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

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

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

Robust and sustained export growth 8 percent in the 1980s; 15 percent post-1990s; 22 in the current decade

Leading to changes in production structure, boosting productivity Averaging more than 25% of GDP against 20 percent share in the 80s. 28 percent in current decade so far.

Per capita income growth on a higher trajectory – changing consumption patterns? 4.7 percent post-1990; 3.7 percent in 1980s.

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

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

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

What is happening to relative prices?

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

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.

Traded/nontraded sectors – A profile 7 of the 15 mfg sub-sectors more than trebled export/production shares between 1980 and 2006. Share of tradable services in total value of its output changed little between 1980 and 1990 but more than doubled in next decade. By 2006, its again increased more than twofold. More than 3/4ths of business services are tradable (more than half of aggregate services output). Still, only 3 of the 11 services in NAS can be classified as tradable in 2006-07.

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

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.

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?

How do the two exchange rate measures correlate? Diverge in the 1980s, but more closely aligned after 1991. Possible reasons: the post-1991 reforms corrected an overvaluation, which kept the domestic price of tradables unsustainably higher relative to the foreign price. Switch to a flexible exchange rate regime? More validity to the LOOP? Trade taxes? A decline in protection will appreciate the internal RER by lowering tradable goods’ prices and increasing the relative price of nontradable goods in the economy. Productivity growth in tradable sector – causing the internal RER to appreciate more than the external RER (latter includes relative price levels plus the foreign country’s relative nontradable/tradable prices).

What is driving this divergence?

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) Supply-side models (Balassa, 1964; Samuelson, 1964) describe it as a part of cross-country convergence in productivity levels. Demand pressures originating from income growth (Kravis and Lipsey, 1983; 1988; Bergstrand, 1991). Assuming nonhomothetic tastes, i.e. income elasticity of demand for services (goods) exceeds (is less than) unity, a rise in per capita income will induce an expenditure shift towards nontradables, which translates into a higher relative price of nontradables (particularly services) as resources shift towards the production of nontradable goods. 4. Lower tariffs are reflected in falling input costs and consequently lower prices in the tradable goods sector, in particular manufacturing. 5.Transitory demand disturbances, e.g. shocks like a rise in government spending (Obstfeld and Rogoff, 1996). 6. Deregulation of administered prices and liberalization or the adjustment of regulated prices to cost-recovery levels during transition.

Supply factors: Tradable/Nontradable productivity growth 1. Both definitions show that the tradable-nontradable sector productivity growth gap narrowed steadily after the mid-1980s until 2000. 2. The annual average labor productivity growth of the services sector increased from 4.2 percent to 7.6 percent between 1982–90 and 1992–2002 while that of manufacturing sector increased only marginally from 7.0 percent to 7.4 percent. 4. The tradable-nontradable labor productivity growth gap averaged 4 percent in 1982–90, halved to 1.6 percent in 1992–2004. 5. Excluding agriculture, the manufacturing-services productivity growth gap almost disappears in the latter half of the sample.

This is striking because relative nontradable prices accelerated at the same time! They are also negatively correlated…. Both trends suggest no B-S effect. For this to hold, the gap should widen and be positively related to the inflation differential.

So have demand factors induced the relative price increase? Public demand increase in 1980s but stable in 1990s, falls in current decade. Private demand accelerates, notably consumption of services by almost 2 percentage points between 1980s and post-reform phase.

Import liberalization? Tariffs in 1995 one-third of the level in 1991. Role of convergence in tradable prices?

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 Robust to number of sensitivity checks – alternative estimation methods, omission/inclusion of variables, alternative definition of variables, stability checks, etc

Pronounced role of private demand and convergence in international prices

Implications for macroeconomic policies The Past and the Future

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

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 5 percent annually. Slowed to 2.8 percent 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.

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

GDP growing above 8 percent annually

Per capita income growth above 7 percent for last four years

Export growth has doubled in this decade

Foreign capital inflows add further force

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.

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

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

Results can be used to endorse the role of fiscal policy in correcting relative price distortions Figure traces the dynamic contribution of each independent variable (column portion) to the mean of the relative price level. Stacked columns add up to the fitted values from the regression. Fiscal correction, leading to decline in the GFD ranging between 0.3-1.1 percent every years, restrained relative nontradable prices from increasing more than they might have, through incipient contraction in demand pressures.

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.

Thank You!