What Explains India’s Real Appreciation?

1. What Explains India’s Real Appreciation? Renu Kohli & Sudip Mohapatra International Monetary Fund - India Presentation to India Policy forum, July 15, 2008

2. Disclaimer The views expressed are personal and are not necessarily those of the IMF.

3. Since 1990, many structural changes have taken place in India’s economy • Production structures • Consumption patterns • Economic policies

4. Robust and sustained export growth

5. Leading to changes in production structure, boosting productivity

6. Per capita income growth on a higher trajectory – changing consumption patterns?

7. Changing economic policies • Trade liberalization • Deregulation of industry as well as some services • Price deregulation in some sectors levels

8. What’s happened to prices? • Structural changes impact price dynamics • Change relative prices in the economy • A key relative price – nontradable/ tradable goods • A measure of the real exchange rate

9. Outline • What is happening to relative prices within the economy? • What is driving these changes? • Implications for macroeconomic policies – The Past and the Future

10. What is happening to relative prices?

11. Why this measure of the RER? • Lack of analytical framework for assessing internal competitiveness, impact of real shocks • The nontradable/tradable price ratio provides insights into • Internal competitiveness • Incentives guiding production and consumption decisions • Determinant of external current account position

12. How do we compute this measure? • Not easy as India does not have a services’ price index • Divide the aggregate economy into traded/nontraded sectors, using export shares in total production • Tradable sectors - those exporting at least 5 percent of the total value of production • Derive the implicit price series from nominal and real output data.

13. Traded/nontraded sectors – A profile

14. The inflation rate in nontradables exceeds that of the tradable sector from the 1980s…

15. Sectoral inflation divergence: Some important facts • Significant acceleration in nontradables inflation in the 1990s. • Annual average divergence exceeds one percentage point in the post-reform phase.

16. The relative price increase implies a real exchange rate appreciation • Contrary to popular perception of a constant real exchange rate since 1993! • But latter based upon relative price levels in home and foreign countries – a measure of external competitiveness • How are the internal and external measures of the real exchange rate related?

17. How do the two exchange rate measures correlate?

18. What is driving this divergence?

19. Economic theory; Reforms • Supply factors - Balassa-Samuelson hypothesis • Demand factors - income growth (Kravis-Lipsey); government spending (Obstfeld-Rogoff) • Economic reforms (trade liberalization, deregulation of prices and services, adjustment of prices to cost-recovery levels)

20. Supply factors: Tradable/Nontradable productivity growth

21. This is striking because relative nontradable prices accelerated at the same time! They are also negatively correlated….

22. So have demand factors induced the relative price increase?

23. Import liberalization?

24. Formal evidence confirms the interplay of both demand and supply factors • Estimated magnitude of Balassa-Samuelson impact - 0.06-0.15 (OECD-0.10-0.26; East Asian economies-0.21-0.63) • Import prices’ - 0.05-0.07 • Shift in preferences towards nontradables - 0.15-0.27 • Magnitude of impact of fiscal growth -0.20

25. Pronounced role of private demand and convergence in international prices

26. Implications for macroeconomic policies The Past and the Future

27. The macroeconomic response to relative price shifts so far?Fiscal expansion combined with exchange rate adjustment

28. Illustrates how exchange rate regimes can be determined to correct relative prices when fiscal imbalances are persistent • 1986-1990 - the NEER depreciated by an average 5percent annually. Slowed to 2.8percent in 1993–98. • The extent of real appreciation implied by the change in the relative price of nontradables during these two episodes: annual average of 1.03 and 1.29 percent. • Fiscal expansion added considerably to the relative price increase throughout this period. • Nominal exchange rate policy deployed to recoup competitiveness losses.

29. Can this macroeconomic policy mix continue? • Real appreciation pressures in the current economic environment • Permanent factors – Productivity, income growth, foreign capital inflow • Transitory – fiscal shocks • Future trends emphasize the need for change

30. GDP growing above 8 percent annually

31. Per capita income growth above 7 percent for last four years

32. Export growth has doubled in this decade

33. Foreign capital inflows add further force

34. What do these trends signify for future macroeconomic policy? • A productivity driven real appreciation reflects a natural evolution of the economy. • Reinforced by associated increases in incomes. • More so if demand is biased towards services as living standards converge to advanced country levels. • Equilibrium phenomenon – irreversible, cannot be restrained • Must, therefore, be absorbed.

35. But a real appreciation arising from persistent fiscal deficits? • Is not an equilibrium phenomenon. • It further erodes the competitiveness of the tradable sector.

36. The monetary-fiscal policy mix as India transits to a higher growth trajectory? • The exchange rate regime must be freed to absorb the equilibrium shifts through a nominal appreciation • A break from past policies – flexible exchange rate policy • Points towards the deployment of fiscal policy to achieve inflation convergence

37. Results can be used to endorse the role of fiscal policy in correcting relative price distortions

38. Fiscal policy can play a meaningful role • Achieve inflation convergence; limit competitiveness losses • Our results suggest a one percent cut in the real government expenditure to GDP ratio leads to a 0.20 percent decline in the inflation rate in the nontradable goods sector. • Therefore, continuing fiscal reforms could significantly facilitate absorption of equilibrium shifts induced by real shocks.

39. Thank You!