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External Sector

Ques. 1 : What do you understand by Balance of Payments?

Ans. The highlights of BoP developments during 2010-11 were higher expors, imports, invisibles, trade,
CAD and capital flows in absolute terms as compared to fiscal 2009-10. Both exports and imports showed
substantial growth of 37.3 per cent and 26.8 per cent respectively in 2010-11 over the previous year. The
trade deficit increased by 10.5 per cent in 2010-11 over 2009-10. However, as a proportion of gross
domestic product (GDP), it improved to 7.8 per cent in 2010-11 (8.7 per cent in 2009-10) Net invisible
balances showed improvement, registering a 5.8 per cent increase in 2010-11. The CAD widened to US$
45.9 billion in 2010-11 from US$ 38.2 billion in 2009-10, but improved marginally as a ratio of GDP to 2.7
per cent in 2010-11 vis-a-vis 2.8 per cent in 2009-10. Net capital flows at US$ 62.0 billion in 2010-11 were
higher by 20.1 per cent as against US$51.6 billion in 2009-10, mainly due to higher inflows under ECBs,
external assitance, short-term trade credit, NRi deposits, and bank capital. In 2010-11, the CAD of US$45.9
billion and it resulted in acretion to foreign exchange reserves to the tune of US$13.1 billion (US$13.4
billion in 2009-10).

During the first half (H-1-April-September 2011) of 2011-12, CAD in absolute terms was higher than in the
corresponding period of the previous year, mainly due to higher trade deficit. The net capital flows in
absolute terms were also higher during H1 of 2011-12 vis-a-vis the corresponding period of 2010-11.

Balance of payments is an overall statement of a country’s economic transactions with the rest of the world
over some period- usually one year. It includes all outflows and inflows (payments and receipts) Countries
have either balance of payment surplus or a balance of payment deficit. Balance of payments is a way of
listing receipts and payments in international transactions of a country. Balance of payments can be broken
down into balance of trade (export & import of goods); balance of current account (includes the balance of
trade, the balance of services and remittances; and capital account (investment and borrowing). Trade
account is a part of the current account. Capital account deals with investment and borrowings and the rest
of the 130P is the current account of which foreign trade is a part.

Balance of Payments in the l990s

The 1990s witnessed some major changes in India’s balance of payments front. The decade began with a
crisis caused both by the immediate Gulf war and the cumulative problems of the Indian economy. It led to
an IMF-sponsored bail out. The response to the crisis also spurred a host of reforms which had a significant
bearing on the balance of payments The rupee was devalued substantially, foreign portfolio investments
were Welcomed and Indian companies were allowed to raise capital from the international markets.
Convertibility of the rupee was gradually brought in from 1992-1993 budget onwards: India’s foreign trade
expanded as tariff and non-tariff barriers to trade dropped.

The Gulf crisis of 1990-91 and the subsequent rise in crude prices rudely exposed the inadequacy of
reserves. The consequent rise in India’s import bill, depleted reserves. International rating agencies
downgraded Indian. This fuelled the crisis further as India’s credit worthiness plunged. A substantial
outflow of deposits held by Non-resident Indian during 1990-91 added to the crisis. Reserves declined to a
low of $0.9 billion in January 1991.
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India had to pledge gold in May 1991 and again in July 1991 to avoid a default on its short term obligations.
Further, in October 199i, India forex through India Development Bonds and Foreign Exchange Immunity
Scheme.

Confidence building measures were taken up after a new government was formed in June 1991. The rupee
was devalued. The rupee was partially freed in 1992, wherein 40 per cent of the foreign exchange earnings
were to he surrendered at the official exchange rate and the remaining 60 per cent could be converted at
market determined exchange rates.

The partial convertibility was extended to full convertibility and rates were unified on trade account in 1993
and an effective current account convertibility in 1994. In August 1994, India assumed obligations under
Article VIII of the International Monetary Fund, as a result of which, India is committed to adopt current
account convertibility.

The measures helped in international investors reposing faith in India once again.

Surge in Capital Flows

India’s response to the crisis was essentially tailored to build confidence of the international investing
community in India. Foreign institutional investments (investments into financial assets like shares, debt
instruments etc) were permitted and Indian companies were permitted to raise resources in the international
capital markets in the form of GDRs. Norms for foreign direct investments were liberalised and
multinational companies were wooed by Central/state governments to invest in infrastructure and other
projects. The dramatic change in the environment led to a surge in capital flows. Foreign investments into
India shot up dramatically. The RBI by October 2011 has $3l0b forex reserves including gold and SDRs. In
January 2012 Forex Reserve was $292.86.

Balance of Payments and Invisibles

Invisibles in international trade, is used as a synonym for “service.” Invisibles trade is trade in services.
Visible, in referring to international trade, is used as a synonym for “goods.” “Visibles trade” is trade in
goods.

Invisibles are in three parts

• Services
• Transfers and
• Income.

Services include transportation, financial services, travel, telecommunications, computer—services and

professional services. India’s share in global trade in services doubled in the last one decade from 0.6% to
1.2% and stands at $76 6illion Transfers include remittances from Indians working abroad.

Income receipts are the income earned (as profits, interest and dividends) from the ownership of overseas
assets by Indian companies, government and individuals

The net inflow on invisible account has continued to be a major support to the balance of payments.
Invisible receipts have shown robust growth, increase being spurred by increased private transfer receipts
(remittances by Indian living and working abroad).Tourism receipts have been on the rise. The receipts
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under the miscellaneous category in the invisible account, which include software exports rose substantially.
Software exports continue to show exceptional growth rates.

Remittances
India receives about $50 b in remittances. Remittances to India have been on the rise over the past few years
as it became one of the preferred destinations for global flows of capital.

The Gulf region accounted for an average of 27% of the total remittance inflows into India, with major
source countries being the UAE and Saudi Arabia.

According to Reserve Bank of India figures North America continued to be the most important source of
remittances to India.

Indian diaspora- about 25m- which is one of the most prosperous in the world is sending money home.
Controls are lifted and so there are greater inflows. Rupee exchange rate is also attractive.

The government has progressively reduced the red tape involved in NRI investment in real estate and stock
markets. The strength of Indian economy is the most compelling reason.

Ques. 2 : Give an account of Convertibility of Rupee?

Ans. Convertibility refers to the freedom of the holder of a currency to freely convert it into any other
foreign currency. The larger the scope of convertibility that is permitted by a country, the stronger and the
more resilient its economy is said to be. No country grants full convertibility but restricts it for certain
purposes and excluding certain other purposes. For example, the trade account convertibility is confined to
exports and imports and certain associated aspects like remittances (what Indians living abroad send to their
friends and relatives in India) etc. Convertibility for investment and borrowing abroad comes under capital
account convertibility.

Since the beginning of economic reforms in 1991, one of the most consistent aspects of economic policy of
the country was with regard to deregulating the external sector dynamics and the valuation of the rupee. As
detailed above, from 1992, initially partially and later fully convertibility was ushered in as it moves the
economy closer to the global dynamics.

Convertibility has three dimensions:

• Freedom to convert
• Convert at market rate and
• Removal of restrictions for conversion on current and capital account. That is, liberalization of flows.
It means convertibility for more purposes (like FDI in retail); higher or no caps on existing
convertibility regime (49% FDI in insurance etc) and Indians being allowed greater freedom to take
their money abroad.

The rupee’s external value was regulated by the Reserve Bank of India till 1992. Unlike in the developed
countries where, by and large, the market forces dictate the exchange rate of the currency, the rupee was
artificially valued by the RBI because the country did not have a policy that is pro-exports or pro-FDI.
However, since 1991, reforms emphasized on external sector security through forex earnings- by exports
and FDI and FDI. In the 1992-93 Union Budget, the freeing of the rupee began gradually culminating in the

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1994-95 Union budget granting current account convertibility. The reform, however, was slowed down after
the currency crisis of East Asia in 1997 but resumed momentum since 2000. The fact that India has current
account convertibility means that it has acceded to Art. VIII of the IMF with accompanying benefits.

Current account convertibility: It refers to freedom to convert domestic currency into foreign currency and
vice versa for the following purposes:

1. exports and imports

2. payments due as interest or loans etc . -
3. moderate remittances for living expenses etc.

Capital account : It covers investment and borrowings. For example, foreign investment in India; how much
Indian companies can borrow. Similarly, Indians to open bank accounts in foreign countries; invest abroad;
hold assets abroad etc.

Capital Account Convertibility

Full convertibility means freedom to convert rupee -into foreign currency and vice versa for both current and
capital account purposes with least restrictions. That means, there should be 100% FDI and FII allowed
across all sectors, more or less except security related areas). Similarly, there should be very liberal regime
for outflows that is, Indians can invest abroad and borrow from abroad.

Full convertibility is gradually being introduced in India since the reforms began. We have virtual capital
account convertibility for foreigners and NRIs for investing in India and taking out profits relating to FDI,
portfolio investment and bank deposits in India. For Indian residents and corporates, fairly conservative
limits still exist on how much they can invest abroad. Indian companies also need RBI permission to borrow
funds from abroad for some designated purposes. The controls are being relaxed.

Why do we need fuller capital account convertibility?

Advantages
• we get foreign capital for investment
• FlI flows can modernize our financial sector
• Creates competition for our domestic players
• All advantages of FDI will be available-technology, investment and trade (TIT)
• There will be macro economic discipline
• Indians have a wider range of choice for investment and borrowing.

Fears are
• As the global financial crisis shows, adoption of fuller convertibility should be calibrated or it can be
quite destabilizing
• Domestic interests in retail are hurt as it can create unemployment
• Rupee still not being a foreign currency, can be subject to flight of capital
• FDI hike in defence also needs to be discussed well before being adopted

Prerequisites for fuller convertibility

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• Fiscal deficit should be minimal

• Forex reserves should be adequate
• NPAs of banks should be minimal
• Inflation and interest rates should be moderate

Unless these conditions are met, great steps towards fuller convertibility should be kept on hold.

Benefits of fuller convertibility phrased differently are:

First, India needs huge resources, especially to upgrade its infrastructure. Domestic savings alone are not
enough. More foreign funds would come in only if they are sure of free entry and exit.

Second, Indian businesses (especially, the established companies) would be able to access cheaper foreign
funds that would improve their international cost competitiveness.

Third, unhindered access to foreign funds would facilitate Indian companies taking over firms abroad and
developing more Indian MNCs in the process. For example, Tatas acquiring Corus, the international steel
major.

Fourth, Indian banks would be able to borrow foreign funds at lower rates which would, in turn, enable them
to lend at a lesser rate to Indian small and medium enterprises which may not otherwise be able to borrow
directly from the international capital market.

Fifthly, it exerts macro-economic discipline.

Sixthly, outflows are necessary to balance the inflows or the problem of appreciation will plague the
economy.

Finally, ordinary Indian investors would be able to further diversify their asset portfolios

Among dangers, most importantly, Dutch disease may result. Netherlands experienced Dutch disease as a
result of its discovery of oil and related fuels in 1960s. The foreign exchange inflows led to the Guilder
appreciating so much that the competitiveness of Dutch industry was affected adversely. Exports suffered
and imports increased due to appreciation. Deindustrialization is the result. The Dutch disease is something
similar to what the emerging market economies have experienced due to capital inflows, particularly of the
portfolio variety.

Tarapore Committee on CAC that was set up in 1997 and gave a road map for introduction of capital
account convertibility. But it could not be implemented as East Asian currency crisis struck in 1997.

The fears regarding CAC are:

1. capital flight
2. volatile capital movement can destahilise the equity market and banking sector
3. to manage the exchange rate the Central bank has to intervene in a costly way
4. imports will surge as the rupee appreciates and so there can be a current account deficit that will be
difficult to solve
5. interest rates will be high to hold the foreign capital and also to curb speculative activities

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It is also observed that since there is no correlation between FDI and free float and also because much higher
level of domestic savings can be tapped in the country by appropriate financial reforms, it is suggested that
adoption of CAC may be postponed.

Capital account transactions continue to be regulated under the FEMA which is a highly liberalized version
of the earlier FERA.

Foreign direct investment, barring a few strategic industries is put on automatic route, with most of the
sectors permitted to have ever increasing foreign equity participation.

The foreign portfolio investment by FIIs is allowed liberally.

The external commercial borrowings (ECB) no longer require the R131 or Ministry approval up to a value.

Inflows are liberalized far more than outflows for obvious reasons of security. The relaxation on outflows to
balance the inflows that were made earlier in 2007 are

• Overseas investment limit (total financial commitments) for Indian companies enhanced.
• Aggregate ceiling on overseas investment by mutual funds enhanced.
• Prepayment limit of external commercial borrowings (ECBs) without prior Reserve Bank approval
increased.
• an Indian citizen can invest up to $2,000O per year in foreign markets

Tarapore Committee on Fuller Convertibility that presented its report in 2006 recommended that India
should make the rupee more freely convertible over the next five years to realize the country’s “maximum”
economic potential. Tarapore committee said that in view of the huge investment needs of the country and
that domestic savings alone will not be adequate to meet this aim inflows of foreign capital become
irrperative. The shift toward fuller convertibility should be phased over three phases starting in 2006-07. A
“comprehensive review” should be undertaken in 2011 to chart the future path.

But, before making the rupee more freely tradeable, India must “improve regulatory and supervisory
standards across the banking system” and get its financial house in order, including taming its worsening
deficit, said the committee.

Current Account Deficit

The current account of the balance of payments is the sum of the balance of trade (exports minus imports of
goods and services), net factor income (such as interest and dividends) and net transfer payments (such as
foreign aid). A current account surplus increases a country’s net foreign assets by the corresponding amount,
and a current account deficit does the reverse. Both government and private payments are included in the
calculation. The balance of trade is typically the most important part of the current account. This means that
changes in the patterns of trade are key drivers of the current account.

CAD is said to be good upto a limit as the country uses foreign savings which are imports for its
development. However, two points must be made to qualify the same. One, it should be financed from
dependable inflows like FDI. Two, it should be within limits.

CAD 2010
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India had a 2.9% of GDP of current account deficit in 2009-10. Government says that it is manageable and
will be covered by capital inflows. It is basically because of the widening of the trade deficit to more than
$115b. Since the economy is doing well and foreign capital flows are strong on FIT and FDI fronts, the
deficit is not a worry. However, the fact that speculative FIT inflows are banked cover the CAD is
worrisome, according to some. Therefore, we need FDI flows to step up growth, exports and thus stabilize
the external account.

Currency Mechanisms
There are many ways a currency’s exchange rate is arrived at. Some are

1. In floating rate, the forces of demand and supply determine the valuation and the role of monetary
authority is nil or negligible except in indirect terms like buying and selling currency in the market,
changes it makes in the interest rates, cash reserves ratio etc
2. In dirty float the exchange rate is largely market determined but the central bank manages the rate in
a specific band that suit certain national goals like export promotion etc. Management of the
currency valuation is within a band called the target zone. The objective here is to make exchange
rate conducive for certain macro economic goals like export promotion and balancing it with import
liberalization; remittances etc. It is also called managed float. India follows the system.
3. In the fixed exchange rate, the Central Bank artificially and arbitrarily fixes the exchange rate which
may not have any relation to market forces. India had the system till 1992 when trade account
convertibility was introduced. India had the system as it did not need any FDI or exports.
4. In the pegged system the currency is pegged to the international hard currency like dollar. Its
movements are determined by the hard currency. It is essentially meant for imparting stability and
credibility to the domestic currency so as to invite investors. The stability, however, depends on the
ability of the country to manage the rate that is necessary for its exports and that is reflective of its
fundamentals. For that, the Central bank should have sufficient forex reserves to intervene whenever
necessary. Otherwise, there will be speculative attacks and currency meltdowns. China is an example
of currency peg. (Yuan revaluation story in Current Affairs). It is called dirty peg and is a managed
peg.
5. Crawling peg means, the Government accepts that the currency will crawl (devalue) gradually by a
certain annual rate.

Ques. 3 : Write a short note on Purchasing Power Parity.

Ans. In economics, purchasing power parity (PPP) is a method used to calculate theoretically, exchange
rates between the currencies, of different countries. PPP exchange rates are used in international
comparisons of standard of living. They calculate the relative value of currencies based on what those
currencies will buy in their nation of origin and compare the same.

PPP is arrived at by calculating the price of a set of goods and services in the US and the same set in India
and thus arriving at the rate of conversion. For example if it costs $1 in the USA and Rs. 10 in India, then
the PPP is Rs. 10 for one dollar.

What is the Real Value of the Rupee?

Since 1991 when dollar fetched 16 rupees, rupee has depreciated to Rs. 46.5 per dollar by August 2010.
Erosion is caused by the fact that unlike the arbitrary value fixed till 1991, the rupee is finding its market
value according to demand and supply in the market. The factors that influence the value are

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1. Demand and supply

2. Capital flows
3. Performance of economy and its prospects
4. Forex reserves with the RBI
5. Interest rates
6. Short term debt and the Current Account Deficit (CAD) or CAS
7. International prices of the commodities on whom the nation depends. For example, the crude prices
in the international markets influence exchange rate of rupee as India depends for more than 70% of
its requirements on imports

The prevailing official exchange rate is called the nominal effective exchange rate (NEER) The potential for
adjustment — upward or downward — according to factors mentioned above brings in real effective
exchange rate (REER). REER is an inflation adjusted exchange rate — the differential between the inflation
in India and India’s trading partners is factored to arrive at the REER. NEER always tends towards REER
even though there may be a time lag to suit the macro- requirements of the economy.

How Much Reserves are Enough / Necessary?

Today RBI has more than $298.2b of reserves. It is acquired by the RBI for the following reasons

• To check the appreciation of rupee

• To gain external account security
• To defend the rupee when needed
• To import essentials for economic and social security
• To enable the country to globalise further

Whether it is adequate or not is determined by the composition of our flows and external debt. NRI deposits
and FII investment (hot money) are vulnerable. Global crude prices are also a factor in estimating the
quantum of forex that is necessary. Drought and resulting food position is one more. Short term debt is
another input. With all these factors, including the import cover required, we have to decide the extent of
forex necessary.

Rupee Devaluation/depreciation and Export Performance and

Promotion
It is argued that when rupee depreciates due to market forces of supply and demand or is devalued by the
Central bank, exports go up as in price terms Indian goods and services will be cheaper especially in relation
to similar goods and services from competitive countries. In fact, since the beginning of reforms one of the
reasons for the growth in exports in dollar terms was the depreciation of rupees. With depreciated rupee,
FDI will also flow in and better goods can be exported. Devaluation becomes necessary if competing
countries for any reason suffer depreciation or resort to it deliberately. For example, China undervaluing its
Yuan.

The export strategy of the Government banks partly on appropriate exchange rate policy. The forex reserves
that the RBI holds are partly explained by the need for RB! intervention in the forex market to see that the
rupee does not appreciate too much and thus help exports.

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There is a point beyond which export promotion based on rupee depreciation can not be hoped for as
quality, reliability, packaging-and so on matter. Price-elasticity of our exports is also to be considered before
depreciation is advocated. Further, competitive devaluation will harm the economy.

Also, import elasticity of Indian exports- about 50% exports like engineering goods, gems and jewellery etc
is high and thus depreciation hurts them.

Thus, all the necessary factors need to be balanced before the rupee movements are managed.

Normally, currencies appreciate when the economies are doing well. An appreciating currency is the result
of a booming economy. Performance of economy brought in FIIs; huge FII inflows into financial asset
markets and an increasing reliance on low cost foreign loans (ECB) add to the supply glut, and help power
the rupee higher. NRI deposits also explain the appreciation.

The resentment is among exporters while importers, borrowers from abroad and the consumers are gainers.
Borrowers gain as they can prepay at reduced cost. Importers and borrowers in foreign currency are
delighted with the rupee’s appreciation to the dollar as most imports and external borrowings are
denominated in dollars.

The Indian consumer is a beneficiary too, as costs of a host of imported goods — from petro products to
electronic, electrical and consumer items would be cheaper. The rupee’s appreciation is one of the reasons
for the current low inflation rate.

The effect on exporters too is not all negative. With increasing global integration an ever-increasing
proportion of exports consists of imported raw materials and components. This is particularly true of the
diamond, high-end textile and engineering industries that use a high proportion of imported goods in their
exports.

The rupee’s rise has helped these exporters to rein in their costs and increased their competitiveness in the
global market place. However, exporters, in general, have seen their profit margins erode as a result of the
rupee’s unexpected appreciation.

Appreciation is suggested for the following reasons

• Helps manage inflation

• Puts pressure on export sector to scale up the value chain and export niche products
• Forces the industry to cut costs and be competitive or quality terms.

Rupee Depreciation
Forex reserves and infrastructure

India is currently facing the problem of plenty on the foreign exchange reserves front. The country ranks
sixth after Japan, China, Taiwan, South Korea, and Hong Kong for highest foreign reserves. With the
increase in quasi-fiscal costs of holding large reserves, and the need to increase the yield on current reserves,
policymakers have advocated the use of the ‘excess’ reserves to augment the country’s physical
infrastructural capacity, Another idea floated is to start a sovereign wealth fund.

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Monetary experts short down the idea of diversion of reserves for infrastructure as it may adversely impact
on our credibility. These are reserves and not resources and need to be kept up for security reasons.
Infrastructure can always be financed by other means. SWF can set up if there are opportunities.

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