An Empirical Analysis of the Relationship Between Capital Flows and the Real Exchange Rate in India

This paper analyzes the relationship between the net capital flows (NCFs) and other fundamentals and the real exchange rate (RER) in India consequent to the liberalization of the capital account in 1990s for the period 1996–1997 to 2012–2013 using the Autoregressive Distributed Lag approach to cointegration. Most studies in the literature emphasize the role of a number of real and monetary variables and domestic policies in determination of RER. But there is no consensus on what actually determines the RER. The estimation includes NCFs, government consumption expenditure, terms of trade, trade openness, Gross Domestic Product growth rate, change in foreign exchange reserves, current account balance as explanatory variables for investigating the relationship with the RERs. The empirical results confirm that the NCFs in India have been associated with the RER appreciation and the association is statistically significant. Government consumption expenditure is not found to be significantly associated with real appreciation. Current account balance has a positive and statistically significant association with RERs indicating that the outflows on account of current account deficits have been associated with depreciation of RER or prevention of the appreciation on account of capital flows. The change in foreign exchange reserves has a negative and statistically significant association with RERs indicating that the accumulation of reserves by the Reserve Bank of India in the face of increasing capital flows has prevented the appreciation of RERs and mitigated their adverse consequences on the competitiveness of the Indian economy