Exchange Rate volatility and its impact: Case of India and China

Group 7

Exchange Rate VolatilityThe tendency for foreign

currencies to appreciate or depreciate in value.

Measurement of the amount that these rates change and the frequency of those changes.

Exchange Rate VolatilityExchange rate volatility is expected to decrease international

trade due to uncertainty of domestic currency receiptsExport margins especially for Heckscher-Ohlin goods (labor-

intensive and bulk goods in the context of developing country exports) are thin

Hedging in forward markets involves additional costs studies show that measure of exchange rate volatility (e.g.

standard deviation) enter a regression equation explaining trade with a significant estimated negative coefficient confirming the adverse effects of volatility on trade.• This effect is over and above the standard effect of exchange rate on trade, i.e., a depreciated domestic currency in real terms increases trade.

Volatility in the Indian Context

Volatility can be either in the short run or in the long run. The standard deviation of the exchange rate of a currency steadily depreciating in the long run could be as high as (or even higher than) that of a currency volatile in the short run around a steady long run level.

Moreover the volatility can be measured either in nominal terms or in real terms.

The bilateral nominal exchange rates of the rupee w.r.t. major currencies exhibits greater volatility than the real effective exchange rate (REER).•

In a situation of generalized floating, it is the EER which is more relevant; and in particular the inflation adjusted EER, i.e., REER

The Indian Exchange Rate Policy has effectively been to hold the REER constant over the long run.

Exchange Rate Policy

India follows a managed floating exchange rate regime

The avowed exchange rate policy of the RBI is that the rate is basically determined by the market, but since the market-determined rate tends to be volatile, the RBI manages the rate to avoid excess volatility in the market

This implicitly means that the RBI does not influence the level of the rate

Exchange Rate Policy 2Yet the Real Effective Exchange Rate of the

rupee has been relatively stable over the entire period

It can be said that volatility is being avoided not only in the short run, but also in the long run!

Apparently, the nominal rate is being managed to maintain the real rate in the face of higher domestic inflation compared to the trading partners

Impact of Exchange rate volatility on INDIA

Important for countries that depend mainly on trade such as INDIA .

Increase in the world exports share, it has risen from 0.55% in 1991 to 2.1% in 2015.

Excessive fluctuations in exchange rate could lead to instability and the economy risk - it increases trade costs and reduces the gain that could be made in international trade.

 

Since 1991 liberliazation Indian currency showing both appreciation and depriciation trends.

Also affects capital flows, the rising cross-border tradeVolatililty affecting the revenue and expenditure of

different business in the short run and the long run as well

Exchange rate pass-through – (It means the relationship between price and exchange rate) Indian Exporters use market power to obtain prices they want when the currency(rupee) experiences volatility.

Rupee Trend Through the Years

Impact of Exchange rate volatility on China • China is world leader for manufacturing,

and is the 2nd largest economy in the world as well as the largest exporter of finished goods in the world

• The renminbi is the official currency of China

• As China transitioned from a centralized economy to market economy, and they have also increased their participation in foreign trade, their currency’s value was decreased to increase the growth and competitiveness of Chinese industry

• Since 2006, the renminbi exchange rate has varied between a small range around a fixed rate which is determined in reference to some country’s currencies

• Appreciation actions by the Chinese government and quantitative easing steps taken by the Federal Reserve have caused the renminbi to gain 8% of its equilibrium value by the middle of 2012

• Increase in the exchange rate flexibility of renminbi and the rapid globalization of its currency resulted in renminbi to become the 8th most traded currency in 2013.

Managed float The renminbi moved to a managed floating

exchange rate based on market supply and demand with reference to a basket of foreign currencies

In 2005 the renminbi in the interbank foreign exchange market was allowed to remain within a narrow band of 0.3% around the central parity targeted by the People's Bank of China

The stringent management of the renminbi and USD (annual exchange limit) leads to a bottled-up demand for exchange from both directions. It used a major tool to keep the currency peg, preventing inflows of hot money

The shift of Chinese reserves into the currencies of their other trading partners has lead not so great change in the value of their currency against the USD.

In 2015 china further devaluated its currency to give boost to its economy.

THE IMPACT OF DEVALUATION OF YUAN ON INDIAN AND CHINESE

MARKETS

The devaluation in mid August 2015 was one of the most important downward shift to the Yuan since early 90’s. Its aim behind this step was to boost exports and achieve the official reserve currency status.

  On August 10, People’s Bank of China set the reference rate for Yuan

at 6.2298 for 1$, compared to 6.1162 Yuan earlier- which meant a fall by 1.86%. This step was followed by further devaluations.

  Central to this is a bid to have the Yuan accepted by the

International Monetary Fund into its basket of reserve currencies, placing the Yuan on par with the Dollar, Euro, Yen and British pound, and boosting China’s global stature.

What it means for India?For India, China is its largest trading partner. There

is a significant imbalance of trade between the two countries, though.

Over the last ten years, the trade balance has seen an increase by 33 times. The figure in 2004 was 1.4 billion dollars, while it is 48.5 billion dollar for 2014.

In the year 2015, more than 80% of the total imports from China to India comprised of capital and intermediate good. With the devaluation of the Yuan, projects based on supplies from China are facing profits, allowing other projects to flourish simultaneously.

IMPACT ON EXCHANGE RATE BETWEEN INR AND RMB AFTER THE DEVALUATION

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