Chapter

7 Maintaining Competitiveness in the Global Economy

Author(s):
Charalambos Tsangarides, Carlo Cottarelli, Gian Milesi-Ferretti, and Atish Ghosh
Published Date:
September 2008
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The appreciation of the rupee in recent years has raised concerns about India’s export competitiveness. Between end-2002 and 2005, the Indian rupee appreciated by 6 percent against the U.S. dollar and by 8 percent in real effective terms. Imports were also growing at a rapid clip, and in the course of 2006, the current account moved from a position of surplus to one of deficit.1 Against this background, this chapter assesses external competitiveness, reviewing India’s export performance and estimates of the “equilibrium” real effective exchange rate during 2005.

Export Performance

India has witnessed a marked acceleration in export growth in recent years (Table 7.1). Between 2000 and 2005, the value of India’s exports grew three times faster than in the latter half of the 1990s. This acceleration was led by exports of services—particularly software and information technology—which gained momentum, with growth pushing past 100 percent in 2004/05.2 Much less appreciated is the fact that exports of Indian goods also performed strongly over the same period. As a result, exports

Table 7.1.Indicators of Export Growth(Annual percent change)
Fiscal Year
FY1995/96–1999/00FY2000/01–2004/052000/012001/022002/032003/042004/05
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 IMF staff estimates.
Sources: Reserve Bank of India, and IMF staff estimates.

India’s exports have become more diverse by region. Between 2000 and 2005, India’s market share of Asian goods imports nearly doubled. As a result, Asia has surpassed the European Union as the most important destination for Indian exports, accounting for almost one-third of total goods exports, suggesting that India may be becoming integrated into regional production chains.3 The EU accounted for only about one-fifth of Indian exports, down from almost 30 percent a decade before, and the share of the United States fell 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 those in Asia, with India accounting for almost 4 percent of the Middle East’s imports and just over 2 percent of Africa’s imports—India has become less dependent on, and less 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.

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 second half of the 1990s, export growth was in single digits and narrowly based (Table 7.2). The pickup in growth since 2000 has occurred across a wide range of categories. Figure 7.1, which plots the changing world market share of India’s 15 largest exports (at the Standard International Trade Classification [SITC] 3-digit level) against the changing share of those exports 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 a growing share of global trade, India’s exports have been growing faster than the global average. Since 1990, India’s share of global petroproduct exports has doubled, and its share of the chemicals and electrical equipment markets has tripled, albeit from a small base.

Table 7.2.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 and lubricants0.20.20.50.139.623.40.08.99.9
Animal and vegetable oils and fats0.70.80.840.75.40.31.70.40.0
Chemicals0.50.60.714.111.915.79.015.614.4
Manufactured goods1.51.61.913.88.910.443.345.632.0
Machinery and transport0.10.10.112.26.919.57.47.114.2
Miscellaneous manufactured items1.01.01.111.810.58.719.928.614.1
Commodities0.00.00.0–4.7112.3–2.4–1.0
Total0.60.60.712.27.612.2100.0100.0100.0
Sources: World Bank, World Integrated Trade Solution; and IMF staff calculations.
Sources: World Bank, World Integrated Trade Solution; and IMF staff calculations.

Despite these gains India’s export performance has lagged behind that of Asia, and its share of global exports remains low. Indian exports have grown more slowly than those in the rest of Asia, particularly those in China (Figure 7.2). India continues to account for a relatively small share of global goods exports. China accounts for over six times as much, and four member countries of the Association of Southeast Asian Nations (ASEAN)—Indonesia, Malaysia, the Philippines, and Thailand—together account for 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 1.3 percent.

Figure 7.1.World Market Position of Indian Exports, 1990–2003

(Percent)

Sources: World Bank, World Integrated Trade Solution; and IMF staff calculations.

Note: Size of bubble for each product represents 2003 value of exports of that product.

The fact that India has not made greater inroads into world export markets is surprising given India’s low wages and strong productivity growth. Indians earn only a fraction of what their competitors earn, about US$0.60 an hour. Although wages in certain sectors, such as information technology, were rising at rates of about 20 percent a year between 2000 and 2006, a large informal sector and steady supply of new labor entrants is likely to have limited the pressure on overall wage levels. Labor has also become more productive. Rodrik and Subramanian (2005) estimate that labor productivity in India has grown by more than 3½ percent since the 1980s. Improvements in labor productivity have helped boost overall productivity in the manufacturing sector, with estimates suggesting that 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.

Figure 7.2.India’s Export Performance Relative to Other Asian Countries

(In percent of world goods exports)

Source: IMF, Direction of Trade Statistics.

Note: ASEAN-4 countries are Indonesia, Malaysia, the Philippines, and Thailand.

Various surveys suggest that poor infrastructure and a high regulatory burden hinder India from making greater inroads into world markets (Figure 7.3). 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 with only 15 days from China and 12 days from Hong Kong SAR. In addition to Indian firms’ facing some of the highest industrial electricity prices in the world, electricity outages cost them 8 percent of annual sales, four times more than their counterparts in China. Customs processing times are also slow. Shipments take just over 10 days to clear Indian customs compared with 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.

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 17 percent in 2005—such tariffs are still about twice as high as the average among member countries of ASEAN. IMF staff estimate that 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 of about 12.6 percent. If nontrade barriers, such as technical and safety requirements, were included, the antiexport bias implied by India’s tariff system would be even higher. These estimates suggest that 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. Elimination of import tariffs would boost the value of the country’s exports by 45 percent.

Figure 7.3.IMD Competitiveness Indicators, 2005

Sources: IMD (2005).

The performance of the Indian textile sector following the removal of the quotas under the Multifiber Arrangement 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, and those to the EU rose by about 80 percent (Ananthakrishnan and Jain-Chandra, 2005). Through September 2005, Indian exports to the United States grew, in value and volume terms, by a more modest rate of about 20 percent, with similar rates of growth being experienced in the EU market. The fact that India did not gain larger 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.

Exchange Rate and Competitiveness

The impact of the exchange rate for a country’s currency on the country’s competitiveness is typically examined by estimating measures of a real “equilibrium” exchange rate. Studies on India employ one of three approaches. The extended purchasing power parity approach assumes that purchasing power parity 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 real effective exchange rate (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 in which the current account equals either the “normal” level of capital inflows or the “structural” savings-investment balance. The third approach, base year comparison, compares the actual REER to a base year when the REER and the current account were in “equilibrium.”

Each of these approaches has drawbacks. The purchasing power parity approach assumes that perfect labor mobility links wages in the traded and nontraded sectors and that the 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 year comparison approach does not account for how the underlying equilibrium evolves over time with changes in the economy.

The various methodologies yield a wide range of estimates about the impact of a country’s exchange rate on its competitiveness. Table 7.3 summarizes 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–40 percent to +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.

Developments in the Real Effective Exchange Rate

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 the country’s most important trading partners. When assessing developments in India, most analysts have utilized the Reserve Bank of India’s (RBI) five-country REER index, which is based on the average bilateral trade shares of G-5 countries during the 1992/93–1996/97 period and wholesale price index inflation rates. Asian and other emerging market economies are not included in the index, despite their growing importance as Indian trading partners. The RBI released a revised REER index in December 2005 that includes China and Hong Kong SAR. This study utilizes a revised measure of India’s consumer price index–based REER that utilizes updated weights (Table 7.4) based on 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 trade in services as well as goods and incorporate the competition Indian exports face from goods of trading partners in third markets.

The revised index suggests that the REER for the rupee fluctuated in a relatively tight band in the decade to 2006, 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 an increasing inflation differential with trading partners have been contained to a large extent by nominal effective depreciation. However, the exchange rate regime has 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 1997 Asian crises, when sudden stops in capital inflows triggered large depreciations in the nominal value of the rupee (Figure 7.4).

Table 7.3.Estimates of Deviation from the Equilibrium Real Effective Exchange Rate
Independent Variables
StudySampleDependent VariableRelative productivityNet foreign assetsOtherAssessment YearEstimated Gap to Equilibrium
Extended purchasing power parity panel estimates
Davoodi (2005)133 countries; Penn World Table, 2000Relative price level to the United StatesPer capita GDP relative to the United States2000–40 percent
Bénassy-Quéré and others (2004)15 countries, 1980–2001CPI-based REERRatio of CPI to PPPCumulative current accounts scaled by GDP2001–16.4 percent
Lee and others (2005)39 countries, 1980–2003CPI-based REERGDP per worker relative to trading partnersCumulative current accounts scaled by GDPCommodity terms of trade; output of manufactured goods relative to trading partners2004–30 percent
Macroeconomic balance approach
Union Bank of Switzerland (2003)IndiaCPI-based REER2005–7 percent
Base year comparison
JPMorgan (2005)/ Deutsche Bank (2005)IndiaReserve Bank of India five-country REER20054.5–8 percent
Table 7.4.Revised RBI and IMF Country Weights in REER Indices(In percent of total)
Old RBI 5 CountryIMF Broad 43 Country
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

The updated REER shows that although the rupee continued to appreciate in real effective terms over the course of 2005/06, it did so less than suggested by older measures. Although the revised REER generally tracks the RBI measure quite well, the updated index shows that the rupee appreciated in real effective terms by about 5 percent between April 1993 and March 2005 and by a further 5 percent between the start of the 2005/06 fiscal year (March) and end-August 2005 (Figure 7.5). In contrast, the more-dated five-country RBI REER index points to an appreciation of about twice the magnitude shown by the revised IMF REER measure between April 1993 and March 2005, whereas the RBI’s revised REER index released in late December 2005 suggests that the rupee appreciated in real terms by a more modest 6.4 percent in the same period. However, comparing the value of the REER at a fixed point in time to an earlier base period 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. Deriving estimates of the underlying equilibrium real effective exchange rate to compare with the actual REER will provide greater insights into how the exchange rate is affecting competitiveness.

Determinants of the Real Effective Exchange Rate

An extended relative purchasing power parity approach can be 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 purchasing power parity–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 estimate generated by the exchange rate equation. The model estimated here incorporates the impact of relative productivity gains, as well as other fundamentals:

Figure 7.4.CPI-Based Real Effective Exchange Rate and Its Components

(1993 = 100)

Source: IMF staff calculations.

  • Relative productivity gains, proxied by GDP per worker relative to trading partners (In_Prod).5 Faster productivity growth in a country’s tradables sector relative to its nontradables sector, compared to productivity growth of the country’s trading partners, typically pushes up wages in the country’s tradables sector, 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 (Open_World Trade) or, alternatively, to Indian GDP (Open_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 it more closely matches our measure of the REER. We also measure openness by scaling India’s trade by world trade to try to determine whether increased openness has 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 a 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.

Figure 7.5.RBI Five-Country REER and IMF Revised REER Measure

(1993 = 100)

Sources: Reserve Bank of India; and IMF staff calculations.

The equilibrium exchange rate is estimated using cointegration techniques. The long-run equilibrium (cointegrating) relationship between the real exchange rate and the explanatory variables is derived from a vector error correction model using annual data for India from 1980–2004.6 The results are reported in Table 7.5. Specification 1 in the table measures openness by scaling India’s trade by world trade; Specification 2 scales openness by GDP and includes a dummy variable to capture the move to a managed float in 1992–93 (Dummy92-93). 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, 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 limits the number of variables that can be included in the analysis.

Table 7.5.Real Effective Exchange Rate Determinants
Specification
Variable12
Dependent variable: 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: IMF staff estimates.Note: t-statistics are reported in parentheses below coefficient estimates. All estimates are derived using VECM. The short-term dynamics derived using 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: IMF staff estimates.Note: t-statistics are reported in parentheses below coefficient estimates. All estimates are derived using VECM. The short-term dynamics derived using 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.

Although the results are sensitive to model specification, they suggest that the appreciation of the rupee between 1980 and 2004 was not 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 point increase in India’s productivity relative to its trading partners results in a sizable 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 7.6 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 other studies, and Figure 7.6 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 reestimates the long-run relationship including a dummy variable to capture the change in the exchange rate regime in 1992–93 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 7.7).

Figure 7.6.Specification 1: Actual and Estimated CPI-Based REER

(1995 = 100)

Source: IMF staff calculations.

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 (see Égert, Halpern, and MacDonald, 2004). 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.

Figure 7.7.Specification 2: Estimates of the Equilibrium REER

(1995 = 100)

Source: IMF staff calculations.

Outlook for India’s Export Competitiveness

The econometric analysis suggests that various opposing forces will affect 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-Samuelson effect, assuming that India will grow in real terms by 6½ percent a year, 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 a year in the coming years.9 Capital inflows are likely to 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.

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 differences across countries in the volatility of capital inflows are taken into account (Figure 7.8).10 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 7.8.Effective Exchange Rate Flexibility

(Ratio of exchange rate movements to reserve movements)

Source: IMF staff calculations.

Conclusions

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 that of its Asian neighbors. Although the real exchange rate appreciated between 2002 and 2005, this does not appear to have caused a competitiveness problem. Looking forward, steps to lower trade tariffs and nontariff 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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1These trends continued through 2007. See IMF (2008).
2The high rate of service export growth in 2004/05 may reflect, in part, misclassification of earnings.
3For example, Indian auto components are exported as inputs for Asian automobile makers.
4The size of the bubble in Figure 7.1 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 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 these data.
6Stationarity tests confirm that 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, however, by Rahn (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 available in E-views confirmed the existence of a structural break in the cointegrating relationship in 1992–93.
9The 10-year average growth rates reported in IMF (2005) are 2 percent a year for the European Union, 3.3 percent for the United States, and 5.3 percent for emerging market and developing countries.
10Exchange 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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