Project on Indian Financial Market - Module: 3
Financial Market Integration
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Trade Openness

Openness of an economy relates to its cross-border movements of goods, services and factors of production, particularly capital and labour. While parity conditions reflect the degree of integration between domestic and offshore financial markets, they have some limitations. Alternative measures for openness have also been proposed that focuss more on trade integration (Box V.3). Historically, the approaches of different countries as well as separate regimes within the same country towards openness have varied widely. Trade openness of an economy has two distinct but often interrelated dimensions, i.e., ex ante openness and ex post openness. Ex ante openness of trade of an economy relates to the orientation of its policy frameworks towards exports and imports. The levels of tariff and non-tariff measures applied by the country on cross-border trade flows are the most important indicators of ex ante trade openness of the economy. Ex post trade openness of an economy, on the other hand, refers to the actual levels of imports and exports in relation to domestic economic activities. At any point of time, high (low) levels of ex ante openness may co-exist with low (high) levels of ex post trade openness. A major problem in the analysis of trade openness is that openness is neither directly observable nor is strictly defined. The simplest measures of trade orientation, therefore, use the actual trade flows, such as, the share of trade (imports plus exports) in GDP or the growth rates of imports and exports.

Notwithstanding the limitation that these simple versions could be imperfect proxies, they could still be useful to interpret a country's openness based on such ex-post indicators. In doing so, however, it would be useful to consider different variants of such indicators. Although foreign trade relates to both goods and services, customarily trade in goods alone is used in the calculation of trade-GDP ratio. In the case of India, the trade-GDP ratio showed a decline in India's trade openness in most part of the 'eighties. After showing a rising trend from 1987-88 to1995-96, the ratio exhibited a somewhat declining pattern thereafter. This could, however, provide somewhat distorted picture of India's trade openness, with the problems emanating from both the denominator and the numerator of the ratio. The 'services' sector, which accounts for bulk of India's GDP, recorded a high rate of growth during the period of trade liberalisation. The share of the 'services' sector in GDP, which was around 40 per cent in 1980-81 rose to nearly 52 per cent in 1998-99. On the numerator side, petroleum crude and products account for a sizable portion of India's foreign trade. International prices and the behaviour of domestic consumption and production shape their trends (especially of the oil imports), and they have little to do with the policies of trade openness.

Two alternative measures that could take care of the problem of high growth of services sector component of GDP would be: (i) the ratio of total (merchandise plus services) trade to GDP, and (ii) the ratio of merchandise trade to GDP net of services (hereafter referred to as commodity sector GDP). The first measure is provided, based on the Reserve Bank's Balance of Payments data, while the second measure is based on trade data from the DGCI&S

Sharp increase in the inflows of foreign private capital into India in the 'nineties, has increased the cross-border financial integration. Till 1992-93, foreign investment flows to India were insignificant. Following the opening up of the Indian capital markets to portfolio investments, India attracted large foreign investment flows during 1993-94 to 1997-98 averaging US$ 5.1 billion per annum (Table 5.9). Most of these flows were in the form of portfolio investments during 1993-94 and 1994-95. From 1995-96 direct investment flows also picked up and exceeded $2.0 billion in each year. Foreign investment flows dipped in 1998-99, mainly on account of weakening sentiment for emerging markets in the aftermath of the financial crises in East Asia. In 1999-2000, foreign investment flows revived, with direct investment exceeding $2.0 billion and portfolio investment $3.0 billion mark.

Another way to measure degree of financial openness is to see the co-movement in the domestic stock markets and international stock markets. As a result of large capital flows, especially portfolio investments since 1993-94, the sensitivity of the Indian stocks to developments in international stocks has increased. The impact was particularly strong in 1999-2000 as movements in the technology stocks in the NASDAQ had a significant bearing on the Indian stock markets. An analysis of the prices of the Indian GDRs/ADRs in the international stock markets and the stocks in the domestic markets also reveals that the two prices are highly correlated. The correlation coefficient between the BSE Sensex and the Skindia GDR Index for the period from April 1996 to August 2000 worked out to 0.64. It, however, may be noted that many Indian GDRs/ADRs listed on the International stock markets during the period from 1993-94 to 2000-2001 (up to August) traded either at discount or at premium.

It also needs to be noted that at present all market participants are not able to exploit arbitrage opportunities due to certain restrictions. FIIs have better arbitrage opportunities between these two markets as resident investors are not allowed to invest overseas.6 However, the arbitrage operations are only one way since domestic shares cannot be converted into GDRs/ADRs. As a result, only when the GDRs/ADRs are at discount, FIIs can reap arbitrage profits. For most part of the 1990s, however, GDRs/ADRs floated at a premium.

In India, a comparison of the prices of GDRs/ ADRs against their underlying shares listed in India shows that the international prices of GDRs/ADRs generally fetched a premium or discount, with the premium at some point touching 170 per cent (for Infosys in 1999-00) and discount rising to more than 35 per cent (for HINDALCO in 1998-99).

In response to the ongoing process of reforms in trade, industry and finance, India's openness to cross-border trade and private capital has increased considerably in the 'nineties, notwithstanding some slow down in the process towards the end of the decade. The trade openness as measured by the trade to GDP ratio improved. However, it needs to be recognised that a high ratio of trade to GDP need not be the ideal indicator of trade openness for several reasons. First, if the share of non-tradeables in GDP continues to be high even after significant trade liberalisation, it reflects the competitive strength of India's non-tradeables. Secondly, benefits of trade openness should essentially emanate from equalisation of cross-border prices of goods and services so that residents no longer pay higher prices for goods produced under protection. Though it is difficult to validate whether liberalisation has actually contributed to the expected price convergence, the behaviour of the exchange rate in India, which does not reflect large and persistent misalignment from PPP, indicates the possibility of such a price convergence. Thirdly, India continues to operate with an intermediate target for the external sector, in the form of a sustainable level of current account deficit as an integral element of its sound strategy for the management of the external sector. As a result, trade openness is essentially linked to export performance. More than 20 per cent growth recorded in India's exports during the first 8 months of 2000-01 would have helped in furthering India's openness to international trade.

As regards openness to international capital flows, India's share in the total FDI flows to the developing countries increased significantly in the first half of the 'nineties following the far reaching liberalisation of policies on FDI. In the last few years, however, India's share declined somewhat. This is essentially due to several structural constraints. FDI policies of emerging markets have also become fiercely competitive.

In the domestic financial markets, liberalization has given rise to market orientation and there is evidence of increasing co-movement of risk adjusted returns in different segments of the market. Forward premia in India, though increasingly becoming sensitive to interest rate developments, continue to be influenced by the demand-supply mismatches in the forward segment of the forex market. Alternating phases of spot market stability and market corrections for perceived misalignments have influenced both the risk premia and the demand-supply positions in the forward market. Furthermore, the requirement of genuine underlying transactions in the forward market and the restrictions on cross-market shifts in positions also hinder the parity conditions to hold in India. Such restrictions, however, form an integral element of the cautious and gradual approach to the reforms in India and are viewed as essential to avoid disorderly market developments. The Indian approach strives to attain a balance between efficiency gains associated with faster reforms and the need to preserve financial stability by pursuing a cautious and gradual approach to reforms.