by,

DERRICK VIJAYAN

BOP: BASIC OVERVIEW

PRE-CRISIS PERIOD

BOP 1991 CRISIS: CAUSES

BOP 1991 CRISIS: IMPACTS

REFORMS AND POLICIES

DEVELOPMENTS AFTER THE CRISIS

AGENDA

India’s BOP crisis

“The balance of payments of a country is asystematic record of all economic transactionsbetween the residents of a country and the rest ofthe world. It presents a classified record of allreceipts on account of goods exported, servicesrendered and capital received by residents andpayments made by them on account of goodsimported and services received and capitaltransferred to non-residents or foreigners.”

–Reserve Bank of India

Balance of payments (BOP)

An accounting record of all monetary transactions between a country and the rest of the world.Summarises international transactions for a specific period, usually a yearPrepared in a single currency, typically the domestic currencyIndicator of economic and political stabilityVisible Items: All types of physical goods exported/importedInvisible Items: All types of services Capital transfers: Capital receipts/payments

Definition

Current Account• Import and Export of goods• Import and Export of services• Unilateral transfers from one country to another

Capital Account• Foreign Investment

• FDI & portfolio Investment• Loans

• Commercial Borrowings, External Assistance & Banking Capital Transactions

Components of BoP

Current Account Balance =

Balance of Visible Trade(goods) + Balance of Invisible Trade(services) + Balance of Unilateral transfers

Capital Account Balance = Inflow of foreign exchange – outflow of foreign exchange

Official Reserves: The holdings of foreign reserves and gold by official institutions like the central bank

Overall Balance of Payment =

Current Account Balance+ Capital account balance+

Official Reserve Account

Overall Balance of payments

Overview of Macroeconomic and Monetary situations of the economyStudy on prospects of direct investment to the nationImplications on the exchange rate of the currency Provides data for economic analysis Reveals changes in the composition & magnitude of foreign trade Provides indications of future repercussions of country’s past trade performances Reveals the weak and strong points of a country’s foreign trade relations

Uses of BoP Analysis

Economic factors• Huge development expenditure owing to which there are large

scale imports• Business cycles in terms of recession, depression, recovery and

boom• High rate of inflation running up to large scale imports of

essential goods• Decline of import substitutes which would necessitate and

increase in imports• Change in cost structure of trading partners

Political factors• Political Instability leading to decline in FDI and FII• Populism policies which may encourage imports

Social factors• Change in tastes and preferences leading to demand changes• Cross border prejudices which may lead to expensive sources of

imports

BoP crisis- Factors and causes

Pre-CRISIS PERIOD

GDP growth rate: 5.5 % (3.3% on a per capita basis)

Industrial Growth : 6.6%

Agriculture: 3.6%

Investments went from nearly 19% of GDP from to 1970s to 25% by end on 1980s

Composition was predominantly primary sector which accounted for 32.8% of the GDP

Economic Indicators-pre Crisis period

Protectionist Policies- defined objective of self reliance through industrialization and import substitution

Focus was on substituting imports and promoting domestic industries by heavy intervention while a gross negligence on exports

External Debt- The development projects caused a large scale foreign borrowing which created pressure on the government

Economic Policies

Export promotion- Indian exports were largely dependent on world trade situation due to predominance of primary goods in trade mix combined with lower quality standards.

Exchange rate- Fixed exchange rate was followed and constant devaluations by the central bank to promote exports raised the amount of external debt.

Strong inward looking policy in all

Economic policies

Government Deficit and Current Account- Pre 1991 levels

Real and Nominal Exchange ratesPre 1991 levels

External Debt and For-ex reserves-Pre 1991 levels

Capital inflows mainly consisted of aid flows, commercial deposits and Non resident Indian deposits

FDI was heavily restricted and foreign portfolio investments generally channelized to public sector issued bonds

Gradual loss of for-ex reserves and deterioration of trade balance due to fixed nominal exchange rate which was declining over the 1980s

Trends in Pre BOP crisis period

Trends in For-ex reserves-Figures

Sharp rise in imports due to growth orientation and ( petroleum imports rose by 40% from 1986-87 to 1989-90 )

Doubling of external debt from 1984-85 ($35 bn) to 1990-91 ($69 bn)

Loss of investor confidence led to outflows being increasingly dependent on short term external debts. An unstable government and the gulf crisis further aggravated the situation

Trends… contd

Trends in trade deficit-Figures

High revenue deficits especially after 1986, for which the government responded by creating a surplus capital account to finance them

Trends….contd

THE CRISIS

Also known as the “Unfortunate period” of Indian Economy.

Gulf crisis of 1990 – increase in oil import bill

Deterioration of invisible account

Increase in price of oil => overall current account deficit in 1990-91 : US $ 9.7 billion

•Important trading partners like US, Russia turned up to invest in India

•Export growth reduced to 4%

Balance of payments: The Crisis

World growth declined from 4.5% in 1988 to 2.5% in 1991

Political turmoil – VP Singh government overthrown, Rajiv Gandhi assassination – reduced credibility of India, investors lost interest and trust in India’s government.

Foreign reserves very low at $1.2 billion

Overshot IMF SDR reserves

Simultaneous outflow of NRI deposits

Serious difficulties in rolling over of short term loans

Current account deficit of $9.7 billion almost impossible to finance

Balance of payments: The Unbalance

Current account deficit averaging 2.2% of the GDP hit hard by the Gulf war

Triggers• oil bill increased by $2 billion• overseas markets for exports shrinked (West Asia, Soviet Union)

• Fall in remittances

The Reserve Position in IMF of $660 million was drawn in full by September, 1990 to add to the reserves

The international credit rating agencies placed India on the “watch list” in August 1990

Developments in 1991

Curb imports to reduce deficit• Surcharge on oil imports

• Cash margin

Import compression

-20

-10

0

10

20

30

1989-90 1990-91 Apr-Sep 1991

% ch

ange

Import Trends

Bulk imports

Capital goods

Export related imports

-50

-40

-30

-20

-10

0

10

20

30

40

% c

hang

e

IIP and Imports

IIP

Non -oil Imports

Import compression effects

Agreement with IMF for a drawing of $1,025 billion under its Compensatory and Contingency Financing Facility (CCFF)Drawings of $789 million from the first credit tranche made in Jan,1991 Despite the drawings, the situation was hardly under control. Between March 1991 and June 1991, there was a sharp withdrawal of non-resident deposits to the extent of $952 million leading to further drop in foreign exchange reserves

What actually happened…..

Despite low trade deficit ,the slide in foreign reserves continued unabated

Essentially became a “crisis of confidence”

The Crisis

Foreign exchange reserves fell below $1 b

Barely enough to cover 2 weeks of imports

Likely ramifications

The Crisis (Contd.)

Foreign exchange reserves

As a first step, in May 1991, the government leased 20 tonnes of confiscated gold to the State Bank of India for $200 million

Later, RBI moved in four installments 47 tonnes of the gold held by it to the vaults of the Bank of England to raise a temporary loan of $405 million jointly from the Bank of England and the Bank of Japan

Loan repaid in Sep-Nov. and the pledged gold was redeemed

New government assumed charge in June ,1991

The response

Two-step downward adjustment in the exchange rate of rupee was effected on July 1 and 3, 1991

This effectively translated into devaluation of 18-19 per cent against major international currencies

This was coupled with the liberalisation of the trade regime and lower import tariffs

Besides exceptional financing arrangements with the World Bank, Asian Development Bank and a few industrial countries were also negotiated

Due to the currency devaluation the Rupee fell from 17.50 per dollar in 1991 to 26 per dollar in 1992

Short term Structural changes

A High Level Committee on Balance of Payments was set up in December 1991

Liberalized Exchange Rate Management System (LERMS) and move to a single market based exchange rate system

This obviates the need for the RBI to determine the rate daily

However, the need to monitor and watch the movements in the markets assumes importance, as foreign exchange markets tend to overshoot often

Long term Structural changes

Macroeconomic stabilization on four fronts to basically improve efficiency and spur exports•Fiscal correction – lowering of government spending

•Trade policy reforms – eximscrips• Industrial policy reforms – end of “license raj”

•Public sector reforms – autonomy and efficiency

Long term Structural changes (Contd.)

REFORMS & IMPACTS

Rebalancing by changing the exchange rate

An upwards shift in the value of domestic currency relative to others will make exports less competitive and make imports cheaper and will tend to correct a current account surplus.

Exchange rates can be adjusted by government in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance

Balancing mechanism

Government allowed Reserve Bank of India to ship 47 tonnes of Gold to the Bank of England in July 1991.

Short-term debt was reduced and strict controls put in place to prevent future expansion

Foreign exchange reserves were consciously accumulated to provide greater insurance against external sector stresses and uncertainties

Balance of Payments: Policies

Fiscal Correction:

Abolishing export subsidies, increasing fertilizer prices, as well as by keeping non- plan expenditure in check.

Budget projected a sharp decline in the budget deficit to Rs.7719 crore in 1991-92.

Fiscal deficit was also projected to decline from Rs 43,331 crore in 1990-91 to Rs 37, 772 crore in 1991-92.

Reforms Undertaken

Industrial Policy Reforms:

80 % of the industries were taken out from the licensing framework.

MRTP Act was amended to eliminate the need for prior approval by large companies for capacity expansion or diversification.

Areas reserved for public sector was narrowed down and greater participation was permitted from the private sector.

Reforms Undertaken

The limit of foreign equity holders was raised from 40 to 51 % in the wide range of priority industries.

Technology imports for priority industries are automatically approved for royalty payments upto 5 % of domestic sales and 8 % of export sales or for lumpsum payments of Rs 1 Crore.

Reforms Undertaken

Results of Industrial Reforms:

The number of investment approvals rise from 3335 in 1990 to 5538 in 1991.

505 foreign technology import agreements were also approved.

In 1991, a total of 244 cases of foreign equity participation with the proposed equity investment of $ 504 million was approved.

Reforms Undertaken

Public Sector Reforms:

Government undertook a limited disinvestment of a part of public sector equity to the public through financial institutions and mutual funds in order to raise non- inflationary finance for development.

Sick Industrial Companies Act: To Bring public sector undertakings also in purview.

Reforms Undertaken

Trade Policy Reforms:

Large part of administered licensing of imports was replaced by import entitlements linked to export earnings.

Advance licensing system for exports was simplified so as to improve exporters’ access to imported inputs at duty- free rates.

Scope of canalization for both exports and imports was narrowed.

Reforms Undertaken

Anti-export bias in the trade and payments regime was also reduced substantially

Effects of these reforms was to reduce the degree of licensing in import trade, to broaden, to enhance and harmonize export initiatives.

Reforms Undertaken

Foreign exchange reserves had been build up to respectable level of $5.63 billion from a low of $1.29 billion at the end of July 2001.

Introduction to LERMS( Liberalized exchange rate management system)

Mobilization of external assistance from IMF, World Bank , ADB and Bilateral donors to support the BOP

Balance of Payments: 1992-93

Introduced, from March 1992, a dual exchange rate system in the place of a single official rate.

One official rate for select government and private transactions and the market-determined rate for the others.

Treated current and capital transactions in different ways.

Decision to permit gold imports was linked to LERMS

LERMS

Despite the increase in imports to more normal levels during 1992-93, it has been possible to manage the BOP with the stable exchange rate and comfortable foreign exchange reserves throughout the year.

Contd..

BOP Surplus:• External sector - growth rates moving up to 11 and

20% in the two years ended March 2001• India successfully withstood the sharp rise in

international oil prices since the closing months of 1999.

• NRI deposits with the banking system in India on the rise from 13 billion dollars in 1991-92 to 23.8 billion dollars by March 2001

• BOP recorded an overall surplus consecutively for five years from 1996-97

• India’s foreign exchange reserves, 1 billion in 1990 reached $ 40 billion the average annual addition being 4.5 billion dollars

Effects of Liberalization

Trade and Investments:

Rise in FDI’s and other capital flows

Under the category of “Invisibles”, a significant increase in private transfers.

Private transfers grew to a level of 10-12 billion dollars in the latter half of 1990’s.• Increase in exports level and exchange rate reforms :

the major factors that helped contain the current account deficit in BOP to 1 to 1.5 per cent of GDP between 1991 and 2001

• In ten years, 1991- 2001, • Over 37 billion dollars of foreign investment flowed• 18 billion $ was direct investment.

Effects of Liberalization

Acceleration of GDP growth to 6.7 per cent in the period 1992-97 was the highest India had ever achieved over a five year period.

Sum of external current payments and receipts as a ratio to gross domestic product (GDP) doubled from about 19% in 1990–91 to around 40% by March 2001

Manufacturing achieved average real growth of 11.3 per cent in the four years 1993-94 to 1996-97

Export growth in dollar terms averaged 20 per cent in the three years 1994 – 1996 and the rates of aggregate savings and investment in the economy peaked in 1995-96

Developments in the next decade

Private Investments showed an high growth of 16.34 % per annum during 1992-96.

Real fixed investment rose by nearly 40 %, led by a more than 50 % increase in industrial investment

Developments in the next decade

External Commercial Borrowings

External Commercial Borrowings

1993-94:

1994-95:

1995-96:

External Assistance

PMU : Project Management Unit was introduced,as part of the department of Economic Affairs to monitor ,supervise and strengthen various projects.

In 1994-95 decided not to approach IMF for medium term funds.

Advance release of funds to state governments

Developments in the decade

Export Growth

Decline in world trade since the second half of 1997

Decline in export prices of some major items of manufactured goods

Growing infrastructure bottlenecks

Appreciation of the rupee in real effective exchange rate terms.

Decline of Growth in 1997

Growth of Imports

References