People's Democracy

The liberalising economic reforms of the 1990s were explicitly determined by the performance of the external sector. To begin with, the crisis in the balance of payments is widely identified as the proximate cause of the impetus towards substantial economic liberalisation that was initiated in 1991. Also, the explicit orientation of the economic reform programme has also been largely external, in terms of attempting to make the Indian economy more "competitive" in international trade terms, and trying to attract quantitatively significant flows of foreign capital to augment domestic savings.

This is also the sphere in which the reformers claim to have been successful, because of relatively low current deficits and a more manageable external debt situation as well as build up of external reserves. However, a closer look at the actual patterns reveals that the actual performance has been far from satisfactory. Not only has export growth failed to pick up as desired and expected, but net capital flows have actually been lower than in the earlier decade in real terms, and there is greater dependence on volatile short term capital. Thus the balance of payments and the economy as a whole are now more vulnerable, even as there has been no real improvement in performance of exports or capital account.

Consider the performance of exports. This was supposed to be one of the main results of the reform programme, which would make Indian producers more cost-effective and therefore internationally competitive. However, one of the failures of structural adjustment in India has been its inability to stimulate India's exports to a degree that would counteract any tendency to stagnation in the domestic market. Nor can this be blamed on adverse international market conditions – throughout the period from the early 1970s to now, the share of Indian exports to world exports has remained stubbornly stuck at levels between 0.5 and 0.6 per cent.

As Table 1 shows, the decade of the 1990s has actually been substantially less dynamic than that of the 1970s in terms of export growth, and indeed was only marginally better than the 1980s. It is significant to remember that in the 1970s India was still seen as a highly closed economy, yet both exports and imports grew at much faster rates in US dollar terms in that period than in the more "open" 1990s. This overall rate of growth of exports in the 1990s masks the high degree of volatility in exports, which is much more in the recent period than ever before.

Also, the trade deficits as revealed by the Customs data do not give a full idea of the actual trade deficit. This is because certain imports made by the government (especially defence-related imports) do not come through Customs and are therefore excluded from that data. A more complete accounting of imports, and therefore of the true extent of the trade deficit, is given by the RBI data. If the difference between these two sets of data were more or less constant over time, this would not matter, but in fact the discrepancy has been growing very substantially over the decades. This is evident from Table 2.

In fact, by the closing years of the 1990s, the actual trade deficit was 7-9 billion dollars more than that recorded by the Customs data. This has quite significant implications : it means that the extent of the trade deficit that has to be financed through other inflows of foreign exchange is not only much larger than is generally recognised, but also that it is growing over time and especially in the recent period. This in turn makes the problem of financing the deficit much more acute, and shows the inherent and continuing fragility of the balance of payments despite a prolonged period in which the focus has been on strengthening the balance of payments and preventing trade-based vulnerability as in the past.

The fact of the larger RBI trade deficit also affects the extent to which the foreign exchange reserves held by the Reserve Bank of India can be held to be adequate for all contingencies. In the past, the yardstick by which the adequacy of such reserves was judged was in terms of the number of months of import cover they provided. Of course, this was the relevant yardstick for a context in which capital flows were extremely limited and highly volatile short term capital flows were almost unknown. Now that such flows are not only possible but quite significant, clearly the holding of foreign reserves must be necessarily much larger, simply in order to stave off any sudden speculative attacks or capital flight. However, the actual import cover provided by the foreign exchange reserves (which is just above six months’ import value) is not much higher than it was in the 1970s, despite the very significant increase in the dollar level of such reserves to about $ 42 billion at the current time.

It is generally supposed, because of the obsessive focus of the policy makers over the last decade, that the capital account of the balance of payments has been much more active in the 1990s than earlier. Certainly, the very substantial capital account liberalisation that has occurred would be expected to lead to substantial inflows of capital as well. However, as Table 3 shows, the net effect of total capital inflow has actually been much lower than expected. The table provides calculations of the total capital inflow (which combines all the various forms of foreign capital : foreign aid, foreign direct investment, portfolio investment in the form of FII investments as well as GDRs and ADRs, special deposits held by NRIs and external commercial borrowing, in the second column. In the third column, calculations of net capital inflow, that is net of outflows of investment income (in the form of repatriation of interest, profits and dividends) are given. It is apparent that these are significantly lower, and more so for the recent period compared to earlier periods. Indeed, in terms of net capital inflows, the decade of the 1990s shows barely any improvement over the previous decade even in nominal dollar terms, which implies a decline in real terms (that is, relative to GDP or total investment).

In fact, the most startling thing about Table 3 is not even the relatively small increase in net capital flows, but rather the much more significant role played by net private remittances. These are dominantly in the form of private remittances from workers abroad (as compared to the much smaller amount of capital inflows from higher income professional migrants, which are typically held in the form of NRI deposits). So major has the role of such remittances been, that it would not be incorrect to argue that in the 1990s this has been the one single factor that has saved the Indian balance of payments and allowed official policy makers some degree of respite from continuous external payments pressure. Once again, this is a variable which has been increasing rapidly over the 1990s, so that in the past few years it has been in the region of 10 billion dollars every years. What is significant is that in 2000-01, as indeed in almost every other year since 1991, net private transfer payments (led essentially by workers’ remittance income) have been greater than all forms of capital inflow taken together. And they have been more than two and half times the net value of capital inflows.

It is noteworthy that these remittances have been flowing in despite the absence of any special benefits or schemes for such inflows, in marked contrast to the hullabaloo around and huge incentives offered to NRI investments, which have yielded much less in terms of net capital inflow. Furthermore, unlike most forms of capital which subsequently entail an outflow in terms of repatriation of profits or debt servicing and the like, this form of inflow – workers’ remittances – involves no subsequent outflow.

Overall, one of the consequences of financial sector reform was India's growing dependence on volatile short-term flows of capital in the form of FII and NRI investments and NRI deposits. Combined with the decision to allow the value of the rupee to be determined by market forces, which made central bank purchases and sales of foreign exchange the only means by which the government could influence the value of the rupee, this resulted in considerable uncertainty regarding the value of the rupee. Further, domestic policies with regard to expenditure, interest rates and exchange rates were now influenced by perceptions of how it would affect whimsical foreign investor sentiment. This has substantially reduced the manoeuvrability of the government, and made it difficult for it to change policy track, if and when it chooses to, in order to deal with many of the problems that have emerged during the period of reform.

Despite these sacrifices, as has been seen, the capital account has not really been affected in the aggregate in terms of significantly higher inflows over the 1990s. However, the structure of inflows has changed quite dramatically over the 1990s, with much greater reliance on relatively short-term inflows such as portfolio capital, NRI deposits and special schemes for NRIs and external commercial borrowing. The total stock of such short term capital has amounted to between 60 and 70 per cent of the total foreign exchange holdings of the RBI over the 1990s.

Clearly, strategy of the 1990s has not achieved its basic aims with respect to the external sector, even while it has substantially added to the external vulnerability of the Indian economy and simultaneously put major constraints on macroeconomic policy autonomy. Furthermore, there are important danger signals looming in terms of the external management of the economy. The question is how much these can be dealt with within the current paradigm of progressive external liberalisation and the evident attempt to woo foreign investors at all costs.

(in US Dollar terms)

Source for this and subsequent tables : Calculated from

RBI Handbook of Statistics on Indian Economy

and GOI Economic Survey 2000-01

Table 3 : Gross and net capital inflow, and net private transfers, million dollars.