A Study on the effect of Capital Inflow in India on Exchange Rate Indices

Abstract

Inflow of foreign capital to India have increased manifold in the past two decades as a result of the phased liberalisation of the capital account. Inflow through official channels like external assistance have reduced and private flows like foreign portfolio investment and external commercial borrowings have assumed a major role in the total capital inflow to the country. The changing pattern of capital inflow can cause changes in the real and nominal exchange rates among other macroeconomic variables. This paper studies the pattern and composition of capital inflow over the study period (2000 Q2 to 2018 Q3) and the exchange rate indices. After testing the time series data for stationarity in the bivariate analysis, Granger causality test has been conducted to identify any causal relationship between capital inflow components and exchange rate indices. The study found no causal relationship between exchange rate indices and capital inflow through NRI deposits and external commercial borrowings although both these channels account for a considerable portion in total capital inflows to India. Capital inflow through foreign direct and portfolio investment granger cause both export and trade based REER but not vice versa. Unidirectional relationship also exists from capital inflow through external assistance to REER indices.

Keywords: Capital inflow, Real Effective Exchange Rate, Nominal Effective Exchange Rate, Causality.