Mr. Reddy reports on the recent performance of the Indian economy  (Central Bank Articles and Speeches, 1 Oct 98)
Central bank: rbi | Type: speech | Date: 1998-10-01

Mr. Reddy reports on the recent performance of the Indian economy Speech by Dr.

Y.V.

Reddy, a Deputy Governor of the Reserve Bank of India, entitled, 'Managing Capital Account' in Hyderabad on 01/10/98.On behalf of the Reserve Bank of India, I would like to convey my warm greetin all the delegates from various South Asian countries.

I have special pleasure in welcoming guest, Governor A.

S.

Jayawardhene.The forex markets in many parts of the world are going through a turmoil d currency crises, which are intensively affecting more and more countries.

Many of these c characterized by volatile capital flows - though the underlying causes for such crises Currently, there is a raging debate on the issues relating to managing capital flows, reopening many issues such as the merits of capital controls, and the adequacy of the in financial architecture.

There are references to India also in this debate and intere expressed on how we are managing our capital flows.

I will, therefore, share with perceptions on the following issues.

## First, why is it that India has remained relatively unaffected by the Asian crisis?Second, what role did policy relating to capital flows play in imparting stab put it differently, what was the policy and operational framework in managing capital flo was the current account handled to ensure effective management of the capital account?

Wha the strategies for crisis avoidance?

What were the means adopted to meet extraordinary situThird, in view of emerging global developments, can India continue to be wha been described as an island of tranquility amidst a sea of turbulence in the emerging econ put it differently, what are the immediate prospects for India in the external sector?

## India and Asian CrisisThe

performance of the Indian economy, by all accounts, has been by and l impressive both in terms of growth and stability.

During the period 1992-97, the annual av GDP growth rate was 6.8 per cent.

Our annual average growth rate during this period was than the developing countries' average at 6.4 per cent.

Our inflation during the period 1 8.7 per cent, which compares favourably with the developing countries' average.

Our account deficit as a percentage of GDP was only 1.3 per cent during this period.

Foreign reserves went up from US$ 9.2 billion in 1991-92 to US$ 26.4 at end-March 1997.The data that I have just presented will show that our fundamentals are making us less vulnerable to contagion, and this is clear from our performance in 1997 when the crisis struck East Asia.

During 1997-98, real GDP growth has been estimated at cent, a decline from the previous year's growth of 7.5 per cent, mainly attributable to decline in agricultural output.

The rate of inflation as measured by the wholesale p declined in 1997-98 to 5.3 per cent on a point-to-point basis.

In 1997-98, the current acc continued to be low at 1.7 per cent of GDP and there was accretion to foreign exchange re the tune of US$ 3 billion.The reason as to why we escaped the contagion can be analysed in terms of policies that we have been pursuing in areas where serious concern has been expressed in th of the Asian crisis.

Investment as a percentage of GDP has been reasonably steady in the rat around 27 per cent on average, and about 95 per cent of this was financed by domestic s managing our external account, we ensure a sustainable current account deficit, strict reliance on short-term external debt, limit access to external debt, and emphasise produc such debt.

We do encourage Foreign Direct Investment and portfolio investments through f institutional investors as the main sources of non-debt-creating capital inflows.

Also, t rate is market determined.

The RBI closely monitors it, and when warranted makes purchas sales of foreign currency to ensure orderly conditions in forex markets.

We undertook, ea reform period, financial sector reforms - especially banking reform, which included stre the regulatory framework, imposing prudential norms and reducing non-performing assets discourage banks' investments in real estate and stock markets.

Corporates' exposure especially external debt, is within reasonable limits.

As compared with other central ban widely recognised transparency in operations of the Reserve Bank of India.

There is, t reason to believe that it is not just chance but sound macroeconomic management which sa from the South-East Asian contagion.

It is nonetheless necessary for us to learn from the of the Asian crisis.

## Policy FrameThe broad approach to reform in the external sector after the Gulf crisis was in the Report of the High Level Committee on Balance of Payments chaired by Dr. C.

Rangar currently the Governor of Andhra Pradesh.

It recommended, inter alia:

liberalisation o account transactions, leading to current account convertibility; compositional shift in c away from debt to non-debt-creating flows; strict regulation of external commercial bor especially short-term debt; discouraging volatile elements of flows from non-resident gradual liberalisation of outflows; and disintermediation of the Government in the flow o assistance.

The Committee also recommended the introduction of a market-determined exch rate regime while emphasing the need to contain the current account deficit within limits. framework for the external sector based on the Rangarajan Committee Report was implemen along with policy changes in the trade, industrial and financial sectors.Under trade policy, there has been a virtual elimination of licensing, a pr shift of restricted items of imports to Open General Licence (OGL) and a lowering of tarif Industrial policy has been characterised by delicensing, removal of monopoly clauses defin industrial houses and removal of most reservations for public sector enterprises.

The ref area of the financial sector were guided by the recommendations of the Narasimham Commi Alongside the deregulation of the banking industry, including entry for new private sector general thrust of monetary policy has been towards reduction in pre-emptions, greater re open market operations, deregulation of interest rates and widening and deepening of f markets.

Simultaneously, measures have been undertaken to strengthen the institutional fr in banking, non-banking financial companies, financial institutions and stock markets prudential norms, capital adequacy stipulations, improvements in payments and sett mechanisms and strengthening of the supervisory framework.

Institutional measures have included recapitalisation of banks, improvements in debt recovery and, most importa setting-up of the Board for Financial Supervision and strengthening Bank's supervisory mech A second Narasimham Committee has given a road map for further reform of the banking sectorWe have taken various measures to ensure that the banking system does not get maturity mismatch bind.

With a view to encouraging banks to mobilise longer-term deposi increased the interest rate ceiling on FCNR-B deposits above one year while simultan reducing the ceiling on such deposits below one year.

Banks have been asked to monitor unforeign currency exposures of their clients.

Draft guidelines for asset-liability manag been prepared and after discussion with banks will be put in place.

We are monitoring the position in the economy very closely.Fiscal adjustment has been undertaken and a very significant measure is th system of automatic monetisation of the fiscal deficit was replaced by a system of ways a advances.In brief, reform in the external sector was meshed with reform in other relate and, within the external sector reform, capital flows were managed, keeping in view the efficiency and stability.

There was a fairly smooth movement from an administered exchan system to a market-determined exchange rate, and the Reserve Bank always ensures that vo and speculative elements are curbed through both direct and indirect measures.

## Operational FrameworkBased on the policy frame and the projected financing requirement for each management

of the capital account is operationalised through procedures for foreign investment, portfolio investment, external commercial borrowings, NRI deposits and outflowsThe broad approach to targeting of foreign direct investment has been through route, i.e. automatic and non-automatic.

Where the approval is automatic, activities and ownership are listed, while in regard to the rest, a case-by-case approval by a high-power adopted.Portfolio investments are restricted to select players, viz.

FIIs.

They could, some restrictions, operate in equity and debt markets.

FIIs are permitted to invest in equi a ceiling of 10 per cent for individual FIIs in a single company and 30 per cent collectiv ceiling in a single company.

Indian corporates are permitted, again through a process of a individual cases satisfying general guidelines, to access funds through global depository r euroconvertibles.The approach to external commercial borrowings has been one of prudence, wi self-imposed ceilings on commitments and a careful monitoring of the cost of raising fund as their end use.

External commercial borrowings are subject to a 'dual route', viz component of automatic and a major part through case by case approval, based on the si sector.

Short-term debt, including trade-related payments beyond 180 days, is subject case-by-case approval of purpose, amount and terms.

An overall annual ceiling is kept for flows - both for short-term and medium to long-term.In respect of NRI deposits, control over inflows is exercised through specific interest rates or interest rate ceilings for different maturities in respect of deposits i while, more generally, variable reserve requirements are stipulated to encourage or discou flows.As regards external assistance, both bilateral and multilateral flows are adm by the Government of India.In respect of capital outflows, the approach has been to facilitate direct investment through joint ventures and wholly owned subsidiaries and provision of financialto promote exports, especially project exports from India.

There are dual routes, namely and case-by-case and there is an aggregate annual ceiling for such approvals.

Export exchange earners have also been given permission, on a selective basis, to maintain foreig accounts and use them for permitted purposes which facilitate their overseas business prom growth.

## Current Account ManagementWhen

India adopted current account convertibility in 1994, it was recognise emphasised by the Rangarajan Committee, that there could be capital outflows in the guise o account transactions.

Hence, certain safeguards were built into the regulations relating account transactioins.First, the requirement of repatriation and surrender of export proceeds was co Exporters were, however, allowed to retain a portion of their earnings in foreign currenc in India which could be used for approved purposes, thereby avoiding costs of conversi reconversion.Second, all authorised dealers were allowed to sell foreign exchange for unde current account transactions which could be readily identified and supported by some docu evidence.Third, indicative value limits were given for different kinds of transactions amounts sold were reasonable in relation to the purpose.

For higher amounts, the banks approach the RBI.

This operational framework for the current account enabled eff management of the capital account.Fourth, the RBI has been taking an active interest in the development of m government securities and forex markets.

A proactive interest in the development of these has also enabled effective management of the current and capital accounts.Fifth, while ensuring orderly and cautious deregulation, every effort has been improve the information base on major transactions in the forex markets with respect to and magnitude.

Constant improvements are made to ensure the appropriateness, timelines quality of the information base.

The insistence on adequate and timely details from a dealers in forex markets also helped in fine tuning the management of the current and accounts.It must be noted that we insist as a general rule that foreign currency transac place for financing defined underlying transactions.

No doubt, genuine hedging of exposur specified conditions is allowed.

Transactions merely involving currency exchange or with speculative motives are viewed with serious disfavour.

This consistent approach has lent to the management of both current and capital transactions.As explained by Governor Jalan, the objective of the current policy in regard foreign exchange market is to maintain orderly conditions in the financial markets.

The aimed at preventing any destabilizing speculation in the market while at the same time f foreign exchange transactions at market rates for all permissible purposes.

## Crisis avoidanceIt would not be appropriate to conclude that managing capital flows on the lines, however efficient, will ensure that there would be total tranquility in the capital even with a managed capital account, we had to contend with occasional surges in capita between 1993 and 1997.

In general, the short-term response has taken a number of forms, viz of reserve requirements, reviewing the pace of removal of restrictions on capital inflows, of end-use specifications, liberalization of capital outflows, partial sterilization throu operations, and deepening the foreign exchange market by routing an increased volum transactions through the market.The prolonged stability in the exchange rate of the rupee from March 1993 under stress in the second half of 1995-96.

In response to the upheavals, the RBI interve market to signal that the fundamentals were in place and to ensure that market correcti exchange rate was orderly and calibrated.

Exchange market intervention was supported by mo policy action to withdraw liquidity.

The pressures intensified towards the end of January the first week of February 1996.

The Reserve Bank undertook a number of measures to enco the faster realization of export proceeds and to prevent an acceleration of import paym interest rate surcharge on import finance was raised, the scheme of post-shipment expo denominated in foreign currency was scrapped and the RBI continued to intervene actively spot, forward and swap markets.The year 1997-98 and the first quarter of 1998-99 posed severe challenge exchange rate management in the face of the threat of external contagion and other unce Distinct phases of exchange rate movements and response by the RBI can be identified.

Durin to September 1997, excess supply conditions prevailed in the market and the Reserve undertook large net purchases of foreign currency.

From September 1997 to mid-January 1998, exchange market pressure was staved off through sales of foreign currency, coupled administrative measures such as restricting certain forward contracts and monetary policy Mid-January to April 1998 marked the return of stability and enabled the rolling-back monetary measures introduced in January 1998.When the foreign exchange market was characterised by considerable uncertaintie May to June 1998, several measures were announced by the RBI in June 1998 to reverse demand/supply mismatches in the market.

The market responded positively to these measures, August 1998 there were fluctuations in the exchange rate in view of international developme RBI again undertook strong administrative and monetary measures, which included an increa the repo rate and the cash reserve requirement of banks.A vigilant and proactive policy by the RBI was, therefore, essential to avoid a highly unsettled atmosphere in international currency markets.

## Managing Extraordinary EventsAn extraordinary situation arose consequent upon the imposition of sanctions the issue of Resurgent India Bonds (RIBs) is an interesting example of management of the account in such a situation.

The RIBs were designed to compensate for the extraordinary e 1998-99, which may result in some shortfall in the normally expected level of capital though the current account deficit would continue to be well within 2 per cent of GDP.

Du sudden developments in 1998-99, a temporary disruption in capital flows, especially debt fanticipated.

Instead of dipping into currency reserves, which might affect sentiment adv cutting the current account deficit through drastic import cuts, which would affect rea activity, the alternative was to enhance debt flows at the least possible cost.

There w offset the adverse negative market sentiment created in the international capital markets downgrading of India's sovereign rating to non-investment grade.

This could be don demonstrably raising debt resources at a cost lower than that any organised financial in was prepared to provide in the context of the rating downgrade.

Raising resources through borrowing was considered to be time-consuming and in any case inadvisable as a maiden of under adverse circumstances.

At the same time, it was necessary to ensure that amounts so were restricted quantitatively to meet essential needs as a replacement for normal debt keeping an option for premature closure.

Furthermore, we had to ensure that the borrowing appropriate medium-term maturity, say five years.

RIBs, which are essentially in the n foreign currency deposits on a par with FCNR-B, were devised in the light of these consider was also necessary for the RBI to ensure that these funds did not disrupt the money, government securities market.There have been three main points of criticism regarding RIBs, i.e. cost of RIBs, substitution of FCNR-B deposits and exchange rate guarantee.A total amount of $ 4.23 billion has been mobilised at a moderate cost in the difficult international environment and the recent downgrading of our credit rating.

S called it the deal of the year.

To quote an international investor, '… the cost at which been raised imply a perceived sovereign rating three to four notches higher than current comparison sake China's 2003 Yankee Bond Issue, rated A3 by Moody's trades at a spread of basis points (on August 21) over the ten year US Treasury implying a dollar yield of 7.90 and the RIB issue is not even sovereign risk.'On the second point, as most of the banks that have actively mobilised RIBs m aware by now, there has been limited substitution from FCNR-B deposits and moreover, t extent there has been substitution, it would result in elongation of the maturity of dep years, while at the same time bringing into the country actual foreign exchange that is pr unswapped.In regard to the exchange guarantee extended, it is recognised that under circumstances, issuance of such a guarantee is inadvisable.

However, it can be legitimatel the recent times have been far from normal.

In return for a specific guarantee on R Government can claim benefits in four ways, viz.

addition to forex reserves, sup macroeconomic environment and sentiment, indirect support for its own borrowing programme resources for infrastructure development, including for public sector entities.

It can al that the Government bears exchange risk in regard to bilateral and multilateral flows for i onlending.

Moreover, given the Indian track record on prudent macroeconomic management, burden of the exchange guarantee could be said to be manageable.

## ProspectsThe trend growth rate of real GDP in India during the nineties so far has a 6.1 per cent per annum as against 5.4 per cent in the 1980s.

Taking the entire 17-year p 1980-81 to 1997-98, India's trend growth has averaged 5.8 per cent per annum, whi significantly higher than the trend, annual average rate of 4.7 per cent for the developi and 2.4 per cent for the advanced countries.

The performance during 1997-98 also reconsiderable resilience and inner strength to meet the macroeconomic challenges posed b domestic and external developments.

The performance of various sectors clearly suggests growth of real GDP during the current year (1998-99) would be about 6.5 per cent - an im figure, especially in the current international environment.As regards prices, we have an impressive record of maintaining a modest single annual inflation rate during the 1980s and most of 1990s.

However, during the current annual inflation rate has been a little over 8 per cent on a point-to-point basis as at 1998.

The principal sources of current inflation lie in the primary articles group, within contributions were from fruits and vegetables, oilseeds and cereals.

The price situation se to reflect a shortage of supplies of certain primary articles and is perhaps attributabl factors.There were some concerns earlier in the current year that interest rates coul significantly due to the large borrowing programme of the Government.

However, most of market borrowing requirement of the Government for this year has already been met with very marginal increase in yields on government paper.

Moreover, the genuine credit requir the productive sectors would be comfortably met by the significant accretion in bank deposiDuring the 1980s the average current account deficit was of the order of 2.0 of GDP.

Even when we faced the Gulf crisis we had a current account deficit of a mere 3.2 Since then, it has remained well below 2 per cent.

In 1997-98, despite large uncertainties, account deficit remained modest at about 1.7 per cent of GDP.

In 1998-99, the relatively lo oil prices in international markets and trends in invisible receipts should help maintain account deficit at a sustainable level of about 2 per cent of GDP.

This order of curre deficit is clearly sustainable and we expect it to be financed by capital flows.

In additio the comfort of a reasonable level of foreign currency reserves, which we would not hesitat curb speculative activities and ensure orderly conditions in the market.During 1997-98, we added $ 3 billion to our foreign currency assets despite pa of over $ 2 billion effected directly from reserves under the FCNR-A deposits schem repayments to the IMF.

During 1998-99 also, despite all the turbulence, we have increa foreign currency assets marginally from $ 25,975 million as at end-March 1998 to $ 26,135 as on September 18, 1998.We fully recognise that the uncertain international financial and economic si poses considerable policy challenges.

Of late, there have been some unfavourable developm the Russian economy and in a few Latin American countries.

The developments in the indu countries, in particular Japan, are also being closely watched as they impact not only account, but also capital flows.

On the whole, the international scene has been unfavo developing countries.

However, in so far as markets in India are concerned, the response fairly reasonable and has been less volatile than other countries in the region.From the presentation I have made on prospects, it should be evident that Indi position to meet the challenges of possible adverse international developments.

The recent the Resurgent India Bonds is a clear testimony to the confidence which investors have country.

We fully recognise that there is no room for complacency, but we do believe economic fundamentals, prudent management as well as the operational framework of capital will ensure the reasonable stability in the external sector that has been the hallmark of I process.In conclusion, the relative tranquility of the Indian economy in the face of crisis was neither an accident nor a stroke of luck.

The management of the capital ac displayed pragmatism and a contextual response to a changing environment.

The prospect 1998-99 indicate continued stability in our external sector, consistent with our recor performance.

In fact, I expect that the second half of the current fiscal year will be b first half, in terms of sentiment and economic performance.