Deepak Mohanty: Perspectives on India's balance of payments
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
School of Management, KIIT University, Bhubaneswar, 7 December 2012.
* * *
The assistance provided by Rajan Goyal & Rajeev Jain is acknowledged.
I thank Professor Sar for inviting me to address this young audience. In the recent years,
India's integration with the global economy has increased significantly. This is reflected in our
expanding volume of external trade and financial transactions. While this process has
several benefits arising from wider access to consumption and investment, there is attendant
cost of periodic instability. Over the last two years, the Reserve Bank has been drawing
attention to the widening current account deficit (CAD) in our balance of payments (BoP).
The risks to our BoP have increased both in the global and domestic context: first, following
the global financial crisis trade volumes have slumped and capital flows have become
volatile; second, slowing domestic growth coupled with a large fiscal deficit alongside a high
CAD poses twin deficit risks. In this context, I propose to capture the evolution of India's BoP
in the historical context and trace how did we respond to risks to external stability from time
to time?
Let me start from the basics. What is BoP? It is our transaction account with the rest of the
world. It can be better appreciated in terms of the national income accounting identity:
GDP = C+G+I+X-M. In other words, domestic output (GDP) is equal to private consumption
(C), plus government consumption (G), plus domestic investment (I), plus net exports (X-M).
If net exports of goods and services (X-M) are negative, the domestic economy is absorbing
more than it can produce. In other words, absorption (C+G+I) by the domestic 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 the global and
domestic economic outlook are not very favourable. Against this background, my scheme of
presentation will be as follows: identify the key events those shaped India's BoP since
independence; examine the changes in the composition of capital inflows; and in conclusion
highlight a few risks and make some suggestions to reinforce India's BoP.
India's BoP evolved reflecting both the changes in our development paradigm and
exogenous shocks from time to time. In the 60 year span, 1951-52 to 2011-12, six events
had a lasting impact on our 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. I will analyse the BoP
trend in this sequence.
The first phase can be considered from the 1950s through mid-1960s. In the early 1950s,
India was reasonably open. For example, in 1951-52, merchandise trade, exports plus
imports, accounted for 16 per cent of GDP. Overall current receipts plus payments were
nearly 19 per cent of GDP. Subsequently, the share of external sector in India's GDP
gradually declined with the inward looking policy of import substitution. Moreover, Indian
export basket comprised mainly traditional items like tea, cotton textile and jute
manufactures. Not only the scope of world trade expansion in these commodities was less
but additionally India had to face competition from new emerging suppliers, such as Pakistan
in jute manufactures and Ceylon and East Africa in tea.
During this period, policy emphasis was on import saving rather than export promotion, and
priority was given to basic goods and capital goods sector. It was argued that investment in
heavy industries would bring in saving in foreign exchange, as output from such industries
would replace their imports in the long-run. Import-substituting strategies were expected to
gradually increase export competitiveness through efficiency-gains achieved in the domestic
economy. But this did not happen. Hence, exports remained modest. In fact our external
sector contracted in relation to GDP from the level observed in the early 1950s. By 1965-66,
merchandise trade was under 8 per cent of GDP and overall current receipts and payments
were below 10 per cent of GDP (Table 1).
Notwithstanding the contracting size of the external sector, as imports growth outstripped
exports growth, there was persistent current account deficit (CAD). Emphasis on heavy
industrialisation in the second five year Plan led to a sharp increase in imports. On top of
this, the strains of Indo-China conflict of 1962, Indo-Pakistan war of 1965 and severe drought
of 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 other than to devalue. Rupee was devalued by
36.5 per cent in June 1966.1
Though India's export basket was limited, the sharp devaluation clearly increased the
competitiveness of India's exports. Concurrently, India had to undertake a number of trade
liberalising measures. Even though the net impact of devaluation was a contentious issue
among the leading economists,2 data show that exports growth, though modest, outpaced
imports growth (Chart 1).
In fact, the current account turned into a surplus in 1973-74 as not only the exports growth
was significant but invisible3 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 (CAB) 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, which
was linked to a multi-currency basket with pound sterling as intervention currency,
depreciated against the US dollar (Chart 2).
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 (Chart 3).
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 (Chart 4).
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 is 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 (Reddy, 2006).4
In response to the BoP crisis, a combination of standard and unorthodox policies for
stabilisation and structural change was undertaken to ensure that the crisis did not translate
into generalised financial instability. Such steps included pledging gold reserves,
discouraging of non-essential imports, accessing credit from the IMF and other multilateral
and bilateral donors. While dealing with the crisis through an IMF programme, a
comprehensive programme of structural reforms was undertaken simultaneously with special
emphasis on the external sector.
The broad approach to reform in the external sector was laid out in the Report of the High
Level Committee on Balance of Payments (Chairman: C. Rangarajan, 1993). Trade policies,
exchange rate policies and industrial policies were recognised as part of an integrated policy
framework so as to boost the overall productivity, competitiveness and efficiency of the
economy. In addition, to contain the trade and current account deficits and enhance export
competitiveness, the exchange rate of rupee was adjusted downwards in two stages on July
1 and July 3, 1991 by 9 per cent and 11 per cent, respectively. A dual exchange rate system
was introduced in March 1992 which was unified in March 1993. Subsequently, India moved
to current account convertibility in August 1994 by liberalising various transactions relating to
merchandise trade and invisibles.
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. 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. Software exports rose from 0.9 per
cent of GDP in 1999-2000 to a peak of 3.8 per cent of GDP by 2008-09. Private remittances
also rose from 2.7 per cent of GDP to 3.8 per cent during this period. Thus, in the 2000s
software exports and private remittances emerged as two main financing items for the
current account mitigating to a large extent the merchandise trade deficit (Tables 2 & 3).
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. Let me
now turn to the financing aspects of the current account.
India's openness, both in terms of trade flows and capital flows which increased in the 1990s
accelerated in the 2000s (Chart 5). This was made possible due to substantial liberalisation
of the capital account and greater openness to private capital.
In the first three decades after the independence, CAD was mainly financed by external
assistance and drawdown of forex reserves. Since much of India's planning strategy was
conceived in terms of a closed economy theoretical framework, private investment inflows
into the economy were not encouraged much. Therefore, foreign resources came primarily in
the form of official transfers. The private investment came mainly through technology
transfer, but played a minuscule role. During this period, the development efforts and stress
on BoP from time to time led India to tap diverse aid sources for specific projects.
In the 1980s, as the traditional source of official concessional flows dried up there was a
need to access private capital. But, this came in the form of debt creating flows though
costly external commercial borrowings (ECBs) and NRI deposits. The limitations of
financing CAD through debt creating flows were exposed in the 1991 crisis. Subsequent
reforms and opening up the capital account to non-debt creating flows of foreign direct
investment (FDI) and portfolio equity flows not only completely transformed the sources of
financing of the BoP but it also resulted in substantial addition to reserves in the 2000s
(Table 4 & Chart 6).
Concluding remarks
With the gradual external liberalisation of Indian economy, not only the size of BoP has
increased manifold, but the pattern of current and capital account has changed. Even though
the reform process has strengthened resilience of India's external sector, at the same time
vulnerabilities arise with greater exposure of the economy to the rest of world through
liberalised trade and investment environment.
India's current account particularly remains vulnerable to developments in the trade account.
It is evident from the size of trade deficit growing from 0.5 per cent of GDP during 1951-55 to
8.7 per cent during 2007-12. In 2011-12, the current account deficit has widened to a record
4.2 per cent of GDP (Chart 7). Over the years, current account derived some resilience from
surplus generated by invisibles, particularly software exports and private transfers, but trade
deficit continues to dictate the overall trend in the current account. Whenever trade account
worsens reflecting downswings in the global business cycle or rise in international oil prices,
the current account also comes under stress as is evident in the present context. Going
forward, since India's linkage with the world economy, in terms of trade and finance, is likely
to grow further, it is important that resilience in its trade account is built up mainly by
promoting productivity based export competitiveness and improving domestic fundamentals
that are supportive of least costly non-debt creating flows, particularly foreign direct
investment (FDI). In this context, I make a few suggestions.
First, the current level of CAD is far above the level sustainable for India. As per estimates, at
a nominal growth rate of about 13 per cent, the sustainable current account to GDP ratio is
2.3 per cent (Rangarajan, 2012).5 Reserve Bank's own research shows that economy can
sustain CAD of about 2.5 per cent of GDP under a scenario of slower growth (RBI, 2012).6 A
slowing global economy and protracted high levels of unemployment in advanced economies
make it difficult to boost services exports in the short run. If the slowdown continues, it could
also have an adverse impact on inward remittances. Hence, there is a need to reduce
imports and boost merchandise exports to bring the CAD to sustainable levels.
Second, structural policy measures are needed to reduce vulnerability emanating from high
oil and gold imports. While oil has been a major component of India's imports, the sharp
increase in demand for gold has put an additional pressure. During 2008-09 to 2011-12, on
average, the net gold imports stood at about 2 per cent of GDP, almost double the level
recorded during 2004-05 to 2007-08. Thus, during the same period, CAD-GDP ratio,
excluding net gold imports, would seem less problematic at 1.1 per cent as compared to a
surplus of 0.2 per cent. In addition to the traditional motive of gold demand for jewellery, gold
seems to have become a safe investment asset and a hedge against inflation as is observed
in other advanced economies. Its dematerialisation like any other financial product can
reduce its physical imports (Gokarn, 2012)7. Furthermore, inflation indexed bonds could also
be another option to offer investors the inflation linked returns and detract them from gold
investments. In the case of oil, we need to become more energy efficient to reduce our
dependence on oil imports. Stepping up of production of electricity could reduce oil demand
from backup generation systems. Moreover, the domestic pricing of oil should be aligned
further to the international prices to rationalise oil consumption.
Third, current policies towards further diversification of India's export basket, both destination
and products, needs to be stepped up. Indian exporters need to accelerate efforts to move
up in the value chain at the global level.
Fourth, given the global uncertainties and volatility in capital flows, the resilience of capital
account needs to be further enhanced by encouraging FDI inflows.
To conclude, the Indian economy is much more open and globalised now than ever before.
The periodic pressures on BoP have been addressed through policy changes. While the BoP
has again come under stress since 2011-12 as emphasised by Governor Dr Subbarao, the
situation is not as serious as it was in 1991.8 This is because the structure of the economy
has changed in a fundamental way with flexible exchange rate and greater depth in financial
markets, besides much larger foreign exchange reserves than those in 1991. However, there
is a need to bring the CAD to sustainable levels in the short run and over the medium-term to
accelerate efforts towards structural reforms that help boosting our competitiveness, raise
growth potential and bring in more stable flows into the economy.