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

Foreign Investment, NRI Deposits External Commercial Borrowings

Foreign Investment

During the first three decades after independence, foreign investment in India was highly regulated. In the 1980s, there was some easing in foreign investment policy in line with the industrial policy regime of the time. The major policy thrust towards attracting foreign direct investment (FDI) was outlined in the New Industrial Policy Statement of 1991. Since then, continuous efforts have been made to liberalise and simplify the norms and procedures pertaining to FDI. At present, FDI is permitted under automatic route subject to specific guidelines except for a small negative list. In the recent period, a number of measures have been taken to further promote FDI. These include: raising the foreign ownership cap to 100 per cent in most of the sectors, ending state monopoly in insurance and telecommunications, opening up of banking and manufacturing to competition and disinvestment of state ownership in Public Sector Undertakings (PSUs). Though the FDI companies have generally performed better than the domestic companies, FDI to India has been attracted mainly by the lure of the large market (RBI, 2002b).

Responding to the policy efforts, foreign investment inflows to India (direct and portfolio investments taken together) picked up sharply in 1993-94 and have been sustained at a higher level with an aberration in 1998-99, when global capital flows were affected by contagion from the East Asian crisis. Total foreign investment has averaged at US $ 5.4 billion during the three year period 1999-2000 to 2001-02 as against negligible levels of the 1980s. However, this level of flows matches the average recorded in the earlier three-year period 1994-95 to 1996-97. FDI, which was US $ 0.6 billion in 1993-94 increased sharply over the years to US $ 3.9 billion in 2001-02. Foreign portfolio investment (FPI) on the other hand, has shown larger year-to-year variations, moving in the range of a net inflow of US $ 3.8 billion in 1994-95 to a net outflow of US $ 61 million in 1998-99.

An industry-wise breakup reveals that the direction of FDI inflows has undergone a structural change over the reform period in line with the policy efforts. During the year 2001-02, computers, electronics and electrical equipments accounted for 34 per cent while services accounted for around 38 per cent of total FDI (excluding NRI investment). A country-wise breakup of FDI inflows reflects the increasing importance of Mauritius as the source of FDI in India during the recent years. This pattern highlights, in a sense, the role of tax policies in influencing the pattern of FDI flows at the global level.

Although India took significant steps towards inviting FDI in pursuance of its policy of emphasising non-debt creating capital inflows during the reform period, the actual FDI inflows did not pick up on the expected lines. FDI inflows in India remained low in comparison to other emerging market economies. An international comparison of annual average FDI and FPI inflows for the period 1997-2001 shows that such inflows to India were lower than those to emerging market economies like Argentina, Brazil, China, Korea, Mexico, Thailand and Malaysia. India’s failure to attract enhanced inflows of FDI strongly underlines the need for further reforms in this context (Bhagwati, 2001). Given the projected need for financing infrastructure projects, on a rough and ready estimate, about 15 per cent of the total infrastructure financing may have to come from foreign sources. Since the ratio of infrastructure investment to GDP is projected to increase from 5.5 per cent in 1995-96 to about 8 per cent by 2006, with a foreign financing of about 15 per cent, foreign capital of about 1.2 per cent of GDP has to be earmarked only for the infrastructure sector to achieve the GDP growth rate of about 8 per cent (RBI, 2001b).

While inward FDI has been actively pursued, the policy framework has also been substantially liberalised in regard to direct investment from India to other countries during the 1990s. Overseas investment in Joint Ventures (JVs) or Wholly Owned Subsidiaries (WOS) have been recognised as important instruments for promoting global business by Indian entrepreneurs. Continuing with the direction of liberalisation of the capital account, companies have been allowed to invest abroad in JVs or WOS with limits which have been relaxed from time to time. At present, the complete use of American Depository Receipts (ADR)/ Global Depository Receipts (GDR) proceeds and the EEFC account balance for this purpose is also permitted. Taking advantage of the policy, the Indian investment abroad has increased from very meagre amounts in early 1990s to US $ 190 million in 1995-96 and further to US $ 639 million in 2001-02. The current levels, however, do not reflect the full potential of the Indian business and its improved competitiveness after a decade of wide-ranging reforms.

Like FDI, the environment for FPI was also made more congenial through procedural changes for investment and by offering more facilities for investment in equity securities as well as in debt securities to a select category of portfolio investors, viz., the Foreign Institutional Investors (FIIs). Furthermore, the sectoral limits for FIIs in the Indian companies were progressively increased over time; these limits have been done away with altogether, except in select specified sectors. The NRIs, Overseas Corporate Bodies (OCBs) and Persons of Indian Origin (PIOs) are also permitted to invest in shares and debentures of Indian companies, government securities, commercial papers, company deposits and mutual funds floated by public sector banks and financial institutions.

NRI deposits in the form of Non-Resident (External) Rupee Account (NR(E)RA) and Foreign Currency Non-Resident Account (FCNR(A)) emerged as a steady flow of foreign capital in India from the 1970s, following the labour migration boom in West Asia in the wake of the first oil shock. The onset of the 1990s saw the introduction of as many as five NRI deposit schemes [Foreign Currency Bank and Ordinary (FC(B&O)), Foreign Currency Ordinary NonResident (FC(ON)), Non-Resident Non-Repatriable Rupee Deposit (NR(NR)RD), Non-Resident Special Rupee Account (NR(S)RA) and Foreign Currency NonResident Bank (FCNR(B))] between 1990 and 1993 designed to attract foreign exchange in the face of external payments crisis of 1991. With the recovery of the external sector, taking into account the lessons of the experience of various NRI deposit schemes during the 1980s and their contribution in aggravating the payments imbalance of 1990-91, the policies with regard to NRI deposits during the 1990s have been aimed at attracting stable deposits. This has been achieved through: (i) a policy induced shift in favour of local currency denominated deposits; (ii) rationalisation of interest rates on rupee denominated NRI deposits; (iii) linking of the interest rates to LIBOR for foreign currency denominated deposits; (iv) de-emphasising short-term deposits (up to 12 months) in case of foreign currency denominated deposits; and (v) withdrawal of exchange rate guarantees on various deposits. The Reserve Bank has also made an active use of reserve requirements on these deposits as an instrument to influence monetary and exchange rate management and to regulate the size of the inflows depending on the country’s requirements. Continuing with the policy of progressive liberalisation of capital account, the NR(NR)RD scheme was discontinued with effect from April 1, 2002 and the maturity proceeds of NR(NR)RD can be credited to the account holder’s NRE account only on maturity

In line with the above policy perspective, the 1990s witnessed the discontinuation of all foreign currency denominated schemes, where exchange guarantee was provided by the Reserve Bank. In order to minimise the short-term debt burden of the country, the minimum maturity for FCNR(B) deposits has been raised from six months to one year. In view of the Government’s policy of deregulating the interest rates, the banks are free to determine the interest rates on rupee denominated NRI deposits. The interest rate on foreign currency denominated FCNR(B) deposits has been linked to LIBOR in order to reduce the arbitrage possibilities.

An analysis of the movement in NRI deposits reveals that outstanding NRI deposits grew steadily from US $ 13.7 billion at end-March 1991 to US $ 25.2 billion at end-March 2002. Deposits under the FCNR(B) scheme increased from US $ 1.1 billion at end-March 1994 to US $ 9.7 billion at end-March 2002. In case of NR(E)RA scheme, the deposits increased from US $ 3.6 billion as at end-March 1991 to US $ 8.4 billion as at end-March 2002. On the other hand, for the non-repatriable rupee denominated NR(NR)RD scheme, the outstanding balances increased from US $ 621 million in 1993 to US $ 7.1 billion at end-March 2002.

The NRI deposits have emerged as a major source of capital inflows during the 1990s. Apart from the size, the success of the policy towards NRI deposits is also reflected in an increase in the proportion of local currency denominated deposits (from around one-fourth in 1991 to almost two-third by 2002) and a substantial decline in short-term NRI deposits.

Commercial debt capital includes a whole range of sources of foreign capital where the overriding consideration is commercial. External commercial loans include bank loans, buyers’ credit, suppliers’ credit, securitised instruments such as Floating Rate Notes and Fixed Rate Bonds, commercial borrowings and the private sector window of multilateral financial institutions.

The policies towards External Commercial Borrowings (ECBs) since the reform programme have been guided by the overall consideration of prudent external debt management by keeping the maturities long and cost low. ECBs are approved within an overall annual ceiling. Over time, the policy has been guided by a priority for projects in the infrastructure and core sectors such as power, oil exploration, telecom, railways, roads and bridges, ports, industrial parks, urban infrastructure and for 100 per cent Export Oriented Units (EOUs). To allow further flexibility to borrowers, end-use and maturity prescriptions have been substantially liberalised. Moreover, corporates have been allowed to borrow upto a certain limit under the ‘automatic route’. Apart from these, special bonds (India Development Bonds (IDBs), Resurgent India Bonds (RIBs) and India Millennium Deposits (IMDs)) were issued by the State Bank of India aimed at NRIs. The success in mobilising foreign exchange resources through such exceptional schemes reflected the confidence of the global investor community in the Indian economy and imparted an element of stability to the external sector and the overall balance of payments position.

At times, the rationale behind raising such high cost debt capital has been questioned. Experience, however, would suggest that each time this option was resorted to, it helped in strengthening the confidence in the Rupee and the ability of the country to honour its obligations. The costs of an exchange rate crisis are too severe in relation to cost of debt capital. In a situation of moderate debt-service ratio, such debt capital makes more sense than allowing the exchange rate to fall under pressure. As in the event of payments crisis such as that in 1991, servicing of short-term debt can become difficult, the policies in the 1990s have regulated build-up of short-term debt by allowing short-term credits only for trade-related purposes. Until recently, suppliers’ credits of more than 180 days and buyers’ credit of all maturities required prior approval from the Reserve Bank. Effective September 2002, with a view to simplify and liberalise the exchange control procedures, the prior approval of the Reserve Bank has been dispensed with for amounts not exceeding US $ 20 million per import transaction. 7.67 Over the same period, official aid has waned in importance. This reflected mainly growing amortisation payments in the face of sluggish disbursements of external assistance as also availability of alternative private capital flows. Unlike aid, the share of ECBs in total capital flows have increased from around 31 per cent in 1990-91 to around 40 per cent in 1997-98. This has been mainly on account of the higher appetite for ECBs in view of the strong import demand and industrial growth. Subsequently, the increase in ECBs was entirely on account of RIBs and IMDs in 1998-99 and 2000-01, respectively, as the demand for ECBs remained low on account of weak investment demand.

The impact of the continuum of reforms initiated in the aftermath of the balance of payments crisis of 1991 on India’s current account and capital account resulted in an accumulation of foreign exchange reserves of over US $ 70 billion as at end-February 2003. Capital account surplus increased from US $ 3.9 billion during the 1980s to US $ 8.6 billion during 1992-2002 with a steadily rising foreign investment. As a proportion of GDP, capital flows increased from 1.6 per cent during 1980s to 2.3 per cent during 1992-2002. The significant increase in capital flows during the 1990s raises the issue of their determinants as well as their impact on growth. Granger-causality tests indicate a unidirectional causation from net capital flows in the Indian context to growth in GDP over the 1970-2000 period. On the other hand, a componentwise analysis suggests that non-debt creating flows seem to Granger cause GDP growth. Capital flows, both debt and non-debt, have also been found to crowd-in investment. Non-debt creating flows are discouraged by a higher fiscal deficit and exchange rate depreciation while greater openness and higher reserves have a positive effect on such flows (RBI, 2002b).

The sustained increase in capital inflows as discussed above, coupled with the moderate current account deficit, resulted in a surplus from 1993-94 onwards (excepting 1995-96) in the overall balance of payments. The surplus amounted to US $ 11.8 billion in 2001-02 as against a deficit of US $ 0.6 billion in 1992-93.

The evolution of capital flows over the 1990s reveals a shift in emphasis from debt to non-debt flows with the declining importance of external assistance and ECBs and the increased share of foreign investment - both direct and portfolio. Apart from financing the current account gap, capital flows have played a significant role in India’s growth performance. Evidence of strong complementarity with domestic investment suggests that capital flows brighten the overall investment climate and stimulate domestic investment even when a part of the capital flows actually gets absorbed in the form of accretion to reserves. The growth-augmenting role of foreign capital, particularly FDI, however, seems to have been constrained by the low levels of actual and planned absorption of foreign capital in India (RBI, 2001). The key indicators of balance of payments as explained in Table 7.13 show considerable improvement in India’s balance of payments since 1991.