Does FX market in India integrated to exchange rate theories? a review amidst COVID-19

Abstract

The exchange rate theories argue that the parity between two currencies is determined by various macroeconomic factors prevailing across economies. It is quite interesting to examine what happened to currency exchange rates in a period of inactivity for the overall economies due to COVID-19 outbreak. In this context a study was carried out during the period of turbulence to empirically test whether foreign exchange market in India moves in accordance with the principles of exchange rate theories. The bound test of co-integration (Pesaran,et.al., 2001) was employed to examine the evidence of a long-run relationship between the macroeconomic variables with the exchange rate of hard currencies such as USD, EUR, GBP and JPY against INR. The cross sectional relationship was further validated by using auto regressive distributed lag (ARDL) model. The absolute version of purchasing power parity theory (PPP) is evident in the Indian foreign exchange market as the analysis established a strong integration of Wholesale Price Index (WPI) and Consumer Price Index (CPI) with leading hard currencies such as USD, EUR and JPY. The association of 364 days Treasury bill return (TBR) and government Bond Return (GBR) further confirmed the postulation of Interest Rate Parity (IRP) theory as any increase in interest rate can cause exchange rate depreciation to INR. Results of this study add to the existing literature by confirming the bondage between price levels across the economies and the exchange rates during COVID-