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 - Preface & Introduction

The external sector has exhibited a marked transformation since the balance of payments crisis in 1991. The crisis was overcome by a series of stringent measures with an overriding objective to honour all external obligations without resorting to rescheduling of any external payment obligation. While successfully dealing with the crisis through an adjustment programme, it was decided to launch simultaneously a comprehensive programme of structural reforms in which the external sector was accorded a special emphasis.

After the 1991 crisis, the broad approach to reform in the external sector was laid out in the Report of the High Level Committee on Balance of Payments, 1993 (Chairman: C. Rangarajan). The objectives of reform in the external sector were conditioned by the need to correct the deficiencies that led to the payment imbalances of 1991. Recognising that an inappropriate exchange rate regime, unsustainable current account deficit and a rise in short-term debt in relation to the official reserves were the key contributing factors to the crisis, a series of reform measures was put in place. A swift transition to a market determined exchange rate regime was felt necessary so as to deal effectively with the uncertain response to reforms introduced in other areas of the external sector at that time. It may be recalled that other reforms initiated in the external sector included dismantling trade restrictions, moving towards current account convertibility, liberal inflows of private capital, removal of restrictions on all inflows and related outflows, as also, gradual liberalisation of certain restrictions on outflows. The overall objective of the reform process was to achieve higher growth and efficiency without exposing the system to greater vulnerability. Consumer welfare was sought to be improved by making available better quality products at globally competitive prices and by providing greater freedom of choice to residents to undertake current transactions on a global scale.

Responding to the reform process, the external sector has gained considerable strength, resilience and stability. This is evident from an unprecedented accretion to reserves, modest current account deficit (of late, a surplus), larger non-debt creating capital inflows, orderly exchange rate movements and containment of external debt within sustainable levels. Notwithstanding these comforts, there are areas of concern and challenges, arising primarily from the growing openness of the economy, the need for accelerating growth in the medium-term and also the need to meet the Tenth Plan growth target through higher capital flows for investment. In this context, while it is important to review and assess the impact of various reform programmes and policies relating to the external sector, there is also a need to examine a range of emerging issues. These include: current account sustainability in the wake of increased openness, the possibility of a "Dutch disease" type effect (on account of strong performance of software exports and remittances), more open capital account and cost of accretion to reserves, including its implications for monetary management.

Against this backdrop, this module attempts to profile the changes in the external sector and its implications for macroeconomic management. First four articles analyse the developments relating to trade liberalisation in terms of tariff rationalisation and dismantling of quantitative restrictions, institutional arrangements, strengthening of regional groupings and India’s position in the World Trade Organisation (WTO). The next three articles ( 5 to 7) discuss the changing structure of foreign trade, changing role of invisibles in the current account, and the current account balance in the post reform period. Articles 8 to 10 present an overview of the capital account developments and outlines the capital account liberalisation process in India. This section also offers an assessment of the external debt scenario in India and the exchange rate developments. Articles 11 to 13 examine the range of issues relating to adequacy of foreign exchange reserves and the associated implications for monetary management and growth.

External sector reforms were initially conditioned by the need to correct the deficiencies that led to the payments imbalance of 1991. Inappropriate exchange rate regime, unsustainable current account deficit and a rise in short-term debt in relation to the official reserves were the key factors contributing to the crisis. The swift transition to a market determined exchange rate regime was felt necessary to create an important pre-condition to deal with the uncertain responses to reforms introduced in other spheres of the external sector. These reforms include: dismantling of trade restrictions alongwith tariff rationalisation, moving in the direction of current account convertibility, liberal inflows of private capital, removal of restrictions on all inflow-related outflows and gradual liberalisation of restrictions on outflows involving residents. Simultaneously, priority was accorded to make available better quality products at globally competitive prices, and provide greater freedom of choice to residents to undertake current transactions on a global scale.

The strength and resilience of the external sector has been the hallmark of India’s macroeconomic environment during the last decade. Amidst a series of crises in several emerging markets, India successfully avoided any crisis while consistently pursuing a process of opening up to benefit from larger access to global markets, private capital, foreign technology and global competition. At every stage of major policy reforms - from the switchover to a market determined exchange rate regime in March 1993 to the recent phasing out of quantitative restrictions on imports - there were apprehensions in certain quarters that the economy may become more vulnerable to crises as a result of reforms. However, in the pursuit of a prudent capital account liberalisation, the timing, pacing and sequencing of reforms seemed to have been influenced by both the capability of the economy to withstand shocks in terms of its ability to meet initial pre-conditions, and the need for avoiding policy reversals. On account of this gradualist approach to the reform process, the external sector acquired strength and greater stability. This is exemplified by modest deficit/surplus in the current account, strong capital flows in relation to the financing-gap and absorptive capacity of the economy, orderly exchange rate, comfortable foreign exchange reserves and sustainable external debt.

The success of India’s exchange rate policy in managing volatility without a fixed exchange rate target has been reflected in maintaining the exchange rate of the Rupee at a realistic level during the reform period. Recent international research on viable exchange rate strategies in emerging markets has lent considerable support to the exchange rate policy followed by India.

The policy of emphasising non-debt creating flows and de-emphasising debt creating flows and short-term debt has been reflected in the consolidation of external debt. The accretion to higher level of foreign exchange reserves brought about primarily by non-debt creating capital flows has ensured sustainability of the external debt. These achievements not only led India to be classified as a "less indebted country" by the World Bank but also enhanced the credibility of the Indian economy in international fora.

In terms of reserve adequacy indicators, India is among the leading reserve holding countries in the world, which has encouraged the authorities to utilise reserves to prepay high cost debt. The high level of foreign exchange reserves has not only provided strength to the Indian economy by fostering stability to the exchange rate, sustainability to the external debt and credibility to the capital account liberalisation process, but also provided enormous support against unforeseen external shocks

The reserve management policy coupled with the exchange rate management and monetary policy pursued by the Reserve Bank has created an atmosphere of a soft interest rate regime which is conducive to higher economic growth. In addition, the recent policy initiatives undertaken by the Reserve Bank and the Central Government have created an investment atmosphere where foreign investment supplements domestic investment, which in a medium term perspective, would ensure a growth trajectory consistent with the Tenth Five Year Plan.

Notwithstanding the favourable developments in the external sector, there are several short-run and medium-run policy challenges. In the short-run, the major challenge comes from the surge in capital inflows and there is a need for fully channelling these flows into the productive activities. Assuming that the short run absorptive capacity of the economy is sticky but can be augmented in the medium-term, there are at least four policy options to deal with excess market supply. The first option is to allow the Rupee to appreciate, which by increasing imports and reducing exports would allow capital inflows to be utilised. This, however, raises the issue of sustainability of balance of payments, particularly, in view of the synchronised current global economic slowdown that has implications for the export prospects of developing countries. Under these circumstances of the BoP turning unsustainable due to weak export performance, a change in market expectations could induce reversal of capital flows and can trigger a crisis. The second alternative is to tighten regulation of capital inflows, which needs to be avoided keeping in view the medium-term larger financing requirements for growth as envisaged in the Tenth Five Year Plan. The third alternative is to hasten the pace of liberalisation of restrictions on capital outflows, which would be justifiable only when all the preconditions to liberalisation are met. The fourth option is to absorb capital inflows in the form of higher foreign exchange reserves.

In the medium-run, the policy challenges primarily arise from the need to meet both the Tenth Plan growth targets and the export targets envisaged by the Government. Accordingly, the current account deficit (CAD) is targeted at a higher average of about 2.8 per cent of GDP consistent with the Tenth Plan growth target. Such widening of the current account deficit will only be achieved if there is a much higher import growth than experienced in recent years. Such change will take place only if there is a resurgence of both public and private sector investment. A 12 per cent compound annual growth in exports is also envisaged in the Medium Term Export Strategy (2002-03 to 2006-07) and this would have to be achieved and sustained if India were to raise its share in world exports from 0.7 per cent at present to 1 per cent over the next five years. This is perceived as a necessary condition for the sustainability of balance of payments; else, there could be a significant depletion of reserves, which may have adverse consequences unless the exchange rate depreciates substantially. The important challenge, thus, would be to boost export growth, along with higher import, attract larger capital inflows to finance the planned level of CAD and maintain comfortable reserves consistent with the requirements of a growing and increasingly integrated economy. As regards the exchange rate policy, the preferred option would be to continue with the present policy approach of managing volatility with no fixed rate target, which has stood the test of time.

Despite the success of the policy efforts pursued in the external sector, there remain a few areas of challenge requiring sustained efforts. India’s tariff rates continue to be high relative to South East Asian levels. The Government has, however, already indicated a move in tariffs comparable to the East Asian levels by 2004-05. The customs procedures, though somewhat simplified, need further rationalisation. The growth in merchandise exports needs to be leveraged further. A robust growth in exports alongwith import growth would impart efficiency gains to the economy. India has taken an active role in the Doha Development Agenda but collective efforts would be required from all developing countries in order to benefit from the negotiations. In addition, larger financing requirements for growth as envisaged in the Tenth Five Year Plan underline the need for further concerted efforts in the direction of attracting higher FDI. Therefore, along with the liberalisation of both, inward and outward capital flows, a more focused approach should be pursued for attracting higher FDI flows which is important for achieving higher economic growth.

Despite a relatively lower degree of openness, synchronisation of global business cycles has emerged as a policy concern, particularly because a global slowdown in economic activity seems to influence the domestic investment climate more than the actual volume of trade and capital flows. The current phase of global slowdown that started in mid-2000 suggests a weaker and delayed global recovery than was initially anticipated. Uncertain global prospects would also have a bearing on the course of future reforms in the external sector.