Rice Manufacturers in India | Shree Krishna Exports
Rupee voltility, twin deficits and exchange rate policy
1. Rupee Volatility, Twin Deficits
and Balance of Payments
avadhoot nadkarni
University of Mumbai
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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
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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.
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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. 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.
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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.
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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
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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. 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. 120.00
100.00
NEER vs. REER (36 Countries)
80.00
60.00
NEER-36
REER-36
40.00
20.00
0.00
11. NEER & REER (1993-94 to 2004-05)
110.00
105.00
100.00
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
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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
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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
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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.
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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
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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.
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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
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28. Financing of Imports over the Three
Periods
Period Exports Services Transfers Income Foreign I Loans Banking K
2001-04 81.01 6.70 26.17 -6.81 11.35 -0.96 6.31
2005-08 67.67 14.54 16.42 -3.49 11.30 10.67 2.38
2009-12 62.35 13.80 14.75 -3.04 9.26 4.44 0.88
Period Current Account Normalised by Imports
2001-04 7.07
2005-08 -4.86
2009-12 -12.14
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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
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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.
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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.
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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.
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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.
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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.
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36. Country Categories
Developing Developed
Africa (5) -
America (3) America
Asia (4) Asia
Oceania Oceania
- Europe
Transition Economies
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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.
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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.
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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.
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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.
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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.
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42. Country-Commodity Intersection III
• Our exports to the developed world markets
of America, Europe and Oceania still consist
largely of low technology exports.
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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.
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44. New Commodities: Geographical
Distribution & 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.
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