Indian Economy – Lecture 7

Dr Ritesh Kumar Mishra, Department of Finance and Business Economics, University of Delhi
 India and the External Sector

Dr Ritesh Kumar Mishra, Department of Finance and Business Economics, University of Delhi
 The External Sector
• We will now discuss one of the most important sectors of the Indian economy.

• What is happening in a country’s external sector often captures the news headlines and can become
the focus of attention of international investors.

• A good or bad set of open-economy macroeconomic figures (such as BoP and external debt) can
have an influential effect on the exchange rate and overall stability of the economy and may lead
policy-makers to change the content of their economic policies.

• Deficits may lead to the government raising interest rates or reducing public expenditure to reduce
expenditure on imports.

• Alternatively, deficits may lead to call for protection against foreign imports or capital controls to
defend the exchange rate.

Dr Ritesh Kumar Mishra, University of Delhi

 Introduction to the External Sector

• BoP: is a statistical record of all the economic

transactions between residents of the reporting
country and residents of the rest of the world
during a given time period (a year, usually).

• It reveals how many goods and services the

country has been exporting and importing.

• It also reveals whether the country has been

borrowing from or lending money to the rest of
the world.

• In addition, whether or not the central monetary

authority has added to or reduced its reserves
of foreign currency is also reported.

Dr Ritesh Kumar Mishra, University of Delhi

 A primer on the External Sector of the Economy

• Trade balance (visible balance) – it represents difference between receipts (+ or Credit) for exports
of goods and expenditures (- or Debit) on imports of goods which can be visibly seen crossing
frontiers.

• When the trade balance is in surplus – means that the country has earned more from its exports of
goods than it has paid for its imports of goods.

• Current Account Balance (=Visible trade balance + invisible balance)

• The invisible balance shows the difference between revenue received for exports of services and
payment made for import of services such as shipping, tourism, insurance and banking.

• Receipts and payments of interest, dividends and profits are recorded in the invisible balance
because they represent rewards for investment in overseas companies, bonds and equity, while
payments reflect the rewards to foreign residents for their investment in the domestic economy.

Dr Ritesh Kumar Mishra, University of Delhi

 A primer on the External Sector of the Economy

• Unilateral Transfers – these are payments or receipts for which there is no corresponding quid pro
quo. [For example, migrant workers’ remittances to their families back home, the payments of pension to foreign residents and
foreign aid].

• Capital and Financial Accounts – it records transactions concerning the movements of capital into
and out of the country.

• Capital inflows (Credit “+”) – capital comes in the country by – Borrowing, sales of overseas assets,
investment in the country by foreigners. Capital inflows are, in effect, a decrease in the country’s
holding of foreign assets or an increase in liabilities to foreigners.

• Capital Outflows (Debits “–”) – capital leaves the country due to lending, buying of overseas assets,
and purchases of domestic assets owned by foreign residents. Capital outflows are, in effect, an
increase in the country’s holding of foreign assets or a decrease in liabilities to foreigners.

Dr Ritesh Kumar Mishra, University of Delhi

 A primer on the External Sector of the Economy

• Settlements Balance – it shows the transactions, if any occur, undertaken by the central bank. This
has two items recorded as per the practice:

• Rise and fall in foreign exchange reserves

• Borrowing funds and or repayments of loans to international institutions such as IMF.

• Central banks normally holds a stock of reserves made of foreign currency assets. Such reserves are
held primarily to enable the central bank to purchase its currency should it wish to prevent it
depreciating.

• If CB intervenes – to purchase its currency then its forex reserves fall and this is recorded as PLUS in
the settlement account.

• [why “+” Think this way – reserves increase when authorities have been purchasing the foreign currency because the
domestic currency is strong. This implies that other items in the balance of payments are in surplus, so reserve increases
have to be recorded as a debit to ensure overall balance].

Dr Ritesh Kumar Mishra, University of Delhi

 A primer on the External Sector of the Economy

• If CB intervenes – to sell its currency then its forex reserves rise and this is recorded as a MINUS in
the settlements account.

• [Why “ – “? Think this way – reserves fall when the authorities have been supporting a currency that is weak, that is, all
other items of BoP sums to a deficit so reserve falls must be recorded as a plus to ensure overall balance].

• If a country borrows from IMF then this is an increase in its liabilities and is recorded as a plus in the
settlements accounts.

• If a country pays back the loan to the IMF then this is recorded as a minus in its settlements account.

• Statistical Errors – Given the huge statistical problems involved in compiling the balance of
payments statistics, there will usually be a discrepancy between sums of all items recorded in CA,
Financial account and settlement account – which in theory should sum to zero.

Dr Ritesh Kumar Mishra, University of Delhi

Balance of Payment of India

Dr Ritesh Kumar Mishra, University of Delhi

A Simplified Balance of Payment of India

Source: RBI

Dr Ritesh Kumar Mishra, University of Delhi

 Balance of Payment of India

• India’s current account balance (CAB) recorded a deficit of US$ 8.1 billion (1.0 per cent of GDP) in Q4:2020-21.

• The current account deficit in Q4:2020-21 was primarily on account of a higher trade deficit and lower net invisible receipts
than in the corresponding period of the previous year.

• Net services receipts increased on the back of a rise in net earnings from computer, transport and business services on a
year-on-year basis.

• Private transfer receipts, mainly representing remittances by Indians employed overseas, increased to US$ 20.9 billion, up by
1.7 per cent from their level a year ago.

• Net outgo from the primary income account, primarily reflecting net overseas investment income payments, increased to US$
8.7 billion from US$ 4.8 billion a year ago.

• In the financial account, net foreign direct investment at US$ 2.7 billion was lower than US$ 12.0 billion in Q4:2019-20.

• Net foreign portfolio investment (FPI) increased by US$ 7.3 billion – mainly on account of net purchases in the equity market
– as against a decline of US$ 13.7 billion in Q4:2019-20.

Dr Ritesh Kumar Mishra, University of Delhi

 India’s Balance of Payments: some facts

• COVID-19 pandemic has triggered the worst global recession in 2020 since the Great Depression; the adverse
economic impact is, however, expected to be lesser than initially feared.

• The resulting economic crisis has led to a sharp decline in global trade, lower commodity prices and tighter
external financing conditions with varying implications for current account balances and currencies of different
countries.

• Global merchandise trade is expected to contract by 9.2 per cent in 2020. Trade balance with China and the US
improved as imports contracted.

• The changing nature of India’s global trade manifested in terms of sliding exports of gems and jewellery,
engineering goods, textile and allied products and improving exports of drugs and pharma, software and
agriculture and allied products.

• Pharma exports, in particular, used this opportunity to enhance their share in total India’s exports and indicate
India’s potential to be the pharmacy of the world.

• Supported by resilient software service exports, India is expected to witness a current account surplus during the
current financial year after a gap of 17 years. Balance on the capital account, on the other hand, is buttressed by
robust FDI and FPI inflows.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in International Capital inflows – Capital account
• Foreign Investment, consisting of foreign direct investment
(FDI) and foreign portfolio investment (FPI), is the largest
component of the capital account.

• The latest aggregate data on FDI is available till November

2021.

• While net FDI recorded a lower inflow of US$ 24.7 billion,

the gross FDI inflows moderated at US$ 54.1 billion during
April-November, 2021 compared to corresponding period
last year, largely due to lower equity investment.

• As far as sector-wise FDI inflows are concerned, computer

software and hardware attracted the highest FDI equity
inflows of US$ 7.1 billion in April-September, 2021.

• Singapore continues to be the top investing country in

terms of FDI equity inflow while USA occupies the second
position.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in International Capital inflows – Capital account
• The latest aggregate data on FPI is available till
December 2021.

• As depicted in Figure16, FPI flows remained volatile

due to global uncertainties relating to US monetary
policy normalisation, rising global energy prices, fear
of new variants of COVID-19 and strong
inflationary pressures.

• While the debt market witnessed net purchases

during April-December, 2021, valuation concerns
and profit booking by portfolio investors led to
outflows from the Indian equity market, leading to net
FPI outflow of 0.6 billion, vis-à-vis net FPI inflow of
US$ 28.5 billion in corresponding period a year
earlier.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in India’s International Trade

• India’s exports of both goods and services have been exceptionally strong so far in 2021-22.

• Merchandise exports have been above US$ 30 billion for eight consecutive months in 2021-22.

• This is despite a rise in trade costs arising from global supply constraints such as fewer operational shipping
vessels, exogenous events such as blockage of Suez Canal and COVID-19 outbreak in port city of China etc.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in India’s Trade in Services

• The net services exports have also risen sharply.

• This rise in services export was mainly driven by professional and management consulting services, audio visual
and related services, freight transport services, telecommunications, computer and information services.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in India’s Current Account Balance
• From a demand perspective, India’s
total exports are expected to grow by
16.5 per cent in 2021-22 surpassing
pre-pandemic levels.
• Imports also recovered strongly with
revival of domestic demand and
continuous rise in price of imported
crude and metals. Imports are expected
to grow by 29.4 per cent in 2021-22
surpassing corresponding pre-
pandemic levels.
• Resultantly, India’s net exports have
turned negative in the first half of 2021-
22, compared to a surplus in the
corresponding period of 2020-21 with
current account recording a modest
deficit of 0.2 per cent of GDP in the first
half (Figure 24).
• However, robust capital flows in the
form of continued inflow of foreign
investment were sufficient to finance the
modest current account deficit.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in India’s Balance of Payments

• Commodities in which India's

merchandise Trade Balance is
favourable (2019-20):

• Drug formulations, biologicals

• Marine products

• Gold and other precious metal

jewellery

Dr Ritesh Kumar Mishra, University of Delhi

 Trends in India’s Balance of Payments

• Commodities in which India's

merchandise Trade Balance is
unfavourable:

• Petroleum: Crude

• Gold

• Coal,Coke and Briquittes Etc.

• Telecom Instruments

Dr Ritesh Kumar Mishra, University of Delhi

 Trends: Top 10 Export items

• Petroleum, Oil and Lubricants (POL)

exports, which constitute about 10-15 per
cent of the total exports, have contributed
negatively to export performance during the
period under review. The fall in POL
exports was largely driven by the softening
of international crude oil prices.

• Drug formulations, biologicals have

consistently registered positive growth and
highest increase in absolute terms in
recent months.

• Iron and Steel is another commodity

whose share has increased from 3.0 per
cent to 4.4 per cent in the said period.

Dr Ritesh Kumar Mishra, University of Delhi

 Trends: Top 10 import items

• Crude Petroleum continues to be the

highest imported commodity in April-
November, 2020, accounting for 14.3 per
cent share.

• The share of gold imports reduced to 5.6

per cent in April-November, 2020 from
6.3 per cent in corresponding period a year
ago, slipping to third position from second
earlier.

• Computer hardware and peripherals is one

of the new additions in the list of top 10
import commodities in April-November,
2020, accounting for 3.0 per cent of total
imports driven by increased demand due to
more people working from home.

Dr Ritesh Kumar Mishra, University of Delhi

 Top 10 Export Sources of India (2021-22)

• United States of America (USA)

remained the top export destination in
April-November, 2021 followed by United
Arab Emirates (UAE) and China (Figure
6).

• Belgium has replaced Malaysia and

entered into the top ten leading export
destinations during April-November 2021,
with more than a billion dollars’ worth of
pearls, precious and semi-precious
stones, and iron and steel shipped to the
country.

Dr Ritesh Kumar Mishra, University of Delhi

 Top 10 Import Sources of India (2019-20)

• Among the top ten countries for import

origin, China, UAE and USA were the top
import sources for India in April November,
2021, with China's share reducing to 15.5
per cent from
17.7 per cent in corresponding period a
year earlier – reflecting increased
diversification of India's import sources.

• Switzerland, which was ousted last year

from top ten sources of India’s
import, bounced back at sixth position with
a share of 4.7 percent in April-November,
2021.

• Indonesia – second biggest source of crude

palm oil – remains to be one of top ten
suppliers of India, with a share of 2.9
percent in total imports during same period
(Figure 8).

Dr Ritesh Kumar Mishra, University of Delhi

 India’s Trade Balance with Other Countries

• India had the most favourable trade balance with

USA followed by Bangladesh and Nepal.

• The highest trade deficit is with China followed

by Iraq and Saudi Arabia during April-November,
2020-21 and April-November, 2019-20.

Dr Ritesh Kumar Mishra, University of Delhi

 Net International Investments Positions (NIIP)

• One way to gauge country’s resilience is to look at its net international investment position.

• Net International Investment Position (IIP) is the difference between the value of financial assets
of residents of an economy that are claims on non-residents and the liabilities of residents of an
economy to non-residents at a point in time.

• It represents either a net claim on or a net liability to the rest of the world.

Dr Ritesh Kumar Mishra, University of Delhi

 Net International Investments Positions (NIIP)

• When a country invests abroad in foreign bonds, equities and money market securities, it is
increasing its holding of external financial assets.

• When foreigners purchase domestic bonds, equities and money market securities, these financial
investments are liabilities of the domestic residents to the foreign residents.

• NIIP = Country’s ownership of foreign financial assets – country’s financial assets liabilities to foreign residents.

• If the external financial assets are greater than the external financial liabilities then the NIIP of the
country will be positive and the country is a net creditor nation.

• If the external financial liabilities are greater than the external financial assets then the NIIP of the
country will be negative and the country is a net debtor nation.

Dr Ritesh Kumar Mishra, University of Delhi

 Net International Investments Positions (NIIP)

• If a country is running a CA deficit – means that it has to be financed by either selling assets to
foreigners or borrowing the funds, which will worsen its NIIP position by making it less positive or
more negative, other things being equal.

• If the country is running a CA surplus – means it earns more than it spends and so thereby lends
money to the rest of the world or pays the debt it owes to the rest of the world, so increasing its
assets and decreasing liabilities. The NIIP will become more positive.

• The NIIP is affected by the following factors:

• Valuation changes in the external financial assets and liabilities of the country (increase and
decrease in the value of foreign stocks and bonds held by domestic residents).

• Exchange rate movements.

Dr Ritesh Kumar Mishra, University of Delhi

 Net International Investments Positions (NIIP)

• India’s net IIP stood at (-) 11.3 per cent of

GDP (US$ -332 billion) as at end-
September 2021 – a sustained
improvement since end-March 2019 – led
by a higher asset-liability ratio, which
improved to 73.6 per cent as at end-
September 2021 from end-March 2021
(Figure 20).

• The improvement in asset- liability ratio is

due to significant build-up of reserve
assets (US$ 58.4 billion between Q4:
FY21 and Q2: FY22), which more than
compensated for build-up in liabilities on
account of FDI, FPI and other
investments.

Dr Ritesh Kumar Mishra, University of Delhi

 Devaluation of Exchange Rate and BoP

• Balance of payment disequilibrium can be corrected in the following ways:

• By increasing exports (increasing productivity, reducing cost, devaluation of currency)

• By reducing imports

Dr Ritesh Kumar Mishra, University of Delhi

 Marshall – Lerner condition and Devaluation of Exchange Rate

• The Marshall – Lerner condition says that:

• Price elasticity of demand for exports (foreign elasticity of demand for exports):

• Price elasticity of demand for imports (home elasticity of demand for imports):

Dr Ritesh Kumar Mishra, University of Delhi

 BoP and the Marshall – Lerner condition

• ML condition says that – starting from a position of equilibrium in the current account:

• Devaluation will improve CA – only if the foreign elasticity of demand for exports and home
country elasticity of demand for imports is greater than Unity.

• Devaluation will lead to deterioration in CA – if the sum of two elasticities are less than unity.

• Devaluation of exchange rate – BoP will improve – if sum of elasticties are more than 1

• Devaluation of exchange rate – BoP will deteriorate – if sum of elasticties are less than 1

Dr Ritesh Kumar Mishra, University of Delhi

 External Debt
• At end-September 2020, India’s
external debt was placed at US$
556.2 billion recording a decrease
of US$ 2.0 billion (0.4 per cent)
over the level, as at end-March
2020.

• Excluding the valuation loss, due to

the depreciation of the US$ vis-à-
vis major currencies, the decrease
in external debt would have been
US$ 8.3 billion.

• ECBs, the largest component of

external debt, at US$ 207 billion as
at end- September 2020,
contracted by 5.8 per cent over the
level as at end March 2020.
Debt- and Reserve-Related Indicators of External Vulnerability-IMF.pdf

Dr Ritesh Kumar Mishra, University of Delhi

Ratio of External Debt to GDP (and Export)

Dr Ritesh Kumar Mishra, University of Delhi

 Sustainability of Debt

• The debt sustainability depends on the “interest rate growth rate differential” (IRGD), i.e. the difference
between the interest rate and the growth rate in an economy.

• If the interest rate paid by the government is less than the growth rate, then debt sustainability is possible.

• In India, as established by Economic Survey 2020 – 21, economic growth leads to debt sustainability but
not necessarily vice-versa.

• This is because the interest rate on debt paid by the Indian government has been less than India’s growth
rate by norm, not by exception.

• As the IRGD is expected to be negative in the foreseeable future, a fiscal policy that provides an impetus to
growth will lead to lower, not higher, debt-to-GDP ratios.

• In fact, simulations undertaken till 2030 highlight that given India’s growth potential, debt sustainability is
unlikely to be a problem even in the worst scenarios.

Dr Ritesh Kumar Mishra, University of Delhi

 Sustainability of Debt

• As a norm in India, over the last two

and a half decades, GDP growth rates
have been greater than interest rates
(Figure 2a).

• This evidence is consistent with the

phenomenon described by Blanchard
(2019) in his 2019 Presidential
Address to the American Economic
Association: “If the interest rate paid
by the government is less than the
growth rate, then the intertemporal
budget constraint facing the
government no longer binds.”

• Intuitively, when nominal growth rate

exceeds the nominal interest rate for
the foreseeable future, debt
sustainability is obtained as explained
in the figure below.

Dr Ritesh Kumar Mishra, University of Delhi

 India’s External Sector: The Problems

• India’s current account deficit – how much more it imports than it exports – is very sensitive to the
global price of crude oil. When oil is expensive, the CAD is too high for comfort; when it falls, the CAD
can look manageable.

• Indian producers are not particularly competitive – which means that even when you take oil and gold
imports out of the picture, exports are growing far less than the imports.

• Any CAD has to be paid for by capital inflows into the economy. For stability, these should be long-
term flows like FDI – but India depends too much instead on short – term ‘hot money’.

• When a country exports less than it imports, its currency depreciates – or loses value. But a lengthy
and outsized depreciation of the rupee, while a natural consequence of high CAD, would also stroke
fears about macroeconomic instability.

Dr Ritesh Kumar Mishra, University of Delhi

 India’s External Sector: The Solutions

• The government will have to commit to reducing its fiscal deficit – and to pushing states to reduce
theirs. When the government spends more than it earns, it pushes up the CAD as well.

• The tradable sector – both exporters and those Indian producers who compete with imports – has to
become more competitive, so exports grow faster than imports and the CAD decreases. This would
need more and better infrastructure, more flexible land and labour laws, and a focus on growing
agricultural exports.

• As long as India is a big oil importer, it will not be totally insulated from higher prices. But if there were
better ways to reduce the uncertainty caused by sudden shifts in the oil price, you could at least
ensure there was less instability. Institutions that allow companies and the government to hedge
against changes in oil prices need to be built.

• Another source of stability would be attracting long-term capital flows, such as FDI. This would again
need the government to make investing in India look genuinely attractive.

Dr Ritesh Kumar Mishra, University of Delhi

 India’s Export – the Problems

• Exports are essential for growth and job creation, as they allow a country to produce for the entire
world and not just its own people. But India’s exports have underperformed, not only in comparison to
the China but also to neighboring countries like Bangladesh.

• Many exporters, particularly in industries like textiles that create the most jobs, are small and medium
enterprises. They find it particularly hard to fit into global supply chains and get loans. They are also
hardest hit by the GST.

• India’s labour force does not have sufficient skills, and labour regulations make it hard for exporters
to employ the number of people that would make them more efficient.

• Our transport infrastructure is insufficient, outdated and badly planned – bureaucratic red tape makes
it even harder for exporters to stay competitive.

Dr Ritesh Kumar Mishra, University of Delhi

 India’s Export – the Solutions

• The government will have to make sure that the macroeconomic environment is favorable for trade –
by signing trade agreements and by avoiding arbitrary taxes, restrictions and tariffs.

• Focus on ensuring the SMEs get access to loans, and reform the GST to ensure that it no longer
hurts them.

• Conduct labour reforms together with a comprehensive attempt to raise the Indian workforce’s skills.

• Upgrade the country’ transport infrastructure and cut red tape so that Indian producers can get goods
to its own markets at least as quickly as China’s do.

Dr Ritesh Kumar Mishra, University of Delhi

 Readings

• For further readings, see BGRS: Chapters 3 and 6

• For Debt and economic growth, see Economic survey 2020-21 Does Growth Lead to Debt-Economic survey 2020-21.pdf

• For recent trends in India’s BoP, see Economic Survey 2020-21 External Sector-Economic Survey 2020-21.pdf

Dr Ritesh Kumar Mishra, University of Delhi

Thank You

Dr Ritesh Kumar Mishra, University of Delhi