MODULE 3: TRADE AND PAYMENT REFORMS IN INDIA

Background: The post-independence trade regime till the early 1980s was
characterised by high nominal tariffs and non-tariff bariers coupled with a
complex import licensing system and restrictions on exports.
• The history of India’s external sector policies since independence can be
divided into three phases: Phase 1: 1950–75, when the trend was
toward tighter controls, culminating in virtual autarky by the end of the
period; Phase 2: 1976–91, when some liberalization took place,
especially during the last five to seven years; and Phase 3: from 1992
onward, when deeper and more systematic liberalization was
undertaken.
Phase 1: Toward Virtual Autarky, 1950–75
• Actually, phase 1, characterised by tariff protection and quantitative
restrictions on imports owes its origin long back.
• Quantitative import controls were introduced in May 1940 to conserve
foreign exchange and shipping during World War II.
• Starting in 1947, however, regulation of the balance of payments
became the central concern, and the Government introduced explicit
restrictions on the rate at which foreign exchange could be run down.
• From then until the launch of the First Five Year Plan in 1951, India
alternated between liberalization and tighter controls. The India Tariff
(Second Amendment) Act of 1954 stepped up tariff rates for thirty-two
items and paved the way for the liberalization of import quotas through
additional licenses over and above normal entitlements.
• A balance-of-payments crisis in 1956–57 led to a major reversal of this
liberalization, as India resorted to comprehensive import controls.
• This pushed India into a highly protectionist regime guided by ambitious,
powerful and self-interested bureaucracy.
• Under the regime that evolved, producers needed to make only minimal
effort to get absolute protection against imports.
• The authorities applied the principle of indigenous availability, according
to which the government denied the allocation of foreign exchange for
importing a product if domestic import substitutes were available in
sufficient quantity.
• Therefore, all a producer needed to do to block the entry of imports of a
product was to let the relevant agency know that the producer made a
substitute for it in the requisite quantity.
• The quality of the substitute, the price at which it was supplied, and any
delay in delivery were of secondary importance to the authorities.
• An important switch in policy came in June 1966, when India undertook
a major devaluation from 4.7 rupees to 7.5 rupees to the dollar and,
alongside, took steps toward liberalization of import licensing, tariffs,
and export subsidies.
• The liberalization measures gave fifty-nine industries, covering 80 per
cent of output in the formal sector freedom to import.
• Paradoxically, however, the need to obtain a license remained. Because
the licensing procedures continued to apply the principle of “indigenous
availability,” the actual liberalization turned out to be very limited ex
post.
• The impetus for the devaluation and other measures had come from the
World Bank, which promised a package of $900 million annually for
several years to help finance the expansion of imports that would result
from the liberalizing measures.
• Unfortunately, this policy measure coincided with a second consecutive
crop failure, which led to an industrial recession.
• As a result, a large proportion of the World Bank aid remained unutilized
in 1966–67.
• More important, the timing of the recession gave credence to the widely
held and popular view that the measures forced by the World Bank were
the wrong prescription in the first place.
• Intense domestic criticism, a political leadership that was keen to
distribute export subsidies, and an industry that had learned to profit
from protection came together to reverse the policy in less than two
years.
• Two factors paved the way for a return to liberalization in the late 1970s,
however.
• First, industrialists came to feel the adverse effect of the tight import
restrictions on their profitability and began to lobby for liberalization of
imports of the raw materials and machinery for which domestically
produced substitutes did not exist.
• Second, improved export performance and remittances from overseas
workers in the Middle East led to the accumulation of a healthy foreign
exchange reserve, raising the comfort level of policymakers with respect
to the effect of liberalization on the balance of payments.
Phase 2: Ad Hoc Liberalization: 1976–91
• The new phase of liberalization began in 1976 with the reintroduction of
the Open General Licensing (OGL) list, which had been a part of the
original wartime regime but had become defunct as controls were
tightened in the wake of the 1966 devaluation.
• The system operated on a positive-list basis: unless an item was on the
OGL list, its importation required a license from the Ministry of
Commerce.
• Inclusion on the OGL list did not necessarily mean that the good could be
imported freely, however, since the importer usually had to be the
actual user and, in the case of machinery imports, could be subject to
clearance from the industrial licensing authority if the sector in which
the machinery was to be employed was subject to industrial licensing.
• Upon its introduction in 1976, the OGL list contained only 79 capital
goods items. But by April 1988 it had expanded to cover 1170 capital
goods items and 949 intermediate inputs.
• By April 1990 OGL imports had come to account for approximately 30
per cent of total imports.
• Although tariff rates were raised substantially during this period, items
on the OGL list were given large concessions on those rates through
“exemptions,” so that the tariffs did not significantly add to the
restrictive effect of licensing. Mainly, they allowed the government to
capture the quota rents, thus helping relieve the pressure on the
budget.
• The government also introduced Export-Import policy for three years
and Computer Software policy during 1985-86.
• In addition, by 1990 thirty-one sectors had been freed from industrial
licensing. This measure had a trade-liberalizing dimension as well, since
it freed machinery imports in these sectors from industrial licensing
clearance.
• Import flows were also helped by improved agricultural performance
and by the discovery of oil, which made room for nonoil, nonfood
imports, mainly machinery and intermediate inputs.
• The significant trade liberalisation during this phase was the result of
recommendations of a number of Committees set up during 1970’s and
1980’s, the major being the Committee on Import Export Policies and
Procedures (Chairman: P.C. Alexander, 1978) and the Committee on
Trade Policies (Chairman: Abid Husain, 1984).
• The Alexander Committee recommended the simplification of the
procedure of import licensing and provided a framework involving a shift
in the emphasis from ‘control’ to ‘development’.
• The Abid Husain Committee envisaged ‘growth led exports’ rather than
‘exports led growth’ and stressed upon the need for harmonisation of
foreign trade policy with other economic policies arguing for a phased
reduction of effective protection.
 • During 1985–90, nonoil imports grew at an annual rate of 12.3 per cent.
• Although the liberalization complemented by expansionary fiscal policy
raised India’s growth rate, the external and internal borrowing that
supported the fiscal expansion was unsustainable and culminated in a
balance-of-payments crisis in June 1991.
• This time, however, the government turned the crisis into an
opportunity: instead of reversing the course of liberalization, it launched
a truly comprehensive and systematic reform program that continues to
be implemented today.
Trade and Payment Reforms:
• Starting with the July 1991 budget, there was a clear switch in favor of a
move toward an outward-oriented, market-based economy. The trade
liberalization program initiated in the 1991 budget was comprehensive,
although the pace remained gradual and there were occasional hiccups.
Contours of Trade and Payment Reforms:
• The broad contours of trade and payments reforms in India initiated
since 1991 may be grouped as under:
• Rationalisation of exchange rate policy – full convertability on current
account and partial convertability on capital account;
• Liberalisation of imports – gradual removal of QRs, reduction in duties,
etc.;
• Incentives to exporters – Duty Exemption Scheme (DES) and Export
Promotion of Capital Goods Schemes (EPCGS), etc.; and
• Simplification of procedural formalities and fostering of transparency.
Import Liberalisation:
• Liberalisation of imports was considered as pre-requisite for expansion
of exports.
• On the eve of reforms, in 1990-91, the import-weighted average of
tariffs for all import stood at 87% (with tariffs on some imports
exceeding 300%).
• Import-weighted average tariffs on consumer goods imports were as
high as 164%.
• Tariffs have been reduced from an average of 71 per cent in 1993 to 35
per cent in 1997, however, the tariff structure remained complex and
escalation remains high in several industries, notably in paper and paper
products, printing and publication, wood and wood products, food and
beverages and tobacco.
• As of December 1995, more than 3000 tariff lines covering raw-
materials, intermediaries and capital goods were freed from import
licensing requirements.
 • Peak tariff rates reduced from 300 per cent at the beginning of 1990s to
40 per cent by the end of the decade.
• In the same period, the weighted tariff average fell from 75 per cent to
25 per cent.
• Tariff rates fell across the board, on intermediate, capital and consumer
goods From a very complex customs tariff structure in 1991 with an
incredible array of general, specific and user-end exemptions, the
structure has been simplified.
• In 2002, customs duties included only four rates (35 per cent, 25 per
cent, 15 per cent and 5 per cent).
• In general, bound tariffs are substantially higher than applied rates,
particularly for agricultural products.
• The import licenses continue to be the main non-tariff barriers.
• Over the years, the number of goods subject to import licensing have
been reduced with an emphasis on industrial and capital goods rather
than consumer products.
• In 1997, India presented a programme for the removal of remaining
restrictions to its trading partners.
• The removal of quantitative restrictions took place in 2000 and 2001,
after India failed in its attempt to defend them on balance of payments
grounds at the WTO.
• In 2001, the removal of all import restrictions maintained for balance of
payments reasons were effected.
• Import weighted means tariffs have slowly increased from 24.6 per cent
in 1996-97 to 30.2 per cent in 1999-2000.
• While removing QRs on imports in 2001, the government has raised the
tariff rates from the lower applied to higher bound levels.
• In case of agricultural commodities, India engaged in ‘dirty’ tarification
by setting very high bounds way above applied levels.
• India began to make use of all measures to protect the domestic
economy under the WTO rules.
• It includes the use of sanitary and phyto-sanitary (SPS) measures.
• The government set up a “war room” to monitor the imports of 300
sensitive tariff lines.
• The protective measures that came into vogue are in the form of tariff
adjustments, levy of antidumping and countervailing duties, safeguard
actions such as temporary imposition of QRs and SPS measures.
• India amended its copyright law in 1994 to comply with its obligations
under the Trade Related Intellectual Property Rights (TRIPs) agreement.
Export Liberalisation:
 • India had restricted exports of several commodities.
• As a part of its liberalization policy, the government began to reduce the
number of products subject to export controls in 1989-90.
• But prior to the July 1991 reforms, exports of 439 items were still
subject to controls, including (in declining order of severity) prohibition
(185 items), licensing (55 items), quantitative ceilings (38 items),
canalization (49 items), and prespecified terms and conditions (112
items).
• The March 1992 export-import policy reduced the number of items
subject to controls to 296, with prohibited items reduced to 16.
• The process continued subsequently, so that export prohibitions
currently apply to a small number of items on health, environmental, or
moral grounds; export restrictions are maintained mainly on cattle,
camels, fertilizers, cereals, peanut oil, and pulses.
Export Promotion:
• India’s export regime continues to be complex.
• Export prohibitions and restrictions have remained unchanged since
2002.
• In order to reduce the anti-export bias inherent in import and indirect
tax regime, a number of duty remission and exemption schemes have
been in place to facilitate exports.
• The schemes are open to all exporters who use imported inputs. The
scheme of tax holidays are offered to sectors such as electronics, farm
products, services, export processing zones, export-oriented units and
special economic zones.
Market Access Initiatives Scheme:
• Market Access Initiatives (MAI) Scheme is an Export Promotion Scheme
under WTO agreement envisaged to act as a catalyst to promote India’s
export on a sustained basis.
• The scheme is formulated on focus product-focus country approach to
evolve specific market and specific product through market
studies/survey.
• Assistance would be provided to Export Promotion Organizations/ Trade
Promotion Organizations/ National Level Institutions/ Research
Institutions/ Universities/ Laboratories, Exporters, etc., for enhancement
of export through accessing new markets or through increasing the
share in the existing markets.
• Under the Scheme the level of assistance for each eligible activity has
been fixed.
Recent EXIM Policy:
 • The modifications in India’s export-import policy (2009-14) underlined
the importance of increasing exports and facilitate those imports which
are required to stimulate the economy.
• The foreign trade policy is built around two major objectives. These are:
1. To double the percentage share of global merchandise trade within
next five years; and 2. To act as an effective instrument of economic
growth by giving a thrust to employment generation.
• The key strategies outlined to achieve this are:
• Unshackling of controls and creating an environment of trust and
transparency to unleash the capabilities of enterprises;
• Neutralizing incidence of all levies and duties on inputs used in export of
products;
• Nurturing special focus areas which will generate additional employment
opportunities, especially in semi-urban and rural areas;
• Simplifying the procedures and bringing down transaction costs;
• Facilitating technological and infrastructure up gradation of all sectors;
• Promotion of “Brand India” goods; and
• Emphasis on “focussed market and product scheme”.
Miscellaneous Measures in Recent Times:
• 1. India negotiated and concluded free trade agreements with ASEAN,
the Republic of Korea, Malaysia and Japan.
• 2. India continues to unilaterally reduce its tariffs and barriers to foreign
trade.
• The simple average MFN tariff rate declined from 15.1 per cent in 2006-
07 to 12 per cent in 2010-11. Both the average agricultural and industrial
average tariffs have declined over time. The tariffs on 71 per cent of our
tariff lines are between 5 and 10 per cent.
• 3. During the period 2007-11, the Government continued to streamline
customs procedures and implement various trade facilitation measures.
Some of the initiatives taken include the introduction of "self
assessment" for imports as well as exports and increased coverage of
the risk management system to carry out assessment on randomly
selected bills of entry based on risk parameters. The level of customs
intervention in the clearance of import and export cargos has been
progressively reduced.
Procedural Simplification:
• 1. There were systemic efforts to reduce paper work and control the
economic activity in general.
• 2. With a positive attitude towards private sector, private sector was
encouraged to enter the foreign market.
 • 3. Product standardisation and quality testing procedures have
improved.
• 4. Institutional infrastructure to assist exporters was made more
efficient.
• 5. The problems of exporters are now addressed quickly.
• 6. The data collection and dissemination has improved.
Liberalisation of Foreign Investment:
• India has also simplified its foreign investment regime and opened up a
number of sectors to foreign direct investment.
• This was the case in manufacturing where foreign participation of up to
51 to 74 per cent can take place automatically in a number of sectors.
• Major changes since 1993 have included automatic permission for
foreign equity participation of up to 50 per cent in some mining
activities.
• This also applies to oil exploration and offered incentives such as tax
holidays.
• FDI policy has been further liberalized.
• Investment is allowed in greater number of sectors and made eligible for
automatic investment procedures.
• However, FDI was not permitted in a few sensitive sectors.
Reforms in Service Sector and Foreign Investment: background:-
• India is a participant in the WTO-GATS negotiations.
• In the Uruguay Round, India made limited commitments.
• Many sectors such as energy, distribution, education and environmental
services to name but a few, were not scheduled Even important sectors
such as financial and telecom services, key sub-sectors and activities
such as insurance or international long distance telephony were not
committed.
• Moreover, the commitments typically bound less than the status quo
create a gap between the existing market access conditions and the level
committed under the WTO.
• India’s multilateral commitments in services reflected a conservative
approach and no additional market opportunities for trading partners.
• In the Doha Round, services negotiations, which were based on bilateral
requests and offers, India received request in almost all sectors.
• These requests centered on the expansion of India’s commitments to
include more services and activities within the scheduled sectors and
liberalize its commitments.
• In response to these requests, India submitted its initial offer in 2004.
 • This offer did not substantially improve upon its earlier Uruguay Round
commitment mainly because there was little progress in the
commitments by other member countries’ sectors in which India
expressed its interest.
• In its 2005 revised offer, India significantly improved upon its Uruguay
Round commitment by including several new services sectors and sub-
sectors.
• India indicated its willingness to remove commercial presence
restrictions in key areas which it had autonomously liberalized earlier.
• Its revised offer covered 11 sectors and 94 sub-sectors as opposed to 7
sectors and 47 sub-sectors in its initial conditional offer.
• Some of the new areas included were education, distribution,
accountancy and environmental services.
• These changes reflected new approach to India’s negotiating stance.
• With respect to trade policy, India has been a proponent of
multilateralism.
• However, in recent years, it has entered into bilateral and regional
negotiations.
• India is a latecomer on the bilateral and regional scene.
• So far India has signed only one regional agreement on services, namely
India-Singapore Comprehensive Economic Cooperation Agreement
(CECA).
• The agreement came into force in August 2005.
• Efforts are made to expand the service sector agreement to other
countries.
• Such agreement exists with Sri Lanka, Bay of Bengal Initiative for Multi-
sectoral Technical and Economic Cooperation (BIMSTEC) and Thailand.
• CECA has a positive list approach.
• It has a general obligations pertaining to recognization, domestic
regulation and transparency as well as sector specific obligations with
regard to market access and national treatment commitments with
similar aims and objectives as those of GATS.
Reforms in Service Sector and Foreign Investment:
• Since the initiation of reforms in 1991, there has been opening up of the
service sector to private participation, both domestic and foreign.
• Many services including construction, tourism, health and computer
related services have been placed on automatic approval route for FDI.
• Telecom services have experienced greater amount of liberalization.
• Now, fully-owned foreign firms are allowed in several segments of
telecom sector, government monopoly in long distance telephony and
 internet has been eliminated and there are no restrictions on the
number of providers.
• In several services, government increased the foreign holding limits to
74 per cent from the earlier ceiling of 49 per cent.
• Similarly in financial services there has been some liberalization.
• From the earlier limit of 20 per cent minority participation for foreign
banking companies or financial companies in private Indian banks
through technical or through the Foreign Investment Board route, the
limit of foreign ownership has been raised to 74 per cent in 2004 under
automatic route.
• In 2000, the Insurance Regulatory Bill was ratified permitting foreign
equity participation up to 26 per cent only through joint ventures and
partnership.
• Since the limit has been raised to 49 per cent, various other segments of
the financial sector, including mutual funds and capital market have
been opened up to foreign participation.
• Other areas such as health services, construction and engineering
services an autonomous liberalization has been undertaken.
• Since 2000, the hospital segment has been opened to 100 per cent FDI
participation on automatic route. There are more than 30 foreign firms
present in healthcare sector through various kinds of arrangements,
including subsidiaries, technology, training and joint ventures.
• Similarly, in construction sector, the government has permitted 100 per
cent FDI through automatic route in civil works.
• Autonomous liberalization has not taken place in certain services,
namely education, retail, accountancy and legal services.
• As a result, opening up in these areas has been limited.
• In the higher education sector, regulatory pre-conditions are required to
support liberalization.
• Foreign equity participation is permitted up to 100 per cent under the
automatic route since 2000 for entry through franchises, twinning
arrangements, study centres, and programme collaboration.
• There is a 49 per cent cap for research and teaching activities.
• However, the sector remains closed to the establishment of foreign
universities, education testing and training services.
• In the distribution services sector, unilateral liberalization has varied
across segments.
• While non-retail segments such as wholesale trading, export trading,
cash and carry and franchising are permitted up to 100 per cent through
automatic route, retail sector was partially open.
• In 2006, the government allowed 51 per cent FDI in single brand retailing
subject to FIPB approval and subject to certain other conditions.
• There remains a restriction on multi-brand retailing although these
restrictions can be bypassed through other channels such as local
sourcing, manufacturing and franchising, hence, this segment is not
completely closed.
• The opening up of multi-brand retail segment to foreign players was
subject to debate as well as the entry of big domestic entities.
• The strong domestic stakeholder’s sensitivity is present in the case of
accountancy services.
• Major international players in the US and the EU have been pushing for
the removal of all barriers to the established foreign professional
accountancy firms in India.
• However, the sector remains closed to FDI and foreign services providers
are not allowed to undertake statutory audit of the companies in India.
• The Institute of Chartered Accountants of India (ICAI) has resisted the
opening up of the sector to foreign accountancy firms unless the level
playing field is created for domestic firms, with amendments in domestic
legislation permitting domestic firms to enter into limited liability
partnership, multi-disciplinary work and the removal of restrictions on
the number of partners and solicitation of business by Indian
accountants.
• In addition, ICAI has urged the government to seek reciprocal
arrangements for domestic accountants of Indian firms in other
countries, thus linking FDI liberalization in the sector to greater market
access and recognition of Indian accountancy professionals in other
countries.
• The Indian accountancy firms need reciprocity and domestic regulatory
reforms.
• In legal services sector, there is a domestic opposition to the opening up
to foreign commercial presence as well as cross-border delivery of legal
services.
• The Bar Council of India has maintained that it is neither interested in
accessing international markets nor in liberalization to foreign law firms.
• It is concerned about uneven playing field, given the domestic
regulations which prevent Indian firms from having more than 20
partners, multi-disciplinary practice, limited liability partnerships and
restrictions on advertising by Indian lawyers.
• It enhanced the recognition of Indian qualifications and reciprocal
treatment of Indian legal professionals.
 • There is a concern that the entry of foreign law firms will make it difficult
for small Indian law firms to survive and the market segmentation and
price effect of such entry.
Merchandise Trade Performance and Determinants:
Growth of Merchandise Trade:
• The trade liberalisation measures undertaken during 1990s and
thereafter led to a rapid expansion of India’s trade.
• The growth rates of India’s exports and imports averaged over 10 per
cent during the 1990s but stepped up to an average of 22 per cent in the
past decade.
• Imports have generally grown at faster rates (24 per cent) than exports
(20 per cent) as shown in Table 1.
• Rapid growth of trade is also reflected from rising trade-to-GDP ratio,
which has more than doubled between 2001-02 and 2011-12 from 21.2
per cent to 43.8 per cent.
• In fact, the global integration of the economy crosses 60 per cent if trade
in services is also included (Figure 1).

•
The other noticeable trend is the widening of deficit in balance of trade
with imports growing at a faster rate than exports.
• The trade deficit has jumped from USD $5-6 billion a year in the
beginning of the last decade to USD $185 billion in 2011-12, which
amounts to over 10 per cent of GDP (Table 1 and Figure 2).
• The widening trade deficit has created balance of payment challenges
for the economy even after taking care of a substantial surplus in
invisibles or services trade.
Changing Structure of Trade:
• The export structure is expected to change with the level of
development from one dominated by primary products to products with
greater value-added.
• Diversification of export structure also makes the exporting country less
vulnerable to external shocks compared to a country with a more
concentrated export structure.
• Table 2 summarises some important shifts in the patterns of India’s
export structure over 1995-2012.
• As expected, the share of primary products including agricultural and
mineral products has declined steadily from nearly a quarter of India’s
merchandise exports to just 15 per cent over the 1995-2012 period.
• However, the declining share of India’s manufactured exports is a matter
of concern, as the same has fallen from a peak of 77 per cent of
merchandise exports in 2000-01 to 60 per cent in 2011-12.
• However, this decline can be seen as a statistical artifact due to the
emergence of India as a petroleum refining hub.
• Exports of refined petroleum products rose from virtually nothing in
1995-96 to 18 per cent of India’s exports by 2011-12.
• If refined petroleum products are considered as value-added products
like other manufactured and processed products, then the share of
 manufactured goods in exports would be nearly 78 per cent in 2011-12,
which is roughly at the level of 2000-01.
• There is also a slight reorganization of exports of manufactured products
as the share of conventional products like textiles and clothing has come
down from a 25 per cent to just 9 per cent since 1995-96, while leather
products declined to 2 per cent, which is only a third of what it was in
1995-96.
• Gems and Jewellery has also lost its importance slightly from a 17 per
cent share to 15 per cent.
• At the same time, the share of engineering goods rose steadily from 14
per cent to 22 per cent of all merchandise exports.
• Among engineering goods, exports of transport equipment have risen
very fast from less than a billion dollars in 1995 to nearly US$21 billion in
2011-12.
• Besides exporting vehicles and two wheelers, India has emerged as a
competitive exporter of auto parts and a number of procurement groups
of auto companies such as Delphi Systems (for General Motors) and
Visteon (of Ford) have set up procurement subsidiaries in India.
• This emergence owes itself to a particular strategic intervention by the
government in the form of an erstwhile performance requirement that
required foreign-owned companies to balance imports by foreign
exchange earnings.
• Machinery and equipment has been another category that has risen in
importance.
• Chemicals and related products is another group of manufactured
products that has improved its share in total merchandise exports even
if only marginally from 11 per cent to 12 per cent.
• But among the chemicals and allied products, chemicals and
pharmaceuticals group has gained the most.
• This is due to India’s emergence as a major exporter of generic
medicines in the world, accounting for a third of global pharmaceuticals
exports by volume.
• A major supplier of cost effective generics to developing countries and
multilateral organizations like the World Health Organization (WHO) for
their healthcare programmes in developing countries, India is sometimes
referred to as the pharmacy of the developing world.
• That success owes itself to another strategic intervention by the
government in terms of the adoption of a patent law abolishing product
patents for pharmaceuticals in 1970, which encouraged development of
generics by Indian companies.
• It is clear that India’s export structure has over time moved from the
export of primary and conventional products such as textiles and
clothing, leather products and gems and jewelry towards products with
greater value-added, such as transport equipment, generic
pharmaceuticals and refined petroleum products.
• However, the share of technology-intensive products in India’s exports is
still very low compared to that of East Asian countries.
• Recent figures suggest that the share of high-technology exports in
India’s export basket was only 7.2 per cent compared to 26.2 per cent
for East Asian countries (UN-ESCAP SSWA, 2012).
• India has also not been able to make a mark in fast-growing high value-
added segments of manufacturing such as electronics and telecom
equipments.
• In fact, growing imports of electronic equipments and other hardwares
are straining India’s trade balance.
• India has also not been able to exploit the job-creating potential of
exports and has been unable to develop highly labour-intensive export-
oriented industries such as toys and electronic assembly, among others.
• India’s import structure has also changed over the years as summarised
in Table 3.
• Imports comprising crude oil, raw materials and certain food imports
account for as much as 44 percent of total merchandise imports in 2011-
12 compared to 39 percent in 1995-96.
• In particular, the share of petroleum, crude oil and petroleum products
has risen rapidly from 21 percent to 32 percent over the same period.
• While consumption of petroleum and crude has risen in the country with
growth of volumes, a part of the increase is due to rising fuel prices over
the past decade.
• Considering that the demand for bulk imports that are mainly raw
materials and foods is relatively price inelastic, in the context of rising
trade deficit, one needs to pay attention to rising imports of capital
goods and others even though their overall share in total imports may
have come down.
• Among the capital goods, major categories include machinery, except
electrical accounting, for $30 billion, electronic goods worth $33 billion,
transport equipment $14 billion, and project imports $8.7 billion in
2011-12.
• In particular, imports of electronic goods are expected to rise to $400
billion by 2020 at current trends.
 • The demise of India’s fledgling electronic hardware industry is to be
partly explained in terms of India’s premature signing of the WTO’s
Information Technology Agreement 2000.
• It exposed Indian manufacturers to direct competition with established
rivals in the East Asian countries that have massive scales of production
due to their links with multinational supply chains.
• It is in these categories of imports that an attempt needs to be made to
pursue strategic import substitution to leverage the sizeable domestic
markets to develop domestic supply capabilities that will also generate
value added and jobs while helping to moderate the trade deficit.
• Gold (other non-bulk) is yet another item, imports of which are growing
and were of the order of $66 billion in 2011-12.
• While a part of the gold feeds into the gems and jewelry exports, a large
part is for domestic consumption and investment by households.
• Expansion of well-rated exchange traded funds (ETFs) might help in
curbing the demand by households especially for investment purposes.
Changing Geography of Trade:
• A major transformation has taken place in the direction of India’s trade
in terms of declining dependence on conventional trade partners like the
European Union and the United States and diversification of trade in
new and emerging markets.
• As Table 4 shows, the share of EU in India’s trade in 2010 is less than half
of what it was in 1990.
• Similarly, North America’s share has come down from 14 per cent to just
8.3 per cent over the same period.
• Japan’s share in India’s trade is now only a fourth of what it was in 1990.
• The trade structure is gradually diversifying in favour of emerging
countries in Asia-Pacific region and beyond.
• The most impressive rise is that of China from a negligible share in 1990
to over 10 percent of India’s trade by 2010, making China the single
largest trade partner of India.
• ASEAN’s share in India’s trade has also gone upfrom5.7 per cent to
nearly10percent in 2009before declining marginally to 9.2 percent in
2010.
• This explains the rising share of ASEAN+6 countries in India’s trade from
17.70 per cent to 26.6 per cent between 1990 to 2010.
• These include China, Japan, Republic of Korea, Australia andNew Zealand
that are India’s partners in the East Asia Summit formed in 2005.
• The shift in the geography of India’s trade from the advanced economies
of the west to the East Asian economies did not happen automatically
 but was a result of conscious and well thought out strategic policy
pursued since 1992 called the Look East Policy.
• Another region rising in prominence as a trade partner is the Middle East
with ashare in India’s trade nearly doubling between 1990-2010 to 18.9
per cent, mainly on account of India’s high dependence on the region for
fuels.
• But trade with the Middle East is also increasing because of India’s
growing exports of manufactures, sometimes transshipped through the
region to other countries like Pakistan.
• Shares of Africa and Latin America and the Carribean have also risen very
fast from rather low bases.
Services in India’s Trade:
• The emergence of the services sector as the most dynamic sector driving
India’s growth has been accompanied by its growing importance in
trade.
• The share of trade in services in India’s GDP has quadrupled from 3.3 per
cent to 14.3 per cent between 1990 and 2010.
• Table 5 shows that unlike in goods trade, the growth rate of service
exports has been higher than that of imports.
• There has been a striking transformation of India as a net exporter of
services from being a net importer at the beginning of the decade.
• Exports of $137 billion worth of services in 2011 left a surplus of $12.5
billion after imports.
• Growth of trade in services in India has also been faster than in other
countries, tripling India’s share in global services trade.
• To understand the dynamism of services trade, Table 6 shows the
sectoral composition of exports of commercial services.
• The bulk of India’s commercial services exports comprise those of
computer, communications and other related services (or ICT services),
which increased from 62.8 per cent to 71.5 per cent over 2000-2011,
while commercial services exports of the country expanded from $17
billion to $137 billion.
• This primarily owes to the emergence of India as a hub for software
development and other IT-enabled services, also referred to as business
process outsourcing services (BPO).
• In these services, India is recognized as the global leader. In the Global
Services Location Index, by AT Kearney, a global consultancy
organisation, India is ranked first globally in 2011 (Table 7), a position it
has consistently retained since the inception of the index in 2004.
 • Among the sources of its strength in the sector are people skills and
their abundance given the large youthful workforce of the country.
India’s success in IT services has been attributed to, among other
factors, a farsighted government policy to spot emerging opportunities
and create high-end education and training facilities and computing
infrastructure way back in late 1970s.
• In future, this strength in ICT services needs to be leveraged to build a
strong electronic goods industry.
Macroeconomics of Indian External Sector:
• We know that foreign savings must fill the gap between private
domestic investment and private plus public domestic savings.
• Foreign savings themselves equal the current account deficit.
• In turn, the balance of payments identity dictates that the current
account deficit be equal to the net external capital inflows minus the
change in the volume of foreign exchange reserves held by the RBI.
• Symbolically, if we denote private domestic investments by IP, private
domestic savings by SP, fiscal surplus of the Government by SG, current
account surplus by CA, net capital inflows by K and the reserves
accumulation of the RBI by δR, we can write
• IP – (SP + SG) ≡ -CA ≡ K – δR.
• We also know that
• CA ≡ (X – M) + NFIA + NFT,
• Where, X and M denote exports and imports of goods and services
respectively, NFIA represents net factor income earned from abroad and
NFT stands for net transfers received from abroad.
• The NFIA equals the income earned by India’s resources located abroad
minus the income earned by foreign factors located in India.
• In the Indian balance of payments, this entry includes only the receipts
on Indian investments abroad and payments on foreign investment in
India.
• The NFT includes unilateral transfers such as foreign aid and
remittances.
• The latter make a major contribution to the current account in India.
• Capital inflows are divided into two main categories: foreign investment
and foreign borrowing.
• In the Indian balance of payments, the former includes foreign direct
investment and foreign portfolio investment.
• Foreign borrowing has three main components: concessional borrowing
reported as ”external assistance,” commercial borrowing, and NRI
deposits.
 • The transactions defining the change in the reserve position of the RBI
(δR) include the changes in the gold reserves, foreign exchange
reserves, the Special Drawing Rights (SDRs), and the reserve position in
the International Monetary Fund (IMF).
• There is a tendency even among specialists to view capital inflows and
unilateral transfers—overwhelmingly comprised of remittances, in the
case of India—as being essentially identical. But there are important
differences between them.
• Remittances generate no future obligations, and therefore they are a
current account item.
• If the RBI does not intervene by accumulating extra reserves to
neutralize the inflows of remittances, either an equivalent capital
outflow or an import expansion (or a combination of the two) must take
place to clear the foreign exchange market.
• In the former case, the current account surplus rises and effectively
reduces foreign savings available to the country.
• Improved current account adds to the national income, however, which
increases domestic private savings.
• In the latter case, unilateral transfers do not reduce foreign savings
available, but they also do not increase the national income or private
domestic savings.
• If the RBI does intervene by accumulating reserves to the extent of the
remittances, the effect is similar to the first of the previous two cases.
• In contrast to unilateral transfers, capital inflows bring future
obligations, are a capital account item, and represent foreign savings
available to the country.
• If the RBI does not take an offsetting action through equivalent reserves
accumulation, the capital inflows generate a corresponding current
account deficit, which is an increase in the available foreign savings.
• In this case, the national income and domestic savings are entirely
unaffected, but the available foreign savings rise.
• If the RBI does take a countervailing action by accumulating equivalent
foreign exchange reserves, the savings potential of capital inflows is
neutralized.
Capital Account Liberalisation:
• Broadly speaking, India’s approach towards external capital flows can be
divided into three main phases.
• In the first phase, starting at the time of independence and spanning up
to the early 1980s, India’s reliance on external flows was mainly
restricted to multilateral and bilateral concessional finance.
• Subsequently, however, in the context of a widening current account
deficit during the 1980s, India supplemented this traditional external
source of financing with recourse to external commercial loans,
including short-term borrowings and deposits from non-resident Indians
(NRIs).
• As a result, the proportion of short-term debt in India’s total external
debt had increased significantly by the late 1980s.
• The third phase was marked by the balance of payments crisis of 1991
and the initiation of the reform process.
• The analytical foundations for capital account liberalisation and
exchange rate reforms were provided by three reports:
• Report of the High Level Committee on Balance of Payments (Chairman:
C. Rangarajan, 1991)
• and the two reports on Capital Account Convertibility (Chairman: S.S.
Tarapore, 1997 and 2006).
• These reports, inter alia, suggested:
• (i) encouragement to private capital inflows;
• (ii) shift from debt creating to non-debt creating flows;
• (iii) a shift within the debt inflows from short-term to long-term debt;
• (iv) emphasized on monitoring of external commercial borrowings; and
• (v) gradual liberalisation of outflows. India adopted a gradual and
calibrated approach towards capital account convertibility.
• In order to operationalise the process of capital account liberalisation
within a regulatory framework, RBI provided license to the entities for
dealing in foreign exchange market, thereby guiding capital flows.
• Such entities are designated as Authorised Dealers (Ads).
• Ads have three categories:
• Category-I: public, private and foreign banks.
• Category-II: authorised on the city basis. They include cooperative banks,
private forex dealers and travel agents etc.
• Category-III: non-banking financial companies.
• The authority vested in the hands of AD-I is the largest, ranging from
stock market transactions to NRI accounts, ECBs, ADRs, etc., while other
categories of Ads have a limited role to play.
• India’s status with regard to capital account liberalisation could be seen
in terms of its policy stance towards capital transactions by residents
and non-residents on the one hand and by the underlying instruments of
cross border flows on the other.
• Non-residents have been provided considerable extent of convertibility
whereas permission to residents to undertake capital account
transactions across borders is relatively restrained.
• Moreover, distinction is made not only between residents and non-
residents but also between different categories of residents.
• If residents are classified into corporates, financial institutions and
individuals, the regime is most liberal in the case of corporates followed
by financial intermediaries and individuals.
• Corporates and financial intermediaries are permitted to raise equity
resources through American Depository Receipts (ADRs)/ Global
Depository Receipts (GDRs) and are allowed to borrow through debt
instruments from abroad.
• External Commercial Borrowings (ECBs) could be raised under both
automatic and approval routes subject to quantity as well as price
restrictions.
• Under automatic route, eligible borrowers in industry, infrastructure
sector and NBFCs (excluding micro finance companies) can now borrow
upto US $ 750 million in a year.
• For borrowing above this stipulation prior approval is required.
• There is an all-in-cost ceiling currently ranging between 350 basis points
and 500 basis points over 6 month LIBOR for loans with minimum
maturity of 3 years to more than 5 years. Banks can borrow up to 50 per
cent of their unimpaired Tier I capital.
• Apart from inflows, corporates are allowed to invest abroad in overseas
joint or wholly owned subsidiaries up to 400 per cent of their net worth.
• Banks can invest overseas up to 25 per cent out of their demand and
time liabilities in India.
• Indian mutual funds can invest abroad within overall aggregate limit of
US $ 7 billion.
• Individuals can remit an amount equivalent to US dollar 200,000 in a
year under liberalized remittance scheme.
• Non-resident corporates and financial intermediaries can invest in
domestic companies and instruments across sectors subject to some
instrument-wise and sector-wise conditions. For portfolio investment,
they need to register themselves with the SEBI.
• Recently, Qualified Foreign Investors (QFI) including individuals and
groups or associations have also been permitted to invest directly in the
equity market in India after meeting the stipulated norms including
Know Your Customer (KYC).
• In terms of instruments, inflows to India are subject to a hierarchy of
preferences with direct investment preferred over portfolio flows, rupee
denominated debt preferred over foreign currency debt and medium
and long-term debt preferred over short-term debt.
• As regards non-debt flows, the overall approach has been to
substantially liberalise FDI flows so as to meet domestic investment
requirements and raise growth potential of the economy.
• However, keeping in view socio-economic implications, FDI is prohibited
in certain sectors, viz., lottery business, chit funds, nidhi companies,
tobacco products, agriculture and plantation, and activities/sectors not
open to private sector investment, e.g., atomic energy and railway
transport other than mass rapid transport systems.
• Apart from direct investment, non-residents can acquire equity stakes
through portfolio investment as well.
• Portfolio investment could be made by the entities which are registered
with the SEBI as Foreign Institutional Investors (FIIs).
• FIIs do not need prior approval as long as they are within the sectoral
and individual limits.
• There are no restrictions on repatriation of equity investments.
• With regard to debt flows, policy levers comprise both quantity and
price based prudential prescriptions.
• There is a ceiling on the extent of FII investment in sovereign debt (US $
15 billion) and corporate debt (US $ 45 billion) and there is also a
withholding tax.
• ECBs flows under both the automatic and approval routes are
moderated by interest rate ceilings and those under the automatic route
through an additional quantity ceiling.
• In addition, there are end use and minimum maturity restrictions of 3
years for ECB.
• However, trade credit is available for short-term with quantity and price
restrictions.
• Foreign Currency denominated Non-Resident Indian (NRI) deposits are
regulated through an interest rate ceiling linked to LIBOR/SWAP rate of
the corresponding currency.
• However, rupee denominated NRI deposits have recently been
deregulated with the condition that interest rate on those should not be
more than the rate offered on domestic deposits of comparable
maturities.
There is no restriction on repatriation of NRI deposits.
Capital Flows :
Trends:
• Since the introduction of the reform process in the early 1990s, India
witnessed a significant increase in cross-border capital flows.
• Net capital inflows increased from $7.1 billion in 1990-91 to $45.8 billion
in 2006-07, and further to $108.0 billion during 2007-08.
• India has one of the highest net capital flows among the emerging
market economies (EMEs) of Asia.
Magnitude:
• Net capital inflows, which increased from 2.2per cent of GDP in 1990-91
to around 9per cent in 2007-08, did not, however, reflect the true
magnitude of capital flows to India.
• Gross capital inflows, as a percentage of GDP, underwent a more than
fivefold increase from 7.2per cent in 1990-91 to 36.6per cent in 2007-08.
• Much of this increase was offset by corresponding capital outflows,
largely on account of foreign institutional investors’ (FIIs) portfolio
investment transactions, Indian investment abroad and repayment of
external borrowings.
• Capital outflows increased from 5.0per cent of GDP in 1990-91 to
27.4per cent of GDP in 2007-08.
• The gross volume of capital inflows amounted to $428.7 billion in 2007-
08 as against an outflow of $320.7 billion.
• Strong capital flows to India during 2003-2007 reflected the sustained
momentum in domestic economic activity, better corporate
performance, the positive investment climate, the longterm view of
India as an investment destination, and favourable liquidity conditions
and interest rates in the global market.
• Apart from this, the prevailing higher domestic interest rate along with a
higher and stable growth rate had created a lower risk perception, which
attracted higher capital inflows.
• The large excess of capital flows over and above those required to
finance the current account deficit resulted in reserve accretion of
$110.5 billion during 2007-08.
• India’s total foreign exchange reserves were $308.4 billion as of 4 July
2008.
Composition:
• As regards the composition of capital flows, the thrust of the policy
reform in India in the aftermath of the balance of payments crisis was to
encourage non-debt-creating flows and discourage short-term debt
flows.
• Accordingly, the composition of capital inflows to India clearly reflected
a shift towards non-debt-creating flows.
• The substantial contribution of external aid towards the capital account
in the 1950s, 1960s, 1970s and 1980s dwindled steadily since the 1990s
(excluding IMF loans in 1991 and 1992) as the official flows started to be
replaced by private equity flows and external commercial borrowing.
• Although non-debt flows, particularly private foreign investments, have
gained in importance, there has also been a significant rise in debt-
creating flows, mainly on account of a rise in external commercial
borrowings by Indian corporates.
• Equity flows under foreign direct investment (FDI) and foreign portfolio
investments constitute the major forms of non-debt-creating capital
flows to India.
• There has been a marked increase in the magnitude of FDI inflows to
India since the early 1990s, reflecting the liberal policy regime and
growing investor confidence.
• India’s share in global FDI flows increased from 2.3per cent in 2005 to
4.5per cent in 2006.
• Inflows under FDI were particularly high during the last two years,
though a large part was offset by significant outflows on account of
overseas investment by Indian corporates.
• In a major break from the past, the spurt in FDI flows to India during
2004-2007 was accompanied by a jump in outward equity investment as
Indian firms established production, marketing and distribution
networks overseas to achieve global scale along with access to new
technology and natural resources.
• Investment in joint ventures (JV) and wholly owned subsidiaries (WOS)
abroad has emerged as an important vehicle for facilitating global
expansion by Indian companies.
• Overseas direct equity investment from India jumped from $3.8 billion in
2005-06 to $11.3 billion in 2006-07, and rose further to $12.5 billion
during 2007-08.
• Overseas investment, which started with the acquisition of foreign
companies in the IT and related services sector, has now spread to other
areas such as non-financial services.
• A marked feature of FDI flows to India is that they have been
concentrated in the services sector, in contrast to the dominance of
manufacturing in the East Asian economies.
• This reflects the service-led growth of the economy and its comparative
advantage in international trade in services.
• IT has enabled greater tradability of a number of business and
professional services.
• With greater potential for growth in such services, FDI has also emerged
as a vehicle to delivery of services to the international markets.
• Moreover, within the services sector, financing, insurance, real estate
and business services witnessed a large increase in their share in FDI
flows to India between 2002-03 and 2007-08.
• Computer services also remains a key sector for FDI as captive
BPO/subsidiaries have been principal instruments for facilitating
offshore delivery of computer services and IT enabled services.
• Like FDI, India’s share in net portfolio flows to emerging market and
developing countries has expanded.
• India has witnessed a dominance of portfolio flows over FDI flows during
various periods of time, which is in contrast to developing and emerging
market economies in most parts of the world, where FDI constituted the
main source of equity flows.
• However, unlike FDI flows, which have exhibited a more or less steady
upward trend over the years, portfolio flows are more volatile, moving in
tandem with domestic and international market sentiments.
• Accordingly, a sharp rise in portfolio investment into India in the recent
period reflects both global and domestic factors.
• The search for yield in view of very low real long-term rates in advanced
economies has been an important factor driving portfolio flows to EMEs
as a group, and India also has attracted such flows.
• Domestic factors, such as strong macroeconomic fundamentals, a
resilient financial sector, a deep and liquid capital market, the improved
financial performance of the corporate sector and attractive valuations
also attracted large portfolio flows during 2004 to 2007.
• Consistent with the principle of the hierarchy of capital flows, India has
been making efforts towards encouraging more inflows through FDI and
enhancing the quality of portfolio flows by strict adherence to the “know
your investor” principle.
• External assistance, external commercial borrowings (ECBs), trade
credits and the nonrepatriable component of NRI deposits constitute the
major portion of the external debt in India.
• External assistance, which consists of external aid flows from bilateral
and multilateral sources, constituted the major source of external
financing for India in the 1950s and 1960s.
• Its importance has declined steadily since the mid of 1970s as it gave
way to private capital flows, with the share in India’s total capital flows
falling from 31.2per cent in 1990-91 to 1.9per cent in 2007-08.
• Conversely, India has started extending assistance to other countries,
mainly grants and loans for technical cooperation and training.
• The grant component dominated external aid with a share of over 90per
cent; the major beneficiaries during 2006-07 were Bhutan, Nepal and Sri
Lanka.
• The recourse to ECBs by Indian corporates, though initiated in the early
1970s, remained modest due to the dominance of concessional, non-
market-based finance in the form of external assistance from bilateral
sources and multilateral agencies.
• Towards the end of the 1970s, the concessionality in the aid flows
dwindled.
• Thus, with the rising external financing requirements beginning in the
1980s and the recognition that reliance on external assistance was not
favourable, commercial borrowings from international capital markets
were preferred.
• After experiencing some slowdown in the aftermath of the balance of
payments crisis, ECBs rose significantly in the latter half of the 1990s,
responding to the strong domestic investment demand, favourable
global liquidity conditions, the upgrade of India’s sovereign credit rating,
lower risk premia on emerging market bonds, and an upward phase of
the capital flow cycle to the EMEs.
• During this period, ECBs constituted about 30per cent of the net capital
flows to India.
• In the late 1990s and the early 2000s, the demand for ECBs remained
subdued due to a host of factors such as the global economic slowdown,
the downturn in capital flows to developing countries and lower
domestic investment demand.
• The period beginning 2003-04 marked the resumption of debt flows to
developing countries, the combined outcome of the higher interest rate
differential emanating from ample global liquidity and the robust growth
expectations and low risk perception towards the emerging markets.
• Net inflows under ECBs increased from $2.5 billion in 2005-06 to $16.2
billion in 2006-07 and further to $22.2 billion during 2007-08.
• ECBs contributed to about 20.5per cent of the net capital flows to India
in 2007-08.
• Higher ECB drawals during 2003-2007 reflected sustained domestic
investment demand, import demand, the hardening of domestic interest
 rates and also the greater risk appetite of global investors for emerging
market bonds.
• Non-Resident Indians/Overseas Corporate Bodies were allowed to open
and maintain bank accounts in India under special deposit schemes,
both rupee- and foreign currency denominated.
• NRI deposits were a generally stable source of support to India’s balance
of payments through the 1990s, although the external payment
difficulties of 1990-91 demonstrated the vulnerability that could be
associated with these deposits in times of difficulty and drastic changes
in perceptions.
• Since the 1990s, the Reserve Bank has aligned the interest rates on
these deposits with international rates and fine-tuned the reserve
requirements, end use specifications and other concomitant factors
influencing these deposits in order to modulate these flows consistent
with overall macroeconomic management.
• As a whole, India’s external debt stock stood at $221.2 billion at the end
of March 2008.
• Consolidation of India’s external debt position was reflected the steady
improvement in India’s debt sustainability and liquidity indicators.
• While the ratio of India’s external debt to GDP registered a decline over
the years from 38.7per cent in 1991-92 to 18.8per cent in 2007-08, the
debt service ratio fell from 30.2per cent to 5.4per cent during the same
period.
• At the end of March 2008, India’s foreign exchange reserves, at $309.7
billion, provided a cover of 140per cent to total external debt, though
there was an increase in the short-term debt in those years.
• As regards the composition of external debt, a distinct decline was
noticed in the share of government debt in total external debt, which fell
from 43.4per cent to 26.3per cent of total external debt between end-
March 2001 and end-December 2007, giving way to non-government
private external borrowings.
• On account of large capital inflows, India’s international investment
position (IIP) deteriorated over the years under analysis.
• Net international liabilities increased from $47.2 billion at end-March
2004 to $73.9 billion at end-December 2007, as the increase in
international liabilities ($222.5 billion) exceeded the increase in
international assets ($195.7 billion) during the period.
• While the increase in the liabilities was mainly due to large capital flows
under portfolio investment, FDI and external commercial loans, the
 increase in international assets mainly reflected a rise in reserve assets,
followed by direct investment abroad.
• A major part of the liabilities, such as direct and portfolio investment,
reflected cumulative inflows, which are provided at historical prices.
• The value of the liabilities would be much higher if marked to market at
current prices.
• The ratio of non-debt liabilities to total external financial liabilities had
witnessed an increasing trend since end-June 2006, rising from 42.3per
cent at end-June 2006 to 50.8per cent at end-December 2007 due to
large capital inflows under direct and portfolio equity investments.
• On the other hand, debt liabilities, which include portfolio investment in
debt securities and other investment (trade credits, loans, currency and
deposits and other liabilities) declined from 57.7per cent to 49.2per cent
during the same period.
Selected References (module 3 and 5)
Government of India (2013). “Financial Sector in India: Regulations and
Reforms”, Reference Note No. 15/RN/Ref./August/2013, Lok Sabha Secretariat.
Reserve Bank of India (2013). “Banking Structure in India: Looking
Ahead by Looking Back”, Speaking Notes of Dr. Duvvuri Subbarao (the then
Governor of RBI) at the FICCI-IBA Annual Banking Conference in Mumbai
(August 13, 2013).
Reserve Bank of India (2013). “Banking Structure in India – The Way
Forward”, Discussion Paper Prepared (jointly) by Department of Banking
Operations and Development (DBOD) and Department of Economic and Policy
Research (DEPR) (August).
Sadhak, H. (2012). “Pension Reforms in India: Progress and Further
Actions”, Presentation in the National Conference on Pension Fund-Untapped
Opportunities, Organised (jointly) by Associated Chambers of Commerce and
Industry of India (ASSOCHAM) and Pension Fund Regulatory and Development
Authority (PFRDA) on November 27, 2012.
Gupta, Ramesh “Pension Reforms in India: Myth, Reality and Policy
Choices”, Working Paper, I.I.M. Ahmedabad.
Annual Reports (various years) of Pension Fund Regulatory and
Development Authority (PFRDA) at http://www.pfrda.org.in.
News updates from various sources and updates provided by the
Department of Financial Services, Ministry of Finance, Government of India at
http://finmin.nic.in.
Confederation of Indian Industry (CII) and Ernst & Young (2013).
“Insurance Industry: Challenges, Reforms and Realignment”, Report Accessed
at http://www.ey.com/Publication/vwLUAssets/Insurance_industry_-
_challenges_reforms_and_realignment/$FILE/EY-Insurance-industry-
challenges-reforms-realignment.pdf.
Kannan, R. (2008). “Second Generation of Reform in Indian Insurance
Industry: Prospects and Challenges”, Accessed at
http://www.icrier.org/pdf/Presentation24june08.pdf.
Sinha, T. (2005). “The Indian Insurance Industry: Challenges and
Prospects”, Accessed at http://icpr.itam.mx/papers/SinhaSwissRe.pdf.
Annual Reports (various years) of Insurance Regulatory and
Development Authority (IRDA) (https://www.irda.gov.in), news updates and
Department of Financial Services, Ministry of Finance, Government of India.
CII and BCG (2012). “Deepening of Capital Markets: Enabling Faster Economic
Growth”, Joint Report Accessed at the Website of the Confederation of Indian
Industry (CII): http://cii.in.
Annual Reports of SEBI (various years) at http://www.sebi.gov.in.
Dua, P. and R. Ranjan (2010). “Exchange Rate Policy and Modelling in India”,
DRG Study, Reserve Bank of India (rbi.org.in).
Jadhav, Narendra (2005). “Exchange Rate Regime and Capital Flows: the
Indian Experience”, Chief Economists’ Workshop, Bank of England (April 4-6).
Hutchison, M.M., R.S. Gupta and N. Singh (2010). “India’s Trilemma: Financial
Liberalisation, Exchange Rate and Monetary Policy”, Working Paper,
Department of Economics, University of California, Santa Cruz, CA.
RBI’s Recent Macroeconomic Reviews and various issues of Economic
Surveys, Ministry of Finance, Government of India.
Panagariya, A. (2008). “India: the Emerging Giant”, U.S.A., Oxford
University Press.
For topics involving data analysis, consult Handbook of Statistics on
Indian Economy (desired years), annual publication of the Reserve Bank of
India; as well as Economic Survey (desired years), Ministry of Finance,
Government of India (relevant chapters).
Trends in Capital Flows to India Since 2008: Investors of capital are loyal only
to assets and markets that promise the highest risk adjusted return.
• There is always a tendency to retrace quickly when the risk-reward
equation changes.
• This happened when the global economic crisis emerged around 2008.
• The adverse impact of the global financial market turmoil was reflected
in lower capital inflows to India during 2008-09.
• There was massive decline in net capital flows from US$106.6 billion in
2007-08 (8.8 per cent of GDP) to US$7.2 billion (0.6 per cent of GDP) in
2008-09.
• The decline was mainly due to net outflows under portfolio investment
including foreign institutional investments (FIIs), American depository
receipts (ADRs)/ global depository receipts (GDRs) (US$14.0 billion),
banking capital including NRI deposits (US$3.2 billion) and short-term
trade credit (US$1.9 billion).
• However, notwithstanding these adverse developments, the resilience
of FDI inflows (US$17.5 billion in 2008-09) reflected the growing
perception of India as one of the favourite long-term investment
destinations.
• Stronger recovery in India, ahead of the global recovery along with
positive sentiments of global investors about India’s growth prospects,
encouraged a revival in capital flows during 2009-10.
• The turnaround was mainly driven by large inflows under FIIs and short-
term trade credits.
• The gross capital inflows at US$345.7 billion during 2009-10 were 10.2
per cent higher than the US$313.6 billion in 2008-09, while gross capital
outflows at US$292.3 billion were lower by 4.8 per cent from US$306.9
billion in 2008-09.
• As a result, net capital flows at US$53.4 billion (3.8 per cent of GDP)
were much higher during 2009-10 as compared to US$6.8 billion (0.5 per
cent of GDP) in 2008-09.
• Both inward as well as outward FDI showed declining trend in 2009-10
vis-a-vis 2008-09, thereby keeping net FDI marginally lower at US$18.8
billion in 2009-10, as compared with US$19.8 billion in 2008-09.
• The FDI was channelled mainly into manufacturing followed by
construction, financial services and the real estate sector.
• The attractive domestic market conditions facilitated net FII inflows of
US$29.0 billion in 2009-10 (as against net outflow of US$15.0 billion in
2008-09).
• At US$3.3 billion, the ADRs / GDRs remained at the same level in 2009-
10 as in 2008-09.
• Net ECBs slowed down to US$2.8 billion (as against US$7.9 billion in
2008-09) mainly due to increased repayments.
• The net short-term trade credits to India increased significantly to
US$7.6 billion in 2009-10 from net outflows of US$2.0 billion a year
earlier, reflecting international confidence in domestic importers.
• Overall net non-resident deposits inflows stood lower at US$2.9 billion
during 2009-10 as compared to US$4.3 billion during 2008-09.
• In 2010-11, In net terms, capital inflows increased by 20.2 per cent to
US$62.0 billion (3.7 per cent of GDP) vis-a-vis US$51.6 billion (3.8 per
 cent of GDP) in 2009-10 mainly on account of trade credit and loans
(ECBs and banking capital).
• The Non-debt flows or foreign investment comprising FDI and portfolio
investment (ADRs/GDRs and FIIs) on net basis decreased by 21.4 per
cent from US$50.4 billion in 2009-10 to US$39.7 billion in 2010-11.
• Decline in foreign investment was offset by the debt flows component of
loans and banking capital which increased by 130.3 per cent from
US$14.5 billion in 2009-10 to US$33.4 billion in 2010-11.
• Sector-wise, deceleration during 2010-11 was mainly on account of
lower FDI inflows under manufacturing, financial services, electricity,
and construction.
• Country-wise, investment routed through Mauritius remained the
largest component of FDI inflows to India in 2010-11 followed by
Singapore and the Netherlands.
• Net accretion to reserves (on BoP basis) in 2010-11, at US$13.1 billion,
remained at more or less the same level as in 2009-10 (US$13.4 billion).
• Net inflows of US$67.8 billion (3.6 per cent of GDP) under the capital
account in 2011-12 were moderately higher than that of US$63.7 billion
(3.7 per cent of GDP) in 2010-11.
• This was primarily on account of a revival in FDI flows to India, a surge in
NRI deposits and higher overseas borrowings by banks.
• However, there was a decline in inflows under FII investments, ADRs/
GDRs, external assistance, ECBs and short term trade credit.
• Risk on/risk off behaviour significantly influenced capital flows to India.
• Even though the FDI to India (inward FDI) of US$33.0 billion in 2011-12
was significantly higher than US$29.0 billion in the preceding year, net
inflows on account of portfolio investments at US$17.4 billion were
lower as compared to US$31.5 billion in 2010-11 reflecting trend
towards risk aversion among FIIs due to global economic uncertainty.
• Sector-wise, manufacturing, construction, financial services, business
services and communication services received significant amount of
inflows.
• Country-wise, investment routed through Mauritius remained, as in the
past, the largest component, followed by Singapore and the UK.
• Since net capital inflows were inadequate to finance the higher CAD
recorded during 2011-12, there was a net drawdown of foreign
exchange reserves to the extent of US$12.8 billion during the same
period.
• In 2012-13, net capital inflows were placed at US$92.0 billion (4.9 per
cent of GDP) and were led by FII inflows (net) of US$27.6 billion and
short-term debt (net) of US$21.7 billion.
• There were, besides, large overseas borrowings by banks together
indicating the dependence on volatile sources of financing.
• On a yearly basis, FII (net) flows remained at high levels post-2008 crisis
on account of the fact that foreign investors had put faith in the returns
from emerging economies, which exhibited resilience to the global crisis
in 2009.
• There was some diminution in net inflows in 2011-12 on account of the
euro zone crisis.
• On an intra-year basis, there was significant change in FII flows due to
perceptions of changing risks which had a knock-on effect on the
exchange rate of the rupee given the large financing need.
• While the declining trend in net flows under ECB since 2010-11
continued in 2012-13, growing dependence on trade credit for imports
was reflected in a sharp rise in net trade credit availed to US$21.7 billion
in 2012-13 from US$6.7 billion in 2011-12.
• Capital inflows were adequate for financing the higher CAD and there
was net accretion to foreign exchange reserves to the extent of US$3.8
billion in 2012-13.
• Outcomes in 2013-14 were a mixed bag.
• The higher CAD in the first quarter of 2013-14 was financed to a large
extent by capital flows; but the moderation observed in the fourth
quarter of 2012-13 continued through 2013-14.
• The communication by the US Fed in May 2013 about its intent to roll
back its assets purchases and market reaction thereto led to a sizeable
capital outflow from forex markets around the world.
• This was more pronounced in the debt segment of FII.
• In the event, even though there was a drastic fall in the CAD in July-
September 2013, net capital inflows became negative leading to a large
reserve drawdown of US$10.4 billion in that quarter.
• FDI net inflows continued to be buoyant with steady inflows into India
backed by low outgo of outward FDI in the first two quarters.
• In the third quarter, while there was turnaround in the flows of FIIs and
copious inflows under NRI deposits in response to the special swap
facility of the RBI and banks’ overseas borrowing programme, there was
some diminution in the levels of other flows.
 • This led to a reserve accretion of US$19.1 billion in the third quarter
notwithstanding that the copious proceeds of the special swap windows
of the RBI directly flowed to forex reserves of the RBI.
• In the fourth quarter, while FDI inflow slowed, higher outflow on
account of overseas FDI together with outflow of short-term credit
moderated the net capital inflows into India.
• Thus for the year as a whole, net capital inflow was placed at US$47.9
billion as against US$92.0 billion in the previous year.
• While net FDI was placed at US$21.6 billion, portfolio investment
(mainly FII) at US$4.8 billion, ECBs at US$11.8 billion, and NRI deposits at
US$38.9 billion, there were significant outflows on account of short-term
credit at US$5.0 billion, banking capital assets at US$6.6 billion, and
other capital at US$10.8 billion.
• The net capital inflows in tandem with the level of CAD led to a reserve
accretion of US$15.5 billion on BoP basis in 2013-14.
• The accretion to reserves on BoP basis helped in increasing the level of
foreign exchange reserves above the US$300 billion mark at end March
2014.
• In the current fiscal year so far, India has witnessed a net inflow of about
US$25 billion in the form of FDI and about US$36 billion as portfolio
flows as against about US$21 billion and (-) US$1 billion respectively in
the corresponding period of the last year.
• It is expected that during 2014-15, capital flows would be more than
adequate to finance current account deficit (which is roughly around 2.1
per cent of GDP).
Effects of Capital Flows:
• The effects of capital flows to any country depends upon its absorbtive
capacity.
• The absorbtive capacity is the ability of a country to translate foreign
capital into domestic investment.
• This ability of a country depends upon a variety of domestic factors, such
as the level of human capital, political stability and the depth of the
domestic financial markets.
• Further more, the type of foreign capital has also macroeconomic
implications for the recipient country.
• Although no theoretical model exists so far analysing the impact of
capital flows, the macroeconomic impact of capital account liberalisation
has long been debated and still remains unresolved.
• One theoretical approach in this regard, following neoclassical,
advocates (assuming, in particular, perfect capital markets): allowing the
 free flow of capital across borders would lead to a more efficient
allocation of resources and would be welfare-enhancing for both
borrowers and lenders, in a fashion similar to the liberalisation of trade.
• An alternative view took a second-best perspective: that removing one
distortion – restrictions on capital movements – in the presence of other
distortions that often exist in emerging markets may not necessarily
enhance welfare.
• This view gained particular relevance after the onset of the Asian crisis.
• This crisis focused attention on how incomplete or malfunctioning
domestic financial markets in recipient countries and poor risk
management in capital-exporting countries could undermine the case
for capital account liberalisation.
• Some commonly observed macroeconomic effects of capital inflows are
exchange rate appreciation, monetary expansion, rise in bank lending if
the flows are intermediated through banks and effect upon saving and
investment.
Impact of Capital Flows on Exchange Rate:
• In theory, an inflow of foreign capital will raise the level of domestic
expenditure in economy, raising the demand for non-tradable goods
that results in an appreciation of the real exchange rate.
• The price adjustment process then leads to a reallocation of resources
from tradable and non-tradable goods.
• The rise in aggregate expenditure also increases the demand for
tradable, leading to rise in imports and widening of the trade deficit.
• During the capital surge in 1992-95 and 1996-97 in India, the real
exchange rate appreciated by 10.7 per cent in August 1995 and 14 per
cent by August 1997 respectively over its March 1993 level.
• The policy responses of India were directed towards capital outflows
through early servicing of external debt.
• The timing of these inflows also facilitated India’s external adjustment as
they coincided with trade reforms of current account convertibility and
liberalization of overseas investment by India firms.
Impact of Capital Flows on Reserves Accumulation:
• Capital inflows can be traced to either international reserves
accumulation or a current account deficit, depending upon the exchange
rate regime.
• If there is no intervention by the central bank i.e., the exchange rate
regime a pure float, then the net increase in capital asset via capital
inflows can be associated with a similar increase in imports and
therefore a widening current account deficit.
 • Alternately, if the exchange rate regime is fixed and central bank
intervenes to counter appreciation pressures, then the capital inflows
would be visible in foreign exchange reserves.
• The choice of intervention, or its size, narrows down the degree of
exchange rate flexibility desirable by authorities and is in essence a
policy choice.
• In 1992, the first year of the capital surge, almost the net capital inflows
were absorbed as foreign exchange reserves.
• In 1994, almost one third of net capital inflows were utilized.
• From 1996 onwards, the RBI has typically absorbed 50 percent of net
capital inflows into international reserves.
Impact of Capital Flows on Monetary Aggregates:
• Capital inflows impact upon money supply through accumulation of net
foreign currency assets with the central bank.
• Whether the monetary base is altered or not depends upon whether the
central bank intervene to maintain a fixed exchange rate or allows it to
float freely with no intervention.
• If there is intervention, then an accumulation of international reserves
represents an increase in the net foreign exchange assets of central bank
and directly affect monetary base.
• Though India had a market determined exchange rate since 1993, the
flexibility permitted by the monetary authority has been limited.
• The size and scale of intervention by the central bank has increased
significantly since 1993 and the foreign exchange reserves build up has
been substantial.
• During the capital surge episode in 1993-95, for example, the central
bank monetary target (M3 growth rate of 15-16 percent) was overshot
and monetary reserves expanded both in nominal and real terms.
• As a result of rapid growth of both the nominal and real money supply,
and the pass through between the exchange rate and domestic prices,
the rate of inflation rose to 10.8 per cent.
• In India, the monetary impact of reserved accumulation is neutralized
primarily through reserve requirement changes in commercial banks
liabilities.
• India still relies on direct monetary control instead of indirect monetary
management due to structural problems like interest rate rigidity and
less developed countries short-term monetary market, which limits
optimal utilization of Open Market Operation (OMO).
 • Open Market Operations (OMO) are increasing as being used since 1991,
though they are limited by the ability of bond and equity markets to
absorb Government Securities.
Balance of Payments:

Refreshing Memories:
• Recall that
• Balance of payments is simply a country’s external transaction with the
rest of the world – current as well as capital.
• Also recall the simple macroeconomic income-accounting identity:
• GDP = C + G + I + X – M.
• In other words, gross domestic output (GDP) is equal to private
consumption © plus government consumption (G) plus domestic
investment (I) plus exports (X) minus imports (M).
• This can be rewritten as:
• X – M = GDP – (C + G + I).
• Thus, if net exports of goods and services (X – M) are negative, this
means that the domestic economy is absorbing more than it can
produce.
• In other words, domestic absorption (C + G + I) by the economy is
greater than domestic output (GDP).
• This is reflected in current account deficit (X – M) which needs to be
financed by external borrowings and/or investments.
• In normal times, external finance may not be a problem. However, it
could be challenging if both global and domestic economic outlooks are
not very favourable.
Evolution of India’s BoP:
• India’s balance of payments evolved reflecting both the changes in our
development paradigm and exogenous shocks from time to time.
• In a span of six and a half decade (1951-52 to 2014-15), six events had a
lasting impact on India’s BoP:
• (i) The devaluation in 1966;
• (ii) First and second oil shocks of 1973 and 1980;
• (iii) External payments crisis of 1991;
• (iv) The East Asian crisis of 1997;
• (v) The Y2K event of 2000; and
• (vi) The global financial crisis of 2008.
Developments in India’s BoP Situation:
• Our external sector contracted in relation to GDP from the level
observed in the early 1950s.
• For example, the share of India’s merchandise trade in GDP declined
from around 16 per cent to below 8 per cent, while overall current
receipts plus payments fell from nearly 19 per cent to below 10 per cent
between 1951-52 to 1965-66.
• Notwithstanding the contracting size of the external sector, as imports
growth outstripped exports growth, there was persistent current
account deficit.
• These developments took place due to:
• 1. India’s transformation from a reasonably open economy in the early
1950s to an inward looking economy relying on import substitution
policy;
• 2. Indian export basket comprised of mainly traditional items like tea,
cotton textile and jute manufactures which were loosing their demand
in the international markets, and additionally, India had to face
competition from new emerging suppliers, such as Pakistan in jute
manufactures and Ceylon and East Africa in tea;
• policy emphasis was on import saving rather than export promotion, and
priority was given to basic goods and capital goods sector, leading to a
sharp increase in imports; and
• Strains of Indo-China conflict of 1962, Indo-Pakistan war of 1965 and
severe drought during 1965-66 triggered a major BoP crisis.
• India’s international economic relations with advanced countries came
under stress during the Indo-Pak conflict.
• Withdrawal of foreign aid by countries like the US and conditional
resumption of aid by the Aid India Consortium led to contraction in
capital inflows.
• Given the low level of foreign exchange reserves and burgeoning trade
deficit, India had no option but to devalue.
• Rupee was devalued by 36.5 per cent in June 1966.
• Sharp devaluation of the rupee along with other trade liberalisation
measures helped in improving India’s export competitiveness and
correct BoP situation.
• In fact, the current account turned into a surplus by 1973–74 as not only
the exports growth was significant but invisible receipts also showed a
sharp turnaround from deficit to surplus mainly on account of official
transfers which largely represented grants under the agreement of
February 1974 with the US Government on the disposition of PL 480 and
other rupee funds.
• Since surplus in current account balance was used for repaying rupee
loans under the same agreement with the US, accretion to reserves was
only marginal.
• Surplus in India’s CAB was, however, short-lived as the first oil shock
occurred by October 1973.
• Sharp rise in international oil prices was evident in higher imports
growth in 1973–74 and 1974–75.
• The share of crude oil in India’s import bill rose from 11 per cent in
1972–73 to 26 per cent by 1974–75.
• As exports improved, particularly to oil producing Middle-East countries,
BoP recovered quickly from the first oil shock.
• By this time, the Indian rupee being linked to a multi-currency basket,
depriciated against the US dollar.
• Depreciating rupee along with other policy incentives to exporters acted
as a supporting factor for India’s exports.
• At the same time, invisible receipts grew sharply stemming from
workers’ remittances from the Middle East.
• Consequently, the current account balance turned into surplus in 1976–
77 and 1977–78.
• Thus, the private transfers added a new positive dimension to India’s
BoP after the first oil shock.
• Further, with the official exchange rate nearly converging to market
exchange rate, there was not much incentive for routing remittances
through unofficial exchange brokers.
• The rapid growth of private transfers reinforced the trade account
adjustment to make the current account situation much more
comfortable.
• During the 1980s, BoP again came under stress.
• The second oil shock led to a rapid increase in imports in early 1980s.
• Oil imports increased to about two-fifths of India’s imports during 1980–
83.
• At the same time, India’s external sector policy was changing towards
greater openness.
• Various measures were undertaken to promote exports and liberalise
imports for exporters during this period.
• However, several factors weighed against external stability.
• First, despite a number of export promotion measures, the subdued
growth conditions in the world economy constrained exports growth.
• Second, the surplus on account of invisibles also deteriorated due to
moderation in private transfers.
• Third, the debt servicing had increased with greater recourse to debt
creating flows such as external commercial borrowings (ECBs) and non-
resident Indian (NRI) deposits.
• Fourth, deterioration in the fiscal position stemming from rising
expenditures accentuated the twin deficit risks.
• Given the already emerging vulnerabilities in India’s BoP during the
1980s, the incipient signs of stress were discernible which culminated in
the BoP crisis in 1991 when the Gulf War led to a sharp increase in the
oil prices.
• On top of that, a slowdown in the world trade following the recessionary
conditions in industrialised countries and the economic disruption in
Eastern Europe including the erstwhile USSR had begun to affect India’s
exports.
• A large number of Indian workers employed in Kuwait had to be airlifted
to India and their remittances stopped.
• Foreign exchange reserves had already dwindled due to significant
drawdown for financing of CAD in earlier years.
• During 1990–91, at one point of time, the foreign currency assets had
dipped below US$1.0 billion, covering barely two weeks of imports.
• With increasing recourse to the borrowings on commercial terms in the
previous years, financing of CAD had also become more sensitive to
creditors’ confidence in the Indian economy.
• Short-term credits began to dry up and the outflow of NRI deposits was
also very substantial.
• Downgrading of India’s credit rating below the investment grade also
constrained India’s access in the international markets for funds,
especially ECBs and trade credit.
• Even though the stress in India’s BoP was unprecedented, the
Government decided to honour all debt obligations without seeking any
rescheduling.
• Several steps including pledging gold reserves, discouraging non-
essential imports, accessing credit from IMF and other multilateral and
bilateral doners were undertaken along with other external sector and
industrial policy reforms.
• The impact of policy changes was reflected in lower CAD and its
comfortable financing in subsequent years.
• India could manage the external shocks that emanated from the East
Asian crisis in 1997 and subsequently, the rise in international oil prices
and bursting of dotcom bubble in 1999–2000.
• Indeed, the Indian economy remained relatively insulated from the East
Asian crisis owing to the reforms undertaken in previous years and
proactive and timely policy measures initiated by the Reserve Bank to
minimise the contagion effect.
• Monetary tightening coupled with flexible exchange rate and steps to
bolster reserves through issuance of Resurgent India Bonds (RIBs) helped
in stabilizing the BoP.
• The BoP came under some stress again in the first half of 2000–01 due
to a sharp rise in oil prices and increase in interest rates in advanced
countries.
• However, the situation improved quickly as at the same time, India’s
software exports got a boost following the demands to address the Y2K
challenges.
• This also encouraged migration of Indian software engineers to the
advanced countries.
• As a result, the surplus in the services exports and remittance account of
the BoP increased sharply which more than offset the deficit in the trade
account.
• Besides software exports and private remittances, a surge in capital
inflows was also witnessed during 2001 to 2007.
• Owing to a combination of factors, in fact, the current account recorded
a surplus during 2001–04.
• Subsequently, as international oil prices started rising and domestic
growth picked up, deficit in current account re-emerged during 2004–05
to 2007–08 albeit remained range bound.
• After a period of stability, India’s BoP came under stress in 2008–09
reflecting the impact of global financial crisis.
• As capital inflows plummeted, India had to draw down its foreign
currency assets by US $ 20 billion during 2008–09.
• Stress since the collapse of Lehman Brothers largely emanated from
decline in India’s merchandise exports and deceleration in growth in
services exports.
• Though there was some improvement during 2010–11 on the back of a
strong pick-up in exports mainly led by diversification of trade in terms
of composition as well as direction, it proved to be short-lived.
• BoP again came under stress during 2011–12 as slowdown in advanced
economies spilled over to emerging and developing economies (EDEs),
and there was sharp increase in oil and gold imports.
• A sharp improvement was seen in the outcome during 201314 with the
CAD being contained at US$ 32.4 billion as against US$ 88.2 billion and
US$ 78.2 billion respectively in 2012-13 and 2011-12.
• The stress in India’s BoP, which was observed during 2011-12 as a fallout
of the euro zone crisis and inelastic domestic demand for certain key
imports, continued through 2012-13 and the first quarter of 2013-14.
• Capital flows (net) to India, however, remained high and were sufficient
to finance the elevated CAD in 2012-13, leading to a small accretion to
reserves of US$ 3.8 billion.
• A large part of the widening in the levels of the CAD in 2012-13 could be
attributed to a rise in trade deficit arising from a weaker level of exports
and a relatively stable level of imports.
• The rise in imports owed to India’s dependence on crude petroleum oil
imports and elevated levels of gold imports since the onset of the global
financial crisis.
• The government swiftly moved to correct the situation through
restrictions in non-essential imports like gold, customs duty hike in gold
and silver to a peak of 10 per cent, and measures to augment capital
flows through quasi-sovereign bonds and liberalization of external
commercial borrowings.
• The RBI also put in place a special swap window for foreign currency
non-resident deposit (banks) [(FCNR (B)] and banks’ overseas borrowings
through which US$34 billion was mobilized.
• Thus, excluding one-off receipts, moderation in net capital inflows was
that much greater in 2013-14.
• The one-off flows arrested the negative market sentiments on the rupee
and in tandem with improvements in the BoP position, led to a sharp
correction in the exchange rate and a net accretion to reserves of
US$15.5 billion for 2013-14.
• India’s BoP situation improved further in 2014-15 (April-February) owing
to the reduction in the levels of CAD along with ample financing and
hence, net accretion to the reserves.
• The improved BoP situation in the current fiscal year may be attributed
to two important developments, namely,
• (i) lower trade deficit along with moderate growth in invisibles resulted
in lower CAD and
• (ii) there was a surge in capital inflows, enabled by higher PI, FDI and
ECB.
• Higher capital inflows were in access of the financing requirement or
CAD and resulted in accretion in foreign exchange reserves.
 • A part of the moderate trade outcome owes to the recent fall in
international prices of crude petroleum.
• Given these developments, the Government decontrolled the prices of
high speed diesel on October 19, 2014 and lifted the restrictions placed
on gold import on November 29, 2014.

Foreign Exchange Reserves:

Definition
• Conceptually, a unique definition of forex reserves is not available as
there have been divergence of views in terms of coverage of items,
ownership of assets, liquidity aspects and need for a distinction between
owned and non-owned reserves.
• Nevertheless, for policy and operational purposes, most countries have
adopted the definition suggested by IMF.
• According to this definition, foreign exchange reserves are external
assets that are readily available to and controlled by monetary
authorities for direct financing of external payments imbalances, for
indirectly regulating the magnitudes of such imbalances through
intervention in exchange markets to affect the currency exchange rate,
and/or for other purposes.
• The standard approach for measuring international reserves takes into
account the unencumbered international reserve assets of the monetary
authority; however, the foreign currency and the securities held by the
public including the banks and corporate bodies are not accounted for in
the definition of official holdings of international reserves.
• In India, the Reserve Bank of India Act 1934 contains the enabling
provisions for the Reserve Bank to act as the custodian of foreign
reserves, and manage reserves with defined objectives.
• The ‘ reserves ’ refer to both foreign reserves in the form of gold assets
in the Banking Department and foreign securities held by the Issue
Department, and domestic reserves in the form of ‘bank reserves’.
• These days, foreign reserves in India mainly constitute the foreign
currency assets, gold reserves, SDRs and reserve tranch position.
Reasons for Holding Forex Reserves:
• Technically, it is possible to consider three motives i.e., transaction,
speculative and precautionary motives for holding reserves.
• International trade gives rise to currency flows, which are assumed to be
handled by private 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, forex reserves are instruments to maintain or manage the
exchange rate, while enabling orderly absorption of international money
and capital flows.
• In brief, official reserves are 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 behind holding the forex reserves include monetary
policy objectives as well as objectives specific to the government
requirements.
• For example, there are cases when reserves are used as a convenient
mechanism for Government purchases of goods and services, servicing
foreign currency debt of Government, insurance against emergencies,
and in respect of a few, as a source of income.
• The objectives of holding forex reserves for India, in broader terms, may
be stated as under:
• (a) maintaining confidence in monetary and exchange rate policies;
• (b) enhancing capacity to intervene in forex markets;
• © limiting external vulnerability by maintaining foreign currency liquidity
to absorb shocks during times of crisis including national disasters or
emergencies;
• (d) providing confidence to the markets, especially credit rating agencies
that external obligations can always be met, thus reducing overall costs
at which forex resources are available to all the market participants; and
• € incidentally adding to the comfort of market participants, by
demonstrating the backing of domestic currency by external assets.
Appropriate Level of Forex Reserves:
• One of the important issues to be addressed under managed float is to
determine the optimal level of reserves to be maintained, because
excess reserves holdings increases the cost without much benefit at
margin and inadequate reserves complicates the exchange rate
management.
• Guided by several ways of measuring the costs and benefits associated
with the holding of forex reserves, a host of indicators of appropriate
level of reserves have been developed by various economists.
• It is possible to identify four sets of indicators to assess adequacy of
reserves, and each of them does provide an insight into adequacy
though none of them may by itself fully explain adequacy.
• First, the money based indicators including reserve to broad money or
reserves to base money which provide a measure of potential for
resident based capital flight from currency.
• An unstable demand for money or the presence of a weak banking
system may indicate greater probability of such capital flights.
• Money based indicators, however, suffer from several drawbacks.
• In countries, where money demand is stable and confidence in domestic
currency high, domestic money demand tends to be larger and reserves
over money ratios, relatively small.
• Therefore, while a sizable money stock in relation to reserves, prima
facie, suggests a large potential for capital flight out of money, it is not
necessarily a good predictor of actual capital flight.
• Money based indicators also do not capture comprehensively the
potential for domestic capital flight.
• Moreover, empirical studies find a weak relationship between money
based indicator and occurrence and depth of international crises.
• Secondly, trade based indicators, usually the import-based indicators
defined in terms of reserves in months of imports provide a simple way
of scaling the level of reserves by the size and openness of the economy.
• It has a straightforward interpretation- a number of months a country
can continue to support its current level of imports if all other inflows
and outflows cease.
• As the measure focuses on current account, it is relevant for small
economies, which have limited access and vulnerabilities to capital
markets.
• For substantially open economies with a sizable capital account, the
import cover measure may not be appropriate.
• Thirdly, debt based indicators are of recent origin; they appeared with
episodes of international crises, as several studies confirmed that
reserves to short term debt by remaining maturity is a better indicator
of identifying financial crises.
• Debt-based indicators are useful for gauging risks associated with
adverse developments in international capital markets.
 • Since short-term debt by remaining maturity provides a measure of all
debt repayments to nonresidents over the coming year, it constitutes a
useful measure of how quickly a country would be forced to adjust in the
face of capital market distortion.
• Studies have shown that it could be the single most important indicator
of reserve adequacy in countries with significant but uncertain access to
capital markets.
• Fourthly, more recent approaches to reserve adequacy have suggested a
combination of current-capital accounts as the meaningful measure of
liquidity risks.
• Of particular interest, is the Guidotti Rule, which has received wide
appreciation from many central bankers including Alan Greenspan,
postulates that the ratio of short term debt augmented with a projected
current account deficit (or another measure of expected borrowing)
could serve a useful indicator of how long a country can sustain external
imbalance without resorting to foreign borrowing.
• As a matter of practice, the Guidotti Rule suggests that the countries
should hold external assets sufficient to ensure that they could live
without access to new foreign borrowings for up to twelve months.
• This implies that the usable foreign exchange reserves should exceed
scheduled amortisation of foreign currency debts (assuming no rollover
during the following year).
• Alan Greenspan suggests a Liquidity at ‘ Risk’ Rule that takes into
account the foreseeable risks that a country could face in the event of
(a) near absence of a purely non-interventionist exchange rate policies
and (b) cost-benefit trade-off in the quantity of reserve accumulation.
• Accordingly, a country’s liquidity position could be calculated under a
range of possible outcomes for relevant financial variables such as
exchange rate, commodity prices, credit spreads, etc.
• While the concept of ‘Liquidity at Risks’ has been broadly discussed at
different fora, it appears that no specific methodology has been
outlined. It has been left to institutions and countries to develop their
own approaches.
Level of Forex Reserves in India:
• India’s approach to reserve management has evolved over time,
especially after the recommendations of the Rangarajan Committee in
1993.
• The shift in India’s approach has occurred from a single indicator
approach to a multiple indicators approach.
 • The adequacy of the level of reserve holding in India over time is
examined in this presentation using some selected indicators.
• One of the reserve adequacy indicator is the reserve to GDP ratio.
• Increase in national income implies growing demand for goods and
services; hence, there will be a corresponding rise in demand for
imports.
• The growing import demand tends to increase reserve requirement.
• Thus, the level of reserves must keep pace with expansion of the
economy.
• In this respect, plots in Fig.1 indicate that there was almost a steady rise
in the reserves to GDP ratio from a mere 1.95 per cent in 1990-91 to
24.82 per cent in 2007-08.
• Thereafter, this ratio declined sharply in subsequent years till 2012-13
owing to a couple of crisis.
Figure 1

Reserves to GDP Ratio (in per cent)

RESGDP
30

25

20

15

10

0
92 94 96 98 00 02 04 06 08 10 12 14

Source: Handbook of Statistics on Indian Economy, RBI.

• Another widely and traditionally used indicator is the import cover of

reserves, as growing import requires larger amount of reserves to meet
the external payment.
• This in a way reflects the growing transaction demand for reserves.
 • The quantum of reserves as months of import cover is portrayed in Fig.2.
• The level of reserves, which was equivalent to two-and-a-half months of
import in 1990-91, rose to a peak of about seventeen months of import
in 2003-04.
• It may further be noticed from this figure that even during the crisis
years, the level of reserves were adequate enough to finance more than
half a year’s import, thereby reflecting the significance of reserve
accumulation.

Figure 2

Import Cover of Reserves (in months)

IMPCOV
18

16

14

12

10

2
92 94 96 98 00 02 04 06 08 10 12 14

Source: Same as for Figure 1.

• Another indicator of reserve adequacy that gained importance due to

growing cross border capital flows is the level of reserve holding against
outstanding external debt position.
• As the external payment obligation increases, the demand for reserves
tends to increase to service the growing external debt.
• The plots displayed in Fig.3 show a steady rise (except 1995-96) in
reserves to external debt ratio from 6.96 per cent in 1990-91 to 138.01
per cent in 2007-08.
 • It, however, exhibits a continuous substantial fall in subsequent years
like other indicators.

Figure 3

Reserves to External Debt Ratio (in per cent)

RESEXDBT
140

120

100

80

60

40

20

0
92 94 96 98 00 02 04 06 08 10 12 14

Source: Same as for Figure 1.

• What is more important is the maturity composition of external debt,

and not the level of external debt that should be linked with quantum of
reserve holdings.
• Hence, the ratio of reserves to short term external debt is chosen as one
of the most important indicators to determine the reserve adequacy.
• This ratio reflects the repaying capacity of external debt which is due to
be paid within a short span of time period, generally, a year.
• The plots in Fig.4 indicate that India’s reserve position in terms of
repaying short term external debt was very comfortable till 2003-04.
• Since then, there is a sharp fall in this ratio due to growing trade credit
and other retail debt.
• Despite the sharp decline in this ratio, the reserve position does not
reflect a great deal of vulnerability as being more than external payment
obligation.
 Figure 4

Reserves to Short Term External Debt Ratio (in per cent)

RESSREXDBT
3,000

2,500

2,000

1,500

1,000

500

0
92 94 96 98 00 02 04 06 08 10 12 14

Source: Same as for Figure 1.

• It is often argued that reserve holdings must be judged on the basis of
domestic monetary base, because growing domestic money supply
might trigger currency depriciation; hence, there will be larger needs for
reserves to defend the value of domestic currency.
• In this respect, the plots shown in Fig.5 reveal that reserves as
percentage of broad money grew from around 4.3 per cent in 1990-91
to a peak of 30.81 per cent in 2007-08 (of course with yearly
fluctuations).
• This ratio too, showed a decline during the crisis years.
 Figure 5

Reserves to Broad Money Ratio (in per cent)

RESM3
32

28

24

20

16

12

4
92 94 96 98 00 02 04 06 08 10 12 14

Source: Same as for Figure 1.

• Overall, the reserve adequacy indicators consistently suggest that the

reserve holdings do keep pace with the recent developments in the
economy.
• Nonetheless, it was a problem of plenty in the past and also reserve
holding incurs a huge opportunity cost and therefore, current reserve
holdings do not reflect any vulnerability of our external payment
position.
How Does Intervention Work?
• The official intervention in the foreign exchange market in the form of
buying and selling of foreign currency assets can be of two types:
• (a) sterilised intervention and
• (b) non-sterilised intervention.
Sterilised Intervention:
• Official intervention is sterilised if the authority takes action to offset the
impact of intervention on the domestic monetary base.
• For instance, the domestic monetary base tends to increase in response
to net official purchase of foreign exchange from the market.
 • Such expansion in money supply can be offset by conducting open
market sale of securities or by resorting to other monetary instruments
that would reduce monetary base.
Non-Sterilised Intervention:
• On the contrary, non-sterilised intervention occurs when the authority
buys foreign exchange against its own currency without taking offsetting
action.
• Thus, non-sterilised intervention affects domestic money supply, which
in turn affects exchange rate.
• However, to what extent exchange rate responds to non-sterilised
intervention depends upon the extent to which changes in money supply
affects the exchange rate.
• There are theories explaining the transmission mechanism between
intervention and exchange rate variations.
Evolution of Reserve Management Policy in India:
• 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 of reserves.
• The prime motive of the foreign exchange policy was to manage imports
and exports, and to restrict official influx of foreign currencies inside the
country through RBI.
• Since the recommendations of the High Level Committee on Balance of
Payments (1993), several measures have been undertaken to alter the
exchange rate volatility and balance of payment situation.
• India’s exchange rate management policy during the last two decades or
so largely aims at ensuring realistic and credible external value of rupee,
reducing current account deficit and maintaining adequate amount of
foreign exchange reserves.
• The exchange rate policy is mainly guided by the following objectives:
• (i) To eliminate lumpy demand and supply in the forex market without
reference to any target of exchange rate;
• (ii) To prevent speculative attack; and
• (iii) To maintain adequate amount of reserves.
• The conduct of monetary policy in this respect largely involves a package
of measures that embraces sale and purchase of currency in both the
spot and the forward segments of the forex market, a wide array of
administrative measures, and adjustment of domestic liquidity by
manipulating monetary policy instruments such as bank rate, CRR, repo
rate, etc.
 • The intention was not to target exchange rate at any level, but to even
out lumpy demand or supply in the forex market.
• Moreover, RBI often adjusted the domestic liquidity to stabilise the
exchange rate.
Some Issues Related to Forex Reserves:
• Foreign exchange reserve forms the first line of defence to calm volatility
in the forex markets and provide adequate liquidity for sudden stop or
reversals in the capital flows.
• Bilateral and multilateral safety nets are also helpful.
• One response to the global financial crisis was signing of bilateral swap
agreements by the Federal Reserve with select central banks.
• Availability and adequacies of such bilateral/multilateral backstop
arrangements is not an easy option during crisis times.
• The Asian crisis triggered a realization that large reserves are needed to
face a crisis as a self-insurance policy.
• Since 1991, the level of foreign exchange reserves has steadily increased
from US$5.8 billion to about US$333 billion, an all-time high.
• India’s foreign exchange reserves are the end consequence of current
account and capital account dynamics.
• Most of India’s foreign exchange reserves are held by the Reserve Bank
of India principally foreign currency assets and gold, SDR allocation and
Reserve Tranche Position in the IMF are held by the Government.
• Reserves are held essentially to instill confidence in the markets and
investors, act as an insurance during periods of crisis and provide pool of
resources for meeting the intervention needs during periods of extreme
volatility and manage BoP mismatches.
• Reserve management is essentially the art of maintaining adequate
liquidity, when required, ensuring safety of capital and generating
reasonable returns under what is popularly known as the Safety,
Liquidity & Return (SLR) framework.
• It, therefore, revolves around decisions involving trade-off between risk
and return.
• The prolonged low interest environment, post the global financial crisis,
has substantially affected the return on reserves, which in 2013-14 was
1.21 per cent.
• This has led to suggestions on the need to enhance returns by either
diversification into non-traditional asset classes and currencies.
• Such strategies, however, have their own share of risks.
• For example, during phases of market turmoil, safe haven flows may
result in losses in investments made in EMDE’s currencies and assets.
• The higher expected returns on non-traditional assets could be wiped
out during periods of market turmoil.
• We should also remember that holding reserves has a cost.
• This cost has a quasi-fiscal implication as the cost of sterilization is either
borne by the Government or by the central bank itself.
• There are different approaches to measure the cost of maintaining
reserves.
• The most common approach is to measure it as the opportunity cost of
investment in domestic securities.
• It can also be looked at as cost-of-carry, being the difference between
the cost of capital borrowed from outside minus the return on reserves.
• The cost of reserves, however, should be weighed against the benefits,
such as, providing a stable exchange rate regime by smoothening
extreme volatility.
• A stable exchange rate regime benefits market participants as it reduces
uncertainty and hedging costs.
• But the benefits of adequate reserves are not easily quantifiable
whereas the costs are more explicit.
• Therefore, any cost-benefit approach to reserve adequacy involves a
judicious assessment of the risks of an economy that is on a path
towards a more open capital account.
• Finally, reserve adequacy has been a long debated and discussed issue.
• Traditional metrics of adequacy are import cover, ratio of short term
debt/volatile capital flows to reserves and ratio of reserves to broad
money.
• In the Indian context, import cover increased to 8.1 months as at end
September 2014 from 6.6 months at end September 2013.
• Ratio of CAD to foreign exchange reserves has improved from 30.1
during 2012-13 to 10.6 in 2013-14. The ratio stood at 166.0 in 1990-91.
• Ratio of short-term debt to the foreign exchange reserves declined from
34.2 per cent as at end September 2013 to 27.5 per cent as at end
September 2014.
• Ratio of volatile capital flows (defined to include cumulative portfolio
inflows and short-term debt) to the reserves declined from 97.2 per cent
as at end September 2013 to 94.7 per cent as at end September 2014.
• India’s net IIP has, however, been negative for a long time and has
deteriorated from US$326 billion in March 2013 to US$353 billion in
September 2014.
• Therefore, while some metrics indicate improvement in some aspects of
our external sector vulnerabilities, there is no room for complacency as
India is basically a current account deficit economy with large
dependence on foreign capital flows which are susceptible to periodic
phases of sudden stops and/or reversals.