Productivity and real exchange rates for India: does Balassa-Samuelson effect explain?

Abstract

PurposeThis study aims to explore the long-run equilibrium relationship between India’s real exchange rate and sectoral productivity trends using internationally comparable KLEMS databases on productivity for India, China, Euro area, the USA, the UK and Japan.Design/methodology/approachThis study uses pooled mean group estimations for panel data suggested by Pesaran et al. (1999). This method is chosen because of the presence of variables with different orders of integration.FindingsThe results find support for an “extended” Balassa–Samuelson (BS) hypothesis which allows labour market frictions that does not allow for wage equalisation between traded and non-traded sectors within a country. This mechanism continues to find some support when we separate out distribution sector that comprises wholesale and retail trade in the domestic services sector. The empirical evidence suggests that India’s real exchange rate is anchored to domestic fundamentals and is closely aligned to its fair value over a medium to long-time horizon.Originality/valueTo the best of the authors’ knowledge, unlike the available literature, which uses aggregate per-capita income as proxy for a country’s productivity growth, this paper perhaps makes the first attempt to validate the BS hypothesis by accounting for productivity differential at the sectoral levels using KLEMS data across countries. Moreover, this study takes the country’s productivity improvement rather than using a basket of countries, a prevalent practice in the literature. While this paper uses India’s data, which witnessed a prolonged appreciation in its real effective exchange rate and rapid technological progress, the authors believe its findings and policy implications could be applicable to the similar emerging market economies.