The Impact of Chinese Real Exchange Rate Appreciation on India's Trade and Investment: A General Equilibrium Analysis

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Abstract

Using a Computational General Equilibrium (CGE) model, we analyze the impacts of Chinese real exchange rate appreciation on India's trade balance and other macroeconomic indicators. We analyze two scenarios of 2.1% and 5% real exchange rate appreciations for our simulation. The results indicate that China's exchange rate appreciation may improve India's total trade, but worsen its total welfare and GDP growth.

Keywords: China-India trade, Computational General Equilibrium, China's real exchange rate.

JEL Classification: F13, F14, F23

INTRODUCTION

China and India are now seen as the world's fast-growing large economies [News Week, August 22-29, 2005]. Both countries have radically different economic models but both have outperformed many countries and they have become the main engines that drive Asia's and world growth. In particular, their trade and investment growths have a tremendous effect on the world economy. The liberalization process started in China in late 1978 while India opened up its economy in 1991 and both countries reduced trade barriers. It is apparent that China and India to some extent compete with each other in terms of trade flows and attracting foreign direct investments (FDIs) to their countries, but they have their own comparative advantage in terms of skills and endowments [Batra and Khan (2005)].

Recently, under the pressure of other countries especially the U.S., China changed its exchange rate by 2.1 percent in July 2005 and has been resisting making big changes in its exchange rates system. This policy change not only indicates that China will no longer peg the dollar at the historically fixed rate with the U.S. dollar but would adjust gradually its currency to a basket of other currencies.

In this study, we analyze the potential impacts of Chinese currency appreciations on India's economy. Our analysis is important because the total trade balance between China and India has exceeded US$13 billion in 2004 as compared to a few millions in the 1990s. India's Prime Minister Manmohan Singh has recognized China as one of the country's leading trade partners [China daily, February 26, 2005]. In April 2005, China and India signed an agreement to boost trade to US$20 billion by 2008 and some pundits predict that the total bilateral trade will reach $450 billion by 2010 [Financial Times, October 31, 2005].

Earlier studies on currency devaluations/revaluations were mainly based on the partial equilibrium analysis. The IMF policies called for currency depreciations for countries that suffered trade deficits. Currency depreciations would increase exports and decrease imports and thereby reduce the trade gap. However, this argument was challenged by many on theoretical grounds. It was commonly believed that many LDCc were facing low elasticities of trade and unless the Marshal-Lerner condition was satisfied (which suggests that export and import elasticities are greater than one) currency depreciation will only make the deficits worse [see, for example, Diaz-Alejandro (1963), Krugman and Taylor (1978)]. On empirical grounds, it was also argued that the devaluations increase the imported price of inputs and thereby increase the cost of production of all exportable goods as well other goods adding to the overall rate of inflation.

In the case of currency appreciation, the theoretical argument is that currency appreciation makes exports more expensive and imports less expensive. Thus exports decrease while imports rise and the aggregate demand for domestic goods declines, causing a contractionary effect on domestic output. However, this contractionary effect could be offset by its effect on the supply side. Currency appreciation lowers the cost of imported intermediate goods and domestic production increases. It may also lower the inflation rate. The net effect depends on the combined effects of the demand and supply shifts [Kendil and Mirzaie (2005)]. …