A Stronger INR against USD: Market Force or Market Distortion? A Study on Recent Trend, its Possible Reasons and Impact on Economy

Posted: 29 May 2007

Date Written: May 26, 2007

Abstract

Rationale of study & Literature Review

The recent trend shows an appreciation in the Indian Rupee against the USD. Indian Rupee stood at INR 44.90 to the USD in April 2006; it dipped to INR 40.57 in third week of May 2007. Skyrocket land prices in urban and urban periphery, rising inflation & interest rate and gossip in the town about NRIs investing in land & banking sector (through formal as well as informal channels) have drawn our attention to test whether INR becoming stronger is reason of market force or unwanted market distortion?

As per one of the World Bank reports, India is the world's top receiver of remittances in 2003, that is around US$ 17.4 billion, and we expect it is yet grown till 2007 substantially. The paper argues that remittances undoubtedly help ease poverty and improve living standards in their home countries by enabling better health care, nutrition, housing, and education. In many communities, however, the money is often put to unproductive uses such as buying land and building houses. The Non Resident Indian population across the world is estimated at over 30 million. Total remittances by the Indian Diasporas have touched a new high. According to the Reserve Bank of India (RBI) figures, overseas Indians remitted $23.3bn in 2005 - almost double the amount of net foreign institutional investor inflows and one-fourth of the merchandise export earnings of the country during the period.

We reviewed recent literature document for finding remedies for preventing ill effect, 'Remittances: Development Impact and Future Prospects' by Samuel Munzele Maimbo & Dilip Ratha, which discusses how such downward spirals might be brought to a halt, and better still, reversed, through a variety of carefully tailored “smart aid” initiatives that can kick-start the productive potential of local economies in areas where high levels of migration have taken place.

We also reviewed IMF working paper by Ralph Chami et al, who developed a framework on the causes and effects of remittances, links for remittances & the motivation and their effect on economic activity. They argue remittances take place under asymmetric information and economic uncertainty; there exists a significant moral hazard problem. The implication is that remittances have a negative effect on economic growth. They conclude that the moral hazard problem in remittances is severe.

We also reviewed World Bank - Development Research Group (DECRG), contributed by Caroline Freund. The report says that recorded workers' remittances to developing countries have grown rapidly, to more than $100 billion in 2004, bringing increasing attention to these flows as a potential tool for development. He argues that these statistics are likely to significantly understate true remittances, as a large share is believed to flow through informal channels. Estimates of the importance of the informal sector vary widely, ranging from 35 percent to 250 percent of recorded flows. We estimate informal foreign exchange flow in India on the model developed by this contribution.

The research paper would like to test whether NRIs investing in realty and high-interest-fetching bank deposits in India, and large amount inflowing unchecked through informal channels distorts market and economy of India or the phenomenon of INR becoming stronger is formal and legitimate market force, and its possible effect on Indian economy.

Questions to be examined, Data sets, Research methodology

We will review the relation between INR and USD during March 2005 to June 2007 and analyzing the trend. The foreign exchange rates are available from secondary source. We will analyze land prices in selected urban area, inflation and interest rates during the period. We will discuss the role of Foreign Exchange Management Act, RBI and related government machinery in checking exchange rate and informal remittance inflow. We will use the DECRG model to measure informal remittance and its impact on distortion of the foreign exchange market. We will than critically analyze the impact of INR becoming stronger on export, inflation and price rise in realty. The export and inflation data for the concerned period are available from concerned government authorities. The research will conclude on the basis of accepted statistical test and multivariate regression analysis.

Lead Questions:

1. Is there any impact of illegal remittance on foreign exchange rate? 2. Whether due to NRI investment in realty, bank deposit and illegal remittance, INR is becoming stronger against USD? 3. What are the other factors impacting significantly on INR - USD relationship? 4. What is the impact of INR becoming stronger against USD on some macro economic parameters like export, inflation, interest rate etc.?

Contribution to the literature & Conclusion

While remittances are not public funds, and decisions about spending is left with remitters and recipients, unproductive expenditures stem mostly from a lack of other investment opportunities and unchecked remittances. Good policies and public infrastructure in major recipient countries are therefore essential to encourage the proper investment of these funds. The study would like to suggest policy measures that can check informal remittance. By selecting appropriate investment policies, unproductive investment by NRI can be visualized and checked. Monitoring not only monetary policies but also town planning investment can provide an instrument to stabilize land prices and foreign exchange rate purely on market force. Implementation of FEMA and notification issued require appropriate data capturing mechanism, close monitoring and speedy execution. The research paper would like to give comprehensive suggestions to develop healthy foreign exchange market and preventing ill effects and market distortions.

Keywords: INR, USD, Foreign Exchange, Market Distrortion, Inflation, Land Prices

JEL Classification: F3

Suggested Citation

Sapovadia, Vrajlal K. and Patel, Kandarp, A Stronger INR against USD: Market Force or Market Distortion? A Study on Recent Trend, its Possible Reasons and Impact on Economy (May 26, 2007). Available at SSRN: https://ssrn.com/abstract=989174

Kandarp Patel

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