Have Economic Reforms Affected Exchange Rate Pass-Through to Prices in India?

Author(s): Jeevan Kumar Khundrakpam

Source: Economic and Political Weekly, Vol. 43, No. 16 (Apr. 19 - 25, 2008), pp. 71-79
Published by: Economic and Political Weekly
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Have EconomicReformsAffectedExchange Rate
Pass-Throughto Pricesin India?
JEEVAN KUMAR KHUNDRAKPAM

Thispaperexaminesthe behaviourofexchange puzzleofthe1990sis thephenomenon of

to domesticpricesinIndiaafterthe
ratepass-through despiteepisodesoflargecurrency
low inflation deprecia-
tion in severalcountries.In the cross-country
Amacroeconomic context,
reforms intheearly1990s.Unlikeobservedin
initiated environ-
thisisshowntobe theresultsofthelowglobalinflationary
severalcountries,itfindsa riseinexchangerate mentitself[Taylor2000; Choudhriand Hakura2001; Gagnon
pass-throughto domesticpricesuntilrecentyears. and Ihrig2004]. Several otherfactorssuch as exchangerate
associated
Besideseconomicfactorstypically volatility,importpenetration,openness,importcomposition,
trade distortions, transportcosts and incomehave also been
the persistenceof
witheconomicliberalisation, determinants of pass-through
identified as important [Goldfajn
higherinflation factorforthe rise
isan important and Werlang2000; Campaand Goldberg2004 and Frankelet al
in pass-through. 2005]. Witheconomicreforms, thesemacroeconomic variables
determiningexchange rate pass-through undergo substantial
transformation duringthetransition.
In India,sincetheearly1990seconomicreforms wereinitiated
on severalfronts and have led to a marketdetermined exchange
rate, full convertibility in the current account, a substantial
reductionin peak and weightedaveragetariff rates,abolitionof
and
importlicensing quantitative restrictions,encouragement of
foreign investment through liberalisation and simplifying pro-
cedures,abolitionofindustrial licensing, allowingprivatesectors
in areas earlierreservedforthepublicsector,decontrol ofinter-
in
est rates,reduction pre-emption banking of resources and
enforcing capitaladequacy and prudentialnorms,government
borrowing at marketratesand discontinuation ofautomatic mon-
étisationof deficit,and gradual liberalisation of administrative
pricecontrolmechanismon a numbercommodities.
Have the economicreformsaffectedthe exchangeratepass-
throughto domesticpricesin India? Do we observethe same
decliningphenomenonas in severalcountries?Currently, there
is notmuchliterature on India.The cross-country studieswhich
have includedIndia do not indicatetemporalbehaviour.This
paper,usingmonthly data further investigates thebehaviourof
exchangeratepass-through to domesticpricesduringthe post-
economicreforms period.
Therestofthepaperhas sixsections.Section1provides a review
oftheliterature to identify factorsdetermining pass-through. In
Section2, thedataissuesandthestylised factsarebriefly discussed.
Theempirical framework is laidoutin Section3 andtheresults are
presented in Section4. Section5 provides a conjecturalexplanation
fortheobserved trendinpass-through. Thefinalsection summarises.
Thisis a revisedversionofthepaperpublishedas BIS Working Paper225
andwhichis availablein theBIS websitewww.bis.org. The viewsare 1 What Determines Pass-Through?
personal. In thetraditional
open-economymacroeconomic models,under
JeevanKumarKhundrakpam is withthe
(jeevankh@rbi.org.in) purchasingpower parity (ppp) assumption,exchange rate
ReserveBankofIndia.
pass-throughto domestic prices is always immediateand
Economic& Politicalweekly 1323 april 19, 2008

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SPECIAL ARTICLE - =

complete.Thus, researchon it was microeconomicin nature Forpass-through toimportprices,CampaandGoldberg(2004)

and the explanation for the evidence of incompletepass- for25 Organisation forEconomicCooperationand Development
throughwas based on imperfectcompetitionand pricingto (oecd) countriesfindthecomposition ofimports to be moreim-
markettheory[Dornbusch 1987and Krugman1987].Firms,in or- portantin explainingthebehaviourofpass-through thaninfla-
der t0 maintain mar' tionand exchangeratevolatility.1
Table1:AnnualisedAverage.nflation,ExchangeRate
andTheirVolatility (in%) ket share, adjust their On domesticprices,Choudhriand Hakura(2001) ina studyof
Period Average InflationAverage Exchange mark-UD
InflationVolatility
instead of 71 countries, consistingofbothdevelopedand developingcoun-
ExchangeVolatility
change fully passing the ex- tries,finda strongpositiveassociationbetweenpass-through
1990:4to1995:3 10.24 6.70 11.19 34.81 change rate move- and the average inflationrate across countries.The inflation
(7-46) (19-59) ment to ratewas foundto dominateothermacroeconomic variablesin
prices [for a
1995:4to2000:3 5.00 6.46 2.91 20.22
^ Gq explaining the cross-country differences in the pass-through.
2000:4to2005:3 4.53 5.27 0.08 21.61 ,
and JKnetter1996] yy
,.
. Similarly, in 122countries,Devereuxand Yetman(2003) finda
Overall 6.25 6.67 4.73 26.65
(3.46) (20.6) Analysing pass- positivenon-linear relationship betweenpass-through and mean
inparentheses
Figure inJuly
thedevaluation
areexcluding 1991.
through6 from a inflation and exchange rate.
Volatility bythestandard
ismeasured deviation.
macroeconomicper- Gagnonand Ihrig(2004) further testwhetherthe changein
spective is related to in
developments open-economy macro- pass-through in 20 industrialised countriesis explainedby
economicsliterature beginning with Obstfeld and Rogoff (1995), the change in inflation regime.Relatingthe estimatedpass-
and itsfurther extensionbyBettsand Devereux(1996,2000) and through forpre-andpost-inflation regimechangeforeachcountry
others.In this new open macroeconomicmodel,pass-through withthe corresponding inflation regimes,theyfindthatthede-
dependsupon the pricingstrategy of firms.Under producer cur- cline in pass-throughexplainedbythefallininflation
is variability.
rencypricing (pcp), the home of
currencyprice foreigngoods Bailliu and Fujii (2004) for11 industrialised countriesalso find
will move one-for-one with changes in the nominalexchange thatpass-through declinedwitha shiftto low-inflation environ-
rate, i e, is
pass-through complete. With local currencypricing ment brought about in
bychange monetary policy.
(lcp), thereis no change in the short-run pricesfaced by the Frankelet al (2005) on eightselectgoodsof76 countries dur-
consumer, and thus, no pass-through. The aggregatepass- ing 1990-2001 also find decline in pass-through, which was
through,therefore, dependsupon the Figure 1: Five Years RollingAverage Inflationand Volatility much more tor
rapid developing coun-
combinationof firmspractisingpcp triesthanhigh-income countries. They
and lcp [Bettsand Devereux1996 and findthatper capita income,bilateral
Engle2002]. distance,tariffs, countrysize, wages,
Anotherinfluential view, based on long-termexchange rate variability
staggeredprice setting and mono- and long-term inflation are important
polistic competition behaviour of determinants of pass-through.
firms,is thata crediblelow inflation
regimeleads to a lowerpass-through Figure 2: FiveYears RollingAverage Exchange Rate Change 1.2 VARApproach
[Taylor2000]. and Volatility
Pass-through is also analysedundera
recursivevar framework byassessing
1.1 Cross-countryEvidence the impulse responsesand variance
Beforeproviding evidencefromthelit- decomposition ofvariouspricesalong
it be
erature, may appropriate point to the distribution chain obtainedfrom
out thatthereare different stages of shocks to exchangerate and import
exchange rate pass-through to domes- prices. For six industrialisedcount-
ticprices.First,thechangeinexchange ries, the pass-through is foundto de-
rateimpactsthe importprices(called clinealongthedistribution chain,with
thefirst of
stage pass-through) and the Figure 3: Recursive Estimates ofCoefficient only a modest effect on consumer prices.
resultingchangein the importprices Further, the pass-through is foundto
in turn affectsthe other domestic be strongerfora moreopen economy
of
prices(secondstage pass-through). [McCarthy 1999].
Goldfajnand Werlang(2000), using Several studies adoptingthis ap-
a sampleof71 countriesfindthatthe proach in individualcountrieshave
main determinantsof pass-through found lower pass-through along the
are the cyclicalcomponentof output, distribution chain,and declinein the
the initialovervaluationof the real exchangerate (rer), the pass-through with lower inflation[Bhundia 2002 for South
initialrate of inflationand the degree of openness. Among Africa;Leighand Rossi 2002 forTurkey;and Belaisch2003 for
them,the rer misalignmentis the most importantdeter- Brazil].Kangand Wang (2003), however,findthatin Thailand
minantforemergingmarketswhile it is the initialinflation for and Korea the pass-throughincreased afterthe Asian crisis
developed countries. due to higherexchangeratevolatilityresulting fromadoption
*7i
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 SPECIALARTICLE
of free-floating
exchangerate regimeand increasein tradeto remainunchangedforindividualcomponents. Fifth,tradedis-
gdp ratio. tortionsresultingfromtariffsand quantitativerestrictions by
actingas a barrierto arbitrage
ofgoodsbetweencountries would
1.3 Asymmetryand Non-linearity lead to lowerpass-through. Sixth,in thepresenceofasymmetry
Pass-throughcan differbetweendepreciationand appreciation and non-linearity,thepass-through woulddependuponthepe-
(asymmetry),andbetweenlargeand smallchange(non-linearity).riodof appreciationand depreciationand the size of exchange
Whenfirmsfacecapacityconstraints and/orthereare tradere- ratechangeduringvarioussub-periods.
strictions,
pass-throughis higherfordepreciation
thanapprecia-
tion[Knetter1994;Pollardand Coughlin2004]. 2 Data Issues and Stylised Facts
Table 2: Model Estimates and Robustness Tests-1990:2 to 2005:3 This sectiondiscussesthedata issues and stylisedfacts.
Model Constant Ae, AP't AYt APt0 Fshock, AM,., R2 LM

Modela 0.0037 0.069 0.373 0.052 0.46 1.67 2.1 Source of Data
(10.4) (5.0) (5.4) (2.3)
Model
b 0.0023 0.068 0.46 0.044 0.254 0.52 2.27 We use the monthlydata duringthe period 1990:1to 2005:3
(4.9) (5.2) (6.7) (2.1) (4.5) fromthe Handbookof Statisticson Indian Economy(Reserve
Modèle 0.0022 ÔÔ57 Ô39 ÔÔ42 Ô3Ô ÔLÎ4 062 ÔÔ9~
BankofIndia).Thevariablesare:wholesalepriceindex(P)2,nomi-
(5.3) (4.9) (6.3) (2.2) (5.9) (6.8)
Model d 0.001 0.056 0.40 0.037 0.31 0.13 0.088 0.62 0.02 nal effectiveexchangerate(e) definedas domesticcurrency per
(1.4) (4.8) (6.5) (1.9) (6.1) (6.1) (1.9) unitofforeign currency, indexofindustrial production (Y), broad
money(M), and tradeweighted
Thefiguresintheparenthesesaret-statistics;
Thereportedstatisticson LMtestforserialcorrelation
isf-statistics.
foreign prices(P*). Tradeweight-
Whenfirms are buildingup marketshare,appreciation allows ed foreignpricesis derivedusingthedefinition ofreal effective
firmsto lowerimportpricesevenwhilemaintaining theirmark exchangerateadoptedbyrbi. As therealeffective exchangerate
up, while depreciation leads to reduction in to
mark-up keepprice (rer)is definedas weighted average ofnominal effective exchange
unchangedto maintainmarketshare[Knetter1994]. rate(e) x [wholesalepriceinflation (P) -rforeign inflation (P*)],we
The non-linearity in pass-through arisesinthepresenceofthe canderiveP*= (e x P) -^rer.3 Alltheseriesareseasonally adjusted.
menucostand dependson thetypeofpriceinvoicing. Underpcp,
a smallchangesin the exchangerateare passed-though, but a 2.2 Some Stylised Facts
largechanges are absorbed by altering the invoice price, while Theannualisedmonth-to-month averageinflation rate,exchange
theoppositehappenswithlcp [Pollardand Coughlin2004]. ratechangeand theirvolatility forsub-sample periodoffiveyears
Manyempiricalstudiessupportasymmetry in pass-through, inTable1 (p 72) showsdeclinein averageinflation and itsvola-
butthe directionshave varied.Forthe us, Mann (1986) found tility,particularlythe former.The average depreciationrate
higherpass-through duringappreciationthandepreciation. For also declined considerablydue to increasingtwo way move-
sevenAsiancountries, Webber(2000) findstheoppositeto hold. mentsin themorerecenttimes.On theotherhand,thedecline
Withregardto non-linear response,Ohno (1989) findsJapanese in volatilitywas farless prominent, particularly withtheexclu-
Figure4: RollingRegressions Coefficients
sion of in
depreciation July1991.
The rollingfiveyearsaveragein Figure1 (p 72)
show thatthe annualisedaveragemonth-to-month
inflation declinedfromover10 percentto around4
to 5 per cent.Volatility also declinedbut to much
lesserextent.
Similarly,theaveragerateofdepreciation steadily
declineddue to increasing two way movements, re-
in
sulting appreciation in the more recent period
exportpricesto respondmoreto large exchangeratechanges (Figure2,p 72). Thevolatility, excluding themajordevaluations in
thansmall changes.For 30 us importindustries,Pollardand July1991,on theotherhand,appearstohavenotchangedmuch.
Coughlin(2004) also findmostfirmsresponding positively tothe
size ofexchangeratechange. 3 EmpiricalFramework
We discussherethemodelused intheexercise.
1.4 Factors Explaining Pass-Through
Thus,severalfactorsaffecting exchangeratepass-through can 3.1 Model Estimated
be identified: first, higher inflation and its volatility would lead to Drawingontheliterature [Bailliuand Fujii2004],a reducedform
higherpass-through and vice versa; second, the impact of ex- specificationis derived from theprofit maximising behaviourof
change rate volatility is not unambiguous,though some of the an exporting foreign firm of thefollowing type,
studiesfindthatthehigherthemisalignment ofrer higheris the Max7i= e-1PQ-C(Q) ...(1)
p
pass-through; a
third, higherimportpenetration ratioand higher
importsand exportsto gdp ratiolead to higherpass-through; whereln'is profit in exporting firm'scurrency, *efis theexchange
fourth,the compositionof importswith varyingdegrees of rate of domesticcurrencyper exportingfirmscurrency, *P'is
pass-through affectsaggregatepass-througheven when they priceindomesticcurrency, C(Q) is thecostfunction inexporting
Economic
& Political
weekly 1333 april 19, 2008 73

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ARTICLE
SPECIAL = = 1_ _

firm's currency and 'Q' is thequantitydemanded.The firstorder Finally,as muchofthemonitoring ofinflationarysituationin

condition formaximisation of(1) is derivedas, Indiais donethroughthemonitoring ofgrowthofmoneysupply,
P = eCq/i ...(2) it is also includedas an additionalvariable.Thus,thefinalaug-
where'Cq'is themarginal costand y is themark-up overmarginal mentedequationis ofthefollowing type.4
costwhichdependson thepriceelasticity ofdemandofthegood.
= + 4- + +
Thus,thepricein domesticcurrency 'P' can changeas a resultof APt a0 a, .2 APM a2.=ZAet_; a3 .IEAP^ a,.^ AYt_{
n n
exchangerate,changein marginalcostof thefirmand mark-up. + a5 .2 fshockt_i + a6.2 AMt_i +^ ...(7)
Themarginal costwillchangebecauseoflocalinputcost,whilethe
mark-up canchangeduetochangeindemandfactors inthedomes- where'M' standsformoneysupply.The lagged inflation term
ticcountry Thus,inreducedform, thepriceequationiswritten as, givesthespeed ofpass-through The short-run
to inflation. pass-
P, = a0 + a,et + ct^P;+ a3Yt+ e, ...(3) throughcoefficient is givenby0^ and thelong-run coefficientby
where'P*'is exportingfirm'smarginalcost and 'Y' is domestic Ota/d-Otj).
demandconditions, withat as the measureof pass-through. In
theliterature, variantsof (3) are used to estimatepass-through 3.2 Asymmetryand Non-linearity
[Golberg and Knetter 1996]. The asymmetry and non-linearity is estimatedby interaction of
To estimatepass-throughat the aggregateprice level, the the exchangerate variablewith appropriatedummiesin the
followingissues needs to be taken into account,and accord- following manner.
inglyadapt (3). As macroeconomic variables such as price, out-
Table 3: TrendFitson RollingRegression Coefficients put and ex- Asymmetry:Two dummiesforappreciationand depreciation
Pass-Through a, a,+a3 R-bar Wald Wald
change rate are respectively are:
Test Test
Square
a,=o ai-Kx}=o generally
„
as- DA = 1 forAe < o, o otherwiseand DD = 1forAe> o, o otherwise
Short-run ^.00023 0.23 37.0 SUmed to follow Interaction oftheabove dummieswithexchangeratechange
(6J) [o-oo] a non-station- yieldstheequation
Short-run 0.0008 -0.00013 0.76 386 1.60 ^^at,*u^
{M_M [0.00] [0.21] ary process Id), APt= cco+ o, .2 APt_i+a2A.ZpAAet_i
+ +
o^AP^
2010 the
a2D.2:oDDAet_i
Long-run 0.0005 0.62 Specifica-
n n n
012) IO00] tions are COm- + cc5
+ a4 .2 AYt_i + a6 . 4-^ ...(8)
Long-run* 0.0008 0.0013 0.75 236.0 50.0 . , . .2ofshockt_i ^AM^
mOnly USed m
(15.4) (7.1) [0.001 [0.001
The inround aret-statistics
brackets insquare
andthose are
brackets first difference, withct,A forappreciation
coefficients
and ct^ as thepass-through
figures
• Each
oftheslope inthetwo
coefficients sample aregreater
periods . . i
p-values;
inintercept l C) form
L11C 1Uim and depreciation,
respectively.
than thefull
for
theaverage which
period, bydecline
isaccounted
dummynotreported. Of an inflation

equation[BailliuandFujii2004 amongothers].In ourcase, as the Non-linearity:The two dummiesforabsolutelargeand small

unitrootproperties discussedintheAppendix(p 78) showthat changerespectively, are:
all thevariablesare stationaryin first and are inany
difference, DL = 1forAe > threshold, andDs = 1forAe< threshold,
o otherwise
case notcointegrated in levelform,we also considerthespeci- 0 otherwise
ficationin firstdifferencein orderavoid spuriousrelationship. Interaction of the above dummieswithexchangeratechange
Second,the lagged effectsof the explanatoryvariablesneed the
yields equation,
to be takenintoaccount,leading to an inflationequation of APt= (Xo+ c^ .2 APt_i+a2L.2oDLAet_i
+ +
Aet_i
a^Ds o^AP^
thetype.
+% • + a4 2 AYt_j .2 AM^ + e,
+ a5 2 fshock^+ cc61=0 ...(9)
APt= ct04-a, JoAet_i
+ a2 .EAP^ + a, .ZAYt_j ...(4) *i=o 3i=o

coefficientsforlargeand
equation,we accountforinflation withc^l and o^ as the pass-through
Third,(4) beingan inflation
persistenceby followingan adaptive expectationsapproach smallchanges,respectively.
This also allows us to distinguish
and includelags of inflation.
and long-run 4 EmpiricalResults
betweenshort- pass-through.
The following are theempiricalresults.
+ a2.IAet_i+ (^.ZAP^ + a^SAY^
APt= cto+ oq.S APt_i ...(5)
the resultsob-
Fourth,in India shockin primarycommodities, particularly 4.1 RobustnessTests: Table 2 (p 73) presents
of alternative defined
foodprices,due to adversesupplyconditionsoftenaffectsthe tainedfromthe estimation specifications
6
to (7) representing model A to modelD, respectively.5'
generalpricelevel. FollowingMohantyand Klau (2001) food by (4)
priceshock'fshock'is definedas theexcessofcurrent foodprice The modelA is well estimatedwithall thevariablesstatistically
inflationoverthe generalpriceinflationof the previousyear, significant, has reasonableexplanatory power,and does notsuf-
ferfromserial correlation. There is substantialdifferencebe-
leadingtothefollowing specification.
tweenthe coefficient of foreignprice (input cost) and the ex-
= + + +
APt Oo+ oj: APt.i (t2.|)Ael_i «3i| APt-i <x4i?0AYt-i changerate.The exchange rate pass-through (0.07 per cent)is
muchlowerthan inputcost pass-through (0.37 per cent),with
+ cl**2 fshockt_i+^ -(6) Waldtest[19.51(0.00)]decisivelyrejectingtheequalitybetween
i=o
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 ' -
- SPECIAL ARTICLE

thetwo.Thiscan ariseas foreignfirmsconsiderchangein input to be stable.7Andrewsand Ploberger(1994) testalso revealsno

costtobe morepermanent thatthanexchangeratechangesthat structuralbreakin the individualcoefficientsand jointly.8The
moreoftheformer is passed-through. recursiveestimatesofthecoefficients,however, show an overall
Figure 5: RollingRegression - Asymmetryand Non-linerity
rise in the coefficientof the exchangerate
(Figure3, p 72). Thus,the pass-through coeffi-
cientcould have undergonea gradualchange,
whichis notcapturedbytheabovetests.Thus,
we carryoutrollingregressions.

4.4 Pass-ThroughCoefficientsfrom Rolling

Regressions9:Figure4 (p 73) showstheshort-
run and long-runpass-through coefficients
ob-
tainedfromrollingregressions, along withthe90
percentconfidence intervals.10Itcanbe seenthat
theshort-run pass-through coefficientsrosefrom
about0.03 to about0.11up tomid-2001 andthen
fallsto about0.07. The riseinthelong-run pass-
through, on theotherhand,ismuchmoreconsist-
ent and steady,increasingfromabout 0.04 to
morethan0.13.
The inclusionof the autoregressive term(modelB) does not Two trendswerefittedto observetheincrease:(1) PT = Po +
alterthepass-through coefficient, thoughitcan differentiate the PjTrend, wherePT is the seriesof pass-through coefficients
ob-
short-runand long-runpass-throughwhile the explanatory tainedfromthe rollingregressions. Forfa > o pass-though has
powerimproves. The alterationsin the impactofforeignprices increased,fa< o thepass-through has declinedand fa = 0 there
and thedomesticdemandshockscannotbe consideredas funda- is no change.(2) PT = Po + (P2 + Po) Dummy+ faTrend+ (fa +
mentallydifferent. Furtherinclusionoffoodpriceshock(model P3)Dummy *Trend.Dummytakesthevalue of1 fromthepointof
C) leadsto a slightdecline in the pass-through coefficients(both significant trend breakand thereafter, and o otherwise.11 The se-
theshortand long-run), butis notsubstantialand fundamentally lectioncriterion is thehighestR-barsquare,fais thetrendbefore
different.
The explanatory powerimprovesmarkedly. Augment- theidentified pointand thereafter, itis (fa + P3).
ing with in
change moneysupply(modelC) hardly makes any Table 3 (p 74) shows that both the short-run andlong-run pass-
differenceintermsofthecoefficients and theexplanatory power through increased.12 While the short-run coefficient increasedbya
compared to model C. Thus, the estimated pass-through coeffi- monthly of
average 0.00023, the long-run coefficient increasedby
cientsare robustto alternativespecifications incorporating im- a highermonthlyaverage of 0.0005. The Wald testsindicate
portantdeterminants ofinflation in India. In theremaining, we thatthe increasesare significantly different fromzero.Forthe
analysepass-through using model C, as we essentiallyestimate short-run after
coefficient, increasingby monthly a averageof
an augmentedsupplycurveand therefore, as mentionedabove, 0.0008, it has levelledoff(the Wald testrejectsthedeclineby
includingmoneysupplymaynotbe appropriate. -0.00013).On otherhand,theincreaseinlong-run coefficients
ac-
celeratesfroma monthly average increase of 0.0008 to a monthly
4.2 Comparisonof Coefficients with Earlier Estimates:Esti- averageof0.0013 (theWaldtestshowsstatistical significance).
matedpass-through coefficients of0.06 in theshort-run and 0.08
Figure6: Openness and ImportPenetration Ratio
to0.09 inthelong-run 10
imply per cent in
change exchangerate,
and lead to increasein finalpricesby 0.6 to 0.9 per cent.Such
magnitudes ofpass-through to finalpricesare typically estimated
andaresimilartotheestimates ofChoudhriand Hakura(2001) of
0.06 and0.10,respectively forIndia.Theshort-run pass-through is
largerthan theaveragepass-through of low inflationcountries and
severalindustrialised countries, whilethelong-run pass-through is
somewhatlowerthantheaveragereportedbythemon quarterly
datafor1979to 2000. Devereuxand Yetman(2003) usingannual
data during1970to 2001,however, estimatea muchhigherpass-
of for
through 0.36 India, as inflation getsaccumulated overa year Thepositiveslopeinthetrendofrollingregression coefficients,
whileexchangeratechangemay not be largedue to bothway however,does not ensurethatthe coefficients are statistically
movements. different fromeach other.Therefore, we perform Wald-testbe-
tweenthecoefficients ofsix pairsof windows,viz: thefirstand
4.3 StabilityofCoefficients: Thestability ofthecoefficients using the5thwindow(withlowestshort-run and long-run coefficient)
theparameter stabilitytestof Hansen (1991) finds thecoefficients against each of the windows with highestshort-run coefficient
Economic& Politicalweekly GQQ APRIL 19, 2008 75

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 =
SPECIALARTICLE -

(76th),highestlong-run coefficient (115th)and the last window coefficients arestatistically significantonlyinthelaterperiodsand

(121st). The results are presented in Table 4. continue to show a small risingtrend (Figure5).
Theincreasesup tothe76thwindowaresignificant at 5 percent
to7 percentcritical valuesforboththeshortandthelong-run. The 5 Explaining Increase in Pass-Through:
short-run pass-through coefficients declines thereafter, bythe Conjectural Evidence18
and
115thwindow, the increases from the initial windowsare statisti- We discuss here the various explanationsforthe increasein
The
callyinsignificant. long-runpass-through, however,records pass-through.
the highestcoefficient by this window and the increaseremains
significant at the 9 per cent critical value. By the lastwindow,the 5.1 Can Asymmetryand Non-linearityExplain?
increasein boththe short-run and long-run pass-through coeffi- Whenthepass-through is higherforappreciation, increaseinthe
cientsturnsstatistically insignificant. the
Thus,during majorpart frequency appreciations of would lead torisein pass-through.From
ofperiodunderconsideration, theexchangeratepass-through to thedataseries,itisobservedthatappreciation accounted for44 per
domesticprices,particularly thelong-run Table 4; Change In Pass-ThroughCoefficientsand Wald Test centof thetotalobservations, butin the
pass-through, increased. 76th 6th 115th 115th 121st 121st second halfand lastone-third ofthesam-
minus minus minus minus minus minus
1st 5th 1st 5th 1st 5th ple period, it accounted for 48 per cent
4.5 Asymmetryand Non-linearity Short-run 0.077 0.078 0.043 0.044 0.034 0.035 and52 percent,respectively. However, the
(0.056) (0.046) (0.15) (0.13) (0.256) (0.23) from
pass-through appreciation dipsmark-
Asymmetry: The pass-through is higher Long-run 0.094 0.094 0.10 0.10 0.077 0.077 edlyaroundthebeginning of2002.
(0.074) (0.068) (0.09) (0.086) (0.16) (0.15)
forappreciation than depreciation.The Thereported inbrackets
statistics arep-values
oftheF-test
ofthenullthat
the The frequency of smallchangeswith
respective coefficients shown in Table 5 isequaltozero.
increase
higherpass-through increasedto 67 per
are 0.07 and 0.10.13Followingdiscussionin Section2 thisis ex- centin thelastone-third ofthesampleperiod,as against63 per
pectedsincemostgoods were domesticallyproducedirrespec- centduringthe total sampleperiod.The pass-through fromit
tiveofqualityundertheerstwhilestrategyof industrialisation. also risesbutis statistically significant only in thelatterperiod.
Table 5: Asymmetryand Non-linearityin Pass-Through Coefficients Thus,itis apparentthatratherthanthemagnitude ofasymmetry
Asymmetry/ Depreciation Appreciation Large Small and non-linearity and theirfrequenciesperse, it is theirtrends
Non-linearity Short Long Short Long Short Long Short Long whichalso explaintheoveralltrend.
Asymmetry 0.05 0.071 0.073 0.105
(3.2) (3.1) (2.9) (2.8) 5.2 Explaining with Macroeconomic Variables
Non-linearity
1)> Sampleaverage 0.053 0.076 0.124 0.178
(4.4) (4.2) (2.6)Exchange Rate Volatility:Devereux and Engel (2001) and
(2.5)
2) > Median 0.06 0.079 0.113 0.16
Bacchettaand vanWincoop(2001) arguethatlowernominalvol-
(4.6) (4.4) (1.8) (1.8)
3) > 0.02 0.047 0.067 0.11 0.156 atilityis associatedwith lower pass-through as currenciesof
(3.7) (3.6) (3.8) (3.7) countrieswith lower exchangerate variabilityimplya stable
Figureinbrackets
aret-statistics.
monetarypolicyand is chosenas the currency of invoice.The
Thus,foreign exporters would have facedsome of
degree compe- counter argument is that rate
greaterexchange volatility implies
titionfromthe locallyproducedsubstitutes, and therefore, ex- commonand transitory fluctuationand makesfirmswaryof
pandingorholdingofmarketsharewouldbe an important objec- changingpricesforfearoflosingmarketshareand adjustprofit
tive.Rollingregression, however, shows that the pass-through Figure7: Weighted Average ImportDuty Rate
fromappreciation dipsmarkedlyaroundthebeginningof2002
whilethatofdepreciation risessteadily(Figure5, p 75).14

Non-linearity: Withno setcriteria toselectthresholdlevelsdistin-

guishing largeand smallabsolute exchange changes,we consi-
rate
deredthreelevelsviz, median (0.91 per cent),sampleaverage
(133 per cent) and 2 per cent (a value higherthanthe sample
average).15As seenfromTable5, theestimatedpass-through coef-
ficientsare foundto be muchhigherforsmallthanlargechanges,
and do not varymuchbetweenthe threealternative threshold
levels.Pass-throughfromsmallchangesrangesfrom0.156to0.178,
as against0.067 to 0.79 forlargechanges.Withmostimports in
Indiapricedin exporter's currency (pcp) or invoicedin us $ [rbi marginsmore[McCarthy1999; Frankelet al 2005]. The empiri-
2001],thehigherpass-through fromsmallexchangeratechangeis cal evidencesare also inconclusive.
As againsttheevidencepro-
as expected.16 The rollingregressions, however,show thatpass- videdbyMcCarthy(1999) and Frankelet al (2005) ofa negative
through from both large and small exchangerate changesin- impactofexchangeratevolatility on pass-through,
Choudhriand
creasedbutflattened out in thelaterperiod,particularly thatof Hakura (2001), Devereux and Yetman (2003) and Kang and
largeexchange rate changes.17 For small changes,however,the Wang(2003) finda positiveimpact.
7& April 19, 2008 rror» Economic& Politicalweekly

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 SPECIALARTICLE
In India,theexchangeratevolatility duringtheperiodunder pass-through,as observed.Removalof otherquantitative trade
considerationdid notchangemuchdue to intervention ofrbi to barrierssuch as quota shouldalso lead to increasein exchange
removeextremevolatility(see Table 1 and Figure2). Therefore, ratepass-through.
irrespectiveofthedisagreementin theliterature,exchangerate
volatility
might nothave played important in explaining
an role ImportComposition:The overallpass-through ofexchangerate
theobservedtrendin pass-through. movements wouldalso dependuponthecomposition ofimports.
Itemssuch as fuel,food and raw materialshave higherpass-
Openness and Import Penetration: Goldfajnand Werlang through, whilethatof manufacturing is lower[see forexamples
(2000) show, and empirically a of
verify, higherdegree pass- Campa and Goldberg2004; Otani et al 2003]. Figure8 showssix
through formore openeconomy[see also Kang and Wang2003]. components commodityof imports in India sincethebeginning of
Figure8: ImportConsumption
the 1990s.Among these six
components, the share of
energy, food and "others"
have increased.Increasein
the share of energyand
foodwouldleadto increase
in overall pass-through,
whilethatof"others" is not
certainas theymostly com-
prise ofmiscellaneousprod-
uctnotclearlydefined.
The remaining three
componentsshoweda de-
Also, rise in importpenetration ratiowill lead to rise in pass- cliningtrend,particularly the "other bulk imports".The bulkim-
through[McCarthy1999]. India, In with importliberalisation, ports consist of items which are manufactured butin thenatureof
many local inferiorgoods produced under the erstwhile import- raw materials such as iron and steel, other metals,paperandpaper
substitution strategy of industrialisation
would likely be substi- boards, etc. Share of capitalgoods, which are manufactured but
tutedbysuperiorimports. 6
Figure (p 75) shows that both import used as industrial inputs, increased and
initially thendeclinedwith
penetrationratio and openness have increased substantially deceleration in growthofgdp in thesecondhalfofthe1990s.As
sincethebeginningof 1990s,indicatinga strongpossibility for
Figure9: Lagged Coefficient(Inflation Persistence)
increaseinexchangeratepass-through to domesticprice.

ReductioninImportTariffs and RemovalofTradeRestrictions:

Frankelet al (2005) arguethatany theoryof incompletepass-
through mustpositsomebarrierto arbitrageof a good between
country originand thecountry
of ofpurchase,and therefore, act
againstlaw of one Tariff
price. is one such barrierand willhave
negativeeffects on thepass-through. Theyfindthatthenegative
pass-throughimpact oftariffis particularly significanttothecpi of
developing countries. A negativerelationship between tariffand
exchangeratepass-through on
can also be argued thefollowing
ground.Underpcp as in India,as tariff is leviedon theexchange these two componentsare mostlymanufactured intermediate
rate changealso, a givenexchangerate changewould impact goods,theirimpacton pass-through is uncertain.
Thus,thetrend
domesticpricesmorewithhighertariff thanwitha lowertariff. in theshareofmanufacturing and rawmaterialsincluding indus-
Forinstance,otherthingsremaining same,10 percentdeprecia- trialinputsis notclear.However, theriseinthesharesoffueland
tionwith50 percenttariff ratewouldincreasedomesticpriceby5 foodcouldhaveledto increaseintheoverallpass-through.
per cent,while it would be 1 per centat 10 per centtariff rate.
Givena targeted pricelevel in the domestic market to maintain its InflationPersistence:We had observedin Figure1 thatboth
marketshare,a firm willabsorba muchhigherpercentage ofthe the average inflationrate and its volatilitydeclined barring
depreciationat highertariff thanat a lowertariff, i e, pass-through periodicspurtsdue to supplyshocks.Literaturesuggestthat
willbe lowerwithhighertariff thanlowertariff. Figure7 (p 76) theyshouldhave led to declinein pass-through, butthechange
showsa markeddeclinein thelevelofweightedaverageimport in the othermacrovariablescould have morethanneutralised
dutyfrom72.5percentin 1992to 25 percentin 1997,thoughthe the impact.While the short-run pass-through stabilised,the
trendreversedsomewhatin thenextfouryears.Thus,thefallin long-runpass-through continuedto increasedue to rise in the
the averagelevel of tariff would have led to increasein pass- coefficient of the autoregressive
termin the model estimated
through, while the reversalin the trendwould have reduced above (Figure9).
Economic
& Political
weekly GEE3 april 19, 2008 77

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 =
SPECIALARTICLE =

Non-decline ofinflation whenthe actual inflation

persistence average growthduring1997-98 to 2002-03 was 5.3 per cent.
has fallensubstantially witha numberofempirical
is consistent The same was reflectedin risingcurrentaccountsurplusessince
findingsforseveralindustrialised and LatinAmericancountries i
2001-02, savingsexceedinginvestment
e, whentheformer was
[Cecchettiand Debelle 2004; O'Reillyand Whelan2004]. lower due to higherpublic sector dis-savings(Figure 10).20
in
Interestingly, the Indiancase so far,forthe followingrea- Fourth,thesupplymanagement was facilitated
bythelargefood
sons, inflation
persistencecould rise withoutactual inflation which
stocks, couldbe released intotheopen marketandthrough
Figure 10: Growth,GovernmentDeficitand CurrentAccountBalance thepublicdistribution to
system keepprices undercheck.Fifth,
allowingfreeimportof commoditiessuch as sugar,edibleoils
and cottonsince the mid-1990simprovedthe supplyposition.
Sixth,exchangerate appreciationswere more frequentthan
depreciationsinthelatterperiod,whichlowereddomestic price.

6 Conclusions
Thispaperinvestigated theexchangeratepass-through todomestic
prices in India the
during post-economic reform periodandfound
fairly robust evidence of a rise in pass-through recentyears.
until
Thisis in contrastto a declineinpass-through observedinsever-
al countries sincethe1990s.Whena largedomesticeconomy lib-
eralises, and getsincreasingly integrated with the global econ-
rising.First,theoil pricecontrolhas been steadilyliberalisedby omy,the influence oftheexternalsector,including theexchange
reducingthedeficit inoil pool accountthatabsorbeda largepart ratemovement, could becomesubstantialduringthetransition.
of the externaloil priceshockson domesticprices,while the Dismantlingvarious types of controlswithinthe economy
demandforfuelis on therise.19 The administrative controlon the itselfcould also affectthewaytheexternalsectorinfluences the
prices of a number of for
commodities, example iron and steel inflationary process in the economy. In consonance with the
and coal, has also been liberalised.Second,fiscaldeficitof the literature, theplausiblefactors arereduction intariff andremoval
government sector remains a matter of major concern with the of quantitative restrictions on trade; rise in the proportion ofim-
deficit whichdeclinedfromabout9 percentduringthefirst half portsand exportsintheincomeand consumption basket;chang-
of 1990sto 6 percentrose sincethelaterpartofthe 1990s and ingcomposition ofimports;increasedinflation persistence dueto
stood over8 per cent.Moreworryingly, the revenuedeficit(dis- dismantling ofpricecontrolsand lackofcontrolon government
savings)worsened,crossing7.0 percentin someoftheyearspri- deficit underlimitedmonetary independence.
marily due to salary revision ofthe public sector employees fol- A few monetary policyimplications follow:First, inassessing the
lowing the recommendation of the FifthPay Commission (Figure inflationary situation, there is the greater need now to monitor the
10). Third,wage revision in the public sector would affect the of
impact exchange rate movement than before, assumingan
as
wage structure of other organised sectors leading to an upward unchanged or lower pass-through could mean underestimating the
revisionorinflation expectation m the nature inflation. Second, removing
economy. Fourth,whenthefiscalsitu- Appendix largeexchangeratevolatility as an im-
Unit Root Properties
ationworsens,itis harderto suppress Three residualbasetests wereconducted, viz,ADF,PPandZivot-Andrews (1992)allowing portantmonetary policyobjectiveof
inflationexpectationswhen the cen- forstructural break. Table AIshows that theunit rootproperties ofonly 'P#/isnot rbi isvindicated, as otherwise thepass-
convincinglydetermined, whiletheremaining seriesare1(1),except 'e'.
tral bank is not fullyindependent Table AI : UnitRoot Tests (1990:1 to 2005:3) thoughimpact on domestic inflation
and credibility on inflation controlnot Variables Level FirstDifference Z-A Order could be much higher both due tohigh-
ADF PP ADF W
fully established. er exchange rate movement itselfanda
Y -1.98(t) -2.84(t) -19.4* -20.21* NB 1(1)
On theotherhand,theactual infla- higherpass-through that could result
M -1.76 -1.69 -16.4* -16.4* NB 1(1)
tionremainedlow due to severalfac- fromgreater volatility. Third, increased
e -3.49*(t) -3.78*(t) 12.47*(t) -12.47*(t) NB 1(0)
tors.First,theabilityofmonetaryau- P* inflation persistence needsto be con-
-3.1(t) -2.78(t) -10.7*(t) -19.23*(t) B NC
thority to control inflation improved P -2.58(t) -2.70(t) -10.68*(t) -10.59*(t) NB 1(1)
trolled as ithas led to higher totalpass-
fromthe limitedautonomyit gained. (1)tinparentheses denoted a trendcomponent; (2)laglengths areselected basedonSBC through when short-run pass-through
andPP-testiswith Newey-West usingBartlettKernel;(3)"denote significance at1per
Second,thebenignworldinflationary cent;(4)NBstandsfornobreakandBforbreak. appearsto havestabilised. Whilesome
situationduringmajor part of the Cointegration Tests reasonsforrisein inflation persistence
Tworesidualbasedcointegration viz,Engle-Granger
tests, (1987)andGregory-Hansen
1990s translatedintolowerdomestic (1996)allowing forstructuralbreakswereconducted. Noneofthemodels indicate would relateto dismantling of price
thevariables.
inflation inseveralcountries including cointegration among controlregime,the otherimportant
India. Third,demandpressureeased Table A2: Cointegration Tests reasonwas relatedtolackofcontrol on
Variables Engle-Granger Gregory-Hansen
due to lowerthantrendgrowthin out- LevelBreak FullStructural TrendwithLevel fiscalimbalanceuntiltheenactment of
put duringthe second half of the
Break Break
FiscalResponsibility and BudgetMan-
1990s.As againsttheaveragerealgdp
P,e,P*,Y,M -2.34(-4,50) -4.69(-5.56)
agement(frbm)Act,whichunderlim-
-5.57(-5.83) -5.57(-6.41)

P,e,P*,Y -2.50H16) -4.70(-5.28) -5.47(-6.00) -4.57(-5.57)

(factorcost) growth of 6.2 per cent in arecritical
valuesat S cent.
ited autonomyof monetary authority
Figure parentheses per
during 1992-93 to 2004-05, the mayreducethecredibility ofmonetary
7° April 19, 2008 CEE3 Economic
& Political
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 - - " " = SPECIALARTICLE
=

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