Exchange Rate Relationship of India with Its Major Trading Partners: A Joint Testing Approach

Abstract

After 1991 economic reforms, India registered tremendous fluctuation in Rupee exchange rate figures owing to its increasing trade and financial relationship with its major trading partners i.e. USA, Europe, and China. This paper examines the International parity conditions viz. Relative Purchasing Power Parity (RPPP), Covered Interest Rate Parity (CIP), Uncovered Interest Rate Parity (UIP), Fisher Effect, and Forward Rate Hypothesis, to reveal the changing financial and economic relations of India with USA, China and Europe. The major objectives of the research are to study the extent to which these International Parity conditions hold for the examined period by employing single cointegration framework and, examining the strong and weak form of parities - allowing for more channels of interaction between variables under joint modeling framework. Using Johansen cointegration test, it is argued that all the parities - except forward rate hypothesis- fail to hold in Rupee/Dollar case, reflecting that the commodity and capital markets of these two countries are not integrated. CIP and Fisher effect hold in weak form in India with respect to China and validity of weak Fisher effect with Europe indicates partial integration and openness of India to these countries. Evidence for the joint validity of strong PPP and weak CIP is reported for India - China suggesting that these parities hold when the actions of importers and exporters, and investors are combined together.