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CHAPTER VII

IMPACT OF REFORMS ON BALANCE OF PAYMENTS

7.1 Introduction

7.2 Impact of Reforms on BOP Indicators

7.3 The Issue of Capital Account Convertibility

7.4 Impact of Reforms on Macroeconomic Indicators

7.5 Global Economic Crisis & India’s Balance of Payments

7.6 Statistical Analysis

7. 7 Testing of Hypotheses

7.8 Summary

7.1 INTRODUCTION

The Indian economy in general and the external sector in particular began to feel the

real and full –fledged impact of the stabilization, structural readjustment and policy

reform measures introduced through New Economic Policy and the strategy of

growth – led exports introduced by the EXIM Policy 1992 – 97, only by the year

1992 – 93 onwards.

7.2 IMPACT OF REFORMS ON BOP INDICATORS

The impact of reforms has been analysed with reference to various balance of

payments indicators like - (1) trade openness, (2) terms of trade, (3) exports &

imports, (4) role of invisibles, (5) trends in current account, (6) trends in capital

account, (7) external debt, (8) exchange rate management, and (9) reserve

management.

7.2.1 Trade Openness

Openness of a country with respect to foreign trade refers to its permissiveness

towards exports and imports. Although the term openness of a country is also used

245

in the context of its attitude towards other types of inflows and outflows, most

importantly capital, the focus is in terms of foreign trade. Ex ante, the openness of a

country towards exports / imports is determined by the tariff and non-tariff

restrictions it imposes on the flows of foreign trade. In the ex post sense, openness is

generally measured by the trade – GDP ratio of the country.

Measured in terms of both ex ante and ex post definitions, the openness of the

Indian economy has increased significantly since the introduction of economic

reforms.

A key aspect of the trade reforms of the 1990s was the reduction in import duties.

India’s customs tariff rates have been declining since 1991. Prior to 1990s, the

maximum import duty rates on certain items were over 300 per cent. The “peak”

rate of import duty on non – agricultural imports was gradually reduced from as high

as 150 per cent in 1991 – 92 to 25 per cent in 2003 – 04. Finally, the peak rate of

import duty on non – agricultural imports has been brought down to 10 per cent. The

weighted average import duty rate declined from the very high level of 72.5 per cent

in 1991 – 92 to 24.6 per cent in 1996 - 97. Thereafter it edged up again, inter alia,

due to the imposition of various surcharges. The increase in the weighted average

tariff rates since 1998 – 99 has been predominantly in agriculture and consumer

goods sectors. In 2002 – 03, the weighted average import duty rate was 29.0 per

cent. Apart from this, the number of basic duty rates has come down drastically from

22 to 4 from 1991 – 92 to 2002 – 03. Table 7.1 gives the weighted average duty

rates in India from 1991 – 92 to 2002 – 03.

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Table 7.1: Weighted Average Import Duty Rates in India

Year All Commodities Peak Customs Duty No. of Basic Duty Rates

1991 – 92 72.5 150 22 1992 – 93 60.6 110 20 1993 – 94 46.8 85 16 1994 – 95 38.2 65 16 1995 - 96 25.9 50 12 1996 – 97 24.6 52 9 1997 – 98 25.4 45 8 1998 – 99 29.2 45 7 1999 – 00 31.4 40 7 2000 – 01 35.7 38.5 5 2001 – 02 35.1 35.8 4 2002 - 03 29.0 30.8 4

Source : Ahluwalia Montek (2002) – “Economic Reforms in India since 1991: Has Gradualism worked?”

Non – tariff barriers are generally considered less desirable than tariffs. The most

common non – tariff barriers are the restrictions or prohibitions on imports

maintained through the import licensing requirements. In the Indian context, for

several decades QRs on imports of a wide range of products (mainly consumer

goods) were justified for balance of payments reasons. Out of nearly 5000

Harmonized System Tariff lines at the 6 – digit level, about 80 per cent were subject

to some form of import licensing restrictions in mid – 1991. With the external

sector gathering strength, along with a reduction in tariffs, India has been following

a consistent policy for gradual removal of restrictions on imports since 1991. In the

initial phase of reforms in 1991 – 92 about 3000 tariff lines covering raw materials,

intermediates and capital goods, were freed from licensing restrictions. India began

removing BOP related Quantitative Restrictions (QRs) unilaterally since 1996.

Tariff line – wise import policy at 10 digit level of Harmonised System (HS),

247

International Trade Classification (ITC) was first announced in 1996, wherein 6161

tariff lines out of 10,096 lines were freed. In the subsequent years from 1997 to 2003

there was an increase in the number of tariff lines which were freed. Thus, the share

of unrestricted products (tariff lines) under imports increased to more than 95 per

cent in 2003 from about 61 per cent in 1996. Table 7.2 shows the details of different

types of Non – Tariff Barriers in the context of India’s imports from 1996 to 2003.

Reflecting the relaxation of quantitative restrictions, the proportion of items under

canalization has declined from 27 per cent in 1988 - 89 to 19 per cent in 1997 – 98.

It is also important to note that over a period of time there has been a shift in the

number of items from Restricted List of Imports to the Open General List in phases.

With effect from 31st March 1999, the convention of publishing a negative list of

exports and imports was discontinued. By 2003 action was completed on removal of

restriction on tariff lines notified under WTO cover. QRs are however, still being

maintained in about 5 per cent of tariff lines as permissible under Articles XX and

XXI of GATT on grounds of health, safety, moral conduct and essential security.

Table 7.2: Different Types of Non – Tariff Barriers on India’s Imports

(Number of Tariff lines, 10 digit levels)

Year/ Type of

NTB

Prohibited Restricted Canalised Special Import Licence (SIL)

Free

Total

1996 59 2984 127 765 6161 10,096 1997 59 2322 129 1043

6649 10,202

1998 59 2314 129 919 6781 10,202 1999 59 1183 37 886 8055 10,220 2000 59 968 34 226 8854 10,141 2001 59 479 29 -- 9582 10,149 2002 52 554 33 -- 11,032 11,671 2003 52 484 32 -- 11,103 11,671

Source: Reserve Bank of India – Report on Currency & Finance 2002 - 03

248

It may be noted that trade liberalization in India has mainly been the result of its

own unilateral initiative rather than brought about by multilateral trade commitments

or regional trade agreements. In fact, in most items, India’s customs tariff rates are at

present significantly lower than the corresponding “bound” rates stemmings from

obligations undertaken in the WTO.

Table 7.3 shows the data about openness of the Indian economy with reference to

exports to GDP, imports to GDP, and export – import ratio. Table 7.3 shows that

India’s exports / GDP ratio increased from 4.6 per cent during the decade of 1980s

to 7.8 per cent in 1990s. The imports / GDP ratio increased from 7.2 per cent to 9.3

per cent during the same period. RBI’s Report on Currency & Finance 2001 – 02

has also pointed out that the ratio of exports to GDP increased from an average of

4.6 per cent during the 1980s to 8.0 per cent during the 1990s (excluding the year

1991 – 92 ) which represents an increase in export orientation of economy by 3.4

percentage points of GDP over one decade. Similarly, imports as a proportion of

GDP increased from 7.2 per cent during the 1980s to 9.5 per cent during the 1990s.1

The noticeable increase in the export – GDP and import – GDP ratios shows the

increasing openness of India’s foreign trade regime to global trade.

Table 7.3: Openness of the Indian Economy

(In Per cent)

Period

Exports / GDP

Imports / GDP

Trade / GDP

Export / Import ratio

1980- 81 to 1989 -90

4.6

7.2 11.8 63.8

1990 - 91 to 1999 -2000

7.8 9.3 17.1 84.0

2000 - 01 to 2006- 07

11.4 15.3 26.8 74.2

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy, 2005 – 06 & 2007 – 08.

249

It is evident from table 7.3, that India’s trade to GDP ratio during the period from

1980 - 81 to 1989 – 90 was 11.8 per cent, which went up to 17 per cent during the

period from 1990 – 91 to 1999 – 2000. As per RBI’s Report, India’s total

merchandise trade, an indicator of degree of openness of an economy, increased

from about 11.8 per cent of GDP in 1980s to 17.4 per cent during the 1990s.2

Further analysis of the data from 2000 – 01 to 2006 - 07 shows that it went up to

nearly 27 per cent. Furthermore, table 7.3 also shows the average export – import

ratio, which is an indicator of the import financing capacity of exports. The export –

import ratio increased from about 64 per cent in the decade of 1980s to 84 per cent

in 1990s. The RBI’s Report too, confirms this view, as per the Report, the average

export – import ratio improved sharply from 64.0 per cent to 84.1 per cent between

the 1980s and 1990s, and further increased to 85.2 per cent in 2001 – 02. The

increase in export – import ratio has thus reflected increase in alignment between

India’s export and import performance during the nineties as compared to eighties.3

Further analysis of export – import ratio from 2000 – 01 to 2006 – 07 shows that it

decreased to 74 per cent. To conclude, the given data confirms the view that there

has been an increase in India’s trade openness after the reforms.

Fig. 7.1 shows India’s foreign trade ratios from 1990 -91 to 2006 – 07. As is clear

from fig.7.1 that all the ratios i.e. exports to GDP ( X/GDP), imports to GDP

(M/GDP) and trade to GDP (TR/GDP) are reflecting an increasing trend, which is a

reflection of India’s growing trade openness.

250

Fig. 7.1 India’s Foreign Trade Ratios 1991 to 2007

05

10152025303540

90-91'

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

As P

er c

ent o

f GDP

X/GDPM/GDPTR/GDP

7.2.2 Impact on Terms of Trade

The success of reform measures also depends upon whether the terms of trade have

moved in India’s favour or not ? There are three concepts of terms of trade which

are commonly used in international economics. They are -

(a) Gross barter terms of trade, (b) Net barter terms of trade, and (c) Income terms of

trade.

(a) Gross barter terms of trade imply volume index of exports expressed as a

percentage of volume index of imports.

(b) Net barter terms of trade imply unit value index of exports expressed as a

percentage of unit value index of imports.

(c) Income terms of trade imply the product of net barter terms of trade and volume

index of exports expressed as a percentage.

In general, a rise in unit value of exports in relation to the unit value of imports

improves the country’s terms of trade and has stimulating effect on export earnings.

251

Hence, it is the concept of net terms of trade which is commonly used by economists

in their analysis of terms of trade.

Table 7.4: India’s Terms of Trade (1978 – 79 = 100)

Period

Gross Net Income

1980 – 81 to 1989 - 90

145.29 110.00 141.50

1990 - 91 to 1999 - 2000 134.38 134.75 439.50

2000 – 01 to 2006 - 07 135.35 125.35 1034.00

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy, 2005 – 06 & 2007 – 08. Table 7.4 shows that India’s average gross barter terms of trade have declined from

145 in 1980s to 135 in 1990s and has been stable thereafter. However, the yearly

data indicates that there was an improvement in the gross barter terms of trade in the

first few years after the reforms. Similarly, India’s net terms of trade, which

measures the relative change in export and import prices have been generally

fluctuating during the 1990s. But, a comparison between 1980s and 1990s shows

that the net terms of trade have improved from 110 to 135. However, from 2000 –

01 to 2006 – 07 it has come down to 125.

Import purchasing power of exports as measured by the income terms of trade have

consistently improved during the 1990s on account of strong export growth in

volume terms. The income terms of trade, increased from on an average from 141.5

in 1980s to 439.5 in the 1990s and further to 1034.0 from 2000 – 01 to 2006 – 07.

In the Indian context, a number of studies have been undertaken to analyse the

movement of terms of trade. An exercise for the period 1970 – 71 to 2001 – 02

252

shows that there has been a secular upward movement in terms of trade ( in all the

three measures : gross, net and income) during this period. The terms of trade

“pessimism” has, therefore, not been validated in the Indian context. There has also

been some apprehension regarding higher volatility of terms of trade following the

opening up of the Indian economy. An analysis of India’s terms of trade during the

1990s reveals that its volatility has come down significantly since 1992 – 93 as

compared to the period between 1970 – 71 to 1989 - 90, a period when the economy

was relatively inward looking. (Table 7.5) Thus, we can conclude that the reforms

have resulted into favourable terms of trade and large gains from trade for India.

Table 7.5: India’s Terms of Trade

(1978 – 79 = 100)

Period

Gross Net Income

1970 -71 to 1989 - 90 Mean CV

126.9

19.6

111.1

17.3

114.6

34.9

1990 – 91 to 2001 - 02 Mean CV

134.6

10.1

134.7

9.6

510.9

33.3

Note : CV = Co-efficient of Variation

Source: Government of India (2003) – Economic Survey 2002 – 03.

With the introduction of economic reforms since 1991 – 92, there has been a

substantial rise in both unit value and volume of exports. Though the increase in the

volume of exports indicates the growth of exports in real terms, the unit value is the

basic determinant of a country’s balance of trade. The phenomenal rise in the unit

value of exports since 1990 – 91 has led to an impressive improvement in India’s

terms of trade leading to a significant rise in exports and reduction in the balance of

trade.

253

Table 7.6 gives the indices of India’s exports in terms of unit value and volume. It is

observed from table 7.6, that from 1980 – 81 to 1990 – 91, the unit value index of

exports rose from 108 to 292, and the volume index rose from 108 to 194. Hence,

from 1980 – 81 to 1990 – 91, the percentage change in unit value index was about

170 per cent and that of volume index was about 80 per cent. From 1990 – 91 to

1999 – 2000, the unit value index increased from 292 to 604, and the volume index

rose from 194 to 461. Hence, from 1990 – 91 to 1999 – 2000, the percentage change

in unit value index was 107, and that of volume index was 138. Thus, the volume

index of exports has shown greater percentage increase in the 1990s after the

reforms. In the year 2006 – 07, the unit value index stood at 863 and the volume

index stood at 1164. Thus, the percentage change in unit value index from 1999 –

2000 to 2006 – 07 is 43 per cent and that of volume index is 153 per cent.

Table 7.6 – Indices of India’s Exports

(1978 – 79 = 100)

Year Unit Value index Volume Index Percentage change

(Unit value)

Percentage change

(Volume) 1980 - 81 108.5

108.1 --- ---

1990 – 91 292.5 194.1

170.35 79.60

1999 – 00 604.0 461.0

106.85 137.60

2006 - 07 863.0

1164.0 42.90 152.50

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy, 2005 – 06 & 2007 – 08.

It is observed from table 7.7, that from 1980 – 81 to 1990 – 91, the unit value index

of imports rose from 134 to 267, and the volume index rose from 137 to 237.

Hence, from 1980 – 81 to 1990 – 91, the percentage change in unit value index was

about 99 per cent and that of volume index was about 72 per cent. From 1990 – 91

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to 1999 – 2000, the unit value index increased from 267 to 450, and the volume

index rose from 237 to 705. Hence, from 1990 – 91 to 1999 – 2000, the percentage

change in unit value index was 68, and that of volume index was 196. Thus, the

volume index of imports has shown greater percentage increase in the 1990s after

the reforms. In the year 2006 – 07, the unit value index stood at 608 and the volume

index stood at 2047. Thus, the percentage change in unit value index from 1999 –

2000 to 2006 – 07 is 35 per cent and that of volume index is 190 per cent.

Table 7.7 – Indices of India’s Imports

(1978 – 79 = 100)

Year Unit Value index Volume Index Percentage change (Unit value)

Percentage change

(Volume) 1980 – 81

134.2 137.9 --- ---

1990 – 91 267.7 237.7 99.00

72.45

1999 – 00 450.0 705.0 68.00

196.00

2006 - 07 608.0 2047 35.12 190.35

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy, 2005 – 06 & 2007 – 08.

An analysis of indices of exports and imports (unit value & volume) supports the

observation in table 7.4 that India’s net terms of trade became favourable and

increased from 110 to 135 in the post – reform period. It also supports the

observation in table 7.4 that there was a decrease in net terms of trade from 135 to

125 from 2000 – 01 to 2006 - 07.

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7.2.3 Impact on Exports & Imports

It can be argued that the trade policy reforms initiated in 1991 have drastically

changed the scenario and have resulted in a shift from inward – oriented policy of

the past to an outward – oriented policy. Hence, the impact of reforms on exports &

imports have been analysed in relation to - changes in export and import growth

rates, changes in composition of exports and imports, direction of exports & imports

etc.

(a) Export – Import Growth Rates – As can be observed from table 7.8 that, both

export and import growth rates registered an increase in the post – reform period vis

– a – vis 1980s. For instance, the average annual export growth rate rose from 16.8

per cent in 1980s to 17.45 in 1990s. From 2001 to 2007, it was 18.0 per cent

showing a marginal improvement. On the other hand, average annual import growth

rate rose from14.55 in 1980s to 18.75 in 1990s. From 2001 to 2007, it was 21.4 per

cent, showing some improvement.

Table 7.8: Growth Rates of Exports & Imports (In `. terms)

(In Per cent)

Particulars

1981 -1990 1991 - 2000 2001 - 2007

Exports

16.80 17.45 18.00

Imports

14.55 18.75 21.40

Source : Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08 However, a detailed calculation on the rates of growth in 1990s shows that the

performance in the second half of the 1990s deteriorated considerably as compared

with the first half of 1990s. (Table 7.9) For instance, on an average annual basis

export growth rate during the first half of 1990s (1991 – 95) was 23.25 per cent,

256

which fell considerably to 9.85 per cent in the second half of 1990s (1996 – 2000).

Similarly, on an average annual basis import growth rate fell from 21.15 per cent in

the first half of 1990s to 11.25 per cent during the second half of 1990s.

Table 7.9: Growth Rates of Exports & Imports (In `. terms)

(In Per cent)

Particulars

1991 -1995 1996 - 2000

Exports

23.25 9.85

Imports

21.15 11.25

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08 Some of the reasons for slowdown in export and import growth rate in the second

half of 1990s can be attributed partly to – slowdown in economic activity, fall in

demand due to East Asian crisis, imposition of Non- tariff barriers by developed

countries, weakening of overall demand and world trade volume.

(b) Structure & Composition of Exports – The impact of reforms can also be

observed with respect to changes in the structure and composition of India’s exports.

The composition of exports is given in table 7.10. Table 7.10 reflects some of the

important observations regarding changes in the composition of exports in the post –

reform period. The observations are as follows:

1) The share of primary products (including agriculture & allied products and

ores and minerals) in total exports was 36.80 per cent in 1980 – 81, and 24.0

per cent in 1990 – 91. It decreased to 17.70 per cent in 1999 – 2000.Further,

by 2006 – 07 it fell to 15.5 per cent.

257

2) Manufactured products account for a major share of the increase in aggregate

exports over the period 1990 – 91 to 2006 - 07. The share of manufactured

products in total exports was 55.8 per cent in 1980 – 81, which increased to

72.9 per cent, in 1990 – 91. By 1999 – 2000, its share went up to 80.7 per

cent. This increase in share of exports of manufactured products clearly

indicates that India has gradually transformed from a predominantly primary

products exporting country into an exporter of manufactured goods. Aided

by various export promotion measures, the share of “manufactured goods” in

India’s total exports increased from 70.7 per cent during 1987 – 90 to 75.3

during 1992 – 97 and further to 77.4 per cent during the 1997 – 2002.4

However, in 2006 – 07, the share of manufactured products in total exports

fell to 67.2 per cent.

3) One interesting development regarding composition of exports can be cited

with reference to exports of petroleum products. The share of petroleum

products increased from 0.4 per cent in 1980 – 81, to 2.9 per cent in 1990 –

91, and further to 14.8 per cent in 2006 - 07.

4) The commodity composition within the major groups has also undergone a

considerable transformation. For instance, within the primary group, the

share of ores and minerals, & traditional items like tea, coffee, cereals,

handicrafts and carpets has declined while that of engineering goods and

processed agricultural products has shown marked improvement in the post

reform years. Similarly, the share of chemicals and allied products has

improved while that of leather and manufactures has declined in the post

reform period.

258

5) Export basket when classified on the basis of technology intensity reveals

certain interesting facts. According to this, exports can be classified into five

groups. The export basket can be categorized into primary commodities

(Group I), manufactures based on labour and natural resources (Group II),

manufactures characterized by low technology intensity (Group III), medium

technology intensity (Group IV) and high technology intensity (Group V).

Disaggregating India’s exports according to this classification shows that

although the share of other low and high intensive technology intensive

exports has improved since the 1980s, the bulk of the structural shift has

been concentrated in labour and natural resource based manufactures. (Group

II). As a result, the products wherein India has the maximum presence in

international market in terms of export share continued to be Group I and II

commodities (such as, spices, marine products, precious and semi-precious

stones, textiles, etc) during most of the 1990s. Data for recent years,

however, indicate that the commodity structure of India’s exports has slowly

begun to shift towards higher technology intensive manufactures.5 (Table

7.11).

6) It is expected that the future export drivers for India will be textiles,

engineering goods, including automobiles and capital goods and processed

food items. Textiles have long been a traditional export item for India

accounting for nearly one fifth of the total exports during the 1990s. With the

phasing out of Multi – Fibre Arrangement (MFA) and dismantling of quotas

from January 1, 2005, the potential for India’s textile exports is likely to

increase significantly. India’s advantage in textile production, which is

259

labour intensive, lies in its competitive advantage in labour, raw materials

including cotton and low import intensity.

7) Finally, India’s export share in the world trade has increased perceptibly

during the recent period. On an average, it was 0.48 per cent in 1980s, which

increased to 0.53 per cent in 1990. By 2000 it was 0.72 per cent and by 2004

it was 0.84 per cent.

To conclude, it can be pointed out that there was a perceptible improvement in

India’s export performance in the initial phase of the reform period – both at the

overall level and across commodities. The commodity composition of India’s export

basket has changed in favour of technology intensive and industrial products such as

engineering goods, besides high – value agricultural products. At the same time,

reservations for the small scale industries, high transaction costs and low levels of

factor productivity have adversely affected the performance of exports of our

country.

Table 7.10: Composition of India’s Exports

(In Per cent)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

Commodity Group

1980 – 81 1990 – 91 1999 – 2000 2006 - 07

I Primary Products

36.80 24.00 17.70 15.50

II Manufactured Products

55.80 72.90 80.70 67.20

III Petroleum Products

0.40 2.90 0.10 14.80

IV Others ( Unclassified)

7.00 0.80 1.50 2.50

Total

100.00 100.00 100.00 100.00

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Table 7.11: Technology Intensity of India’s Exports 1980 – 2000

(Percentage of total non – oil exports)

Commodity Group

1980 1990 2000

Group I – Primary Commodities

40.9 26.6 18.9

Group II - Manufactures (Based on labour & natural resources

38.5 51.1 52.6

Group III – Manufactures (Characterised by low technology intensity)

5.7 4.8 6.6

Group IV – Medium technology intensity

7.0 6.6 6.6

Group V – High Technology intensity

5.1 9.3 11.7

Others

2.8

1.6

3.6

Total

100.00 100.00 100.00

Source: Reserve Bank of India : Report on Currency & Finance 2002 – 03

(c) Competitiveness of Exports - Exports of a country are said to be competitive if

the country is able to sell its products at a lower or same price and earn the same

return as its competitors. Competitiveness could arise from favourable endowment

base in the economy, lower cost consideration or from better quality of the

commodity produced. Export competitiveness depends on variables such as -

remuneration of factors of production, exchange rate, productivity – through the use

of better technical skills and human resource development, and economies of scale.

Besides this, institutional and policy mechanisms also play a pivotal role in

enhancing the competitiveness. Finally, other non – price factors such as quality and

branding are also important which can contribute to exports competitiveness.

An analysis of competitiveness of manufactured exports, as measured by a number

of indicators reveals that India has competitive advantage with respect to some key

indicators, viz., real exchange rate, labour productivity and unit labour cost. In fact,

261

the unit labour cost of manufacturing exports in India is one of the lowest among the

developing countries.

Revealed Comparative Advantage (RCA) is one of the indicators of a country’s

export competitiveness. RCA evaluates an economy’s export share in a given sector

relative to its overall export share. Information based on export data for India’s four

major exporting items viz. iron and steel, chemicals, textiles and clothing, for the

year 1990 and 2000 reveals that India has been able to successfully consolidate its

position in international markets in all these export sectors. Moreover, in sectors,

such as, iron and steel, and chemicals, India appears to have a relatively more

dominant presence in the world market vis – a – vis comparable countries such as

China and Korea. Table 7.12 depicts the RCA of select manufacturing sectors of

India, China & Korea.

Table 7.12: Revealed Comparative Advantage of Select Manufacturing Sectors: Comparison of India, China & Korea

Source: Reserve Bank of India: Report on Currency & Finance 2002 – 03

(d) Structure & Composition of Imports – Prior to 1987 – 88, imports were

classified into four groups namely, food and live animals chiefly for food, (Group I),

raw materials and intermediate manufactures (Group II), capital goods (Group III),

Country Year Iron & Steel

Chemicals Textiles Clothing

India 1990

2000

0.4

1.4

0.8

1.0

4.0

5.3

4.4

4.3 China 1990

2000

0.6

0.5

0.7

0.5

3.7

2.4

4.8

4.0 Korea

1990

2000

1.3

1.4

0.3

0.6

2.3

2.2

2.9

2.7

262

and others (Group IV). However, from 1987 – 88, onwards there has been a change

in the classification of importables. They are classified into mainly two groups

which are - Bulk imports (Group I), and Non – bulk imports (Group II). The analysis

of the changes in the structure and composition of imports in the post – reform

period is based on the classification from 1987 – 88. Hence, strict comparison

between 1980 – 81 and 1990 – 91 is excluded.

The composition of India’s imports and structural changes therein during the post –

reform period are reflected in table 7.13. The main observations are as follows –

1) Petroleum and petroleum products have been the most significant item

among bulk imports. The share of this item was 42 per cent in 1980 – 81,

which fell to 25.0 in 1990 – 91. In 1999 – 2000 its share marginally went up

to 25.40 per cent. In 2006 – 07, its share went up to 30.76 per cent. It is

pertinent to note that, while the share and absolute value of these imports

showed sharp fluctuations over the years mainly on account of the large

movements in international crude prices, the volume of such imports has

grown significantly on account of increase in domestic consumption and the

stagnation in domestic crude oil production.

2) Imports of capital goods occupy a dominant place in non – bulk imports. The

percentage share of imports of capital goods have remained almost stable

during the post – reform period. For instance, its share was 15.2 per cent in

1980 – 81, which increased to 24.2 per cent in 1990 – 91. In 1999 – 2000 its

share decreased to 18.05 per cent, however, by 2006 – 07, its share again

went up to 25.35 per cent.

3) Commodity – wise analysis reveals that while petroleum still continues to

have a dominant presence in India’s imports, capital goods and other

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intermediary products for export purposes have emerged as key items of

imports in the 1990s.

4) To meet the requirements of the gems and jewellery industry pearls and

precious & semi – precious stones are imported in large quantities. Pearls

and precious stones imports were 3.3 per cent of total imports in 1980 – 81,

they more than doubled to 8.7 per cent by 1990 – 91. Its share was 10.95 per

cent in 1999 – 2000. Its share then fell to 4.0 per cent in 2006 – 07. The

declining share indicates high import intensity.

5) As a result of liberalization of trade policy in the post – reform period and

changing consumer tastes and preferences, imports of electronic goods and

consumer goods have increased substantially during the post – reform period.

For instance, in 1993 – 94, imports of electronic goods and consumer goods

were just 4 per cent of total import expenditure. By 2006 – 07, its share went

up to 8.7 per cent of total import expenditure.

6) Another significant development during the 1990s has been the channelising

of imports of gold through official routes. Imports of gold and silver have

increased in the post - reform period due to a switchover from unofficial

channel to official channel, initially through NRI baggage route, and

subsequently through OGL route.

Hence, with respect to imports it can concluded that, there has been compositional

shifts in the structure of India’s imports towards higher technology intensive and

export oriented products during the 1990s.

264

Table 7.13: Composition of India’s Imports

(In Per cent)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

(e) Import Intensity of Exports in India – Import intensity of exports can simply be

defined as the degree of value addition of an imported item that subsequently gets

exported. In the Indian context, gems and jewellery is a typical example of such

export product having high import intensity. Another way of defining import

intensity of exports is to identify those exports which are heavily dependent on

imported inputs. It is observed that import intensity of exports for gems and

jewellery and chemicals and allied products is very high. The extent of such import

intensity however appears to be declining for both the items in recent years. Table

7.14 depicts the import intensity of select exports such as gems & jewellery and

chemicals & allied products. It can be observed from table 7.14 that import intensity

of gems & jewellery which was 72.5 in 1999 – 2000 declined to 46.85 in 2006 – 07

and that of chemicals and allied products declined from 61.1 to 45.15 during the

same period. One possible explanation for this decline in import intensity of exports

can be increase in the domestic production of inputs which are required for this

products.

Items

1990 – 91 1999 – 2000 2006 - 07

I Bulk Imports – Of which (a)Petroleum, Crude & Products (b) Bulk Consumption Goods (c) Other Bulk items

45.10 25.00 2.30 17.80

39.55 25.40 4.85 9.30

45.45 30.76 2.30 12.39

II Non – Bulk Imports – Of which (a) Capital goods (b) Mainly Export Related Items (c) Others

54.90 24.20 15.30 15.40

60.45 18.05 18.35 24.05

54.55 25.35 9.62 19.58

Total Imports

100.0

100.00 100.00

265

Table 7.14: Import Intensity of Select Export Commodities

(In Per cent)

Source: Reserve Bank of India – Report on Currency & Finance 2002 – 03 & Handbook of Statistics on Indian Economy 2008 - 09 (f) Direction of Exports & Imports – For analyzing direction of exports and imports

the countries have been divided into five groups like – OECD (Group I), OPEC

(Group II), Eastern Europe (Group III), Developing countries (Group IV), and

Others (Group V). Some of the important observations regarding direction of

exports as shown in table 7.15 are as follows –

1) Destination - wise analysis of the Indian exports indicates an unchanged

position in respect of Organisation for Economic Cooperation and

Development (OECD) group being the largest market, increasing

prominence of the Organisation of Petroleum Exporting Countries (OPEC)

and the developing countries (Asia, Africa, and Latin America), and a steep

erosion in the relative position of Eastern Europe.

2) As is clear from table 7.15, the share of OECD countries in India’s export

earnings was 46.6 per cent in 1980 – 81, it further increased to 53.5 per cent

in 1990 – 91. It was 57.30 per cent in 1999 – 2000. However, it came down

to 41.2 per cent in 2006 – 07.

3) The share of OPEC group in India’s export earnings was 11.1 per cent in

1980 – 81, which nearly halved to 5.6 per cent in 1990 – 91. By 1999 –

Products

1990 – 91 1999 – 2000 2006 - 07

Gems & Jewellery

71.20 72.50 46.85

Chemicals & Allied Products

74.40

61.10

45.15

266

2000, it doubled to 10.58 per cent in 1999 – 2000. In 2006 – 07, it was

increased to 16.4 per cent.

4) The share of Eastern Europe in India’s exports was 22.1 per cent in 1980 –

81, and 17.9 per cent in 1990 – 91. But, due to the disintegration of

communist regimes, the share of Eastern Europe in India’s export earnings

drastically fell to 3.5 per cent in 1999 - 2000. In 2006 – 07, the share of

Eastern Europe was a mere 2.0 per cent.

5) India’s exports to developing countries were 19.2 per cent of total exports in

1980 – 81. It then marginally decreased to 17.1 per cent in 1990 – 91. But,

within a span of ten years it increased to 28.4 per cent by 1999 – 2000.

Further, within a span of another six years it has shown a marked

improvement and the share went up to 40.2 per cent in 2006 – 07.

6) At the disaggregate level we find that almost half of the exports to OECD

countries, are accounted by European Union Countries.

7) It is observed that among developing countries, India’s exports to Asia

occupies a larger share and has been increasing over a period of time. For

instance, exports to Asia were 13.4 per cent in 1980 – 81, which marginally

increased to 14.4 per cent in 1990 – 91. In 1999 – 2000, its share was 22.28

per cent and it further went up to 29.8 per cent in 2006 – 07.

267

Table 7.15: Direction of Exports

(In Per cent)

Group

1980 – 81 1990 – 91 1999 – 2000 2006 - 07

I OECD – of which (a)European Union (EU) (b) Others

46.60

27.50

19.10

53.50

21.80

31.70

57.30

25.48

31.82

41.20

20.40

20.80

II OPEC

11.10

5.60

10.58

16.40

III Eastern Europe

22.10

17.90

3.50

2.00

IV Developing Countries – Of which (a) Asia (b) Others

19.20

13.40

5.80

17.10

14.40

2.70

28.40

22.28

6.12

40.20

29.80

10.40

V Others

1.00

5.90

0.22

0.20

Total

100.00 100.00 100.00 100.00

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 2006 & 2007 – 08

With respect to direction of imports as depicted in table 7.16 the important

observations are as follows:

1) As is clear from the table 7.16 the share of imports from OECD countries

was 45.7 per cent in 1980 – 81, which further increased to 54.0 per cent in

1990 – 91. It fell to 43 per cent in 1999 – 2000 and further to 34.5 per cent in

2006 – 07. The main reason for this was a fall in the share of European

268

Union from 29.4 per cent in 1990 – 91 to 25.48 per cent in 1999 – 2000 and

to 15.3 per cent in 2006 – 07.

2) The share of imports from OPEC group was 27.8 per cent in 1980 – 81,

which fell to 16.3 per cent in 1990 – 91. It increased to 25.88 per cent in

1999 – 00. By 2006 – 07 it went up to 30.2 per cent.

3) The share of Eastern Europe in imports was 10.8 per cent in 1980 – 81 and

7.8 per cent in 1990 – 91. It drastically fell to 2 per cent in 1999 – 2000,

mainly because of disintegration of USSR. By 2006 – 07, its share

marginally went up to 2.7 per cent.

4) The share of imports from developing countries increased from 15.7 per cent

in 1980 – 81, to 18.6 per cent in 1990 – 91. But within a span of ten years it

increased to 29 per cent in 1999 – 2000. In the year 2006 – 07, imports from

developing countries were 32.2 per cent of India’s total imports.

5) It is important to note that among developing countries, imports from Asian

countries occupy a larger share. For instance, imports from Asian countries

were 14.0 per cent in 1990 – 91, which went up to 20.0 per cent in 1999 –

2000 and further to 25.5 per cent in 2006 – 07.

6) It is important to note that subsequent to the opening up, India’s imports

have been sourced from a wider range of countries. The traditional import

partners like Germany, Japan, UK & Australia have lost their relative market

share, while new import partners from Africa and East Asia (including

China) are gaining importance.

7) In recent years, Belgium from where India imports its major export oriented

item of gems and jewellery, has emerged as one of the principal sources of

imports.

269

Table 7.16: Direction of Imports

(In Per cent)

Group

1980 – 81 1990 – 91 1999 – 2000 2006 - 07

I OECD – of which (a)European Union (EU) (b) Others

45.70

21.00

24.70

54.00

29.40

24.60

43.00

22.10

20.90

34.50

15.30

19.20

II OPEC

27.80

16.30

25.88

30.20

III Eastern Europe

10.30

7.80

2.00

2.70

IV Developing Countries – Of which (a) Asia (b) Others

15.70

11.40

4.30

18.60

14.00

4.60

29.00

20.00

9.00

32.20

25.50

6.70

V Others

0.50

3.30

0.12

0.40

Total 100.00 100.00 100.00 100.00

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 2006 & 2007 – 08

7.2.4 Financing of Trade Deficit – Role of Invisibles in the Post Reform Period

Invisibles have been considered as the most dependable source of financing

country’s trade deficits. The importance of invisibles increased tremendously after

the initiation of trade reform measures in 1991. The fundamental changes in

exchange and payment regime and opening up of the economy has resulted in

buoyancy and substantial improvement in the invisible receipts. This has been

270

further boosted by technology related exports in general and software exports in

particular and also by increase in investment income caused by high and increased

foreign exchange reserves of the RBI.

Invisible receipts mainly include all the income received in the form of travel,

banking, consultancy, transportation, insurance, investment income, private transfers

and official transfers. While invisible payments include all the payments made in the

form of travel, transportation, insurance, investment income, private transfers and

official transfers.

As depicted in table 7.17, over a period of time invisible receipts as a percentage of

GDP doubled from 2.4 per cent in 1990 – 91 to 4.8 per cent in 1994 – 95. It further

increased to 6.7 per cent in 1999 – 2000. Further within a span of seven years it

doubled to 12.5 per cent of GDP in 2006 – 07.

Net invisibles include the difference between the invisible receipts & invisible

payments. A positive net invisibles means invisible receipts are more than invisible

payments. While a negative net invisibles means invisible receipts are less than

invisible payments. Thus, it is the positive net invisibles which finance the trade

deficit. As shown in table 7.17, in 1990 – 91, net invisibles as a percentage of GDP

were negative i.e. – 0.1 per cent. However, within a few years after reforms, it

reached to a positive figure of 1.8 per cent in 1994 – 95. By 1999 – 2000, net

invisibles almost doubled and reached to 2.9 per cent of GDP. Further, within a

span of seven years, net invisibles went up to 5.8 per cent of GDP in 2006 – 07.

As pointed out by RBI’s Report on Currency & Finance 2001 – 02 – “One of the

most significant developments in current account of balance of payments in the

1990s was the remarkable growth in service transactions with the rest of the world,

which was made possible by the revolution in information and communication

271

technology…Reflecting the strong growth emanating from software exports, the

traditional sources of service exports, viz., travel and transportation have declined in

relative importance. Following the heavy inflow of invisible receipts, India’s current

account deficit (CAD) narrowed down considerably during the decade of 1990s.” 6

Table 7.17: Invisible Receipts & Net Invisibles in the Post - Reform Period

(In Per cent)

Particulars

1990 - 91 1994 – 95 1999 – 00 2006 - 07

Invisibles Receipts / GDP

2.4 4.8 6.7 12.5

Net Invisibles / GDP

- 0.1 1.8 2.9 5.8

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 2006 & 2007 – 08

Although year to year fluctuations were there in net invisibles, on an average, 63 per

cent of trade deficit was financed by net invisibles from 1991 – 92 to 2000 – 01.

Earnings from invisibles exceeded the deficit on trade account in 2001 – 02, 2002 –

03 and 2003 – 04, with the result that there was a surplus in current account in these

years.

A detailed analysis of trends in invisibles as depicted in table 7.18 reveals the

following –

(a) From 1991 to 2000, the average invisible receipts to GDP ratio was 4.75 per

cent. In the first half of 1990s (1991 – 1995), it was 3.70 per cent which increased

to 5.8 per cent in the second half of 1990s.(1996 – 2000). Further, within a span of

seven years (2001 – 2007) it increased to 9.35 per cent.

(b) From 1991 to 2000, the average net invisibles to GDP ratio was 1.55 per cent. In

the first half of 1990s (1991 – 1995) it was a mere 0.8 per cent. However, in the

272

second half of 1990s (1996 – 2000) the percentage increased to 2.3 per cent. Further,

from 2001 – 2007, it went up to 4.08 per cent.

(c) The increase in the invisibles receipts to GDP ratio & net invisibles to GDP ratio,

particularly from 1996 to 2007 can be attributed to the increase in service exports.

(d) Table 7.19 depicts plan - wise financing of trade deficit by net invisibles. As is

clear from table 7.19, in the Seventh Plan (1985 – 90), invisibles were able to

finance only 25 per cent of trade deficit. But, from Eighth Plan onwards, the net

invisibles have been able to finance more than 50 per cent of trade deficit. For

instance, in the Eighth Plan (1992 – 97), invisibles were able to finance on an

average, 58 per cent of trade deficit. This financing increased to 82 per cent in the

Ninth Plan (1997 – 02). Further, in the Tenth Plan (2002 – 07), almost 99 per cent of

trade deficit was financed by invisibles. This is because in the first two years of the

Tenth Plan (2002 – 03 & 2003 – 04), the net invisibles were more than the trade

deficit, resulting into current account surplus, in these two years. As is clear from

table 7.19, the period of the Seventh Plan was a pre – reform period and the period

from Eighth Plan onwards is a post – reform period. Hence, it can be concluded that

invisibles have played an important role in the financing of trade deficit in the post –

reform period.

Table 7.18: Invisible Receipts / GDP & Net Invisibles / GDP

(In Per cent)

Particulars 1991 – 2000 1991 – 95 1996 – 2000 2001 - 2007

Invisibles Receipts / GDP 4.75 3.70 5.80 9.35

Net Invisibles / GDP 1.55 0.80 2.30 4.08

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 2006 & 2007 – 08

273

Table 7.19: Financing of Trade Deficit by Net Invisibles

(Plan – wise Annual average)

Particulars Seventh Plan

(1985 – 90)

Eighth Plan

(1992 – 97)

Ninth Plan

(1997 – 02)

Tenth Plan

(2002 – 07)

Trade Balance (In `. Crore)

- 54205 - 29801 - 60467 - 155295

Invisibles Net (In `.Crore)

13162 17219 49832 154165

Financing of trade deficit by Net Invisibles ( In Per cent )

25.00 58.00 82.00 99.00

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 2006 & 2007 – 08

Fig.7.2 Trends in Invisibles 1991 to 2007

-2

0

2

4

6

8

10

12

14

90-91

'

92-93

'

94-95

'

96-97

'

98-99

'

00-01

'

02-03

'

04-05

'

06-07

'

Year

As P

er c

ent o

f GDP

Invisibles Receipts / GDPInvisibles Net / GDP

Fig.7.2 shows the trends in invisibles from 1990 – 91 to 2006 – 07. It is clear from

fig.7.2 that invisible receipts to GDP ratio was 2.4 in 1990 – 91 which increased to

6.7 in 1999 – 2000. Further, within a span of seven years it doubled to 12.5 per cent.

Similarly, the invisibles net to GDP ratio was a negative (- 0.1) in 1990 – 91. In the

274

year 1991 – 92, the figure turned to be positive and gradually increased to 2.9 per

cent in 1999 – 2000. Again within a span of seven years it doubled to 5.8 per cent.

7.2.5 Trends in Current Account

One of the factors underlying the external payments crisis of 1991 was the high

levels of current account deficits (CAD) maintained during the 1980s which at the

time of crisis had reached 3.1 per cent of GDP, well above the sustainable level for

India. However, a combination of prudent and unorthodox policies for stabilization

and structural change ensured that the crisis did not translate into financial instability

or crisis. The external sector policies implemented in 1991, emphasized

competitiveness of exports of both goods & services, a realistic and market – based

exchange rate regime, consolidation of external debt and a policy preference for non

– debt creating capital flows. These policies ensured that the current account deficit

remained around one per cent of GDP and was comfortably financed even as the

degree of openness of the economy rose significantly relative to preceding decades

and capital flows began to dominate the balance of payments.

A detailed study of the data of current account deficit to GDP ratio, as given in table

7.20, indicates that the CAD / GDP ratio reduced from 3.1 per cent in 1990 – 91 to

0.3 per cent in the year 1991 – 92. The average CAD / GDP ratio works out to be

1.02 per cent from the period 1991 – 92 to 2000 – 01. Further, there was a current

account surplus for three consecutive years from 2001 – 02 to 2003 – 04. In 2001 –

02, it was 0.7 per cent, in 2002 – 03, it was 1.2 per cent and in 2003 – 04 it was 2.3

per cent. Thus, it is the first time in post – independence period that there was a

current account surplus in three consecutive years.

275

After recording a surplus for three years in a row, the current account once again

recorded a deficit of 0.4 per cent of GDP in the year 2004 – 05. This deficit

increased to 1.2 per cent in 2005 – 06 and marginally reduced to 1.1 per cent in 2006

– 07.

In the context of current account, the Economic Survey 2007 – 08 observed: “The

current account has followed an inverted “U” shape pattern during the period 2001 –

02 to 2006 – 07, rising to a surplus of over 2 per cent of GDP in 2003 – 04.

Thereafter, it has returned close to its post 1990s reform average with a CAD of 1.2

per cent in 2005 – 06, and 1.1 per cent in 2006 – 07.” 7

Table 7.20: Current Account Deficit 1991 to 2007

(As Percent of GDP)

Year Current Account Deficit

1990 – 91 3.1 1991 – 92 0.3 1992 – 93 1.7 1993 - 94 0.4 1994 – 95 1.0 1995 – 96 1.7 1996 – 97 1.2 1997 – 98 1.4 1998 – 99 1.0 1999 – 00 1.0 2000 – 01 0.6 2001 – 02 -0.7 2002 – 03 -1.3 2003 - 04 -2.3 2004 – 05 0.4 2005 – 06 1.2 2006 – 07 1.1

Note: A minus sign (-) indicates a surplus.

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 – 08

276

In general, the history of the current account in India has followed distinct phases

such as: (1) late 1950s to early 1960s when the current account deficit simply

mirrored the deficits in merchandise trade; (2) mid 1970s till early 1980s when the

trade deficit was moderated to a significant extent by surpluses in the invisible

account; (3) second half of the 1980s when a distinct decline in support from

invisible surpluses turned out to be a key factor in precipitating the crisis of 1990 –

91; and (4) the post 1990 -91 period, when resumption of growth in net invisible

earnings underpinned the favourable movement in India’s current account balance.8

With reference to successful management of current account in the post reform

period, Reddy (2005) has pointed out certain unique features. They are:

(a) The lessons of the 1991 crisis brought forth policies which ensured a low current

account deficit in the ensuing years. This approach stood us in good stead in warding

off the contagion from the Asian crisis of 1997 – 98.

(b) Sustainability of the current account was ensured by a policy choice for non –

debt flows and emphasis on the consolidation and reduction of external debt.

(c)The low current account deficit was underpinned by shifts in international

competitiveness favouring software, IT exports and worker’s remittances over

traditional exports.

(d) Although the fiscal deficit remained somewhat inflexible, it was not allowed to

spill over into the current account, and

(e) The current account deficit being the mirror image of the absorptive capacity, is

best assessed over the business cycle rather than at discrete points.9

Besides analyzing trends in the current account it is also necessary to consider the

relationship between (a) exchange rates and current account, (b) current account and

277

saving – investment balance, (c) fiscal deficit and current account and (d)

operational issues of current account sustainability.

(a) Exchange Rates and the Current Account - The exchange rate is widely

accepted as a key determinant of current account balance. A downward movement in

exchange rate leads to fall in export prices and rise in import prices, thus making

exports cheaper (in foreign currency terms) and imports costlier (in domestic

currency terms). This leads to rise in foreign demand and fall in domestic demand.

These effects, in turn, bring about changes in the current account balance. From a

policy perspective, the desired effects of exchange rate changes on the current

account depend upon the Marshall – Lerner condition i.e. - the sum of the price

elasticities of foreign demand for exports and the domestic demand for imports

should exceed one. The salutary effects of a change in the exchange rate in the on

the current account depends critically on the extent to which exchange rate

adjustment is transmitted to foreign currency export prices and import prices in the

domestic currency i.e. the degree of pass through. Pass – through is said to be

complete when export prices (in foreign currency terms) & import prices (expressed

in local currency) rise or fall by the full amount of the exchange rate change.

Conversely, if the export prices in foreign currency do not change but do, in terms of

domestic currency and on the other hand, import prices in domestic currency remain

stable with prices of overseas exports bearing the exchange rate change, pass –

through is said to be zero.

In the Indian context, studies in the early 1990s, for instance by Ghosh (1990)10 &

Sarkar (1992)11 expressed pessimism regarding the role of exchange rate in

improving export performance. A number of subsequent studies showed empirical

evidence confirming the role of exchange rates as a significant determinant of

278

exports. Patra & Patnaik (1994)12 found Exchange Rate Pass Through (ERPT) of

0.43. Their results suggested that the sequence of reforms in the exchange rate

regime which began since July 1991 should have been initiated from 1988 - 89

onwards to produce a favourable impact on the trade balance in the years of crisis

i.e. 1990 – 91 to 1991 – 92. Ranjan (1995)13 found ERPT of 0.65 and their results

indicated that devaluation had a positive impact on the profitability &

competitiveness of India’s exports, and the evidence was found to be stronger in

case of manufactured exports. Dholakia & Saradhi (2000)14 found ERPT of 0.3 for

the pre – 1991 period and 0.7 for the post 1991 years. Mallik (2005)15 too, observed

a positive association between exchange rate movements and exports. However, for

Veeramani (2007)16, exports were adversely affected by the appreciation of the real

effective exchange rate (REER), during the post – reform period. Thus, in the Indian

context, studies have found that the trade balance of India is sensitive to exchange

rate changes, indicating a significant role for monetary and fiscal policies in

conjunction with the exchange rate in influencing the behaviour of the current

account.

Moreover, the impact of exchange rates on the current account is lagged, formalized

in the literature as the J – curve effect. An exchange rate depreciation initially

worsens the current account but improvement sets in over time. On the other hand, if

there is a currency appreciation, there may be an inverted J – curve. In other words,

certain time lag is necessary to satisfy the Marshall – Lerner condition.

Kulkarni (1996)17, studied the Indian economy’s case of 1991 devaluation of Indian

rupee in order to find out feasibility of J – curve hypothesis and concluded that there

is in fact a good fit of the J- curve for the Indian case of currency devaluation.

279

To test the long term effect of the devaluation on current account balance and

subsequently derive the “J” curve, the data of CAD / GDP ratio from 1990 - 91 to

2006 – 07 (table 7.20) has been considered. The data reveals that in 2001 – 02 there

was a surplus in current account which continued for another two years. Hence,

devaluation had a positive impact on current account, after a time gap of almost ten

years, which supports the “J” curve hypothesis. Fig.7.3 depicts the “J” curve for

India.

Fig. 7.3 “ J ” Curve for India 1991 to 2007

-4

-3

-2

-1

0

1

2

3

90-91'

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

As P

er c

ent o

f GDP

CAD

(b)Current Account and Saving – Investment balance – By the standard national

accounting identity, current account is the mirror image of the domestic saving –

investment balance. Accordingly, developing countries strive to finance the

predominant portion of domestic investment with domestic saving in order to

economise on the reliance on foreign saving and thereby ensure current account

sustainability.

280

A brief study of current account balance and saving – investment relationship as

given in table 7.21 reveals the following –

First, during the period 1995 – 96 to 2001 – 02, there was a negative but low

saving – investment gap, due to stagnation in the rate of investment.

Second, in the case of public sector, investment has remained above the

saving leading to a negative and stable saving investment gap since the

1980s. During the 1980s, there was a sharp decline in public saving and

investment rate with adverse implications for overall investment in the

economy. It also reflected the rising share of current consumption and

consequent crowding out of investment outlays of the government.

Third, since the second half of 1990s, on the one hand, we find an

improvement in private savings, on the other hand, we find that private

investment has remained relatively stagnant.

The rise in private saving has sustained the overall saving rate in the

economy, compensating for the decline in the public sector saving and the

deterioration in the efficiency of the capital use.

The spillover of the private sector saving investment surplus is being

reflected in the modest surplus in the current account in the year 2001 – 02.

Although the investment rate did improve in the 1990s indicating an

expansion of absorptive capacity, a rise in the domestic saving rate appears

to have economized on the reliance on foreign saving.

The decline in CAD / GDP ratio during the 1990s is seen as reflective of the

limited absorptive capacity and infrastructural and other bottlenecks in the

economy that hamper higher levels of investment.18

281

Table 7.21: Saving – Investment Gap of Private & Public Sectors in India

(As Per cent to GDP)

Period

Private Sector Public Sector Overall Gap

S I S-I S I S-I S I S-I

1980 – 81 to 1984 – 85

14.7 10.9 3.8 3.7 9.9 -6.2 18.4 19.8 -1.4

1985 – 86 to 1989 – 90

18.0 13.2 4.8 2.4 10.1 -7.7 20.4 22.7 -2.3

1990 – 91 to 1994 – 95

21.5 14.2 7.3 1.4 8.7 -7.3 22.9 24.3 -1.5

1995 – 96 to 1999 – 2000

22.8 16.2 6.6 0.6 7.0 -6.4 23.4 24.8 -1.3

2000 – 01 to 2001 – 02

26.1 16.1 9.9 - 2.4 6.3 -8.7 23.7 23.9 -0.2

Note: S = Gross domestic savings, I = Investment (Gross capital formation) S – I = Saving Investment gap Source: Reserve Bank of India – Report on Currency & Finance 2002 - 03 (c)Fiscal Deficits and the Current Account –In the case of India, in 1980s, the

large fiscal deficits were accompanied by current account deficits. Some of the

empirical studies undertaken in the context of India, supported the existence of twin

deficit phenomenon and the causality tests showed that fiscal deficits cause current

account deficits. In 1990 – 91, the CAD touched a figure of 3.1 per cent of GDP

which was clearly unsustainable from the balance of payments point of view.

The post – reform period however, shows a different picture and depicts the absence

of twin deficit phenomenon. It is observed that since the mid – 1990s, the

relationship between the fiscal deficit and the current account in India seems to have

blurred. Higher fiscal deficits have been accompanied by a narrowing of the current

account deficit, implying that a major part of the fiscal deficit has been absorbed by

a surplus in domestic saving of the private sector. For instance, the correlation

282

coefficient between fiscal deficit and current account deficit was 0.43 during 1980 –

81 to 1989 – 90, which significantly declined to 0.24 during 1990 – 91 to 2002 – 03.

The weakening of the link between the fiscal and current account deficits between

the late 1980s and the 1990s could be attributed to the changing composition of the

fiscal deficit. In the 1980s, over 70 per cent of Government sector borrowing were

undertaken to finance capital expenditures. On the other hand, it was large revenue

deficits which dominated the fiscal accounts in the 1990s, constituting more than 54

per cent of the gross fiscal deficit whereas the share of capital expenditure in the

gross fiscal deficit declined from around 55 per cent in the early 1990s to around 34

per cent in the late 1990s.19 Hence, we can conclude that in 1990s, fiscal deficits

mainly reflected expansion in revenue deficits.

Table 7.22 shows the current account deficit and fiscal deficit during the period

1991 – 92 to 2006 – 07. The average current account deficit from 1991 – 92 to 2000

– 01 works out to be 1.02, while the average fiscal deficit is 5.67 during the same

period. It is clear from table 7.22 that, although fiscal deficits remained inflexible

downwards, they did not spill over into the external sector during the 1990s.Fig. 7.4

shows the movements in CAD and GFD from 1991 – 92 to 2006 – 07.

283

Table 7.22: Current Account Deficit & Fiscal Deficit

(As Percent of GDP)

Note: A minus sign (-) indicates a surplus.

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 – 08

Fig. 7.4 Movements in CAD & GFD 1992 to 2007

-8

-6

-4

-2

0

2

4

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

As P

er c

ent o

f GDP

CAD / GDPGFD / GDP

Year Current Account Deficit

Fiscal Deficit

1991 – 92 0.3 5.56 1992 – 93 1.7 5.37 1993 - 94 0.4 7.01 1994 – 95 1.0 5.70 1995 – 96 1.7 5.07 1996 – 97 1.2 4.88 1997 – 98 1.4 5.84 1998 – 99 1.0 6.51 1999 – 00 1.0 5.35 2000 – 01 0.6 5.64 2001 – 02 -0.7 6.18 2002 – 03 -1.3 5.92 2003 - 04 -2.3 4.47 2004 – 05 0.4 4.01 2005 – 06 1.2 4.08 2006 – 07 1.1 3.45

284

(d) Operational Issues in Current Account Sustainability – In an open economy

framework, maintaining the current account deficit at a sustainable level is crucial.

Conceptually, sustainability refers to the ability of a nation to finance its current

account deficit (CAD) on an ongoing basis. Therefore, the level of current account

balance (CAB) that could be financed on a continuous basis without resulting in any

external payment difficulties is termed as sustainable level. The sustainability of

current account depends upon external as well as domestic macroeconomic factors.

Some of the external factors affecting current account sustainability are - (a) the

behaviour of real interest rates, in conjunction with the level of external debt, (b)

terms of trade shocks and (c) growth in industrial countries. Some of the domestic

factors are - (a) the ratio of external debt to exports (b) the ratio of interest payments

to exports (c) the degree of openness and export diversification, (d) the level of

national savings investment and fiscal deficits, (e) the financing pattern of external

deficits , and (f) the level of foreign exchange reserves. Accordingly a sustainable

level of CAD would have elements of time and country specificity, and, ultimately it

is determined by foreign investors confidence in domestic economy.

In the recent years, a number of criteria are used to assess sustainability. Some of

the indicators which are used to assess current account sustainability are - (1) Trade

deficit / GDP ratio, (2) CAD / GDP ratio, (3) GFD / GDP ratio, (4) Private sector : S

– I gap, (5) External debt / GDP ratio, (6) Short term debt / total debt ratio (7) Non –

debt capital flows /total capital flows (8) Debt service ratio, (9) Changes in Real

Effective Exchange Rate (REER), and (10) Import cover.

With reference to sustainability of current account in the context of India, it is

observed that CAD has been maintained within a sustainable level of about 2 per

285

cent in the post – reform period. This is broadly in line with the recommendations of

the High Level Committee on Balance of Payments,1993 (Chairman: C. Rangarajan)

which recommended that CAD – GDP ratio could be sustainable at 1.6 per cent,

given the level of normal capital flows. The Report of the Committee on Capital

Account Convertibility, 1997 (Chairman: S. S. Tarapore) felt that a sustainable CAD

– GDP ratio cannot be static for all times. Accordingly, the Committee

recommended that over a period of time, the external sector policies should be

designed to ensure a rising trend in the Current Receipts (CRs) to GDP ratio as well

as reduce the debt service ratio. The CAD/GDP ratio would need to be consistent

with the above parameters.

As shown in table 7.23, the operational indicators of current account sustainability

for India indicate a steady improvement since the 1990s, except for the ratio of fiscal

deficit to GDP.

Table7.23: Indicators of Current Account Sustainability for India

(In Per cent)

Sr.No. Indicators 1991 – 95

1996 – 00

2001 - 03

1 Trade Deficit / GDP - 1.2 - 2.5 -2.2 2 CAD / GDP -1.3 - 1.3 0.2 3 GFD/ GDP -5.7 - 5.1 -5.9 4 Private sector : S – I Gap 7.3 6.6 9.9 5 External Debt /GDP 33.9 24.3 21.2 6 Short term debt / Total debt 6.7 5.3 3.6 7 Non – debt capital flows / Total capital

flows 27.1 49.3 94.8

8 Debt Servicing Ratio 28.9 19.7 15.3 9 Changes in REER - 2.9 -0.8 4.8

10 Import Cover ( In months) 5.9 7.2 11.2

Source: Reserve Bank of India – Report on Currency & Finance 2002 - 03

286

7.2.6 Trends in Capital Account

During 1980s capital account transactions were mainly used to finance the current

account deficits. Besides this, the widening current account deficits during 1980s

were mainly financed through costly & debt creating sources such as – external

commercial borrowings, NRI deposits and loans from IMF. The external payment

crisis of 1991 brought to the fore the weaknesses of this costly sources of financing.

Recognising this, structural reforms and external financial liberalization measures

were introduced during the 1990s.

The High Level Committee on Balance of Payments, 1993 (Chairman: C.

Rangarajan) recommended - (a) compositional shift in capital flows away from debt

to non – debt creating flows, (b) strict regulation of external commercial borrowings,

especially short –term debt, (c)discouraging volatile element of flows from non –

resident Indians, (d) gradual liberalization of outflows, and (e) dis-intermediation of

Government in the flow of external assistance.

Thus, in the post – reform period, India has followed a policy of encouraging

capital flows in a cautious manner. The strategy has been to encourage long – term

capital inflows and discourage short – term volatile flows.

An overview of capital account in the post – reform period reveals that - Capital

account balance has been the second component of India’s balance of payments that

reflects a perceptible positive impact of economic reforms. The yearly data of capital

account from 1991 – 92 to 2006 – 07 reveals that barring 1992 – 93 and 1995 – 96,

the surplus in capital account has been sufficient to wipe out the deficit in current

account and create an overall surplus in the country’s balance of payments.

287

The four main components of capital account are (a) foreign investment, (b) external

assistance (c) external commercial borrowings, and (d) NRI deposits.

A brief analysis of these four components during the post – reform period is as

follows:

(a) Foreign Investment – Foreign investment includes (a) Foreign direct investment

and (b) Foreign Portfolio Investment.

During the first three decades after independence, the foreign investment in India

was highly regulated. In the 1980s, there was some easing in foreign investment

policy in line with the industrial policy regime of the time. The major policy thrust

towards attracting foreign direct investment (FDI) was outlined in the New

Industrial Policy Statement of 1991. It was realized that foreign investment can play

an important role in financing the current account deficit. Since then continuous

efforts have been made to liberalise and simplify the norms and procedures

pertaining to FDI. At present, FDI is permitted under automatic route subject to

specific guidelines except for a small negative list. Foreign Portfolio Investments are

restricted to select players viz. Foreign Institutional Investors (FIIs).

Responding to the policy efforts, the foreign investment inflows into India (direct

and portfolio) picked up sharply in 1993 – 94 and have been sustained at higher

level barring 1998 – 99, due to East Asian crisis.

Table 7.24 gives the data for foreign investment for select years. It can be observed

from table 7.24 that foreign investment in India was just `.339 crore in 1991 – 92,

which increased to `.19961 crore in 1997 – 98. In 1998 – 99 it fell to `.10169 crore

due to the East Asian crisis, but in 1999 – 2000 it again went up to `.22501 crore. In

the year 2006 – 07, foreign investment in India was worth `.134282 crore.

288

Plan - wise analysis of foreign investment (as given in table 7.25) reveals that during

the Eight Plan (1992 – 97) the average foreign investment was `. 13714 crore,

which increased to `.24502 in the Ninth Plan (1997 – 02). From Ninth Plan to Tenth

Plan (2002 – 07) it more than trebled to `.79652 crore.

Table 7.24: Foreign Investment in India – Select Years

(In `.Crore)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 – 08

Fig. 7.5 Trends in Foreign Investment 1992 to 2007

0

0.5

1

1.5

2

2.5

3

91-92

'

93-94

'

95-96

'

97-98

'

99-00

'

01-02

'

03-04

'

05-06

'

Year

As P

er c

ent o

f GDP

Foreign Investment / GDP

Fig. 7.5 gives the trends in foreign investment / GDP ratio from 1991 – 92 to 2006 –

07. It is clear from fig. 7.5 that foreign investment / GDP has been rising after the

initiation of reforms. The foreign investment / GDP ratio was 0.1 per cent in 1991 –

92 which reached to 1.5 per cent in 1994 – 95. Further, since 2003 – 04 it is near 2.5

per cent of GDP.

1991 – 92

1997 – 98 1998 – 99 1999 – 00 2006 - 07

339

19961 10169 22501 134282

289

Fig. 7.6 Foreign Investment Inflows 1991 to 2007

-20000

0

20000

40000

60000

80000

100000

120000

90-91'

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

In R

s.Cr

ore

FDIFPI

Fig. 7.6 shows the foreign investment inflows in the form of foreign direct

investment (FDI), and foreign portfolio investment (FPI) from 1990 – 91 to 2006 –

07. It is evident from fig. 7.6 that the foreign investment has been increasing from

the year 1993 – 94 onwards. It can be further observed that foreign investment

inflows have been dominated by foreign direct investment rather than portfolio

investment.

(b) External Assistance – In 1960s and 1970s, external assistance was the main

source to get capital for the country. However, the reliance on this source has went

down considerably in 1980s and 1990s. The average external assistance from 1991 –

92 to 2000 – 01 is `.4420 crore, although year to year variations are there. Plan -

wise figures (table 7.25) indicate that the average external assistance was `.4773 in

Eighth Plan, which declined to `.3752 crore in the Ninth Plan. For Tenth Plan it

shows a negative figure of `.504 crore.

290

(c) External Commercial Borrowings – The importance of External Commercial

Borrowings (ECBs) in contributing to the country’s capital started increasing since

the late 1970s when external aid started becoming more and more difficult to get.

ECBs were used extensively in the latter half of 1980s to finance the current account

deficit. In fact, in this period, ECBs accounted for more than 25 per cent of the total

capital flows into the economy. In 1986 – 87, their share in total capital flows was as

high as 48 per cent.

The yearly data indicates that in the post – reform period, also (excepting the years

from 1992 – 93 to 1994 – 95 and 1999 – 2000), the dependence on ECBs has been

considerably high. However, external borrowings were negative for three

consecutive years from 2001 – 02 to 2003 – 04. From 2004 - 05, ECBs once again

started increasing and reached to a figure of `.73889 crore in 2006 – 07. Plan - wise

data (table7.25) indicates that average ECBs were `.3720 crore in the Eighth Plan,

which increased to `..9425 crore in the Ninth Plan and further to `.17622 crore in

Tenth Plan.

The policies towards External Commercial Borrowings (ECBs) since the reform

programme have been guided by the overall consideration of prudent external debt

management by keeping the maturities long and cost low. ECBs are approved within

an overall ceiling. Over time, the policy has been guided by a priority for projects in

the infrastructure and core sectors such as power, oil , exploration, etc. and for 100

per cent Export Oriented Units (EOUs). To allow further flexibility to borrowers,

end – use and maturity prescriptions have been substantially liberalized.

(d) NRI Deposits – In addition to external commercial borrowings, the second high

cost method on which India has relied heavily during the latter half of 1980s is the

291

Non – Resident – Indian (NRI) deposits. In the second half of 1980s, the share of

NRI deposits in total capital flows (net) was around 30 per cent.

The yearly data reflects that NRI deposits increased in the post – reform period from

1991 – 92 to 2003 – 04. However, for the first time in 2004 – 05, NRI deposits

became net outflows. Plan-wise data (table 7.25) indicates that average NRI deposits

were `.5226 crore in Eighth Plan, which increased to `.7756 crore in the Ninth Plan.

During Tenth Plan, the average NRI deposits were `.11778 crore.

The policies with regard to NRI deposits during the 1990s have been aimed at

attracting stable deposits. This has been achieved through (a) a policy induced shift

in favour of local currency denominated deposits (b) rationalization of interest rates

on rupee denominated NRI deposits, (c) linking of the interest rates to LIBOR for

foreign currency denominated deposits, (d) de – emphasizing short – term deposits

(up to 12 months) in case of foreign currency denominated deposits; and (e)

withdrawal of exchange rate guarantees on various deposits.20

However, it is necessary to note that external commercial borrowings and NRI

deposits are considered to be high cost methods of raising external resources and are

regarded as fair weather friends. Hence, recourse to both these methods should be

undertaken cautiously.

It can be concluded that the evolution of capital flows over the 1990s reveals a shift

in emphasis from debt to non – debt flows with the declining importance of external

assistance, ECBs and NRI deposits and the increased share of foreign investment.

For instance, the share of foreign investment in capital account increased from 50

per cent in the Eighth Plan to 73.0 per cent in the Tenth plan. While the share of NRI

deposits declined from 19.0 per cent to 11.0 per cent from Eighth Plan to Tenth

Plan. (Refer table 7.25)

292

Similarly in 1990 – 91, the proportion of non – debt creating capital inflows to total

capital inflows was a mere 1.5 per cent and that of debt creating inflows was as high

as 83.0 per cent. But within a span of 10 – 12 years, the situation changed

drastically. For example, in 2001 – 02, the proportion of non – debt creating inflows

to total inflows was 77.0 per cent and that of debt creating flows was 9.0 per cent.21

Table 7.25: Key Components of Capital Account: Plan – wise Annual Average

(In `.Crore)

Sr. No.

Particulars Eighth Plan

(1992 -97

Ninth Plan

(1997-02 )

Tenth Plan (2002-07)

1 Foreign Investment Net

13714 (50.00)

24502 (54.00)

79652 (73.00)

2 External assistance , Net

4773 (17.40)

3752 (8.00)

- 504

3 Commercial Borrowings, Net

3720 (13.60)

9425 (21.00)

17622 (16.00)

4 NRI Deposits, Net

5226 (19.00)

7756 (17.00)

11778 (11.00)

Total

27433 (100.00)

45435 (100.00

109052 (100.00)

Note: Figures in brackets indicate per cent to total.

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 – 08 7.2.7 Impact of Reforms on External Debt

In the 1980s, with the increased requirement of external resources to finance

widening current account deficit and the decline in access to concessional sources of

finance, India had taken recourse to commercial loans especially short – term loans.

Under the exceptional circumstances, the country also accessed funding facilities

from the IMF in the early 1980s. As a result, there was a sharp increase in

commercial debt and debt service ratio. It was the large increase in external debt,

particularly short – term debt which was an important factor for the balance of

payments crisis in 1991.

293

In the context of external debt, the RBI’s Report on Currency & Finance 2002 – 03

observed: “The growth of external debt was particularly noticeable during the

second – half of 1980s and the share of commercial debt in total external debt

increased from 15.0 per cent in 1981 to 40.0 per cent in 1991. As a consequence of

the increase in commercial debt, debt servicing as a proportion of current receipts

increased from 10.2 per cent in 1980 – 81 to 35.3 per cent in 1990 – 91. Hence, the

overhang of large external debt, particularly the short – term debt was one of the

important triggering factors in the balance of payments crisis in 1991.”22

Although India, was on the verge of debt default, it remained resolute not to default

on its external obligations. A conscious decision was taken to honour all debt

without seeking rescheduling and several steps were taken to tide over the crisis like

– (a) a part of the gold reserves was sent abroad to get some immediate liquidity; (b)

non – essential imports were tightened by way of variety of price based and

quantitative measures; (c) the IMF, multilateral and bilateral donors were

approached; (d) macroeconomic stabilization programme was put in place; (e) India

Development Bonds (IDBs) were floated in October 1991 to mobilise medium –

term funds from non – resident Indians ; and (f) credible commitments were made to

bring about structural reforms.23

The severe balance of payments crisis of 1991 necessitated a fresh look at the debt

management strategy to evolve new guidelines. The approach to the debt

management which has been adopted since 1991 is mainly based on the

recommendations of Rangarajan Committee, 1993.

Following the recommendations of the Rangarajan Committee(1993) the external

debt management strategy has been guided by - (a) continuation of an annual cap,

minimum maturity restrictions and prioritizing the use of ECBs; (b) containment of

294

short – term debt; (c) restructuring of more expensive external debt ; (e) measures

to encourage non – debt creating financial flows in the form of foreign investments;

(f) incentives and schemes to promote current exports and other current receipts; and

(g) conscious built – up of foreign exchange reserves to provide effective insurance

against external sector uncertainties.

The major indicators of India’s external debt are given in table 7.26. It can be

observed from table 7.26, that there has been a gradual and steady improvement in

debt sustainability indicators after 1990s. For instance, external debt to GDP ratio

has come down from 28.0 in 1991 to 22.0 in 2000 and further to 17.0 in 2007. The

debt service ratio has come down from 35.0 in 1991 to 17.0 in 2000 and further to

4.0 in 2007. However, one important observation regarding the short – term debt to

total debt needs to be mentioned. There is no doubt that short – term debt was

controlled in the post – reform period from 1991 to 2004. For instance, the ratio of

short – term debt to total debt declined from 10.3 per cent to 4.4 per cent in 2000

and this trend continued till 2004. However, the yearly data from 2005 onwards

indicates altogether a different picture. This ratio suddenly increased to 13.3, in 2005

further to 14.1 in 2006, and 15.5 in 2007.

The main reason behind this increase is revealed in the Economic Survey 2007 – 08

- “The short – term debt included all loans and credits with an original maturity of

one year or less did not so far cover supplier’s credit maturing in less than six

months in India’s external debt statistics. Now, the coverage of short – term debt is

made more comprehensive with the inclusion of (a) supplier’s credit up to six

months and (b) investment made by FIIs in short term debt instruments…The

external debt statistics released for end September 2007 therefore contains the new

series on short – term debt beginning quarter ended March 2005.”24 Hence, the

295

increase in the short – term debt to total debt ratio from 2005 onwards is attributable

to the change in database by including supplier’s credit up to six months and

investment made by FIIs, in the coverage of short – term debt.

Table 7.26: Major Indicators of External Debt

(As at end – March)

(In Per cent)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 – 08 According to Global Development Finance Online database of the World Bank,

among top 10 debtor countries of the developing world, India’s position was fifth in

terms of quantum of external debt, after China, Russian Federation, Turkey &

Brazil. India had the lowest debt service ratio among the top 10 debtor countries

amongst the developing economies. India’s external debt to Gross National Income

(GNI) ratio in 2006 at 17.9 per cent was second lowest after China. (12.0 per cent).

The element of concessionality in India’s debt portfolio at 23.3 per cent was second

highest after Indonesia. (27.1 per cent). The ratio of India’s short – term debt to

foreign exchange reserves at 13.2 per cent in 2006 was the second lowest among the

top 10 debtor countries.25

Sr.No. Particulars

1991 2000 2007

1 External Debt / GDP

28.7 22.7 17.8

2 Short – term Debt / Total Debt

10.3 4.4 15.5

3 Debt – Service Ratio

35.3 17.1 4.8

4 Short – term Debt / Foreign Exchange Reserves 146.5 10.3 13.7

296

The changing profile of India’s external debt depicts the following features –

The level of debt has been relatively stable in the last decade, showing only

a modest increase.

The debt portfolio is characterized by high share of concessional and low

share of short – term debt.

There has been a sustained improvement in key indicators of external

indebtedness position of the country.

Compared to other emerging economies, India’s indebtedness position is

relatively comfortable and has improved overtime.

7.2.8 Exchange Rate Management in the Post – Reform Period

In India, the broad objectives of exchange rate policy are: (a) to reduce excess

volatility, (b) to prevent the emergence of destabilizing speculative activities, (c) to

help maintain adequate level of reserves, and (d) to develop an orderly foreign

exchange market.

In India, the exchange rate system has gone a paradigm shift from a system of fixed

exchange rates (until March 1992) to a market determined regime since March 1993.

Since then the objective of exchange rate management has been to ensure that the

external value of the rupee is realistic and credible as evidenced by a sustainable

current account deficit and manageable foreign exchange situation.

As a part of overall macroeconomic stabilization programme, the exchange rate of

the Rupee was devalued in two stages in terms of US dollar in July 1991. The

transition to market determined exchange rate system took place in two stages and

the sequencing was based on the Report of the Rangarajan Committee, 1993.

Initially, Liberalised Exchange Rate Management System (LERMS) instituted in

297

March 1992 was a dual exchange rate system under which 40 per cent of exchange

earnings were to be surrendered to Reserve Bank at official exchange rate while the

rest 60 per cent could be converted at market rate. The LERMS was essentially a

transition mechanism and a downward adjustment in the official exchange rate took

place in December 1992 and ultimate convergence of the dual rates was made

effective March 1, 1993. The unification of the exchange rate system of the Indian

rupee was an important step towards current account convertibility, which was

finally achieved in August 1994 by accepting Article VIII of the Articles of

Agreement of the IMF.

A study of exchange rate of Indian rupee against US Dollar (as given in table 7.27)

indicates that the average exchange rate was `.31.40 per US Dollar in the years 1993

– 94 & 1994 – 95. However, from 1995 – 96 to 2002 – 03, the rupee depreciated

against US Dollar to the extent of 35 per cent. This depreciation of rupee from 1995

– 96 to 2002 – 03 could be attributed to factors like – (a) imposition of economic

sanctions in the aftermath of nuclear tests during May 1998, (b) rise of US dollar

against other major currencies, (c) crisis in Mexico, Russia & East Asia in 1997 –

98, (d) sharp increase in crude oil prices in 1999 – 2000, and (e) attack on US on

September 9, 2001.

It is pertinent to note that India was successful in containing the contagion effect of

the Asian crisis due to swift policy responses. During the period of crisis, India had a

low current account deficit, comfortable foreign exchange reserves amounting to

import cover of over seven months, a market determined exchange rate, low – level

of short term debt and absence of asset price inflation or credit boom.

During the years from 2003 – 04 to 2005 – 06, rupee appreciated against US Dollar,

though marginally. The rupee appreciated to the extent of 7.0 per cent when

298

compared with the year 2002 – 03. Finally, as shown in table 7.27, the average

exchange rate for the year 2006 – 07 was `.45.30 per US Dollar.

Table 7.27: Exchange Rate of Indian Rupee per US Dollar

(Financial year – Annual average)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

Fig. 7.7 Average Exchange Rate of Indian Rupee 1991 to 2007

0

10

20

30

40

50

60

90-9

1'

91-9

2'

92-9

3'

93-9

4'

94-9

5'

95-9

6'

96-9

7'

97-9

8'

98-9

9'

99-0

0'

00-0

1'

01-0

2'

02-0

3'

03-0

4'

04-0

5'

05-0

6'

06-0

7'

Year

Rs.p

er U

S Do

llar

Rs.Per US Dollar

Fig. 7.7 shows the movements in average exchange rate of Indian Rupees per US

Dollar from 1990 – 91 to 2006 – 07.

Year

Rupees Per US Dollar

1990 – 91 17.95 1991 – 92 24.50 1993 – 94 & 94 – 95 31.40 1995 – 96 33.45 2002 – 03 48.40 2005 – 06 44.30 2006 - 07 45.30

299

A study of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange

Rate (REER)a (as given in table 7.28) reveals that – NEER depreciated nearly by

11.0 per cent, while REER depreciated by 2.0 per cent from 1993 – 94 to 2002 – 03.

From 2003 – 04 to 2005 - 06, there is marginal appreciation in both NEER & REER.

Finally, in the year 2006 – 07, NEER was 87.45, while REER was 97.40.

Pattanaik et al (2003) 26 in their study of exchange rate management in the post -

reform period (1993 to 2002) indicated that monetary policy measures were

successful in ensuring orderly conditions in the foreign exchange market and

containing the impact of exchange rate pass – through effect on domestic inflation.

According to them, real shocks are predominantly responsible for movements in real

as well as nominal exchange rates. Overall, their analysis indicated that exchange

rate management in India has been consistent with macroeconomic stability.

Table 7.28: Indices of NEER & REER of the Indian Rupee

(Base year 1993 – 94 = 100)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

Hence, it can be concluded that the experience with the market determined exchange

rate system has been satisfactory. The foreign exchange market was characterized by

orderly conditions for most of the period, excepting a few episodes of volatility. The

Reserve Bank has focused on managing volatility with no fixed rate target while

Year

NEER REER

1993 – 94 100.00 100.00 2002 – 03 89.10 98.20 2005 – 06 91.15 100.55 2006 – 07 87.45 97.40

300

allowing the underlying demand and supply conditions to determine exchange rate

movements over a period in an orderly way. This policy has stood the test of the

time as it has ensured a judicious mixture of ‘flexibility’ and ‘pragmatism’ rather

than adherence to strict theoretical rules.

7.2.9 Management of Foreign Exchange Reserves in the Post Reform Period

For an economy, maintaining adequate foreign exchange reserves has become

necessary in order to cope up with the globalization and volatile cross border capital

flows.

The main objective of maintaining adequate reserves can be stated as follows:

Maintaining confidence in monetary and exchange rate policies;

Enhancing capacity to intervene in foreign exchange markets;

Limiting external vulnerability so as to absorb shocks during times of crisis;

Providing confidence to the markets that external obligations can always be

met; and

Reducing volatility in foreign exchange markets.

The appropriate size of reserve holdings depends on the factors such as – size of the

economy, current account and capital account vulnerability, exchange rate flexibility

and opportunity costs.

Traditionally, reserve adequacy was determined by a simple rule of thumb i.e. the

stock of reserves should be equivalent to a few months of imports. However, the

financial crises in the 1990s highlighted the limitations of this approach. It is now

being increasingly recognized that focusing only on current account transactions is

insufficient as it is the capital account transactions that are now more important.

Among various components of capital account transactions, short – term external

debt has gained prominence in determining reserve adequacy.

301

India’s approach to reserve management until the balance of payments crisis of

1991, was based on the traditional approach i.e. to maintain reserves in relation to

imports. With the introduction of a market determined exchange rate, the emphasis

on import cover was supplemented with the objective of smoothening out the

volatility in the exchange rate. The Rangarajan Committee, 1993 recommended that

the foreign exchange reserves targets be fixed in such a way that they are generally

in a position to accommodate three months of imports.

In the post – reform period the policy for reserve management is built upon a

number of factors such as – (a) size of the current account deficit, (b) the size of the

short – term liabilities, (c) the possible variability in portfolio investments and other

types of capital flows, (d) unanticipated pressures on the balance of payments arising

out of external shocks, and (e) movements in the repatriable foreign currency

deposits of non – resident Indians.27

With respect to the growth of reserves (as given in table 7.29) it can be observed

that -

In 1990 – 91, the foreign exchange reserves (in terms of foreign exchange

assets) were only `.4388 crore.

The reserves increased to `.66005 crore in 1994 – 95. Hence, there was a

sharp increase in reserves within first few years after reforms were

introduced.

In 1999 – 2000, reserves were `.152924 crore, showing a moderate increase

in the second half of 1990s.

By 2006 – 07, the reserves touched a figure of `.836597 crore showing a

phenomenal increase in a time span of seven years.

302

Table 7.30 shows indicators of reserve adequacy in the post – reform period. The

trends in select indicators of reserve adequacy show a progressive improvement in

the post – reform period. For instance, the traditional trade based indicator of reserve

adequacy i.e. the import cover of reserves (foreign currency assets) which was just

2.5 in 1991, increased to 8.2 in 2000 and further to 11.6 in 2006. Import cover of

reserves further increased to 12.5 months in 2007. Similarly, the ratio of short – term

debt to reserves has gone down from 146.5 in 1991, to 10.35 in 2000 and further to

5.8 in 2006. In 2007, however it increased to 13.25 due to change in the coverage of

short – term debt from 2005 onwards. The external debt to reserves has gone down

from 1436.5 in 1991 to 258.35 in 2000 and further to 82.55 in 2006. However, in

2007 it increased moderately to 85.20.

In brief, there has been a paradigm shift in India’s approach to reserve management

in the post – reform period. Furthermore, the country has adopted a multiple

indicator approach rather than the traditional single indicator approach.

Table 7.29: Growth in Foreign Exchange Reserves – Select Years

(In `.Crore)

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

Year

Foreign Exchange Reserves

1990 – 91 4388 1991 - 92 14578 1992- 93 20140 1994 – 95 66005 1999 – 00 152924 2006 - 07 836597

303

Fig. 7.8 Trends in Foreign Exchange Reserves 1991 to 2007

0

100000

200000

300000

400000

500000

600000

700000

800000

900000

90-91'

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

In R

s.Cr

ore

FER

Fig. 7.8 depicts the trends in foreign exchange reserves from 1990 – 91 to 2006 – 07.

It is clear from fig.7.8 that the growth in foreign exchange reserves has picked up

from the year 1996 – 97 onwards. Further over a period of time there has been a

steady increase in foreign exchange reserves in India.

Table 7.30: Select Reserve Adequacy Indicators of India

Sr. No. Particulars

1991 2000 2006 2007

1 Import Cover of Reserves ( In Months)

2.5 8.2 11.6 12.5

2 Short term Debt to Reserves ( In Per cent )

146.5 10.35 5.80 13.25

3 External Debt to Reserves

1436.5 258.35 82.55 85.20

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2005 – 06 & 2007 - 08

304

Fig. 7.9 Import Cover of Reserves 1991 to 2007

0

2

4

6

8

10

12

14

16

18

90-91'

91-92'

92-93'

93-94'

94-95'

95-96'

96-97'

97-98'

98-99'

99-00'

00-01'

01-02'

02-03'

03-04'

04-05'

05-06'

06-07'

Year

Mon

ths

Import Cover

Fig. 7.9 shows the movements in import cover of reserves from 1990 – 91 to 2007.

It is clear from fig.7.9 that in the year 1990 – 91 the foreign exchange reserves were

just sufficient to cover two and half months of imports. However, over a period of

time after the initiation of economic reforms, there has been a rise in the import

cover of reserves. For instance, in the year 2003 – 04, the foreign exchange reserves

were able to cover 16 months of imports. In the year 2006 – 07, they were sufficient

to cover 12.5 months of imports.

7.3. THE ISSUE OF CAPITAL ACCOUNT CONVERTIBILITY

Capital account liberalization has been viewed by many economists as an important

component of the overall opening up of global trade and financial markets.

Economists along with removal of restrictions on merchandise trade and current

account convertibility, have also advocated full capital account convertibility.

Capital account liberalization essentially provides freedom from prohibitions on

transactions in the capital and financial accounts of the balance of payments.

305

Capital account convertibility refers to the freedom of currency conversion in

relation to capital transactions in terms of inflows and outflows. The path to capital

account convertibility, however, points to a greater degree of openness of economy.

Full convertibility means that restrictions on capital account will be withdrawn by a

country.

7.3.1 Case For & Against Capital Account Liberalization:

In the recent years, Emerging Market Economies (EMEs) are facing increasing

pressures from multilateral institutions and developed countries to liberalise their

capital accounts. The case for capital account liberalization is based on the

following arguments -

(1) Liberal capital account leads to faster economic growth. Capital inflows

would promote long – term economic growth in Emerging Market

Economies (EMEs) through transfer of technology, financial know – how

and management skills.

(2) Developing countries need external capital to sustain an excess of investment

over domestic saving and an open capital account could attract foreign

capital. It achieves optimum allocation of global financial resources, letting

capital flow to those regions where its marginal productivity is highest. It

thus helps EMEs to raise the rate of capital formation above their domestic

savings rate.

(3) An open capital market permits both savers and investors to protect the real

value of their assets through risk reduction.

(4) Full capital account convertibility will force the governments to behave more

responsibly on fiscal balances. Thus, capital inflows have a disciplining

effect on domestic fiscal – monetary policy.

306

(5) Capital inflows dampen the effects of exogenous shocks on domestic

economy.

(6) Free mobility of financial capital is essential for stimulating global trade.28

Although it is claimed that capital account liberalization is advantageous on the

above mentioned grounds, there are several arguments given by Rajwade (2007)29 &

Nachane (2007)30 against capital account liberalization.

Hence, the case against capital account liberalization is based on the following -

(1) There is no conclusive empirical evidence which suggests that a liberal

capital account leads to faster economic growth. On the other hand, there are

several cases of premature liberalization of the capital account leading, or at

least contributing, to balance of payments crises and consequential,

prolonged, social misery.

(2) Most of the empirical studies indicate that it is the high – income countries or

relatively developed countries which have been benefited from capital

account liberalization provided that they have implemented appropriate

prudential measures in the financial system.

(3) It includes five types of risks such as – currency risk, capital flight risk,

fragility risk, contagion risk and sovereignty risk.

(4) In the context of capital account liberalization, we must carefully weigh the

‘risks’ and ‘rewards’ associated with it. While ‘rewards’ are uncertain,

‘risks’ are very obvious as a liberal capital account can amplify and prolong

a crisis. For instance, the experience of East Asian crises of 1997 – 98

reveals that Malaysia imposed capital controls and escaped the crisis which

engulfed and imposed countless costs and hardships on the economies of

307

Thailand, Indonesia and South Korea. Similarly, the experience of Mexico in

1994, Russia in 1998, Brazil in 1998 – 99, and of Argentina in 2001 has

highlighted the risks of capital account liberalization.

(5) There is no necessary link between increased capital flows and capital

account liberalization. For instance, China has attracted huge capital inflows

without currency being convertible even on the current account. Hence, what

is important is the economic and industrial performance of the country and

not capital account convertibility.

(6) There would be distortions in the form of steep rise in asset prices as foreign

capital pours into important asset market prices such as equities and real

estate.

(7) A real exchange rate appreciation could result from an upward pressure on

the asset prices. This could act as an important retardant of exports and

undermine the progress of trade reforms.

(8) Distortions in the financial sector could give rise to improper financial

intermediation and result in excessive foreign borrowing.

(9) There are special problems created by short – term capital mobility in terms

of financial market instability, asset bubbles and other microeconomic

distortions.

(10) There is no empirical evidence regarding the issue that the government will

act more responsibly on the fiscal front after capital account liberalization.

(11) Under full capital account convertibility, if an economy does not perform

well there will be massive outflows from the economy. Thus, the benefits of

outflows are negatively correlated to the health of the domestic economy.

308

7.3.2 India’s Approach to Capital Account Convertibility

Considering the dangers of full capital account convertibility and the unhappy

experience of other countries who opted for capital account convertibility, India

opted for a gradualist and phased capital account liberalization programme. Thus,

the Indian approach to capital account liberalization has been one of gradualism,

treating liberalization of the capital account as a continuous process rather than as a

single event.

As remarked by – RBI’s Report on Currency & Finance 2002 – 03 – “In India, there

is a strong opinion in favour of cautious liberalization, with a greater weight

attached to stability. The policy in India is to approach liberalization on capital

account cautiously, gradually in a sequenced manner, and in response to domestic

monetary and financial sector developments as also evolving international financial

architecture.” 31

In India, like several other EMEs, liberalization of current account preceded the

liberalization of capital account. By August 1994, current account convertibility was

completed by accepting Article VIII of the Articles of Agreement of the IMF. Later

on, capital account transactions were gradually liberalized. Restrictions on inflows

were relaxed first, with an emphasis on encouraging FDI and portfolio equity

investments and discouraging short – term debt – creating inflows. Recently, with

consolidation in external sector, restrictions on capital outflows have also been

liberalized.

For the purpose of liberalization of capital account a Committee was set up by RBI

under the Chairmanship of Shri. S. S. Tarapore. This Committee also known as

Tarapore Committee I, submitted its Report in May 1997. Further, within a span of

ten years another Committee was set up by RBI under the Chairmanship of Shri. S.

309

S. Tarapore to consider the issue of full capital account liberalization. The

Committee submitted its Report in July 2006. This Committee is also known as

Tarapore Committee II .b

Both the Committees mainly recommended -

Phased implementation of Capital Account Convertibility;

Fiscal consolidation;

Maintaining a sustainable level of current account deficit;

Monitoring of exchange rate band;

Mandated inflation rate;

Strengthening of banking and financial system;

Maintaining adequate level of reserves, etc.

7.3.2.1 Status of Capital Account Convertibility –

It is observed that most of the measures undertaken since 1997 – 98, have been

based on the recommendations Tarapore Committee I, while the time table itself has

assumed lesser significance. In the context of capital account liberalization it can be

observed that – “The capital account liberalization (CAL) measures taken since the

submission of Tarapore I report have been substantial as could be seen from their

listing in the annexure of the annual reports of the Reserve Bank of India. They are

characterized by gradualism in respect of quantity as well as quality… In general,

the space between the actual amount of CAL and fuller CAC is small. India, one

could argue, has almost arrived at the doorsteps of full CAC.” 32

Table 7.31 gives a brief status of capital account convertibility as on 2009 - 10,

based on the Tarapore Committee I Report.

To conclude, it can be said that moving towards full capital account convertibility

would benefit the country enormously. Moreover, the move towards full capital

310

account convertibility is not based on the contemporary thinking of economists but it

is essentially based on the choice of policy makers preferences and judgements.

Table 7.31: Capital Account Convertibility – A Status Report

Sr. No

Item Recommendation (up to 1999 – 2000)

Status as on

(2009 – 10)

Remarks

1 Gross Fiscal Deficit as Per cent of GDP

Less than 3.5 6.4 ---

2 Inflation (Per cent)

3 to 5 (3 year average)

5.5 (3 year

average)

Based on WPI ( base year 2004 – 05 = 100 ) No target / mandated rate of inflation approved by Parliament

3 Interest rates To be deregulated Done Savings bank interest rates were deregulated in Oct. 2011

4 CRR To be reduced to 3 Per cent

5.75 ---

5 Gross NPAs(As Per cent of total advances

Less than 5 Per cent 2.2 ---

6 Exchange Rate Band of + / - 5 Per cent around neutral

REER

---- No such band is maintained in India

7 CAD / GDP Less than 2.0

2.8 ---

8 Debt Servicing Ratio

Less than 20 5.5 ----

9 Foreign Exchange Reserves

More than 6 months of import cover

11.1 ----

Source: Reserve Bank of India –Report on Currency & Finance 2002 – 03 & Handbook of Statistics on Indian Economy 2010 - 11

311

7.4 IMPACT OF REFORMS ON MACROECONOMIC INDICATORS

The effect of major policy measures introduced in July 1991 has been analysed with

respect to (a) inflation, (b) industrial growth and (c) Real GDP growth.

7.4.1. Effect on Inflation

In the beginning of 1990s, inflation was in double digits mainly due to the large –

scale monetization of fiscal deficits. Furthermore, this inflationary pressures

continued till 1994 – 95. Some of the factors which led to high inflation were –

supply – demand imbalances in essential commodities, hike in fuel prices and other

administered prices, increase in imports, etc. Thus, first half of 1990s saw a sharp

increase in inflation. However, the second half of 1990s was a marked by a

significant turnaround in inflation. For instance, average annual WPI inflation was

10.5 per cent per annum from 1991 – 92 to 1995 – 96, which declined to 5.0 per cent

per annum from 1996 – 97 to 2000 – 01. During the year 2006 – 07, the average

annual WPI inflation was 5.4 per cent per annum. Thus, during the post – reform

period inflation has shown a decelerating trend.

7.4.2 Effect on Industrial Growth

The major policy changes initiated in the industrial sector since July 1991 viz.,

removal of entry barriers, reduction of areas reserved exclusively for public sector,

rationalization of the approach towards MRTP, liberalization of foreign investment

policy, etc. have contributed to the upsurge in industrial growth.

Some of the important observations regarding industrial growth in 1990s are as

follows:

The average annual growth rate of industrial production which was 7.8 per

cent in the pre – reform decade (1980 – 81 to 1991 – 92) fell to 5.7 per cent

during the period 1990 – 91 to 1999 – 2000.

312

The rate of growth of industrial production in the Eighth Plan (1992 – 93 to

1996 – 97) was 7.4 per cent per annum.

The rate of growth of industrial production in the Ninth Plan (1997 – 98 to

2001 – 02) was 5.0 per cent per annum.

The post – reform period (up to the end of Ninth Plan) was marked by

considerable fluctuations and thus showed a total lack of consistency in

industrial growth performance. For instance, the rate of growth of industrial

production was only 2.3 per cent in 1992 – 93. It increased to as high as 13.0

per cent in 1995 – 96, but fell to 6.1 per cent in 1996 – 97. The rate of

growth of industrial production was just 2.7 per cent in 2001 – 02.

Some of the causes of unsatisfactory industrial performance in 1990s are –

(a) exposure to external competition, (b) slowdown in investment (c)

infrastructural constraints (d) difficulties in obtaining funds for expansion (e)

sluggish growth in exports (f) anomalies in tariff structure, and (g)

contraction in consumer demand.

The period of Tenth Plan (2002 – 03 to 2006 – 07) has witnessed revival of

industrial growth. The industrial growth has shown a rising trend in the

Tenth Plan. For instance, the rate of growth of industrial production was 5.7

per cent in 2002 – 03, 7.0 per cent in 2003 – 04, 8.4 per cent in 2004 – 05,

8.2 per cent in 2005 – 06, and 11.5 per cent in 2006 – 07.

The average rate of industrial growth for Tenth Plan is 8.2 per cent per

annum.

313

7.4.3 Effect on Real GDP Growth

As is well – known the macroeconomic crisis of 1991 also affected the Real GDP

growth adversely. The Real GDP growth which was 5.6 per cent per annum in 1990

– 91 sharply went down to 1.3 per cent per annum in 1991 – 92. However, the

reforms initiated in July 1991 seems to have contributed to economic growth of the

country, because in the very next year the Real GDP growth rate was revived and it

increased to 5.1 per cent per annum. Thus, the economic growth of the country

appeared to have gathered momentum in the aftermath of comprehensive reforms

introduced in the various sectors of the economy. No doubt there was some loss of

the growth momentum in the second half of 1990s, due to east Asian financial crisis,

slowdown in agricultural growth affected by lower than monsoon years, fluctuations

in industrial growth rate, etc. But, since 2003 – 04 the growth momentum has been

once again revived. As pointed out by Mohan (2009) – “Restructuring measures by

domestic industry, overall reduction in domestic interest rates, both nominal and

real, improved corporate profitability, a benign investment climate amidst strong

global demand and commitment rules – based fiscal policy have led to real GDP

growth averaging close to 9 per cent per annum over the four year period 2003 – 04

to 2006 – 07.”33

Table 7.32 depicts the average annual GDP growth rate from Eighth Plan to Tenth

Plan period. As is clear from table 7.32, during the Eighth Plan period, the average

Real GDP growth rate was 6.5 per cent per annum, which reduced to 5.5 per cent per

annum in the Ninth Plan. However, once again in the Tenth Plan, there was increase

in the growth rate and it was 7.5 per cent per annum.

314

Table7.32 Average Annual Growth Rate in Real GDP: (Eighth Plan to Tenth Plan)

Sr. No.

. Period From / To Real GDP

Growth Rate (In Per cent)

1

Eighth Plan 1992 – 1997 6.5

2

Ninth Plan 1997 – 2002 5.5

3

Tenth Plan 2002 - 2007 7.8

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2007 - 08

7.5 GLOBAL ECONOMIC CRISIS & INDIA’S BALANCE OF PAYMENTS

7.5.1 Global Economic Crisis

One of the important developments which took place in the second half of 2007 and

affected the entire world was the US sub – prime crisis. It was the sub – prime crisis

which emerged in the US housing mortgage market in the second half of 2007 which

turned into a global financial and economic crisis. As a result, the global financial

landscape changed significantly during the course of 2008 – 09 wherein several

large international financial institutions either failed or were restructured with the

support of very large government interventions in many countries, to prevent

imminent collapse. The significant deterioration in global financial conditions since

mid – September 2008, led to severe disruptions in the short – term funding markets,

widening of risk spreads, sharp fall in equity prices and inactivity in the markets for

asset – backed securities. Thus, what started off as a sub-prime crisis in the US

housing mortgage sector turned successively into a global banking crisis, global

financial crisis and a global economic crisis. It is the first financial crisis since the

Great Depression that originated in the advanced economies and rapidly engulfed

315

the whole world. Many economists predicted that this ‘Great Recession’ of 2008 –

09 was the worst global recession since 1930s.

At the same time, many economists of the emerging market economies believed in

decoupling theory. The decoupling theory held that even if advanced economies

went into a downturn, emerging economies will remain unaffected because of their

substantial foreign exchange reserves, improved policy framework, robust corporate

balance sheets and relatively healthy banking & finance sector.

The decoupling theory simply asserted that growth in Asia was driven mainly by

domestic factors, that these factors were decoupled from the trends in the West, and

the growth engines in Asia (ASEAN – 5 China and India) would not only continue

to chug along but also serve as a shock absorber for the western economies and

might even help to pull them out of the recession. The strength of the Asian

economies was seen to stem from their recent (i.e. last two decades) shift to market –

oriented policies in a big way, their regional consolidation via trade and investment

relationships, and the benefits they derived from global inflows of capital.34

However, given the capital flow reversals and abrupt currency depreciations, the

decoupling theory stood totally invalidated. Thus, contrary to the decoupling theory,

the emerging economies including India, were also affected by the crisis.

7.5.2 Impact of Global Economic Crisis on India’s Balance of Payments

The global economic crisis started impacting India from the beginning of 2008.

Rising crude prices, along with the global food grain shortage, caused a spill over

into the real economy. As inflation rose, India was forced to repeatedly tighten credit

and money supply. By the middle of September 2008 it became apparent that the

global credit crisis had deepened and key financial institutions were in need of help.

Governments and central banks across the world, including India started intervening

316

to cut interest rates, inject liquidity and recapitalize weakening banks and financial

institutions. The scale of intervention – through the various bailout packages and

other fiscal and monetary measures – has been unparallel in the history of the global

financial system.

The Economic Survey 2008 – 09 observed that – “The year 2008 – 09 was marked

by adverse developments in the external sector of the economy, particularly during

the second half of the year, reflecting the impact of global financial crisis on

emerging market economies including India. Emerging market economies were

affected in varying degrees depending upon the extent of openness and dependence

on capital flows as the external environment deteriorated on account of slowdown of

global demand, reversal of capital flows and reduced access to external sources of

finance in the face of adverse global credit market conditions.”35

The impact of global crisis on the Indian economy can be divided into six phases or

stages – (1) FII outflows and equity market crash (From Jan. 2008) (2) Massive slow

down in external commercial borrowings, trade credit and banking flows (From

April 2008), (3) Forex market crisis, fall in rupee and reserves (From May 2008), (4)

Money – market squeeze (Mid – Sep. 2008), (5) Collapse of exports, imports,

software exports and remittances (From Sep. 2008), and (6) Drying up of Credit

market ( From Nov. 2008).

Table 7.33 gives the trends in exports, imports, and net invisibles (as per cent of

GDP) in the aftermath of global economic crisis. It is clear from table 7.33 that,

there was a fall in exports / GDP and imports / GDP and invisibles, net / GDP in

2009 -10 which can be attributed to the global financial crisis.

317

Table 7.33: Trends in India’s Exports / Imports & Invisibles

(As Per cent of GDP)

Particulars / Year

2007 – 08 2008 – 09 2009 -10 2010 -11

Exports 13.4 15.6 13.2 14.5 Imports 20.8 25.4 21.8 22.0 Invisible Receipts 12.0 13.8 11.8 11.4 Invisible Payments 5.9 6.3 6.0 6.4 Invisibles, net

6.1 7.5 5.8 5.0

Source: Reserve Bank of India – Handbook of Statistics on Indian Economy 2011 -12.

Table 7.34: Trends in India’s Balance of Payments Indicators

Particulars / Year 2007 – 08

2008 – 09

2009 -10

2010 -11

CAD / GDP 1.3 2.3 2.8 2.6 Foreign Investment / GDP 5.0 2.0 4.7 3.2 Import Cover of Reserves ( In months)

14.4 9.8 11.1 9.6

FDI ( In `. Crore) 140180 173741 179059 138462 FPI (In `.crore) 109741 -63618 153516 143435 Exchange Rate of Rupee per US Dollar (Annual average)

40.25 45.92 47.40 45.58

Source: Ibid Table 7.34 gives the changes in select balance of payments indicators from 2007 –

08 to 2010 -11. The following points can be observed from table 7.34 –

The CAD / GDP ratio increased from 1.3 per cent in 2007 – 08 to 2.3 per

cent and further to 2.8 per cent in 2009 -10.

It is also important to note that due to the global financial crisis, there was a

fall in foreign investment / GDP ratio from 5.0 per cent in 2.0 per cent in

2008 – 09.

318

There was an outflow of foreign portfolio investment to the extent of `.

63618 crores in 2008 – 09, which again turned to positive in the year 2009 –

10.

The rupee depreciated against the US dollar in 2008 - 09 & 2009 -10, with

marginal appreciation in 2010 -11.

7.5.3 Impact of Global Economic Crisis on Macroeconomic Indicators

Table 7.35 depicts the effect of global financial crisis on select macroeconomic

indicators. The following points can be noted from table 7.35:

A detailed study of real GDP growth rate indicated that the average real GDP

growth rate from 2003 – 04 to 2007 – 08 was 8.9 per cent. In the year 2007 –

08, the growth rate was a massive 9.3 per cent. However, in the year 2008 –

09, there was a decline in the growth rate to 6.8 per cent.

The average inflation rate from 2003 – 04 to 2007 – 08 was 5.5 per cent. In

the year 2007 – 08, the average rate of inflation was 4.7 per cent. However,

in 2008 – 09 it almost doubled to 8.1 per cent.

The average industrial growth rate from 2003 – 04 to 2007 – 08 was 12.4 per

cent. In the year 2007 – 08, the industrial growth rate was above 15.0 per

cent. However, due to the global economic crisis, there was a sharp

deceleration in industrial growth and it was just 2.5 per cent in 2008 - 09.

After the enactment of FRBM Act, the government was able to contain the

revenue and fiscal deficit well within manageable limits. In the year 2007 –

08, the revenue deficit was 1.0 per cent of GDP and fiscal deficit was 2.5 per

cent of GDP. However, in the year 2008 – 09 there was increase in both the

deficits, which was the result of fiscal stimulus packages declared after the

global economic crisis.

319

Table 7.35: Effect on Select Macroeconomic Indicators

Source: Ibid

7.5.4 Policy Response to the Global Economic Crisis

Both the Government of India and the Reserve Bank of India responded to the crisis

in close coordination and consultation. Besides this, the Securities & Exchange

Board of India (SEBI) also took some measures to contain the effects of crisis. Some

of the important measures were as follows:

(1) To counter the negative fallout of the global slowdown on the economy, the

Indian Government took prompt action by providing substantial fiscal

stimulus. The central government announced three successive fiscal stimulus

packages – in early December 2008, early 2009 and early March 2009. The

packages provided tax relief to boost demand and aimed at increasing

expenditure on public projects to create employment and public assets.

(2) To encourage exports the government provided extension of export credit for

labour – intensive exports, granted assistance to certain export industries in

the form interest subsidy on export finance; and announced refund of excise

duties / central sales tax and other export incentives.

Particulars / Year 2007 – 08 2008 – 09 2009 -10 2010 -11

Real GDP Growth Rate ( In Per cent)

9.3 6.8 8.0 8.5

Inflation ( In Per cent) 4.7 8.1 3.8 9.6 Industrial Growth Rate ( In Per cent)

15.5 2.5 5.3 8.2

Revenue Deficit / GDP ( In Per cent)

1.0 4.5 5.2 3.4

Fiscal Deficit / GDP ( In Per cent)

2.5 6.0 6.4 5.0

320

(3) The RBI took a number of monetary easing and liquidity enhancing

measures including reduction in cash reserve ratio (CRR), statutory liquidity

ratio (SLR) and key policy rates. For instance, through successive steps, the

RBI brought down the CRR from 9 per cent to 5 per cent, the SLR from 25

to 24 per cent, the repo rate from 9 to 4.75 per cent and reverse repo rate

from 6 to 3.25 per cent.

(4) SEBI lifted the curb of 40 per cent restriction for issuance of participatory

notes (PNs) for both cash and derivative segments on the issuance of the PNs

by foreign institutional investors.(FIIs).

(5) SEBI enhanced the FII investment in corporate debt limit from US $ 3

billion to US $ 6 billion.

To conclude, three factors helped India to cope with the crisis and soften the blow.

They are – (1) the robust, fairly diversified, well – capitalized and well – regulated

financial sector; (2) gradual and cautious opening up of the capital account; and (3)

321

7.6 STATISTICAL ANALYSIS

To test the relationship between different variables we have mainly used moving

averages for 5 year, 3 year and 2 year. Besides this we have also used correlation

and regression method in certain cases.

(a)Relationship between CAD & FD – By using the data of Current Account

Deficit(CAD) & Fiscal Deficit(FD) in ` crore, we have examined the relationship

between Current Account Deficit(CAD) and Fiscal Deficit(FD) in the pre – reform

period and post – reform period.

The following are our results -

Model 1 : CAD = -2249 + 0.3948 FD

(-1.708) (7.808 **)

Period 1982 to 1991, n= 10, Adj.R2 = 0.869

** indicates significance at 5 per cent level

t statistics in parentheses

The results of Model 1 indicate that in the pre- reform period from 1981 – 82 to

1990 -91, there was a high positive correlation between CAD and FD. It further

indicates that 86 % of variation in CAD is explained by FD. The model implies

presence of twin deficits and it was the fiscal deficits which affected the current

account deficits. The coefficient of fiscal deficit is found to be statistically

significant at 5 per cent level.

Model 2 : CAD = 15615 – 0.0856 FD

( 0.9772) (-0.544)

Period 1992 to 2007, n = 16, Adj.R2 = - 0.049

The results of Model 2 indicate that in the post – reform period there was a weak

negative correlation between CAD and FD. Hence, in the post – reform period the

322

fiscal deficits did not seem to affect the current account deficits. The coefficient of

fiscal deficit is statistically insignificant.

(b) Fiscal Consolidation - The reforms initiated in 1991 aimed at fiscal

consolidation by augmenting revenue and reducing expenditure resulting into

reduction in FD/GDP ratio.

Our analysis in this context reveals the following ;

(a)The average FD/GDP ratio during the period 1981-82 to 1990 -91 is 7.0 per cent.

Similarly, a 5 year , 3 year and 2 year moving average analysis shows a rising trend

during the said period. (Table 7.36)

Table 7.36: FD/GDP – Moving Averages 1982 – 1991

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1981-82 5.14

1982-83 5.64 6.33 5.58 5.39

1983-84 5.94 7.00 6.22 5.79

1984-85 7.09 7.40 6.96 6.51

1985-86 7.86 7.68 7.80 7.47

1986-87 8.47 7.72 7.98 8.16

1987-88 7.63 7.72 7.81 8.05

1988-89 7.34 7.43 7.48

1989-90 7.33 7.50 7.33

1990 -91 7.85 7.59

Annual Average 7.02

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06

323

Fig. 7.10 shows the moving averages of 5 year, 3 year, and 2 year with respect to

FD/ GDP ratio during the pre- reform period. The figure clearly depicts that the

FD/GDP ratio was showing a rising trend.

Fig. 7.10 FD/ GDP Moving Averages 1982 to 1991

(b) The average FD/GDP ratio during the period 1991-92 to 2006 -07 is 5.30 per

cent. Similarly, a 5 year, 3 year and 2 year moving average analysis shows a falling

trend during the said period. Hence, we can conclude that the reforms have been

successful in reducing the FD/GDP ratio. (Table 7.37)

Fig. 7.11 shows the moving averages of 5 year, 3 year, and 2 year with respect to

FD/ GDP ratio during the post- reform period. The figure clearly depicts that the

FD/GDP ratio was showing a falling trend.

324

Table 7.37: FD/GDP – Moving Averages 1992 – 2007

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1991-92 5.56

1992-93 5.37 5.74 5.98 5.46

1993 -94 7.01 5.60 6.02 6.19

1994-95 5.70 5.70 5.92 6.35

1995-96 5.07 5.83 5.22 5.38

1996-97 4.88 5.53 5.26 4.98

1997-98 5.84 5.64 5.74 5.36

1998-99 6.51 5.90 5.90 6.17

1999-2000 5.35 5.51 5.83 5.93

2000 – 01 5.64 5.24 5.72 5.50

2001 – 02 6.18 4.93 5.91 6.91

2002 – 03 5.92 4.38 5.52 6.05

2003 - 04 4.47 4.80 5.19

2004 – 05 4.01 4.18 4.24

2005 – 06 4.08 3.85 4.04

2006 - 07 3.45 3.76

Annual Average 5.30

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 - 08

325

Fig. 7.11 FD/ GDP Moving Averages 1992 to 2007

(c) Trends in Current Account – We have compared the trends in the current

account in the pre – reform and post – reform period by using the method of moving

averages. Our analysis reveals the following -

(a)The average CAD/GDP ratio during the period 1981-82 to 1990-91 is 2.0 per

cent. At the same time, the 5 year, 3 year and 2year moving averages show a rising

trend during the said period. (Table 7.38)

(b) The average CAD/GDP ratio during the period 1991-92 to 2006 -07 is 0.55 per

cent. At the same time, the 5 year, 3 year and 2 year moving averages show a falling

trend during the said period. (Table 7.39)

So we can conclude that the CAD /GDP ratio has been within 1.5 to 2.0 per cent in

the post – reform period which can be considered as sustainable or manageable

limit.

326

Table 7.38: CAD/GDP – Moving Averages 1982 – 1991

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1981-82 1.70

1982-83 1.70 1.64 1.63 1.70

1983-84 1.50 1.68 1.46 1.60

1984-85 1.20 1.70 1.60 1.35

1985-86 2.10 1.94 1.73 1.65

1986-87 1.90 2.16 1.93 2.09

1987-88 1.80 2.36 2.13 1.85

1988-89 2.70 2.26

1989-90 2.30 2.70

1990 -91 3.10

Annual Average 2.00

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 Fig. 7.12 CAD/ GDP Moving Averages 1982 to 1991

327

Fig. 7.12 depicts the moving averages of CAD / GDP ratios from 1981 – 82 to 1990

-91. It is clear from fig. 7.12 that all the moving averages show a rising trend.

Table 7.39: CAD/GDP – Moving Averages 1992 – 2007

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1991-92 0.30

1992-93 1.70 1.02 0.80 1.00

1993 -94 0.40 1.20 1.03 1.05

1994-95 1.00 1.14 1.03 1.20

1995-96 1.70 1.26 1.95 1.35

1996-97 1.20 1.26 1.43 1.45

1997-98 1.40 1.04 1.20 1.30

1998-99 1.00 0.66 1.13 1.20

1999-2000 1.00 0.12 0.86 1.00

2000 – 01 0.60 -0.54 0.30 0.80

2001 – 02 -0.70 -0.66 -0.46 -0.05

2002 – 03 -1.3 -0.50 -1.43 -1.00

2003 - 04 -2.3 -0.20 -1.06 -1.30

2004 – 05 0.40 -0.23 -0.95

2005 – 06 1.20 0.90 0.80

2006 - 07 1.10 1.15

Annual Average 0.55

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 - 08 Note : (-) sign indicates a surplus.

328

Fig. 7.13 CAD/ GDP Moving Averages 1992 to 2007

Fig. 7.13 shows the moving averages of CAD/GDP ratio during the period from

1991 -92 to 2006 -07. It is clear that all of them show a falling trend.

(d) Role of Invisibles – Invisibles have been an important source of financing trade

deficit and subsequently narrowing down the current account deficit.

Our moving average analysis with respect to invisibles reveals the following –

(a)In the pre – reform period from 1981 -82 to 1990 -91, the average Net Invisibles /

GDP ratio was 1.08 per cent. During the same period, all the three moving averages

i.e. 5 year, 3 year and 2 year, show a falling trend, which points out the fact they

played a negligible role in narrowing down the CAD.(Table 7.40)

(b) During the post – reform period from 1991 – 92 to 2006 – 07 the average Net

Invisibles / GDP ratio was 2.75 per cent. During the same period, all the three

moving averages i.e. 5 year, 3 year and 2 year show a rising trend, this proves the

fact that invisibles have played an important role in narrowing down the CAD.

(Table 7.41)

329

Table 7.40: Net Invisibles / GDP - Moving Averages 1982 – 1991

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1981-82 2.10

1982-83 1.80 1.66 1.83 1.95

1983-84 1.60 1.46 1.63 1.70

1984-85 1.50 1.26 1.46 1.55

1985-86 1.30 1.04 1.30 1.40

1986-87 1.10 0.74 1.06 1.20

1987-88 0.80 0.50 0.80 0.95

1988-89 0.50 0.50 0.65

1989-90 0.20 0.20 0.35

1990 -91 -0.10 0.05

Annual Average 1.08

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 Fig. 7.14 Net Invisibles / GDP Moving Averages 1982 to 1991

330

Fig. 7.14 shows the trends in Net invisibles / GDP during the period from 1981 -82

to 1990 – 91. As is clear from fig. 7.14, all the moving averages show a falling trend

during the period under consideration.

Table 7.41: Net Invisibles /GDP – Moving Averages 1992 – 2007

( In Per cent )

Year Annual 5 Yr 3 Yr 2 Yr

1991-92 0.70

1992-93 0.60 1.12 0.77 0.65

1993 -94 1.00 1.50 1.13 0.80

1994-95 1.80 1.86 1.43 1.45

1995-96 1.50 2.10 1.96 1.65

1996-97 2.60 2.32 2.17 2.05

1997-98 2.40 2.44 2.40 2.50

1998-99 2.20 2.54 2.50 2.30

1999-2000 2.90 2.74 2.70 2.55

2000 – 01 2.10 3.22 2.87 2.50

2001 – 02 3.10 3.52 3.70 3.10

2002 – 03 3.40 4.14 4.13 3.25

2003 - 04 4.60 4.62 4.74 4.00

2004 – 05 4.40 5.03 4.50

2005 – 06 5.20 4.85

2006 - 07 5.50 5.35

Annual Average 2.75

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

331

Fig. 7.15 Net Invisibles / GDP Moving Averages 1992 to 2007

Fig. 7.15 trends in net invisibles / GDP from 1991 – 92 to 2006 – 07, the figure

shows that during the said period, the net invisibles were showing a rising trend,

which resulted into narrowing the current account deficit.

(e) Trends in Foreign Investment - In the pre – reform period, the amount of

foreign investment in India was negligible. Table 7.42 shows that in the pre-reform

period, foreign investment flows in India started from 1986 – 87 onwards. The

average foreign investment during the pre-reform period from 1981-82 to 1990 – 91

was ` 219.60 crore. As per cent of GDP, it was only 0.05 per cent.

However, in the post – reform period, there was a remarkable increase in foreign

investment in India. As depicted in Table 7.43 in the post reform period from 1991

– 92 to 2006 - 07, there was a remarkable increase in foreign investment in India.

The average foreign investment during the post – reform period was ` 36,855.0

crore. As a per cent of GDP, it was 1.50 per cent.

332

Table 7.42: Foreign Investment in India 1982 - 1991

Year In ` crore As Per cent of GDP

1981-82 0.00 0.00

1982-83 0.00 0.00

1983-84 0.00 0.00

1984-85 0.00 0.00

1985-86 0.00 0.00

1986-87 249.00 0.10

1987-88 563.00 0.20

1988-89 517.00 0.10

1989-90 683.00 0.10

1990 -91 184.00 0.00

Annual Average 219.60 0.05

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06

333

Table7.43: Foreign Investment in India 1992 -2007

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

Year In ` crore As Per cent of GDP

1991-92 340.00 0.10

1992-93 1699.00 0.20

1993 -94 13282.00 1.50

1994-95 15499.00 1.50

1995-96 16312.00 1.40

1996-97 21829.00 1.60

1997-98 19961.00 1.30

1998-99 10169.00 0.60

1999-2000 22501.00 1.20

2000 – 01 31016.00 1.50

2001 – 02 38861.00 1.70

2002 – 03 29072.00 1.20

2003 - 04 71728.00 2.60

2004 – 05 68366.00 2.20

2005 – 06 94814.00 2.60

2006 - 07 134282.00 3.10

Annual Average 36855.00 1.50

334

Fig. 7.16 Foreign Investment / GDP Moving Averages 1992 to 2007

Fig. 7.16, clearly shows that foreign investment / GDP ratio was rising during the

post – reform period.

(f) Reserves Management in the post – reform period - Foreign trade can be

considered as a main factor affecting reserves. Exports add to the reserves while

imports drain out the reserves in the form of payments. Besides, this net invisibles

also add to the foreign exchange reserves. Capital inflows in the form of foreign

investments formed a significant portion of the reserves in the post – reform period.

However, in the pre-reform period, foreign investment in India was of negligible

amount. By using the data of foreign exchange reserves, exports, imports and

invisibles in `. crore, we have formed the following models -

Model A – FER = -1940 + 0.0180 EXP + 0.494 IMP + 4.354 INV

(0.1266) ( 4.773 **) (11.31 **)

Period 1982 to 1991, n= 10, Adj.R2 = 0.935

** indicates significance at 5 per cent level. t statistics in parentheses.

335

The results of Model A indicate that in the pre – reform period, 93 % of variation is

explained jointly by exports, imports and invisibles. However, the coefficient of

imports does not have the expected sign. The coefficient of imports and invisibles

are found to be statistically significant at 5 per cent level.

Model B FER = -5577 + 1.612 EXP – 0.629 IMP + 2.139 INV

(3.091 **) ( -2.183 **) ( 2.536 **)

Period 1992 to 2007, n = 16, Adj.R2 = 0.987

** indicates significance at 5 per cent level. t statistics in parentheses

The results of Model B indicate that in the post – reform period, 98 % of variation

in foreign exchange reserves is explained jointly by exports, imports and invisibles.

All the coefficients have the expected sign and are found to be statistically

significant at 5 per cent level.

Trends in Import Cover of Reserves – We have also applied moving average

method to analyse the trends in import cover of reserves, which is considered as the

traditional indicator of reserve adequacy. Our analysis reveals the following –

(a)For the pre-reform period from 1981 – 82 to 1990 – 91, the average import cover

of reserves is 3.5. The 5 year, 3 year and 2 year moving average analysis indicate a

falling trend. (Table 7.44). It is clear from fig. 7.17, that all the three types of

moving averages during the pre – reform period show a falling trend.

(b) For the post – reform period from 1991 – 92 to 2006 – 07, the average import

cover of reserves is 9.5. While, the 5 year, 3 year and 2 year moving averages

indicate a rising trend. (Table 7.45). It is clear from fig. 7.18, that all the three types

of moving averages during the post – reform period depict a rising trend.

336

Table 7.44: Import Cover of Reserves – Moving Averages 1982 – 1991

( In Months )

Year Annual 5 Yr 3 Yr 2 Yr

1981-82 3.3

1982-83 3.6 4.0 3.6 3.5

1983-84 4.1 4.2 4.0 3.9

1984-85 4.5 4.3 4.3 4.3

1985-86 4.5 3.9 4.4 4.5

1986-87 4.4 3.4 4.2 4.4

1987-88 3.8 3.0 3.5 4.1

1988-89 2.4 2.7 3.2

1989-90 1.9 2.3 2.1

1990 -91 2.5 2.2

Annual Average 3.5

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 Fig. 7.17 Import Cover of Reserves – Moving Averages 1982 to 1991

337

Table 7.45: Import Cover of Reserves – Moving Averages 1992 – 2007

( In Months )

Year Annual 5 Yr 3 Yr 2 Yr

1991-92 5.3

1992-93 4.9 6.6 6.3 5.1

1993 -94 8.6 6.9 7.3 6.8

1994-95 8.4 7.3 7.6 8.5

1995-96 6.0 7.2 7.0 7.2

1996-97 6.5 7.2 6.5 6.3

1997-98 6.9 7.7 7.2 6.7

1998-99 8.2 8.7 7.7 7.5

1999-2000 8.2 10.2 8.4 8.2

2000 – 01 8.8 11.9 9.5 8.5

2001 – 02 11.5 13.1 11.5 10.1

2002 – 03 14.2 13.7 14.2 12.9

2003 - 04 16.9 13.9 15.1 15.5

2004 – 05 14.3 14.3 15.6

2005 – 06 11.6 12.8 13.0

2006 - 07 12.5 12.0

Annual Average 9.5

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

338

Fig. 7.18 Import Cover of Reserves – Moving Averages 1992 to 2007

(g) External Debt Management in the post – reform period – As the data with

reference to external debt during the pre – reform period and post – reform period

are not strictly comparable, we have considered debt sustainability indicators in the

post - reform period only and have studied the trends in them by applying moving

average method for 5 years, 3 years, and 2 years. Our analysis reveals the following

(a) The average external debt to GDP ratio during the period from 1992 to 2007 is

24.85 per cent. All the three moving averages, depict a falling trend during the said

period. (Table 7.46). Fig. 7.19, shows the moving averages for the period from 1992

to 2007 and show a falling trend. This indicates that the country has been successful

in bringing down the external debt / GDP ratio.

(b) The average short term debt to total debt ratio during the post – reform period is

6.70. Besides this all the moving averages show a falling trend except for a last

couple of years due to change in the definition of short – term debt. (Table 7.47).

339

Fig. 7.20, shows the moving averages for the post – reform period and depict a

falling trend. Hence, the country has been able to bring down the short – term debt

to total debt ratio in the post- reform period.

Table 7.46: External Debt / GDP – Moving Averages 1992 to 2007

( In Per cent )

Financial Year end

Annual 5 Yr 3 Yr 2 Yr

1992 38.70

1993 37.50 33.55 36.67 38.10

1994 33.80 30.75 34.04 35.65

1995 30.80 28.10 30.54 32.30

1996 27.00 26.06 27.47 28.90

1997 24.60 24.30 25.30 25.80

1998 24.30 23.40 24.17 24.45

1999 23.60 22.70 23.30 23.95

2000 22.00 21.90 22.70 22.80

2001 22.50 20.75 21.87 22.25

2002 21.10 20.05 21.30 21.80

2003 20.30 18.98 19.75 20.70

2004 17.80 18.32 18.87 19.05

2005 18.50 17.84 18.15

2006 17.20 17.84 17.85

2007 17.80 17.50

Annual Average 24.85

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

340

Table 7.47: Short - term Debt / Total Debt– Moving Averages 1992 to 2007

( In Per cent )

Financial Year end

Annual 5 Yr 3 Yr 2 Yr

1992 8.30

1993 7.00 5.78 6.40 7.65

1994 3.90 5.56 5.07 5.45

1995 4.30 5.35 4.54 4.10

1996 5.40 5.34 5.64 4.85

1997 7.20 5.28 6.00 6.30

1998 5.40 4.92 5.67 6.30

1999 4.40 4.04 4.60 4.90

2000 4.00 3.86 2.80 4.20

2001 3.60 3.76 3.47 3.80

2002 2.80 5.62 3.64 3.20

2003 4.50 7.72 3.74 3.65

2004 3.90 10.26 7.24 4.20

2005 13.30 10.43 8.60

2006 14.10 14.30 13.70

2007 15.50 14.80

Annual Average 6.70

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

341

(c) The average debt service ratio is 18.55 per cent during the post – reform period.

Besides this, we can find that all the three moving averages show a falling trend with

respect to debt service ratio in the post – reform period. (Table7.48). Fig.7.21 shows

the moving averages with respect to debt service ratio during the post – reform

period depicting a falling trend. This implies that the country has been able to bring

down its debt service ratio.

Fig. 7.19 External Debt / GDP Moving Averages 1992 to 2007

Fig. 7.20 Short –term Debt / Total Debt Moving Averages 1992 to 2007

342

Table 7.48: Debt Service Ratio – Moving Averages 1992 to 2007

( In Per cent )

Year

Annual 5 Yr 3 Yr 2 Yr

1991-92 30.20

1992-93 27.50 27.04 27.70 28.85

1993 -94 25.40 25.60 26.27 26.45

1994-95 25.90 24.00 25.84 25.65

1995-96 26.20 22.66 25.04 26.05

1996-97 23.00 20.90 22.90 24.60

1997-98 19.50 18.98 20.40 21.25

1998-99 18.70 17.12 18.44 19.10

1999-2000 17.10 16.42 17.47 17.90

2000 – 01 16.60 15.90 15.80 16.85

2001 – 02 13.70 13.70 15.44 15.15

2002 – 03 16.00 12.36 15.27 14.85

2003 - 04 16.10 10.58 12.74 16.05

2004 – 05 6.10 10.70 11.10

2005 – 06 9.90 6.94 8.00

2006 - 07 4.80 7.35

Annual Average 18.55

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

343

Fig. 7.21 Debt Service Ratio Moving Averages 1992 to 2007

(h) Composition of Capital Account – To compare the changes in the components

of capital account during the pre- reform period and post – reform period we have

considered the data in terms of `. crore and have calculated the percentages of the

components. Table 7.49 shows the components of capital account during the period

1981 -82 to 1990 -91. Our analysis of the table 7.49 reveals the following –

(a) Foreign investment flows started in India in the second half of 1980’s i.e. from

1986 – 87 onwards. The average foreign investment during the period from 1981 –

82 is `.219 crore.

(b) The capital inflows in the form external assistance was `.2115 crore. While the

capital inflows in the form of external commercial borrowings and NRI deposits was

a major component of capital account. The average external commercial borrowings

was `.1745 crore, while NRI deposits was `.1782 crore. This implies that the

country had relied on costly sources of borrowing.

344

Table 7.49: Composition of Capital Account 1982 to 1991

( In `.crore)

Year Foreign Investment

External Assistance, Net

External Commercial Borrowings

NRI Deposits

Other Capital

Rupee Debt Service

Total

1981-82 0 746 146 206 -513 0 585

1982-83 0 1125 732 383 -228 0 2012

1983-84 0 1183 785 709 59 0 2736

1984-85 0 1407 1110 879 342 0 3738

1985-86 0 1676 1167 1767 904 0 5514

1986-87 249 1808 2513 1650 -450 0 5770

1987-88 563 2945 1266 1840 -69 0 6545

1988-89 517 3210 2743 3636 1572 0 11678

1989-90 683 3090 2958 4000 886 0 11617

1990 -91 184 3965 4034 2756 4096 -2140 12895

Annual Average

219 2115 1745 1782 660 -214

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005 - 06

Table 7.50 shows the components of capital account during the period from 1981 –

82 to 1990 – 91 in terms of percentage. Our analysis of table 7.50 reveals the

following –

(a)The average foreign investment during the period is a meager 2.45 per cent of the

total capital account.

(b) The average capital inflows in the form of external assistance was 45.60 per

cent.

345

(c) Capital inflows in the form of external commercial borrowings was 28.40 per

cent and that of NRI deposits was 27.95 per cent. It means that more than 50 per

cent of sources were costly sources of borrowing.

Table7.50: Composition of Capital Account 1982 to 1991

( In Per cent)

Year Foreign Investment

External Assistance, Net

External Commercial Borrowings

NRI Deposits

Other Capital

Rupee Debt Service

Total

1981-82 0 127.50 25.00 35.20 -87.70 0 100.00

1982-83 0 55.90 36.38 19.05 -11.33 0 100.00

1983-84 0 43.25 28.75 26.00 2.00 0 100.00

1984-85 0 37.65 29.70 23.50 9.15 0 100.00

1985-86 0 30.40 21.15 32.05 16.40 0 100.00

1986-87 4.30 31.35 43.55 28.60 -7.80 0 100.00

1987-88 8.60 45.00 19.35 28.10 -1.05 0 100.00

1988-89 4.40 27.50 23.50 31.15 13.45 0 100.00

1989-90 5.90 26.60 25.45 34.45 7.60 0 100.00

1990 -91 1.40 30.77 31.30 21.38 31.75 -16.6 100.00

Annual Average

2.45 45.60 28.40 27.95 -2.74 -1.66 100.00

Source : Calculated from Table 7.49

346

Table 7.51: Composition of Capital Account 1992 to 2007

( In `.crore)

Year Foreign Investment

External Assistance, Net

External Commercial Borrowings

NRI Deposits

Other Capital

Rupee Debt Service

Total

1991-92 340 7395 3806 1007 -256 -2785 9507

1992-93 1699 5748 -1095 6097 1768 -2335 11882

1993 -94 13282 5963 1904 3780 8786 -3302 30413

1994-95 15449 4799 3239 539 7811 -3090 28747

1995-96 16312 3357 4549 3822 -9334 -3105 15601

1996-97 21829 3997 10003 11894 -4681 -2542 40500

1997-98 19961 3463 14558 4325 -1987 -2784 37536

1998-99 10169 3484 18557 4059 2072 -3308 35033

1999-00 22501 3915 1360 6709 16675 -3059 48101

00-01 31016 2080 20194 10561 -21850 -2760 39241

01-02 38861 5819 -7543 13127 -7640 -2457 40167

02-03 29072 -14863 -8263 14424 33313 -2306 51377

03-04 71728 -12553 -13274 16869 18996 -1756 80010

04-05 68366 8993 24149 -4439 32870 -1858 128081

05-06 94814 7876 11610 12457 -14567 -2557 109633

06-07 134282 8027 73889 19574 -27030 -725 208017

Annual Average

36855 2968 9852 7800 2184 -2545

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

347

Table 7.51 gives the composition of capital account during the period from 1991 –

92 to 2006 – 07. Our analysis of table 7.51 reveals the following -

(a)Foreign investment has become an important component of capital account. It

shows a mixed picture of increase as well as decrease during the said period.

However, the average foreign investment is `.36855 crore, during the post – reform

period.

(b) The external assistance broadly shows a declining trend. The average external

assistance is `.2968 crore.

(c) The average external commercial borrowings is `.9852 crore and NRI deposits is

`.7800 crore.

Table 7.52 gives the composition of capital account during the period from 1991 –

92 to 2006 -07 in terms of percentage. An analysis of table 7.52 reveals the

following -

(a)The average of foreign investment inflows is 58.07 per cent. It clearly indicates

that foreign investment has become a major source of capital inflows.

(b) The average of external assistance is 13.46 per cent. It shows that our reliance

external assistance has declined.

(c) The average of external commercial borrowings is 16.35 per cent and that of NRI

deposits is 18.32 per cent. This clearly shows that our reliance on costly sources of

finance has declined in the post – reform period.

348

Table 7.52: Composition of Capital Account 1992 to 2007

( In Per cent)

Year Foreign Investment

External Assistance, Net

External Commercial Borrowings

NRI Deposits

Other Capital

Rupee Debt Service

Total

1991-92 3.58 77.78 40.04 10.60 -2.70 -29.3 100.00

1992-93 14.30 48.40 -9.20 51.30 14.85 -19.65 100.00

1993 -94 43.70 19.60 6.25 12.40 28.92 -10.87 100.00

1994-95 53.75 16.60 11.26 1.88 27.26 -10.75 100.00

1995-96 104.55 21.50 29.15 24.50 -59.80 -19.90 100.00

1996-97 53.90 9.85 24.70 29.35 -11.53 -6.27 100.00

1997-98 53.18 9.22 38.78 11.50 -5.28 -7.40 100.00

1998-99 29.00 11.18 52.98 11.58 4.71 -9.45 100.00

1999-00 46.78 8.14 2.82 13.95 34.66 -6.35 100.00

00-01 79.00 5.30 51.45 26.92 -55.67 -7.00 100.00

01-02 96.75 14.48 -18.78 32.68 -19.01 -6.12 100.00

02-03 56.58 -28.92 -16.08 28.07 64.83 -4.48 100.00

03-04 89.65 -15.68 -16.60 21.08 23.75 -2.20 100.00

04-05 53.38 7.02 18.85 -3.45 25.65 -1.45 100.00

05-06 86.50 7.18 10.58 11.36 -13.29 -2.33 100.00

06-07 64.55 3.85 35.52 9.40 -12.98 -0.34 100.00

Annual Average

58.07 13.46 16.35 18.32 2.77 -8.99 100.00

Source : Calculated from Table 7.51

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(i)Overall Balance of Payments – A study of India’s Balance of Payments from

1991 – 92 to 2006 – 07, indicates that the overall balance of payments showed a

surplus in all the years except in 1992 – 93 and 1995 – 96. (Table 7.53)

Table 7.53: India’s Overall Balance of Payments - 1992 to 2007

( In. `.Crore)

Source : Reserve Bank of India - Handbook of Statistics on Indian Economy 2005-06 & 2007 -08

Year Current Account Balance

Capital Account Balance

Overall Balance

1991-92 -2235 9509 7274

1992-93 -12764 11883 -881

1993-94 -3634 30415 26781

1994-95 -10583 28743 18160

1995-96 -19646 15596 -4050

1996-97 -16282 40502 24220

1997-98 -20883 37536 16653

1998-99 -16789 35034 18245

1999-00 -20331 48101 27770

2000-01 -11598 39241 27643

2001-02 16426 40167 56593

2002-03 30660 51377 82037

2003-04 63983 80010 143993

2004-05 -12174 128081 115907

2005-06 -43737 109633 65896

2006-07 -44383 208017 163634

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7.7 TESTING OF HYPOTHESES –

In order to test the hypotheses given in Chapter I – Introduction (page 22) of the

present study we have undertaken statistical analysis of different variables affecting

the components of balance of payments by mainly using moving average method.

For certain variables we have also used correlation and regression method. (Section

7.6 gives our statistical analysis.)

Hypothesis No. 1 – The various measures undertaken to correct disequilibrium in

balance of payments have proved successful.

With reference to the first hypothesis our observations are as follows -

a) It has been observed that the major reforms undertaken in the trade sector

have increased India’s trade openness. For instance, India’s average trade /

GDP ratio was 11.8 per cent from 1980 – 81 to 1989 – 90. This further

increased to 17.1 per cent from 1990 – 91 to 1999 – 2000. Further, from

2000 – 01 to 2006 – 07, this ratio increased to 26.8. (Table 7.3 and

Fig.7.1).Similarly, there has been reduction in India’s import duties since

1991. For example, the “peak” rate of import duty on non – agricultural

imports has been gradually reduced from as high as 150 per cent in 1991 –

92 to 25 per cent in 2003 – 04.

b) With reference to exports & imports it has been observed that, both export

and import growth rates registered an increase in the post – reform period.

For instance, the average annual export growth rate was 16.8 per cent in

1980s which went up to 17.45 in 1990s. Further, from 2001 to 2007, it

marginally went up to 18.0 per cent. At the same time, the average annual

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import growth rate was 14.55 per cent in 1980s which increased to 18.75 in

1990s. From 2001 to 2007, it increased to 21.40 per cent. (Table 7.8)

c) The commodity composition of India’s export basket has changed in favour

of technology intensive and industrial products such as engineering goods

and high – value agricultural products.( Table 7.9) Similarly, India’s imports

are dominated by higher technology intensive and export oriented products.

(Table 7.13)

d) Destination – wise analysis of India’s exports reveal that OECD has the

largest market share, followed by developing countries of Asia and OPEC.

(Table 7.15) With respect to imports it is observed that, traditional import

partners like Germany, Japan, UK & Australia have been loosing their

market share and new import partners from Africa and East Asia are gaining

importance.

e) The reforms initiated in 1991 aimed at fiscal consolidation by augmenting

revenue and reducing expenditure resulting into reduction in FD/GDP ratio.

Our analysis indicates that the average FD/GDP ratio during the period 1991-

92 to 2006 -07 is 5.30 per cent. Similarly, a 5 year, 3 year and 2 year moving

average analysis shows a falling trend during the said period. Hence, we can

conclude that the reforms have been successful in reducing the FD/GDP

ratio. (Table 7.37 & Fig.7.11)

f) The approach towards debt management since 1991 has been mainly based

on the recommendations of Rangarajan Committee, 1993. As a result there

has been a gradual and steady improvement in debt sustainability indicators

after the post – reform period. The average external debt to GDP ratio during

the period from 1992 to 2007 is 24.85 per cent. All the three moving

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averages, depict a falling trend during the said period. (Table 7.46&

Fig.7.19). The average short term debt to total debt ratio during the post –

reform period is 6.70. Besides this all the moving averages show a falling

trend except for a last couple of years due to change in the definition of short

– term debt. (Table 7.47 & Fig.7.20). The average debt service ratio is 18.55

per cent during the post – reform period. Besides this, we can find that all the

three moving averages show a falling trend with respect to debt service ratio

in the post – reform period. (Table7.48 & Fig.7.21)

g) Our analysis with reference to foreign exchange reserves in the post – reform

period indicate that 98 % of variation in foreign exchange reserves is

explained jointly by exports, imports and invisibles. All the coefficients have

the expected sign and are found to be statistically significant at 5 per cent

level. (Model B) With respect to import cover it is observed that the average

import cover of reserves is 9.5 months. Besides all the moving averages

indicate a rising trend. (Table 7.45 & Fig.7.18).

h) In regard to reserve management until the balance of payments crisis of

1991, India had adopted a single indicator approach i.e. to maintain reserves

in relation to imports. However, in the post – reform period the country has

adopted a multiple indicator approach.

i) The overall experience with the market determined exchange rate adopted

since March 1, 1993 has been satisfactory.

j) On the macroeconomic front, the reforms have been successful in controlling

the rate of inflation especially after 1995 – 96. The average industrial growth

rate was 5.7 per cent during the period 1990 – 91 to 1999 – 2000. During the

Tenth Plan (2002 - 03 to 2006 – 07) the average industrial growth rate was

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8.2 per cent per annum showing a revival of industrial growth rate. The

economic growth of the country seems to have gathered momentum in the

post – reform period. For instance, in 1990 – 91, the Real GDP growth rate

was 5.6 per cent which fell to 1.3 per cent in 1991 – 92. The average Real

GDP growth rate was 6.5 per cent in Eighth Plan, which declined to 5.5 per

cent during the Ninth Plan. However, there has been improvement in the

Real GDP growth rate in the Tenth Plan which was 7.5 per cent per annum.

k) Finally, a detailed study of India’s Balance of Payments from 1991 – 92 to

2006 – 07, indicates that the overall balance of payments showed a surplus in

all the years except in 1992 – 93 and 1995 – 96. (Table 7.53)

Hence, on the basis of above analysis we accept the hypothesis that “ “the

various measures undertaken to correct disequilibrium in balance of payments

have proved successful.”

Hypothesis No. 2 – In spite of trade liberalization, the current account deficit has

been within manageable levels.

Definition of Manageable limit of CAD -

There is no strict definition of what is a manageable limit of CAD ? However, in

this context the following observations can be considered important –

1) Callen and Cashin (1999)36 in their study pointed out that in case of India a

current account deficit in the range of 1.5 per cent to 2.5 per cent of GDP

could be considered as sustainable.

2) The High Level Committee on Balance of Payments (Chairman: C.

Rangarajan) recommended that a CAD / GDP ratio at 1.6 per cent can be

considered as sustainable considering the normal capital flows. 37

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3) Research indicates that for most of the developing countries, a CAD /GDP

ratio between 3 to 5 per cent is sustainable in the short – run. While the

steady – state (long run) sustainable CAD/GDP ratio is estimated at below 4

per cent of GDP. The record of the current account deficit of India, when

benchmarked against these findings, shows that it remained well below the

critical limit during the period 1970-71 to 2002 -03, ranging from a surplus

of 0.2 per cent in the period 1976 -80 to a deficit of 2.2 per cent in the period

1986 – 90.38

4) Besides the size, the composition of current account and its financing is also

considered as an important criterion for determining its sustainability.

Capital flows with higher foreign direct investment (FDI) can ensure

sustainability even if the CAD/GDP ratio is relatively high. For instance,

Singapore, on an average, sustained a CAD of 12 per cent of GDP during the

period 1970 -1982 with nearly one half of the capital inflows comprising

FDI. 39

5) Another view, which has emerged in the late 1990s is that – the higher the

ratio of current receipts to GDP, the higher is the CAD/GDP ratio that can be

sustained, given a desired level of the debt service ratio. Per contra, a lower

current receipts to GDP ratio should be consistent with a lower CAD in

terms of GDP.40

With reference to the second hypothesis our observations are as follows –

a) In 1990 – 91, the CAD /GDP ratio had reached to an unsustainable level of

3.1 per cent. The external sector reforms implemented after 1991 ensured

that the current account deficit would remain within reasonable level in spite

of increasing trade openness. The average CAD/GDP ratio during the period

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1991-92 to 2006 -07 is 0.55 per cent. At the same time, the 5 year, 3 year and

2 year moving averages show a falling trend during the said period. (Table

7.39. & Fig.7.13).Further, there was a current account surplus for three

consecutive years from 2001 – 02 to 2003 – 04. So we can conclude that the

CAD /GDP ratio has been within 1.5 to 2.0 per cent in the post – reform

period which can be considered as sustainable or manageable limit.

b) Invisibles have been an important source of financing trade deficit and

subsequently narrowing down the current account deficit. During the post –

reform period from 1991 – 92 to 2006 – 07 the average Net Invisibles / GDP

ratio was 2.75 per cent. During the same period, our moving average analysis

shows a rising trend. Hence, we can conclude that invisibles have played an

important role in narrowing down the CAD. (Table 7.41 & Fig.7.15)

c) In the pre – reform period especially in 1980s, large fiscal deficits were

accompanied by large current account deficits, which indicated the existence

of twin deficit phenomenon. However, the post – reform period shows a

different picture and depicts the absence of twin deficit phenomenon. Since,

mid – 1990s, higher fiscal deficits have been accompanied by a narrowing

down of the current account deficit. Thus, although fiscal deficits have

remained inflexible downwards, they did not spill over into the external

sector during the 1990s.

d) Our analysis with reference to the twin deficit phenomenon shows that there

is a high degree of positive correlation between CAD & FD in the pre-

reform period and it is statistically significant. (Model 1). However, the post

– reform period analysis indicates a weak negative correlation between CAD

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& FD.(Model 2). Hence, we can find absence of twin deficit phenomenon in

the post – reform period.

e) All the operational indicators of current account sustainability indicate a

steady improvement since the 1990s, except for fiscal deficit to GDP

ratio.((Table 7.23)

f) The sustainability of current account was ensured by a policy choice for non-

debt creating flows and emphasis on reduction of external debt. This is

reflected in the form of increase in foreign investment/ GDP ratio during the

post – reform period. In the post – reform period the average foreign

investment is `.36855 crore and 1.50 per cent of GDP. Besides this, the

moving averages also indicate a rising trend.(Table 7.43 & Fig.7.16)

Hence, on the basis of above observations we accept the hypothesis that “in spite of

trade liberalization, the current account deficit has been within manageable levels.”

Hypothesis No. 3 - There has been a compositional shift in the capital account of

the balance of payments, in the post – reform period.

With reference to the third hypothesis our observations are as follows –

a) During the pre – reform period, the capital account transactions were mainly

used to finance the current account deficits through costly sources of finance

such as – external commercial borrowings, NRI deposits and loans from

IMF. Our analysis shows that the average capital inflows in the form of

external assistance was 45.60 per cent, capital inflows in the form of external

commercial borrowings was 28.40 per cent and that of NRI deposits was

27.95 per cent. It means that more than 50 per cent of sources were costly

sources of borrowing. (Table 7.50)

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b) However, in the post – reform period, India has followed a cautious approach

towards capital inflows. The strategy has been to encourage long – term

capital inflows and discourage short – term volatile flows. Our analysis

shows that the average of foreign investment inflows is 58.07 per cent,

average of external assistance is 13.46 per cent, the average of external

commercial borrowings is 16.35 per cent and that of NRI deposits is 18.32

per cent. This shows that we have reduced our reliance on costly sources of

borrowing. .(Table 7.52)

c) An overview of the capital account in the post – reform period reveals that

capital account balance reflects a perceptible positive impact of economic

reforms. The yearly data of capital account from 1991 – 92 to 2006 – 07

reveals that barring the years 1992 – 93 and 1995 – 96, the surplus in the

capital account has been sufficient to wipe out the deficit in current account

and create an overall surplus in the country’s balance of payments. (Table

7.53)

d) In the latter half of 1980s, ECBs were extensively used for financing the

current account deficit. However, in the post – reform years encouragement

has been given to keep their maturities period long and cost low.

e) To conclude, the evolution of capital flows during the post – reform period

reveals a shift in emphasis from debt to non – debt creating flows with the

declining importance of external assistance, ECBs and NRI deposits and the

increased share of foreign investment.

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On the basis of above observations we accept the hypothesis that – “there has been

a compositional shift in the capital account of the balance of payments, in the post –

reform period.”

7.8 SUMMARY

The structural adjustment and policy reforms measures introduced in July 1991,

started showing results only after 1992 – 93 onwards.

The impact of reforms has been analysed with reference to various balance of

payments indicators like - (1) trade openness, (2) terms of trade, (3) exports &

imports, (4) role of invisibles, (5) current account, (6) capital account, (7) external

debt, (8) exchange rate management, and (9) reserve management.

Openness of a country with respect to foreign trade refers to its permissiveness

towards exports and imports. Openness is measured with reference to reductions in

tariffs and non – tariff barriers and trade – GDP ratio of the country. With respect to

tariffs it can be concluded that over a period of time there has been reduction in peak

custom duty rates from 150.0 per cent in 1991 – 92 to 31.0 per cent 2002 – 03.

Besides this, the country has been following a consistent policy for gradual removal

of restrictions on imports since 1991. For instance, by 2003 out of 11670 tariff lines,

11100 were freed. The increase in trade – GDP ratio indicates that the country is

more open now as compared to 1990 – 91. For instance, the average trade – GDP

ratio was 17.0 per cent in 1990s which increased to 27.0 per cent from 2001 to 2007.

The economic reforms have also resulted into improvement in terms of trade (both

net & income) over a period of time.

So far as exports are concerned there was a perceptible improvement in India’s

export performance in the initial phase of the reform period – both at the overall

359

level and across commodities. However, there was a slowdown in exports

performance in the second half of 1990s due to – slowdown in economic activity,

fall in demand due to East Asian crisis, imposition of Non- tariff barriers by

developed countries, and weakening of overall demand and world trade volume. The

commodity composition of India’s export basket has changed in favour of

technology intensive and industrial products. Similarly, there has been

compositional shifts in the structure of India’s imports towards higher technology

intensive and export oriented products during the 1990s. Destination wise analysis

of the Indian exports indicates an unchanged position in respect of OECD group,

increasing prominence of OPEC and the developing countries of Asia, Africa and

Latin America. With respect to imports it is observed that subsequent to the opening

up, India’s import have been sourced from a wider range of countries. The

traditional import partners like Germany, Japan, UK & Australia have lost their

market share, while new import partners from Africa and East Asia (including

China) are gaining importance.

Invisibles were considered as the most dependable source of financing country’s

trade deficits. The importance of invisibles increased tremendously after the

initiation of trade reform measures in 1991. For example, in the Seventh Plan (1985

– 90), invisibles were able to finance only 25 per cent of trade deficit. But, from

Eighth Plan onwards, the net invisibles have been able to finance more than 50 per

cent of trade deficit. In the Tenth Plan (2002 – 07), almost 99 per cent of trade

deficit was financed by invisibles. This is because in the first two years of the Tenth

Plan (2002 – 03 & 2003 – 04), the net invisibles were more than the trade deficit,

resulting into current account surplus, in these two years. Our analysis shows that

during the post – reform period from 1991 – 92 to 2006 – 07 the average Net

360

Invisibles / GDP ratio was 2.75 per cent. During the same period, our moving

average analysis shows a rising trend. Hence, we can conclude that invisibles have

played an important role in narrowing down the CAD.

With respect to current account deficit it is observed that in the post – reform period,

the current account deficit has been comfortably financed and it remained around

one per cent of GDP. The average CAD / GDP ratio works out to be 1.02 per cent

from the period 1991 – 92 to 2000 – 01. Further, there was a current account surplus

for three consecutive years from 2001 – 02 to 2003 – 04. Our analysis shows that the

average CAD/GDP ratio during the period 1991-92 to 2006 -07 is 0.55 per cent. At

the same time, all the moving averages show a falling trend during the said period.

In the case of India, in 1980s, the large fiscal deficits were accompanied by current

account deficits. Some of the empirical studies undertaken in the context of India,

had supported the existence of twin deficit phenomenon. Our analysis also shows a

high degree of positive correlation between CAD & FD in the pre – reform period

from 1981- 82 to 1990 - 91.

The post – reform period however, shows a different picture and reflects the absence

of twin deficit phenomenon. It is observed that since the mid – 1990s, higher fiscal

deficits have been accompanied by a narrowing of the current account deficit. The

average current account deficit from 1991 – 92 to 2000 – 01 works out to be 1.02,

while the average fiscal deficit is 5.67 during the same period. Our analysis shows a

weak negative correlation between CAD & FD in the post - reform period. The

average FD/GDP ratio is 5.30 per cent while the average CAD / GDP ratio is 0.55

per cent, during the period 1991 – 92 to 2006 – 07.

The trends in capital account show that in the post – reform period, India has

followed a policy of encouraging capital flows in a cautious manner. The evolution

361

of capital flows over the 1990s reveals a shift in emphasis from debt to non – debt

flows with the declining importance of external assistance, ECBs and NRI deposits

and the increased share of foreign investment.

Most of the debt sustainability indicators after 1990s. have shown a steady and

gradual improvement. For instance, external debt to GDP ratio has come down

from 38.70 in 1992 to 22.0 in 2000 and further to 17.80 in 2007 and the debt service

ratio has come down from 30.20 in 1992 to 17.10 in 2000 and to 4.80 in 2007.

The Indian approach to capital account liberalization has been one of gradualism,

wherein liberalization of the capital account is considered as a continuous process

rather than as a single event. The program of capital account liberalization has been

undertaken on the basis of Report of the two Committee’s on Capital Account

Convertibility which were chaired by Shri. S. S. Tarapore.

With respect to the impact of reforms on inflation, it is observed that during the first

half of 1990s the average WPI inflation rate was 10.0 per cent per annum, while the

second half of 1990s reflected a declining trend and it was 5.0 per cent per annum.

After the introduction of reforms in July 1991 major changes were also introduced

in the industrial sector. The trends in industrial growth rate showed that the average

industrial growth rate was 7.4 per cent per annum during the Eighth Plan which

declined to 5.0 per cent per annum in the Ninth Plan. The industrial growth rate

however recovered in the Tenth Plan and it was 8.0 per cent per annum.

The reforms initiated in July 1991 seems to have contributed to economic growth of

the country. The data on Real GDP growth reveals that during the Eighth Plan

period, the average Real GDP growth rate was 6.5 per cent per annum, which

reduced to 5.5 per cent per annum in the Ninth Plan. In the Tenth Plan, there was

revival of economic growth and the average growth rate was 7.5 per cent per annum.

362

One of the important developments which took place in the second half of 2007

which affected the entire world was the US sub – prime crisis, which subsequently

became a global financial and economic crisis. The global economic crisis started

impacting India from the beginning of 2008. The global financial crisis led to rise in

CAD / GDP ratio, fall in foreign investments and rise in capital outflows,

depreciation of rupee, etc. At the same time it led to fall in real GDP growth rate,

rise in inflation, fall in industrial growth rate and rise in fiscal deficit. To overcome

the crisis, both the Government of India and RBI undertook several measures. For

instance, the Government of India undertook a fiscal stimulus package and RBI

announced reduction in CRR, SLR and other key policy rates. It can be concluded

that three factors helped India to cope up with the crisis. They were – (a) well –

regulated financial sector, (b) gradual and cautious opening up of capital account,

and (c) the availability of large stock of foreign exchange reserves.

The preceding analysis amply proves that the hypotheses noted at the beginning of

the present research study are hereby validated and thus they stand accepted.

NOTES & REFERENCES NOTES a. Both NEER & REER are 36 currency bilateral trade based weights. b. The detailed Reports of Tarapore Committee I, and Tarapore Committee II, are given in Chapter IV – Review of Literature of the present study. REFERENCES 1. Reserve Bank of India (2002) – Report on Currency & Finance 2001 – 02, Mumbai, Chap. VII, p. 12. 2. Ibid, Chap. VII, p. 12. 3. Ibid, Chap. VII, p. 12. 4. Ibid, Chap. VII, pp. 12 -13.

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5. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. IV, pp. 90 – 91. 6. Reserve Bank of India (2002) – Report on Currency & Finance 2001 – 02, Mumbai, Chap. VII, p. 18. 7. Government of India (2008) – Economic Survey 2007 – 08, Ministry of Finance, Economic Division, New Delhi, p. 109. 8. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. V, p. 131. 9. Reddy Y. V. (2005) – “Overcoming Challenges in a Globalising Economy : Managing India’s External Sector” – RBI Bulletin, Vol. LIX, No. 7, July 2005, p. 618. 10. Ghosh Jayati (1990) – “Exchange Rates & Trade Balance – Some Aspects of Recent Indian Experience” - Economic & Political Weekly, Vol. XXV, No. 9, March 3, 1990, pp. 441 – 445. 11. Sarkar Prabirjit (1992) – “ Rupee Depreciation and India’s External Trade and Payments since 1971 ” – Economic & Political Weekly, Vol. XXVII, Nos. 24 & 25, June 13 – 20, 1992, pp. 1259 – 1266. 12. Patra Michael & Pattanaik Sitikantha (1994) – “Exchange Rate Pass through and the Trade Balance: The Indian Experience” - RBI Occasional Papers, Vol. 15, No. 4, December 1994, pp. 281 – 314. 13. Ranjan Rajiv (1995) – “Competitiveness of India’s Exports: Some aspects” - RBI Occasional Papers, Vol.16, No. 4, December 1995, pp. 257 – 300. 14. Dholakia R. H. & Saradhi R.V. (2000) – “Exchange Rate Pass Through & Volatility: Impact on India’s Foreign Trade” – Economic & Political Weekly, Vol. XXXV, No. 47, Nov. 18, 2000, pp. 4109 – 4116. 15. Mallik Jayanta Kumar (2005) – “India’s Exports – Policy Defeating Exchange Rate Arithmetic” - Economic & Political Weekly, Vol. XL, No. 52, December 2005, pp. 5486 – 5496. 16. Veeramani C. (2007) – “Sources of India’s Export Growth in Pre- and Post – Reform Periods” - Economic & Political Weekly ,Vol. XLII, No. 25, June 23, 2007, pp. 2419 - 2427 17. Kulkarni Kishore G. (1996) – “Balance of Payments Changes & the Exchange Rate Devaluation – A Case of India” – Indian Journal of Economics, Vol. LXXVI, Part IV No. 303, April 1996, pp. 415 – 425. 18. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. V, pp. 127 – 128.

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19. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. V, p. 121. 20. Reserve Bank of India (2002) – Report on Currency & Finance 2001 – 02, Mumbai, Chap. VII, p. 25. 21. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. VI, p. 151. 22. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. VII, p. 215. 23. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. VII, p. 203. 24. Government of India (2008) – Economic Survey 2007 – 08, Ministry of Finance, Economic Division, New Delhi, p. 136. 25. Government of India (2008) – Economic Survey 2007 – 08, Ministry of Finance, Economic Division, New Delhi, pp. 137 – 138. 26. Pattanaik et al (2003) – “Exchange Rate Policy & Management: The Indian Experience”– Economic & Political Weekly, Vol. XXXVIII, No. 2, May 31, 2003, pp. 2139 – 2154. 27. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. VII, p. 192. 28. Nachane D. M. (2007) – “Liberalisation of Capital Account:Perils & Possible Safeguards” - Economic & Political Weekly, Vol. XLII, No. 36, Sept. 8 – 14, 2007, pp. 3633 – 3643. 29. Rajwade A. V. (2007) – “Risks & Rewards of Capital Account Convertibility”– Economic & Political Weekly, Vol. XLII, No. 1, January 6, 2007, pp. 29 – 34. 30. Nachane D. M. (2007) – “Liberalisation of Capital Account: Perils & Possible Safeguards” - Economic & Political Weekly, Vol. XLII, No. 36, Sept. 8 – 14 2007, pp. 3633 – 3643. 31. Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03, Mumbai, Chap. VII, p. 230. 32. Vasudevan A. (2006) – “Great Indian Story of Convertibility”– Economic & Political Weekly, Vol. XLI, No.19, May 13 – 19, 2006, pp. 1882 – 1883. 33. Mohan Rakesh (2009) – “Growth Record of the Indian Economy, 1950 – 2008: A Story of Sustained Savings & Investment” in Kapila Uma (Ed) – Indian Economy Since Independence – New Delhi, Academic Foundation, pp. 684 – 686. 34. Kapila Uma (2009) – “Global Financial Crisis” in Kapila Uma (Ed) - Indian Economy Since Independence – New Delhi, Academic Foundation, p. 644.

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35. Government of India (2009) – Economic Survey 2008 – 09, Ministry of Finance, Economic Division, New Delhi, p. 126. 36. Callen Tim & Cashin Paul (1999) – “External sustainability in India” - IMF Working Paper, No. 99 / 181, December 1999, pp. 1 – 30. 37. Reserve Bank of India (1993) – Report of High Level Committee on Balance of Payments ( Chairman : C. Rangarajan ) – RBI Bulletin ,Vol.XLVIII, No.8, August 1993, pp.1139 – 1180. 38.Reserve Bank of India (2003) – Report on Currency & Finance 2002 – 03 Mumbai. Chap V.p.130.

39. Ibid. Chap. V.p.130.

40. Ibid. Chap. V.p.133.