The Effect of prices and exchange rates on India's foreign trade flows: an empirical study

Abstract

After independence India followed an industrial policy based on import substitution, assuming that price related measures are ineffective due to lower demand elasticities of both, exports and imports. Moreover the exports were assumed to be supply constrained. This environment has changed gradually over the years. Trade liberalization started to a large extent by mid-19805. From the mid-1980s the government actively followed the policy of gradual depreciation of the rupee against foreign currencies (mainly the US dollar). In 1991 the government resorted to a major devaluation of the exchange rate primarily to tide over the BOP crisis as an immediate step under a broader liberalization policy adopted by the Government of India. This approach of devaluation of the currency belongs to the tradition of the elasticity approach to the balance of trade. The elasticity approach focuses on exchange rate as the major determinant of the trade balance, because devaluation of the rupee lowers the foreign currency price of exports and raises the rupee price of imports. The success of devaluation of exchange rate in bringing the desired changes in trade balance depends upon (l) The extent to which the exchange rate adjustment is transmitted to export prices denominated in foreign currency and import prices denominated in domestic currency, i.e. the degree of ERPT, and (2) The extent of adjustment of the quantities to the changes in the export and import prices. After 1993 the exchange rate of the rupee with respect to foreign currencies has been left to the market forces with significantly less intervention from the RBI. This has led to an increase in the volatility of the exchange rate of the rupee. The depreciation of the rupee and the new exchange rate regime has led to a series of studies on the impact of exchange rate on India’s trade. These empirical studies did not agree on the effectiveness of the exchange rate. Only a few studies estimated the ERPT. Moreover, these estimates of pass-through are derived from elasticities and are not directly estimated. The studies on the ERV impact on the trade flows also differ in their conclusions. In this context we set the research agenda as given below. The research questions are: (1) What is the extent of the ERPT in India’s export and import prices? What is the magnitude of the demand-supply elasticities for Indian exports and imports? Whether the volatility in the exchange rate has any impact on India’s trade? All these questions are investigated at the aggregate level simultaneously considering their interactions. ' (2) Are the estimates of ERPT, exchange rate volatility and the export-import elasticities substantially different at the sect oral disaggregated level as compared to the aggregate level? (3) Are these estimates substantially different at a more disaggregated product category level? Given these questions, a simultaneous equation model of trade account of the BOP was developed. This model considers the phenomenon of exchange rate pass-through, exchange rate volatility and price elasticity of demand and supply simultaneously. The study has been conducted at aggregate, sectorial and product levels. The two stage least squares method was employed. The data for the study were obtained from the following secondary sources: publications and websites of Director General of Commercial Intelligence and Statistics (DGCI&S), Central Statistical Office (CSO), International Financial Statistics (IFS), and US Bureau of Labor Statistics (BLS). This study uses quarterly data from 1981 to 1998. The main findings of the study are: Exchange rate pass-through was full and complete with respect to imports at aggregate as well as at sectorial level. It means changes in the exchange rate will fully reflect in the Indian import prices. In case of exports however, the exchange rate pass-through is limited. At the aggregate level, the pass-through is around 50%. At the sectorial level, the pass-through varies between O per cent to 52 per cent. Apparel products (four digit level product) indicate 54 per cent pass-through. The nominal exchange rate volatility as measured in the study does not seem to have any substantial influence on the exports and imports of India at the aggregate level. However, at a more disaggregated level it may have some negative influence on the imports. Aggregate export demand was highly elastic to the price changes. The same is the case with chemicals and manufactured products sectors and machinery and transport sector. The food and tobacco sectors, however, have shown inelastic response. Import demand elasticities are also high except for the essential imports like crude oil and edible oil sectors. Though the supply elasticity of exports at aggregate level is strong, at the sectorial level they were found to be weak. On the export side the income elasticity is high only for the manufactured exports. On the import side, the Income elasticity of the aggregate import is below one (0.70). At sectorial level, different sectors present different pictures. Implications of these findings are: 1. India is a price taker in the international market as far as imports are concerned. 2. Exchange rate depreciation will act as an effective deterrent only in Food and Machinery & Transport Equipment sectors. 3. Exchange rate depreciation will have a favorable impact on the exports given high demand elasticities and partial pass-through. The low supply elasticities are probably the hindrance to the pass-through of the exchange rate to export prices and consequently to the improved exports. Policy measures are needed to improve the export focus of the Indian industry.