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CHAPTER SIX

6. INDIAN SOFTWARE INDUSTRY AND FOREIGN EXCHANGE RISK

6. 1 Introduction

The objective of this chapter is to discuss the evolution, growth, opportunities and challenges, of

Indian software industry and to examine the relationship among Indian software industry, US

economic activity, and INR-USD exchange rate volatility, Cointegration analysis suggested by

Engle-Granger was used.

6.2 Indian Software Industry

The Indian software industry has played a significant role in transforming India’s image from a

slow moving bureaucratic economy to a land of innovative entrepreneurs and a global player in

providing world class technology solutions and business services. The industry has helped India

transform from a rural and agricultural based economy to a knowledge based economy

(NASSCOM, 2011).

The Indian software industry has been a remarkable success story. It has grown more than thirty

percent annually for twenty years, with 2008 exports projected at close to USD sixty billion.

From about USD fifty million in exports in the late 1980s, the industry crossed USD hundred

billion in the year 2013, contributing significantly to the GDP of India. India exports to more

than sixty countries, with two-thirds to the United States, including half of all Fortune 500

companies.

The Indian software exports account for sixty five percent of the total software revenue. Over

eighty percent of exports are software services, which includes custom software development,

consultancy and professional services.

According to NASSCOM, the IT sector went on grow at a CAGR of twenty five percent during

financial year 2000-13, dominating the global IT-BPM market. The Indian IT industry has hit

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revenues of USD 108 billion in Financial Year 2013 with exports contributing USD 76 billion.

Significantly, IT-BPM segment account for about eight percent of India’s GDP, while IT

services remain dominant at fifty two percent. During the period 2007-13 bulk of the export

revenue that is, sixty two percent came from the US, around twenty eight percent came from

Europe. The Indian IT industry has crossed its revenues of USD 100 billion in the year 2013.

The software sector can be divided into five major activities in declining order of complexity and

skill requirements: (1) Project Management (2) Systems Analysis and Design (3) Software

maintenance and support (4) Writing of Code and (5) Data Entry. The Indian software industry

concentrated in the second and fourth activities and predominantly in fourth (Sen, 1995).

Mr. N.R. Narayana Murthy, Chairman of Infosys Ltd., summed up the value proposition of the

Indian software industry as “faster, better and cheaper”.

According to Som Mittal, President of NASSCOM, currently over one lakh foreign nationals are

working for Indian software companies’ around the world, a testimony of the industry’s growing

popularity abroad. The industry totally employs around three million people. India’s IT

workforce has gone global by setting up five hundred and eighty offshore development centres

across seventy five countries and working in thirty five languages. The industry started more

than two decades ago in English speaking countries, and got ninety percent of revenue then came

from the US and the UK. This has changed over the years and revenue from both the countries is

now down to seventy eight percent and the balance twenty two percent comes from non-English

speaking geographies.

6.2.1 Historical Overview

The Indian software industry started in 1970 with the entry of TCS into the domain of outsourced

application migration work. According to Ramadorai, it began in early seventies with the main

frame manufacturer, Burroughs asking its Indian sales agent, TCS to export programmers for

installing system software for a US client.

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Beginning in the 1970s a growing shortage of engineers for the expanding computer industry in

the US and Europe, an oversupply of Indian engineers relative to domestic demand, and a

growing international reputation for the skills of Indian engineers, provided an opportunity, for

body shopping in which Indian firms such as TCS sent Indian engineers overseas to do software

programming onsite, mostly in US firms for limited, billable projects (Bhatnagar, 2001)

In India the software industry developed initially in Mumbai, has been concentrated in six to

seven cities such as Bangalore, Hyderabad, Chennai, Mumbai, Delhi and Pune. Policy makers

within the country viewed the software industry as an engine of growth, a source of employment

and foreign exchange, among other favorable effects (NASSCOM, 2012).

The Indian software industry comprises of few big companies, with a large number of small and

medium sized companies. Many new companies were established in 1980s by entrepreneurs with

ambitions of creating world class software development centers. Firms which had started

primarily as subcontractors for technical manpower gradually shifted to managing complete parts

or phases of projects, and then to delivering complete solutions from India. NASSCOM played

an aggressive role in promoting the Indian brand abroad. In some ways, during this period, India

was building a launching pad for the eventful take off of its software industry.

6.2.2 Structure of Software Exports

Software is the interface between computer and human commands. According to Schware

(1992) “Software is a programme that translates the system of human logic into a set of

electromagnetic impulses. In general, the term software refers both to the instruction that direct

the operation of computer equipment and the information content, or data, that computers

manipulate”. (Nath and Hazra, 2002).

The widely acknowledged model of software development process is known as the Waterfall

Model proposed by Royce in 1970 (Arora et al, 2001).

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Trade in software which is similar to service trade, is carried out mainly through a) Onsite

Services, popularly known in industry circles as ‘body-shopping,’ are rendered the factors move

to the site of the receiver, software manpower is exported to help solve the users software related

problems. The development and execution of the software will be done on site. Under this mode

of export, it has been argued that the net export earnings will be substantially less than the total

export earnings. b) Offshore services, involves limited movement of both the factor and the

receivers. The software is developed offshore according to the specified requirements and

exported to the users. This method could be cost effective and calls for more investment in the

form of hardware and communication network. c) Offshore Packages or Software Product

Development, where neither the factor nor the receiver moves and is also highly capital and labor

intensive and also requires substantial marketing costs, however the net export earnings will be

higher compared to other modes (Joseph and Harilal, 2001).

6.2.3 Growth of Indian Software Industry

At an annual growth rate of fifty percent over the last decade that is, 1900-2000, the Indian

software and service sector has expanded faster than in any other countries of the world. Strong

fundamentals of a large talent pool, sustained cost competitiveness and an enabling business

environment are some of the significant factors which have enabled Indian software industry to

grow exponentially since its inception.

The Indian software industry has grown at a phenomenal compounded annual growth rate of

over fifty percent during the 1990s from modest revenue of USD 195 million in 1989-90 to

evolve into a USD 8.3 billion industry by 2000-01. Furthermore, the industry has earned seventy

five percent of revenue that is, USD 6.2 billion from exports (Kumar, 2001).

The growth rate of the Indian software Industry has been substantially higher than the global

software industry. Apparently India is the only country in the world to register a growth rate of

around fifty percent in the software industry (Kumar, 2001).

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According to Raghavan and Nair, the Indian software and services sector has expanded faster

than in any other countries of the world of comparable size. Such a wonderful and sustained

growth rate has been unparalleled in any of the sectors of the Indian economy since

independence (Illiyan, 2005).

The contribution of IT sector to the GDP of the country has been significantly increasing from

USD six billion in 1997-98 to USD sixty four billion in 2007-2008. Within ten years time the

share of IT sector recorded a five-fold increase from about 1.2 percent in 1997-98 to 5.5 percent

in 2007-08. The major share of this contribution is by software and related service exports. In

1998-99 the industry accounted for just one percent of India’s GNP. Its share nearly doubled by

2000-01 (NASSCOM, 2012).

6.2.4 Factors Responsible for the Growth of Indian Software Industry

India has availability of a large number of English speaking professionals and has second largest

manpower or talent pool available after US. It is believed that the key to the success of the

Indian software exports is the supply of trained low cost of software professionals. The

estimated wage costs in India were about one-third to one-fifth of the corresponding US levels

for comparable work (Arora et al, 2001). With a young demographic profile, where over 3.5

million graduates and post graduates are added annually to the talent base, no other country

offers a similar mix and scale of human resources (NASSCOM, 2009).

During 1980s the government of India, recognizing the growth potential of the software industry,

took key policy actions to open up the sector. A policy change in 1998 that effectively ended a

monopoly on internet service provider (ISP) gateways, allowed India’s private sector to offer

needed bandwidth to the growing industry. In 1990 the government created software technology

parks in 30 locations across India to provide software companies access to high speed data

communications and single window clearance for regulatory compliance. In 1998 a national

telecom policy was announced to clarify the role of the regulator, transition from license fee to a

revenue sharing model and open domestic long distance to private operators. In 2002 India

liberalized international long distance to improve the communication system.

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NASSCOM was created in 1988 and in 1900 STPs were established to represent a fundamental

approach to policy making for the software industry. The companies registered with STPs

account for about sixty eight percent of software exporters.

Demonstrated process quality and expertise in service delivery has been a key factor driving

India’s sustained leadership in global service delivery. Since the inception of the industry in

India, players have been focusing on quality initiatives to align themselves with international

standards. Indian software industry has moved rapidly on the quality front. Indian software

companies have adopted the ISO model as early as it was started. Indian companies have shifted

to one of the important paradigms of quality, that is, Capability Maturity Model (CMM),

enunciated by Software Engineering Institute (SEI).

According to Computer Software Services Exports Statistical Year Book 2010-11, over seventy

five percent of world wide SEI CMM level 5 certified companies are Indian. Over 300 Indian

computer and software and services have already obtained ISO 9000 or CMM level 2

certification.

Another most important reason for the success of Indian software industry is the international

linkage established by Indian software companies. These linkages were both in the form of

equity strategic alliance and non-equity strategic alliance. The non-resident Indians living in US

has played an important role in fetching software projects and many non-resident Indians have

established software firms in India.

NASSCOM, the apex association of Indian software and services companies has played a

significant role in establishing a brand image for India in the global software service markets by

participating in global trade fairs and events and organizing learning events in India that feature

prominent experts from major markets.

India’s public investments in technical education beginning in the 1960s provided the

foundation for growth of the IT industry. In the 1960s the government created a series of elite

institutes for higher education in engineering and management, in collaboration with leading

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universities in the US. One reason for concentration of software companies in the southern India

is the proximity of the locations to a very large number of engineering colleges (Kumar, 2001).

The phenomenal growth of Indian software exports can be attributed to the growing respect for

Indian software industry in the international market. According to the estimate by NASSCOM

(2000), Indian software companies earned around sixteen percent of their export revenue from

Y2K related work in 1998-99 and twelve percent in 1999-2000. The Indian software industry

earned an accumulative total of USD two and half billion from 1996-1999, from Y2K solutions.

This is one of the significant factors for the growth of Indian software industry.

During the initial phase Indian software exports were dominated by onsite development than

offshore development. However, in the recent past, the dominance of offshore software

development has been increasing. This shift has been possible because of establishment of STPs,

which inter alia provided access to modern telecommunication facilities, and liberalized policies

towards telecom sector which has led not only to the entry of private sector in telecom

companies but also low telecom tariff and high speed data communication links to the industry.

Besides the above facts, more liberal foreign investment policies, geographical time difference

with the western world enabling round the clock development and proactive role by NASSCOM

are other factors that gave fillip to the faster growth of India’s software exports.

Government policy changed to a supportive stance with the election of a new prime minister, Mr.

Rajiv Gandhi in 1984. The New Computer Policy (NCP) of 1984, which consisted of a package

of reduced import tariffs on hardware and software. In 1985 all export revenue including

software exports, were exempted from income tax. The NCP was designed to serve as a catalyst

for the software industry and the establishment of Software Technology Parks (STPs).

Until 1991-92 there was virtually no policy support for the software sector, since then the

government has taken a number of positive steps. The government of India visualized the

importance of electronics and information technology and its critical role in the economic growth

of country, and as a result, established the Department of Electronics (DOE) in 1970 and the

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Electronics Commission in 1991. In 1999, to benefit the emerging digital economy, the central

government has created a new Ministry of Information Technology by merging the DOE,

National Informatics Centre (NIC) and Electronics and Software Export Promotion Council

(ESEPC).

Various policy announcements like the Import Policy (1983), Computer Policy (1984),

Electronic Policy (1985), and Software Policy (1986) laid the foundations for the liberalized

growth of IT industry in the country. Information Technology Act (2000) and Communication

Convergence Bill (2001) of the Government clearly showed the direction in which the country is

moving to facilitate a single communication network catering to all types of technologies such as

Internet, Datacom, Telecom, Wireless, Wireline, Fixed, Mobile, Cellular, Satellite

Communications and e-Commerce. National Task Force on Information Technology and

Software Development (1998) of the Central Government has suggested a plan of action to make

India, information technology super power in the world.

The Data Security Council of India (DSCI) was launched in 2007 to institutionalize efforts to

further enhance the information security environment in India. Supportive policy and active

private enterprise have helped in creating an enabling business environment to facilitate the rapid

growth of Indian IT-BPO (NASSCOM, 2008).

The Information Technology Ministry has set up various autonomous organizations such as C-

DOT, C-DAC, CMC, STQC, CCA, NCST, ERNET, DOEACC, SCI etc., to address the

requirements of different sectors of IT in a focused manner. These organizations are playing a

major role in training and development of human power for electronics and computer industry.

In 1992 the government extended the tax exemption on export profits available to merchandise

exporters through section 80-HHC of the Income Tax Act to software exporters by introducing

Section 80-HHE was on an annual basis. Section 10A and 10B of Income Tax Act, which

provide income tax relief to EPZs and 100 percent EOUs were extended to software exports

from such schemes in 1993.

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A mix of provider, industry and government initiatives are helping further strengthen India’s

lead. India’s young demographic profile complemented by a vast and growing academic system

continues to add to its pool of educated talent. In the financial year 2009, as a proportion of

GDP the sector revenues were estimated to be around six percent. Software and service exports

accounting for over ninety nine percent of the total exports, reached USD forty seven billion and

directly employed over one million seventy lakh professionals (NASSCOM, 2009).

6.2.5 Challenges of Indian Software Industry

The most formidable challenge faced by Indian software industry is sustainability of high growth

rate of software exports in future. Though software exports registered an annual average growth

of more than fifty percent during 1900-2000, it has come down to around thirty percent since

2001. Furthermore, countries such as China, Russia, Philippines, Canada and Ireland have

started emerging as competitors to India in the international market.

In software industry, good communication infrastructure is considered vital for the continued

growth and more particularly for offshore software development. Overall, the data

communication infrastructure in India is expensive and in limited supply. Even though the

country is known for its human resource for software industry world over, it has been struggling

hard to meet the growing demand for skilled professionals.

The imminent challenges for Indian software industry are volatility of Indian Rupee vis-à-vis US

dollar, US economic slowdown since 2000 as sixty percent of our software exported to US and

US immigration Bill, which proposes to cap the number of H1B and L1 visa holders employed

on-site.

6.3 Relationship between Indian Software Industry and US Software Industry

The Indian software industry is largely complementary to US software industry. Indian software

companies provide essential maintenance and development services, enabling US software

companies to use their scarce in-house staff for higher value added work, such as design and

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develop new types of applications. The rise of Indian software industry has provided substantial

benefits to US software companies, both users and developers of software. US software

companies benefit because Indian software companies compete fiercely among themselves for

contracts.

India exports its software and services to more than 100 countries. Out of which US continues to

be the most favored destination for Indian software exports as it is the world’s largest software

market (Illiyan, 2005). It is a well known fact that export oriented software and service sector is

indeed the driving force of Indian software industry and it is widely held as the engine of growth

and earner of foreign exchange.

The significance of the US market for Indian software exports is due to the fact that US is by far

the world’s largest software market. The US information technology and financial services

companies have moved much faster than their European counterparts to take advantage of

offshore activities. The US had relatively more liberal immigration rules for work or residence

than most other developed countries (Chakraborty and Jayachandran, 2001).

6.4 Relationship between Indian Software Exports and INR-USD Exchange Rate Volatility

Foreign exchange rate is a key factor in foreign trade. Recent changes in global economy such

as recession and looming threat of deflation in the US and Europe has contributed to the

weakening of the USD against major other currencies including the rupee. This has affected

India’s export sector, especially information technology sector because sixty seven percent of

their revenues come from US and about ninety percent of exports are invoiced in USD.

Consequently operating margins of information technology companies have been hit hard. The

volatility of the INR against USD has been one of the greatest concerns especially for

information technology sector companies (NASSCOM).

The Indian software industry started in 1984-85 with modest software exports crossed USD 100

billion in 2013. It has emerged as a major export earner for the country, contributing eight

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percent of total merchandise exports. India exports to more than 100 countries and over half of

Fortune 500 companies outsource their software requirements from India.

The growth in Indian software industry has been spurred mainly by the growth in export market

demand. The export market is concentrated in the US and Europe. Almost two-thirds of the

software revenue of Indian companies accrues from export sales in the US market. It is a known

fact that export oriented software and services sector is indeed the driving force of Indian

software industry and considered as the engine of growth and earner of foreign exchange.

In 2008 software and service exports were around USD forty billons and directly employed

nearly over two million professionals. While the US and UK remain the largest export markets

accounting for about sixty one percent and eighteen percent respectively in the financial year

2007 (NASSCOM, 2008). As a proportion of national GDP, the sector revenues have grown

from 1.2 percent in financial year 1998 to an estimated 5.8 percent in financial year 2009

(NASSCOM, 2009).

During 2010-11, the share of computer and software services accounts for 4.33 percent in India’s

GDP at current prices. Out of the total production around seventy seven percent was exported.

India’s share in the world market during the year 2010-11 is estimated to be 7.8 percent as

compared to 6.83 percent estimated in the year 2009-10.

According to Computer Software and Services Exports Statistical Year book 2010-11, during

the past five years, on an average India has been exporting software services to over 147

countries and US remains the top destination for India’s exports. During 2010-11 US accounted

for a share of over fifty one percent of India’s total export of software services. In value terms,

software exports to US were around USD 30 billion.

The Indian software industry business model is export oriented, where the majority of the

revenues comes from exports, exposes these businesses to risks involved with foreign trade such

as exchange rate fluctuations. In the recent past, volatile INR-USD exchange rate has been one

of the biggest challenges faced by Indian software industry.

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During the period 1975-1992, the exchange rate of the rupee was officially set by the RBI in

terms of a (weighted) basket of currencies of India’s major trading partners and there were

significant restrictions on not only capital but current account transactions as well (Bose, 2006).

The movement towards market determined exchange rates in India began with the official

devaluation of the rupee in July 1991. In March 1992, a dual exchange rate system was

introduced in the form of the Liberalized Exchange Rate Management System (LERMS). In

March 1993, India moved from the dual exchange rate regime to a single, market determined

exchange rate system based on demand and supply in the foreign exchange market.

The INR has been fluctuating a lot against dollar. The INR has declined by nearly twenty five

percent from 54.28 on April 1st, 2013 to Rs. 68.85 on August 28th, 2013. On September 2, 2013

the rupee breached an all time low of INR 68.75, the biggest one day fall in last twenty years.

This kind of change has a huge impact on business and it requires a strong strategy to handle

such exchange risks. The fluctuating INR has also depreciated significantly against major

currencies such as Euro, Yen and Pound. But the most impact on the software industry is from

USD fluctuation only because nearly seventy percent exports from India are to the US.

According to Som Mittal, President of NASSCOM, volatility is not good for business in the long

run. It will be positive for the industry in the short-term making them more cost competitive. He

also said that it is a real problem. We do not know where [at what rate] to hedge, our customers

do not where to hedge. The gains from the falling rupee are not likely to be very significant as

most IT companies hedge their foreign exchange position. The industry needs a stable currency

as it helps in signing contracts.

He also added that “volatile and uncertain” currency would create problems for the industry as it

would make it difficult to evolve a strategy. Uncertainty was a matter of concern for the industry

as a whole. In the industry’s perspective, a stable currency would enable it prepare for long-term

contracts and hedging strategies. Though the depreciating currency could have short-term

benefit for the IT industry, such considerations were narrow as majority contracts were being

taken on the longer term for five years. The companies entering into longer term contracts hedge

at the constant prices so that the contract could be covered for the period. We cannot depend on

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currency management for profits. We do not think our core competency is currency

management. It is to get the business delivered and get the money.

In 1947 that one rupee was indeed equal to one dollar. Ten grams of gold was above INR 88.62

in 1947, today it is about INR 29000. The rupee was 43.77 and 44.77 per US dollar in 2004 and

2010 respectively. The rupee was remarkably stable during 2004 and 2010. However, in the

month of august of 2011, 2012 and 2013 it was 44, 55 and 68 respectively. The rupee became

highly volatile after 2011 due to various uncertain factors prevailing in global financial markets.

The INR exhibited two-way movements during 2006-07 moving in a range or INR 43.14-46.97

per USD. The rupee initially depreciated against the USD during the year, reaching INR 46.97

on July 19, 2006 reflecting higher crude oil price, FII outflows and geo-political risks in the

Middle East region. The rupee, however, strengthened thereafter on the back of moderation in

crude oil prices, revival of FII inflows and weakness of the USD in the international markets.

The rupee appreciated further to reach INR 40.59 per USD on May 7th, 2007 due to increased

supply of dollars in the market. Thereafter, however the rupee depreciated to INR 40.85 per

USD on May 16th, 2007. At this level, the rupee appreciated by 6.7 percent over end March

2007 and 9.2 percent over end March 2006. Against the Euro, the rupee appreciated by 4.7

percent over end March 2007, but depreciated by 2.4 percent over end March 2006 (Rakesh

Mohan, 2007).

The INR has largely been volatile since January 2009, trading in a wide range between INR

46.75 and 52.18. Since 2011 the rupee has been depreciating and from an annual average value

of 46.6 in 2011, the currency weakened to 53.4 in 2012 and in 2013, the average value has

depreciated further to 56.34. While the downward spiral in rupee’s value which hit a historic

low of INR 68.85 per USD in the month of august 2013, is expected to provide short-term

benefits, it will affect signing of new contracts by domestic IT firms (NASSCOM).

The appreciation or depreciation of the INR, as the case may be is more influenced by the

weakness or strength of the USD.

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Foreign exchange risk is the change in the domestic currency value of assets and liabilities to the

changes in the exchange rates. This may be positive or negative. Positive exposure gives rise to

gain and negative exposures gives rise to loss. Foreign exchange risk is measured by the

variance of the domestic currency value of asset or liability or an operating income, which can be

related to unexpected changes in the exchange rates (Gandhi, 2006).

According to Infosys Chairman Mr. N R Narayana Murthy, for every one percent movement in

the INR against the USD has an impact of approximately fifty basis points on operating margins

of a software company.

6.5 Cointegration Analysis

In this section, an attempt has been made to examine the relationship among Indian software

exports, US economic activity, and INR-USD exchange rate volatility, using Engle-Granger two-

stage Cointegration method.

To test the hypothesis that, “there exists no significant statistical relationship among Indian

software exports, US economic activity, and INR-USD exchange rate volatility”, quarterly data

for the period 2000-01 Ist Quarter to 2012-13 IVth Quarter was collected and used for analysis.

Data Notation Table

S.No. Notation Variable Source Units of measurement

1 lSWX Software Exports RBI USD Million.

2 lEX Exchange Rate RBI INR/USD.

3 lFEA US GDP BEA USD Billion.

4 lVOL INR-USD Volatility14 - Absolute percentage change of INR-USD

Table 6.5.1

_______________________ 14 Based on Bailey and Tavlas (1988), volatility was computed as absolute percentage change of exchange rate.

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From the table 6.5.1, it can be understood that the data pertaining to software exports and INR-

USD nominal exchange rates, which is a proxy for price competitiveness between India and US

were collected from the Reserve Bank of India (RBI) and US GDP values which are proxy for

Economic Activity of US were collected from Bureau of Economic Analysis (BEA), US.

Volatility14 was computed as an absolute percentage change of INR-USD quarterly exchange

rates. All the series have been subjected to log transformation. The data has been denoted as

lSWX for log of software exports, lEX for log of INR-USD exchange rates, lFEA for US

Economic Activity, and lVOL for volatility of INR-USD exchange rate.

Engle-Granger or Augmented Engle-Granger Method

According to this method, first, all the series must be checked for stationarity or unit root using

Augmented Dickey-Fuller (ADF) test. From the table 6.5.2, it can be understood that the

computed absolute t-statistic values of all the variables were less than the absolute critical values

at both 5% and 1% significance levels. Therefore, the null hypothesis of a variable has unit root

has been failed to be rejected and concluded that all the variables are non-stationary in levels.

Step 1: Checking all the variables for stationarity using ADF test

Variable Test

Statistic

Critical

Values H0: Has Unit

Root Decision

1% 5%

lSWX 0.2792 -4.12 -3.49 |t| < |CV| Do not Reject

lEX -2.8838 -4.12 -3.49 |t| < |CV| Do not Reject

lFEA 0.2962 -4.12 -3.49 |t| < |CV| Do not Reject

lVOL -3.207 -4.12 -3.49 |t| < |CV| Do not Reject

Table 6.5.2

Source: Data Analysis.

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Since all the variables were found to be non-stationary in levels, their first differences were

computed and again tested for stationarity or unit root using ADF test. If these first differenced

series are found to be stationary, then a Cointegration regression equation can be estimated.

Variable Test

Statistic

Critical

Values H0: Has Unit

Root Decision

1% 5%

∆ lSWX -7.8226 -4.12 -3.49 |t| > |CV| Reject

∆lEX -4.2847 -4.12 -3.49 |t| > |CV| Reject

∆ lFEA -4.9625 -4.12 -3.49 |t| > |CV| Reject

∆ lVOL -6.9831 -4.12 -3.49 |t| > |CV| Reject

Table 6.5.3

Source: Data Analysis.

∆ denotes the first difference operator and all the variables were tested for stationarity or unit

root using ADF test. From the table 6.5.3, it can be inferred that the computed absolute t-statistic

values of all the variables were more than the absolute critical values at both the 5% and 1%

significance levels. Therefore, the null hypothesis of a variable has unit root has been rejected

and concluded that all the variables are stationary at first difference.

Step 2: Cointegrating Regression Equation:

lSWXt= β1 + β2lEXt + β3lFEAt + β4lVOLt + εt

lSWXt= -52.532 + 1.483lEXt + 5.867lFEAt – 0.029VOLt + εt

Variable Coefficients t-statistic p-value

R2 =0.970

d=0.957

Intercept -52.532 -29.270 .000***

lEX 1.483 5.360 .000***

lFEA 5.867 38.649 .000***

lVOL -0.029 -1.704 .095*

Table 6.5.4 Adjusted R2:0.9682 ***Significant at 1%. F-Statistic: 517.8 P-value: .000 *Significant at 10%. Standard Error of the Regression: 0.1475

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According to Engle-Granger Cointegration method, the residuals (εt) of the Cointegration

regression equation should be checked for stationarity, if they are found to be stationary then it

can be concluded that there exists a long-term stable relationship among all the variables existing

in the Cointegration regression equation. However, the estimated residuals are based on the

estimated Cointegrating parameters (βs), the Dickey-Fuller (DF) and Augmented Dickey-Fuller

(ADF) critical significance values are not quite appropriate. Engle-Granger has calculated these

values, which are known as Engle-Granger (EG) or Augmented Engle-Granger (AEG) critical

values (Gujarati 2008, p.842)

Variable t-

statistic

AEG

Critical Values H0: Has

Unit Root Decision

1% 5%

Residuals (εt) -4.4798 -2.57 -1.94 |t| > |CV| Reject

Table 6.5.5

Source: Data Analysis.

From the table 6.5.5, it is evident that the computed absolute t- statistic value of residuals is more

than the absolute critical values at both 5% and 1% significance levels. Therefore, the null

hypothesis of residuals has unit root has been rejected and concluded that residuals are

stationary.

Thus, according to the results of the Augmented Engle-Granger (AEG) test, it can be concluded

that there exists Cointegration or long-term equilibrium relationship among all the variables of

the Cointegrating regression equation. There exists a significant positive relationship between

Indian software exports and US economic activity and a significant negative relationship

between INR-USD exchange rate volatility and Indian software exports.