A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 5 - External Sector - Capital Account, External Debt and
Exchange Rate: Approach, Development & Issues

External Debt & Exchange Rate Management

External Debt Management

Efforts towards prudent management of external debt, keeping in view sustainability, solvency and liquidity were put in place in most of the countries in response to the Latin American debt crisis of 1982. Subsequently, the financial crisis of Mexico in 1994-95 and Indonesia, Korea, Malaysia, Thailand and other Asian countries in 1997 highlighted the need for a sound macroeconomic policy for managing short term private capital flows, particularly the debt creating ones. The East Asian crisis emphasised the need for monitoring:

1. both public and private debt;

2. the size as well as the composition and maturity structure of external debt;

3. inter company debt between direct investors and subsidiaries, branches and associates;

4. trade credits, buyers and suppliers credits;

5. money market instruments;

6. loans from foreign financial institutions for normal inter bank transactions and other commercial purposes;

7. foreign currency denominated deposits held by non-residents (Kappagoda, 1999).

The East Asian crisis not only highlighted the need for monitoring the short-term debt, but it also emphasised the need for compilation of external debt (both long-term and short-term) on residual maturity basis, rather than original maturity basis. The former gives a better picture of the scheduled foreign exchange drain in the coming years on account of amortisation payments. In addition, the need for greater transparency and accountability, particularly in information disclosed by the private sector, has also been recognised as essential for avoidance of payments crisis (Kumar, 1999; Das, 1999; Williamson, 1999; Mohanty et al, 1999; Patra et al, 1999).

Apart from the need to contain current account deficit to sustainable level, one of the lessons from the external payment crisis of 1991, was to avoid excessive reliance on commercial debt especially of short-term maturity to finance the current account deficit. The approach to the external debt management was broadly based on the recommendations of the Rangarajan Committee, 1993. Following these recommendations, the strategy for external debt management during the 1990s has been guided by:

1. the continuation of an annual cap, minimum maturity restrictions and prioritising the use of ECBs;

2. LIBOR based ceilings on interest rates and minimum maturity requirements on foreign currency denominated NRI deposits to discourage the volatile component of such deposits;

3. reduction of short-term debt together with controls to prevent its undue increase in future;

4. retiring/ restructuring/ refinancing of more expensive external debt;

5. measures to encourage non-debt creating financial flows such as FDI and FPI;

6. incentives and schemes to promote exports and other current receipts; and

7. conscious build-up of foreign exchange reserves to provide effective insurance against external sector uncertainties.

Key indicators of debt sustainability point to the continuing consolidation and improved solvency in the 1990s. Although, in nominal terms, India’s total outstanding external debt increased from US $ 83.8 billion at end-March 1991 to US $ 98.5 billion at end-March 2002, external debt to GDP ratio declined sharply from 28.7 per cent at end-March 1991 to 20.9 per cent at end-March 2002. Prudent external debt management is also reflected in the proportion of short-term debt to total debt declining from 10.2 per cent in 1991 to 2.8 per cent in 2002 and in the ratio of short-term debt to foreign exchange reserves from a high of 146.5 per cent in the crisis period of 1991 to only 5.1 per cent in 2001-02. Debt service ratio declined from 35.3 per cent in 1990-91 to 14.1 per cent in 2001-02. Interest payments to current receipts ratio declined from 15.5 per cent in 1990-91 to 5.4 per cent in 2001-02.

The decade of 1990s witnessed a steady move towards consolidation of India’s external debt statistics in terms of size, composition and indicators of solvency and liquidity. Containing the increase in the size of external debt to a modest level in the face of a tremendous growth in foreign exchange reserves during the decade definitely points towards the success of India’s debt management strategy. Reflecting this, in terms of indebtedness classification, the World Bank has categorised India as a less indebted country since 1999. Among the top 15 debtor countries of the world, India improved its rank from third debtor after Brazil and Mexico in 1991 to ninth in 2000 after Brazil, Russian Federation, Mexico, China, Argentina, Indonesia, Korean Republic and Turkey. Moreover, among them, key external debt indicators such as short-term debt to total debt and short-term debt to forex reserve ratios are the lowest for India; the concessional to total debt ratio is the highest, while debt to GNP ratio is the second lowest after China.

In the context of globalisation and currency crises, recent years, particularly, have seen a renewed interest on the issues relating to exchange rate regime, which is evident in the large and growing body of theoretical and empirical literature on the subject. Nevertheless, both in theory as well as in practice, the state of the debate is unsettled. A worldwide consensus is still evolving in search of an appropriate and credible exchange rate regime. Contemporaneously, in India also, discussion and debate on issues relating to the appropriate exchange rate system, policies on intervention, capital control and foreign exchange reserves figure very prominently. This is especially relevant with the introduction of a market-based exchange rate system in March 1993 and in the context of global currency crises, particularly the East Asian Crisis.

The task of determining appropriate exchange rate and market intervention policies is extremely difficult for central banks all over the world. In principle, and in theory, there is a strong case for either freely floating exchange rates (without intervention) or a currency board type arrangement of fixed rates (Edwards, 2000; Summers, 2000; Buiter 2000). In practice, however, because of the operational realities of foreign exchange markets, empirical research shows that most countries have adopted intermediate regimes of various types including crawling pegs, fixed rates within bands, managed floats with no pre-announced path, and independent floats with market intervention moderating the rate of change and preventing undue fluctuations (Williamson, 2000). By and large, most countries have some variety of "managed" floats and central banks intervene in the markets periodically.

Reflecting the growing role of private capital flows in the 1990s, there has been a shift in the exchange rate regimes with a trend towards corners-either fixed regimes or floating regimes. For instance, about half of the IMF member countries as at end-December 2001 were at the corners. In contrast, the proportion of countries at the corners was only one-fourth as at end-December, 1991. As at end-December 2001, 41 countries had independent float exchange rate system, 42 countries had managed float with no pre-announced path for exchange rate, 40 countries had exchange arrangements with no separate legal tender, 40 countries had other conventional fixed pegged arrangements, eight countries had currency board arrangements, five countries had pegged exchange rates within horizontal bands, four countries had crawling pegs and six countries had exchange rates within crawling bands.

In India the exchange rate system has undergone a paradigm shift from a system of fixed exchange rate (until March 1992) to a market-determined regime in March 1993. Since the switchover to a market determined exchange rate regime in March 1993, the behaviour of the exchange rate has remained largely orderly, interspersed by occasional episodes of pressures, which were relieved through appropriate intervention operations consistent with the stated policy of avoiding undue volatility in the exchange rate without reference to any target, whether explicit or implicit. The financial crises encountered by the emerging markets in the last decade have brought to the fore the importance of an appropriate exchange rate policy. The present Indian regime of managed flexibility that focuses on managing volatility without reference to any target has gained increasing international acceptance and well served the requirements of the country in the face of significant liberalisation of external sector transactions. This is particularly so in the context of the series of exchange rate crises experienced by several emerging economies undertaking similar macroeconomic reforms.

In the post-Bretton Woods period, the Rupee was effectively pegged to a basket of currencies of India’s major trading partners from September 1975. This system continued through the 1980s, though the exchange rate was allowed to fluctuate in a wider margin and to depreciate modestly with a view to maintain competitiveness. However, the need for adjusting exchange rate became precipitous in the face of the external payments crisis of 1991.

As a part of the overall macroeconomic stabilisation programme, the exchange rate of the Rupee was devalued in two stages by 18 per cent in terms of the US dollar in July 1991. The transition to market determined exchange rate system took place in two stages and the sequencing was based on the Report of the High Level Committee on Balance of Payments, 1993 (Chairman: C. Rangarajan). The Liberalised Exchange Rate Management System (LERMS) instituted in March 1992 was a dual exchange rate arrangement under which 40 per cent of the current receipts were required to be surrendered to the Reserve Bank at the official exchange rate while the rest 60 per cent could be converted at the market rate. The 40 per cent portion surrendered at the official rate was for meeting the essential imports at a lower cost. Although the experience with the dual exchange rate system in terms of volatility in the market determined segment of the forex market was satisfactory, it involved an implicit tax on exports and other invisibles receipts and thereby emerged as a source of distortion. As a system in transition, the LERMS performed well in terms of creating the conditions for transferring an augmented volume of foreign exchange transactions on to the market.

The unified market determined exchange rate regime replaced the dual regime on March 1, 1993 and since then "the objective of exchange rate management has been to ensure that the external value of the Rupee is realistic and credible as evidenced by a sustainable current account deficit and manageable foreign exchange situation. Subject to this predominant objective, the exchange rate policy is guided by the need to reduce excess volatility, prevent the emergence of destabilising speculative activities, help maintain adequate level of reserves, and develop an orderly foreign exchange market" (Jalan, 1999). In order to reduce the excess volatility in the foreign exchange market, the Reserve Bank has undertaken market clearing sale and purchase operations in the foreign exchange market to moderate the impact on exchange rate arising from lumpy demand and supply as well as leads and lags in merchant transactions. Such interventions, however, are not governed by any predetermined target or band around the exchange rate.

The experience with the market determined exchange rate regime has been satisfactory, although the exchange rate management had to occasionally contend with a few episodes of volatility. The period from March 1993 till August 1995 was a phase of significant stability. Capital inflows coupled with robust export growth exerted upward pressure on the exchange rate. However, the Reserve Bank absorbed the excess supplies of foreign exchange. In the process, the nominal exchange rate of the Rupee vis-à-vis the US Dollar remained virtually unchanged at around Rs.31.37 per US Dollar over the extended period from March 1993 to August 1995. The real appreciation that resulted from the positive inflation differentials prevailing during this period triggered off market expectations and resulted in a market led correction of the exchange rate of the Rupee during September 1995-February 1996. In response to the upheavals, the Reserve Bank intervened in the market and also resorted to monetary tightening so as to restore orderly conditions in the market after a phase of orderly correction for the perceived misalignment (RBI, 1996).

The period since 1997 has witnessed a number of adverse internal as well as external developments. The important internal developments include the economic sanctions imposed in the aftermath of nuclear tests conducted during May 1998 and the border conflict during May-June 1999. The external developments included, inter alia, the contagion from the Asian crisis, the Russian crisis during 1997-98, sharp increases in international crude oil prices in the period beginning with 1999, especially May 2000 onwards, and the post-September 11, 2001 developments in the US. These developments created a large degree of uncertainty in the foreign exchange market at various points of time, leading to excess demand conditions in the market (Chart VII.19). The Reserve Bank responded through appropriate intervention supported by monetary and other administrative measures like variations in the bank rate, repo rate, cash reserve requirements, refinance to banks, surcharge on import finance and minimum interest rates on overdue export bills. These measures helped in curbing destabilising speculation, while at the same time allowing an orderly correction in the value of the Rupee (Pattnaik, Kapur and Dhal, 2002).

A related issue that has figured in the literature is whether the exchange rate should be managed by monitoring Nominal Effective Exchange Rate (NEER) or Real Effective Exchange Rate (REER). "From a competitive point of view and also in the medium term perspective, it is the REER, which should be monitored as it reflects changes in the external value of a currency in relation to its trading partners in real terms. However, it is no good for monitoring short term and day-to-day movements as ‘nominal’ rates are the ones which are most sensitive of capital flows... Thus, in the short run, there is no option but to monitor the nominal rate" (Jalan, 2002).

Since the introduction of the market determined regime in March 1993, the Rupee has depreciated by 35 per cent upto February 2003 against the US dollar, i.e., from Rs.31.52 to Rs.48.73 per US dollar. In terms of effective exchange rates, the NEER depreciated by 31.1 per cent, while the REER (5 country trade based index) recorded a depreciation of 2.2 per cent during the period 1993-94 to 2002-03 (up to February 2003) (Table 7.15). A notable feature of the exchange rate in the recent years has been the two-way movement that has increased the risk profile of such market players who maintain open positions guided by the perception that the exchange rate can move only one way in India.

The Indian Rupee depreciated against all the other major currencies during the 10-year period 1993-94 to 2002-03 (up to February 2003). The Rupee depreciated against the Pound Sterling and the Japanese Yen by 37 per cent and 27 per cent, respectively, during this period. It depreciated against the Euro by 6 per cent between 1999-2000 and 2002-03 (up to February 2003).

As a whole, India’s current exchange rate policy seems to have stood the test of time. It has focused on the management of volatility without fixed rate target, while underlying demand and supply conditions are allowed to determine the exchange rate movements in an orderly way. The Reserve Bank will continue to follow the approach of watchfulness, caution and flexibility by closely monitoring the developments in the domestic and financial markets in home and abroad. It will co-ordinate its market operations carefully, particularly in regard to forex market with appropriate monetary, regulatory and other measures as considered necessary from time to time (RBI, 2002c).