| For several years now, I have been arguing two things. First, that most of our policy-oriented economists tend to think that what works in the west will work in exactly the same way in India. The 'stages of development' problem completely escapes them. |
| Second, because of this aping, Indian economic research is sadly lacking in microeconomic strength. It is mostly what is called hawa mein baat. |
| Within this context it is instructive to examine how useful are the suggestions about exchange rate management generally and in respect of inflation management particularly. In other words, what would happen, say, to inflation if the RBI stopped managing the exchange rate? The answer, as everyone knows, depends on what happens to exchange rate pass-through. This is defined as the extent to which an exchange rate change is reflected in the prices of imported goods. |
| If the pass-through is full, the prices of imported goods change by exactly the same amount as the increase or decrease in the price of the foreign currency. With no pass-through, prices of imports remain the same. In developed countries, empirical studies show that there has been steady decline in pass-through. |
| To the best of my limited knowledge, this sort of research has not been done in India. So it came as a delightful surprise to see a paper* by Jeevan Kumar Khundrakpam of the RBI. The paper is on the BIS website where he spent some time. His analysis comes to a conclusion that will not please the market fundamentalists. He finds that Indian firms tend to fully pass on the exchange rate change. "Unlike what has been observed for several other countries, there is no clear-cut evidence of a decline in exchange rate pass-through to domestic prices in India during the post-economic reform period so far." |
| Not just that. He finds something else that will really annoy the fundamentalists. This is that "there is asymmetry in pass-through between appreciation and depreciation." So there is a higher pass-through for appreciation than depreciation. When imports become cheaper, Indian firms pocket the difference; when they become more expensive they pass the increase on fully. |
| Also, foreign firms appear to be "more willing to pass on the benefit of lower prices from appreciation to domestic consumers and capture a larger market share than pass on the higher prices from depreciation and lose their market share." There is a difference in business culture also but that can't be measured, I suppose. |
| And folks, that is not all. In India producers make a distinction between small and large changes. So, says the author, "the estimated pass-through coefficients are found to be much higher for small than large changes." |
| Why does this happen? Because between 80 and 90 per cent of the imports into India are either priced in the exporter's currency or invoiced in dollars. This is where something called menu-cost kicks in. |
| Menu costs are those costs that arise when you update something. Often, for small changes in input costs, firms do not change their prices. So, says the author, "...changing invoice price is worthwhile only if the exchange rate change is above a certain threshold. If the invoice currency is the foreign firm's currency, a small change in the exchange rate does not make it worthwhile for the foreign exporter to change the price of its product in its own currency." The result is a higher pass-through. |
| The reverse is also true so that for large changes in the exchange rate the pass-through is lower. The discussion by Khundrakpam of the pricing behaviour of firms is hugely instructive. |
| For that and several other reasons, I think all those offering advice on exchange rate management should read this paper. As it deals with what is and not what ought to be, they may become a little more circumspect with their advice. |
| Economic reforms and exchange rate pass-through to domestic prices in India, BIS Working Papers No 225, February 2007, http://www.bis.org/publ/work225.pdf |
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