India’s Balance of Payments- Part II

This article is a continuation of my previous article on India’s Balance of Payments.

Trends in India’s BOP (2000-2010)

The easy going and conservative attitude of the policy makers were shaken by the 1990-91 crisis. Forty long years of slumber and indifferent attitude had done sufficient damage to the economy by then. The basis of a sound BOP situation lies in the inner economic strength of the country. The domestic economy has to be strong enough to face international challenges.

After independence, India adopted inward oriented policies with this very objective. The objective by itself was good, no doubt; but the planners and politicians became so obsessed with domestic, indigenous self sufficiency that the country was almost completely sealed from all foreign influence. The advantages of foreign trade were overlooked year after year. Indian entrepreneurs were dragging with cheap, obsolete technology and devouring subsidies, creating a huge national burden of large sick public sector units. Instead of acting as an incentive, government protection in fact harmed our industrial development.

The New Economic Policy of the nineties aimed at opening up the economy, to allow free trade and competition and reduce the role of government significantly in foreign trade matters. Restrictions on international trade were removed, foreign investments were allowed and a new Liberalized Exchange Management System was introduced to reap the benefits of competition and counter the disadvantages of a closed, inward looking trade policy.

The changes towards liberalization and globalization of the Indian economy were carried out very cautiously in phases.

There were political hurdles as well as genuine fears on the national economy front. The exchange rate could be changed from fixed to free market rate determination system only when the domestic economy and BOP are strong enough to absorb fluctuations in the global market. The other important fear was regarding the foreign investments. Foreign Direct Investment (FDI) was preferred over Foreign Institutional Investment (FII). FII or portfolio investment does inject foreign exchange in the country, but such portfolio investment is highly volatile. It can be taken back at the slightest hint of weakening economy, causing outflow of foreign exchange.

With liberalization FII was expected more than FDI, because then our infrastructure was not developed enough to attract much FDI. Rupee too was only made partially convertible. Therefore these sectors were opened slowly. This cautious approach saved India from the South East Asian Financial crisis in 1999 when exchange value of many Asian countries went tumbling down drastically.

After overcoming the initial hiccups and doubts in the last decade (1991-99), the Indian economy has finally got a sound base with a strong BOP.

Foreign Investment

India successfully attracted Foreign investors to the country with its sincere positive economic changes like reduced paperwork and other cumbersome formalities. From a meager US$103 million  net foreign investment in the year 1990-91, it has grown to us$ 8669 million  in 2008-09.

Foreign investments kept the country afloat during the recent global recession. Because the effect of recession was worse in the advanced countries, the investors turned to the less affected emerging economies like China and India. Although initially foreign investment in the country did slow down considerably due to risk aversion in the face of the recession, but it picked up again because emerging economies like India and China were swift to implement corrective measures to fight recession, showing commendable resilience to the recession which badly shook the much advanced economies.

There was massive decline in net capital flows from US $ 106.6 billion in 2007-2008 (8% of GDP) to US $ 7.2 billion (0.6 % of GDP) IN 2008-09.

The decline was mainly due to net outflows under portfolio investment. Inspite of this the FDI inflow remained buoyant at US $ 21.0 billion during Apr.- Sept. 2009 as against US $ 20.7 billion in Apr.-Sept. 2008. FDI inflow has been mainly in manufacturing, communication services and real estate sector.

Foreign exchange reserves

• Foreign exchange reserves (FER) are an essentially important factor in the country’s economy, reflecting it’s economic strength in the global scenario.
• Foreign investors brought in the much required foreign exchange to country adding to our foreign exchange reserve which was reduced to a meager 1 billion $ in 1990, barely able to sustain a month’s imports. The rise in foreign exchange reserve meant lesser need for interest bearing foreign loans for development projects and essential imports.
• From a low level of US $ 5.8 billion at end- March 1991, FER gradually increased to US $ 25.2 billion by end-March 1995, US $ 113.0 billion by end-March 2004 and US$ 314.6 billion in end-May 2008.
• The reserves declined to US$ 252.0 billion at end-March 2009. This decline was due to the global crisis/recession and the strengthening of US Dollar against other international currencies. During 2009-10, the level of foreign exchange reserves from US$ 252.0 billion at end-March 2009 to US$ 283.5 billion at the end of December 2009, due to depreciation of the US dollar. Today India is the fourth largest foreign exchange holder in the world after China, Japan and Russia.
• An important development in 2009-10, is the investment of foreign exchange reserves in domestic infrastructure projects. Financing domestic infrastructure projects from the FER means doing away with the need for external assistance and carrying out the project without the fear of monetary expansion.

Exchange Rate

• The RBI monitors and manages the exchange rate with flexibility, while allowing the market demand and supply conditions to determine its movements over a period of time. RBI intervenes to reduce excess volatility, to prevent destabilizing speculative activities and maintaining adequate levels of reserve.
• The rupee value after fluctuating frequently in the last decade, adjusting to the new liberalized policies of the country and the free ways of the global market, has now stabilized to a great extent owing to the strengthening of the economy.
• In 2008-09, the Rupee depreciated against major international currencies due to the decline in capital flows and widened trade deficit. But it strengthened again as capital inflows in the form of FDI and NRI deposits increased in 2009-10.

Current Account of BOP

• The current account of BOP comprises of the merchandise trade (export and import) and the invisibles (services, transfers etc.). The liberalized policy and comparatively hassle free formalities for export and imports have given a boost to our export industries as well as industries catering to domestic demands. Exports and imports both recorded double digit growth rate. India is now a mainly manufactured goods and services exporter enjoying a better terms of trade, compared to what it was, primary goods exporter, prior to 1991. The share of India’s exports in world trade has risen from 0.7 % in 2000 to 1.2 % in 2008. Services too have expanded to various fields catering to both domestic and international clients. The share of India’s export
• The current account balance widened in 2008-09 (-2.4 % of GDP) compared to that of 2007-08 (-1.3% of GDP) due to recession, but it was sustainable. The external demand shock led to decline in export growth from57 % in April-June 2008 to (-) 8.4 % in Oct.- Dec. 2008 and further to (-)20 % in January-March 2009, a fall for the first time since 2001-02. Imports too declined similarly due to domestic industrial demand and sharp decline in international crude oil and other primary commodity prices.
• The surplus in the invisibles account has always helped compensate the trade deficit to a great extent. In the face of the recent global recession too, it was the net positive invisibles account balance that kept the current account deficit to a sustainable level. Software services and workers’ remittances were mainly responsible for the higher invisible surplus. These remained unaffected by recession. However, travel and transportation were badly hit by global recession.
• India’s net invisibles increased by 18.7% in 2008-09.
• With the economy ( domestic as well as global) picking up momentum once again, there is hope of sunshine once again in the trade and financial world. India having cruised fairly successfully through the rough patch of recession can look forward to reaping greater benefits from world market, at least till the time the advanced economies which were badly affected by recession, revive fully. Our reserves are comfortable, exchange rate is competitive, service sector exports are also buoyant and capital inflow through FDI is also encouraging. In short, the BOP situation is quite well managed and comfortable. However, learning from the experiences of the financial crises occurring from in various parts of the world from time to time, we need to continue our cautious approach towards BOP management. The country cannot afford a setback to its economic growth achieved through drastic changes in national economic policies. India certainly has come a long way since the days of the protectionist policies, but there is yet a lot to be achieved, particularly in the infrastructure sector, in order to become a truly strong economy.

(Reference- Economic Survey 2009-10, Government of India)