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4 Maintaining Competitiveness in the Global Economy

Author(s):
Catriona Purfield, and Jerald Schiff
Published Date:
August 2006
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Author(s)
Catriona Purfield

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 6 percent and 8 percent against the U.S. dollar and in real effective terms, respectively. 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.

Export Performance

India has witnessed a marked acceleration in export growth in recent years (Table 4.1). Since 2000, the value of India’s exports has grown three times faster than in the latter half of the 1990s. This acceleration has been led by services exports—particularly software and information technology (IT)—which continue to gain momentum with growth pushing past 100 percent in 2004/05.1 Much less appreciated is the fact 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 4.1.Indicators of Export Growth(Annual percentage change)
1995/96–

1999/2000
2000/01–

2004/05
2000/012001/022002/032003/042004/05
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. The past five years have seen India’s market share of Asian goods imports nearly double. As a result, Asia has surpassed the European Union (EU) 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.2 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 with India now 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 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.

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 4.2). The pickup in growth since 2000 has occurred across a wide range of categories. Figure 4.1, 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.3 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 the global petro-product export market has doubled, while its share of the chemicals and electrical equipment markets has tripled, albeit from a small base.

Figure 4.1.World Market Position of Indian Exports, 1990–2003

Sources: World Integrated Tra de Solution; and IMF staff calculations.

Table 4.2.Composition of Goods Exports
Share of World Goods TradeAverage Annual Grow 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
Commodities, n.e.s.0.00.00.0−4.7112.3−2.4−1.0
Total0.60.60.712.27.612.2100.0100.0100.0
Sources: World Integrated Trade Solution; and IMF staff calculations.
Sources: World Integrated Trade Solution; and IMF staff calculations.

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 4.2). 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 South East Asian Nations (ASEAN)—Indonesia, Malaysia, 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 4.2.India’s Export Performance Relative to Other Asian Countries

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

Source: IMF, Direction of Trade Statistics.

1Indonesia, Malysia, Philippines, and Thailand.

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 their competitors, about $0.60 an hour. While wages in certain sectors, such as IT, have been rising at rates of about 20 percent a year since 2000, 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 grew by over 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.

Various surveys suggest that poor infrastructure and a high regulatory burden hinder India in making greater inroads into world markets (Figure 4.3). 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 (Winters and Mehta, 2003). 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 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.

Figure 4.3.IMD Competitiveness Indicators, 2005

Source: International Institute for Management Development (IMD), World Competitiveness Yearbook, 2005.

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 of member countries of ASEAN. IMF staff estimates 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 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.

The performance of the Indian textile sector following the removal of the quotas under the Multifiber 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 2005, 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 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 on 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 (PPP) approach assumes 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 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 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 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 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 the exchange rate on competitiveness. Table 4.3 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.

Table 4.3.Estimates of Deviation from the Equilibrium Real Effective Exchange Rate
Independent VariablesEstimated
StudySampleDependent VariableRelative productivityNet foreign assetsOtherAssessment YearGap to Equilibrium
Extended PPP panel estimates
Davoodi (2005)133 countries; Penn World Tables, 2000Relative price level to the U.S.Relative per capita GDP to the U.S.2000−40 percent
Benassy-Quéré and others (2005)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 goods2004−30 percent
Macroeconomic balance approach
Union Bank of Switzerland (2003)IndiaCPI-based REER2005Approx. −7 percent
Base year comparison
JP Morgan/Deutsche BankIndiaRBI 5-country REER2005Approx. 5–10 percent

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 India’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 that 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 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 (CPI)-based REER that utilizes updated weights (Table 4.4) 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 4.4.Revised RBI and IMF Country Weights in REER Indices(In percent of total)
Old RBIIMF Broad
5-Country43-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 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 4.4).

Figure 4.4.CPI-Based Real Effective Exchange Rate and Its Components

(1993=100)

Source: IMF staff calculations.

The updated REER shows that while the rupee appreciated in real effective terms over the course of 2005/06, it did so by 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 the 2005/06 fiscal year (Figure 4.5). 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 2005 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. 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 affecting competitiveness.

Figure 4.5.RBI Five-Country REER and IMF Revised REER Measure

(1993=100)

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

Determinants of the Real Effective Exchange Rate

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 REER 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:

  • Relative productivity gains proxied by GDP per worker relative to trading partners (In_Prod).4 According to Balassa-Samuelson, 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 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 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 it more closely matches our measure of the REER. We also measure openness by scaling India’s imports and exports by world trade to try to capture if increased openness translated into a greater share of world trade.
  • Net foreign assets (NFA) of India (as calculated by Lane and Milesi-Ferretti, 2005) scaled by GDP. 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.

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 from India from 1980 to 2004.5 The results are reported in Table 4.5. Specification 1 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. 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 could be included in the analysis.

Table 4.5.Real Effective Exchange Rate Determinants
Specification1
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.

T-statistics are reported in parentheses below coefficient estimates. All estimates are derived using a vector error correction model (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: IMF staff estimates.

T-statistics are reported in parentheses below coefficient estimates. All estimates are derived using a vector error correction model (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.

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 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.6 Comparing the estimated path of the “equilibrium” real effective exchange rate to the actual exchange rate in Figure 4.6 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 the other studies, and Figure 4.6 also reveals long persistence in deviations in the real exchange rate from “equilibrium” and possible structural breaks in the “equilibrium” relationship7 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 4.7).

Figure 4.6.Specification 1: Actual and Equilibrium REER (EREER)

(1995=100)

Source: IMF staff calculations.

Figure 4.7.Specification 2: Estimates of the Equilibrium REER (EREER)

(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.8 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.

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-Samuel-son 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 taking into account differences across countries in the volatility in capital inflows (Figure 4.8).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 4.8.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 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 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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1The high rate of service export growth in 2004/05 may reflect, in part, misclassification of earnings.
2For example, auto components in India are exported as inputs for Asian automobile makers.
3The size of the bubble in Figure 4.1 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 5½ percent of world trade—rose by 1.3 percentage points between 1990 and 2003 but the share of this good in global exports has fallen marginally.
4The author would like to thank Jaewoo Lee for providing this data.
5Stationarity tests confirm the variables are all Johansen trace and maximum eigenvalue tests point to a single cointegration vector at the 10 percent level of significance.
6The sign is counter to expectations. Other studies on Eastern European countries 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.
7The Gregory-Hansen test confirmed the existence of a structural break in the cointegrating relationship in 1992–93.
9The 10-year average growth rates reported in International Monetary Fund (2005) are 2 percent a year for the EU, 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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