Productivity and Real Exchange Rates for India: Does Balassa-Samuelson Effect Explain?

We attempt to explore the long-term equilibrium relationship between India’s real exchange rates and sectoral productivity trends using internationally comparable productivity databases such as KLEMS databases for India, China, Euro area, USA, UK and Japan. Our panel-ARDL results find support for an ‘extended’ Balassa-Samuelson hypothesis that allows for labour market frictions that does not allow for wage equalisation between traded and non-traded sectors within a country. These empirical findings are also robust to both labour productivity and total factor productivity as alternative measures of sectoral productivity. This mechanism continues to find some support when we separate out distribution sector, that comprises wholesale and retail trade in the domestic services sector. Our empirical evidence suggests that India’s real exchange rate is anchored to domestic fundamentals and is closely aligned to its fair value over a medium to long-time horizon.