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Exchange rate volatility hampering sustained growth of industrial production: RBI study

16 May 2014

The persisting volatility in exchange rates has adversely impacted India's industrial growth across various sectors with the increasing integration of the country's industrial sector with the global economy through higher export and import intensity.

A Reserve Bank study on the impact of real exchange rate volatility has found that the adverse effect of changes in real effective exchange rate (REER) of six countries was visible across use-based components of the index of industrial production (IIP), barring basic goods.

Magnitude-wise, with the exception of the large negative impact of REER volatility on capital goods, the impact on other use-based industries has been generally limited, the RBI study pointed out, adding that these differences may be ascribed to the varying extent of the direction, quantum and composition of trade, competitiveness and the sufficiency of domestic demand.

''The implication of this finding is that the stability of REER is important for sustaining the growth of industrial production, underlining the need for appropriate management of volatility of both the nominal exchange rate and domestic inflation,'' the RBI study states.

A study based on empirical evidence for 36 country REER suggests that the adverse impact of REER volatility is uniformly evident in the use based sub-components of IIP, viz, basic, capital and intermediate goods, except for consumer goods, RBI stated.

The RBI study also explores the implications of exchange rate volatility on the use-based components of the index of industrial production (IIP) using EGARCH methodology for calculating volatility of real effective exchange rate (REER).

Theoretically, it is assumed that exchange rate volatility increases risk and hence dampens economic activity through well identified channels. Internationally, there have been empirical evidences in this regard that lent support to the adverse effect of exchange volatility/risk on growth, the study points out.

The implication of this finding is that the adverse impact of REER volatility on industrial production can be assuaged by moderating the volatility of both the nominal exchange rate and domestic inflation, RBI said.

According to the neoclassical growth model and its extension to situations of dynamic economies of scale, elimination of the exchange rate risk leads to an increase in economic growth.

Elimination of exchange risk reduces systemic risk which in turn lowers the real interest rate.

Since investors would require a lower risk premium, a less risky environment, due to lower discounted rate for investment, facilitates accumulation of capital and thus provides space for domestic manufacturers to adjust to a changing economic environment to support economic growth, according to findings of the European Commission.

Exchange rate volatility hinders the flow of international trade as it represents uncertainty and hence imposes costs on risk-averse commodity traders.
This is because exchange rate is agreed upon at the time of contract agreement while payment is made at delivery.

Therefore, unpredictability in exchange rate creates uncertainty about profits and by implication, reduces the benefits of international trade and the growth potential of an economy, the study points out.

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