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Delicate Situation of India's BOP
Delicate Situation of India's BOP
Delicate Situation of India's BOP
BY
Report submitted in partial fulfillment of the requirements of course ECON C421: Issues in Indian Economy
Table of Contents
1 3 4 5 6 7 8 ACKNOWLEDGEMENTS ........................................................................................................................................................... 3 INTRODUCTION ....................................................................................................................................................................... 4 SIGNIFICANCE OF THE STUDY .................................................................................................................................................. 5 OBJECTIVE AND PERIOD OF THE STUDY .................................................................................................................................. 6 REVIEW OF LITERATURE .......................................................................................................................................................... 7 UNDERSTANDING BALANCE OF PAYMENTS ............................................................................................................................ 8 HISTORY OF INDIAS BOP SINCE INDEPENDENCE .................................................................................................................... 9 8.1 8.2 8.3 9 Period from 1949-1991: ................................................................................................................................................ 9 Period from 1990-99: .................................................................................................................................................... 9 Period from 2000-present: .......................................................................................................................................... 10
CAUSES OF BOP DISEQUILIBRIA WITH SPECIAL REFERENCE TO INDIA .................................................................................. 11 9.1 9.2 9.3 9.4 9.5 9.6 9.7 Structural changes in the economy ............................................................................................................................. 11 Cyclical changes in the economy ................................................................................................................................. 11 Changes in exchange rate ............................................................................................................................................ 11 Changes in National Income ........................................................................................................................................ 12 Price changes ............................................................................................................................................................... 12 Capital movements...................................................................................................................................................... 12 Other factors ............................................................................................................................................................... 12 ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE ECONOMY ........................................................... 13 10.1 Merits of CA Deficit ..................................................................................................................................................... 13 Sound Capital Market ........................................................................................................................................ 13 Current Account financed by foreign investment .............................................................................................. 14 Benefits of Long term Investment ..................................................................................................................... 14 CA deficit as an engine of growth ...................................................................................................................... 14
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Demerits of CA Deficit ................................................................................................................................................. 15 Financing of CA deficit by Borrowing ................................................................................................................. 15 Low Competitiveness ......................................................................................................................................... 15 Increasing claim on Indian assets by foreigners ................................................................................................. 15 Drying up of Capital Flows ................................................................................................................................. 16 Lower Economic Growth.................................................................................................................................... 16 Replacement of Domestic Products with Imported Goods................................................................................ 16
1 ACKNOWLEDGEMENTS
I would like to thank our course instructor, Mr. N. Kubendran, without whose support, this report couldnt have been completed. Id also like to thank our other instructor, Mr. Ashwini Kumar Mishra, whose deep insights into this topic have proven useful to me in the completion of this report.
3 INTRODUCTION
The international Balance of Payments (BOP) of any country is a measure of its economic performance as compared to the rest of the world. In this regard, it becomes imperative to study the nations Balance of Payments trends, so that necessary corrective policies and actions may be taken to improve the nations economic standing in the world. With respect to India, its BOP situation is quite delicate now. The problem of BOP disequilibrium has been persisting in India right since independence, which led to the BOP crisis of 1990-91. Even though the BOP situation has improved since then, BOP management still remains one of the main concerns for Indian policy makers. This report describes ,firstly, the structure of BOP (the manner in which BOP is calculated) so that it is easier for the reader to appreciate the significance and implications of the BOP trends and it then moves on to describe in detail the trends of BOP in India right from Independence till today. Secondly, a list of all internal and external factors for BOP disequilibria problem have also been listed as well as the impacts of the various policies on Indias BOP, that the Government of India has implemented. Both pros and cons of such policies have been evaluated. Lastly, further policy recommendations have been made to further improve the current BOP scenario and reduce the BOP deficits.
6 REVIEW OF LITERATURE
The problem regarding the current BOP scenario of India is of significant importance. According to Anita Chanda (Indias Balance of Payments-2010), Indias poor BOP situation during the post independence period right till the 1990s was because of the protectionist policies that India implemented. She also maintains that it was only because of the New Economic Policy (NEP) regime that Indias BOP situation improved. She also says that even though India has maintained a decent BOP position, BOP management still remains an issue of concern for policy makers, as now India is exposed to every change in the global scenario. Manu Gupta (What is Balance of Payments and what does it mean for your business-2009) is of the opinion that healthy BOP position term is relative to every country. While developed countries have surplus in Current Account, developing countries like India place more importance on Capital Account surplus. He also says that BOP position of a country is of prime importance for a countrys trade as it influences the decisions of policy makers. Richard Pettiger (Is a Current Account deficit harmful? 2005) says that a current account deficit can prove to be harmful only if the deficit is financed by borrowing or by running down reserves as this leads to depreciation of the currency. He further says that if however, the deficit is financed by long term investment; it can lead to increased productive capacity and more exports and help in the growth of the economy.
Capital Account (KA) This measures the change in the domestic countrys assets abroad and foreign assets owned in the domestic country. It includes the following subheads Foreign Investment (FIIs and FDIs), Loans, Banking Capital, Rupee Debt Service and Other Capital.
The Foreign Exchange Reserves of a country can be measured as the negative of the sum of the Current Account and the Capital Account, that is, R = - (CA+KA)
done to counter the weak BOP position of India. Some of them were float of the Rupee, Industrial delicensing, fiscal adjustment, tight caps on external borrowing and lowering of direct and indirect taxes. The BOP position of India steadily became more stable, after overseeing the initial doubts during the period 1991-99.
Currently, Indias foreign exchange reserves are quite comfortable, exchange rate is pretty competitive and exports and capital inflow through FDIs are also encouraging. The BOP situation of India is fairly well managed, although it rests on a very precarious position. The main concern for India now, is the increasing Current Account deficit.
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10 ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE ECONOMY
As mentioned earlier, BOP of any nation has two components: Current Account (CA) Capital Account (KA)
Currently, India has a CA deficit and a KA surplus. Its BOP situation is precarious and unless India treads with caution, it might worsen again. A Current Account deficit can have both favourable and unfavourable impacts on the Indian economy. Both the merits and the demerits of a CA deficit have been presented below, through a detailed analysis.
10.1.1
India is emerging as one of the most favoured venues for overseas investments, especially after the global recession of 2008. It has one of the most open and sound capital markets in the world, and since so far, after 2008, financing a trade deficit in goods and services has not led to a sharp decline in the value of the Rupee, there is little need to be concerned about the CA deficit. In such a case, a CA deficit will only serve to strengthen a developing economy like India.
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10.1.2
A Current Account deficit can be considered to be a by-product of Indias rapid economic growth and its appeal as a hot destination for foreign investment. CA = S I, where S = Savings & I = investments According to this relation, a CA deficit exists when I>S, as a result of which foreign investment occurs. Whenever I>S, the overspending or the investments abroad must be financed by foreign investment. This implies that there will exist a KA surplus, because more and more foreign firms will invest capital in India, thus making up for the CA deficit. India currently has a CA deficit; this simply indicates that India is importing capital from abroad. This can in turn allow India to increase its exports and eventually, reverse its deficit.
10.1.3
CA deficit is financed partly by long term investment. In such a scenario, India stands to gain a lot from the benefits of long term investment, which include: Increased productive capacity Favourable working practices of foreign firms More jobs Increased exports in the distant future
10.1.4
A Current Account deficit for India indicates a growing demand for imports, and only if Indias economy is growing and expanding as well as creating jobs and Disposable Income can there be an increase in the demand for imports. This clearly shows that there is a direct coherence to Indias CA deficit and its economic growth.
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10.2.1
Financing of CA deficit through borrowing or running down reserves will prove unsustainable in the long run. This in turn would lead to depreciation of the Rupee as the supply of the Rupee would exceed it demand. Such a rapid depreciation will in turn lead to problems like inflation and falling confidence in India. Imported good will become more expensive and depreciation of the Rupee will reduce the living standards.
10.2.2
Low Competitiveness
Indias CA deficit has been persisting since 2004 and has been increasing since then. Such a persisting deficit suggests a fundamental weakness in the Indian economy. It may lead to: Decreasing competitiveness Decreasing productive capacity Declining comparative advantage in various manufactured goods
These factors could have a profound and adverse impact on job creation in India, leading to unemployment, thereby worsening the situation and leading to lower growth and development of the economy.
10.2.3
India has primarily relied upon attracting foreign investment in the form of FDIs and FIIs to finance the CA deficit. This means that foreigners now have an increasing claim on Indian
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assets. If the foreigners were to withdraw their investment from India due to some economic crisis, it would leave India highly vulnerable.
10.2.4
Since the rates of borrowing from other countries is pretty high, Capital flows may dry up and India will no longer be able to finance its CA deficit by attracting capital flows from different countries. This will in turn pile up the external debt burden of India.
10.2.5
If the Indian CA deficit is due to excessive consumer demand, a recession or slowdown will help to resolve the problem. As consumers cannot go on spending far in excess of their income forever, they have to start saving and controlling their expenditure to improve their own finances. To accomplish this, both high interest rates and significant reductions in consumer spending will be required, and this could ultimately push India into recession or slowdown of the economy, leading to overall lower economic growth.
10.2.6
Since India faces a CA deficit, most often domestic products are replaced by imported goods, and thus, when the imported goods are growing, it signals a weakening Indian economy.
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Adopt import substitution and introduce QRs thereby prohibiting imports and solving Indias current CA deficit. The CA deficit of India can also be corrected to a large extent by taking loans, attracting FDIs and FIIs and through Tourism and Transportation development as well.
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12 CONCLUSION
The volume of a countrys current account (one of the two main components of BOP) is a good sign of economic activity. By analyzing the current account, one can get a clear picture of the extent of economic activity of a country- including its industries and its capital markets. However, depending on whether the nation is a developed or a developing nation and its goals, the state of the current account decides whether the economy is prospering or not. Since India is a developing country, a Current Account deficit works well for Indias economic progress as long as it is kept in check. However, since 2004, the Current Account deficit of India has been increasing continuously and if it continues to increase, Indias economic growth might become unsustainable. When analyzing the Current Account of India, it is important to know what is fueling the extra deficit and what is being done to counter the effects and whether the actions being taken are providing results or not. The primary aim for India is to control this deficit before it gets out of hand. This report has dealt exclusively with the causal factors of BOP disequilibria in India and various policy measures that reduce the demand for imports and increase exports have been suggested that can combat the Current Account deficit of India.
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13 BIBLIOGRAPHY
Article by Richard Pettinger on the topic Is Current Account Deficit Harmful (2005)
Pierre-Olivier Gourinchas, Olivier Jeanne.2002. On the benefits of Capital Account Liberalization for Emerging Economies June 2002. Article by Manu Gupta on the topic What is Balance of Payments and What does it mean for your Business? (2009) Article by Anita Chanda on the topic Indias Balance of Payments (July 2010) Dominick Salvatore.2004. International Economics 8th edition by John Wiley & Sons, Inc.
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