The Financial Sector

Structure, Performance and Reforms

THE financial sector plays a major role in the mobilisation and

allocation of savings. Financial institutions, instruments and markets
which constitute the financial sector act as a conduit for the transfer
of financial resources from net savers to net borrowers, i.e., from
those who spend less than they earn to those who earn less than they
spend. The gains to the real sector, therefore, depend on how
efficiently the financial sector performs this function of
intermediation. l

Financial Sector Development in India

The Indian financial sector today comprises an impressive
network of banks and financial institutions and a wide range of
financial instruments.

Institutional Structure
At present, the institutional structure of the financial system is
characterised by (a) banks, either owned by the government, the RBI,
or the private sector (domestic or foreign) and regulated by the RBI;
(b) development financial institutions and refinancing institutions, set
up by a separate statute or owned by the Government, RBI, private,
or other development financial institutions under the Companies Act
and regulated by the RBI; and (c) non-bank financial companies
(NBFCs), privately and regulated by the RBI.
Provision of short-term credit is entrusted primarily to commercial and
cooperative banks. Of late, commercial banks have owned diversified into
several new areas of business such as merchant banking, mutual funds,
1. Rangarajan, C. and Narendra Jadhav (1992). "Issues in Financial Sector Reforms", in Bimal Jalan
(ed.), The Indian Economy: Problems and Prospects, Viking, New Delhi.
Pedormance
leasing, venture capital, factoring and other financial services. In
addition, there is a wide network of cooperative banks and
cooperative land development banks at state, district and subdistrict
levels. Together, commercial and cooperative banks hold around
two-thirds of the total assets of the Indian financial system
(Rangarajan and Jadhav, 1992).
Medium-term and long-term finance is provided primarily by a
few large all India development banks together with a spectrum of
state level financial institutions. While the Industrial Development
Bank of India (IDBI), the National Bank for Agriculture and Rural
Development (NABARD), the Export-Import Bank of India (EXIM
Bank) and the National Housing Bank (NHB) serve as apex agencies
in their respective areas of concern, there are also other financial
institutions which specialise in areas like tourism and the small-scale
industry.
Besides these, there are investment institutions, which include
the Unit Trust of India (UTI), the Life Insurance Corporation (LIC)
and the General Insurance Corporation (GIC). In recent years, a
number of public sector mutual funds have been set up by banks and
financial institutions. In addition, a large number of private sector
non-bank financial companies undertake para-banking activity
mainly in the area of hire-purchase and leasing.
The capital market has witnessed a remarkable growth in the
paidup capital of listed companies and market capitalisation in recent
years. With a network of 23 stock exchanges and as many as 9,413
listed companies in 2003, it has emerged as one of the important
markets in the developing world. The Securities and Exchange
Board of India (SEBI) has been established to regulate the capital
market.
Capital Markets
The 1990s have been remarkable for the Indian equity market.
The market has grown exponentially in terms of resource
mobilisation, number of stock exchanges, number of listed stocks,
market capitalisation, trading volumes, turnover and investors' base
(Table 22. l). Along with this growth, the profile of the investors,
issuers and intermediaries have changed significantly. The market
has witnessed a fundamental institutional change resulting in drastic
reduction in transaction costs and significant improvement in
efficiency, transparency and' safety (NSE, 2002). In the 1990s,
The Financial Sector: Structure, Performance and Reforms 463
reform measures initiated by SEBI, market determined allocation of
resources, rolling settlement, sophisticated risk management and
derivatives trading have greatly improved the framework and
efficiency of trading and settlement.
Almost all equity settlements take place at the depository. As a
result, the Indian capital market has become qualitatively
comparable to many developed and emerging markets. crore)
Sources : The Stock Exchange, Mumbai and National Stock Exchange.
Rakesh Mohan (2004). Economic Developments in India, Vol. 74. Academic
Foundation, New Delhi.

Although the Indian capital market has grown in size and depth
in the post-reform period, the magnitude of activities is still
negligible compared to those prevalent internationally. India
accounted for 0.40 per cent in terms of market capitalisation and 0.59
per cent in terms of global turnover in the equity market in 2001. The
liberalisation and consequent reform measures have drawn attention
of foreign investors and led to rise in the Flls investment in India.
During the first half of the 1990s, India accounted for a larger
volume of international equity issues than any other emerging market
(IMF Survey, 1995). Presently, there are nearly 500 registered Flls in
India, which include asset management companies, pension funds,
investment trusts and incorporated institutional portfolio managers.
Flls are eligible to invest in listed as well as unlisted securities.
The short-term money market which has links with the entire
spectrum of the financial system, comprises five segments:
the call money market, the inter bank
term deposit market, the bills re discount
market, and the Treasury bill market the
inter-corporate funds market
In recent years, new money market instruments such as Certificates of
Deposits (CDs), Commercial Paper (CP) and 182 days Treasury bills have
been introduced so as to impart liquidity and depth to the money market.
Moreover, a specialised money market institution, named the Discount and
Finance House of India (DFHI), has been established with the objective of
providing liquidity to money market instruments, thereby helping to
develop an active secondary market.

Strategy of Development
The role of central banking and the financial system in the
process of economic development was recognised at an early stage.
The First Five Year Plan stated that:
"Central banking in a planned economy can hardly be confined
to the regulation of overall supply of credit or to a somewhat
negative regulation of the flow of bank credit. It would have to take
on a direct and active role, firstly in creating or helping to create the
machinery needed for financing developmental activities all over-the
country and secondly, ensuring that the finances available flow in the
directions intended. "
During the 1950s and 1960s, the major concern was to create the
necessary legislative framework to facilitate reorganisation and
consolidation of the banking system. The year 1969 was a major
turning point in the Indian financial system when 14 large
commercial banks were nationalised. The main objectives of bank
nationalisation were:
Re-orientation of credit flows so as to benefit the hitherto neglected
sector such as agriculture, small-scale industries and small borrowings.
Widening of branch network of banks, particularly in the rural
and semi-urban areas.
Greater mobilisation of savings through bank deposits.
Between June 1969 and March 1991, the total number of
commercial bank offices rose from 8,262 to as much as 60,570. The
number of rural branches increased from 1,833 to 35,187 during the
same period, accounting for 58.4 per cent of the total as compared
with barely 22 per cent in 1969. Accordingly, the average population
served per bank office declined from 64,000 in 1969 to about 14,000
in March 1991.
 As a ratio of the GDP at current prices, bank deposits expanded
during the period from 15 per cent in 1969-70 to around 48 per cent in
1990-91, thus indicating the banking industry's importance in the
mobilisation of savings. In respect of advances, the expansion during
the same period was from 10 per cent to around 25 per cent of the
GDP, thus providing increasing support to expanding agricultural,
industrial and commercial activities.
The ratio of priority sector advances (i.e. advances to agriculture,
small-scale industries and small borrowers) to net bank credit rose
from 15 per cent in June 1969 to nearly 39.1 per cent in June 1991.
The role of indigenous bankers and moneylenders has declined
considerably over the years. Studies based on surveys indicate that
the dependence of rural households for cash debt from non-
institutional agencies has come down from about 93 per cent in 1950-
51 to as low as 39 per cent in 1981. Thus, the benefits of banking are
no longer confined to a narrow segment of the population. Banking
has acquired a broad base and has also emerged as an important
instrument of socioeconomic change. The other components of the
financial system such as the term lending institutions have also
recorded a similar quantitative and qualitative change.

Indicators

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5
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6.

7.
8.

9.

The mid-1980s saw some movement away from this regulated

regime. Commercial banks were permitted to enter new activities.
Apart from the introduction of new money market instruments,
interest rates in the money market were freed from control. Great
flexibility was introduced in the administered structure of the interest
rate. While deposit rates were made attractive to savers by making
the rate positive in real terms, the structure of lending rates was
simplified by linking the rate of interest largely to the size of loans.
While the progress made by the financial system in general and
the banking and other financial facilities to a larger cross-section of
the people and the country is well recognised, there is a growing
concern over the operational efficiency of the system. There has been
a perceptible decline in the productivity and profitability of
commercial banks. It is estimated that in 1989-90, gross profits
before provisions were no more than 1.10 per cent of working funds.
In 1990, the spread between interest earned and paid as a proportion
of working funds was 3.2 per cent. The establishment expenses as a
proportion of working funds in the same year was 2.05 per cent.
With the decline in the quality of loan assets, (the sticky advances
account for more than 20 per cent of the credit outstanding) the need
for provisioning has become more urgent and several banks are not
in a position to make adequate provisions for doubtful debts. The
financial position of the Regional Rural Banks is far worse with the
accumulated losses completely wiping out the capital in most banks.
The balance sheet of the performance of the financial sector is thus
mixed, strong in achieving certain socioeconomic goals and in
general, widening the credit coverage but weak as far as viability is
concerned (Rangarajan and Jadhav, 1992).
 Directions of Reforms
The financial markets in the industrially advanced countries have
undergone far-reaching changes in the 1980s. Innovations spurred by
deregulation and liberalisation have been a marked feature of this
transformation. Rapid strides in technology in the areas of
telecommunication and electronic data processing have helped to
speed the changes. A major consequence of these changes is the
blurring of the financial frontiers in terms of instruments, institutions
and markets. The distinction between banks and non-banking
financial institutions has become thin. Restrictions imposed earlier
on banks regarding the activities that they can undertake have been
removed one by one. Effectively, universal banking has become the
trend. Another feature of the market is the interlinking of different
national markets. With the dismantling of exchange controls and the
rapid developments in communications systems, funds have started
moving rapidly from one country to another.
It is the interlinking of different national markets which has come to
be known as globalisation. Important financial institutions are present in
all the leading market centres and markets are in operation on a 24 hour
basis. Deregulation has thus meant the dismantling of regulations
relating to entry and expansion; it has also meant the removal of all
direct controls over interest rate wherever they existed. The integration
of markets, both financially and spatially, has led to a more unified
market for the allocation of savings and investment among the
participating countries. The functioning of the financial markets in the
decade of 1980s has, however, raised some serious concerns. There is a
fear that the state of the financial markets is now inherently more risky
than in the past. In a technologically integrated financial world, the
chances of systemic risk increase. The potential damage to the system
arising out of the failure of a large globally active banking or
nonbanking financial institution can be immense. Because of the intense
competition which banks have come to face, both as a consequence of
the growth of non-banking financial institutions as well as securitisation,
it is feared that the quality of bank loans has suffered. With the
spectacular growth of non-bank financial institutions, the question of
adequate supervision of these institutions has also gained urgency. It is
for these reasons that increasing attention is being paid in these countries
towards evolving a common code of prudential regulations applicable to
all countries. Several significant steps have already been taken in this
direction. The new approach is somewhat loosely summarised in the
phrase "with as much freedom as possible and with as much supervision
as necessary" (Rangarajan and Jadhav, 1992).
The issues in financial sector reform, as far as India is
concerned, are in some ways similar to the issues that have surfaced
in the advanced countries. However, there are concerns which are
specific to the Indian situation. The ultimate objective of financial
sector reform in India should be to improve the operational and
allocational efficiency of the system. Even from the point of view of
meeting some of the socioeconomic concerns, it is necessary that the
viability of the system is maintained. It is in this context that a fresh
look at the administered structure of interest rates is called for. The
reform of the Indian financial system must really begin here.
Administered Structure of Interest Rate
The fundamental reason for introducing an administered
structure of interest rates in our country is to provide funds to certain
sectors at concessional rates. While there may be ample justification
for concessional credit to be provided to finance certain activities, a
highly regulated interest rate system has a number of weaknesses.
Government borrowing at concessional rates of interest has become
possible only because of the compulsion imposed on the financial
institutions. This also results in the monetisation of public debt if the
Reserve Bank of India (RBI) is to pick up what cannot be absorbed
by banks and other institutions. Such restrictions, limit the ability of
these institutions to raise resources at market rates. In the case of
credit to other priority and preferred sectors, the burden on the
financial institutions can be tolerable so long as the quantum of such
credit is limited, as there is a limit to cross-subsidisation. The
regulated interest rate structure has, therefore, implications for the
viability of the financial institutions. The reform of the interest rate
structure is thus linked to the system of directed credit as it is
practiced now.
In the case of commercial banks, directed credit takes the forms
of prescription of cash reserve requirement (CRR), statutory liquidity
requirements (SLR) and the allocation of credit for priority sectors. The
CRR and SLR taken together now pre-empt a significant proportion of
the deposit liabilities. Banks are now required to provide 40 per cent of
net bank credit to priority sectors which include agriculture, smallscale
industry, etc. CRR has to be distinguished from SLR. The former is an
instrument of monetary control and its level has to be determined by
monetary authorities taking into account the overall economic situation.
However, statutory liquidity ratio is of a different character and has
become basically an instrument for providing credit to the government
by the commercial banks.
In relation to directed credit for priority sectors the real problem
is not so much the proportion of credit allocated for priority sectors
as much as the concessional rates of interest enjoyed by the
borrowers. Clearly there is a case for re-examination of those who
are entitled to borrow at concessional rates from the banking system.
One immediate way of doing this is to eliminate large borrowers
from the credit to the priority sector. No more than two concessional
rates of interest should be prescribed so as to keep the burden on the
banking system within limits.
The financial system must clearly move towards an interest rate
regime which is free from direct controls. Obviously, interest rate is
an important policy instrument. Monetary authorities the world over
try to influence the level of interest rate through the various
instruments that are available to them. It is not, therefore, argued that
monetary authorities should abdicate an important function of theirs.
The general level of interest rate should be influenced by the
monetary authorities taking into account the overall economic
environment. The issue is whether a structure should be imposed by
the monetary authorities. In moving towards a more deregulated
structure of interest rate, there is considerable historical evidence to
show that such experiments succeed only when the inflationary
pressures are under control. Sharp increases in nominal and real rates
of interest can result in adverse economic consequences. However,
the broad outlines of the reform agenda in terms of the interest rate as
far as India is concerned are quite clear. At least initially from an
elaborate administered structure of interest rate we should move
towards a more simplified system where only a few rates are
determined (Rangarajan and Jadhav, 1992).

Autonomy, Prudential Regulations and Supervision

Even as the external constraints such as administered structure of
interest rate and pre-empted credit are eased, the financial institutions
must act as business units with full autonomy and by the same token
become fully responsible for their performance. There are instances
of countries like France where the major banks are in the public
sector but are allowed to operate with a high degree of autonomy
without any interference from the government. In the Indian context,
'adverse selection' and 'moral hazard' which have been discussed in
 recent literature arise more because of outside interference with
decision making than as a consequence of interest rate policy. In fact,
decisions such as waiver of loans also have an adverse effect on the
performance of financial institutions as they vitiate the recovery
climate. In short, the operational efficiency of the system will
improve only if we restore functional freedom to the financial
institutions.
The need for stringent prudential regulations in a more
deregulated environment has become apparent in many countries.
The elements of prudential regulation which have assumed greater
importance in the recent period relate to capital adequacy and
provisioning. The Indian system has so far been slack in relation to
both these aspects. Capital adequacy did not perhaps receive
adequate emphasis because of the false assumption that banks and
financial institutions owned by the government cannot fail or cannot
run into problems.
With major Indian banks now having branches operating in
important money market centres of the world, this question can no
longer be ignored. This apart, even banks operating domestically
need to build an adequate capital base. The Bank for International
Settlements has prescribed the norm for capital adequacy at 8 per
cent of the risk weighted assets. As the Narasimham Committee
(Government of India, 1991) has recommended, banks which have
had a consistent record of profitability may be allowed to tap the
capital market for meeting this additional requirement. This would
involve a dilution of ownership which cannot be avoided and which
may also serve a useful purpose. What has been said about banks
holds good in relation to term lending institutions as well as other
financial institutions. Whether they be leasing companies or hire
purchase companies or investment companies, prescription of
appropriate capital requirements is a must since capital is the last line
of protection for all depositors.
Closely related to prudential guidelines is supervision. A strong
system of supervision becomes necessary in order to ensure that the
prudential regulations are followed faithfully by financial
institutions. As the financial sector grows, it is quite possible to have
different agencies supervising different segments of the market and
institutions. In this background two issues arise. One relates to the
coordination among supervisory agencies and the other regarding
consolidated supervision. Financial institutions no longer operate in
one segment of the market. Under the circumstances, the
segmentation of the market for regulatory purposes can run into a
number of difficulties. Apart from multiple authorities exercising
control over one institution, differing prescriptions by different
authorities can also lead to inconsistencies and conflicts. It is in this
context that the concept of 'lead regulator' has emerged under which
one authority is recognised as a primary regulator in relation to one
type of institution.

1991 and After: The Reform Years1

The reform in the financial sector was attuned to the reform of
the economy, which now signified opening up. Greater opening up
underscores the importance of moving to international best practice
quickly since investors tend to benchmark against such best
practices and standards. Since 1991, the Indian financial system has
undergone radical transformation. Reforms have altered the
organisational structure, ownership pattern and domain of operation
of banks, DFIs and Non-Banking Financial Companies (NBFCs).
The main thrust of reforms in the financial sector was the creation of
efficient and stable financial institutions and markets. Reforms in the
banking and nonbanking sectors focused on creating a deregulated
environment, strengthening the prudential norms and the supervisory
system, changing the ownership pattern, and increasing competition.
The policy environment was stanced to enable greater flexibility
in the use of resources by banks through reduced statutory pre-
emptions. Interest rate deregulation rendered greater freedom to
banks to price their deposits and loans and the Reserve Bank moved
away from micromanaging the banks on both the asset and liability-
sides. The idea was to impart operational flexibility and functional
autonomy with a view to enhancing efficiency, productivity and
profitability. The objective was also to create an enabling
environment where existing banks could respond to changing
circumstances and compete with new domestic private and foreign
institutions that were permitted to operate. The Reserve Bank focused
on tighter prudential norms in the form of capital adequacy ratio,
asset classification norms, provisioning requirements, exposure norms
and improved level of transparency and disclosure standards. As the
market opens up, the need for monitoring and supervising becomes

1 . This section has been drawn extensively from Rakesh Mohan (2004). "Globalisation: The
Role of Institution Building in the Financial Sector: The Indian Case", in Uma Kapila (ed.),
Economic Developments in India, Vol. 74, Academic Foundation, New Delhi
 even more important systemically. The greater flexibility and the
prudential regulation were fortified by 'on-site inspections' and 'off-
site surveillance'. Furthermore, moving away from the closed
economy objectives of ensuring appropriate credit planning and credit
allocation, the inspection objectives and procedures, have been
redefined to evaluate the bank's safety and soundness; to appraise the
quality of the Board and management; to ensure compliance with
banking laws and regulation; to provide an appraisal of soundness of
the bank's assets; to analyse the financial factors which determine
bank's solvency and to identify areas where corrective action is
needed to strengthen the institution and improve its performance. A
high-powered Board for Financial Supervision (BFS) was constituted
in 1994, with the mandate to exercise the powers of supervision and
inspection in relation to the banking companies, financial institutions
and nonbanking companies. Currently, given the developing state of
the financial system, the function of supervision of banks, financial
institutions and NBFCs rests with the Reserve Bank.
Role of Competition
It is generally argued that competition increases efficiency.
Competition has been infused into the financial system by licensing
new private banks since 1993. Foreign banks have also been given
more liberal entry. New private sector banks constituted 11 per cent
of the assets and 10 per cent of the net profits of scheduled
commercial banks (except regional rural banks) as at end-March
2003. The respective shares of foreign banks were 6.9 per cent and
10.7 per cent, respectively. In February 2002, the Government
announced guidelines for foreign direct investment in the banking
sector up to a maximum of 49 per cent (since raised to 74 per cent in
2004). The Union Budget 2002-03 announced the intention to permit
foreign banks, depending on their size, strategies and objectives, to
choose to operate either as branches of their overseas parent, or, as
subsidiaries in India. The latter would impart greater flexibility to
their operations and provide them with a level-playing field vis-a-vis
their domestic counterparts. While these banks have increased their
share in the financial system, their presence has improved the
efficiency of the financial system through their technology and risk
management practices and provided a demonstration effect on the
rest of the financial system.
Capital Adequacy and Government Ownership in the Banking
Sector
In a globalised system, banks tend to get rated if they have to
enter the market to raise debt or equity. Internationally, banks follow
the Basel norms for capital adequacy. Banks were required to adopt
these norms for maintaining capital in a phased manner in order to
avoid any disruption. However, as a result of past bad lending, a few
banks found it difficult to maintain adequate capital. The
Government had contributed Rs. 4,000 crore to the paid-up capital of
banks between 1985-86 and 1992-93. Subsequently, over the period
1992-93 to 200203, the Government contributed over Rs. 22,000
crore towards recapitalisation of nationalised banks. In view of the
limited resources and the many competing demands on the fisc, it
became increasingly difficult for the Government to contribute any
substantial amount required by nationalised banks for augmenting
their capital base. In this context, Government permitted banks that
were in a position to raise fresh equity to do so in order to meet their
shortfall in capital requirements; the additional capital would enable
banks to expand their lending.

Since the onset of reforms, there has been a change in the

ownership pattern of banks. The legislative framework governing
public-sector banks (PSBs) was amended in 1994 to enable them
to raise capital funds from the market by way of public issue of
shares. Many public-sector banks have accessed the markets since
then to meet the increasing capital requirements, and until 2001-
02, the government made capital injections out of the budget to
public-sector banks, totalling about 2 per cent of GDP. The
government has initiated a legislative process to reduce the
minimum government ownership in nationalised banks from 51 to
33 per cent, without altering their public-sector character. The
underlying rationale of the proposal appears to be that the salutary
features of public-sector banking are not lost in the transformation
process.

Some Perspectives for the Future

of the Indian Financial System
The basic emphasis of the Indian approach remains the
creation of an enabling environment so as to foster deep,
competitive, efficient and vibrant financial institutions and
markets, with emphasis on stability. A number of measures have
been initiated to achieve convergence with international best
practices. Keeping in view the fast pace of technological
innovations in the financial sector and product development at the
international level, the focus has been to bring the Indian financial
system at par with such standards. However, while adapting to
international standards and trends, special attention is being
devoted so as to customise norms and standards keeping in view
various country-specific, including institution-specific
considerations.
As the economy begins to grow rapidly, the process of
financial intermediation is likely to increase. However, in the
Indian case, the ratio of bank assets to GDP is low among
developing countries (Barth et al., 2001). By comparable
international standards, although the financial reach of the system
is high, the extent of financial widening is much lower. This
would mean that there is a lot of room for credit expansion to take
place, which, in turn, envisages enhanced credit appraisal and risk
management skills, which is an important challenge.
At present, around 76 per cent of the banking sector assets are
accounted for by public sector banks, with the remaining being
accounted for by private and foreign bank categories. The share of
nonpublic sector banks has been increasing continuously over the
låst few years, with a sizeable rise in the market share (in terms of
assets) being evident for new private banks. It is not difficult to
imagine that the new private banks, with no legacy of economic
structure and with their ability to leverage technology to produce
highly competitive types of banking, are comparatively better
placed to outperform their public sector counterparts. This would
imply a rise in their market share along with the foreign bank
group and accordingly, a concomitant decline in the market share
for public sector banks. The scope for this expansion obviously
depends on the expansion of the total banking system. As it
stands, the intermediation process has been taking place parallel
with the development of the capital market. Therefore, the issue
remains for public sector banks as to how to adjust the loss of
relative market share in an environment where the absolute size of
the pie is not expanding rapidly. Moreover, the ability of different
public sector banks to cope up with this challenge is likely to be
quite different, which is an important issue that would need to be
addressed. An important issue relates to the manner in which
public sector banks would cope when Government ownership is
reduced to 33 per cent, which is likely to be fructified once the
Banking Companies (Acquisition and Transfer of Undertakings)
and Financial Institutions (Amendment) Bill, 2000 is passed by
the Parliament. In fact, international evidence tends to suggest a
significant scaling down of Government ownership in the banking
system in most countries (Barth et al., 2001). In such a scenario,
banks will have to embrace modern management and corporate
governance practices and acquire higher quality of human capital.
Another major concern for the banking system is the high cost and
low productivity as reflected in relatively high spreads and cost of
intermediation. Both spreads and operating costs, measured as
percentage of total assets of banks have generally been higher vis-
a-vis developed countries. An important challenge for the banking
sector, therefore, remains its transformation from a high cost, low
productivity structure to a more efficient, productive and
competitive set up. The capital requirement of banks is likely to
increase in the coming years with the pick up in credit demand
and the implementation of Basel Il norms around 2006, which has
accorded greater emphasis on risksensitivity in credit allocation.
Banks would need to increase their profitability to generate
sufficient capital funds internally, since maintaining the additional
capital position in line with the prescribed norms could pose a
major challenge. Commercial banks continue to face the problem
of the overhang of NPLs, attributable, inter alia, to systemic
factors such as weak debt recovery mechanism, non-realisability
of collateral and poor credit appraisal techniques. The recent
enactment of the Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest (SARFAESI) Act has
increased the momentum for the recovery of NPLs. Banks need to
intensify their efforts to recover their overdues and prevent
generation of fresh NPLs.
 A major challenge facing the banking and financial community
emanates from the high growth in volumes of financial transactions
and the impact of today's globalisation efforts the world over.
Traditional geographical boundaries are getting blurred and greater
challenges are confronting banks owing to the explosion of
technology. It is in this context that there is an imperative need for
not mere technology upgradation but also integration of technology
with the general way of functioning of banks.
Internationally, deposit insurance has been recognised as an
important component of the financial safety net for a country. A
riskbased deposit insurance premium system has been identified as a
measure that can reduce negative externalities of the deposit
insurance system. Introduction of such a system is currently under
consideration of the Government.
In view of the gradual withdrawal of DFIs from longer-term
financing, an issue remains about how to fill the void being created
by such restructuring. There is a need to develop the private
corporate debt market and introduce appropriate instruments to
reduce the risk arising out of long-term financing by other players
such as banks.
In recent times, attempts have been made to achieve regulatory
and supervisory convergence between commercial and cooperative
banks in certain key areas including prudential regulations. These
steps are in the interest of the stability of the overall financial system
as well as healthy development of the cooperative credit institutions.
However, in view of the impaired capital position of many
cooperatives and their large overhang of NPLs, achieving such
convergence would prove to be difficult. It is, however, for the
cooperative banks themselves to build on the synergy inherent in the
cooperative structure and stand up for their unique qualities. In this
context it is encouraging to note that during the recent years in the
face of the restructuring process, cooperative banks are making
efforts to reduce their operating cost.
The issue of corporate governance has assumed prominence in
recent times, more so in view of the recent accounting irregularities in
the US. The quality of corporate governance would become critical as
competition intensifies, ownership is diversified and banks and
cooperatives strive to retain their client base. This would necessitate
significant improvements in areas such as housekeeping, audit
practices, asset-liability management, systems management and
internal controls in order to ensure the healthy growth of the financial
sector.
Prior to enactment of legislative reforms for NBFCs, they
mobilised a significant portion of their fund in the form of public
deposits, often at high interest rates. This, coupled with relaxed
regulatory and supervisory arrangements for NBFCs, created
negative externalities including moral hazard. Introduction of reform
measures for NBFCs has, however, substantially eliminated such
problems and the share of public deposits in the •total liability of
NBFCs has declined substantially. Notwithstanding this, protection
of the depositors' interests remains paramount. Towards this
objective, the RBI continues to pursue with various State
Governments the case for enacting legislation for protection of
interest of depositors in financial establishments. Creating public
awareness about activities and risk-profile of NBFCs along with
improvement in corporate governance practices and financial
disclosures needs to be focused upon in future.
The entry of private sector players in the insurance sector is yet
to make a significant dent in the market share of the public sector
entities. Recent evidence, however, suggests that the state-of-the-art
services provided by private players have begun to make an impact
on the existing insurance industry. Accordingly, promoting the role of
competitive forces in the process of insurance liberalisation is
essential, not only for customer choice, but also for raising resources
for longterm infrastructure finance.
In the securities market, instituting enabling legal reform poses
an important challenge for its orderly growth. A number of reforms
in the financial system have been held back pending legal changes.
There is lack of transparency in the corporate debt market, which
is operating predominantly on a private placement basis. A
wholesome view has to be taken by the different regulators to
develop a vibrant corporate debt market.
Lessons from the Indian Experience
The process of globalisation has important implications for the
financial sector and the institutions comprising it. In an increasingly
globalised environment, the role of the policy-maker in the domestic
institutional building process can be envisaged in the form of
providing a stable macroeconomic environment, increasing
competition, establishing a strong regulatory and supervisory
framework, evolving an enabling legal system and strengthening
technological infrastructure. A well-knit institutional set up facilitates
the growth and development process of an economy. Effective
institutions can make the difference in the success of market reforms.
If the financial system is well diversified and the markets are liquid
and deep, effective mobilisation and allocation of resources will be
ensured. Many broad generalisations can be discerned from the
Indian experience.
Development of the Indian financial system is premised on the
conviction that financial development makes fundamental
contributions to economic growth. At the time of Independence, the
financial system was fairly liberal. By the 1960s, controls over the
financial system were tightened and aligned in accordance to the
centralised Plan priorities. The priority was to set up institutions to
mobilise saving and allocate the saving to specified sectors. The RBI
was vested with the responsibility of developing the institutional
infrastructure in the country. Towards this end, controls on lending
and deposit rates were introduced and specialised development
banks, catering to varied segments of the economy were established.
This institutional design did not achieve the desired results. The
process culminated with the twostage nationalisation process of
banks, first in 1969 and thereafter in 1980. Around the same time, the
insurance business was also brought under the domain of
Government control in phases. The process of nationalisation
expanded the reach of financial services to remote parts of the
country. However, the basic principle of mobilising savings and
channeling resources to certain sectors at a price not related to the
market remained. Notwithstanding the numerous achievements of
'social banking', such as branch expansion and diversion of credit to
rural sectors, the high degree of controls on the financial system also
manifested itself in several inefficiencies.
In order to address these shortcomings, gradual liberalisation of
the financial system was initiated in the late 1980s, which received
greater momentum in the 1990s. The closed-economy framework
gradually gave way to greater externally oriented and liberal
financial system. The
 1990s witnessed the advent of economic reforms in the country
encompassing trade, industry and the real sectors. The external sector
was liberalised. The country adopted a flexible exchange rate regime
early in the reform period and encouraged non-debt creating flows in
the form of foreign direct investment and foreign institutional
investment. Liberalisation of the external current account was also
undertaken early in the reform cycle. The macroeconomic
environment then influences institutional building. As the economy
opens up, the financial system can no longer afford to remain
repressed. The financial system also has to undertake reforms in the
form of interest rate deregulation, prudential regulation, good
supervisory standards, legal changes and technological upgradation.
New institutions operating on market principles have to emerge and
old institutions would either have to change to cope with the
emerging changes or close. Thus, macroeconomic reform and
reforms in the financial system have to progress simultaneously. In
the early 1990s, a wide-ranging set of reforms were undertaken,
encompassing both financial institutions and markets. These reforms
paved the way for more market-driven allocation and pricing of
resources. The process of globalisation has tended to exhibit itself,
both domestically, in terms of greater integration of domestic
financial markets with global ones and internationally, in terms of the
adoption of a process of gradual convergence with international best
practices.
The pre-reform experience suggests that governments that
suppress their financial systems in order to finance spending, end up
with underdeveloped, inefficient and repressed financial systems.
Prior to reforms, Indian institutions were typically set up to mobilise
savings and allocate resources at administered rates. Initially, the
authorities concentrated on regulating both the quantity and cost of
credit. This undermined the efficiency of the financial system and
ultimately led to financial repression. The post- reform institutional
structure recognised the need for institutions to be market based. The
major elements for adequate development of the financial sector in
India constituted a stable macro-economic environment,
competition, effective prudential regulation, sound supervision,
enabling legal framework and modern technological infrastructure.
The driving forces for important innovations in the financial
system can come from within or from external forces. In fact, in the
Indian case, although the trigger for the economic reform process
was the balance of payments crisis resulting from the Gulf War of
1990, the reforms in the financial sector were the result of a well-
crafted internal strategy.
The early part of macroeconomic reform saw changes in the
exchange rate system, the opening up of the economy to foreign
investors and adoption of current account convertibility. This
necessitated the financial system to undertake reform to keep pace
with the changes in the other sectors of the economy. The Indian
experience suggests that it was slightly ahead of the learning curve
insofar as the implementation of reforms in the financial sector was
concerned. The process was initiated through High-Level
Committees that provided road maps for implementation of reforms
so as to progressively reach international best standards while taking
the unique country circumstances into consideration. For instance, in
the first phase, greater emphasis was placed on policy deregulation
(interest rate deregulation, easing of statutory preemptions, etc.),
improving prudential norms (imposing capital adequacy ratio, asset
classification, exposure norms, etc.), infusing competition
(permitting entry of new private sector banks), diversifying
ownership, developing money, debt and foreign exchange markets
(for risk-free yield curve and monetary policy transmission as well as
global integration), establishing regulatory and superviSory standards
(Board for Financial Supervision) and insisting on greater
transparency and disclosures. It was only in the second stage that
many legal amendments (Securities Contract Regulation Act,
Government Securities Bill, SARFAESI Act, etc.) and diversification
of ownership of public sector banks, etc., were undertaken.
The Indian experience also shows that there is no optimal
sequencing in respect of either policies or institutions, both within
and across countries. For instance, some countries that reformed after
a crisis did so with a 'big bang', while others such as India followed a
'gradualist' approach. In fact, reforms in the financial and external
sectors were not treated as a discrete event, but as a continuous and
complementary process. For instance, in the Indian context, reforms
in the financial sector were undertaken in the early part of the
economic reform cycle and embraced the banking sector in view of
its dominance in the financial sector and the money and Government
securities markets initially in view of their inexorable linkages with
the rest of the financial system. Reform of development financial
institutions, cooperative banking institutions and non-banking
financial companies followed. Further, in India, prudential reforms
were implemented first and the structural and legal changes followed
whereas in some countries, legal changes have preceded prudential
and structural reforms.
It is very critical that reforms maintain a balance between efficiency
and stability, especially in an emerging market economy like India.
Greater competition modifies the effectiveness of existing
institutions. It improves efficiency, increases incentives for
innovation and promotes wider access. There is, therefore, a need to
modify existing institutions to complement the new and better
institutions. It is important that the transition is managed without
disruption to the market and the economy. The Indian approach of
cautious liberalisation vindicates this position, since the balance
between markets and the State is delicate. The Indian experience
shows that consultations with market practitioners, and the
announcement of a time table for reforms designed to give time for
market players to adjust goes a long way in ensuring stability.
The intervention of governments and the central bank in
institution building depends on specific country circumstance. In
India, the government and central bank were directly involved in
institution building from the time of Independence. However, the
main difference was that the pre-reform period was characterised by
micro management of institutions by government and central bank
whereas in the post- 1991 period, institutions have had greater
autonomy and flexibility in operations and monitoring while
regulations were more market based and incentive driven. Effective
institutions are those that are incentive compatible. An important
issue in the design of institutions is in ensuring that the incentives
that are created actually lead to the desired behaviour. Greater
competition modifies the effectiveness of existing institutions. It
improves efficiency, increases incentives for innovation and
promotes wider access. There is, therefore, a need to modify existing
institutions to complement the new and better institutions.
A well architectured financial system mitigates and diversifies
risks, but a badly designed system can lead to magnification of risks.
The challenge to policy-makers is to build a financial system that
assists in risk mitigation. It is well recognised by now, especially
after the Asian crisis, that a multi-institutional financial structure
mitigates the risk to the financial system. The Indian experience
vindicates this stance. Banks, DFIs, and capital markets have co-
existed from the postIndependence era; only that the character of
these institutions has changed depending on the evolutionary stage of
the economy. In this context, development of a domestic debt market
becomes important. The motivation for development of a debt
market can arise from different reasons viz., to develop corporate
debt market, overall financial market development, existence of a
dominant Government securities market (like in India), part of
pension reform, etc. Globalisation can be a driving force in this
regard. In a simplistic sense, as market opens up and forex reserves
accumulate, the need for sterilisation itself would motivate
development of financial markets. As foreign investors and foreign
direct investment comes in, the need for transparency, institutional
mechanism, good settlement and payment systems, etc. will
predominate. The Government securities market is the most
dominant component of the debt market in India. Among others, the
key elements of development of Government securities market have
been institutional development, infrastructure development,
technological infrastructure, and legal changes.
A salient feature of the move towards globalisation has been the
intention of the regulators and the responsiveness of the authorities to
progress towards international best practices. An institutional process
in the form of several Advisory Groups set upon the task of
benchmarking Indian practices with international standards in areas
relating to monetary policy, banking supervision, data dissemination,
corporate governance and the like. Although the standards have
evolved in the context of international stability, they have enormous
efficiencyenhancing value by themselves. Standards by themselves
may be presumed to be, prima facie, desirable, and it is, therefore, in
the national interest to develop institutional mechanisms for
consideration of international standards. Thus, the implementation of
standards needs to be given a domestic focus with the objectives of
market development and enhancing domestic market efficiency
(Reddy, 2002).

Conclusion
The Indian financial system today has a wide network of
institutions. The commercial banks have their presence in the most
remote parts of the country. The development of the different
segments of the financial system is, however, uneven. The
 cooperative credit system is effective only in certain parts of the
country. But new institutions have come on the scene. The capital
market has also become more active, with both primary and
secondary markets showing strong upward movement.
The Indian financial development is a classic illustration of the
supply leading' phenomenon under which financial institutions come
into existence first and then create the demand for their services. The
geographical spread of the Indian banking system was a conscious
policy decision. Regional disparities in the provision of financial
services have come down even though some states do complain of
inadequate provision of credit in relation to deposits mobilised in
their states. The involvement of banks and financial institutions in
the schemes for providing credit to select segments of the society is
very active. Banks are also closely associated with credit linked
poverty alleviation programmes such as the Integrated Rural
Development Programme (IRDP), the Self-Employment Programme
for Urban Poor (SEP UP) and Self-Employment Scheme for
Educated Unemployed Youth (SEEUY). The experience with the
poverty alleviation programmes has been mixed, as revealed by
many studies. Even where such programmes have succeeded in
raising the incomes of the beneficiaries, the recovery performance
has not been that good.
Reform efforts in terms of strengthening of prudential norms,
enhancing transparency standards and positioning best management
practices are an ongoing process. Efforts are also on for furtherance
of efficiency and productivity within an overall framework of
financial stability. Organised banking has made its presence felt in
remote parts of the country. Insurance, hitherto a public sector
monopoly, has since been transformed into a competitive market in
both life and non-life segments. Strengthening corporate governance
in cooperative banks has been making headway. Disclosures
standards have been strengthened for non-banking financial
companies. DFIs are also restructuring themselves in an era of global
competition. A great deal of reforms has been undertaken in most
areas of financial sector, reflected in the growing sophistication of the
financial system. The resilience of the system is reflected in terms of
absence of any major crisis in the financial system, a sustainable and
broadbased growth environment, lower levels of inflation and strong
external sector position. No doubt, the institutional framework in the
financial sector had a major role to play in this process and the
globalisation process in the financial sector has been beneficial for
the economy. At the same time, the stance of the authorities has been
proactive, reacting to the macroeconomic policy stance, global
challenges and constantly endeavouring towards international best
practices. One can do no better than observe as to what Jalan (2001)
reminds us, in a similar vei , "...India of 2025 will be a very different
place, and a much more dominant force in the world economy, than
was the case twenty-five years ago or at the beginning of the new
millennium."
 Foreign Trade

Constraints Arising from Foreign Trade and Import

Substitution based Policies
INDIAN economic development strategy, particularly relating to
industrialisation has been driven by perceived foreign exchange
scarcities and the desire to ensure that scarce foreign exchange is
used only for purposes deemed 'essential' from the perspective of
development. Industrialisation and self-sufficiency in essential
commodities have been important objectives of policy because of the
fear that dependence on other, more powerful countries, for imports
of essential commodities would lead to political dependence on them
as well. Nearly a decade before Independence, in 1938, the National
Planning Committee was set up by the Indian National Congress (the
political party that led the struggle for Independence) under the
chairmanship of the future prime minister Jawaharlal Nehru. This
committee viewed, " the objective for the country as a whole was the
attainment, as far as possible, of national self-sufficiency,
International trade was certainly not excluded, but we were anxious
to avoid being drawn into the whirlpool of economic imperialism."
Later the First-year Plan went further:
"Control and regulation of exports and imports, and in the case
of certain select commodities state trading, are necessary not only
from the point of view of utilising to the best advantage the limited
foreign exchange resources available but also for securing an
allocation of the productive resources of the country in line with the
targets defined in the Plan. "l

l. Planning Commission (1950). First Five Year Plan, p. 42.

Inward Looking Strategy
India adopted an 'inward looking' strategy of industrialisation.
This strategy relied on encouraging domestic production for the
domestic market behind high tariffs and high degree of effective
protection to the domestic industry. This resulted in an uncompetitive
domestic industrial structure. T.N. Srinivasan has argued that the
development strategy based on import substituting industrialisation
and the system of controls that were implemented failed to produce
rapid growth, selfreliance, and eradication of poverty, but instead led
to lacklustre growth, an internationally uncompetitive industrial
structure, a perpetually precarious balance of payments, and, above
all, rampant rent seeking and the corruption of social, economic and
political systems. 2
Far from viewing foreign trade as an engine of growth, Indian
planners sought to minimise import demand and viewed exports
more or less as a necessary evil mainly to generate the foreign
exchange earnings to meet that part of the import bill not covered by
external assistance. They created an elaborate administrative
regulatory machinery in an attempt to control investment and
resource allocation in the economy and ensure their consistency with
five-year plan targets. Controls over imports and exports were also
part of this regulatory system.

Broad Trends: Exports and Imports

Exports
1. 1950 to early 70s - Import substitution became the keystone of
development strategy in the late 1950s. Consequently,
exports were neglected by the Government. The value of
exports as a percentage of GDP at market prices declined
from an average of over 6 per cent (1950-51 to 1955-56) to
less than 4 per cent in the period following. This declining
trend in the value of exports continues till 1971-72 (Table
23.1). The decline is in spite of the introduction of many
incentive scheme for the exporters in the sixties. The sixties
can be seen as the period of induction of export orientation
through incentive schemes for exports along with import
2 . Srinivasan, T.N. "Foreign Trade Policies and India's Development", in Uma
Kapila (ed.), Indian Economy Since Independence, ch. 25 (2003-04 edition).
 substitution. With the decision to devalue the rupee in 1966,
changes in tariffs and export subsidy policy, it was evident
that the policy-makers
were trying to use fiscal measures to step up exports and
curb imports. But, the incentives given to exporters could
not offset the bias against exports which was implicit in the
over valued exchange rate (except for 1966 devaluation) and
the prevalent level of import restrictions.

TABLE - 23.1
Source : India's Balance of Payments = 1948-49 to 1988-89. Department of Economic
Analysis and Policy, Reserve Bank of India, Bombay, published in July 1993.

2. Early 70s to late 80s - The value of exports as a percentage of

GDP at market prices picked up after 1971-72 and increased
till end of seventies. Eighties again shows a declining trend
in value of exports with a recovery to over 6 per cent level
only in the last couple of years in eighties (Table 23.2). It
was realised after the first oil shock of 1973 that India had to
step up exports simply to finance the rising import bill on
account of an increase in oil prices.
Eighties can be viewed as a period of growing uneasiness
with the policies of excessive protectionism. The Abid
Hussain Committee on import and export policies (1985-
1988) recommended more liberal access to imports by
exporters. The second major recommendations of the
Committee was that the real exchange rate of the rupee
should not be allowed to appreciate and it should be
maintained at a level considered appropriate for ensuring the
competitiveness of exports.
 .

3. 1990s - The 1990s have witnessed an increase in the value of

exports as a percentage of GDP at market price to over 8 per
cent from over 6 per cent level (Table 23.3). After the
payment crisis of 1990-91, when the foreign exchange
reserves had fallen drastically and were enough to pay for
two weeks of imports, the process of economic reforms was
started in 1991. The chief elements of reforms are
devaluation of the rupee, liberalisation of import licensing,
reduction in tariffs, abolition of cash subsidies for exports,
introduction of partial convertibility of the rupee on the
current account and later full convertibility of the rupee on
the current account.
: Economic Surveys.

After three successive years of robust growth at an annual

average of 19.7 per cent (in US Dollars) during 1993-94 to 1995-96,
export momentum slowed down since 1996-97, with exports
registering a modest growth of 5.3 per cent and decelerating further
to 1.5 per cent in 1997-98. Both global and domestic factors have
contributed to the slowdown in export growth in India since 1996-97.
The share of East Asian Countries in India's exports was around one-
sixth before the crisis, India could not escape the fall out from the
import compression in these countries. The slump in global trade and
continued recessionary phase has caused not only import contraction,
but has also triggered protectionist measures. Amongst the domestic
factors that continue to hamper exports infrastructure constraints,
high transaction costs, SSI reservations, labour inflexibility, quality
problems and quantitative ceilings on agricultural exports remain
problematic. The growth of exports picked up in 1999-2000 and
2000-2001.
India's merchandise exports (in dollar terms and customs basis),
by continuing to grow at over 20 per cent per year in the last 3 years
since 2002-03, have surpassed targets. In 2004-05, export growth
was a record of 26.2 per cent, the highest since 1975-76 and the
second highest since 1950-51. Supported by a buoyant world
economy (5.1 per cent). The good performance of exports (growth of
18.9 per cent) continued in April-January 2005-06, despite the
slightly subdued growth of global demand, and floods and transport
disruptions in the export nerve centres of Mumbai and Chennai.
Factors for Export Growth since 2002-03
Both external and domestic factors have contributed to the
satisfactory performance of exports since 2002-03. While improved
global growth and recovery in world trade aided the strengthening of
Indian exports, firming up of domestic economic activity, especially
in the manufacturing sector, also provided a supporting base for
strong sector-specific exports. Various policy initiatives for export
promotion and market diversification seem to have contributed as
well. The opening up of the economy and corporate restructuring
have enhanced the competitiveness of Indian industry. Infact India's
impressi€e export growth has exceeded world export growth in most
of the years since 1995; but, since 2003, it has lagged behind the
export growth of developing countries taken together, mainly
because of China's explosive export growth. India's share in world
merchandise exports, after rising from 0.5 per cent in 1990 to 0.8 per
cent in 2003, has been stagnating at that level since then with
marginal variation at the second decimal place (Table 23.5). This is a
cause for concern. Foreign Trade Policy (FTP) 2004-2009 envisages
a doubling of India's share in world exports from 0.75 per cent to 1.5
per cent by 2009. To achieve this target, Indian exports may need to
exceed US$ 150 billion by 2009 as world exports are also growing
fast.
Source: Economic Survey, 2005-06.

While high growth in global output and demand, especially in

the major trading partners of India, helped, it was the pick up in
domestic economic activity, especially the consistent near double-
digit growth in manufacturing, that constituted the main driver of the
recent export surge. In 2004-05, India's manufacturing exports grew
by 21 per cent and had a share of around 74 per cent in total exports.
Further productivity gains in the export sector require a deepening
of domestic reforms, and an accelerated removal of infrastructure
bottlenecks, including export infrastructure. Infrastructure remains the
single most important constraint to export growth. Achievement of the
ambitious export target set in Foreign Trade Policy (2004-2009)
requires a projected augmentation of the installed capacity of ports by
140 per cent. Indian ports, which handle over 70 per cent of India's
 foreign trade even in value terms, have a turnaround time of 3-5 days
as against only 4-6 hours at international ports like Singapore and
Hong Kong. As for internal transport, while there has been a
perceptible improvement in the national highways, secondary roads
need to be improved and the issue of delays caused at inter-state
checkpoints need to be addressed. Exporters need to place more
emphasis on non-price factors like product quality, brand image,
packaging, delivery and after-sales service. A more aggressive push to
FDI in export industries will not only increase the rate of investment in
the economy but also infuse new technologies and management
practices in these industries.
The strengthening of Indian exports has been aided by positive
trends in global demand, which was also reflected in world trade.
After a sharp downturn in 2001, volume growth of world
merchandise trade rebounded to 3.0 per cent in 2002 and further
increased by 4.5 per cent in 2003. According to World Trade
Organization (WTO), real merchandise trade accelerated by nearly 10
per cent in the first half of 2004, and is estimated to have grown in
2004 by 8.5 per cent, or nearly twice as fast as in the preceding year.

Imports
1. 1950 to early 1970s - The value of imports as a proportion
of GDP at market prices, fluctuated through the 1950s
(around 6 to 9.8 per cent) and thereafter declined slowly till
the early 1970s (from 6.8 per cent in 1960-61 to 4.2 per cent
in 197273, Table 23.1).
The severe foreign exchange crisis of 1956-57 led to the
adoption of strict measures for import controls. The import
licensing system was intensified in the late fifties and early
sixties. After a brief attempt at using fiscal measures instead
of physical controls in mid-sixties, the import licensing was
intensified. Import policy became increasingly restrictive
and complex. The quantitative restrictions were used to
provide protection to any domestic activity that substituted
for imports. The decline in public investment and industrial
growth after the mid-1960s also contributed to reducing the
pressure on imports.
 2. Early 1970s to late 1980s - After 1972-73, the value of
imports as a proportion of GDP showed a distinct increase.
The import needs became stronger as the industrial growth
recovered in mid-seventies and showed an accelerating
trend in the 1980s. The eighties is marked with a clear shift
in the trade strategy towards reduction of quantitative
restrictions on imports. The number of items in the category
of OGL—that is, a licence to import but with no quantitative
restrictions— increased substantially in this period. The rise
in the value of imports as a proportion of GDP at market
prices is in spite of the sharp increase in tariffs in eighties.
The value of imports as a proportion of GDP increased from
a level of 4.6 per cent (1973-74) to over 6 per cent in the
remaining years of seventies. It was around 8 to 9 per cent
in the decade of eighties (Table 23.1).
3. 1990s - The value of imports as a proportion of GDP at
market prices show a distinct increase in the 1990s except
for 199192. The decline in 1991-92 was due to severe
import curbs introduced after the payment crisis of 1990-91.
The value of imports as a proportion of GDP increased from
8.8 per cent in 1990-91 to 12.5 per cent in 1997-98 and 13
per cent in 200001 (Table 23.3).
Merchandise imports displayed strong growth in 2003-04, and
rose faster than exports. Lower tariffs, a cheaper US dollar and a
buoyant domestic economy boosted imports. Imports, in US dollar
terms and on customs basis, increased by 27.3 per cent in 2003-04,
on top of a rise of 19.4 per cent in the previous fiscal.
Growth in India's merchandise imports in 2004-05 at 40 per cent
in dollar terms was the highest since 1980-81. This surge in growth
in 2004-05 was mainly due to the steep rise in price of crude
petroleum and other commodities with value of POL imports
increasing by 45.1 per cent. While volume growth in import of POL
was subdued at 6.4 per cent, largely in response to the price increase,
larger imports filled the gap between growing demand and stagnant
domestic crude oil production. In 2004-05, lower tariffs, a cheaper
US dollar, a buoyant manufacturing sector and high export growth
boosted non-oil imports by 39 per cent, particularly capital goods,
intermediates, raw materials and imports needed for exports.
 Buoyant growth of imports of capital goods at 21 per cent, on top of
the 40 per cent growth in 2003-04, reflected the higher domestic
investment and firming up of manufacturing growth. A significant
contributor to the rise in non-POL imports was the 59.6 per cent
growth of gold and silver on the back of a 59.9 per cent growth in
2003-04, due to the high international gold prices. The duty
reduction on imported gold from Rs.250 to Rs. 100 per 10 gram and
liberalisation of such imports as per trade facilitation measures
announced in January, 2004 could also have provided a fillip. Non-
oil, non-bullion imports increased by 31 per cent in 2004-05,
compared to a rise of 28.5 per cent in 2003-04.
Unlike in 2003-04, the surge in POL imports in 2004-05 and
2005()6 (April-November) was dominated by the price impact.
International crude oil (Brent variety, per barrel) prices, trending
upwards since 2002, on average, rose from US$ 27.6 in 2002-03 to
US$ 28.9 in 2003-04, US$ 42.1 in 2004-05, and further to US$ 56.64
per barrel in AprilNovember 2005 with a peak of US$ 67.33 on
August 12, 2005. The stiffening of global crude oil prices was
contributed by a combination of heightened demand, limited spare
capacity and geopolitical threats to the existing capacity. The surge in
crude oil prices has sharpened the focus on the adverse impact of
such volatility on domestic prices and the need to minimise such
impact. Given India's relatively high oil intensity and increasing
dependence on imported crude oil, efforts are being made to diversify
sourcing of such imports away from the geopolitically sensitive
regions. Another development has been the decision to build up
strategic oil reserves, equivalent of about 15 days requirement, to
minimise the impact of crude price volatility in the short term. In a
related initiative, India is coordinating with large oil importing
countries in Asia, in exploring possibilities for evolving an Asian
products marker, in place of an Asian premium, which would reduce
the premium paid by Asian countries and thus, to some extent help in
controlling the country's oil import bill.
Bulk of the increase was contributed by growth in non-oil imports,
which shot up from 17.0 per cent in 2002-03 to 31.5 per cent in 2003-04.
The acceleration of such imports was mainly due to higher imports of
capital goods, industrial raw materials and intermediate goods. It reflected
the higher domestic demand and firming up of industrial growth.
Factors for Imports Growth
Imports continued to rise at a rate faster than that of exports in
the current financial year, rising by 34.7 per cent in April-January,
2004-05 on back of good industrial performance and rising
international crude oil prices. The rise has been contributed by a
continuing robust growth in non-POL imports of 32.7 per cent and
acceleration in POL imports by 40.1 per cent. The higher non-POL
non-bullion imports are indicative of the economy's growing
absorptive capacity for imports. These along with rising trends in
domestic production of capital goods and strong growth in non-food
credit indicate a quickening pace of investment activity during the
current fiscal,
India moved one notch up the rankings in both exports and
imports in 2004 to become the 30th leading merchandise exporter
and 23rd leading merchandise importer of the world.

Changing Structure of India's Foreign Trade

In order to study the structure of India's foreign trade we have to
analyse the changing pattern of imports and exports.
Since the purpose of the import control regime was to confine
imports to essential consumer goods, raw materials, and investment
goods needed for domestic production and exports, it is not
surprising that changes in the commodity composition of India's
imports reflected this. For example, foodgrains and edible oils
accounted for about 16 per cent of total imports in 1960-61, and
about 1 per cent in 1990-91. Imports of gems, which were negligible
in 1960-61, accounted for US $ 2.079 million or nearly 8 per cent of
imports in 1990-91, reflected the fact that gems and jewellery
exports at $1.667 million comprised nearly a sixth of total exports.
The share of crude petroleum, oils, and lubricants in total imports
rose from about 6 per cent in 1960-61 to a high of roughly 40 per
cent in 1980-81. However, it fell to about 23 per cent partly on
account of fall of crude petroleum prices and partly also to rapid
growth of domestic crude output from the Bombay High Field.
Turning to exports, India's share of world exports has fallen
steadily from about 2 per cent in 1950 to less than 0.5 per cent in
1990. Since world export grew rapidly between 1950 and 1973 and
somewhat more slowly thereafter, India's exports grew in absolute
terms in spite of a declining share. But the dramatic fall in share
reflects the fact that other countries were able to take greater
advantage of growing world trade.
The composition of India's exports has, as expected, shifted
moderately away from primary products to manufactured goods,
whose share rose from about 45 per cent in 1950-51 to 79 per cent in
199091. However, primary exports have been virtually stagnant, and
manufactured products have accounted for almost the entire growth
in total exports (Table 23.7). Among manufactured products, just
four items leather, gems, garments, and textiles—accounted for most
of the
Foreign Trade 495

growth in recent years. In contrast, the export of engineering goods,

which rose by over 20 per cent per year in value terms between
195051 and 1975-76 and between 1970-71 and 1978-79, declined
between 1980-81 and 1985-86.
The export of gems has grown rapidly since the early 1970s.
This export is heavily dependent, however, on the import of uncut
small gems, the cost of which is determined in large part by the
South African monopoly De Beers. The exports of garments and
textiles are governed by India's quotas under the Multi-Fibre
Arrangement (MFA). Bhalla (1989) points out that until the 1980s,
India did not fully use quotas, and India's competitors did better in
quota, as well as, non-quota countries. It is possible that the spurt in
India's garment and textile exports reflects better use of quotas and
higher prices realised on the average. Whether India will be able to
compete in the textile and apparel market in the absence of the MFA
is debatable, particularly in view of the fact that the Indian textile
industry has fallen behind technologically in the past four decades
primarily because of the government's textile policy.
During the high-growth phase of India's exports, that is, between
1993-94 and 1995-96, major export items which had contributed
significantly to the growth process included engineering goods,
cotton yarn, fabrics, chemicals and allied products, rice, coffee,
processed fruits, juices and miscellaneous processed items and
marine products. The growth rates of export of all these items have
dropped considerably during 1996-1998. Among the manufactured
exports, the deceleration of growth rate has been most marked for
engineering goods. Within the agricultural and allied products group,
export levels of both rice and coffee declined between 1995-96 and
1997-98. 3

Comparison between 90s and 80s

For the purpose of analysis at the aggregate level, India's trade
performance during 1992-93 to 1998-99 (referred to here as the
nineties) has been compared with that during 1980-81 to 1990-91
(the eighties). The year 1991-92 witnessed considerable strain on the
balance-ofpayments. To meet the crisis, severe restrictions were

3 . Reserve Bank of India (1997-98). Report on Currency and Finance, Vol. l.

placed on imports and the Rupee was adjusted downward in July
1991. Being an exceptional year, 1991-92 should be excluded in any
time series based analysis of trade developments. The periodisation
of the analysis captures the structural shifts in the growth of exports
and imports during the sub-periods. For instance, on an average
annual basis, export growth during 1992-93 to 1998-99 at 9.8 per
cent was higher than that of 8.2 per cent registered during 1980-81 to
1990-91. Similarly, the average import growth observed during the
nineties at 12.0 per cent remained substantially higher than that of
7.8 per cent recorded during the eighties (1980-81 to 1990-91).
The world trade has undergone significant changes since 1996
due to a host of developments including a sharp fall in international
prices for manufactured products and the emergence of economic
crises in certain parts of the world. In addition, protectionist policies
and practices adopted by various industrialised countries during the
recent years and perhaps most importantly anti-dumping and
countervailing measures seriously affected the export efforts of the
developing countries (Stiglitz, 1999). These unfavourable factors
have had their impact on the developing countries including India's
trade performance.
In the light of the above factors, it would be appropriate to
examine the trade performance of India during the two sub-periods
of the nineties; the first sub-period covering the first four years
following the introduction of reforms (i.e., 1992-93 to 1995-96) and
the second subperiod consisting of the subsequent three years (i.e.,
1996-97 to 199899). During the first sub-period, on an average basis,
India's exports and imports increased by 15.7 and 17.5 per cent,
respectively, which were significantly higher than the growth rates
during the eighties. Broadly in line with the unfavourable external
developments, between 1996-97 and 1998-99, growth in India's
exports and imports, on an average basis, decelerated to 2.0 per cent
and 4.5 per cent, respectively. India's share in world exports, which
had declined from 0.52 per cent to 0.47 per cent between 1984 and
1987, improved to 0.53 per cent in 1992. Notwithstanding the
slowdown in India's export growth since 1996, reflecting the
relatively better performance by India vis-a-vis restof-the-world, its
share in global exports reached 0.62 per cent during 1997 (IMF,
1998).

Trade GDP Ratio

 India's trade-GDP ratio showed substantial improvements during
the nineties as compared with the eighties. The export-GDP ratio
declined from 4.9 per cent in 1980-81 to 4.2 per cent in 1985-86 and
thereafter it gradually improved and reached 6.1 per cent in 1990-91.
During the nineties, the ratio reached its highest level at 8.7 per cent
im 1995-96. The ratio declined, marginally, during the next three
years and was at
8.1 per cent in 1998-99. On an average basis, export-GDP ratio
increased from 5.0 per cent to 8.2 per cent between the eighties and
the nineties. Between these two periods, on an average basis, India's
importGDP ratio increased from 7.7 per cent to 9.4 per cent. The
noticeable improvements in the export-GDP and import-GDP ratios
point to the increasing openness of India's foreign trade regime to
global trade.

Trade Deficit-GDP Ratio

Along with the increase in trade-GDP ratio, there has been a
decline in India's trade deficit-GDP ratio between the two periods.
This is borne out by the fact that the difference between export and
import-GDP ratio on an average basis, declined from 2.7 per cent in
the eighties to 1.2 per cent in the nineties. This indicates that the
divergence between export and import performance was more
pronounced during the eighties than in the nineties. Similarly, the
export-import ratio (on an average basis) increased substantially
from 65.1 per cent during the eighties to 87.0 per cent during the
nineties reflecting thereby the increasing alignment between India's
export and import performance during the nineties as compared with
the eighties.
Structural Change in Exports
Changes in Terms of Broad Categories
Reflecting the development of a large and diversified industrial
sector, during the post-Independence period, India has gradually
transformed from a predominantly primary product exporting
country into an exporter of manufactured products. In the mid-
eighties, manufactured exports accounted for about two-thirds of
India's total exports while the rest comprised of primary products.
During the years preceding the introduction of economic reforms,
i.e., between 1987-88 and 1991-92, while the share of manufactured
goods increased from 67.8 per cent to 73.8 per cent, that of primary
products declined from 26.1 per cent to 23.1 per cent. These trends
were reinforced during the subsequent period (i.e., 1992-93 to 1998-
99). On an average basis, the share of manufactured products
increased by 4 percentage points while that of primary commodities
declined by 2 percentage points between the eighties and the
nineties. The share of residual exports including petroleum products
declined almost continuously between 1987-88 and 1998-99.
An analysis of the commodity composition of India's exports
shows that the combined share of the top six export categories,
namely, gems and jewellery, readymade garments, engineering
goods, textile yarn, fabrics, made-ups, etc., leather and manufactures
and chemicals and allied products increased steadily i.•om 59.4 per
cent in 1987-88 to 65.7 per cent in 1991-92. On an average basis, the
combined share of these exports at 66.8 per cent during the period
1992-93 to 1998-99 was 3 percentage points higher than that during
the eighties.
The increase in the share of the top six categories of exports in
the total exports by 9 per cent between 1987-88 and 1998-99 reflects
a rise in the concentration of India's exports in terms of broad export
categories. It may, however, be mentioned that each of these top
export categories consists of a large number of individual items.
Even if the export shares of traditional items within a broad category
decline, the share of the whole product category in total exports can
increase due to appearance of newer products within that group. The
emergence of newer export items, however, indicate export
diversification and in order to get a clear picture about the change in
the concentration of exports, it is essential to examine the issue at a
more disaggregated level.

Commodity Composition: Exports

The changes in the structure of India's exports is more noticeable
at the disaggregated level. Items that registered considerable
improvements in relative export performance between the eighties
and the nineties include coffee, processed fruits, juices and
miscellaneous processed items, rice, spices, works of art excluding
floor coverings and other items like sugar and mollases and raw
cotton (not elsewhere included). On an average basis, the total export
earning from these six items taken together declined by 2.9 per cent
in the eighties, while they registered an impressive 20.5 per cent
growth rate in the nineties. Items, which have exhibited steady
relative export performance through the two periods include drugs,
pharmaceuticals and fine chemicals, other agricultural and allied
items, cotton yarn, fabrics, made-ups, etc. On an average basis, the
total export earning from these three items taken together increased
by 16.1 per cent and 12.8 per cent during the eighties and the
nineties, respectively. The relative export performance of items such
as oil meal, hand-made carpets excluding silk carpets, other ores and
minerals and rubber, glass, paints, enamels and products worsened
considerably during the nineties as compared to the eighties. As
against an average growth of 18.1 per cent during the first period, the
average growth rate of export earnings by these four items taken
together decelerated sharply to 6.5 per cent during the nineties. Items
which registered relatively low growth rates during the both periods
include cashew, gems and jewellery, iron ore, leather and
manufactures, natural silk yarn, fabrics, made-ups, etc., petroleum
products and tea. The combined export earnings of these seven items
taken together, on an average basis, increased by 6.3 per cent and 6.7
per cent, during the pre-1992 and post-1992 periods, respectively.
The change in the relative performance of individual export
items between the two periods indicates that the change in the
structure of agriculture and allied exports has been more marked than
manufactured exports. Items such as coffee, rice, processed fruits,
juices and miscellaneous processed items remained relatively less
important export items during the eighties. These items, however,
can be identified as crucial emerging exports during the nineties. In
terms of average growth rate, these exports had declined by 3.2 per
cent in the eighties, while they increased by an impressive 29.7 per
cent in the nineties. The combined share of these three exports in
India's total agricultural and allied exports had declined from 23.3
per cent in 1987-88 to 15.4 per cent in 1990-91. Their share more
than doubled to reach 34.2 per cent in 1998-99. Alongside the
emergence of newer products, the relative importance of some of
India's traditional agricultural and allied export items such as cashew,
oil meal, tea and tobacco declined considerably as between the two
periods. On an average, the growth rate of these exports decelerated
from 7.9 per cent in the eighties to 4.2 per cent in the nineties. More
importantly, their combined share in total agricultural and allied
exports, which increased from 38.1 per cent in 1987-88 to
43.6 per cent in 1989-90, declined sharply to 26.2 per cent in 1998-99.
Move Towards Value-addition
There are indications that during the nineties, some of the Indian
exports have moved upwards in the value-addition chain whereby
instead of exporting raw materials, the country has switched over to
the export of processed items. For example, while the value of iron
ore exports declined, that of primary and semi-finished iron and steel
increased many fold between the two periods. Reflecting this trend,
the share of ores and minerals in total exports declined, on an
average basis, from 5.5 per cent to 3.5 per cent between the eighties
and the nineties.
There were also significant compositional shifts within the major
manufactured product groups such as engineering goods, chemicals
and allied products, etc. as between the two periods. On an average
basis, the share of basic chemicals, pharmaceuticals and cosmetics
within the chemicals and allied group, declined from 71.4 per cent to
62.4 per cent between the eighties and the nineties. In particular, the
average export share of cosmetics, toiletries, etc. within this group
declined sharply from 12.4 per cent to 4.7 per cent between these two
periods. Within the same group, the average export share of plastic
and linoleum increased from 6.4 per cent during the eighties to 13.2
per cent in the nineties. Among the components of engineering
goods, the average share of machinery and equipment in total
engineering exports declined from 30.6 per cent to 21.7 per cent
while that of primary and semi-finished iron and steel increased from
2.9 per cent to 11.9 per cent as between the two periods. Among the
textile products, while the importance of man-made yarn, fabrics,
made-ups increased as between two periods, that of jute
manufactures declined sharply. The internal export composition of
leather and leather manufactures and readymade garments remained
stable before and after the initiation of economic reforms.

Moving Away from Traditional Exports Towards New

Manufactured Products
India's manufacturing exports are showing tendencies of shifting
away from traditional exports towards relatively new manufactured
products. Another interesting point about the compositional change
in the manufactured exports is that, by and large, major export items
within the category for which internal composition remained
unchanged between the eighties and the nineties (e.g., leather and
leather products, readymade garments) recorded relatively poor
 export performance as compared with groups which recorded
changes in their internal composition (e.g., chemicals and allied
products, engineering goods). This indicates the existence of a close
link between export performance and structural change in the case of
India's manufactured exports.
As mentioned earlier, since 1996-97 there has been a marked
deceleration in the growth of India's manufactured exports. Apart
from its negative impact on the overall export growth, a fall in the
growth of manufactured exports also likely to have constrained
structural transformation within the category of manufactured
exports. A number of external as well as domestic factors contributed
to the process of slowdown in India's exports in general and
manufactured exports in particular. These included: decline in
international manufactured prices, increased protectionism by the
industrialised countries coupled with non-implementation of the
transitional agreements on integration of trade in textiles and clothing
with the WTO by the industrialised countries. While these factors had
adverse implications for Indian manufacturing exports, particularly
exports of engineering goods, chemicals and allied products and
textiles and clothing, the sharp price fluctuation in the international
market for raw diamonds and gold between 1996 and 1998, had
contributed to the decline in gems and jewellery exports, the single
largest export item of India.

India's Share in Global Exports:

Compositional Change
The foregoing discussion focuses solely on the internal change in
the commodity composition of India's exports. It is also important to
study whether there has been any change in India's share in global
trade. It may be noted that commodities for which India's share in
global exports have increased considerably as between the two
periods include rice, coffee and substitutes, feeding stuff for animals,
textile yarn (in particular, cotton yarn), pearls, precious and semi-
precious stones and gold and silver jewellery. Items for which India's
global export share declined as between the two periods include
shellfish, tea and mate, spices, iron ore concentrate, leather, leather
manufactures and certain categories of textile and garment articles.
It is interesting to note that during the eighties, there were many export
items for which India's global market shares were high while growth in
 world trade for those products was low. It is argued that lack of alignment
between the composition of India's export basket and the demand structure
in foreign markets has been a major constraint for expansion of India's
exports. Reversing such trends, during the nineties, by and large, India's
global shares have improved for those commodities for which world trade
showed relatively high growth potential and India's global shares declined
for those commodities for which growth in world trade decelerated. In other
words, the alignment between the structure of world demand and the
composition of India's exports has improved during the nineties as
compared to the eighties. This is likely to have major impact on the future
behaviour of India's exports.
India's export share in world trade has increased perceptibly
during the recent period. India's exports as a percentage of world
exports improved to 0.56 per cent during 1991-1996 and further to
0.65 per cent during 1996-2002 from 0.48 per cent in the 1980s. The
ratio was 0.71 per cent in 2000-01, the highest achieved so far since
the 1970s. Nonetheless, India's share in world exports is still very
low and appears unimpressive when compared with the other major
trading Asian countries, such as, China and other East Asian
economies like Malaysia, Thailand, Singapore, Korea and Indonesia
(Table 23.9). China demonstrated the most dramatic change as its
share in world exports more than doubled in a decade from 2.0 per
cent in 1991 to 4.4 per cent in 2001. Group-wise, India's share in the
imports of industrialised countries in the 1990s declined as compared
to that in 1986. In respect of the developing countries as a group,
however, it has increased from 0.5 per cent in 1986 to 1.1 per cent
during 1996-2000.
The Ministry of Commerce and Industry, Government of India
has set an export target of 1 per cent share of world exports by 2006-
07 for the medium-term which would be co-terminus with the Tenth
Five Year Plan. This target is based on historical trends, current
prospects and the requirement of a compound annual growth rate of
about 12 per cent for exports till the year 2006-07 (Government of
India, 2002a). The export performance is known to depend on price
competitiveness, as well as non-price factors. As regards the price
competitiveness, a number of earlier studies have emphasised that
real exchange rate may be an important variable influencing the price
competitiveness of India's exports. In India, large exchange rate
misalignment has not oCcured in the last one decade as the market
itself has corrected the misalignment gradually over different
episodes.
India's export performance is affected by domestic as well as
external impediments. The domestic factors inhibiting India's export
growth are infrastructure constraints, high transactions cost, small-
scale industry reservations, inflexibilities in labour laws, lack of
quality consciousness and constraints in attracting FDI in the export
sector. High levels of protection in relation to other countries also
explain why FDI in India has been much more oriented to the
protected domestic market, rather than as a base for exports. The
exports of developing countries like India are facing increasing
difficulties by emerging protectionist sentiments in some sectors in
the form of technical standards, environmental and social concerns
besides non-trade barriers like anti-dumping duties, countervailing
duties, safeguard measures and sanitary and phyto-sanitary measures.
Indian products which have been affected by such barriers include
floriculture products, textiles, pharmaceuticals, marine products and
basmati rice exports to the European Union and mushroom and steel
exports to USA and also grapes, egg products, gherkins, honey, meat
products, milk products, tea, and spices. Differential tariffs against
developing countries have also adversely affected market access into
these countries (Government of India, 2002b; WTO, 2002).
According to the WTO, exports from India are currently subject to 40
anti-dumping and 13 countervailing measures mainly for agricultural
products, textiles and clothing products and chemicals and related
products. This brings into focus the importance of non-price factors
like quality, packaging and the like mentioned earlier, where India
still seems to be lacking as compared to the international standards.
This has adversely affected India's export performance vis-a-vis other
developing countries which may have an improved standing in these
non-price factors.

Commodity Composition of Imports

In the discussion on the structural change in India's imports in
this sub-section, the relative shares of the major commodities/groups
in total imports should generally be exclusive of gold and silver
imports. This has been done keeping in view the sharp increase in
gold and silver imports in the recent years, which obscures the
changes in the relative shares of other items. The import of gold and
silver rose from US $ 4 million in 1990-91 to US $ 4,876 million in
1998-99 and formed as much as 11.6 per cent of India's total imports
during that year.
The relative share of capital goods in India's total imports net of
gold and silver improved, marginally, from 25.6 per cent during
198791 to 26.0 per cent during 1992-1999. Within the capital goods
group, the rise in import was more pronounced in the case of
manufacture of metals, machine tools, and electrical machinery
(including electronic and computer goods), while that of non-
electrical machinery and transport equipment recorded a relatively
low order of increase. While the overall increase in the import of
industrial raw materials and intermediate goods was less pronounced,
certain individual items mainly catering to export activities such as
cashew nuts, textile yarn, fabrics, made-ups etc., and chemicals
(organic and inorganic), however, recorded sharper rise.
Among other items, the imports of petroleum (crude and
products) showed wide fluctuations, reflecting inter alia, the
movements in international prices. There was a sharp increase in its
import during 1989-90 (25.2 per cent) and 1990-91 (60.0 per cent)
and the average annual growth rate during 1988-1991 was
considerably higher at 27.2 per cent as compared with the 12.0 per
cent growth in total imports. After attaining a high base in 1990-91,
the oil imports declined during 1991-92 by 11.7 per cent. During the
period 1992-93 to 1998-99, the growth rate in oil imports ranged
between 33.4 per cent in 1996-97 and a negative of 21.2 per cent in
1998-99. Although the average annual growth rate of this item during
1992-1999 was low (4.6 per' cent), the average value at US $ 7,134
million stood 79.2 per cent higher than US $ 3,981 million during
1987-1991. Consequently, the relative share of oil imports moved up
to 22.5 per cent during 1992-1999 from 19.4 per cent during 1987-
1991.
Similarly, the average level of import of manufactured fertilisers
during 1992-1999 also stood 77.7 per cent higher than that during
19871991, although the average annual growth rate remained
considerably lower at 9.5 per cent during 1992-1999 than that of
79.5 per cent during 1988-1991. The increase in the imports of
consumption goods was relatively less pronounced (27.3 per cent),
with its share dropping from 4.3 per cent during 1987-1991 to 3.6
per cent during 1992-1999. Within this category, the import of edible
oils, however, increased by 55.9 per cent and that of sugar increased
by 269.3 per cent.
 The changes in the structure of India's imports are reflective of
the influence of three factors:
(1) movements in international prices;
(2) changes in trade policy; and
(3) pattern of domestic demand.
The role of international prices in shaping the trends in the
import of petroleum, crude and products has already been discussed
earlier. This apart, it may be indicated that the international prices of
manufactured goods have declined considerably during the recent
years, keeping their import value depressed.
The surge in the imports of gold and silver, edible oils and
manufactured fertilisers were to some extent policy driven. Similarly,
reflecting the impact of further easing of the restrictions on the
import of capital goods, these items recorded higher import growth
during 1992-1999. Since a sizable part of India's imports cater to the
needs of the industrial sector, the trends in the demand for imports
may be judged from the overall growth in industrial production.

Direction of Foreign Trade

Prior to Independence, a large part of India's trade was either
directly with Great Britain or its colonies or allies. This pattern
continued for some years after Independence as well since India had
not till then explored the possibilities of developing trade relations
with other countries of the world. For example, the combined share
of UK and USA in India's export earnings was 42 per cent in 1950'-
51. Their share in India's import expenditure was as much as 39.1 per
cent in the same year. With other capitalist countries like France,
Germany, Italy, Japan, etc. India either did not have trade relations at
all or they were very insignificant. As political and diplomatic
contacts developed with other countries, economic relations also
made a headway. Thus new vistas for developing trade relations with
other countries opened up. The situation has changed very much
since, and now after four and a half decades of planning, the trading
relations exhibit marked changes. The diversification in trade
relations has reduced the vulnerability of the economy to outside
political pressures.
In the year 1950-51, the share of UK in India's imports was 20.8
per cent and that of USA was 18.3 per cent. Thus, the combined
share of these two countries was 39.1 per cent. This reflected the
colonial heritage of the country. Within a decade, the picture started
showing some changes. New trading partners like West Germany,
Canada and USSR emerged. There was a change in the relative
position of UK and USA as well, with the latter pushing down the
former to the second place. Excepting a year or two, USA has
continuously maintained the first position thereafter. During the
planning period as a whole, India has obtained maximum imports
from USA, the reason being that India has imported large scale
quantities of capital goods, intermediate products and foodgrains
(under P.L.480 agreement) from that country. With the expansion of
trading relations with Japan, West Germany and USSR, the
dependence on the UK declined considerably. Thus the share of UK
in Indian imports declined from 19.4 per cent in 1960-61 to 5.7 per
cent in 1997-98. On the other hand, the share of Japan increased
from 1.5 per cent in 1950-51 to 5.4 per cent in 1960-61 and further
to 7.5 per cent in 1990-91. However, thereafter, it decreased in
percentage terms to 6.5 per cent in 1995-96 and 5.2 per cent in 1997-
98.
Another significant development was the expansion in trading
relations with the socialist countries especially the erstwhile USSR.
Imports from USSR were negligible in 1950-51. In 1960-61 they
amounted to a meagre Rs. 16 crore. However, thereafter, they
increased rapidly increasing the share of USSR in India's imports
from 1.4 per cent in 1960-61 to 6.5 per cent in 1970-71. For a
number of years it occupied the second place after USA. For
instance, during 1980-81 to 1983-84, USA occupied the first place in
India's imports and USSR was second. In 1984-85, the share of
USSR was 10.4 per cent and it displaced USA from the first place.
The picture changed thereafter. In 1985-86, USA was first, Japan
second and USSR third. In 1990-91, with a share of 12.1 per cent,
USA occupied the first place. It was followed by Germany with a
share of 8.0 per cent (the figure is for unified Germany). Japan had
the third position (share 7.5 per cent). UK and Saudi Arabia shared
the fourth position with a share of 6.7 per cent each, Belgium had the
fifth position (share 6.3 per cent) while USSR had the sixth position
(share 5.9 per cent). With the disintegration of USSR the direction of
imports has now changed markedly. For instance, in 1997-98, USA
occupied the first position in India's imports (share 8.9 per cent),
followed by Saudi Arabia (share 6.2 per cent), Germany (share 6.1
per cent), Belgium (share 6.0 per cent), Kuwait and UK (share 5.7
per cent each) in that order.
Direction of Exports
As is clear from Table 23.10, OECD group accounts for a major
portion of India's exports. The share of this group in 1960-61 was
66.1 per cent and in 1997-98 was 55.7 per cent. Almost 46 per cent
of these exports were accounted for by the EU countries in 1997-98.
The OPEC group accounted for 4.1 per cent of exports in 1960-61
and its share in 1997-98 rose to 10.0 per cent. Most significant was
the rapid increase in exports to the countries of Eastern Europe
particularly USSR For instance, Eastern Europe accounted for 7.0
per cent of export earnings in 1960-61 and its share shot up to 22.1
per cent in 1980-81. During recent years, exports to this group have
suffered a setback due to marked political upheavals in these
countries and the disintegration of the USSR. In 1997-98 the share of
Eastern Europe in total exports had slumped to a mere 3.1 per cent.
Developing nations of Africa, Asia and Latin America accounted for
more than one-fourth of India's export earnings in 1997-98. Most
important in this group have been the countries of Asia. In fact,
exports to Asian countries accounted for 21.3 per cent of India's total
export earnings in 1997-98. Thus, countries of Asia now account for
more than one-fourth of India's export earnings.
Direction of exports in 1999-2000 show significant increases in
India's exports to its major destinations like OECD, Asia and OPEC
regions. Exports in US Dollar value, grew by 12.8 per cent to OECD,
20.1 per cent to Asia (other than OPEC countries) and 12.3 per cent
to OPEC in 1999-2000 as compared with declines of 1.5 per cent,
14.4 per cent and low growth of 0.8 per cent respectively in 1998-99.
Other regions recording robust growth in exports included Eastern
Europe (due mainly to turnaround in exports to Russia) and Latin
America and Carribbean region with Mexico, Peru, Chile, Barbados
and Panama accounting for major increases. Exports to developing
countries in Africa, however, declined by 5.4 per cent in 1999-00 as
against a rise
of 9.9 per cent in the previous year. In terms of region-wise share in
total exports, while the share of OECD, OPEC and developing
countries from Africa declined in 1999-2000, those of Eastern
Europe and Asian developing countries from Africa declined in 1999-
2000, those of Eastern Europe and Asian developing countries
increased during this period. The share of developing countries from
the Latin America and Carribean region was, however, maintained at
1.7 per cent. Although the share in total exports to OECD countries,
as a group, registered a marginal decline from 57.8 per cent in 1998-
99 to 57.6 per cent in 1999-2000, exports to many developed
countries like Canada (25.8 per cent), UK (21.1 per cent), USA (18.5
per cent), Netherlands (16.1 per cent), France (10.9 per cent) and
Belgium (7.2 per cent), in this region recorded significant increases
during the year. The share rise in share of exports to developing
countries of Asia was largely on account of the recovery from the
crisis by East Asian countries as a result of which the share of our
exports to selected East Asian countries rebounded from 11.6 per
cent in 1998-99 to 13.7 per cent in 1999-2000.

Direction of Imports
Sources of imports reveal a sharp decline in share of imports in
total imports from OECD countries from 51.6 per cent in 1998-99 to
44.8 per cent in 1999-2000 as imports from these countries declined
by 3.2 per cent in 1999-2000. Bulk of this decline in share was
appropriated by imports from the OPEC region whose share rose to
23.8 per cent in 1999-00 (as compared to 18.3 per cent in 1998-99)
mainly because of increase in international petroleum crude oil
prices. Similarly, the share of imports sourced from non-OPEC
developing countries (of Africa, Asia and Latin America and
Carribbean) improved from 21.1 per cent in 1998-99 to 22.6 per cent
in 1999-2000. The share of imports from Eastern Europe was broadly
maintained in 1999-2000 due mainly to recovery in imports from
Russia. Imports from developing countries of Africa and Latin
America and Carribbean regions grew by 21.9 per cent and 20.3 per
cent respectively in 1999-2000 and was contributed among others, by
countries like Egypt, Ghana, Brazil, Chile and South Africa. Imports
from developing countries from Asia also recorded a high increase of
18.5 per cent with robust growth from countries like China, Hong
Kong, Malaysia and Thailand. The share of selected East Asian
countries in total imports increased from 14.9 per cent in 1998-99 to
 15.5 per cent in 1999-2000 due partly to the share depreciation of
currencies of these countries during the Asian crisis.
A sharp increase in imports from other residual destinations,
coupled with decline in share of OPEC region, may suggest a change
in sourcing of oil imports away from the OPEC region during the
current financial year.
Structural changes are also discernible from the data on sources
of India's imports. While there has been a sharp increase in the
relative share of the developing countries, that of the industrialised
countries declined. Between 1987-1991 and 1992-1999, the relative
share of the developing countries as a group moved up from 18.0 per
cent to 23.0 per cent. This was largely on account of the increase in
the imports from the newly industrialised countries in South East
Asia. Among the commodities that contributed to the import growth,
petroleum (crude and products) from Malaysia and Singapore,
vegetable oils from Malaysia, chemicals from Republic of Korea and
Singapore, and electronic goods from Hong Kong, Republic of
Korea, Malaysia and Thailand were prominent. Between the two
periods, the relative shares of the countries belonging to the OPEC
group also increased from 14.5 per cent to 21.9 per cent. This is
mainly reflective of the surge in the oil import bill on account of
higher prices.
The share of the OECD as a group in India's imports dropped
considerably from 59.4 per cent during 1987-1991 to 52.1 per cent
during 1992-1999. Within this group, the relative share of the EU
countries fell from 31.8 per cent during 1987-1991 to 26.9 per cent
during 1992-1999. The import shares of some of the individual EU
countries such as Denmark, Greece, Ireland and Italy, however,
recorded relatively high growth, while those from traditionally
important countries such as Germany, Netherlands, Sweden and UK
showed lower rise. The relative share of the UK fell to 5.8 per cent
during 1992-1999 from 7.9 per cent during 1987-1991. Among other
OECD countries, the imports from Australia, New Zealand and
Switzerland recorded relatively large growth. The relative share of
Switzerland moved up from 1.1 per cent during 1987-1991 to 4.0 per
cent during 1992-1999. This was largely on account of the import of
gold and silver and non-electrical machinery. It may be indicated that
during 1992-1999, the import of gold and silver formed as much as
69.2 per cent of India's total import from Switzerland, while
 Switzerland along accounted for 58.1 per cent of India's total import
of gold and silver during this period. The relative share of the East
European countries declined from 8.1 per cent during 1987-1991 to
just 2.9 per cent during 1992-1999 with absolute decline in the
imports from most of the countries belonging to this group.
Summing Up
Notwithstanding the earlier policy initiatives aimed at
liberalisation of India's foreign trade, the outward-looking trade
policy measures announced in 1991 marks the initiation of a new era
in India's foreign trade. India's foreign trade performance improved
significantly during the recent years and there has been a perceptible
change in the structure of India's foreign trade between the eighties
and the nineties.
The share of manufactured products has increased in India's total
exports. At the same time, since the introduction of reforms, the
proportions of high-value and differentiated products have increased
in India's export basket.
Along with the increase in India's aggregate share in world trade,
the alignment between the country's export basket and world demand
has increased during the nineties.
The relative share of certain capital goods in India's total imports
has also increased in this period. Imports of manufactured fertilizers
and edible oils also recorded higher growth during the post-1991
period.
In line with the policy changes, imports of gold and silver have increased
sharply during the nineties.
Reflecting the increased link between exports and imports, the
shares of certain export-related imports have also increased during
the recent years.
The most remarkable change in the country-wise composition of
India's exports and imports since 1991 has been the increase in the
share of developing countries in India's overall trade.
While the share of the East European countries has declined in
India's total trade, that of the OECD countries has declined in the
case of imports.
 India's foreign trade has, however, been adversely affected by certain
unfavourable external developments since 1996.
Notwithstanding these negative developments, India's trade
performance during the nineties as a whole has been better than that
during the eighties.
BALANCE OF TRADE
Balance of Trade, simply defined is, the difference between the
value of export of goods and the value of import of goods or more
generally between exports and imports or (X - M) where X denotes
value of exports and M, value of imports.
When value of exports is more than value of imports (i.e., X >
M) balance of trade (BOT) is said to be favourable or positive. On
the other hand when exports are less than imports (X < M) or imports
more than exports (M > X), the balance of trade (BOT) is said to be
unfavourable, or negative or there is said to be a deficit in the
balance of trade.
Since goods are also called merchandise, the balance of trade or trade
balance is also called balance of merchandise account.

India's Balance of Trade

Ever since the beginning of planning era in 1951, India has
continued to suffer from an unfavourable balance of trade. The only
exceptions to this trend have been the years 1972-73 and 1976-77
when the country had a positive trade balance of Rs. 104 crore and
Rs. 68 crore, respectively.
In the early years after Independence, the value of India's exports
as well as imports were low and the difference between them was
small. This resulted in comparatively lower magnitude of deficit in
trade balance. From Rs. 163 crore average annual deficit it rose to an
annual average of Rs. 36,363 crore during 1997 and 2002. The early
years of Tenth Plan; it was Rs. 42,069 crore in 2002-03 which
increased to Rs. 62,870 crore in 2003-04. Thus, the trade deficit has
not only persisted since 1951 but has increased widely over the years
to reach alarming levels by the end of the century as is shown in
Table 23.11.
Causes of Unfavourable Balance of Trade
Continued excess of imports over exports has perpetuated the
unfavourable balance of trade since 1950-51. To begin with, the trade
deficit was small, but it widened over time, more particularly from
the Sixth Plan onwards, it rose sharply to assume serious dimensions
during and after the Eighth Five-year Plan. This has happened
because exports from India have not been able to keep pace with the
high growth rate of Imports.
Large Increase in Imports
In terms of value, India's imports have increased sharply
between 1950-51 and 2005-06 from a level of Rs. 608 crore to
estimated Rs. 4,90,532 crore in 2004-05. Some of the factors that
have contributed to this massive import growth are as below:
(i) Large Increase in Developmental Imports: Under planned
economic development of the country starting with the First Plan,
there has been a continuous expansion in imports of capital goods,
machinery equipment, etc. The value of capital goods imports
(including transport equipment) increased from Rs. 366 crore in
1960-61 to Rs. 1,910 crore in 1980-81, Rs. 10,486 crore in 1990-91
and Rs. 63,175 croré in 20042005. Similarly there was increase in
raw materials and maintenance imports such as equipment needed to
replace the worn-out machinery and maintain it in working order.
(ii) Large Increase in Import of Petroleum: Petroleum, oils and
lubricants (POL) have registered more than 500-fold increase
between 1960-61 and 1991 as the value of POL imports increased
from Rs. 69 crore to Rs. 10,816 crore, which further rose to Rs.
1,34,094 crore in 2004-05. Petroleum is a major source of energy
used in industry and in surface as well as air transport. It is also used
for domestic fuel in the form of kerosene and cooking gas. Personal
transportation modes comprising motor cars and scooters,
motorcycles, etc., depend on petroleum. Petroleum is also used in
industry as raw material for many synthetic products. Therefore, a
massive increase in demand for and import of POL is thus inevitable.
(iii) Fertiliser Imports: In spite of increased domestic
production, fertilisers are imported to meet their fast growing
consumption requirements. Thus, between 1960-61 and 2000-01,
import of fertilisers has gone up from Rs. 13 crore to Rs. 3,034 crore
in 2000-01 and Rs. 5,143 crore in 2004-05.
 (iv) Import of Pearls and Precious Stones: The import of
unfinished and finished/worked precious and semi-precious stones
has increased from Rs. 1 crore in 1960-61 to Rs. 42,336 crore in
200405.

Modest Growth in Exports

Growth of exports was quite low and insignificant till the Third
Five-year Plan. The total value of exports increased from Rs. 642
crore in 1960-61 to Rs. 32,553 in 1991, Rs. in 2000-01 and
R s. 3,61,879 in 2004-05. Both external and internal factors are
responsible for this modest growth.

External Factors
(i) Low World Demand: The world demand for many goods has
remained low due to continuing recession and economic downturn in
many countries.
(ii) Low Income and Price Elasticity of Goods Exported: Many
of the goods exported by India are primary products such as cereal
preparations, fish and marine products, etc. The demand for these
goods is generally less elastic, i.e., the demand does not change r
much with change in income or prices. Thus, when we make efforts
to sell more and increase supply, prices fall but demand does not
increase much. Hence, we end up earning lower value even for larger
quantity sold and our export earnings either do not increase much or
sometimes may even decline.
(iii)Import Restriction on Our Goods Entering Foreign
Countries: Many countries have imposed restrictions on goods
imported by them and this adversely affects our exports. These
restrictions may be in the form of quotas, (not more than a certain
given quantity of a given product is to be imported from outside),
tariff restrictions (imposition of import duty on goods entering the
country and thus making them costlier for purchasers in the home
market of the importing country) or non-tariff restrictions such as
health laws that do not permit import of agricultural goods from
underdeveloped countries in USA and some other countries on
grounds of posing health hazard to the people. Such physical
restrictions and tariff as well as non-tariff barriers by USA and
countries of European Union have contributed to slow growth of
exports from India.
 (iv)Disintegration of the Soviet Union: The Soviet Union/USSR
was among our largest trading partners and a big market for Indian
goods. Its disintegration caused a major setback to our exports.

Internal Factors
(i)Increasing Domestic Demand: Increase in income of people
due to growth of the economy has contributed to higher domestic
demand. The supply side has however not been able to match this
increased demand due to slow growth in agricultural and industrial
output. Not much is thus left for exports as producers sell bulk of
output at home quite profitably. This reduction in surplus of goods
(over domestic consumption) for exports has contributed to their
slow growth.
(ii) Low Quality and High Cost of Production: India
emerged as high cost low quality production country which could not
face foreign competition either at home or abroad. Hence, Indian
goods were not favoured by foreign buyers and, therefore, our
exports remained low.
Measures to Correct Deficit in Balance of Trade
The Government of India has been adopting and implementing
various policies for restricting imports and promoting exports to
reduce trade deficit.
Restrictions on Imports
Following measures have been taken to regulate imports:
(i) Licensing of Imports: For quite a long time, the import of
nonessential consumer goods was not permitted while the importers
of capital goods essential for country's development were given
import licences. However, now under the liberalised trade policy,
licensing requirements for most of the goods have been abolished;
only a small negative list of import items remains under licensing
system.
(ii) Tariff Restrictions: For the goods that are permitted to be
imported under licence from the government, further restrictions are
imposed by way of custom duties or import duties also called import
tariffs. This means a tax is imposed on the goods which arrive at the
Indian ports and thus the price of such goods becomes higher for the
Indian buyers. The higher the rate of custom duty, the greater is the
 price that Indian buyers need to pay for imported goods. These high
prices of imported goods are expected to reduce their demand in the
domestic market and thereby to restrict imports.
(iii) Quantitative Restrictions: The government may determine
the total import quota of goods, i.e., the total amount of goods that
can be imported and allot this quota to various importers. Nothing
beyond the quota is allowed to be imported. This naturally limits the
quantity of imports. However, under an agreement with the World
Trade Organization (WTO), such quantitative restrictions have been
removed on many goods, while for others they are to be removed in
near future.

Export Promotion
With the continuing large deficits in India's balance of trade and
limited scope for imports reduction, the only long-term solution to
the problem lies in promotion of exports to earn sufficient foreign
exchange to pay for our growing imports. Export promotion
measures opening up wider international market for our
entrepreneurs will stimulate industrial development in the country
under the incentive of larger world demand for our goods.

Export Promotion Measures

The export promotion measures adopted by the Government of
India include monetary and non-monetary incentives, fiscal reliefs,
credit facilities, establishment of institutions to help exporters as well
as strict quality controls and inspection of goods meant from export.
Some of the major steps in this direction are as below:
(i) Devaluatio: In July 1991, the rupee was devalued by about 20
per cent in terms of major world currencies. This was expected to
cheapen our goods to foreign buyers thereby encouraging our
exports.
(ii) Cash Assistance: Under this scheme cash assistance is
given to exporters to compensate them for indirect taxes (e.g.,
custom duties) levied on the imported inputs that are used in
production of goods for exports.
(iii) Income Tax Concessions: Income from exports is
given several concessions under the income tax laws. For example
profits from exports are totally exempted from income tax.
 (iv) Import Concessions: Several concessions in imports
of machinery, equipment and technology are given to export
production units. Export oriented units are allowed duty free imports
of machines, raw materials and technology. Exporters are also
allocated foreign exchange for import of raw materials used in
production of export goods.
(v) Concessional Bank Credit to Exporters : For financing
production meant for exports and also for financing exports
themselves, banks give credit to exporters at concessional terms.
(vi) Import Licences to Exporters : Since imported goods
fetched very high prices in the domestic market as their imports were
highly restricted, the exporters were granted licences for import of
goods up to a certain percentage of value of goods exported by them.
This was expected to provide added incentive for exports.
(vii) Issue of Exim scrips : The system of granting import
licences to exporters was later replaced by exim scrips. The exporters
were given exim scrips equivalent to 30 per cent of value of their
exports. These exim scrips could be used to import a large variety of
items. The exim scrips could also be sold in the market. Since these
enjoyed a premium, the exporters could make additional profits from
their sale. This could act as a great incentive to exporters.
(viii) Convertibility of the Rupee : The system of exim
scrips was also replaced by partial convertibility of rupee in March
1992. Under this scheme, exporters, who earlier had to surrender
their entire foreign exchange earnings to the Reserve Bank of India
(RBI) at a rate fixed by it, were now obliged to sell only 40 per cent
of their exchange earnings at the official rate to the RBI. The rest
they were free to sell in the market at the market determined rate,
which was obviously higher than the official rate. This indeed was a
great liberalisation measure and a bigger incentive. In March 1997
even this was replaced by a system of full convertibility of rupee on
the trade account.
(ix) System of Advanced Licensing: Exporters are given
advance licences for duty free import of goods used in production of
export items.
(x) Relaxation of Controls on Exports and Simplification
of Procedures: Controls on exports have been relaxed. Exports of
many items have been decontrolled while export procedures and
formalities have been simplified.
(xi) Export Processing Zones : Many export processing
zones have been set up. The units operating there are allowed free
trade with other countries. They also enjoy various concessions like
five-year tax holiday.
(xii) Export Promotion Organisations: Some such
organisations are Export Advisory Council, Export Promotion
Councils, Directorate of Export Promotion, etc.
(xiii) Export Import Bank: The EXIM Bank provides
financial services to exporters and importers and coordinates the
work of other institutions engaged in financing export trade. It pays
special attention to export of capital goods.
 Balance of Payments and Trade
Policy

Concepts
BALANCE of payments (BoP) is a systematic record of all
economic transactions between the residents of a country and the rest
of the world. Like all double-entry book keeping accounts it always
balances i.e., Sum of credit entries = Sum of debit entries.
There are two types of accounts in BOP, namely, (i) Current
Account and (ii) Capital Account.
Current Account records transfers of goods and services i.e.,
merchandise trade and net invisibles which includes services like
travel, transportation, insurance, etc. and transfer payments.
Capital Account shows transfers of claims to money or titles to
investment between a country and the rest of the world. It includes
foreign investment inflow minus the foreign investment outflow,
loans including external assistance and external commercial
borrowings (inflow — outflow) and other capital which includes
rupee debt service, IMF transactions and SDR allocation.
A current account deficit is financed through net inflow of capital
on the capital account and the change in the Government's foreign
exchange reserve position.

Trade Policy: An Overviewl

As we embarked on a period of planning, during the fifties, import
substitution came to constitute a major element of India's trade and
 l. This section draws from C. Rangarajan's paper, India's Balance of Payments: The
Emerging Dimensions, in Uma Kapila (ed.), Indian Economy Since Independence
2000-01 edition, Academic Foundation, New Delhi.
industrial policies. Planners more or less chose to ignore the option
of foreign trade as an engine of India's economic growth. This was
primarily due to the highly pessimistic view taken on the potential
for export earnings. A further impetus to the inward orientation was
provided by the existence of a vast domestic market. In retrospect, it
is now abundantly clear that the policy-makers not only under-
estimated the export possibilities but also the import intensity of the
import substitution process itself. It has been as a consequence that
India's share of total world exports declined from 1.91 per cent in
1950 to about 0.53 per cent in 1992.
The inward looking industrialisation process did result in high
rates of industrial growth between 1956 and 1966. However, several
weaknesses of such a process of industrialisation soon became
evident, as inefficiencies crept into the system and the economy
turned into an increasingly 'high-cost' one. Over a period of time this
led to a 'technological lag' and also resulted in poor export
performance.
In the meantime, some change in the attitude towards exports became
perceptible. Several export promotion measures were put in place from the
early 1960s. The 1966 devaluation, while not resulting in the expected
improvement in trade deficit due to a combination of circumstances,
brought out the problems stemming from an overvalued exchange rate.
Nevertheless, it will be correct to say that until the end of the 1970s, exports
were primarily regarded as a source of foreign exchange rather than as an
efficient means of allocating resources. Import substitution over a wide area
remained the basic premise of the development strategy.

The Political Economy of the Foreign Exchange

Regimes
The political economy of India's foreign trade and exchange control
regimes before reforms were initiated in 1991 can be understood from the
implications of its selective, discretionary, and non-market-oriented
character. First, macroeconomic instruments, including most importantly
the exchange rate of the rupee, were never used to address balance of
payments problems except for the rupee devaluation of 1966. Given that
QRS on imports were substantially below market demand, the domestic
price of an imported commodity far exceeded its landed cost inclusive of
tariff duties and other taxes. As such there were rents associated with a
licence to import. It hardly requires much imagination to reglise that if rents
could be created and allocated, individuals and groups would spend
resources in influencing their creation and allocation in their favour.
It should be evident even to a casual observer of the Indian seene
that a significant amount of scarce talents and material resources that
could have been used for producing goods and services were spent
instead on seeking and dispensing rents. Senior bureaucrats who
wielded power spent much of their time in meetings that decided
individual cases rather than set broad policies. Of course, if adoption
of favourable decisions and the prevention of unfavourable decisions
had to be bought, so to speak, only those who could afford to pay the
price would enter the market. Clearly entrepreneurs with relatively
few material resources and contacts at crucial decision-making
agencies were unlikely to enter the market.
Foreign trade policy issues became the subject of intensive
discussion in early eighties. It came to be realised that a scheme of
import licensing under which imports were permitted only to the
extent that domestic production fell short of domestic demand
irrespective of difference in cost and prices, could only lead to
inefficiency. The view gained ground that a more liberal policy of
imports of capital goods and technology would enable India to reap
the benefits of international division of labour. The attempt therefore
was to move away from import substitution per se towards efficient
import substitution, so that considerations relating to cost and
efficiency were incorporated in the overall policy framework. It also
became increasingly clear that production for export could not be
isolated from _production for the home market and that trade policy
had to be integrated with the policy for domestic industrialisation.
While the signs of liberalised trade policy became visible in the
latter half of eighties, it was only in 1991 that the country embarked
on a truly liberalised trade policy with a short negative list of exports
and imports and with quantitative controls over imports withdrawn
for all, except consumer goods. It was recognised that trade,
exchange rate and industrial policies must form part of an integrated
policy framework if the aim was to improve the productivity and
efficiency of the economic system.
 Trade Policy since 1991
The trade policy changes in the post 1991 period sought to
minimise the role of quantitative restrictions and substantially reduce
the tariff rates on the lines suggested by the Tax Reforms Committee
(Chairman: Raja J. Chelliah). The developments in India's trade
policy during this period needs to be viewed in conjunction with
policy reforms initiated in other spheres of the economy. The
devaluation of the Rupee in July 1991 and the transition to the
market-based exchange rate regime deserve mention in this regard.
These measures were aimed at enhancing the price competitiveness
of exports. The policies governing foreign investment and foreign
collaboration also have undergone significant change, which have a
bearing on trade performance. Apart from unilateral measures, the
liberalisation of India's trade policies also reflects the multilateral
commitments of the country to the World Trade Organization (WTO).
The focus of these reforms has been on liberalisation, openness,
transparency and globalisation with a basic thrust on outward
orientation focusing on export promotion activity and improving
competitiveness of Indian industry to meet global market
requirements. In early 2002, the Government presented a Medium-
Term Export Strategy (MTES) for 2002-2007 providing a vision for
creating a stable policy environment with indicative sector-wise
targets, with a mission to achieve one per cent of global trade by
2007. The new Export and Import (EXIM) Policy framed for the
period 2002-2007 and unveiled on 31 March, 2002 also seeks to
usher in an environment free of restrictions and controls (Box 24.1).
Synergy between these policies/strategies is expected to realise
India's strong export potential and enhance the overall
competitiveness of its exports.
.

subsidy have been provided for the export of fruits, vegetables,

floriculture, poultry and dairy products. All Quantitative restrictions
on exports (except a few sensitive items) have been removed with
only a few items being retained for export through State Trading
Enterprises. To improve the productivity and export competitiveness
of small-scale, cottage and handicrafts sector, the Policy provides a
package of incentives, including exemption from maintaining the
average export obligation under the Export Promotion Capital Goods
(EPCG) scheme, permission to achieve a lower threshold level for
achieving the Export House status, preferential access to Market
Access Initiative funds and duty free access to trimming and
embellishment for achieving value added exports. The towns of
export excellence (such as Tirupur for hosiery, Panipat for woolen
blanket and Ludhiana for woolen knitwear) are intended to be
regional rural motors of economic development for the small scale
sector, focusing on plugging critical infrastructural bottlenecks and
enhancing quality of support services for industrial development.
To provide the necessary impetus to star achievers, EXIM Policy
provides a strategic package for status holders comprising
new/special facilities like issuance of Licence on self-declaration
basis, fixation of input-output norms on priority, exemption from
compulsory negotiation of documents through banks, cent per cent
retention of foreign exchange in Exchange Earners' Foreign Currency
account, enhancement in normal repatriation period from 180 days to
360 days and not mandating exports in each of the three licensing
years for achieving the status. The Policy has operationalised the
procedure for duty free import of fuel under the Advance Licensing
Scheme, provided the licence holder has a captive power plant.
In view of phasing out of all restrictions on textile products by 2005
under the Agreement on Textile and Clothing (ATC), the EXIM
Policy has focused on measures to encourage value added exports in
the garment sector. Electronic Hardware Technology Park (EHTP)
scheme has been modified to enable hardware sector to face the zero
duty regime under Information Technology Agreement (ITA-I),
mandating only a positive net foreign exchange as a percentage of
exports criteria and obviating any other export obligation for units in
Electronic Hardware Technology Parks. The changes carried out in
the gems & jewellery scheme include abolition of the licensing
 regime for the import of rough diamonds, reduction in the value
addition norms for export of jewellery and
Trade policy reforms in the recent past, with their focus on
liberalisation, openness, transparency and globalisation, have provided an
export friendly environment with simplified procedures for trade
facilitation. Such continued trade promotion and trade facilitation efforts of
the Government have also aided the current strengthening of export growth.
The Union Budget 2004-05 reiterated the policy approach of lowering
customs duties in a measured way to align India's tariff structure to those of
ASEAN countries. It underlined the need for a special fiscal and regulatory
regime for the Special Economic Zones (SEZs), given their role as growth
engines that can boost manufacturing, exports and employment. Towards
this, a Bill for regulating SEZs, to make India a major hub for
manufacturing and exports, is proposed. Other proposals announced in the
Budget included: identification of another 85 items to be taken out from the
SSI reservation list to provide space to these units to grow into medium
enterprises; proposal to set up a Fund for regeneration of traditional
employment generating industries (like coir, handloom, handicrafts,
sericulture, leather, pottery and other cottage industries) for development of
their export potential; abolition of the mandatory Cenvat duty regime and
introduction of a new tax regime for the textile sector to make the sector
more efficient and competitive; and a proposal to set up a National
Manufacturing Competitiveness Council as a continuing forum for policy
dialogue to energise and sustain the growth of manufacturing industries and
to enhance competitiveness in the manufacturing sector. Various trade
facilitation measures announced in the review of credit policy by the RBI in
October 2004 included liberalisation of guarantee by Authorised Dealers
(ADS) for trade credit, relaxation of time limit for export realisation for
Export Oriented Units (EOUs). Government also announced, on August 31,
2004, a new Foreign Trade Policy for the period 2004-2009, replacing the
hitherto nomenclature of EXIM Policy by Foreign Trade Policy (FTP). A
vigorous export-led growth strategy of doubling India's share in global
merchandise trade in the next five years, with a focus on the sectors having
prospects for export expansion and potential for employment generation,
constitute the main plank of the Policy (Box 24.2). These measures are
expected to enhance international competitiveness and aid in further
increasing the acceptability of Indian exports.

BOX - 24.2
Highlights of Foreign Trade Policy 2004-2009
Objectives and Strategy
The new Foreign Trade Policy (FTP) takes an integrated view of the
overall development of India's foreign trade and essentially provides a
roadmap for the development of this sector. It is built around two major
objectives of doubling India's share of global merchandise trade by 2009
and using trade policy as an effective instrument of economic growth
with a thrust on employment generation.
Key strategies to achieve these objectives, inter alia, include:
unshackling of controls and creating an atmosphere of trust and
transparency; simplifying procedures and bringing down
transaction costs; neutralizing incidence of all levies on inputs
used in export products; facilitating development of India as a
global hub for manufacturing, trading and services; identifying
and nurturing special focus areas to generate additional
employment opportunities,
Contd.
particularly in semi-urban and rural areas; facilitating technological and
infrastructural upgradation of the Indian economy, especially through
import of capital goods and equipment; avoiding inverted duty structure
and ensuring that domestic sectors are not disadvantaged in trade
agreements; upgrading the infrastructure network related to the entire
foreign trade chain to international standards; revitalising the Board of
Trade by redefining its role and inducting into it experts on trade
policy; and activating Indian Embassies as key players in the export
strategy.
Special Focus Initiatives
The FTP 2004 has identified certain thrust sectors having prospects for
export expansion and potential for employment generation. These
thrust sectors include agriculture, handlooms and handicrafts, gems &
jewellery and leather and footwear sectors.
Sector specific policy initiative for the thrust sectors include, for
agriculture sector, introduction of a new scheme called Vishesh Krishi
Upaj Yojana (Special Agricultural Produce Scheme) to boost exports of
fruits, vegetables, flowers, minor forest produce and their value added
products.
Under the scheme, exports of these products qualify for duty free credit
entitlement (5 per cent off.o.b value of exports) for importing inputs
and other goods. Other components for agriculture sector include duty
free import of capital goods under Export Promotion Capital Goods
(EPCG) scheme, permitting the installation of capital goods imported
under EPCG for agriculture anywhere in the Agri-Export Zone (AEZ),
utilising funds from the Assistance to States for Infrastructure
Development of Exports (ASIDE) scheme for development of AEZs,
liberalisation of import of seeds, bulbs, tubers and planting material,
and liberalisation of the export of plant portions, derivatives and
extracts to promote export of medicinal plants and herbal products.
The special focus initiative for handlooms and handicraft sectors
include extension of facilities like enhancing (to 5 per cent of f.o.b
value of exports) duty free import of trimmings and embellishments for
handlooms and handicrafts, exemption of samples from countervailing
duty (CVD), authorising Handicraft Export Promotion Council to
import trimmings, embellishments and samples for small
manufacturers, and establishment of a new Handicraft Special
Economic Zone.

Contd. .
Major policy announcements under gems and jewellery sector
encompass: permission for duty free import of consumables for metals
other than gold and platinum up to 2 per cent of f.o.b value of exports;
duty free re-import entitlement for rejected jewellery allowed up to 2 per
cent of f.o.b value of exports; increase in duty free import of commercial
samples of jewellery to Rs.l lakh, and permission to import of gold of 18
carat and above under the replenishment scheme. Specific policy
initiatives in leather and footwear sector are mainly in the form of
reduction in the incidence of customs duties on the inputs and plants and
machinery. The major policy announcements for this sector include:
increase in the limit for duty free entitlements of import trimmings,
embellishments and footwear components for leather industry to 3 per
cent of f.o.b value of exports and that for duty free import of specified
items for leather sector to 5 per cent of f.o.b value of exports; import of
machinery and equipment for Effluent Treatment Plants for leather
industry exempted from customs duty; and re-export of unsuitable
imported materials (such as raw hides and skin and wet blue leathers)
has been permitted. The threshold limit of designated 'Towns of Export
Excellence' has also been reduced from Rs.1,000 crore to Rs.250 crore
in the above thrust sectors.
New Export Promotion Schemes
A new scheme to accelerate growth of exports called 'Target Plus' has
been introduced. Under the scheme, exporters achieving a quantum
growth in exports are entitled to duty free credit based on incremental
exports substantially higher than the general actual export target fixed.
Rewards are granted based on a tiered approach. For incremental growth
of over 20 per cent, 25 per cent and 100 per cent, the duty free credits
are 5 per cent, 10 per cent and 15 per cent of f.o.b value of incremental
exports. Another new scheme called Vishesh Krishi Upaj Yojana has
been introduced to boost exports of fruits, vegetables, flowers, minor
forest produce and their value added products. Export of these products
qualify for duty free credit entitlement equivalent to 5 per cent of f.o.b
value of exports. The entitlement is freely transferable and can be used
for import of a variety of inputs and goods.
To accelerate growth in export of services so as to create a powerful and
unique 'Served from India' brand instantly recognised and respected the
world over, the earlier duty free export credit (DFEC) scheme for
services has been revamped and re-cast into the 'Served from India'
scheme. Individual service providers who earn foreign exchange of at
least Rs. 5 lakh, and other service providers who earn
Comd.
Pedbrwance

foreign exchange of at least Rs.10 lakh are eligible for a duty-credit

entitlement of 10 per cent of total foreign exchange earned by them. In
the case of stand-alone restaurants, the entitlement is 20 per cent,
whereas in the case of hotels, it is 5 per cent. Hotels and restaurants
can use their duty credit entitlement for import of food items and
alcoholic beverages.
To make India into a global trading-hub, a new scheme to establish
Free Trade and Warehousing Zone (FTWZs) has been introduced to
create trade-related infrastructure to facilitate the import and export of
goods and services with freedom to carry out trade transactions in
convertible currencies. Besides permitting FDI up to 100 per cent in
the development and establishment of these zones, each zone would
have minimum outlay of Rs. 100 crore and five lakh sq. mts. built up
area. Units in the FTWZs qualify for all other benefits as applicable
for SEZ units.
Further Simplification/RationaIisation/
Modifications of Ongoing Schemes
EPCG scheme has been further improved upon by providing
additional flexibility for fulfilment of export obligation, facilitating
and providing incentives for technological upgradation, permitting
transfer of capital goods to group companies and managed hotels,
doing away with the requirement of certificate from Central Excise (in
the case of movable capital goods in the service sector) and improving
the viability of specified projects by calculating their export obligation
based on concessional duty permitted to them. Import of second hand
capital goods without any restriction on age has been permitted and
the minimum depreciated value for plant and machinery to be re-
located into India has been reduced from Rs. 50 crore to Rs. 25 crore.
The new policy has allowed transfer of the import entitlelnent under
Duty Free Replenishment Certificate (DFRC) scheme in respect of
fuel to the marketing agencies authorised by the Ministry of Petroleum
and Natural Gas to facilitate sourcing of such imports by individual
exporters. The Duty Entitlement Passbook (DEPB) scheme will
continue until replaced by a new scheme to be drawn up in
consultation with exporters. Additional benefits have been provided to
export oriented units (EOU), including exemption from service tax in
proportion to their exported goods and services, permission to retain 100
per cent of export earnings in Export Earners Foreign Currency (EEFC)
accounts, extension of income tax benefits on plant and machinery to
DTA units which convert to EOU/Electronic Hardware Technology Park
(EHTP)/Software
Contd.
-Contd.

Technology Park (STP)/Bio-technogy Park (BTP) units, allowing

import of capital goods on self-certification basis and permission to
dispose of (for EOU in textile and garment manufacture) leftover
materials and fabrics up to 2 per cent of c. i.fvalue or quantity of import
on payment of duty on transaction value only. Minimum investment
criteria has been also waived for brass hardware and hand-made
jewellery EOUs (this facility already exists for handicrafts, agriculture,
floriculture, aquaculture, animal husbandry, IT and services). The FTP
proposes setting up of BTPs by granting all facilities of 100 per cent
EOUs. The FTP 2004 has introduced a new rationalised scheme of
categorisation of status holders as Star Export Houses, with benchmark
for export performance (during the current and previous three years)
varying from Rs. 15 crore (for One Star Export House) to Rs. 5000
crore (for Five Star Export House). The new scheme is likely to bestow
status on a large number of hitherto unrecognised small exporters. Such
Star Export Houses will be eligible for a number of privileges including
fast-track clearance procedures, exemption from furnishing of bank
guarantee, eligibility for consideration under Target Plus Scheme, etc.
Simplification of Rules and Procedures and
Institutional Measures
Policy measures announced to further rationalise/simplify the rules and
procedures include exemption for exporters with minimum turnover of
Rs. 5 crore and good track record from furnishing bank guarantee in any
of the schemes, service tax exemption for exports of all goods and
services, increase in validity of all licences/entitlements issued under
various schemes uniformly to 24 months, reduction in number of returns
and forms to be filed, delegation of more power to zonal and regional
offices, and time-bound introduction of electronic data interface (EDI).
Institutional measures proposed in the FTP 2004 include revamping and
revitalising the Board of Trade, setting up of an exclusive Services
Export Promotion Council to map opportunities for key services in key
markets and setting up of Common Facility Centres for use of
professional homebased service providers in state and district level
towns. Pragati Maidan in Delhi is proposed to be transformed into a
world class complex, with state-of-the-art, environmentally controlled,
visitor friendly exhibition areas and marts. The FTP 2004 also proposes
provision to deserving exporters, on the recommendation of the Export
Promotion Councils, of financial assistance for meeting the costs of
legal expenses connected with trade related matters.
 Source: Economic Survey 2004-05.
India's Balance of Payment Trends 1950-2000
The Decades of Fifties and Sixties
Prior to 1956-57, for most years in the fifties, India had a current
account surplus. But the position changed in 1956-57 when India
faced BOP crisis. The trade deficit increased from 3.8 per cent of
GDP at market prices to 4.5 per cent. The BOP crisis of 1956-57
precipitated the imposition of exchange controls which then became
endemic to the import substitution regime.
The BOP position deteriorated once again in 1966-67. In 1965,
the United States suspended its aid in response to the Indo-Pakistan
war and later refused to renew the PL 480 agreement on a long-term
basis. There was a concerted effort by the United States, the World
Bank, and the IMF to use external assistance as an instrument to
induce India (a) to adopt a new agricultural strategy, and (b) to
devalue the rupee. The rupee was devalued by 36.5 per cent in June
1966, and tariffs and export subsidies were simultaneously
rationalised, on the understanding that the inflow of aid would be
substantially increased.
The BOP improved after 1966-67 but largely because of the
decline in imports. Exports performed indifferently despite the
devaluation.

Balance of Payments in the Seventies

A Decade of Comfort
India's balance of payments remained comfortable during the
Seventies. The adjustment to the first oil shock of 1973-74 was
rendered smooth by a happy combination of buoyant exports, spurt in
private transfer receipts and increased inflow of aid. Exports,
benefited by the expansion in global trade, rose at an annual rate of
6.8 per cent in volume terms and by 15.6 per cent in US dollar terms
during the decade. An effective depreciation of the rupee occurred
due to the link with Pound Sterling until 1973 and later, because of
the lower growth in prices in India relative to other countries. Private
transfers rose sevenfold from $ 296 million in 1974-75 to $ 2175
million in 1979-80 and in fact, in the post first oil shock period,
financed roughly 80 per cent of the trade deficit. Within two years of
the shock, the current account balance turned into surplus and it was
only in 1978-79 that a deficit of about 0.2 per cent of GDP appeared.
The utilisation of aid was significant and was substantially higher
than the financing requirement for the decade, allowing for a build up
of reserves. At the close of the decade the foreign exchange reserves
stood at $ 7361 million providing cover for over 7 months of imports.
Balance of Payments up to 1981-82
The Period of Difficulties
During the eighties, issues relating to the balance of payments
came to occupy the centre stage in terms of India's macroeconomic
management. The impact of the second oil shock of 1979, the full
effects of which spilled over into the eighties, was more severe than
of the 1973-74. Between 1978-79 and 1981-82, imports almost
doubled. The increase in POL imports accounted for a little over half
the increase in the overall imports. This was followed by the second-
round effects on non-POL imports. Export performance was
depressed by the severe international recession of 1980-1983 and
recorded a volume growth of just a little over 3 per cent. Net
invisible receipts continued to provide support to the balance of
payments, largely in the form of earnings from tourism and the
sustained buoyancy of private transfers. However, the sharp
widening in the merchandise trade deficit resulted in a turnaround in
the current account balance from a surplus in 1977-78 to a deficit in
1981-82 of the order of US $ 3,166 million or 1.8 per cent of GDP.
Adjustment efforts consisted essentially of an Extended Fund Facility
(EFF) negotiated with the IMF, although there were also intensified
efforts to improve domestic production of crude petroleum. Balance
of Payments during 1982-83 to 1984-85
Easing of Pressure
A reprieve came during the period 1982-83 to 1984-85, with the
easing of pressure on the balance of payments mainly due to a
decline in the volume growth of imports from an average rate of 11.0
per cent during 1978-1982 to a little over 2 per cent. Net oil imports
(net of crude oil exports which commenced in 1981-82 after the
discovery of crude oil in Bombay High), declined substantially as
domestic production spurted to 29.0 million tonnes by 1984-85. This
indeed was the main cause of the easing of the balance of payments.
Non-POL imports rose at an average rate of 3.6 per cent in dollar
terms. Exports however, grew only at an average rate of 3.2 per cent,
in volume terms, due to a combination of adverse internal and
external conditions. The invisibles account deteriorated as the
interest payments to service external borrowing acquired a steady
rising trend. Private transfers stagnated with the arrest in the labour
migration boom. As a result, invisibles including private transfers
and other surpluses, which had financed 89 per cent of the trade
deficit in 1978-79 could meet only 57 per cent of the trade deficit in
1984-85. The current account deficit fell to US $ 2,416 million or 1.2
per cent of GDP in 1984-85 and reserves, which were US $5,952
million at the end of the year, stood to cover a little over 4 months of
imports. Twenty nine per cent of the financing requirement of the
first half of the eighties was met by the EFF. Commercial borrowings
and non-resident deposits emerged as important sources of finance,
meeting 21 per cent and 15 per cent respectively of the financing
need. However, external assistance remained the major source of
foreign capital inflows, accounting for 39 per cent of the financing
requirement.
Balance of Payments during 1985-1990
The Build-up to the Crisis
The second half of the eighties witnessed the building up of
strains on the balance of payments. Current account deficits acquired
a structural character, remaining at high levels throughout. Large
trade deficits occurred year after year despite a robust growth in
exports. Recovering from the stagnation in 1985-86, the volume
growth of exports in the succeeding four years ranged between 10 to
12 per cent per annum on an average. The share of manufactured
exports rose from 56 per cent in 1980-81 to 75 per cent in 1989-90.
Imports in US dollar terms rose in every year of the period. The
volume of net POL imports increased from 12.4 million tonnes in
1984-85 to 23.5 million tonnes in 1989-90. However, the fall in
crude oil prices during the period helped to contain the oil import
bill. On the other hand, non-oil imports rose sharply by an average of
13.4 per cent in US dollar terms partly due to large imports of
foodgrains in 1988-89. Imports of capital goods rose by an average
of 16.2 per cent during the period. Export-related imports as well as
other miscellaneous imports also rose significantly. The category of
non-DGCIS imports, comprising defence imports and imports of
ships and aircrafts etc., also rose significantly from about US $1.2
billion in 1985-86 to US $ 3.1 billion by 1989-90. The support from
invisible receipts fell in the face of steadily growing interest
payments and the outgo on account of profits, dividends, royalty,
technical fees and professional fees. The current account deficit
averaged $ 5.8 billion or 2.4 per cent of GDP during the period as
against the Planning Commission's estimate of 1.6 per cent. The
period also marked a deterioration in fiscal imbalances as the ratio of
gross fiscal deficit to GDP rose from 6.3 per cent in the first half of
the eighties to 8.2 per cent during 1985-1990. Repurchases from the
IMF under the EFF exacerbated the deterioration in the balance of
payments. External assistance, commercial borrowing and non-
resident deposits shared equiproportionally in the financing need.
The result was a doubling of external debt and a rise in the debt
service ratio from 13.6 per cent in 1984-85 to 30.9 per cent in 1989-
90.

The Crisis: 1990-1992

In 1991, India found itself in its worst balance of payments crisis
since 1947. That there was a crisis in the making during the second
half of 1980s had been evident for a long time. The inflow of foreign
borrowing had increased at a rapid rate during the late 1980s. This
was due to the excess domestic expenditure over income—the fiscal
deficit of the Centre and the States soared to over 11 per cent in
1991. During this period total public debt as a proportion of GNP
doubled reaching the level of 60 per cent and foreign currency
reserves were depleted rapidly.
Matters were made worse by an accompanying double-digit
inflation in 1990-91. The oil price increase resulting from Iraq's
invasion of Kuwait in August 1990 reinforced the crisis-like situation
in India.
India's credit rating got downgraded as, for the first time in its
history, India was on the verge of defaulting on its international
commitments and was denied access to external commercial credit
markets. A net outflow of Non-Resident Indian (N RI) deposits
commenced in October 1990 and continued during 1991. The only
way left for India was to borrow against the security of its gold
reserves transported abroad.
But something good emerged out of the BOP crisis of 1991—the
long overdue economic reforms. Apart from an immediate
programme of macroeconomic stabilisation, structural reforms were
also introduced in the industrial and trade policy regimes with a view
to improving the efficiency, productivity and international
competitiveness of India's economy.
The overvalued exchange rate was corrected by devaluation in
1991, followed by partial convertibility of rupee in 1992-93 and then
making the rupee fully convertible on trade account in 1993-94.
Tariffs were also cut steeply to open Indian industry to foreign
competition. The focus of import liberalisation has primarily been on
intermediate and captial goods industries with the imports of
consumer goods remaining, by and large, regulated.
Balance of Payments during 1993-94 to 2005-06
The initial response of the economy, especially exports, was very
good. The years 1993-94 to 1995-96 were years of excellent
economic performance with GDP having grown at 6.2 per cent in
1993-94 and by more than 7.5 per cent during 1994-95 and 1996-97.
Exports grew by
19.7 per cent during 1993-94 to 1995-96.
The major reasons for such a high growth rate in exports were: 4
World GDP grew by an average rate of 4.1 per cent per
annum during 1994-97 compared with 2.4 per cent during
1990-1993. World trade (dollar terms) grew by an average
rate of 9.8 per cent per annum during 1994-1997 compared
with 6.0 per cent during 1990-1993.
Imports of advanced countries (dollar terms) grew by an
average rate of 11.5 per cent during 1994-1997 compared
with 2.1 per cent during 1990-1993.
Increase in India's share in world exports of its three major
commodity groups, viz. Textiles, yarn and fabrics; pearls,
precious and semi-precious stones; and clothing and
accessories during 1994-96.
Increase in the Index of Comparative Advantage (ICA) of
the above.
Other export commodity groups in which India gained in
terms of ICA during 1994-1996 include fish and fish
4 . Chadha, Rajesh (1999). "Balance of Payments and Trade Policy", paper presented at
ADBNCAER Seminar on Economic and Policy Reforms in India (Dec. 9) India
International Centre, New Delhi.
 preparations; rice; coffee and substitutes; organic chemicals;
footwear; and gold and silver jewellery.
However, the boom was short-lived. Since 1996, India's export
performance has been poor.
There could be several explanations for this. Firstly, there has
been a major downturn in world trade since 1996, which has affected
India's trade as well. Export growth has been further hampered by an
appreciation of the real effective exchange rate in 1996-97 and
199798. This trend has, however, been reversed since 1998-99. There
has also been an adverse movement in terms of trade, which appears
to have affected exports. Finally, there are the host of domestic
factors—both policy related and administrative—which continue to
hamper imports. These include infrastructure constraints, high
transaction costs, SSI reservations, labour inflexibility, quality
problems and quantitative restrictions on export of agricultural
commodities.
However the surplus on invisibles has helped to reduce the
deficit on the current account. Earnings from invisibles have helped
particularly during the critical years of 1996-97 and 1997-98 when
the deficit on the trade account touched alarming levels close to $ 1.5
to 1.6 billion.
A current account surplus for the third successive year, coupled
with an expanding capital account, further strengthened India's
balance of payments in 2003-04. The year witnessed accumulation of
reserves of US$ 31.4 billion (excluding valuation changes, gold,
Special Drawing Rights and Reserve Tranche at the IMF). Almost
one-third of the reserves were contributed by the surplus in the
current account (Table 24. l). Rising surpluses in the current account
have been one of the distinguishing features of India's balance of
payments in the current decade, as it has been for most other major
Asian economies (e.g. China, Hong Kong, Japan, Korea, Malaysia,
Philippines, Singapore, Taiwan and Thailand). While for the
predominantly export-oriented South East Asian economies (e.g.
Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand),
strong growth in merchandise exports has been the main driver
behind the current account surpluses, buoyant invisible inflows,
particularly private transfers comprising remittances, along with
software services exports, have been instrumental in creating and
sustaining current account surpluses for India.
 The strength provided by the surplus in the current account was
reinforced by robust capital inflows in 2003-04. During the year,
capital account surplus was almost double its previous year's level
(Table 24.1). While major components of loans (e.g. external
assistance and commercial borrowings) recorded net outflows,
foreign investment flows increased more than three-fold. Heavy
portfolio inflows, comprising essentially FII investment, shored up
total foreign investment and the overall capital account surplus.
Banking capital inflows, particularly expatriate deposits, also
contributed to the expanding surplus.
Balance of payments estimates for April-September, 2004-05,
2005-06 indicate the emergence of a current account deficit (Table
24.1). The year 2004-05 marked a significant departure in the
structural composition of India's balance of payments (BOP), with
the current account, after three consecutive years of surplus, turning
into a deficit. In a significant transformation, the current account
deficit, observed for 24 years since 1977-78, had started shrinking
from 1999-00. The
contraction gave way to a surplus in 2001-02, which continued until
2003-04. However, from a surplus of US$14.1 billion in 2003-04, the
current account turned into a deficit of US$5.4 billion in 2004-05.
The turnaround in the current account during 2004-05 was
accompanied by a significant strengthening of more than 80 per
cent in the capital account resulting in continued reserve accretion.
Compared with 2003-04, when loan inflows had turned into net
outflows, such inflows shot up rapidly during 2004-05 and
bolstered the size of the capital account surplus with good support
from robust foreign investment inflows. Reserve accumulation
during 2004-05, at around four-fifths of such accumulation during
2003-04, maintained India's status as one of the largest reserve-
holding economies in the world.
The broad trends observed in the current and capital accounts
in 2004-05 have been maintained during 2005-06. The current
account continues to be in deficit with the size of the deficit during
the first half of the current year (April-September 2005) almost
twenty seven times that of the deficit in the corresponding previous
period. Indeed, the current account deficit of US$ 5.3 billion
during the first quarter (April-June 2005) itself was almost
equivalent to the deficit for the whole of 2004-05. During the
second quarter (July-September 2005), the deficit became even
larger (US$7.7 billion) after growing at almost 45 per cent over
and above that of the previous quarter. The rapidly enlarging trade
deficit, buoyed by remarkable import growth, has been pushing the
current account deficit. During the period 2001-02 to 200304, the
invisibles (net) always overcame the trade deficit to maintain the
current account in surplus. However, the trend was reversed in
200405 and appears to be continuing in 2005-06. At present, India
is one of the few leading economies in the South East Asian region
to have a fairly large current account deficit.
The widening of the current account deficit has been
accompanied by a similar widening of the capital account surplus.
The capital account surplus during the first half of the current year
has been more than one and a half times the surplus in the
corresponding period of the previous year. Moreover, between the
first and second quarters, while the current account deficit
increased by 45 per cent, the capital account surplus almost
 doubled in size (US$ 12.9 billion in July-September 2005 visa-vis
US$6.5 billion in April-June 2005). Since 2002-03, much of the
strengthening of India's capital account has emanated from
augmentation of non-debt creating foreign investment (nét)
inflows, particularly Foreign Institutional Investor (FII) inflows.
During the
540 Indian Economy: Performance and Policies

current year, robust FII inflows were more than eleven times
higher than such inflows during April-September 2004. The bulk
of this increase occurred during July-September 2005, in response
to the rising buoyancy in the stock markets. The period also
witnessed an increase in inflows of commercial borrowings and
short term credits on account of lower interest rate spreads on
external borrowings and higher import financing requirements. The
cumulative impact of higher debt and nondebt creating flows was a
notable expansion in the size of the capital account surplus. The
expansion succeeded in retaining an overall surplus in the balance
of payments and resulted in a net reserve accretion of US$6.5
billion during April-September 2005, which was only marginally
lower than the accretion of US$ 6.9 billion during AprilSeptember
2004.

Invisibles
In the three successive years of current account surpluses
ending in 2003-04, buoyant net earnings from invisibles more than
compensated for the trade deficits. In 2004-05, with growth of
more than 12 per cent, earnings from invisibles crossed US$30
billion; but with the trade deficit growing by a much larger 167 per
cent to over US$36 billion, the current account balance turned into
a deficit. In the first half of 2005-06 as well, while invisibles grew
by 31 per cent, the trade deficit grew much faster by 114 per cent,
and resulted in a sharp widening of the current account deficit.
Within invisibles, the contribution of different categories to
overall invisible earnings has changed significantly since the early
1990s. Traditionally, private transfers, comprising mainly
remittances from Indians working abroad, had been the main
source of invisible earnings. Over time, however, non-factor
services have emerged as another key component of invisibles.
Indeed, beginning from 1991-92 till 2001-02 (except 1999-2000),
private transfers always exceeded invisibles (net). However, since
2002-03, overall invisibles have been higher than private transfers,
mainly due to rising contribution of non-factor services. As a
proportion of total invisibles (net), the share of private transfers
has declined from 121 per cent in 1996-97 to around 65 per cent in
2004-05, while that of non-factor services has improved from 7
per cent to 45.5 per cent during this period.
The increasing share of non-factor services in invisibles can
be traced to the buoyancy in export of software services. Net
earnings from software services increased by 34.1 per cent from
US$] 2.3 billion in 2003-04 to US$16.5 billion in 2004-05. The
rate of growth was more or less maintained during the first half of
2005-06 with such receipts growing by 30 per cent from US$7.6
billion in April-September 2004 to US$9.8 billion. Indeed, the
robust growth in export of software services has been responsible
for an overall growth of 59 per cent in net non-factor services
receipts in April-September 2005 vis-a-vis AprilSeptember 2004,
since the other leading components of non-factor services, travel
and transportation, became net outflows during AprilSeptember
2005. While higher outbound tourist traffic has resulted in net
travel outflows, such developments in transportation also reflect
higher outgo related to rising volume of imports and mounting
freight rates.
India continues to remain the highest remittance receiving
country in the world (Box 24.3). Buoyant private transfers have
imparted strength and stability to net invisibles receipts. Between
1990-91 and 2003-04, private transfers increased every year
except in 1997-98 and 1998-99. In 2004-05, however, private
transfers declined by 6.3 per cent. Developments in the first half of
the current year, with growth of 20.8 per cent in private transfers,
probably indicate a return to the earlier secular trend.
Capital Account, External Debt and Exchange Rate
Approach, Developments and Issues
Reflecting the inward oriented economic policies in pursuit of
selfreliance through export bias and import substitution, the role of
the capital account during the 1980s was basically that of financing
the current account deficits (RBI, 1999). The widening of the current
account deficit during the 1980s coupled with the drying up of
traditional source of official concessional flows necessitated a
recourse to additional sources of financing in the form of debt
creating commercial borrowings, non-resident deposits and
exceptional financing in the form of IMF loans.
The external payment crisis of 1991 brought to the fore the
weaknesses of the debt-dominated capital account financing.
Recognising this, structural reforms and external financial
liberalisation measures were introduced during the 1990s. The policy
shift underscored the need for gradually liberalising capital account
recognising that this is a process rather than a single event (Jalan,
1999). Throughout the 1990s the role assigned to foreign capital in
India has been guided by the consideration of financing a level of
current account deficit that is sustainable and consistent with
absorptive capacities of the economy (Rangarajan, 1993; Tarapore,
1995; Reddy, 2000). In India, the move towards full capital account
liberalisation has been approached with extreme caution. Taking
lessons from the international experience, the Committee on Capital
Account Convertibility, 1997 (Chairman: S. S. Tarapore) suggested a
number of pre-conditions, attainment of which was considered
necessary for the success of the capital account liberalisation
programme in India (Box 24.4). The High Level Committee on BOP
had recommended the need for achieving this compositional shift.
Keeping in line with the policy thrust, capital flows have undergone
a major compositional change in the 1990s in favour of non-debt
flows.
 BOX - 24.4
Committee on Capital Account Liberalisation
(Chairman: S.S. Tarapore)

With the growing role of private capital flows and the possibility of
occasional sharp reversals, the issue of capital account liberalisation
and convertibility has spurred extensive debate since 1992—the
period which witnessed a series of currency •crises; in Europe
(1992-93), Mexico (1994-95), East Asia (1997-98), Russia (1998),
Brazil (1999), Turkey (2000) and Argentina (2001-02). These crises
have raised the question of desirability of liberalisation and whether
it is advisable to vest the IMF with the responsibility for promoting
the orderly liberalisation of capital flows. The IMF in its study
(1998) stated that "As liberalised systems afford opportunities for
individuals, enterprises and financial institutions to undertake greater
and sometimes imprudent risks, they create the potential for
systematic disturbances. There is no way to completely suppress
these dangers other than through draconian financial repression,
which is more damaging." The view of IMF itself has changed over
time (RBI, 2001). While opening up of the capital account may be
conducive to economic growth as it could make available larger
stocks of capital at a lower cost for a capital-deficient country, the
actual performance of the economy, however, typically depends on a
host of other factors. For a successful liberalised capital account,
emerging market countries could: (i) pursue sound macroeconomic
policies; (ii) strengthen the domestic financial system; (iii) phase
capital account liberalisation appropriately, and (iv) provide
information to the market. At the international level, there is also the
role of surveillance to consider, including the provision of
information and the potential need for financing (Fischer, 1997).
In India, the move towards full capital account liberalisation has
been approached with extreme caution. The Report of the
Committee on Capital Account Convertibility, 1997 (Chairman:
S.S.Tarapore) taking into account lessons from international
experience suggested a number of signposts, the attainment of which
are a necessary concomitant in the move towards capital account
convertibility. Fiscal consolidation, lower inflation and a stronger
financial system were seen as crucial signposts for India.
India followed a gradualist approach to liberalisation of its
capital account. India did not experience reversal of its policies
towards the capital account as was the case with some emerging
market economies that had followed a relatively rapid liberalisation
without entrenching the necessary preconditions. This is particularly
 important since crosscountry studies do not provide clear evidence
of increase in capital flows resulting from capital account openness
across all developing countries, with only 14 developing countries
accounting for about 95 per cent of net private flows to developing
countries in the 1990s. Besides, empirical evidence on the positive
effects of financial capital flows on economic growth is not yet
conclusive (Edison et al., 2002).

Foreign Investment
During the first three decades after Independence, 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. 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. In the recent
period, a number of measures have been taken to further promote
FDI. These include: raising the foreign ownership cap to 100 per cent
in most of the sectors, ending state monopoly in insurance and
telecommunications, opening up of banking and manufacturing to
competition and disinvestment of state ownership in Public Sector
Undertakings (PSUs). Though the FDI companies have generally
performed better than the domestic companies, FDI to India has been
attracted mainly by the lure of the large market.

Magnitude
Responding to the policy efforts, foreign investment inflows to India
(direct and portfolio investments taken together) picked up sharply in
1993-94 and have been sustained at a higher level with an aberration
in 1998-99, when global capital flows were affected by contagion
from the East Asian crisis. Total foreign investment has averaged at
US $ 5.4 billion during the three year period 1999-2000 to 2001-02
as against negligible levels of the 1980s.

Foreign Portfolio Investment (FPI)

Like FDI, the environment for FPI was also made more
congenial through procedural changes for investment and by offering
more facilities for investment in equity securities as well as in debt
 securities to a select category of portfolio investors, viz., the Foreign
Institutional Investors (Flls). Furthermore, the sectoral limits for Flls
in the Indian companies were progressively increased over time;
these limits have been done away with altogether, except in select
specified sectors. The NRIs, Overseas Corporate Bodies (OCBs) and
Persons of Indian Origin (PIOs) are also permitted to invest in shares
and debentures of Indian companies, government securities,
commercial papers, company deposits and mutual funds floated by
public sector banks and financial institutions.
NRI Deposits
NRI deposits in the form of Non-Resident (External) Rupee
Account (NR(E)RA) and Foreign Currency Non-Resident Account
(FCNR(A)) emerged as a steady flow of foreign capital in India from
the 1970s, following the labour migration boom in West Asia in the
wake of the first oil shock. The onset of the 1990s saw the
introduction of as many as five NRI deposit schemes [Foreign
Currency Bank and Ordinary (FC(B&O)), Foreign Currency
Ordinary Non-Resident (FC(ON)), NonResident Non-Repatriable
Rupee Deposit (NR(NR)RD), Non-Resident Special Rupee Account
(NR(S)RA) and Foreign Currency Non-Resident Bank (FCNR(B))]
between 1990 and 1993 designed to attract foreign exchange in the
face of external payments crisis of 1991. The policies with regard to
NRI deposits during the 1990s have been aimed at attracting stable
deposits. This has been achieved through: (i) a policy induced shift in
favour of local currency denominated deposits; (ii) rationalisation of
interest rates on rupee denominated NRI deposits; (iii) linking of the
interest rates to LIBOR for foreign currency denominated deposits;
(iv) de-emphasising short-term deposits (up to 12 months) in case of
foreign currency denominated deposits; and (v) withdrawal of
exchange rate guarantees on various deposits. The Reserve Bank has
also made an active use of reserve requirements on these deposits as
an instrument to influence monetary and exchange rate management
and to regulate the size of the inflows depending on the country's
requirements.

External Commercial Borrowings

Commercial debt capital includes a whole range of sources of
foreign capital where the overriding consideration is commercial.
External commercial loans include bank loans, buyers' credit,
 suppliers' credit, securitised instruments such as Floating Rate Notes
and Fixed Rate Bonds, commercial borrowings and the private sector
window of multilateral financial institutions.
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
annual ceiling. Over time, the policy has been guided by a priority
for projects in the infrastructure and core sectors such as power, oil
exploration, telecom, railways, roads and bridges, ports, industrial
parks, urban infrastructure and for 100 per cent Export Oriented
Units (EOUs). To allow further flexibility to borrowers, end-use and
maturity prescriptions have been substantially liberalised. Moreover,
corporates have been allowed to borrow up to a certain limit under
the 'automatic route'. Apart from these, special bonds (India
Development Bonds (IDBs), Resurgent India Bonds (RIBs) and
India Millennium Deposits (IMDs) were issued by the State Bank of
India aimed at NRIs. The success in mobilising foreign exchange
resources through such exceptional schemes reflected the confidence
of the global investor community in the Indian economy and
imparted an element of stability to the external sector and the overall
balance of payments position.
At times, the rationale behind raising such high cost debt capital
has been questioned. Experience, however, would suggest that each
time this option was resorted to, it helped in strengthening the
confidence in the Rupee and the ability of the country to honour its
obligations. The costs of an exchange rate crisis are too severe in
relation to cost of debt capital. In a situation of moderate debt-service
ratio, such debt capital makes more sense than allowing the exchange
rate to fall under pressure.

Decline in Foreign Aid

Over the same period, official aid has waned in importance. This
reflected mainly growing amortisation payments in the face of
sluggish disbursements of external assistance as also availability of
alternative private capital flows. Unlike aid, the share of ECBs in
total capital flows have increased from around 31 per cent in 1990-91
to around 40 per cent in 1997-98. This has been mainly on account of
the higher appetite for ECBs in view of the strong import demand
and industrial growth.

Impact of Reforms on BOP

The impact of the continuum of reforms initiated in the aftermath
of the balance of payments crisis of 1991 on India's current account and
capital account resulted in an accumulation of foreign exchange
reserves of over US $ 141 billion as at end-March 2005. Capital
account surplus increased from US $ 3.9 billion during the 1980s to US
$ 8.6 billion during 1992-2002 with a steadily rising foreign
investment. As a proportion of GDP, capital flows increased from 1.6
per cent during 1980s to 2.3 per cent during 1992-2002. The significant
increase in capital flows during the 1990s raises the issue of their
determinants as well as their impact on growth.
Since 1990-91, India's capital account has experienced several
interesting changes in terms of the relative roles played by different
varieties of capital flows in augmenting the overall balance. Between
1998-99 and 2001-02, the share of foreign investment in the overall
capital account balance increased steadily from 29 per cent to 80 per
cent. Thereafter, however, the proportion has followed an oscillating
pattern within a band of 39 to 79 per cent. It appears that the
importance of debt-creating flows in the overall balance of payments
increased with the emergence of a current account deficit in 2004-05.
Debt-creating flows comprising external assistance, commercial
borrowings and nonresident deposits, after being negative for two
successive years, were 19 per cent of the capital account surplus in
2004-05. This trend in debtflows appears to have continued in 2005-
06.
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 and ECBs and the increased share of foreign
investment—both direct and portfolio. Apart from financing the
current account gap, capital flows have played a significant role in
India's growth performance.
Evidence of strong complementarity with domestic investment
suggests that capital flows brighten the overall investment climate
and stimulate domestic investment even when a part of the capital
flows actually gets absorbed in the form of accretion to reserves. The
growthaugmenting role of foreign capital, particularly FDI, however,
 seems to have been constrained by the low levels of actual and
planned absorption of foreign capital in India (RBI, 2001). The key
indicators of balance of payments as explained in Table 24.3 (also
Table A-23.1 in ch. 23) show considerable improvement in India's
balance of payments since 1991.

External Debt Management

Key indicators of debt sustainability point to the continuing
consolidation and improved solvency in the 1990s. Although, in
nominal terms, India's total outstanding external debt increased
fronrUS $ 83.8 billion at end-March 1991 to US $ 98.5 billion at
end-March 2002, external debt to GDP ratio declined sharply from
28.7 per cent at endMarch 1991 to 20.9 per cent at end-March 2002.
Prudent external debt management is also reflected in the proportion
of short-term debt to total debt declining from 10.2 per cent in 1991
to 2.8 per cent in 2002 and in the ratio of short-term debt to foreign
exchange reserves from a high of 146.5 per cent in the crisis period
of 1991 to only 5.1 per cent in 2001-02. Debt service ratio declined
from 35.3 per cent in 1990-91 to 14.1 per cent in 2001-02 (Table
24.4). Interest payments to current receipts ratio declined from 15.5
per cent in 1990-91 to 5.4 per cent in 2001-02.

The decade of 1990s witnessed a steady move towards

consolidation of India's external debt statistics in terms of size,
composition and indicators of solvency and liquidity. Containing the
increase in the size of external debt to a modest level in the face of a
tremendous growth in foreign exchange reserves during the decade
definitely points towards the success of India's debt management
strategy. Reflecting this, in terms of indebtedness classification, the
World Bank has categorised India as a less indebted country since
1999. Among the top 15 debtor countries of the world, India
improved its rank from third debtor after Brazil and Mexico in 1991
to ninth in 2000 after Brazil, Russian Federation, Mexico, China,
Argentina, Indonesia, Korean Republic and Turkey. Moreover,
among them, key external debt indicators such as short-term debt to
total debt and short-term debt to forex reserve ratios are the lowest
for India; the concessional to total debt ratio is the highest, while
debt to GNP ratio is the second lowest after China.
Exchange Rate Management
In the context of globalisation and currency crises, recent years,
particularly, have seen a renewed interest on the issues relating to
exchange rate regime, which is evident in the large and growing
body of theoretical and empirical literature on the subject.
Nevertheless, both in theory as well as in practice, the state of the
debate is unsettled. A worldwide consensus is still evolving in search
of an appropriate and credible exchange rate regime. In India also,
discussion and debate on issues relating to the appropriate exchange
rate system, policies on intervention, capital control and foreign
exchange reserves figure very prominently. This is especially
relevant with the introduction of a market-based exchange rate
system in March 1993 and in the context of global currency crises,
particularly the East Asian Crisis.
In India the exchange rate system has undergone a paradigm
shift from a system of fixed exchange rate (until March 1992) to a
market determined regime in March 1993. Since the switchover to a
market determined exchange rate regime in March 1993, the
behaviour of the exchange rate has remained largely orderly,
interspersed by occasional episodes of pressures, which were
relieved through appropriate intervention operations consistent with
the stated policy of avoiding undue volatility in the exchange rate
without reference to any target, whether explicit or implicit. The
financial crises encountered by the emerging markets in the last
decade have brought to the fore the importance of an appropriate
exchange rate policy. The present Indian regime of managed
flexibility that focuses on managing volatility without reference to
any target has gained increasing international acceptance and well
served the requirements of the country in the face of significant
liberalisation of external sector transactions. This is particularly so in
the context of the series of exchange rate crises experienced by
several emerging economies undertaking similar macroeconomic
reforms.
In the post-Bretton Woods period, the Rupee was effectively
pegged to a basket of currencies of India's major trading partners
from September 1975. This system continued through the 1980s,
though the exchange rate was allowed to fluctuate in a wider margin
and to depreciate modestly with a view to maintain competitiveness.
However, the need for adjusting exchange rate became precipitous in
the face of the external payments crisis of 1991.

Transition to Market Determined Exchange Rate System

As a part of the overall macroeconomic stabilisation programme,
the exchange rate of the Rupee was devalued in two stages by 18 per
cent in terms of the 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 High Level Committee on
Balance of Payments, 1993 (Chairman: C. Rangarajan). The
Liberalised Exchange Rate Management System (LERMS) instituted
in March 1992 was a dual exchange rate arrangement under which
40 per cent of the current receipts were required to be surrendered to
the Reserve Bank at the official exchange rate while the rest 60 per
cent could be converted at the market rate. The 40 per cent portion
surrendered at the official rate was for meeting the essential imports
at a lower cost. Although the experience with the dual exchange rate
system in terms of volatility in the market determined segment of the
forex market was satisfactory, it involved an implicit tax on exports
and other invisibles receipts and thereby emerged as a source of
distortion. As a system in transition, the LERMS performed well in
terms of creating the conditions for transferring an augmented
volume of foreign exchange transactions on to the market.
The unified market determined exchange rate regime replaced
the dual regime on March 1, 1993 and 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.
Subject to this predominant objective, the exchange rate policy is
guided by the need to reduce excess volatility, prevent the emergence
of destabilising speculative activities, help maintain adequate level of
reserves, and develop an orderly foreign exchange market" (Jalan,
1999). In order to reduce the excess volatility in the foreign exchange
market, the Reserve Bank has undertaken market clearing sale and
purchase operations in the foreign exchange market to moderate the
impact on exchange rate arising from lumpy demand and supply as
well as leads and lags in merchant transactions. Such interventions,
however, are not governed by any predetermined target or band
around the exchange rate.
 The experience with the market determined exchange rate regime
has been satisfactory, although the exchange rate management had to
occasionally contend with a few episodes of volatility. The period
from March 1993 till August 1995 was a phase of significant
stability. Capital inflows coupled with robust export growth exerted
upward pressure on the exchange rate. However, the Reserve Bank
absorbed the excess supplies of foreign exchange. In the process, the
nominal exchange rate of the Rupee vis-a-vis the US Dollar remained
virtually unchanged at around Rs.31.37 per US Dollar over the
extended period from March 1993 to August 1995. The real
appreciation that resulted from the positive inflation differentials
prevailing during this period triggered off market expectations and
resulted in a market led correction of the exchange rate of the Rupee
during September 1995—February 1996. In response to the
upheavals, the Reserve Bank intervened in the market and also
resorted to monetary tightening so as to restore orderly conditions in
the market after a phase of orderly correction for the perceived
misaligm„ent.
The period since 1997 has witnessed a number of adverse
internal as well as external developments. The important internal
developments include the economic sanctions imposed in the
aftermath of nuclear tests conducted during May 1998 and the border
conflict during May-June 1999. The external developments included,
inter alia, the contagion from the Asian crisis, the Russian crisis
during 1997-98, sharp increases in international crude oil prices in
the period beginning with 1999, especially May 2000 onwards, and
the post-September 11, 2001 developments in the US. These
developments created a large degree of uncertainty in the foreign
exchange market at various points of time, leading to excess demand
conditions in the market. The Reserve Bank responded through
appropriate intervention supported by monetary and other
administrative measures like variations in the bank rate, repo rate,
cash reserve requirements, refinance to banks, surcharge on import
finance and minimum interest rates on overdue export bills. These
measures helped in curbing destabilising speculation, while at the
same time allowing an orderly correction in the value of the Rupee,
 FOREIGN EXCHANGE RESERVES:
APPROACH, DEVELOPMENTS AND ISSUES
The subject of foreign exchange reserves has received renewed
interest in recent times in the context of increasing globalisation,
acceleration of capital flows and integration of financial markets.
The debt-banking-financial crises in several countries have also
necessitated the need for an international financial architecture in
which the management of foreign exchange reserves has emerged as
one of the critical issues.
Contextually, the subject of foreign exchange reserves may be
broadly classified into two inter-linked areas, viz., the theory of
reserves and the management of reserves. The theory of reserves
encompasses issues relating to institutional and legal arrangements
for holding reserve assets, conceptual and definitional aspects,
objectives for holding reserve assets, exchange rate regimes and
conceptualisation of the appropriate level of foreign reserves. In
essence, a theoretical framework for reserves provides the rationale
for holding foreign exchange reserves. Reserve management is
mainly guided by the portfolio management consideration, i.e., how
best to deploy foreign reserve assets subject to statutory stipulations?
The portfolio considerations take into account inter alia, safety,
liquidity and yield on reserves as the principal objectives of reserve
management. The institutional and legal arrangements are largely
country specific and these differences should be recognised in
approaching the critical issues relating to both reserve management
practices and policy-making (Reddy, 2002).
The motives for holding reserves may be broadly classified
under three categories, viz., transaction, speculative and
precautionary. International trade gives rise to currency flows, which
are assumed to be handled by banks driven by the transaction motive.
Similarly, speculative motive is left to individuals or corporates.
Central bank reserves, however, are characterised primarily as a last
resort stock of foreign currency for unpredictable flows, which is
consistent with precautionary motive for holding foreign assets.
Precautionary motive for holding foreign currency, like the demand
for money, can be positively related to wealth and the cost of
covering unplanned deficit, and negatively related to the return from
alternative assets. Furthermore, foreign exchange reserves are
instruments to maintain or manage the exchange rate, while enabling
 orderly absorption of international capital flows. Official reserves are
mainly held for precautionary and transaction motives keeping in
view the aggregate of national interests, to achieve balance between
demand for and supply of foreign currencies, for intervention, and to
preserve confidence in the country's ability to carry out external
transactions.
The objectives for maintaining reserves are:
(i) maintaining confidence in monetary and exchange rate
policies;
(ii) enhancing capacity to intervene in foreign exchange
markets;
(iii) limiting external vulnerability by maintaining foreign
currency liquidity to absorb shocks during times of crisis
including national disasters or emergencies;
(iv) providing confidence to the markets, including credit rating
agencies, that external obligations can always be met (thus
reducing the overall costs at which foreign exchange
resources are available to all the market participants); and
(v) adding to the comfort of the market participants, by
demonstrating the backing of domestic currency by external
assets.
India's approach to reserve management, until the balance of
payments crisis of 1991 was essentially based on the traditional
approach, i.e., to maintain an appropriate level of import cover
defined in terms of number of months of imports equivalent to
reserves. For example, the import cover of reserves shrank to three
weeks of imports by the end of December 1990, and the emphasis on
import cover constituted the primary concern say, till 1993-94. The
approach to reserve management, as part of exchange rate
management, and indeed the overall external sector policy underwent
a paradigm shift with the adoption of the recommendations of the
High Level Committee on Balance of Payments, 1993 (Chairman: C.
Rangarajan). The Committee had recommended that the foreign
exchange reserve targets be fixed in such a way that they are
generally in a position to accommodate imports of three months. In
the view of the Committee, the factors that are to be taken into
consideration in determining the desirable level of reserves are:
 (i) the need to ensure a reasonable level of confidence in the
international financial and trading communities about the
capacity of the country to honour its obligations and
maintain trade and financial flows;
559

(ii) the need to take care of the seasonal factors in any balance
of payments transaction with reference to the possible
uncertainties in the monsoon conditions of India;
(iii) the amount of foreign currency reserves required to counter
speculative tendencies or anticipatory actions amongst
players in the foreign exchange market; and,
(iv) the capacity to maintain the reserves so that the cost of
carrying liquidity is minimal.
With the introduction of market determined exchange rate, a
change in the approach to reserve management was warranted and
the emphasis on import cover had to be supplemented with the
objective of smoothening out the volatility in the exchange rate,
which has been reflective of the underlying market condition.
Against the backdrop of currency crises in East-Asian countries and
in the light of country experiences of volatile cross-border capital
flows, there emerged a need to take into consideration a host of
factors. The shift in the pattern of leads and lags in payments/receipts
during exchange market uncertainties brought to the fore the fact that
besides the size of reserves, the quality of reserves also assumes
importance. Unencumbered reserve assets (defined as reserve assets
net of encumbrances such as forward commitments, lines of credit to
domestic entities, guarantees and other contingent liabilities) must be
available at any point of time to the authorities for fulfilling various
objectives assigned to reserves. As a part of prudent management of
external liabilities, the policy is to keep forward liabilities at a
relatively low level as a proportion of gross reserves.
An important issue which has figured prominently in the current
debate on foreign exchange management is the question of
appropriate policy for management of foreign exchange reserves. In a
regime of free float, it can be argued that there is no need for
reserves. In the light of volatility induced by capital flows and self-
fulfiling expectations that this can generate, there is now a growing
consensus among emerging market economies to maintain 'adequate'
reserves (Jalan, 2002). Therefore, while focusing on prudent
management of foreign exchange reserves in recent years, the
'liquidity at risk' associated with different types of flows has come to
the fore. With the changing profile of capital flows, the traditional
approach to assessing reserve adequacy in terms of import cover has
been broadened to include a number of parameters which take into
account the size, composition, and risk Profiles of various types of
capital flows as well as the types of external shocks to which the
economy is vulnerable. A sufficiently high level of reserves is
necessary to ensure that even if there is prolonged uncertainty,
reserves can cover the liquidity at risk on all accounts over a fairly
long period. Taking these considerations into account, India's foreign
exchange reserves have reached a very comfortable level. The
current thinking in this regard has been clearly articulated: "The
prevalent national security environment further underscores the need
for strong reserves. We must continue to ensure that, leaving aside
short-term variations in reserves level, the quantum of reserves in the
long-run is in line with the growth of the economy, the size of risk-
adjusted capital flows and national security requirements. This will
provide us with greater security against unfavourable or
unanticipated developments, which can occur quite suddenly" (RBI,
2002c). In the context of the uncertain ramifications of the current
developments in Iraq, the relevance of a comfortable reserve level
appears particularly important. Unlike 1990-91, implications of such
developments in the Gulf region for the external sector appears
modest and manageable, mainly due to the comfortable reserve level.
The foregoing discussion points to the evolving considerations
and a paradigm shift in India's approach to reserve management. The
shift has occurred from a single indicator to a menu or multiple
indicators approach. Furthermore, the policy of reserve management
is built upon a host of factors, some of which are not quantifiable,
and in any case, weights attached to each of them do change from
time to time.
Developments: In India, reserves have been steadily built up by
encouraging non-debt creating flows and de-emphasising debt
creating flows, particularly short-term debt. This strategy, coupled
with the maintenance of an acceptable level of current account deficit
and market determined exchange rate regime was the cornerstone of
the policy of external sector management. In the context of the
 changing interface with the external sector and the importance of the
capital account, reserve adequacy is now evaluated by the Reserve
Bank in terms of several indicators and not merely through
conventional norms, such as, the import cover. As a matter of policy,
as far as possible, foreign exchange reserves are kept at a level which
is adequate to withstand both cyclical and unanticipated shocks.
India is amongst the top 10 reserve holding emerging market
nations. India's foreign exchange reserves increased from US $ 4.7
billion in June 1991 to US $ 163.7 billion as on May 12, 2006. (US $
151.6 billion in 2005-06.) The predominant component of foreign
561
exchange reserves is in the form of foreign currency assets that
increased from US $ 1.1 billion to US $ 156.6 billion during the
same period. The movement in India's foreign exchange reserves
since 1993-94 can be divided into three phases: (i) the period March
1993 to March 1995, when reserves increased sharply from US $ 9.8
billion to US $ 25.2 billion, (ii) the period March 1995 to March
1999, when reserves increased moderately to US $ 32.5 billion, and
(iii) finally since 19992000, when there was a phenomenal increase
in reserves reaching the peak figure of US $ 163.7 billion.
While the significant accretion to foreign exchange reserves has
provided comfort on external sector management, two contentious
issues have come to the fore. These are the trade-off between costs
and benefits accruing from the reserves accretion and the associated
monetary impact that emanates from it.

Summing Up
The external sector reform prograniik.e initiated in the wake of
the balance of payments crisis of 1991 was all encompassing. Even
though the reforms were largely crisis led, the policy initiatives were
unique in terms of their gradual, cautious and country specific
approach. As against balance of payments problems of varying
intensities experienced during 1956-1991, India's b?' e of payments
position strengthened over the 1990s even as the p d coincided with
the liberalisation of external account, external cure ncy crises and
domestic political uncertainties.
Prudent exchange rate management, low current account deficit,
steady flow of non-debt creating capital flows, particularly in the
form of FDI, a significant reduction in the external debt to GDP ratio
and containment of short-term debt to manageable and prudent limits
have been some of the positive outcomes of policy reform in the
external sector. Resilience of the external sector has helped India
successfully avert the contagion effects of the East Asian crisis.
There are, however, a few areas, which require further efforts.
India's competitiveness in exports would require to be strengthened
to achieve a sustained export growth of at least 12 per cent per
annum in order to achieve the medium-term goal of increasing
India's share in world exports to 1 per cent by 2006-07. India also
needs to make the transition from exports of labour-intensive low
technology goods to a wider variety of goods, including technology
intensive goods. India's tariff levels continue to be high; accelerated
pace of reduction of tariffs and removing the constraints on the
small-scale industries would be conducive to industrial growth and
exports. Rapid growth in exports would also require addressing the
domestic constraints of supply bottlenecks and inadequate
infrastructure.
A sustained surge in capital flows in the recent past has
implications for monetary and inflation management although, the
Reserve Bank has so far been able to sterilise the monetary impact of
foreign exchange reserves through large open market sales of
government securities. The financial cost of additional reserve
accretion in the recent period is low.
The external debt management policy of the Government
continued to focus on raising loans from least expensive sources
with longer maturities, monitoring of short-term debt, keeping
commercial debt under manageable limits with end-use stipulations
and option to convert external commercial borrowings into equity,
restriction on trade credits, encouraging non-debt creating capital
flows and accelerating the growth of exports.
There has been a debate that high accretion to forex reserves has
resulted in a substantial output loss in the 1990s. It needs to be
recognised, however, that the steady growth path is functionally
related more to macroeconomic constraints of saving and investment
than to the reserve management policy per se. The reserve
management policy, coupled with the exchange rate management and
monetary policy pursued by the Reserve Bank has created an
atmosphere of softer interest rate regime, which is conducive to
higher economic growth. In addition, the recent policy initiatives
have created an investment atmosphere where foreign investment
supplements domestic investment, which in a medium-term
perspective would ensure a higher growth trajectory.
 India and the WTO

World Trade Organization

THE World Trade Organization (WTO) is an international organization
that oversees the operation of the rules-based multilateral trading system.
The WTO is based on a series of trade agreements negotiated during the
Uruguay Round (1986-1994), the eighth and final trade round conducted
under the General Agreement on Tarriffs and Trade (GATT). The Treaty of
Marrakesh established the WTO at the close of the Uruguay Round in 1994.
The WTO began operations on January l , 1995, the WTO was comprised of
148 members. The WTO is one of the Big Three international organizations
that oversee economic relations among nations, joining the International
Monetary Fund (IMF) and the World Bank. The WTO's headqurters is
located in Geneva, Switzerland. Pascal Lamy of France, current WTO
director-general, began a four-year, renewable term of office on September
1, 2005.
The WTO's main function is to monitor and enforce trade rules
in the global economy. The WTO administers the complex trade
agreements listed in the WTO agreement. Article 1 of the WTO
agreement, the General Agreement on Tariffs and Trade, deals with
rules of merchandise trade. The General Agreement on Tariffs and
Trade in Article 1 is often called GATT 1994 to distinguish it from
the orginal GATT agreement of 1947. Article 2, the General
Agreement on Trade in Services (GATS), pertains to the trade of
commercial services. Article 4, the Agreement on Trade-Related
Aspect of Intellectual Property (TRIPS), provides uniform legal
protections for scientific, technological, and artistic achievements. In
addition, the WTO is a forum for trade negotiations, a dispute
settlement mechanism, a source of technical expertise on trade and
development for the world's poorer countries and a sister
organization to the World Bank and IMF. Unlike the World Bank and
IMF, the WTO does not make loans to countries.
The WTO inherited many of GATT's guiding principles. These
fundamental principles are incorporated in the numerous agreements
that Comprise the Agreement Establishing the World Trade
Organization. In its Understanding the WTO (2003), the World Trade
Organization identified five core principles.
The first principle is "trade without discrimination," which involves
most-favoured-nation (MFN) status and national treatment. MFN states that
a trade concession granted to one WTO member automatically applies to all
members. National treatment guarantees equal treatment of imported goods
with domestically produced output in nations' markets. The second principle
is freer trade through the progressive liberalisation of trade regimes.
The third principle is the predictability of trade rules.
Predictability, in this context, prevents governments from arbitrarily
raising existing tariffs or non-tarriff trade barriers.
The fourth principle is fair competition. Fair competition
attempts to level the playing field in international trade and minimise
the market distortions caused by export subsidy, dumping, and other
disruptive trade trade practices.
The fifth principle is economic development through trade.
Economic development for the world's poorer countries should be
enhanced by trade assistance and increased market access through
preferential trade arrangements.
The WTO's dispute settlement process is the enforcement arm of
the organization. The WTO's apparatus for dispute settlement is
stronger and more defined than GATT's dispute settlement
procedures. The ". TTO's dispute settlement process is the essence of
multilateralism. That is, a country or group of countries can air trade
grievances in a global forum. A trade complaint is made to the
WTO's Dispute Settlement Body (DSB), which consists of the entire
WTO membership. The DSB, in turn, establishes a panel of three to
five experts to hear the evidence and render a ruling. the panel's
ruling can only be reversed by a unanimous vote of the DSB. Under
normal conditions, the entire process takes one year or less to
complete. One or both sides in the d; pute can appeal the panel's
decision. A seven-member Appellate Boe w•onsiders an appeal and
renders a decision. Again, only a unanimous 'Ote of the DSB can
reverse the Appellate Body's ruling. The appellate. process could add
as much as three months to the dispute settlement process. A member
country found guilty breaking WTO trade rules is required to
India and the WTO 565
correct the violation with due speed. The DSB is empowered to
initiate retaliatory tariffs or other trade sanctions for non-compliance
with a WTO ruling.

India and the WTO

India was one of the 23 founding Contracting Parties to the
General Agreement on Tariffs and Trade (GATT) that was concluded
in October 1947. India has often led groups of less developed
countries in subsequent rounds of multilateral trade negotiations
(MTNs) under the auspices of the GATT.
In the last round (8th) of the multinational trade negotiation
under the auspices of the GATT, The World Trade Organization was
created to subsume the GATT in 1995. Even after the inception of
WTO in 1995, till the Doha Ministerial (2001), the developing
countries were not very active at the negotiating table. It is indeed
ironic, as free trade is much more favourable for a developing
country than its developed counterparts. However, a new trend
emerged from Cancun (2003) onwards, and since then the former
group has become much more vocal at the multilateral trade forums
on the protectionist policies of the latter.
Despite being a founder member of GATT, India was never very
active in various negotiating rounds until late eighties. Since the
Indian economy followed the import-substitution led growth strategy
during sixties and seventies, gaining from the import liberalisation at
principal export markets (the EU and US) was never a prime
objective. In addition, a considerable proportion of India's trade was
directed to the Soviet bloc countries, and the presence of this assured
market weakened the incentive to search for newer outlets. On the
other hand, opening the domestic market to foreign competition
through progressive tariff cuts was perceived harmful for the local
industries. Instead, the country was more willing to discuss trade and
development related issues at UNCTAD forums in collaboration with
other developing countries like Brazil (primarily through the G-77
network). Despite adoption of a proactive approach at WTO, India
still feels comfortable to discuss trade-related issues at UNCTAD
forums for coalition building among developing counries on areas
pertaining to mutual interest. Table 25.1 illustrates India's
participation in WTO meetings. l
 l. Sengupta, Dipankar, Debashis Chakraborty and Pritam Banerjee (eds.) (2006). "India at
the WTO: The Story so Far", in Beyond the Transition Phase of WTO: An Indian
Perspective on Emerging Issues, Academic Foundation in association with Centre de
Sciences Humaines, New Delhi. stock
Source : Compiled from WTO Ministerial Declarations and other documents.

The first two ministerial meetings were held at Singapore (1996)

and Geneva (1998) respectively, where various provisions of the
agreement were discussed and the state of their implemeritation was
reviewed. In addition, two new agreements, namely Information
Technology agreement and Global E-Commerce agreement were
signed