PERSPECTIVES

Some Issues in External Broadly speaking, there were three

types of changes. First, India gave up the

Sector Management inward-looking approach and abandoned

the import substitution policy that domi-
nated India’s economic policy since inde-
pendence. India signalled that it was
C Rangarajan boldly abandoning its export pessimism
and was accepting the challenge of inte-

I
The Indian external sector has t is a great honour to deliver the grating into the world economy. The new
undergone radical changes post Saumitra Chaudhuri Memorial Lec- policy effectively meant the beginning
ture. More than an honour, it is my of a process of dismantling all quantita-
1992. Against this background, an
duty. For almost a decade, Saumitra and tive controls and reducing the tariff rate
attempt is made to look at the role I interacted on a daily basis, examining on imports to levels seen in other emer-
of the exchange rate, level of many issues and problems confronting the ging industrialised countries. A World
current account deficit, adequacy economy. Saumitra was a versatile econo- Bank (2014) study finds that the weighted
mist who was at home in every branch of mean tariff rate on manufactured prod-
of foreign exchange reserves and
economics. However, he was particularly ucts came down from 76.3% in 1990 to
capital flows, and capital account focused on financial markets—both do- 8.3% in 2009.
convertibility. The balance of mestic and foreign—and the external The second change was with respect
payments in India has been environment. While he carefully looked to exchange rate management. The deval-
at developments in most economies, he uation of the Indian rupee in 1991 was an
managed well so far. There is a
was especially a keen observer of the important first step. But that does not con-
need to increase export Chinese economy. Invariably, Saumitra stitute a reform. The exchange rate of the
competitiveness, which requires wrote the first draft of the two reports rupee until then was determined by the
among other things an efficient, which the Economic Advisory Council Reserve Bank of India (RBI) by linking
used to put out. It was his draft which its value to a basket of currencies. But, in
well-knit infrastructure. To
was subsequently discussed and approved the 1980s, we had virtually moved away
prevent a rise in the real effective with whatever modifications that were from the basket. The rupee in nominal
exchange rate, we should keep found necessary. One must also mention terms had decreased steadily. Since the
domestic prices stable. The the extraordinary feel that Saumitra had mid-1980s, there was in fact a substantial
for data. It was in the fitness of things that reduction in real terms. In 1991, we moved
surpluses in the services sector
he was asked to chair several committees first to a dual exchange rate system (RBI
will also need nurturing. to revise the data series, such as the Index 2013) and, in early 1993, we moved to a
of Industrial Production. His laptop was market-determined exchange rate system.
a treasure house of information. In the The system, however, does not preclude
demise of Saumitra, the country has lost interventions by the RBI. The Indian cur-
an eminent economist, a serious thinker, rency became convertible on the current
and a critical analyst. The country will account in 1994.
sadly miss his inputs on policymaking. The third important change was with
Since one of Saumitra’s interests was the respect to the financing of the current
external sector, I have chosen to speak account. The new regime allowed foreign
today on some issues in external sector direct investment (FDI) over a wide range
management. of sectors with even majority ownership
except in certain areas. Portfolio invest-
Break with the Past ment in Indian stocks was of course per-
The year 1991 was a great divide in India’s mitted to financial institutional investors.
post-independence economic history. The Thus, the landscape of the external
This is the edited version of the Saumitra country faced an acute economic crisis sector went through far-reaching changes.
Chaudhuri Memorial Lecture delivered on triggered by a severe balance-of-payments Contrary to fears expressed in some
16 March 2018. The author is grateful to (BoP) problem. The crisis was converted quarters at that time, India’s new external
Priyadharshini for her assistance in the writing
into an opportunity to bring about fun- sector regime has turned out to be on
of this article.
damental changes in India’s economic the whole beneficial. While the need to
C Rangarajan ([email protected]) is an policy. One area that underwent a deep be on the watch continues, the external
economist.
transformation was the external sector. sector has acquired sufficient resilience
34 MAY 26, 2018 vol lIiI no 21 EPW Economic & Political Weekly
 PERSPECTIVES
Figure 1: Current Account Deficit, Trade Balance, and Net Invisibles (% of GDP) in 2014–15, the dominant flows were FDI,
8 which was equivalent to 1.5% of GDP,
and portfolio investment, which was
equal to 2.1% of GDP. In absolute terms,
4
FDI in 2016–17 was $35.6 billion and
Net invisibles
portfolio investment was $7.6 billion.
Figure 2 shows the behaviour of the two
0
2000–01 2002–03 2004–05 2006–07 2008–09 2010–11 2012–13 2014–15 2016–17 inflows over the years. While FDI has
shown a steady rise, portfolio invest-
ment fluctuates, even turning negative
-4
Current account deficit
in 2008–09 and 2015–16. Portfolio in-
vestment is strongly influenced by the
-8 worldwide trends in stock markets.
Trade balance The net effect of the capital flows and
the CAD is the change in foreign exchange
Current Account Deficit(% of GDP) Trade Balance (% of GDP) Net Invisibles(% of GDP)
-12 reserves. At the height of the 1991 crisis,
Source: Handbook of Statistics on Indian Economy, RBI. our reserves were hardly a few billion dol-
Figure 2: Foreign Direct Investment and Foreign Portfolio Investment ($ bn) lars. Today, these reserves stand at $420
60
billion. While the size is comforting, it
must be noted that these have been built
out of excess capital flows rather than
40
current account surpluses.
Direct investment
Portfolio investment
Export Performance
Before moving to review some critical
20
issues relating to the external sector, we
need to have some understanding of the
behaviour of exports and imports. In the
0
2000–01 2002–03 2004–05 2006–07 2008–09 2010–11 2012–13 2014–15 2016–17 first few decades after India’s independ-
ence, the pursuit of the imports substitu-
tion strategy had an adverse impact on
-20
Source: Handbook of Statistics on Indian Economy, RBI.
India’s exports. India’s share in world
exports, which stood at 1.85% in 1950,
to withstand shocks. Unlike many of the problems in 2011–12. However, 2012–13 came down to 0.50% by 1991. The share
East Asian countries, including China, was different and the authorities had to started moving up in the post-liberalisation
which have a current account surplus, take specific measures to contain im- period and touched 1.70% in 2013. This
India still has a current account deficit ports, particularly of gold. Since 2012–13, was possible only because Indian exports
(CAD). The trade deficit is high. The CAD the average CAD has been 1.2% of GDP. grew at a faster rate than world exports.
is low because of the surplus in services. It is likely that in 2017–18 the CAD may In fact, there is a strong correlation be-
It is imperative that we strive towards be 2% of GDP. The merchandise trade tween India’s export growth and world
keeping the CAD at a level that can be balance reached a peak of deficit of 10.4% export growth (Table 1, p 36).
financed by normal capital flows. in 2012–13. Even though it has come India’s exports started rising in the
down, it still remains high at 5% as 1980s. There were a number of policy
Balance of Payments of 2016–17. Invisibles accounted for a initiatives undertaken at that time to help
Let us now take a look at some of the surplus of 4.3% of GDP in 2016–17. With- export promotion (Panagariya 2004a,
salient features of our external sector. In in it, net transfers constituted 2.5% of 2004b). However, India’s exports just kept
1990–91, India’s CAD stood at 3% of the GDP. These numbers show broadly the pace with world exports so that India’s
gross domestic product (GDP). The prob- strength and vulnerability. share in world exports did not show any
lem at that time was twofold: one, the On the financing side of the CAD, there increase. A strong pickup happened post
CAD was high; and, second, it could not is a sea change. In 1990–91, there was 1992. Between 1993 and 1997, the aver-
be financed. That is why the crisis neither FDI nor portfolio investment. age annual growth rate was 12.4% and
exploded. Figure 1 depicts India’s CAD. The three elements that dominated the India’s share in world exports went up to
The CAD has come down since 1991–92, sources of financing were net external 0.63%. In 1998, the export growth fell
except in 2011–12 and 2012–13, when it assistance, net commercial borrowings, and turned negative, primarily because
touched unusually high levels by cross- and non-resident Indian deposits, each of the East Asian crisis. India’s exports
ing 4%. But, the financing posed no equivalent to 0.7% of GDP. In contrast, started showing strong growth from
Economic & Political Weekly EPW MAY 26, 2018 vol lIiI no 21 35
PERSPECTIVES

2000. Between 2000 and 2008, India’s is the rise in petroleum products. Oil prices until recently. Despite a reasonably
exports grew at 21% annually, taking its exports, which stood at $397 million in good performance with respect to exports,
share in world exports to 1.21%, a virtual 1993–94, jumped to $63,179 million in if the trade deficit has widened it is
doubling of its share in nine years. The 2013–14. The share of petroleum products because of the sharp rise in certain cate-
impact of the financial crisis of 2008 led to total exports has reached 20.1%. In gories of imports. Apart from oil, electronic
to a negative growth of 15.4% in 2009. the last two years, when India’s export goods have also shown a steep increase.
In the same year, world exports fell by value fell, one of the significant contri- At around $40 billion, they account for
22.3%. India’s export performance picked butors was petroleum products, because 10% of total imports. They accounted for
up strongly in 2010 and 2011. Thereafter, of the sharp fall in oil prices (Table 2). In less than 3% in 1998–99. Another item
the performance has been weak. In both 2015–16, the top eight export sectors that has shown a sharp upward surge is
2014–15 and 2015–16, the export growth were petroleum products, gems and gold. In 2003, India’s gold imports were
turned negative. In 2015–16, India’s jewellery, textiles, chemicals and allied 854 tonnes, valued at $5.4 billion. In
exports declined more strongly than products, agriculture and allied sectors, 2015, they went up to 1,047 tonnes, valued
world exports. In 2016–17, there was a transport equipment, base metals, and at $35 billion.
positive growth of 5.4%. This came, machinery. It must, however, be noted There were years like 2011 and 2012
however, on a low base. India’s CAD has, that the share of some of the sectors, like when the value of imports of gold crossed
however, been contained at a low level textiles, has been declining. $50 billion. These three categories—oil,
in the last few years despite the poor Table 2: Growth Rates for India’s Oil Exports, electronic goods, and gold—will require
performance of exports because imports Non-oil Exports and Total Exports (%) different approaches if we have to con-
Year Oil Exports Non-oil Exports Total Exports
declined even more sharply due to the 2001–02 13.30 -2.30 -1.60
tain their growth. To contain import of
steep decline in oil prices. In 2017–18, dur- 2002–03 21.60 20.20 20.30 crude oil, efforts need to be directed to-
ing the period from April 2017 to Janu- 2003–04 38.50 20.20 21.10 wards more efficient use of energy, find-
ary 2018, the export growth was 11.74%. 2004–05 95.90 27.00 30.80 ing alternative sources of energy, and in-
Export growth in value terms is com- 2005–06 66.50 19.50 23.40 creasing domestic production. As far as
posed of growth in quantum and price 2006–07 60.10 17.90 22.60 electronic goods are concerned, attention
changes. Table 1 provides the behaviour 2007–08 52.20 24.80 28.90 is needed to expand the domestic base of
of the quantum index of India’s exports. 2008–09 -2.90 17.20 13.70 production. Gold import is deeply rooted
2009–10 2.30 -4.60 -3.50
It is seen that there is much less volatility in the Indian psyche. High inflation forces
2010–11 47.10 39.30 40.50
in the quantum figures than in value people to use gold as a hedge. While
2011–12 35.10 19.20 21.80
figures. The commodity composition of moderation in inflation will help, over a
2012–13 8.60 -4.20 -1.80
India’s exports has undergone many 2013–14 3.80 4.90 4.70
period of time the lure towards gold
changes, the most significant of which 2014–15 -10.10 0.90 -1.30 must be weaned. So far, the various gold
Table 1: Growth Rates of India’s Exports (Value 2015–16 -46.20 -8.60 -15.50 schemes introduced by various govern-
and Volume), World Exports (Value and Volume), 2016–17 3.40 5.70 5.40 ments have not had much of success. The
and Share of Indian Exports (%)
Year World Indian Share of World Indian
Source: Handbook of Statistics on Indian Economy, RBI. idea that gold is a better investment
Exports Exports Indian Exports Exports An analysis of region-wise exports avenue is also not always true. Gold
Growth Growth Exports Volume Quantum
Index Index clearly indicates a shift towards faster- prices also rise and fall. For example, in
Change Change growing economies. The share of exports 2010–11, the price of gold per ounce was
2000 13.0 18.8 0.7 * 25.0
going to European Union countries has $1,293. After rising for the next two
2001 -4.1 2.3 0.7 0.2 0.8
2002 4.9 13.6 0.8 4.0 19.0 come down from 26.1% in 1993–94 to years, it fell and, as of 2016–17, it stood
2003 16.9 19.7 0.8 6.3 7.3 16.5% in 2013–14. On the other hand, the at $1,258 per ounce. Of course, in rupee
2004 21.5 30.0 0.8 11.0 11.2 share of exports to developing Asian coun- terms, it has not fallen because of the
2005 13.9 30.0 0.9 6.8 15.1 tries has increased from 22.0% to 30.4% depreciation of the rupee in terms of the
2006 15.4 22.3 1.0 8.4 10.2 during this period as per the Handbook of dollar. However, between 2000 and
2007 15.6 23.3 1.1 6.7 7.9
Statistics on Indian Economy (RBI 2017). 2017, gold prices in rupee terms went up
2008 15.2 29.8 1.2 1.8 9.0
6.4 times. During the same period, the
2009 -22.3 -15.4 1.3 -11.9 -1.1
Import Behaviour Sensex went up 6.7 times (Table 3, p 37).
2010 21.9 37.3 1.5 14.6 15.2
2011 18.9 33.8 1.6 5.9 8.9 In the post-liberalisation period, imports
2012 0.8 -2.0 1.6 3.4 7.9 have shown a steady increase from $27.9 Factors Influencing Exports
2013 2.5 6.1 1.7 3.2 5.9 billion in 1990–91 to $393 billion in Given this background, what are our
2014 0.3 2.5 1.7 2.0 5.0 2016–17. As a proportion of GDP, they concerns? It must be said that manage-
2015 -13.3 -17.1 1.6 1.4 -27.0
stand at close to 20%. There have been ment of the external sector is one of the
2016 -3.2 -1.3 1.6 1.7 7.9
(1) Quantum Index of Indian Exports is provided in fiscal
years when it had touched 27% of GDP. success stories of liberalisation. Prior to
year basis starting 2000–01 to 2016–17. The rise in imports of oil is explained by 1992, India had to go to the International
(2) * Data not available.
Source: World Development Indicators, World Bank and
the growth in the economy, stagnation Monetary Fund (IMF) six times at periodic
Handbook of Statistics on Indian Economy, RBI. in domestic production, and the rise in oil intervals to tide over the BoP difficulties.
36 MAY 26, 2018 vol lIiI no 21 EPW Economic & Political Weekly
 PERSPECTIVES

Post 1992, there has been no such occa- Figure 3: Change in REER Index, Quantum Index of Indian Exports, and Growth Rate for India’s Exports (%)
sion. Even in 2013, when India had a 40
%
sudden shock because of the withdrawal
of capital consequent on the United Quantum index change
20
%
States’ Federal Reserve’s (Fed) intended
decision to bring to close the easy mone-
tary policy, we were able to manage on
0
%
our own. The low CAD in the last few
years has also been helped by a steep
drop in crude oil prices. They have, REER change
-20
%
however, begun to rise again. If we have
to maintain stability on the external
account, what are the areas in which
-40
%
action is required? To what extent can 2001–02 2003–04 2005–06 2007–08 2009–10 2011–12 2013–14 2015–16 2016–17
we leverage external demand to spur Source: Handbook of Statistics on Indian Economy, RBI.
growth? Is the concept of export-led
growth relevant today? In the days when prices. Besides the sharp decline in deemed to be unsustainable (Rangarajan
South Korea, Taiwan, and Thailand were crude oil prices, there has been a de- and Mishra 2013). On the role of the
going ahead with huge trade surpluses, cline in other prices such as metals exchange rate, there are some who
it was felt that what was applicable to and minerals. The revival of India’s ex- strongly hold the view that the rupee
small countries did not hold good for a ports depends strongly on the pace of should be kept undervalued. The fre-
big country like India. Then, China came the recovery of advanced economies. It quently cited example is that of the East
and moved ahead with rapid growth, also points to the need for Indian ex- Asian countries in the 1970s and 1980s
supported by a strong external sector. ports to shift the direction of trade even that were able to maintain strong export
China’s exports equal $2 trillion, compared more towards faster-growing emerging growth by keeping the value of their
to India’s merchandise exports of $200 market economies. currencies low. In theory, there is no
billion. China’s share in world exports is In the export demand equation, the doubt that the exchange rate as a price
14%. There is still an opportunity there, exchange rate can be taken as a kind of variable must have an impact on the
even though the external environment price variable. If the Indian rupee is volume of exports. However, how strong
is getting cloudy. overvalued, it has a negative impact on the variable is will be known only
We have already reviewed the behaviour India’s exports. In popular perception, through empirical testing. A visual in-
of India’s exports. In the post-liberalisation the rupee’s value in relation to the dollar is spection of the two indices does not pro-
era, there have been periods of sharp dominant. However, we need to look at vide any evidence (Figure 3; Figure 4,
increase in exports. At a theoretical level, the behaviour of the rupee in relation to p 38). The impact of the exchange
there are three factors that influence the currencies of our major trading
Table 3: Gold Prices in `/10 gm and $/10 gm
India’s exports. partners. That is why the RBI started con- and Sensex
An important factor influencing India’s structing the nominal effective exchange Year `/10 gm $/10 gm Sensex Change in Change in
Sensex Gold Price
exports is the behaviour of the GDP of rate (NEER) and real effective exchange
(%) (`) (%)
importing countries or world GDP. This rate (REER) beginning in the late 1980s. 2000 4,119.4 88.25 3,972.12
is the direct income effect. As the incomes We now have two series under each head 2001 4,287.08 88.91 3,262.33 -17.87 4.07
of importing countries increase, they depending on the number of countries 2002 5,353.13 111.64 3,377.28 3.52 24.87
increase expenditure, part of which spills included. The REER is the NEER adjusted 2003 6,106.56 133.84 5,838.96 72.89 14.07
into imports. The contrary behaviour for relative inflation. The weights can 2004 6,088.59 140.06 6,602.69 13.08 -0.29
occurs when incomes fall. As referred to depend upon either exports or total 2005 7,424.48 164.95 9,397.93 42.33 21.94
earlier, India’s exports follow a pattern trade. The launch of the liberalisation 2006 8,994.31 203.22 13,786.91 46.70 21.14
similar to world exports, which can be reforms began with the devaluation of 2007 10,566.64 268.09 20,286.99 47.15 17.48
taken as a proxy for world GDP. For the rupee in two stages in early June 2008 13,625.15 279.66 9,647.31 -52.45 28.94
example, the 2008 crisis had an imme- 1991. The rupee was devalued by 17.38% 2009 16,272.28 349.68 17,464.81 81.03 19.43
2010 20,208.02 451.93 20,509.09 17.43 24.19
diate impact on India’s exports. The poor in relation to the sterling, which was
2011 26,142.68 492.28 15,454.92 -24.64 29.37
performance of India’s exports since then the intervention currency. India
2012 29,200.78 532.96 19,426.71 25.70 11.70
2014–15 is also largely a reflection of the moved to a new exchange rate regime in
2013 23,956.38 387.3 21,170.68 8.98 -17.96
tepid growth of advanced economies. February 1993 when the rupee was left 2014 2,4477.73 387.78 27,499.42 29.89 2.18
Apart from affecting the quantum of to be determined by and large by the 2015 2,2548.43 340.84 26,117.54 -5.03 -7.88
India’s exports, it had affected the value market. This, however, did not preclude 2016 25,007.14 368.46 26,626.46 1.95 10.90
of India’s exports in dollar terms because the RBI from intervening if there was 2017 26,495.6 415.11 26,711.15 0.32 5.95
of the fall in international commodity volatility in the market or if the rate was Source: World Gold Council and Historical Indices, BSE.

Economic & Political Weekly EPW MAY 26, 2018 vol lIiI no 21 37
PERSPECTIVES
Figure 4: Quantum Index of Indian Exports and REER Index Therefore, we need to examine the role
245 that the exchange rate can play a little
more closely.
215
Exchange Rate Policy
185 What should be the policy towards the
exchange rate? The stated policy of the
Quantum index
155 RBI is that it has no specific target and
that it intervenes only to reduce volatility.
125 This is only partially true. For example,
in 2007–08 when there was a huge in-
95
flow of capital, to prevent appreciation,
the RBI entered the market and bought
REER index dollars. This was responsible for the
65
2000–01 2002–03 2004–05 2006–07 2008–09 2010–11 2012–13 2014–15 2016–17 sharp increase in reserves. There are
REER base year: 2004-05=100. many other instances of intervention in
Quantum Index base year: 2004-05=100.
Source: Handbook of Statistics on Indian Economy, RBI. both directions that can be cited.
In the past, when capital inflows were
rate also depends on the import content significant. The REER is also significant “passive,” the exchange rate was merely
of exports. As this share goes up, the im- and is negatively related to exports. How- determined by the level of the CAD, that
pact will go down. The import content of ever, in some of the equations estimated, is, when the purchasing power parity
India’s exports has risen from 9.4% in the REER had a negative sign, but was theory held good. With the emergence of
1995 to 24% in 2011. not statistically significant. In the case of capital flows, as an independent factor,
While world GDP and exchange rate are service exports, the REER has a negative this is not true anymore. With inflows in
the main variables influencing exports, sign, but is statistically significant only excess of the CAD, the nominal exchange
we must also take note of many other at the 10% level. World exports have rate may remain the same or even appre-
factors that have a bearing on exports. a significant positive sign. We broke ciate. In fact, if at that time the domestic
The various trade policy measures that up services into four components and inflation is higher than that of the trad-
have been undertaken from time to time tested these. In the case of software, ing partners, the REER will appreciate.
result in cutting costs and improving and financial and business communica- in the contrary case of sudden with-
export competitiveness, one way or tion services, which constitute 75% of drawal of capital, as happened around
another. It is very difficult to compress the total service exports, the REER was June 2013, the exchange rate can decline
them into a single quantifiable variable. negative and significant. World exports very sharply. The critical question is:
But this, however, must be kept in mind had a positive coefficient and were in the context of very large capital
in any empirical estimation. significant. In the case of imports, the inflows, what should be the stand of the
Demand has to be supported by avail- unit value index had a negative sign and central bank? If the flows are allowed to
ability. In the first few decades after it was significant. The Indian real GDP pass through the market, the currency
independence, domestic demand was had a positive sign and was significant. will begin to appreciate in nominal terms
so strong that the surplus available for On the factors influencing India’s exports, even when there is a CAD. On the other
export was limited. As the economy has we have no control over world exports. hand, if the central bank intervenes and
grown, this situation has changed. How- The only policy variable is the REER. buys foreign exchange, the nominal
ever, it does happen even now that in the However, it has been found that, of the exchange rate may not appreciate. But,
years of poor monsoon, exports of agri- two variables, the dominant impact comes in real terms, it could, if the additional
cultural products suffer. from world exports or world output. reserves accumulated cause an increase
Many analysts have estimated export
demand functions. This has been done
at various points in time. Some of these Permission for Reproduction of
have been analysed by this author in a Articles Published in EPW
recent article (Rangarajan and Kannan No article published in EPW or part thereof should be reproduced in any form without
2017) and updated for this article. These
prior permission of the author(s).
are given in the Appendix (p 42). Let me
briefly summarise the results. In the A soft/hard copy of the author(s)’s approval should be sent to EPW.
equation relating to merchandise exports,
world exports, which is a proxy for In cases where the email address of the author has not been published along with the
world output, turns out to be a strong articles, EPW can be contacted for help.
variable with the coefficient being highly
38 MAY 26, 2018 vol lIiI no 21 EPW Economic & Political Weekly
 PERSPECTIVES

in money supply beyond the desirable PPP exchange rate as some kind of a level of CAD? Some people may dismiss
level and prices rise as a consequence. If market equilibrium rate. this question as irrelevant, saying that
the impact of the additional reserves on India does have a large trade deficit, whatever level of deficit that can be con-
money supply is to be neutralised, the even though the CAD is low, because of veniently financed would be appropriate.
authorities will have to issue bonds to the surplus on the services account. With It is best to look at the issue in terms of
absorb liquidity out of the system. But, capital flows playing a significant role in consequences of a high level of CAD
there is a cost to it, which depends on the the determination of the exchange rate, (Rangarajan 2015). As high deficits con-
return on the reserves and the interest it is important to neutralise the impact tinue to accumulate, the external liabili-
on stabilisation bonds. of capital flows and prevent the appreci- ties keep rising at a faster rate, and the
The appreciation in real terms can occur ation of the rupee in real terms. We must outflows in terms of interest and divi-
because of the influence of both capital also take note that the nominal depreci- dends begin to rise. This has an impact
flows and higher domestic inflation rela- ation of the currency has an effect on on the current account itself. Therefore,
tive to the trading partners. As the Eco- capital flows. Foreign investors would one must look at interest payments and
nomic Survey 2015 points out, between want the return to be much higher if the dividend payouts as a proportion of the
January 2014 and February 2015, the currency of the country in which they total receipts as a measure to determine
REER of the rupee had appreciated by are investing is depreciating. Thus, one the level of comfort. Also, the CAD must be
8.5%. Of this, higher inflation in India must be conscious of the implications of kept at a level that can be financed with-
relating to trading partners contributed exchange rate depreciation on various out undue stress. As pointed out earlier,
only 2.3 percentage points, while the re- forms of capital flows. the problem in 1991 was one of inability
maining 6.2 percentage points were ac- It should not be forgotten that the to finance the CAD.
counted for by the rupee strengthening stability of domestic prices is an important India’s CAD, as we have seen already,
in nominal terms because of the surging factor in stabilising the external value of in the recent period has been on an
capital inflows (GoI 2015). There are the currency in real terms. Therefore, a average around 1.2% of GDP; 2011–12 and
other years in which higher inflation has monetary policy framework with a focus 2012–13 were serious aberrations. The
contributed more to appreciation. For on price stability has a key role. Simply debt indicators (IMF 2000) have shown
example, in 2010–11, the REER rose by raising the nominal exchange rate to improvement. The debt service ratio was
8.5%. In the same period, the NEER rose compensate for higher inflation is not as high as 35.3% in 1991. As of 2017, it
by 2.8%. Thus, the bulk of the change in the answer. The broad conclusion is that was 8.3%. The ratio of foreign exchange
REER was accounted for by higher infla- there is a need to moderate the impact of reserves to total debt as of 2017 was 78.4%
tion relative to the trade partners. large capital inflows on the rupee so as compared to 7% in 1991 (Table 4).
India’s REER has touched 124.45% as long as we continue to have a CAD. An However, it has come down from the
of January 2018. Should the apprecia- appreciating currency will erode the Table 4: Key External Debt Indicators and Measure
tion of the currency really matter? competitiveness of our exports. The of Reserve Adequacy
Raghuram Rajan (2016) said: crucial factor is not so much exchange Year Debt Service Ratio of Foreign Ratio of Ratio of
Ratio (%) Exchange Foreign Foreign
So offsetting any rise in the real exchange
rate as competitiveness. The whole gamut Reserves to Exchange Exchange
of policy measures that the government Total Debt Reserve to Reserve to
rate is any productivity differential we en- (%) (Imports + Imports
joy with respect to the rest of the world. introduces from time to time are aimed Short-term
Assuming conservatively that this is about at this objective. We have not been able Debt)
2% a year, much of the real appreciation that 1990–91 35.3 7 17.8 24.2
to take this factor into account explicitly.
economists complain about is offset by pro- 1995–96 26.2 23.1 52 59.14
ductivity differentials.
Exchange rate is one element in this bas-
2000–01 16.6 41.7 78.1 83.67
ket of measures. An aggressive policy of
2001–02 13.7 54.7 99.91 105.23
Using the Balassa–Samuelson theory undervaluation will raise the hackles of 2002–03 16 72.5 115.18 123.92
(Balassa 1964; Samuelson 1964) of the many and face much opposition. Adjust- 2003–04 16.1 100.3 136.8 144.56
impact of productivity on price rise, some ing the nominal rate to keep the real rate 2004–05 5.9 105.6 109.51 126.91
have come to the conclusion that the rupee steady may be an acceptable strategy. 2005–06 10.1 109 89.88 101.65
is undervalued. The crucial question to Maintaining domestic price stability and 2006–07 4.7 115.6 93.14 107.24
ask is: Can we assume such a sustained improving the productivity, particularly 2007–08 4.8 138 104.23 123.18
increase in productivity as far as India is of the traded goods sector, are other fac- 2008–09 4.4 112.2 72.62 82.97
concerned, assuming the validity of the tors that have to be kept in mind. 2009–10 5.8 106.9 81.91 96.77
argument? In a similar vein—but on a 2010–11 4.4 95.9 70.11 82.44
Level of Current Account Deficit 2011–12 4.4 95.9 51.88 60.17
different note—Avinash Persaud (2015)
2012–13 5.9 71.3 49.72 59.51
argued that on a purchasing power parity In managing the external sector, a critical
2013–14 5.9 68.8 56.41 67.59
(PPP) basis, $1 was equivalent to `18.5 question that arises is the appropriate 2014–15 7.6 71.9 64.03 76.25
and, therefore, this meant that the rupee level of the CAD. What is the level of deficit 2015–16 8.8 74.2 77.56 94.53
was more than 60% undervalued. It ap- beyond which the country should get 2016–17 8.3 78.4 78.59 96.66
pears somewhat far-fetched to treat the worried? In short, is there a sustainable Source: Handbook of Statistics on Indian Economy, RBI.

Economic & Political Weekly EPW MAY 26, 2018 vol lIiI no 21 39
PERSPECTIVES

peak of 138% in 2007–08. The debits capital flows are influenced by a variety CAD and intervention by the RBI. Thus,
under investment income consist pri- of factors and have a tendency to be the character of the reserves is somewhat
marily of interest payments and dividend volatile, it is best to reduce the depend- different than in the case of China. The
outflows. As of 2016–17, the two together ence on capital flows. While it is impera- accumulation of reserves started pick-
amounted to $40.1 billion, which was tive not to let the CAD go beyond 2% of ing up after 2001. The big jump happened
only 9.6% of the total exports of goods GDP, we should actually work towards in 2007–08 when the foreign exchange
and services. maintaining a much lower level so that reserves increased from $199 billion to
Let us look at the issue from another fluctuations in capital flows do not cause $310 billion. Thereafter, there was a
angle: What level of CAD can be financed? distortions in the economy. However, it substantial drop in 2008–09 after which
A CAD of the order of 2%–2.5% of is important that we do not on this score reserves started moving up again. In
GDP would mean an absolute amount abandon the process of liberalisation and 2012–13, despite a strong inflow, the
of $45 billion–$56 billion. Can this level go back to the bad old days of import addition to reserves on BOP basis was
of deficit be ordinarily financed? This substitution. What is needed is to create minimal because of the high CAD. The
required inflow constitutes only 4%–5% an appropriate domestic policy environ- inflows were quite strong in 2014–15
of the total capital flows to emerging ment which will lead us to a lower CAD. and 2017–17. Currently, we have crossed
market economies and as such should the previous peak and touched the level
not pose a problem (Institute of Interna- Foreign Exchange Reserves of $420 billion.
tional Finance 2017). The quantum will, Another policy issue relates to the accu- Reserves serve as a buffer and make
however, increase as India’s GDP keeps mulation of foreign exchange reserves. the economy withstand shocks when
increasing. However, vulnerability comes What is a desirable level of foreign ex- there are fluctuations in capital flows
from fluctuations in capital flows. Any change reserves? Reserve accumulation (Rangarajan 2015). Reserves cannot, how-
level of CAD beyond 2.5% of GDP should normally happens when countries are ever, solve fundamental weaknesses. It
ring alarm bells. In 2011–12 and 2012–13, in current account surplus. This has not is a protection only against volatility. The
we were somewhat complacent because been the case with respect to India. adequacy of reserves is measured either in
of large capital flows. But, the sudden Reserves have been accumulated be- terms of imports or short-term external
outflow in 2013 gave us a shock. Since the cause of the excess of inflows over the debt or the addition of the two (IMF 2011).

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40 MAY 26, 2018 vol lIiI no 21 EPW Economic & Political Weekly
 PERSPECTIVES

The High-level Committee on Balance India are concerned has changed dramati- Capital flows have helped India manage
of Payments in 1993 emphasised the cally over the last two decades. Prior to the CAD with ease. However, the easy
need to take into account short-term 1990–91, our major concern was to mobi- availability of capital flows should not
obligations. This was long before the lise enough capital flows to finance the make us complacent about the level of
Guidotti–Greenspan rule was formulated. CAD. That position has changed. Thanks CAD. The tail of capital flows should not
In 2007–08, India’s foreign exchange to the development of the international wag the dog of the CAD.
reserves were 23% more than its total capital markets, today, emerging econo- There is a near-consensus on capital
imports. This was an extremely strong mies, including India, are able to attract account convertibility. We need to pro-
position. In 1990, when the crisis hit us, large capital inflows. The recognition of ceed in steps, and cautiously. We first
we hardly had foreign exchange equiva- the importance of capital flows does not need to enlarge the scope of businesses
lent to three weeks’ imports. As of end of preclude the need for regulating these to be able to function effectively in terms
March 2017, the foreign exchange reserves flows, particularly at the time of the of raising funds and investment. Capital
were equivalent to 97% of India’s imports. “surge” of such flows. There is a greater account convertibility should not be-
Foreign exchange reserves as a proportion appreciation of this approach even come a route for all individuals and even
of imports and short-term debt stood at among multilateral financial institutions business entities to freely keep funds
79% at the end of March 2017 (Table 4). (Ostry et al 2010). abroad. The time for that has not come.
Thus, in a broad sense, the reserve Countries normally prefer long-term
adequacy is met. However, as Thailand and durable funds. It is from this angle Conclusions
found at the time of the East Asian that FDI is the most desirable form of The world is entering a new phase as far
crisis, reserves—however high they may capital flows. This is true for India as well. as trade is concerned. Seventy years ago,
be—cannot provide a shield if the fun- Our own experience clearly shows the it was the developed countries that were
damentals go wrong. A judicious use of durability of the inflows in this category. preaching the virtues of globalisation
reserves at the time of temporary fluc- We need to encourage the flow of funds and free trade. The developing countries
tuations in capital flows can stabilise under this channel. While changes in were then expressing concerns about
the economy and provide relief. But, it procedures will help, fundamentally, it total free trade. Now the tables have been
is possible to use the reserves as a tool depends on how Indian economy func- turned. It is the developed countries that
of economic strength only when the tions. FDI flows towards countries which are turning against free trade and are
nature of reserves change and they are grow fast in an environment of low moving towards protectionism. This has
built out of the accumulation of current inflation and modest fiscal deficit. All come certainly at a wrong time for India.
account surpluses. these boil down to making India an at- It is only now that India is fully ready to be
tractive investment destination. The re- integrated with the rest of the world, even
Policy on Capital Flows cent changes enlarging the scope of FDI though India still has certain concerns.
Capital flows, in general, are welcome in are welcome. The only caution we have It is not known how far US President
developing economies. They all add to to exercise is in relation to speculative Donald Trump will go. He has talked
the productive capacity of the country. flows such as investment in real estate. about “reciprocal taxes” in relation to India
They also lead to the development of Portfolio flows do fluctuate not only and China. It will be hard for India to
financial markets. Such flows are also from year-to-year, but within the year. raise tariff walls. The recent decision of the
viewed as vehicles for the transfer of On occasion, they have caused severe government to raise import duties was
technology and management skills. In fluctuations in the stock market. Since ill-advised. Leaving aside this issue, there
effect, international capital markets try 2013, there have been several days on are still some areas of concern. The trade
to distribute the available world savings which the Sensex has fallen by more deficit remains high. This requires action
among countries, with countries show- than 600 points. The cause for the tum- in relation to both imports and exports.
ing high productivity growth attracting ble is not what happened in India, but A reference was made earlier to three
more capital. However, the problem with what was happening elsewhere in the categories of imports: oil, gold, and elec-
capital flows is their size and volatility. world. Net negative flows over the year tronic goods. Electronic goods require
When the capital flows are large and are uncommon. However, this happened special attention. Will electric vehicles
that too with a high degree of fluctuation, in 2008–09. In 2013, for three months in bring about a fundamental change in
they have a bearing on macroeconomic a row, there were strong outflows. Again the demand for oil? Will the increase
stability. If capital flows are volatile or in 2015–16, there was a net outflow $4 in production of electricity that may be
temporary, the economy will have to go billion. Those are inevitable. We need to required offset some of the gains if power
through an adjustment process twice, in strengthen our domestic investment in- generation depends on imported diesel?
both the real and financial markets, stitutions to keep the impact nominal. A careful look at these areas becomes
once when the funds flow in and second Allowing foreign institution investors to imperative. There is scope for expanding
when they flow out. invest in rupee-dominated securities is a our exports base. As was argued earlier,
The position with respect to capital good idea as the exchange risk is borne there is a case for keeping the real effec-
flows as far as emerging economies like by the foreign investors. tive rate from rising. The impact of capital
Economic & Political Weekly EPW MAY 26, 2018 vol lIiI no 21 41
PERSPECTIVES

flows on the exchange rate needs to be External Sector: Do We Need to Worry?” Samuelson, P A (1964): “Theoretical Notes on Trade
Economic & Political Weekly, Vol 48, No 7, Problems,” Review of Economics and Statistics,
neutralised. But, this by itself is not ade- pp 52–59. Vol 46, No 2, pp 145–54.
quate. We need to increase the competi- RBI (2013): The Reserve Bank of India Volume 4, World Bank (2014): World Development Indicators:
tiveness of our exports, which requires 1981–1997, Part A and Part B, New Delhi: Tariff Rate, Applied, Weighted Mean, Manu-
Academic Foundation. factured Products (%) (India), https://data.
among other things an efficient and well- — (various years): Handbook of Statistics on the worldbank.org/indicator/TM.TAX.MANF.WM.
knit infrastructure. We should not under- Indian Economy. AR.ZS?locations=IN.
estimate the importance of domestic price Appendix: Estimated Equations Table 2: Service Exports
stability as a contributing factor to pre- Table 1: Merchandise Exports (a) Estimated regression equations
(i) Estimated regression equations (dependent variable—Log of Service Exports of India)
vent a rise in the REER. The surpluses on (dependent variable—Log of Export Quantum Index) Variables (1)
the services sector will also need nur- Variables (1)
ln REER -1.155* (-1.81)
turing. Hard work is needed to maintain ln REER -1.17** (-2.48)
ln WSE 2.06*** (6.80)
our leadership in information technology. ln WOREX 0.77*** (4.75)
Constant -1.11 (-0.22)
A significant part of the invisibles comes Constant 5.74** (2.49)
Time trend 0.039** (2.15)
Time trend 0.049*** (4.90)
from transfers, which will also depend R-squared .9889
R-squared .9793
upon the state of the world economy. Sample period 1992–93 to 2016–17
Sample period 1991–92 to 2016–17 Service Exports—value of aggregate service exports of
We have so far managed our BOP well. Export Quantum Index with 1999–2000 = 100 (fiscal year). India deflated by CPI−US (fiscal year).
However, we need to be conscious of our REER (Real Effective Exchange Rate)—36 countries’ REER (Real Effective Exchange Rate)—36 countries’ export
export-based index with 2004–05 = 100 (fiscal year). based index with 2004–05=100 (fiscal year).
vulnerabilities in relation to imports and WOREX (World Export Index)—value of world exports WSE (World Service Exports) deflated by CPI−US (calendar year).
exports and this will require advanced deflated by CPI−US, 1991 = 100 (calendar year). Figures in brackets indicate t values.
Figures in brackets indicate t values. *** significant at 1% level, ** significant at 5% level,
action. There is no doubt that a well- *** significant at 1% level, ** significant at 5% level. * significant at 10% level.
managed external sector can be an impor- (b) Estimation results for major categories of service exports where dependent variable is
tant driving force of economic growth. (1) travel, (2) transport, (3) insurance and (4) miscellaneous (software, financial, business, and communication services)
Variabes (1) (2) (3) (4)
ln REER 2.503*** (3.48) 1.64** (2.26) 0.929 (0.78) -4.189*** (-3.00)
References
ln WSE 1.504*** (4.38) 2.54*** (7.32) 2.72*** (4.81) 1.95*** (2.94)
Balassa, Bela (1964): “The Purchasing Power Parity
Doctrine: A Reappraisal,” Journal of Political Constant -24.81*** (-4.31) -35.58*** (-6.11) -37.07*** (-3.90) -.624 (-0.06)
Economy, Vol 72, No 6, December, http:// Time trend -0.002 (-0.14) -0.045 (-2.13) -0.036 (-1.05) .120*** (2.96)
dx.doi.org/10.1086/258965. R-squared .9676 .9748 .9488 0.9719
GoI (2015): Economic Survey 2014–15, Ministry of
Sample period 1992–93 to 1992–93 to 1992–93 to 1992–93 to
Finance, Government of India.
2016–17 2016–17 2016–17 2016–17
Institute of International Finance (2017): “Capital
Flows to Emerging Markets.” All dependent variables have been deflated by CPI−US and are on fiscal year basis.
Figures in brackets indicate t values.
IMF (2000): “Debt- and Reserve-Related Indicators
*** significant at 1% level, ** significant at 5% level, * significant at 10% level.
of External Vulnerability,” International Monetary
Fund, https://www.imf.org/external/np/pdr/ Table 3: Merchandise Imports (c) Estimated regression equation (dependent variable—
debtres/debtres.pdf. log of Quantum Index of Imports)
(a) Estimated Regression Equation (dependent variable−
— (2011): “Assessing Reserve Adequacy,” Interna- Log of Quantum Index of Imports)
Variables (1)
tional Monetary Fund, https://www.imf.org/ Variables (1) Ln UVI -1.03*** (-5.15)
external/np/pp/eng/2011/021411b.pdf.
ln RGDP 2.86*** (8.82) Ln WPI 1.72*** (3.04)
Ostry, J D, A R Ghosh, K Habermeier, M Chamon,
M S Qureshi and D Reinhardt (2010): “Capital Ln UVI -1.16*** (-5.02) Ln RGDP 1.25** (2.09)
Inflows: The Role of Controls,” IMF Staff Position Constant -20.22*** (-8.53) Constant -11.73*** (-3.40)
Note 10/04, IMF, Washington, https://www.
R-squared .9486 R-squared .9643
imf.org/external/pubs/ft/spn/2010/spn1004.pdf.
Panagariya, A (2004a): “India in the 1980s and Sample period 1991–92 to 2015–16 Sample period 1991–92 to 2015–16
1990s: A Triumph of Reforms,” IMF working All data are on fiscal year basis. All data are on fiscal year basis.
paper WP/04/43, https://www.imf.org/exter- Import Quantum Index with 1999–2000 = 100. Import Quantum Index with 1999–2000 = 100.
nal/pubs/ft/wp/2004/wp0443.pdf. RGDP Index for Real GDP of India with 1991–92 = 100. RGDP Index for Real GDP of India with 1991–92 = 100.
— (2004b): “India’s Trade Reform,” India Policy UVI Unit Value Index of Imports with 1999–2000 = 100. UVI Unit Value Index of Imports with 1999–2000 = 100.
Forum, Brookings Institute, https://www.brook- Figures in brackets indicate t values. WPI Wholesale Price Index with 1999–2000 = 100.
ings.edu/wp-content/uploads/2016/07/ *** significant at 1% level, Figures in brackets indicate t values.
2004_panagariya.pdf. ** significant at 5% level. *** significant at 1% level, ** significant at 5% level.
Persaud, Avinash (2015): “The Rupee, Its Valuation (b) Estimation results for major categories of imports where dependent variable is log of quantum index of 1) food and
and the Missing Trade Surpluses,” Economic & live animals, 2) crude materials, 3) mineral fuels, 4) chemicals, 5) manufactured goods, and 6) machinery
Political Weekly, Vol 50, No 12, March. Variables (1) (2) (3) (4) (5) (6)
Rajan, Raghuram (2016): “India in the Global ln UVI -0.744*** -.397** 0.09 -2.951** -.751** -1.339***
Economy,” First Ramnath Goenka Memorial
(-3.38) (-2.13) (0.54) (-2.27) (-2.60) (-9.97)
Lecture, RBI Bulletin, April, https://www.rbi.org.
in/scripts/BS_SpeechesView.aspx?Id=994. ln RGDP 2.01*** 1.85*** .83** 2.13*** 2.144*** 3.052***
Rangarajan, C (2015): “Issues in India’s External (7.68) (10.11) (2.59) (2.99) (8.07) (14.59)
Sector,” Fifth Dr Raja J Chelliah Memorial Constant -13.32*** -13.14*** -4.75* -8.60 -14.65*** -21.10***
Lecture, National Institute of Public Finance (-7.21) (-11.64) (-1.80) (-0.80) (-9.69) (-12.65)
and Policy, March, http://www.nipfp.org.in/
media/medialibrary/2015/04/fifth_RJC_Me- R-squared .87 .9686 .9288 0.9641 0.969 0.928
morial_Lecture_March_12_2015_2.pdf. Sample period 1991–92 to 1991–92 to 1991–92 to 1991–92 to 1991–92 to 1991–92 to
Rangarajan, C and P Kannan (2017): “Determi- 2015–16 2015–16 2015–16 2015–16 2015–16 2015–16
nants of India’s Exports,” Journal of Quantita- All data are on fiscal year basis.
tive Economics, Vol 15, No 3, pp 629–46. Figures in brackets indicate t values.
Rangarajan, C and Prachi Mishra (2013): “India’s *** significant at 1% level, ** significant at 5% level, * significant at 10% level.

42 MAY 26, 2018 vol lIiI no 21 EPW Economic & Political Weekly