Trade Dynamics and Foreign Exchange Reserves Management in India : An Empirical Study

This paper empirically examines the post-1991 trade dynamics in India in terms of their impact on foreign exchange reserves by estimating export and import functions for the period from January 1994 to October 2008. Implementing the Johansen (1995) maximum likelihood method of cointegration and vector error correction on monthly data, the study finds a long-run significant relationship among exports, world exports, and real effective exchange rate in the export function, and among imports, domestic demand and real effective exchange rate in the import function. These findings imply that the trade flows are sensitive to changes in demand and real exchange rate. The error correction mechanisms seem to be robust and respond faster to any short-run disequilibrium in the cointegrating systems. Impulse response functions indicate an average shock persistence of 12 months, except shock to imports by itself that does not tapper off over a 36-month time horizon. Further, the findings suggest that a minimum precautionary holding of reserves is desirable in order to delay any unwarranted adjustments in output and exchange rate