Gry

6M e*

The Finan cial 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.r

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),
owned privately and regulated by the RBI.
Provision of short-term credit is entrusted primarily to commercial
and cooperative banks. Of late, commercial banks have diversified into
several new areas of business such as merchant banking, mutual funds,

in Financial Sector Reforms", in Bimal

1. Rangarajan, C. and Narendra Jadhav (1992). "Issues
Jalan (ed.), The Indian Economy: Problems and Prospects, Viking, New Delhi.
462 Indian Econonl: Perfornance and Policiet

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 paid-
up 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
22.1). 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, 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.
Tbe Financial Sector: Stracttre, Performance and Reforms 463

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.

TABLE _ Z2.L
Select Stock Market Indicators in India Year
(end-March) t961* 1971* 1980* 1991 2000 2002 2003

Number of
stock exchanges '789 A2 23 23 23

Number of
listed companies |,203 ,599
1 2,26s 6,229 s,871 9,644
Market capitalisation
(Rs. crore) I,200 2,700 6,800 1,10,2'19 11,92,630 7,49,248 6,31,921
Note : *: end-December, BSE only.
Sources : The Stock Excbange, Mumbai and National Stock Exchange'
Rakesh Mohan (2004). Economic Developments in India, Vol' ?4. Academic Founda-
tion, 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 FIIs 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 FIIs in India, which include asset
management companies, pension funds, investment trusts and
incorporated institutional portfolio managers. FIIs 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
464 Indiar Ecamnl,: Pe(ornante and Policiet

In recent years, new money market instruments such as Certificates

of Deposits (CDs), Commercial Paper (CP) and I82 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 Developrnent
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 ovbr-Qe country and
secondly, ensuring that the finances available flow in ihb.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:
o 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
r99t.
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
The Financial Scctor: Stxcture, Performance and Reform 465

1990-9I, 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 GDR
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 ofrural
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.

TABLE _ 22.2
Progress of Commercial Banking in India
(Amount in Rs. Crore, Unless Mentioned Otherwise)

1. No. of Commercial Banks 73 t54 272 284 298 292

2. No. of Bank Offices 8,262 3,4s94 60,570 64,234 67,868 68,561
Of which:
Rural and semi-urban
Bank Offices 5,172 23,227 46,5s0 46,602 ' 47,693 47,496
3. Population per Office ('000s) 64 16 14 15 15 t6
4. Deposits SCBs
of 4,646 40,436 2,0t,199 3,86,859 8,s1,593 12,80,853
5 Per capita Deposit (Rs.) 88 738 2,368 4,242 8,s42 t2,2s3
6. Credit of SCBs 3,599 25,078 t,21,865 2,1t,560 4,54,069 7,29,214
7. Per Capita Credit (Rs.) 68 457 |,434 2,320 4,555 ',1
,2',1 5
8. Share of Priority Sector
Advances in Total Non-Food
Credit of SCBs (per cent) 15.0 37 0 39.2 33 7 35.4 13.7+
9. Deposits (per cent of
National Income) 15.5 36.0 48.1 48 0 535 51.8*

Note : *: As at end-March 2002.

Source : Reserve Bank of India.
466 Indian Ecoroal: Perlornance ad Policiet

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
The Financial Sector: Stracture, Performance and Reformt
467

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 non-
banking 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.
468 Indian Econanl: Petlormance and Policiet

Adrninistered 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, small-
scale 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 Fimncidl Sector: Structure, Performance and Reforms 469

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 ofinterest 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
470 Itdian Econoal: Pe(ormance and Policiet

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 Years2

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

2. Tbis 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 Indis, Vol. 74, Acaderuic Foundation, New Delhi
The Financial Sector: Structure, Performance and Reforms 471

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 non-
banking 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 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 non-
banking 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.
472 Itdiar Econonl: Perfornance and Poliriet

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 I0.7 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-d-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 2002-
03, 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.
The Fiuncial Sector: Stxcture, Performance and Refotms 473

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 non-
public sector banks has been increasing continuously over the l'ast few
years, with a sizeable rise in the market share (in terms of assets) being
474 Indier Econonl: Performazte ail Paliciet

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 facr,
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-d-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
IInorms around 2006, which has accorded greater emphasis on risk-
sensitivity 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.
The Finarcial Sectol: Stuctarc, Performance and Reformt 475

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 insurancei has been recognised as an
important component of the financial safety net for a country. A risk-
based 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
fill the void being created by
financing, an issue remains about how to
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
bedifficult. 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.
476 Indian Econonl: Perlornance and Policiet

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 long-
term 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.
The Financial Sector: Structure, Performance and Reforms 477

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 two-
stage 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
478 Indiau Economl: Performatce and Policiet

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,
in the financial system have to
macroeconomic reform and reforms
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 Financial Sector: Strvcture, Performance and Reforms 479

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.
4ao Irdian Ecorum1: Performance and Pzlicie[

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 post-
Independence 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
 The Financial Sector: Structure, Performance and Reforms
4E1

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 efficiency-
enhancing 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 mobilis'ed in their
states. The involvement of banks and financial institutions in the
4a2 Indiar Etonoarl: Perforttaace ail Policiet

schemes for providing creditto 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
(SEPUP) 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 veir'. "'..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."
 " T,2

Foreign Tnde

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."t

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

 Intliar Economl: Perfornance and Polieiet
484

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, self-
reliance, and eradication ofpoverty, 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 Tlends: 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 ofover 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 I97l-12 (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 substitution. With the
decision to devalue the rupee in 1966, changes in tariffs and
export subsidy policy, it was evident that the policy-makers
,.Foreign Trade Policies and India's Development", in Uma Kapila (ed.)'
2. Srinivasan, T.N.
Indian Economy Since Independence, ch.25 (2003-04 edition)'
Forcign Trade
4E5

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
Current Account Ttansactions as Per Cent of GDp at Market prices
(19s0-1990)

M X Trade X+M Net Current

Imports Exports Balance Invisibles Account
Balance

1 950-5 I 6.9 6.9 13.8 0.4 +0.4

1 960-6 I 6.8 3.9 -2.9 10.7 0.5 -2.4
1970-77 4.2 -J--1 -0.9 7.5 -0.1 - 1.0
I 980-8 I 9.5 4.9 -4.6 14.4 2.9 -r.5
I 990-9 1 9.1 6.3 -2.9 t5.4 0.1 -2.5
ifot? : Figures for 1990-91 are provisional.
source: lndia's Balance of Payments = l94B-49 to 1989-99. Department of Economic
Analysis and Policy, Reserve Bank of India, Bonbay, puUtiJhed in July 1993.

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

of GDP at market prices picked up after l97l-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 fhe 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 (1995-1939)
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.
486 Irdian Econony: PerJormance and Policies

TABLE - 23.2
Value of Exports and Imports in the Planning Period
(US $ Million)
Year Exports Imports Trade Rate of Change
Balance Exports Imports

l 950-5 I 1269 t2'13 -4 24.9 -1.5

t960-6t 1346 23s3 -1007 0.3 t6.1
r910-7 I 2031 2162 - 131 8.8 3.5
1980-8 1 8486 15869 -73 83 6.8 40.2
1990-9 I 18143 24075 -5932 9.2 13.5
t993-94 22238 23306 -1068 20.0 6.5
1994-95 26330 286s4 -2324 18.4 22.9
1995-96 31797 36618 -48 8l 20.8 2 8.0
t996-97 33470 39133 -5663 5.3 6.7
1997 -98 35006 4t484 -6478 4.6 6.0
1 998-99 332t8 42389 -9111 -5.1 2.2
1999-2000 36822 49671 -r2849 10.8 17.2
2000-0 I 44560 50536 -597 6 2r.0 t.'7
200t-02 43827 51413 -75 86 -1.6 1.7
2002-03 52719 61412 -8693 20.3 t9.4
2003-04 63843 '78t49 -14306 2t.1 27.3
2004-os 80s40 109173 -28633 26.2 39.'7
2005-06

Source: Government of India, Economic Survey, 1998-99, Statement 7.1 (B) p. S-81 and
E c onomi c Su rv ey, 2O0O -0 1, 200 1 -02, 2OO3 -04, 2OO4-05, 2005-06, p. S-79.

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.
Foreign Tiade 487

TABLE _ 23.3
Current Account Tlansactions as a Percentage of GDP
at Current Market Prices 90s

Exports Imports Trade X, Current X+M

X M Balance M(Vo) Account
Balance

1990-91 5.8 8.8 -3.0 66.2 -3.1 14.6

t991-92 6.7 7.7 - 1.0 86.1 -0.3 r4.4
1992-93 7.r 9.4 )1 71 .6 -r .7 I 6.5
1993-94 8.3 9.8 -i.5 84.8 -0.4 18.1
t994-95 8.3 11.1 -2.8 748 -1.0 19.4
199s-96 9.1 12.3 -5.1 74.8 -t .7 2t .4
1996-97 8.9 t2.1 -3.8 69.7 -t.2 2t.6
1997 -98 8.7 12.5 -3.8 69.7 -t.4 2t.2
1998-99 8.3 11.5 -3.2 72.t -1.0 r9.8
1999-00 8.4 12.4 -4.0 67,8 -1.1 208
2000-01 9.8 r 3.0 -3. I 75.8 -0.5 22.8
200r-02 9.4 12.0 -2.6 85.2 0.2 21.4
2002-03 10.6 t2.1 )1 85.8 1 .2 23.3
2003-04 10.8 13.3 -2.5 81 6 1.8 24.1

Note : * Export-Import ratio is not given as a percentage of GDP at cunent market prices
Source: Economic Suneys.

After three successive years of robust growth at an annual average

of I9.7 per cent (in US Dollars) during 1993-94 to 1995-96, export
momentum slowed down since 1996-9'7, 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 rernain problematic. The $rowth of
exports picked up in 1999-2000 and 2000-2001.
488 Indian Econonl: Perfornance ail Policiet

India's merchandise exports (in dollar terms and customs basis),

by continuing to grow at over 2O 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.

TABLE _ 23.4
Performance of the Foreign Trade Sector
(Annual Percentage Change)

Year Export Value in Import Value

US Dollar in US Dollar

1 990-2000 1 .'I 8.3

I 990-95 8.t 4.6

1 995-2000 t.J 12.0

2000-0 1 21 .0 1.1

200t-02 -1.6 r.7

2002-03 20.3 194
2003-04 2t.r 27.3

2004-05 26.2 39.7

2005-06 (April-January) 18.9 26.7

Source : Economic Survey,2005-06.

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 impressive export
growth has exceeded world export growth in most of the years since
 Foreign Tiade
489

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, haJbeen
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.

TABLE - 23,5

Export Growth and Share in World Exports of Selected Countries

Percentage Growth Rate Share in World Exports 2004

Value
Country 1995-01 2003 2004 2005* 2001 2003 2004 2005* ($ bn)

China 12.4 34.5 35.4 32.1 4.3 59 6.6 7.2 593.0

Hong Kong 3.6 lt.9 15.6 11 4 3. I 3.0 2.9 2.8 259.0
Malaysia 6.6 6 5 26.5 12.1 1.4 1.3 t.4 1.4 r2s.7
Indonesia 5.1 5.1 t1 .2 44.6 0.9 0.9 0.8 0.8 7 t.3
Singapore 4.t 15.2 24.5 14 8 2.0 1.9 2.0 2.0 179.6
Thailand 5.9 r7 .l 20.0 r2.9 1.1 1.1 1.1 1.1 96.0
India 8.s 15.8 25.1 2l .0 0.7 0.8 0.8 0.8 7 1 .8
Korea 7,4 19.3 30.9 18 1. 2.s 2.6 2.8 2.8 254.0
Developing
countries 7.9 18.4 27.1 2t.2 36.8 38.8 40.7 42.4 3685.1
World 5.5 1s.9 2t.2 14.9 100.0 100.0 100.0 100.0 9049.8

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 2l 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
 Indian Economl: Perfornarce ard Paliciet
490

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 l0 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 1972-
73, 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'
Foreign Trade 49r
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
(I973-74) 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. 19903 - The value of imports as a proportion of GDP at market
prices show a distinct increase in the 1990s except for 1991-
92. The decline in l99l-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 2000-
01 (Table 23.3).
Merchandise imports displayed strong growth in 2OO3-04, 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 2OO3-04, 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 2I per cent, on top of the 40 per cent growlh in 2003-04,
reflected the higher domestic investment and firming up of
manufacturing growth. A significant contributor to the rise in non-POL
492 Indiau Ecoronl: Performance ail Policles

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 2OO4-05,
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-
06 (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 April-
November 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 in2002-03 to 31.5 per cent in2003-04.
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'
2OO4-05 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
 Foreign Tiede
493

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 Tbade

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 oftotal imports in 1960-61, and about I per cent in lgg0-gl.
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, reflecred
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 offall 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 2per 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 tlat 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 pu cent in 1950-5 1 to 79 per cent in 1990-
91. 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 1950-
51 and 1975-76 and between l97O-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 l99l-92 witnessed considerable strain on the balance-of-
payments. To meet the crisis, severe restrictions were placed on imports
and the Rupee was adjusted downward in July 1991. Being an
exceptional ycal l99I-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

3. Reserve Bank of India (1997-98). Report on Currency and Finance, Yol. 1

Foreign Trade 497

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 sub-
period consisting of the subsequent three years (i.e., 1996-97 to 1998-
99). 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
1996-91 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
to0.47 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 yis-ti-yis rest-
of-the-world, its share in global exports reached 0.62 per cent during
1997 (rMF, 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 4.2per 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 in. 1995-96.
The ratio declined, marginally, during the next three years and was at
498 Irdian Economl: Petlormance and Policiet

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 import-
GDP 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.

TABLE - 23.8

India's Foreign Trade Ratios

(Per Cent)
Period Average X/GDP M/GDP T/GDP X/M

1980-81 to 1989-90 4.6 7.2 I1.8 64.0

1990-91 to 1999-00* 8.0 9.5 t7.4 84.1
1990-91 ro 1994-95* '7.3 8.4 15.7 86.9
1995-96 to 1999-00 8.5 lo.4 18.9 81.8
2000-01 to 2001-02 9.4 10.8 20.2 86.7

Notes : * Excluding l99l-92.

X =Exports, M-Imports, T=Exports+Imports, GDP=Gross Domestic Product at cur
rent market prices in rupees.
Sources :1. Directorate General of Commercial Intelligence & Statistics.
2. Economic Szney, (various years) Govemment of India.

Ihade 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.
Foreign Tiade 499

Structural Change in Exports

Changes in of Broad Categories
Terms
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 l99l-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 r^'om 59.4 per cent in 1987-88 to 65.7
per cent it l99l-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
expilrt 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 Camposition: Exports
The changes in the structure of India's exports is more noticeable
500 Indian Ecanany: Perfarttance aud Policies

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-I992 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 ftom23.3 per cent in 1987-88 to 15.4 per
cent in 1990-91. Their share more than doubled to reach 34.2per 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
Foreign Tiade
501

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.

Mov e 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 7 I .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 I3.2 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 2I.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
502 Indian Ecozottl: Petfotnance anl Policies

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, ready-
made 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 therc 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
Foreign Trade
503

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 199l-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. Inrespect
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 I 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.
504 Inlian Econanl: Prfornance and Po/icies

TABLE _ 23.9
Share of Select East Asian Countries in World Exports
(Per Cenr)

Average
Country I99I 1995 1999 2001 I99r- 1996-
1995 2000

India 0.5 0.6 0.6 0.7 0.7 0.6 0.6

China 2.0 2.9 3.5 4.0 4.4 2.5 3.4
Indonesia 0.8 0.9 0.9 1.0 0.9 0.9 0.9
Korea 2.0 2.4 2.6 2.7 2.5 3.0 2.5
Malaysia 1.0 1.4 1.5 1.6 t.4 1.2 1.5
Singapore 1.7 2.3 2.0 2.8 2.0 2.0 2.3
Thailand 0.8 1.1 1.0 1.0 2.0 1.0 1.0

Source : Intemational Financial Sratistics, February 2003.

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 basmatl 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, exporrs from
India are currently subject to 40 anti-dumping and l3 countervailing
measures mainly for agricultural products, textiles and clothing products
Foreign Trade 505

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-d-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 ll.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 1987-
9l 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 at27.2
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 ll.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 stood79.2 per cent higher than
506 Indian Econonlt: Performance and Policiet

US $ 3,981 million during 1987-199I. Consequently, the relative share

of oil imports moved vp 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 pet cent higher than that during 1987-
1991, although the average annual growth rate remained considerably
lower at 9.5 per cent during 1992-1999 than that of79.5 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 1987-199I 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 TFade

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 1950-5 l. Their
share in India's import expenditure was as much as 39.1 per cent in the
Foreign Tiade 507

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 1990-9 1 . 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
l.4per 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 l2.l per cent, USA occupied the first
place. It was followed by Germany with a share of 8.0 per cent (the
508 Indiau Econnl: Perfornarce aul Policiet

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 pet 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 22.1per 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
earnlngs.
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) ar,d I2.3 per cent
to OPEC in 1999-2000 as compared with declines of 1.5 per cent,l4.4
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
 Indian Ecoroml: Perlornance ad Policiet
510

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.I pu 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 sign.ficant 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
3.2pu 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
afi,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.
Foreign Trade
5tt
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 2l .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 1987-199I 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 1987-199I 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 1987-199I. 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-I99I 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 cant 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.
 5r2 Itdian Etauantlt Perlotaunu and policies

Summing Up
Notwithstanding the earlier policy initiatives aimed at
liberalisation of India's foreign trade, the outward-looking trade policy
measures announced in lggl 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 aggrelate 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 totar 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

increased sharply during the nineties.
of gold and silver have

Reflecting the increased link between exports and imports, the

shares of certain export-related imports have also increased
iuring 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.
Foreign Trade
5r3
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 I976-77 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 2OO2.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
rmports.
514 hdian Econal: Perlornaue and Policiet

TABLE - 23.11
India's Baiance of Trade

Arerage Annual
Exports Imports

First Plan 605 735 - 130

(I 9s6-6 l) 606 973 -36'7
Third Plan (1961-66) '753 r,240 -48'1
Annual Plans (1966-69) I,238 1,998 -760
Fourth Plan (1969-74) 1,8 10 1,973 -t63
Fifth Plan (1974-79) 4,728 5,53 8 -8 l0
Annual Plans (1979-80) 6,418 9,t43 _) 7)\
Sixth Plan (1980-85) 8,967 t4,683 -s,7 t6
Seventh Plan (1985-90) 1.'7,382 25,112 -7,730
Annual Plans (1991-92) 38,297 45,52s -7,278
Eighth Plan (1992-97) 86,557 97,609 -1t ,352
Ninth Plan (199'7 -02) 1,68,400 2,04,763 -36,363
Tenth Plan (2002-07)
(2002-03) 2,55,r37 2,97,206 -42,069
(2003-04) 2,93,367 3,5 9,108 -65,7 41
' (2004-05) 3,61,879 4,90,532 -r,28,653
(2005-06)
(Apr.-Dec.) t_91 829 4,25,667 1,31,937

Soarce : Compiled fron Economic Survey, 2003-2004, 2005-06.

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 cror'e 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,I75 crore in 2004-
2005. Similarly there was increase in raw materials and maintenance
Foreign Trade 5lj

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 5OO-fold increase between
1960-61 and 1991 as the value of POL imports increased frorn 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. I crore in 1960-61 to Rs. 42,336 crore in2OO4-
05.

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. 2,03,571 in 2000-01 and
Rs. 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 fncome 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'much with
change in income or prices. Thus, when we make efforts to sell more
5t6 Indian Econony: Performaue ad Policiet

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 Cowect 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.
Foreign Trad.e 5t7

Restrictions on Imports
Following measures have been taken to regulate imports:
(i) Licensing of Imports: For quite a long time, the import of non-
essential consumer goods was not permitted while the importers of
capital goods essential for country's delvelopment 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:
518 Indian Econonl: Perfornaut aild Pzli.ier

(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 alarge 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
Foreign Tiade 5r9

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 ofAdvanced 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.
 .ffi.
"W/ffi
#
"f
tuffi

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.

Tfade 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
1. This section draws from C. Rangarajan's paper, India's Balance of Payments: The
Emerging Dimensions, in Uma Kapila (ed,), Indian Econorny Since Independence 2O0O-01
edition, Academic Foundation, New Delhi.
522 Indian Ecoronl: Petfarnarce and Po/iciet

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 oftotal 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 realise that if
rents could be created and allocated, individuals and groups would spend
resources in influencing their creation and allocation in their favour.
 Balance of Payments and Trade policy
523

except consumer goods. It was recognised that trade, exchange rate and
industrial policies must form part of an integrated policy frinework
if
the aim was to improve the productivity and efficiency oi the economic
system.

Trade Policy since l99l

 Indian Econon5,: PetJbrnance and Policiet
524

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 200'7.The new Export and Import (EXIM) Policy
framed for the period 2002-2007 and unveiled on 31 March, 2OO2 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.
BO){ - 24.1

Export Import (EXIM) Policy 2002-2007

The Special Economic Zone (SEZ) scheme has been strengthened by
permitting the setting up of offshore Banking Units, hedging of
commodity price risks and sourcing of short-term External Commercial
Borrowings. Supplies by domestic units to SEZs would entitle the
former to avail of Duty Entitlement Passbook Scheme benefit. The
policy has also ensured procedural simplification in the process of
subcontracting carried out by the SEZ units. To ease the power
situation in and around the SEZs, units for generation and distribution
of power have been permitted to be set up in the SEZs.
The Policy gives a major thrust to agricultural exports by removing
export restrictions on designated items. The efforts to promote exports
of agro and agro-based products in the floriculture and horticulture
sector have been sustained with the notification of 32 Agri-Export
Zones across the country. Non-actionable subsidies such as transport

Contd.
Balance of Palment: and Tiade Poticl
525
. Contd

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

floriculture, poultry and dairy products. A1l 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-1), 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 norr.ns for
export of jewellery and permitting personal carriage of jewellery.
Contd.
526 Itdian Econanl,: PetJbrnance tnl Palides

The medium-term Policy continues with all the duty exemption/

remission schemes, along with existing dispensation of not having any
value caps. Procedural simplifications introduced in the policy include
abolition of DEEC Book and withdrawal of Annual Advance License
under the Advance License scheme, dispensation with technical
characteristics for audit purposes under the Duty Free Replenishment
Certificate scheme, 12 years export obligation period with 5 years
moratorium for Export Promotion Capital Goods licenses of Rs.100
crore or more and supplies under deemed exports to be eligible for
export obligation fulfilment along with deemed export benefits.
Procedural simplifications have been made in the EXIM policy to
further reduce transaction costs covering Directorate General of
Foreign Trade, customs and banks. These include adoption of 8 digit
commodity classification for imports which would eliminate the
classification disputes, reduction of maximum fee limit for electronic
filing from Rs.l.5 lakh to Rs.l lakh, introduction of same day
licensing, new norms for reduction in percentage of physical
examination of export cargo, introduction of the simplified brand rate
of drawback scheme and permitting direct negotiation of export
documents. Other salient features of the EXIM Policy 2002-2007
include: widening of the scope of the Market Access Initiative scheme
to include activities considered necessary for a focused market
promotion of exports, setting up of 'Business Centre' in India missions
abroad for visiting Indian exporters/businessmen for ensuring a facilitatory
environment for exporters, transport subsidy for exports to units located
in North East, Sikkim and J&K and introduction of Focus Africa with
Focus CIS to follow, to diversify markets.

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
Balance of Pdymentt and Trade Policy
527

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 TFade 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 efflective 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.
52E Inlian Ecarunty: Pclbrnance and Po/iciet

Cotrtd

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 of f.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.
Balance of Paymertt and Tratl-e Policy
529
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.1 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 ca|7ed'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, l0 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
 Inditt Ecomny: Pcjorttanre and Plli.itt
530
Contd....

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/Rationalisation/
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 entitlernent 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
Balnnce of Paymenx and Trade Policy
537

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./ value 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 ofhitherto 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 home-
based 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 Suney 2004-05.
532 ltdian Lconanl: Perlornanre and Policier

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 seven-
fold 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 Payruents and, Tiade Policy 533

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 full effects
1979, the
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
534 Indian Econonl: Petlornance aild Policie!

to US $ 2,416millionor 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 2l 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 l0 to l2 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
Balance of Payments and Trade Policy >5>

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 cant 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 1l 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 (NRI) 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 199L-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.
536 Irdiar Econonl: Perfornann and Policiet

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 1996-91. Exports grew by
19.7 pu cent during 1993-94 to 1995-96.
The major reasons for such a high growth rate in exports were:2
. World GDP grew by an average rate of 4.1 per cent per annum
during 1994-97 compared with2.4 per cent during L990-1993.
. 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 pu 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 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, 1997-
98. 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

2. Chadha, Rajesh (1999). "Balance of Payments

and Trade Policy", paper presented at ADB-
NCAER Seminar on Economic and Policy Reforms in India (Dec- 9) India International
Centre. New Delhi.
Balance of Payments and Tiade Policy 537

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
24.1). Rising surpluses in the current account have been one ofthe
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 in2OO3-04. During the year, capital
account surplus was almost double its previous year's level (Table 24.I).
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
Balance of Payruents and Tt'ade Policy 539

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$7.7 billion) after growing at almost
45 per cent over and above that of the previous quarter' The rapidly
enlarging trade deficit, buoyed by remarkable import growth, has been
pushing the current account deficit. During the period 2001-02 to 2003-
04, the invisibles (net) always overcame the trade deficit to maintain
the current account in surplus. However, the trend was reversed in2004-
05 and appears to be continuing in 2005-06. At present, India is one of
the few leading economies in the South East Asian region to have a fairly
large current account deficit.
The widening of the current account deficit has been accompanied
by a similar widening of the capital account surplus. The capital account
surplus during the first half of the current year has been more than one
and a half times the surplus in the corresponding period of the previous
year. Moreover, between the first and second quarters, while the current
account deficit increased by 45 per cent, the capital account surplus
almost doubled in size (US$ 12.9 billion in July-September 2005 vis-
d-r,is 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 (net) inflows,
particularly Foreign Institutional Investor (FII) inflows. During the
540 Indian Economl: Performance and Policiet

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 non-
debt 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 April-
September 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 3l per cent, the
trade deficit grew much faster by ll4 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 2OOl-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$12.3 billion in
542 Iulittn Ennon)': Pelbrttance atl Po/icies

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 2OO4
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 2OO5 vis-d-vis April-
September 2004, since the other leading components of non-factor
services, travel and transportation, became net outflows during April-
September 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.

BOX - 24.3
Trade in Services

Services account for more than 60 per cent of world GDP, and trade in
services has grown more rapidly than merchandise trade since 1985.
Ln2004, while India's share in world merchandise exports was 0.8 per
cent, the corresponding share in world commercial services was 1.9
per cent. Services, accounting for 54.1 per cent of GDP in 2005-06, is
a sector of critical interest in India.
In terms of annual average rate of growth, world exports of commercial
services, i.e. non-factor services (services henceforth), not only
increased faster (7 per cent) than such exports of merchandise (5 per
cent) between 2000 and 2003, but also accelerated from 7 per cent in
2002 to 13 per cent in 2003. Reflecting the importance of services in
their overall economic activities, industrial countries dominate global
exports of services. Nearly two-thirds of the global trade in services is
contributed by the EU, US and Japan. While the share of US and Spain
continue to rise, that of UK, France, Italy, Japan and the Netherlands
have registered declines over the years. India accounted for 1.4 Per cent
Balance of Paymenx and Trade Policl
543

.Contd....

of total exports and 1.2 per cent of world imports of services in 2003.
China, Ireland, Korea and India have emerged as important service
exporters. Between 1992 and 2003, China's and India's export of
services increased from US$ 9.1 billion to US$ 46.4 billion, and from
US$ 4.9 billion to US$25.0 billion, respectively. A sharp rise in
earnings from tourism and increased earnings from IT and ITES,
including software exports, were the reasons for the enhanced services
exports in China and India, respectively. India was the 20th leading
exporter of services in 2003.
Table
Export of Major Services as per cent of Total Services Exports

Trdnsportation Software Miscellaneous*

t995-96 36.9 2't.4 to.2 22.9

2000-0 r 2t.5 12.6 39.0 21.3
200t-02 18.3 12.6 44.t 20.3
2002-01 r6.0 12.2 46.2 22.4
2003-04 16.5 13. r 48.9 r 8.7

Apr.-Sept., 04 9.9 tt.7 36.9 3'7.2

Note: * Miscellaneous services excluding software.

The potential for growth, however, continues to be large. There was an

upward shift in the trend growth of services exports (in US dollar terms)
from 7.9 per cent in the first half of the decade of the 1990s to 15.3
per cent during 2000-01 to 2003-04. Software and other miscellaneous
services (including professional, technical and business services) have
emerged as the main categories in India's export of services. The
relative shares of travel and transportation in India's service exports
have declined over the years, while the share of software exports has
gone up to 49 per cent in 2003-04. The buoyant growth of professional,
technical and business services has provided a cushion against the
slowdown in traditional services such as travel and transportation. The
share of other miscellaneous services, which was around 20 per cent until
2003-04, registered a sudden rise to 37 per cent in April-September,
2004. The comparative advantage of India in software, telecom and
other business services is well-documented in several studies.
Services exports grew by 20.2 per cent in 2003-04,7 1 per cent in 2004-
05 and 75 per cent in April-September, 2005. In 2004-05, software
service exports grew by 34.4 per cent and 32 per cent in the first half

Contd
)++ Itdi,tu Etauaq^: Peryotu,tn,e auJ Poli,ie:

.. Contd

of 2005-06. India's share in the world market for IT sofrware and

services (including BPO) increased from around 1.7 per cent in 2003-
04 to 2.3 per cent in 2004-05 and an estimated 2.8 per cent in 2005-
06. A new development in services exports is the explosiv egrowth of
business services, including professional services. This is reflected in
the growth of miscellaneous services excluding software, which grew
by 216 per cent to US $ 16.3 billion in 2004-05, and 181 per cent in
the first half of the current year to reach a level of US $ 15.4 billion
and surpass even the value of software services exports. The enormous
opportunities for further growth of these services make WTO
negotiations in services all the more important for India. With the
liberalisation of exchange restrictions on current account, services
imports have also increased over time. Travel payments, for example,
rose on account of outward movement of workers and professionals,
and a spurt in outbound tourist traffic from India and exceeded travel
receipts in April-September, 2004. However, overall faster growth of
services receipts over payments resulted in the net surplus from services
trade increasing from US$ 980 million in 1990-91 to US$ 6,591 million
in 2003-04.
Software exports have grown at an annual compound growth rate of
around 36 per cent between 1995-96 and 2003-04. While the market
share of India in global IT spending has increased, yet its low level of
an estimated 3.4 per cent in 2003-04 indicates a large scope for future
expansion, particularly in payment services, administration and finance.
It is estimated that outsourcing has been resulting in cost saving in the
range of 40- 60 per cent of trans-national corporations. The IT industry
is projected to grow to 7 per cent of GDP (2.64 in 2003-04) and account
for 35 per cent of total exports (27.3 per cent in 2003-04) by 2008. An
export potential of US$ 57-65 billion for the software and services
sector can be realised, with ITES-BPO sector contributing $ Zl-24
billion by 2008.
The constraints on potential opportunities in services trade include lack
of set up like export promotion councils other than for computer
software, various visible and invisible barriers to services trade, for
example visa restrictions, economic needs test, sector specific
restrictions and selective preferential market access through regional
initiatives. These need careful examination in the context of the
requests and offers of different countries in WTO. Despite the
constraints, there is scope for increasing diversification into a variety

Conrd
Balance of Paymentt and Trade Policy
545
..Contd. ...

of areas such as consultancy and R&D services, healthcare,

entertainment services, ship repair services, satellite mapping services,
telecom, educational services, accounting services and hospitality
services and also beyond the major markets of EU, US, and Japan. The
policy measures announced in the Foreign Trade policy 2004-09 to
promote services exports should help along with proper synergy
between economic policies and trade strategies.
In the ongoing negotiations at WTO under the General Agreement on
Trade in Services (GATS), the offers of most countries do not provide
any significant new openings for trade, especially in areas of interest
for developing countries. Given its strong competitive edge in IT and
ITES, and competence of its professionals, India,s efforts have been
to get binding commitments in cross-border supply of services (Mode
l) and movement of natural persons (Mode 4). In Mode 4, India has
been pushing for clear prescription of the duration of stay and removal
of the Economic Needs Test (ENT). Though the services negotiations
have been salvaged at the Hong Kong Ministerial, quick and detailed
work is needed in the form of examining the detailed requests and
offers and arriving at concrete proposals in each of the 12 main
categories and 156 sub-categories of services.
Besides software in which India has already made an impact, there is
good potential for export of many other professional services, like
super-speciality hospital; satellite mapping; printing and publishing;
accounting, auditing and book-keeping services. Besides greater efforts
at marketing, there is a need to negotiate both multilaterally and
bilaterally, issues like the National Health Service Systems in European
countries like UK which virtually deny market access; lack of coverage
of medical expenditure incurred abroad by US medical insurance
companies; need based quantitative limits; need to be natural persons;
and accreditation rules. Similarly, in the case of accounting, auditing
and bookkeeping services, market access limitations, which are mainly
in the form oflicensing, accreditation, in-state residency and state level
restrictions in countries like US, have to be negotiated. Some liberal
sectoral commitments by developed countries get automatically negated
by the restrictive horizontal limitations of entry for speciality
occupations which needs to be addressed in WTO negotiations.

Source: Economic Survey 2004-05 and 2005-06.

 Indiau Econonl: Perlornance ail Policies
546

Capital Account, External

Debt and Exchange Rate
Approach, Developments and Issues
Reflecting the inward oriented economic policies in pursuit of self-
reliance 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.
Balance of Payments axd Trade Policy 547

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 (1991-98), Russia (1998), Brazil (1999),
Turkey (2000) and Argentina (200I-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,
Iower 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
54E Indian Ecanonl: Pe(ornance and Po/icies

that had followed a relatively rapid liberalisation without entrenching

the necessary preconditions. This is particularly important since cross-
country 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 Portfulio 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
 Baknce of Paywen* and Trade Policy
549

to a select category of portfolio investors, viz., the Foreign Institutional

Investors (FIIs). Furthermore, the sectoral limits for FIIs 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)), Non-
Resident Non-Repatriable Rupee Deposit (NR(NR)RD), Non-Resident
Special Rupee Account (NR(S)RA) and Foreign Currency Non-Resident
Bank (FCNR(B))I 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
 Indian Econttl: Perfornatct and Policie'r
55O

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 Reforrns 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
Balance of Palments and Trade Policy
551

and capital account resulted in an accumulation of foreign exchange

reserves of overus $ 141 billion as at end-March 2005. capital account
surplus increased from US $ 3.9 billion during the 1980s to US $ g.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 !n 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 non-
resident deposits, after being negative for two successive years, were
19 per cent of the capital account surplus in 2004-05. This trend in debt-
flows 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 growth-
augmenting 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 .
552 Indiax Ecoroml: Perlormance and Policiet

TABLE _ 24.3
Balance of Payments - Key Indicators
(Per Cent)

hent 1990-91 1995-96 1999-00 2000-01 2001-02

l. Trade
i) Exports/GDP 5.8 9t 8.4 9.8 9.3
ii) Imports/GDP 8.8 r2.3 r2.4 t2.9 12.0
iii) Trade Balance/GDP -3.0 -3.2 -4.0 -3.1 -2.'7
2. Invisibles Account
i) Invisible Receipts/GDP 2.4 5.0 6.8 '7.5 t.4
ii) Invisible Payments/GDP 2.4 3.5 3.8 4.9 4.s
iii) Invisibles (NeI)/GDP -0.1 1.6 3.0 2.6 2.9
3. Current Account
i) Current Receipts@/ GDP 8.0 14.0 15.1 17 .2 16.7
ii) Current Receipts Growth@ 6.6 t8.2 12.9 t7 .t 1.4
iii) Current Receipts@/
Current Payments 7 r.5 88.8 93.0 96.4 r}t.2
iv) CAD/GDP -3.1 -1.7 - 1.0 -0.5 0.3
4. Capital Account
i) ForeignlnvestmenI/GDP 1.4 1.2 1.1 r.2
ii) Foreign Investment/
Exports 0.6 r4.9 13.8 r1.4 r3.2
5. Others
i) Debt-cDP Rario 287 2'7.0 22.2 22.3 20,8
ii) Debt Service Ratio 353 24.3 16.2 17.3 t4,t
iii) Liability Service Ratio 356 24.'t t7 .0 18.3 15.3
iv) Import Cover of
Reserves (in months) 25 60 82 8.6 11.3

Notei @ i Excluding official transfers. - : Negligible.

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 from'US $ 83.8
billion at end-March 1991 to US $ 98.5 billion at end-March 2002,
Balance of Palmen* and Tiade Policy
,53
external debt to GDP ratio declined sharply from28.7 per cent at end-
March 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 centin2O02
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
in20Ol-02. Debt service ratio declined from 35.3 per cent in 1990-91
to l4.l per cent in2OOl-02 (Table 24.4).Intercst payments to current
receipts ratio declined from 15.5 per cent in 1990-91 to 5.4 per cent in
200r-02.

TABLE _ 24.4
Major Indicators of External Debt
(as at end-March)

(Per Cent)

Items t99r 1996 2000 2001 2002

1. Total Debt to GDP 28.1 21 .0 22.t 22.4 20.9

2. Short-term Debt 2.9 t 4 0.9 0.8 0.6
(original maturity)
to GDP
3. Concessional Debt 45.9 44.7 8.9 35.5
3 3 6.0
to Total Debt
4. Short-term Debt 146.5 23 .2 10.3 8.6 s. 1
(original maturity) to
Foreign Exchange Reserves
5. Short-term Debt 382.1 29 .5 tt .2 9.2 5 .4
(original maturity) to
Foreign Currency Assets
6. Non-Debt Liabilities 148.2 92.3 99.9 100.8 8 8.4
and Short-term Debt
to Reserves
7. Short-term Debt 146.6 1t.t 59.0 58.5 48.1
and Non-debt Reversible
Liabilities to Reserves
8, Debt Service Ratio 35.3 24.3 16.2 17.5 14.r
9, Debt to Current 328.9 188.9 t45.6 126.2 122.5
Receipts
10. Liability Service Ratio 35.6 24.7 t1.o 18.3 15.3

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
554 Idian Ecoronl: Perfornaxre and Policiet

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
Balance of Palments and Trade Policy )))
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 exchan Ee tate 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 l, 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 curyent
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
 556 Indian Ecoronl: Pefornance and Po/iciet

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-d-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 misalignu,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 1l,2O0I
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,
Balance of Paymentt and. Trade Policy >)/
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 ofreserves
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
 Irdian Econntl: Perforttatce and Policiet
558

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;
Balance of Payments and Trade Policl 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 rale, 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, 2OO2).
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
560 Indiat Etonattl: Pelbrnatca ard Paliriet

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.
Developmenrs: 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
Balance of Payments and Trade Poliq,
567

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 1999-
2000, 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 progranr,,,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 1956-199l,India's br' :e of payments position strengthened
over the 1990s even as the p C coincided with the liberalisation of
external account, external curr. ncy crises and domestic political
uncertainties.
Prudent exchange rate monagement, 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 I 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
 Indian Econonl': Perfarnarce axd Policiet
562

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 conYert
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.
 f*Fs^ Mf
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India the S7TO

^nd

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 I,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.
 Indian Econonl: PerJbrnatee and Poliriet
564

The WTO inherited many of GATT's guiding principles' These

fundamental principles are incorporated in the numerous agreements that
toinprise the Agreement Establishing the World Trade Organization' In
its Understanding the WTO (2003), the World Trade Organization
jdentified 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
:.: 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
l-.t19'r 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 rrr.'mbership. 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; .rute can
appeal the panel's decision. A seven-member Appellate BoC .:onsiders
an appeal and renders a decision. Again, only a unanimous rote 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 |VTO 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.r

1. Sengupta, Dipankar, Debashis Chakraborty and Pritam Banerjee (eds.) (2006). ':India at the
WTO: tne Siory 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.
566 Indian Ecorozl: Performance azd Policies

TABLE _ 25.1

India at the WTO Meetings

No. of PLace of Year Outcome India's Role
Ministerial Occurrence

I Singapore 1996 Mere presence.

Geneva 1998 Mere presence.

1999 Was vocal against

introduction of
environmental and
labour-standard
related issues
under WTO.

1. Doha 200 l Mostly singled out

rn lts protest.
However, made its
presence and
position felt for the
first time.
5 Ohncun

Source i Cornpiled 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