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Empirical analysis of long run equilibrium between exchange rate and foreign exchange reserve – an Indian perspective

Empirical analysis of long run equilibrium between exchange rate and foreign exchange reserve – an Indian perspective
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The present study makes an effort to find the long run equilibrium between Exchange Rate and Foreign Exchange Reserve. Fifteen years data of these variables has been extracted from the official website of Reserve Bank of India and has been analyzed by devising statistical software E – Views.

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Empirical analysis of long run equilibrium between exchange rate and foreign exchange reserve – an Indian perspective

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  1. International Journal of Management (IJM)
    Volume 7, Issue 6, September–October 2016, pp.89–94, Article ID: IJM_07_06_010
    Available online at
    http://www.iaeme.com/ijm/issues.asp?JType=IJM&VType=7&IType=6
    Journal Impact Factor (2016): 8.1920 (Calculated by GISI) www.jifactor.com
    ISSN Print: 0976-6502 and ISSN Online: 0976-6510
    © IAEME Publication

    EMPIRICAL ANALYSIS OF LONG RUN EQUILIBRIUM
    BETWEEN EXCHANGE RATE AND FOREIGN
    EXCHANGE RESERVE – AN INDIAN PERSPECTIVE
    Dr. Pritpal Singh Bhullar
    Assistant Professor – Department of Humanities & Management Studies,
    Giani Zail Singh Campus College of Engineering & Technology, India.

    Manika Dhameja
    CA (Final), ICAI New Delhi, India

    ABSTRACT
    The present study makes an effort to find the long run equilibrium between Exchange Rate and
    Foreign Exchange Reserve. Fifteen years data of these variables has been extracted from the
    official website of Reserve Bank of India and has been analyzed by devising statistical software E –
    Views. Regression analysis has been applied through SPSS to evaluate the relationship between
    foreign exchange reserve and exchange rate. The statistical output of present research supports the
    previous research documents and shows the existence of long run equilibrium between these
    foreign exchange reserve and exchange rate. It also supports the influence of foreign exchange
    reserve on the exchange rate of country.
    Key words: Foreign exchange Reserve, Exchange Rate, Regression. Cointegration Test and Unit
    Root Test.
    Cite this Article: Dr. Pritpal Singh Bhullar and Manika Dhameja, Empirical Analysis of Long Run
    Equilibrium between Exchange Rate and Foreign Exchange Reserve – An Indian Perspective.
    International Journal of Management, 7(6), 2016, pp. 89–94.
    http://www.iaeme.com/IJM/issues.asp?JType=IJM&VType=7&IType=6

    1. INTRODUCTION
    Capital flow acts as the blood in veins of the economy. High capital flow boosts the chances of growth of
    economy. The positive global macroeconomic signs are true symbolic representation of rise of capital flow
    in any economy. With globalization, the interdependence of economies has been increased. The global
    events have significant impact on the capital flow of the economies. The financial recession of 2008 dent
    the capital inflow in all the major economies across the globe. With globalization, the financial flow has
    been inclined developed countries to developing countries and under developed countries. The manifold
    rise has been reported in capital flows in many developing economies. Kohli (2203) supports the fact that
    increase in capital flow to any economy boost its liquidity, stock market growth and growth prospects of
    corporate. Carderelli et al (2010) analyzed that capital flow has significant effect upon the economic
    sectors like real estate, financial sector and manufacturing sectors. Dua and Sen (2013) documents the

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  2. Dr. Pritpal Singh Bhullar and Manika Dhameja

    dependency between capital flow and several macro economic variables like current account deficit,
    liquidity, inflation and money supply. Since last one decade, India has been emerged as a global
    destination for investment. Major global investors have been attracted to India for their bulk investment as
    Indian market has sent positive sentiments to the global investors. The countries maintain their foreign
    exchange reserves to meet their international short term and long term payment obligations. These
    obligations consists of sovereign debt, import financing, commercial debt, for intervention in the foreign
    currency markets during periods of volatility, besides helping to boost the confidence of the market in the
    ability of a country to meet its external obligations and to absorb any unforseen external shocks,
    contingencies or unexpected capital movements. Foreign exchange reserve comprises of Foreign Currency
    Assets, Gold and SDR (Special Drawing Rights) and Reserve Tranch Position in which each member is
    allocated a special quota by IMF. These include sovereign bonds, treasury bills and short-term deposits in
    top-rated global banks besides cash accounts. with the change in the patterns of global trade and other
    developments including several currency crises. Foreign exchange reserves acts as catalyst in maintaining
    stability of macro-economy. The accumulation of foreign exchange reserve build the strong platform for
    enhancing the control of economy of any country, rise in efficiency in currency intervention and also
    avoids the probability of occurring financial crisis and national and international level. The rapid
    fluctuations in foreign exchange reserve indicates the weak foreign trade activities and economic policies.
    Reza, Ostry and Sheehy (2011) quote that foreign exchange reserve acts as external assets that assists in
    maintaining Balance of Payments (BOP) and controlling exchange rate with other countries. The exchange
    rate intervention also have significant effect upon the foreign exchange reserve of any country. Kasman
    and Ayman (2008) examines short term and long term unidirectional flow of causality from foreign
    exchange rate to real exchange rate as well as from nominal exchange rate to foreign exchange reserve.

    2. REVIEW OF LITERATURE
    Emmanuel (2013) study the effect of foreign exchange reserve on exchange rate in Nigeria and finds that
    foreign exchange reserve has significant effect upon the exchange rate of Nigeria. Hoshikawa (2012)
    analyzed the existence of long term rerelationship between foreign exchange reserve and exchange rate.
    Romero (2011) perform a comparative analysis of factors affecting foreign exchange reserve on India and
    China and find that an inverse relationship between exchange rate and foreign reserve. They find that with
    rise in exchange rate the foreign exchange reserve falls down. Prasad and Raju (2010) find an inverse
    relationship between foreign exchange international reserve and exchange rate. They explore that an
    inverse relation between foreign exchange reserve and exchange rate when the currency of home country
    depreciates. Kasman and Ayan (2008) study the relationship between foreign exchange reserve and
    exchange rate in Turkey and finds that long run relationship exist between them. Elhiraika and Ndikumana
    (2007) examine that countries maintain foreign exchange reserve to lower the inflation and foreign
    exchange rate in home country. Bachhante et al. (2006) confirms the harmful effect of volatile exchange
    rate and foreign exchange reserve on the economic growth of any economy. Dua and Sen (2006) analyse
    empirically from financial year 1993 to financial year 2004 and finds that Cointegration exist between
    capital flow level, volatility in capital flow and real exchange rate. Aizenman and Lee (2005) confirms that
    countries reserve foreign exchange reserve to maintain low exchange rate and enhance economic growth

    3. OBJECTIVES OF STUDY
    The present study is aimed at fulfil the following objectives from Indian prospective:
    • To analyze the existence of long run equilibrium between foreign exchange reserve and exchange rate
    • To analyze the existence of causal relationship between foreign exchange reserve and exchange ratio

    4. RESEARCH METHODOLOGY
    To achieve the objectives stated in the present research paper, statistical techniques have been devised.
    Causal relationship between foreign exchange reserve and exchange reserve has been measured by Unit

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  3. Empirical Analysis of Long Run Equilibrium between Exchange Rate and Foreign Exchange Reserve – An
    Indian Perspective

    Root Test, Johansson Co -integration Test and Vector Auto Regression (VAR) test. E-views Statistical
    software has been used to devised these tests for the statistical interference. Foreign exchange reserve data
    and exchange rate have been used as the variables. The data of Indian foreign exchange reserve and
    exchange rate from FY 2005 to FY 2016 has been collected from the official website of Reserve Bank of
    India. The influence of foreign exchange reserve and exchange rate has been examined by the regression
    analysis by applying SPSS software.

    5. HYPOTHESIS
    • Hypothesis I – A long run relationship does not exist between foreign exchange reserve and foreign
    exchange rate
    • Hypothesis II – Foreign Exchange Reserve has no significant affect on Exchange rate.

    6. DATA ANALYSIS
    6.1. Unit Root Test at Levels (Augmented Dickey – Fuller Test)
    Unit Root Test has been performed to analyze whether the data is stationary of not.

    Table 1 Unit Root Test at Level

    Level
    No Trend With Trend

    Variables t– t-
    p p
    statisti Critical Values statisti Critical Values
    value value
    c c
    1% 5% 10% 1% 5% 10%
    0.199 – 0.767
    LNEXRATE -2.221 -3.438 -2.865 -2.568 -1.66 -3.415 -3.130
    1 3.969 3
    LNFRXCRAT –
    3.000 -3.438 -2.865 -2.568 1.000 -0.201 -3.415 -3.130 0.993
    E 3.969

    6.2. Unit Root Test at First Difference (Augmented Dickey – Fuller Test)
    Table 2 Unit Root Test at First Difference

    First Difference
    No Trend With Trend

    Variables p t- p
    t-
    Critical Values valu statisti Critical Values valu
    statistic
    e c e
    1% 5% 10% 1% 5% 10%

    LNEXRATE -3.438 -2.865 -2.568 0.000 -23.861 -3.969 -3.415 -3.130 0.000
    23.7980
    LNFRXRAT
    -10.893 -3.438 -2.865 -2.568 0.000 -11.500 -3.969 -3.415 -3.130 0.000
    E

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  4. Dr. Pritpal Singh Bhullar and Manika Dhameja

    The above statistics shows that series is not stationary in both the cases but it become stationary after
    taking first difference. The p value for both the variables becomes lower than 0.05 that shows the
    stationarity of series.

    6.3. Johansen Juselius (J-J) Cointegration Test
    Johansen and Juselius Cointegration test (1990) has been performed to analyze the long run relationship
    between variables

    Table 3 J-J Cointegration Test

    Trace Max-Eigen Critical Values (5% )
    Hypothesized No. p – Values
    of CEs
    Trace Max –
    Statistics Statistics Trace Max-Eigen
    Eigen

    r=0 13.30554 11.79033 15.49471 14.26460 0.1041 0.1188

    r≤1 1.515210 1.515210 3.841466 3.841466 0.2183 0.2183

    The above Trace test statistics and Max – Eigen statistics shows that no Cointegration exists between
    the variables as the p values in both the cases is higher than 0.05. Higher the p – values more than its
    significant vale (5%) leads to rejection of null hypothesis at this level. The non – existence of Cointegration
    supports the existence of long run equilibrium in both the variables.

    6.4. Pairwise Granger – Casuality Test
    The Granger Causality test indicates a causality run from foreign exchange reserve to exchange rate

    Table 4 Granger Causality Test

    Null Hypothesis: A variable does not Granger cause the other

    F- p- p value &
    S. No Null Hypothesis Decision
    statistics value Significant level

    LNEXRATE does not Granger Reject Null
    3.80371 0.0227 0.022 < 0.05
    Cause LNFOREXCRESERVE Hypothesis.

    1

    LNFOREXCRESERVE does not Can’t Reject
    0.63018 0.5328 0.532 > 0.05
    Granger Cause LNEXRATE Null Hypothesis

    The above statistical table depicts a causal relationship between Exchange rate and foreign exchange
    reserve. The p values (0.02 < 0.05) show that Foreign Exchange Reserve cause changes in change in
    Exchange Rate.

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  5. Empirical Analysis of Long Run Equilibrium between Exchange Rate and Foreign Exchange Reserve – An
    Indian Perspective

    7. RESIDUAL GRAPH
    The residual graphs show that no autocorrelation exists between residuals
    LNEXRATE Residuals
    .06

    .04

    .02

    .00

    -.02

    -.04

    -.06
    100 200 300 400 500 600 700

    LNFOREXCRESERVE Residuals
    .06

    .04

    .02

    .00

    -.02

    -.04

    -.06
    100 200 300 400 500 600 700

    8. REGRESSION ANALYSIS

    Model Summaryb

    Model Change Statistics
    Adjusted Std. Error R
    R R of the Square Sig. F Durbin-
    R Square Square Estimate Change F Change df1 df2 Change Watson
    1 .563a .453 .448 .12881 .448 111.253 1 784 .000 .005
    dimension0

    a. Predictors: (Constant), LNFOREXCRESERVE
    b. Dependent Variable: LNEXRATE

    Coefficientsa

    Model Unstandardized Standardized
    Coefficients Coefficients
    B Std. Error Beta t Sig.
    1 (Constant) 2.953 .089 33.010 .000
    LNFOREXCRESERV .078 .007 .353 10.548 .000
    E
    a. Dependent Variable: LNEXRATE

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  6. Dr. Pritpal Singh Bhullar and Manika Dhameja

    The above graphs shows that there foreign exchange reserve affects the exchange rate of country. The
    statistics depit in the above model that foreign exchange reserve affects 35.3% to the exchange rate of
    Indian Economy.
    Regression Equation
    = +
    = 0.353 ∗ + 2.953

    9. CONCLUSION
    We observe that there is a stable long run relationship between Exchange Rate and Foreign Exchange
    Reserve. The result of our study produces similar result with previous studies Hoshikawa (2012). The
    present study also explores the effect of foreign exchange reserve on the exchange rate of country. This
    finding also similar with Prasad and Raju (2010) and Aizenman and Lee (2005). The findings of the
    present study helps in providing the firm roots to the previous studies and provide guidelines to the future
    researchers to consider the influence of other variables.

    REFERENCE
    [1] Bhatia, A., & Kishor, N. (2013). Impact of FII Investments on Stock Market Volatility and Foreign
    Exchange Reserves: The Indian Experience. Transnational Corporations Review, 5(3), 26-45
    [2] Emmanuel Umeora Chinweobo (2013) , “Accumulation of External Reserves and Effects on Exchange
    Rates and Inflation in Nigeria” International Business and Management, Vol. 6, No. 2, 2013, pp. 105-
    114
    [3] Dua, P., & Sen, P. (2006). Capital Flow Volatility and Exchange Rates: The Case of India”, Centre for
    Development Economics, Working Paper No. 144, Department of Economics, Delhi School of
    Economics, Delhi University, New Delhi. Retrieved from http://www.cdedse.org/pdf/work144.pdf
    [4] Elhiraika A. and Ndikumana (2007), Reserves Accumulation in African Countries: Sources, Motivations
    and Effects, University of Massachusetts Amherst Working Paper, 2007-12, pp 1-27
    [5] Soniya Mohil, “Liaison between Exchange Rate and Trade Balance: an Empirical Study on India”.
    International Journal of Management (IJM), 4(6), 2013, pp. 159–164.
    [6] Kasman & Ayhan. (2008). Foreign Exchange reserves and Exchange rate in Turkey: Structural breaks,
    unit roots and Cointegration. Journal of Economic Modeling, 25: 83-92.
    [7] Prasad & Raju. (2010). Foreign Exchange Reserves management in India: Accumulation and
    Utilization, Global Journal of Finance and Management,2: 295-306.
    [8] Olayungbo D.O. and Akinbobola T.O. (2011), Foreign Exchange Reserves and Exchange Rates in
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    [9] Dr. M. Sheik Mohamed and Dr. M.A.Shakila Banu, “”Study on Weak-Form Efficiency of Foreign
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    [10] Reza M, Ostry J.D and Sheehy R. (2011), Assessing Reserves Adequacy. IMF, prepared by Money and
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    [11] Romero A.M (2011), Comparative Study: Factors that Affect Foreign Currency Reserves in China and
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