Capital Inflows and Misalignment of the Indian Real Exchange Rate

The purpose of this paper is to study capital flows and its impact on the real exchange rate in India.  After years of inward looking policies, the Indian economy began liberalizing trade and investment in the 1980s.  Capital flows provide much needed investment in a country and have become part of an overall growth and development strategy for several emerging markets.  However, capital flows can also create problems for an economy such as an overvaluation of the real exchange rate which as Milesi-Ferretti and Razin (1996) note have been linked to unsustainable current account deficits.  This is because real exchange rate overvaluation can lead to a misallocation of resources in favor of nontraded goods at the cost of the traded goods sector.  India experienced a major crisis in 1991 that some argue was linked to an overvalued rupee.  Following the crisis, there were several reforms including further liberalization and a shift to a floating regime.  Using data from 1976 – 2006 this paper analyzes the impact of capital inflows on misalignment of the rupee.  Since this period includes an exchange rate regime shift, this paper also addresses whether this relationship is affected by the exchange rate regime. 
Athukorala and Rajapatirana (2003) find that capital flows lead to real exchange rate appreciation for Asian and Latin American economies and Dua and Sen (2007) find the same for India.  In floating regimes, capital flows by increasing the demand for domestic currency lead to a nominal and thus a real exchange rate appreciation.  In fixed regimes the capital inflows can lead to increased demand and thus prices which cause a real exchange rate appreciation.  Therefore, as Athukorala and Rajapatirana (2003) show capital inflows lead to a real exchange rate appreciation irrespective of the exchange rate regime. 
An appreciating real exchange rate is not necessarily problematic.  The concern is if this appreciation also implies an overvalued real exchange rate. To determine the impact of capital flows on an overvalued real exchange rate, this paper first estimates the equilibrium real exchange rate using Edwards (1989) theoretical framework.  The model which is widely used in the literature (see Dagdeviren, Ogus Binatlý and Sohrabji, 2009) shows that the real exchange rate is determined by factors such as terms of trade, trade value, government consumption, investment, capital flows and technological progress. 
The model is estimated for India from 1976-2006 using cointegration and error correction model methodology which is standard in the literature.  Cointegration tests identify the “fundamental” or long-run factors which determine the equilibrium real exchange rate.  The paper also employs a cointegration test with structural breaks to determine if the nature of the cointegrating relation between the real exchange rate and its fundamentals has changed due to the exchange rate regime switch.  Misalignment is computed as the difference between the actual and equilibrium real exchange rate.  This paper analyzes the relation between capital flows and real exchange rate overvaluation.  In addition, the paper also tests if the exchange rate regime matters in this relationship.