factors, then decreasing the domestic interest rate can depreciate the currency and avert any adverse effects of the previous appreciation, ceteris paribus. 2. Money supply is another major factor affecting exchange rate. There is a negative relationship between them i.e. any increase (decrease) in the money supply will decrease (increase) the exchange rate. 3. Inflation has a negative impact on exchange rate but is not prominent. This is a diversion from the existing literature which states a prominent effect of inflation rate to exchange rate. It implies that, until and unless some other factor is reinforcing the effect of inflation rate, there will not be a significant change in the exchange rate.

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Aswini Kumar Mishra &Rahul Yadav

But our study gives a reason for such high correlation between inflation rate and exchange rate in the real world. It can be explained by considering the impact of change in inflation rate on real interest rate. An increasing (decreasing) inflation rate will reduce (hike) the real interest rate which in turn will depreciate (appreciate) currency in a much pronounced way. It is depicted from our study that inflation rate has a significant impact on the real interest rate. So, inflation rate has significant negative impact on exchange rate but it is not direct but indirect. 4. There is also some impact of trade balance on the exchange rate. The data included in the present study is in positive terms but should have negative values because it shows trade deficit. Therefore, our study shows a negative relationship between trade balance (deficit) and exchange rate. It implies that increasing (decreasing) trade balance (deficit) will lead to depreciation (appreciation) of currency. 5. The additional information which is originating from here is the impact of real GDP on exchange rate. Ideally, for a developing country increase (decrease) in GDP will increase (decrease) the demand for goods which in turn would increase (decrease) imports. Hence, demand of foreign currency is increasing (decreasing) which should decrease (increase) exchange rate. But here it is showing a positive relationship. The reason for this may be due to overshadowing of Indian GDP by USs GDP. It develops a kink in the VAR model by not effectively accounting for increase or decrease in Indian GDP in ( y t

yt* ) due to comparatively large values of US GDP as compared

to Indias. This is a drawback of our model and further research can be done to improve on this. 6. The effect of exchange rates past values on the present value is very less. It is pretty understandable due to highly dynamic nature of the variable. On the other hand, real interest rate shows a good dependency on its past values. The above discussion was about the impact of other variables on exchange rate whereas the present study also gives information in the opposite direction. So, the exchange rate affects rest of the variables in the following ways:1. Exchange rate has significant impact on the relative inflation rate (w.r.to foreign economy). It is so because, due to high exchange rate, the imports become costlier which lead to increase in demand of domestic goods. This increase in demand results in increase in the prices of the domestic goods. This effect is not seen in short run but is mostly a long run phenomenon. The relatively high value of coefficient maybe due to application of first difference in the model instead of actual series but is depicting the correct line of thought. 2. The negative relationship between exchange rate and real interest rate depicted in the table is not a direct causal relationship but is a regulatory mechanism from RBI. This is done to disperse the inflationary pressures which arise from the high value of the exchange rate. This is not a long run phenomenon because RBI applies it as a precautionary measure well beforehand so as to discourage inflationary pressures at the beginning. 3. The effect of exchange rate on trade balance is pretty obvious. High (Low) value of exchange rate lead to reduction (increase) in net exports. This concept is reinforced by the present study. The rest of the effects of exchange rate are not that important because money supply is a highly regulated phenomenon and cannot be easily influenced by exchange rate and GDP also depends on a lot of exogenous factors, so, the effects on these are not stressed in the present study.

CONCLUSIONS & POLICY IMPLICATIONS

From the above discussion, we can get some idea about the inter-relationships between major economic variables like Money supply, Gross domestic product, Inflation rate, Real interest rate and Trade Balance. One thing is definite that

Exchange Rate Behaviour and Management in India: Issues and Empirics

15

nothing is in isolation i.e., a change in a certain variable will have its repercussions as changes in some other variable. The following discussion summarizes the present study:It is always given that exchange rate is determined by a countrys performance with respect to the rest of the world. So, if a shock occurs in the outside world, then it will show its effects in the exchange rate of the domestic country. Similarly, if the outside world is volatile, then the exchange rate also seems to be volatile. But we can still make our exchange rate stable which is very important for various things like trade, investment, etc. As for the future, different VAR models can be used instead of unrestricted VAR to get better accuracy. New models can also be formulated to effectively describe all the relationships mentioned above. Also, a policy paper can also be built on the present framework describing the complete journey of Indian exchange rate management and forecasting its future values.

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