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India: Selected Issues

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International Monetary Fund
Published Date:
February 2006
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II. Assessing India’s External Competitiveness1

A. Introduction

1. The appreciation of the rupee in recent years has raised concerns about India’s export competitiveness. Since end-2002, the Indian rupee has appreciated by 5 percent both against the U.S. dollar and in real effective terms. Imports have grown at rapid clip and in the course of the past year, the current account has moved from a position of surplus to one of deficit. Against this background, this chapter assesses external competitiveness, reviewing India’s export performance and estimates of the “equilibrium” real effective exchange rate.

B. Export Performance

2. India has witnessed a marked acceleration in export growth in recent years (Table II.1). Since 2000, the value of India’s exports have grown three times faster than in the latter half of the 1990s. This acceleration has been led by services exports—particularly software and IT—which continue to gain momentum with growth pushing past 100 percent in 2004/05.2 Much less appreciated is the fact that that exports of Indian goods have also performed strongly since 2000. As a result, exports of goods and services now account for about one fifth of Indian GDP, up from a mere 10 percent a decade ago.

Table II.1.India: Indicators of Export Growth
1995/96–2000/01–
1999/002004/052000/012001/022002/032003/042004/05
(Annual percentage change)
Export value6.121.015.90.220.520.347.4
Goods3.015.521.1-1.620.320.424.9
Services16.433.33.65.421.120.2105.7
Export volumes10.314.417.03.715.58.032.7
Goods7.19.222.21.715.28.112.4
Services21.126.14.59.016.07.985.2
Sources: Reserve Bank of India; and staff estimates.
Sources: Reserve Bank of India; and staff estimates.

3. India’s exports have become more diverse by region. (Figure II.1). The past five years has seen India’s market share of Asian goods imports nearly double. As a result, Asia has surpassed the EU as the most important destination for Indian exports, accounting for almost one third of total goods exports, suggesting India may be becoming integrated into regional production chains.3 The EU now only accounts for about one fifth of Indian exports, down from almost 30 percent a decade ago, and the share of the United States has also fallen to 17 percent from 20 percent. With its trading partners becoming more diverse—gains in the Middle East and Africa have been even more impressive than in Asia—India has become less dependent on, and vulnerable to, developments in specific markets. This has helped India to sustain a rapid pace of export growth even as growth in some key industrial markets slowed in recent years.

Figure II. 1.India: Market Trends for Goods Exports

(India’s share of imports to each region, in percent)

Source: DOTS.

4. India’s export base has also broadened and become more dynamic. Looking at the composition of India’s exports by commodity group and its share of world exports by commodity reveals a pattern of accelerating growth and diversification. In the mid-1990s, export growth was in single digits and narrowly based (Table II.2). The pickup in growth since 2000 has occurred across a wide range of categories. Figure II.2, which plots the changing world market share of India’s 15 largest products (at the SITC 3 digit level) against the changing share of those products in world trade illustrates that Indian exporters are moving into some of the most dynamic segments of world trade.4 In areas such as petroleum products, organic chemicals, and electrical equipment which account for growing share of global trade, India’s exports have been growing faster than the global average. Since 1990, India’s share of the global petro-product exports has doubled, while its share of the chemicals and electrical equipment markets has tripled, albeit from a small base.

Table II.2.Composition of Goods Exports
Share of World Goods TradeAverage Annual Growth RateContribution to Growth
1990–951996–20002000–031990–951996–20002000–031990–951996–20002000–03
Food and live animals1.01.21.217.0-2.17.822.5-4.28.0
Beverages and tobacco0.30.30.3-2.70.77.4-0.20.10.3
Crude materials0.90.91.1-2.4-4.322.7-1.2-2.68.1
Mineral fuel/lubricants0.20.20.50.139.623.40.08.99.9
Animal.vegetable oil fat, etc.0.70.80.840.75.40.31.70.40.0
Chemicals0.50.60.714.111.915.79.015.614.4
Manufactured goods1.51.61.913.88.910.443.345.632.0
Machinery/transport0.10.10.112.26.919.57.47.1142
Miscellaneous manufactured items1.01.01.111.810.58.719.928.614.1
Commodities, n.e.s.0.00.00.0-4.7-112.3-2.4--1.0
Total0.60.60.712.27.612.2100.0100.0100.0
Sources: WITS; and Fund staff calculations.
Sources: WITS; and Fund staff calculations.

Figure II. 2.World Market Poistion of Indian Exports, 1990–2003

Sources: WITS; and staff calculations.

5. Despite these gains India’s export performance has lagged that of Asia and its share of global exports remains low. Indian exports have grown more slowly than in the rest of Asia, and particularly China (Figure II.3). India continues to account for a relatively small share of global goods exports. China accounts for over six times as much, and the ASEAN-4 almost four times as much. The picture changes little when exports of services are included with India’s market share in global goods and service exports rising only to 1.4 percent.

Figure II. 3.India’s Export Performance Relative to Asia

(Value of country x’s exports in percent of world goods exports)

Sources: DOTS.

6. The fact that greater inroads into world export markets have not been made is surprising given India’s low wages and strong productivity growth. Indians earn only a fraction of their competitors, about $0.60 per hour. While wages in certain sectors, such as IT, have been rising at rates of about 20 percent per annum since 2000, a large informal sector and steady supply of new labor entrants is likely to have limited the pressure on overall wage levels (Table II.3). Labor has also become more productive. Rodrik and Subramanian (2005) estimate that labor productivity in India grew by over 3½ percent since the 1980s. Improvements in labor productivity have helped boost overall productivity in the manufacturing sector with estimates suggesting total factor productivity in the official manufacturing sector rose annually by 3½ percent over the course of the 1990s and the early part of this decade.

Table II.3.Wage/Earnings Per month in Manufacturing(In U.S. dollar)
1996199719981999200020012002
India 1/33.631329 436.028 540.123.8
Philippines 1/260.0247.1189.1213.5189.1
Malaysia 1/443.2430.1365.3402.9
China, P.R.
Mainland 1/56.659.671.178.588.198.4110.8
Hong Kong SAR 3/1,334.81,463.61,512.11,527.91,523.51,555.81,532.4
Brazil 1/1,289.6,275.3618.1414.5417.0358.2308.8
Mexico 1/182.8206.5228.8250.2307.8360.5366.4
Indonesia 2/77.072.025.638.346.550.4
Thailand 3/217.1189.2154.5156.2
Source: International Labour Organization.

Earnings per month.

Wage per month.

From survey conducted by Minister of Agriculture.

Source: International Labour Organization.

Earnings per month.

Wage per month.

From survey conducted by Minister of Agriculture.

7. Various surveys suggest poor infrastructure and a high regulatory burden hinder India in making greater inroads into world markets (Figure II.4). Poor roads and inadequate investment in ports and airports result in long delays and higher transport costs for Indian exporters. It takes 24 days for Indian exports to reach the United States compared to only 15 days from China, and 12 days from Hong Kong. In addition to facing some of the highest industrial electricity prices in the world, electricity outages cost Indian firms 8 percent of annual sales, four times higher than in China. Customs processing times are also slow. Shipments take just over 10 days to clear Indian customs compared to only 7 days in Korea and Thailand. Cumbersome procedures and regulations work to increase the cost of imported and domestic inputs used in producing Indian exports.

Figure II. 4.IMD Competitiveness Indicators, 2005

8. High import tariffs have also discouraged exports. In addition to raising the cost of imported intermediate imports for the export sector, import tariffs lower the price of exports relative to domestic sales making exports less attractive. They also alter the level of wages and rates of return on capital. Despite the progress made in reducing trade tariffs in recent years—the average nonagricultural tariff declined from over 40 percent in 1997 to 14½ percent in 2005—such tariffs are still about twice as high as the ASEAN average. India’s import tariffs are equivalent to a tax on exports of about 31 percent, which is well above the simple average export-tax equivalent in developing countries about 12.6 percent (IMF, 2005a). If nontrade barriers, such as technical and safety requirements were included, the anti-export bias implied by India’s tariff system would be even higher. These estimates suggest a strategy that seeks to reduce import tariffs by subjecting higher rates to deeper cuts than lower rates could boost the value of Indian exports by as much as 10 percent relative to a 2001 base. Complete elimination of import tariffs would boost their value by 45 percent.

9. The performance of Indian textiles sector following the removal of the quotas under the Multi Fiber Arrangement (MFA) regime is a case in point. In the first six months following the removal of these quotas, exports from China to the United States in liberalized tariff lines rose at rates in excess of 200 percent, while those to the EU rose by about 80 percent (Ananthakrishnan and Jain-Chandra, 2005). Through September, Indian exports, in value and volume terms, to the United States grew by a more modest rate of about 20 percent, with similar rates of growth being experienced in the EU market. The fact that India has not gained market share in the textile sector following the removal of the quotas that bound Indian textile exports for decades reflects problems of scale economies, inflexible labor markets, low rates of investment, lack of full duty drawback, and poor infrastructure.

C. Exchange Rate and Competitiveness

10. The impact of the exchange rate on competitiveness is typically examined by estimating measures of a real “equilibrium” exchange rate. Studies on India employ one of three approaches. The extended PPP approach assumes purchasing power parity (PPP) holds in the long run but several factors interact to prevent the actual exchange rate from converging to this level in the near term. The “equilibrium” exchange rate is estimated using a single equation relating the actual REER to its determinants. The macroeconomic balance approach estimates the change in REER needed to bring about equilibrium in the balance of payments, where equilibrium is defined as a situation where the current account equals either the ‘normal’ level of capital inflows, or the ‘structural’ savings-investment balance. The third, the base approach compares the actual REER to a base year where the REER and the current account were in “equilibrium.” Each approach has drawbacks. The PPP approach assumes that perfect labor mobility links wages in the traded and nontraded sectors, and that law of one price holds continuously for the traded goods sector so that prices in this sector are given exogenously, conditions that may not hold in reality. Results are also sensitive to the variables included in the model. The macroeconomic balance approach relies heavily on researchers’ judgment on what constitutes ‘normal’ balance of payments flows. The base approach does account for how the underlying “equilibrium” evolves over time with changes in the economy.

11. The various methodologies yield a wide range of estimates about the impact of the exchange rate on competitiveness. Table II.4 summaries the results from these various studies, including the estimates of the gap between the actual REER and its “equilibrium” level. Estimates of this difference range from a -40 percent to plus 8 percent depending on the methodology used. The wide range of results highlights the extreme difficulty in determining an “equilibrium” exchange rate, particularly in a developing country where a multitude of factors can influence exchange rates and ongoing structural changes make underlying relationships unstable.

Table II.4.India: Estimates of Deviation From the Equilibrium Real Effective Exchange
Independent Variables
DependentRelativeNetOtherAssessmentEstimated Gap
StudySampleVariableproductivityforeign assetsYearto Equilibrium
Extended PPP Panel Estimates
Davoodi (2005)133 countries;Relative priceRelative per capita2000-40 percent
Penn Worldlevel to the U.S.GDP to the U.S.
Tables, 2000
Benassy-Quere et15 countries,CPI-based REERRatio of CPI toCumulative current PPP2001-16.4 percent
al. (2005)1980–2001PPPaccounts scaled by
GDP
Lee et al. (2005)39 countries,CPI-based REERGDP per workerCumulative currentCommodity terms2004-30 percent
1980–2003relative to tradingaccounts scaled byof trade; output of
partnersGDPmanufacture goods
Macroeconomic Balance Approach
UBSIndiaCPI-based REER2005Approx. -7 percent
 Base Year Comparison
JP Morgan/IndiaRBI 5 country2005Approx.
Deutsche BankREER+5-10 percent

Developments in the Real Effective Exchange Rate

12. The accuracy of any assessment of the impact of the exchange rate on competitiveness hinges on an accurate measure of the REER. An outdated REER index risks giving misleading signals about competitiveness if it does not include information on how inflation and the exchange rate are evolving relative to India’s most important trading partners. When assessing developments in India, most analysts have utilized the RBI’s five-country REER index that is based on the average bilateral trade shares of G-5 countries during the 1992/93–1996/97 period and WPI inflation rates. Asian and other emerging economies are not included in the index, despite their growing importance as trading partners. The RBI released a revised REER index in December 2005 that include China and Hong Kong. This study utilizes a revised measure of India’s CPI-based REER that is based on updated weights (Table II.5) using data from 46 industrial and emerging market economies derived from Bayoumi, Lee and Jayanthi (2005). In addition to capturing the impact of changing trade patterns, the weights also reflect services, as well as goods trade, and incorporate the competition Indian exports face when they compete with goods of trading partners in third markets.

Table II.5.Revised RBI and IMF Country Weights in REER Indices
Old RBIIMF Broad
5 Country43 Country
(In percent of total)
Euro Area34.6
Germany19.7
France6.3
United States38.718.8
Japan18.77.1
United Kingdom16.66.2
China3.8
Other emerging Asia13.5
Other countries16.1
Source: Bayoumi, Lee and Jayanthi (2005).
Source: Bayoumi, Lee and Jayanthi (2005).

13. The revised index suggests that the REER fluctuated in a relatively tight band over the past decade, with some marked exceptions. Since the adoption of a managed float in 1993, pressures on the rupee to appreciate in real effective terms arising from a rising inflation differential with trading partners was contained to a large extent by nominal effective depreciation. However, the exchange rate regime afforded India ample flexibility to cope with shocks, with the slow upward appreciation of the REER punctuated by sharp depreciations in the context of the 1995 Mexican and the 1997 Asian crises when sudden stops in capital inflows triggered large depreciations in the nominal value of the rupee (Figure II.5).

Figure II. 5.CPI Based Real Effective Exchange Rate and Its Components

(1993=100)

14. The updated REER shows that while the rupee has appreciated in real effective terms over the past year, it has done so less than suggested by older measures. While the revised REER generally tracks the RBI measure quite well the updated index shows that the rupee appreciated in real effective terms by about 4½ percent since 1993, and by 5 percent since the start of 2005/06 fiscal year (Figure II.6). In contrast, the more dated five country RBI REER index points to an appreciation of about twice this magnitude, while the RBI’s revised REER index that was released late-December suggests the rupee appreciated in real terms by a more modest 6.4 percent since 1993. However, comparing the current value of the REER to some fixed historical point can present a misleading picture about competitiveness as the appreciation of the exchange rate may reflect improvements in underlying economic fundamentals that do not impair competitiveness.

Figure II. 6.India: RBI 5 Country REER and IMF Revised REER Measure

(1993=100)

Deriving estimates of the underlying “equilibrium” real effective exchange rate to compare with the actual REER will provide greater insights about how the exchange rate is impacting competitiveness.

Determinants of the Real Effective Exchange Rate

15. An extended relative PPP approach is used to explain movements in the updated CPI-based REER. The approach is based on the premise that a country’s nominal exchange rate tends to converge to its PPP-determined level, but various factors can prevent convergence in the near term. These factors are used in a single equation to estimate the real effective exchange rate and the latter is said to be in equilibrium when it equals the estimated exchange rate equation. The model estimated here incorporates the impact of relative productivity gains, as well as other fundamentals: (Figure II.7):

Figure II. 7.India: Variables Used in Estimation of Equilibrium Exchange Rate

Sources: IMF staff calcuations; Milesi-Ferretti and Lane (2005).

  • Relative productivity gains proxied by GDP per worker relative to trading partners (In_Prod).5 According to Balassa-Samuleson, faster productivity growth in the home country’s tradable sector relative to its nontradable sector, compared to trading partners, typically pushes up wages in the tradable sectors which in turn leads to higher nontradable wages and prices, and an appreciation in the real exchange rate.
  • Openness to trade measured by the ratio of the sum of goods and services trade to world trade or, alternatively, Indian GDP. Trade liberalization usually leads to an increase in imports, deterioration in the current account balance, and a depreciation in the real exchange rate. Most studies use the ratio of goods trade to GDP. Here, we broaden the measure of trade to include services so that is more closely matches our measure of the REER. We also measure openness by scaling India’s by world trade to try to capture if increased openness translated into a greater share of world trade.
  • Net foreign assets (NFA) of India scaled by GDP as calculated by Lane and Milesi-Ferretti (2005). A long-run increase in the home country’s NFA position (or a decline in its indebtedness) would require a smaller trade surplus over the medium term to match the lower level of debt service, which in turn requires a more appreciated real exchange rate.

16. The “equilibrium” exchange rate is estimated using cointegration techniques. The long-run equilibrium (cointergrating) relationship between the real exchange rate and the explanatory variables is derived from a vector error correction model using annual data from India from 1980–2004.6 The results are reported in Table II.6. Specification 1 measures openness by scaling India’s trade by word trade, Specification 2 scales openness by GDP and includes a dummy variable to capture the move to a managed float in 1992–1993. The coefficients of the cointegrating relationship and the realized values of the explanatory variables are used to derive the path of the “equilibrium” exchange rate to compare to the actual real exchange rate. Relative to panel-based studies in Section C, this has the advantage of deriving India-specific coefficients. However, the results derived need to be treated with caution. The relatively short time-series constrains the number of variables that can be included in the model and the series may not be sufficiently long to capture long-run structural relationships, resulting in imprecise estimates. It also limited the number of variables that could be included in the analysis.

Table II.6.Real Effective Exchange Rate Determinants
VariableSpecification 1/
12
Dependent Varibale: REER
Constant-4.699.73
In Prod4.490.77
(3.98)(3.24)
NFA-1.64-0.50
(-4.27)[10.1023]
Open World Trade-7.27
(-4.37)
Open GDP-1.86
[11.8459]
Dummy 92-930.22
[-5.13789]
Source: Staff estimates.

T-statistics are reported in parentheses below coefficient estimates. All estimates are derived using VECM. The short-term dynamics derived using the VECM are available on request and include one-year lags of the dependent and explanatory variables and the coefficients are significant and of the expected sign

Source: Staff estimates.

T-statistics are reported in parentheses below coefficient estimates. All estimates are derived using VECM. The short-term dynamics derived using the VECM are available on request and include one-year lags of the dependent and explanatory variables and the coefficients are significant and of the expected sign

17. While the results are sensitive to model specification, they suggest that the recent appreciation of the rupee has not been out of line with the estimated real “equilibrium” exchange rate. The coefficients in each model are statistically significant. Specification 1 implies that a 1 percentage increase in India’s productivity relative to its trading partners results in a sizeable real appreciation. On the other hand, a 1 percentage point increase in the NFA position is associated with a depreciation of just over 1½ percent.7 Comparing the estimated path of the “equilibrium” real effective exchange rate to the actual exchange rate in Figure II.8, suggests that by end-2004 the actual real value of the rupee was about 15 percent below its “equilibrium” level. However, the coefficients in Specification 1 are large especially relative to the other studies, and Figure II.8 also reveals long persistence in deviations in the real exchange rate from “equilibrium” and possible structural breaks in the “equilibrium” relationship8 that call into question the reliability of the model. Thus, Specification 2 re-estimates the long-run relationship including a dummy variable to capture the change in the exchange rate regime in 1992–1993, and measures openness relative to GDP to avoid problems of endogeneity when scaling by world trade. The coefficients are closer in magnitude to those derived in other studies and imply that the real exchange rate was broadly in line with the real “equilibrium” exchange rate at end-2004 (Figure II.9).

Figure II. 8.Specification I: Actual and Estimated CPI-Based REER

(1995=100)

Figure II. 9.Specification II: Estimates of the Equilibrium REER

(1995=100)

18. The findings highlight the difficulty in modeling the “equilibrium” REER and the uncertainty attached to specific point estimates. Country specific time-series studies of the type conducted here generally give smaller estimates of misalignment than studies that use a panel of countries such as those reviewed in Section C.9 The results are sensitive to how the fundamentals are modeled, highlighting the problems of relying on point estimates in such a framework. Moreover, the analysis excludes factors such as the terms of trade, the reduction in trade tariffs, and removal of quantitative restrictions, which in India’s case would have tended to exert downward pressures on the “equilibrium” real exchange rate.

Nonetheless, the econometric results and India’s recent export performance suggest that at least at end-2004 the exchange rate was not contributing to competitiveness problems.

D. Outlook for India’s Export Competitiveness

19. The econometric analysis suggests that various opposing forces will impact the future direction of the rupee. As agricultural workers are absorbed by the rest of the economy and structural reforms are implemented, India can expect to see continuing large gains in productivity. This implies that for the foreseeable future India’s economy will likely grow faster than that of its trading partners. Using estimates from the model for the Balassa-Samuelsson effect, assuming that India will grow in real terms by 6½ percent per annum, and taking the weighted average medium-term growth rate of India’s trading partners, the real exchange rate can be expected to appreciate by just over 2 percent per annum in the coming years.10 Capital inflows are likely lead to a stronger NFA position, potentially adding to appreciation pressures. However, trade liberalization, and factors such as increased investment in import intensive infrastructure, are likely to work against these pressures.

20. Going forward safeguarding India’s export competitiveness will require flexibility in exchange rate management. Flexibility in the nominal exchange rate has increased, both in absolute terms and after taking into account differences across countries in the volatility in capital inflows (Figures II.10 and II.11). 11 Given the uncertainty about the future direction of the rupee it will be important to allow two-way flexibility in the exchange rate to respond to the diverging pressures, otherwise India risks experiencing inflationary (or deflationary) pressures.

Figure II. 10.Volatility in the Nominal U.S. Dollar Exchange Rate

(Standard deviation of monthly, log differences)

Figure II. 11.Effective Exchange Rate Flexibility

(Ratio of exchange rate movements to reserve movements,

E. Conclusion

21. Despite recent gains, India remains a comparatively closed economy and the strides it has made into global markets in recent years only hint at its potential. India is making inroads into new markets and product areas, but it still has some way to go before it attains a level of market penetration that can rival its Asian neighbors. Although the real exchange rate has appreciated in recent years this does not appear to have contributed to a competitiveness problem. Looking forward, steps to lower trade tariffs and non-tariff barriers and improve the investment climate, as well as flexibility in exchange rate management, will be key if India is to build on its advantages and become a leading global exporter.

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1Prepared by Catriona Purfield.
2The high rate of service export growth in 2004/05 may reflect, in part, misclassification of earnings.
3For example, auto components in India are exported as inputs for Asian automobile makers.
4The size of the bubble in Figure II.2 represents the value of each export in 2003. So for example, India’s market share of global mineral manufactures—its largest manufacturing export where it accounts for 5½ percent of world trade—rose by 1.3 percentage points between 1990–2003 but the share of this good in global exports has fallen marginally.
5The author would like to thank Jaewoo Lee for providing this data.
6Stationarity tests confirm the variables are all I (1). Johansen trace and maximum eigenvalue tests point to a single cointegration vector at the 10 percent level of significance.
7The sign is counter to expectations. Other studies on Eastern European countries by Rhan, 2003 and Alberola, 2003 find a similar sign. Capital inflows may initially cause debt service to rise and the exchange rate to depreciate until such inflows translate into investment.
8The Gregory-Hansen test confirmed the existence of a structural break in the cointegrating relationship in 1992–1993.
9See Egért, Halpern and MacDonald, 2004.
10The 10-year average growth rates reported in IMF (2005b) are 2 percent per annum for the EU, 3.3 percent for the United States, and 5.3 percent for emerging and developing countries.
11Exchange rate flexibility is measured by comparing the volatility of the exchange rate to the volatility of reserves. The closer this ratio is to zero, the nearer the exchange rate system is to a fixed regime.

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