The Reserve Bank of India today released its Report on Currency and Finance, 2002-03. The theme of the Report is Management of the External Sector in an Open Economy Framework. Last year's report (2001-02) made a comprehensive assessment of the reforms process undertaken.

During the 1990s, India has witnessed wide-ranging economic reforms encompassing various sectors of the economy. With the opening up of the economy since the early 1990s, issues relating to the open economy have become more relevant for macroeconomic policy making. With financial liberalisation and increasing globalisation, capital movements have come to play an important role in influencing the exchange rate and interest rate arithmetic of the financial markets on a day-to-day basis. The volatile nature of the capital flows triggering instability and the subsequent contagion effect has been demonstrated in various episodes of financial crises across the world during the 1990s. The growing interaction between the fiscal deficits, capital flows, exchange rates and interest rates have posed a number of macroeconomic policy challenges.

In India, a number of key features of this opening up process are discernible, such as, focus on export growth, attracting non-debt creating capital flows, de-emphasis on short-term external borrowings, and a flexible exchange rate policy. All these led to a number of consequences like build-up of adequate reserves and reduction in short-term debt. India’s approach has been cautious in opening of the capital account, contingent on achieving certain preconditions to ensure an orderly process of liberalisation and ensuring macroeconomic stability. This approach has been vindicated in recent years with the growing incidence of financial crises elsewhere in the world. All the same, over the years, the policy regime in India in regard to current and capital account inflows and outflows has witnessed very significant change. The trade regime has been significantly liberalised with the abolition of quantitative restrictions and reduction in tariff rates. Moreover, building of institutions, financial infrastructure and putting in place appropriate supervisory and regulatory frameworks have helped to maintain financial stability in India while it has opened the economy substantially since the early 1990s. The success of the policy reforms is evident in the strength and resilience built up in the external sector.

Against this backdrop and in recognition of the growing importance of the external sector in driving the economy, this Report is focused on the theme: "Management of the External Sector in an Open Economy Framework". The Report addresses issues related to the structural change and improvement in the current account, the continuing debate on the appropriateness of exchange rate policies pursued by emerging market economies, management of capital flows, building up of reserves, the speed and sequencing of capital account liberalisation and the framework of international financial architecture. The Report attempts to provide India’s perspective on several of these issues. The Report is timely and topical particularly in view of the large accretion to foreign exchange reserves that has taken place in India and other Asian countries in the last couple of years. Furthermore, the emerging confidence being displayed by Indian companies in an increasingly open economy calls for continuing analysis of these issues.

The Report contains Ten Chapters. The theme of the Report is introduced in Chapter I, followed by an update on the developments during 2003-04 in Chapter II entitled "Recent Economic Developments" highlighting the strong recovery in economic activity as seen in various sectors of the economy. Chapter III deals with "Conduct of Macroeconomic Policy in an Open Economy". Issues relating to merchandise trade are dealt with in Chapter IV entitled "International Trade Dynamics" followed by analysis of the current account in Chapter V entitled "Current Account Dynamics in an Open Economy". The next two Chapters deal with "Management of Capital Flows" and "Foreign Exchange Reserves, Exchange Rate and External Debt Management". Issues relating to "Approach to Capital Account Convertibility" and "International Financial Architecture" are dealt with in Chapter VIII and IX, respectively. Finally, Chapter X on "Assessment of the External Sector" undertakes an assessment of the external sector reforms and the challenges ahead.

The Indian economy is now poised for a higher growth profile. The real GDP growth of 8.4 per cent in the second quarter of 2003-04 places India amongst the fastest growing economies in the world during the current year. Reflective of the growing investor confidence, the growth projections for the financial year 2003-04 made by various agencies/institutions have been successively revised upward. This was triggered by the confluence of several favourable factors, including an above-normal and widespread monsoon leading to an across-the-board increase in production of all major kharif crops, and an equally buoyant rabi forecast, as well as a continuing recovery in industrial production. Importantly, the second quarter estimates show that buoyancy has spread across most sectors of the economy and is not confined only to agriculture, which still accounts for most of the rebound from the drought of last year.

The signs of widespread revival in economic activity are also distinctly discernible in the improved investment climate, pick up in non-food bank credit, improvement in bottom-lines of corporates, optimistic results of various industrial outlook surveys and a healthy external sector. Non-food credit growth recorded a larger expansion on a year-on-year basis. The inflation outlook, by and large, remains benign, though careful monitoring and management would have to continue with a view to cushioning supply shocks and better management of supply bottlenecks for individual commodities so that price volatilities are evened out. The stability in financial markets has been buttressed by an improvement in both the profitability and the health of the commercial banking system. The money, government securities and foreign exchange markets remain stable. The foreign exchange reserves are at a more comfortable level than ever before and there is adequate liquidity in the system. Large inflows from foreign institutional investors leading to broad based rally in the stock markets reflect the prevailing strong business confidence.

The progress of the North-East monsoon is satisfactory, over the above-normal South-West monsoon. As a result, total foodgrain production during 2003-04 is expected to reach a record high, substantially pushing up agricultural GDP. The improved prospects for real activity globally should add strength to the upward momentum in growth. The overall GDP growth for the year 2003-04 as a whole, which was estimated at around 6.0 per cent at the beginning of the year and 6.5-7.0 per cent with an upward bias in November is, on latest assessment, likely to be higher and around 7.0 per cent with a continued upward bias, unless there are unforeseen circumstances. The overall developments in the economy are favourable and provide the main springs for a strong revival of investment by industry. If the fiscal drag could be eased, the macroeconomic prospects would improve further, reinforced by improved public infrastructure. This would need continuing tax and non-tax fiscal reforms, including user charges.

A large increase in cross-border trade and investment in recent years has brought about a growing integration of commodity and financial markets across the world as reflected in increased synchronicity of domestic and international business cycles. The opening up of the Indian economy during the 1990s was marked by low fluctuations vis-à-vis her select major trading partners, vindicating the effectiveness of the post-reform policy framework in maintaining stability. In a world of generalised uncertainty, the conduct of monetary policy has become increasingly complex. The vicissitudes of capital movements have an important bearing on the conduct of monetary policy. The operation of monetary policy has to take into account the risks that greater interest rate or exchange rate volatility entails for a wide range of participants in the economy. Monetary policy in India has been responsive to the developments in the external sector and has been able to reinvent itself in tune with the new priorities and changed operational environment.

In an open economy framework, the issues in fiscal policy making relate to increasing the market friendliness of taxation and implementing efficiency-improving reforms of the expenditure system. In India, several initiatives have been taken in line with the greater openness of the economy. The fiscal deficit, however, has proved to be largely intransigent. In this respect the intermediate targets of the Fiscal Responsibility and Budget Management Act will have to be achieved if fiscal policy in India is to play its fitting role in the economy’s growth process. The financial sector has made rapid strides in reforming itself and aligning itself to the new competitive business environment. The strategy adopted in India was to maximise the beneficial effects of openness while minimising the adverse consequences. The financial system has been progressively deregulated and strengthened with the convergence of the domestic prudential norms with international best practices.

Since the initiation of economic reforms, India’s outward orientation has increased considerably. The destination pattern of Indian exports has remarkably changed whereby the importance of developing countries as an export market has considerably increased. There is, however, some concern that India has not been able to fully utilise its potential in international trade. In contrast to the dramatic changes in exports of East Asia, India’s experience has seemingly fallen short of expectation. India’s share in global trade did not rise as impressively and the commodity structure of India’s exports remained almost unchanged until the mid-1990s. Moreover, unlike the East Asian countries where industry has been the major driver of exports growth, the contribution of industrial exports in India has been comparatively low. This could perhaps be attributed to small-scale industry reservations, high transaction costs and inflexible labour laws besides other structural bottlenecks. The linkages between trade and foreign investment in India indicate that FDI has been much less important in driving India’s export growth, except in information technology. The labour cost in India, however, is one of the lowest among its competitor countries. Moreover, given the exports structure of India, the potential for higher exports of manufactures, especially to the developed countries, is high.

It is important to note that despite significant liberalisation of imports with reduction in tariffs, phasing out of quantitative restrictions and allowing bullion imports through the formal channel, the country’s current account deficit has remained modest during the 1990s. Besides, the overall balance of payments has been in surplus for most of the years and consequently the country’s foreign exchange reserves have increased significantly. This suggests that tariff reductions could be carried out faster than envisaged earlier, without posing any significant risk to the balance of payments.

The modest current account surpluses in recent two years, viz., 2001-02 and 2002-03, are often attributed to cyclical factors such as subdued domestic demand at home and abroad. Over a longer period, current account dynamics reflect inter-temporal smoothing of consumption and, therefore, can be attributed to gaps between domestic savings and investment. Savings behaviour, in turn, is the result of evolving demographic patterns. Regional demographic trends indicate that the current account surpluses witnessed by India and other economies in recent period may not be temporary. Given the higher share of the aged in their population, advanced economies are projected to experience a substantial decline in their saving rates relative to investment in the coming decades, which would then be reflected in current account deficits. These regions will switch to importing capital. Increasingly, it would be the moderate and the low performers among the developing countries which would emerge as exporters of international capital. India is entering the second stage of demographic transition and over the next half-century, a significant increase in both saving rates and share of working age population is expected.

An important dimension of the current account dynamics is the spillover of fiscal deficits to the external sector. More often than not, it is the fiscal deficit of the public sector that tends to be associated with large current account imbalances. The link between fiscal deficits and current account balance implies that if the private sector is in balance, the government deficit will be fully reflected in the current account deficit. The results of cross-country causal relationship between current account balances and fiscal deficits suggest that for developing countries the causality runs from fiscal deficits to current account deficits. In India, the current juxtaposition of high fiscal deficits and low current account deficits or even surpluses reflects mainly high private sector savings, especially that of the household sector, coupled with sluggishness in investment demand. The spillover of fiscal deficits to current account deficits could easily occur in the event of a pick-up in investment demand. Thus, it underlines the importance of fiscal consolidation to avoid any spillover to external imbalances.

Invisibles surpluses have played an important role during the 1990s in providing resilience to India’s current account. Buoyant workers’ remittances and a dramatic rise in exports of software and other IT-related services have been the key sources of the growing strength of India’s invisible earnings. This can, in turn, be attributed to the availability of a vast pool of skilled and semi-skilled labour in India. A comparative analysis of India vis-à-vis its competitors in ITES segment clearly provides an edge to India over others because of its quality of labour pool, cost advantage, English proficiency and supportive government policies.

One of the most significant characteristics of the 1990s has been the spectacular surge in international capital flows, with the expansion of capital flows being much greater than that of international trade flows. Private (bond and equity) flows, as opposed to official flows, have become a dominant source of financing large current account imbalances. Another noteworthy feature of the capital flows during the 1990s has been a shift towards equity flows (especially direct investment) away from debt flows. Foreign investment inflows, both direct and indirect, have emerged as the predominant source of capital inflows. The experience with capital flows suggests that these flows are highly beneficial if they are absorbed. However, if the current account deficits are too large and unsustainable then the reversal of capital flows could cause major problems. The speed of reversals of capital flows could be quite high. The large and volatile capital flows combined with sharp rise in current account deficits played a significant role in exacerbating the vulnerabilities leading to the Asian crisis. Against this background, policy makers in developing countries, therefore, have to manage their capital accounts to ensure an orderly process of liberalisation.

A new challenge in the last two years has been the high order of capital inflows. Initiatives are already underway to explore new means and instruments of sterilisation. It is evident that operations involving sterilisation are undertaken in the context of a policy response which has to be viewed as a package encompassing exchange rate policy, level of reserves, interest rate policy, along with considerations related to domestic liquidity, financial market conditions as a whole, and the degree of openness of the economy. India has made conscious attempt to manage external liabilities and assets to ensure growth with stability through coordinated policy framework and careful calibration of instruments to moderate market pressures without any distortionary shocks on the performance of the economy. As a result, consistent with its macroeconomic objectives, the Reserve Bank was able to offset the expansionary effect of foreign capital flows on domestic money supply. A medium term concern in this respect relates to enhancing the economy’s absorptive capacity to achieve higher levels of real investment.

Foreign Exchange Reserves, Exchange Rate and External Debt Management

In the context of growing foreign exchange reserves, the issue of costs and benefits of reserve build-up has attracted a lot of attention. These economic costs are likely to be substantially higher than the net financial cost, if any, of holding reserves. In this context, it is important to note that in India, in the last few years, almost the whole addition to reserves has been made without increasing the overall level of external debt. The increase in reserves largely reflects higher remittances, quicker repatriation of export proceeds and non-debt inflows. Even after taking into account foreign currency denominated NRI flows (where interest rates are linked to LIBOR), the financial cost of additional reserve accretion in India in the recent period is quite low.

Conventionally, trade flows were deemed to be the key determinants of exchange rate movements. In more recent times, on a day-to-day basis, it is capital flows that influence the exchange rate and interest rate arithmetic of the financial markets. An analysis of the complexities, challenges and vulnerabilities faced by the emerging market economies in the conduct of exchange rate policy reveals that the weight of experience seems to be clearly in favour of intermediate regimes with country-specific features, no targets for the level of the exchange rate, exchange market interventions to ensure orderly rate movements, and a combination of interest rates and exchange rate interventions to counter extreme market turbulence. In general, emerging market economies have accumulated massive foreign exchange reserves as a circuit-breaker for situations where unidirectional expectations become self-fulfilling. It is a combination of these strategies that will guide monetary authorities through the impossible trinity of a fixed exchange rate, open capital account and an independent monetary policy.

Recent experience has highlighted the need for developing countries to keep a continuous vigil on market developments, and the importance of building adequate safety nets that can withstand the effects of unexpected shocks and market uncertainties. The important message that comes out from the analysis of various episodes of volatility and the policy responses is that flexibility and pragmatism are needed in exchange rate policy in developing countries, rather than adherence to strict theoretical rules. Tackling of the contagion of the East Asian crisis clearly points out that there is a need for central banks to keep instruments / policies in hand for use in difficult situations. Against this background, India’s exchange rate policy of focusing on managing volatility with no fixed rate target while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. The Reserve Bank continues to follow the same approach of watchfulness, caution and flexibility in regard to the foreign exchange market. It co-ordinates its market operations carefully, particularly in regard to the foreign exchange market with appropriate monetary, regulatory and other measures as considered necessary from time to time.

The Asian crisis amply demonstrated the need to proceed with caution in opening the capital account. It has been recognised that capital account liberalisation needs to be undertaken as an integral part of economic reforms and synchronised with appropriate macroeconomic, exchange rate, and financial sector policies with prudential restrictions on short-term speculative flows. The Indian approach to capital account convertibility has emphasised that capital account liberalisation is a process, contingent on achieving certain preconditions related to health and strength of the financial sector, sustainability in the fiscal sector and containment of inflation. Over the years, the policy regime in regard to capital account inflows and outflows in India has witnessed a significant liberalisation. There are, however, two areas where extreme caution continues to be exercised, viz., (i) unlimited access to short-term external commercial borrowing; and (ii) providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate).

The approach of multilateral institutions towards capital account convertibility has undergone a significant shift after the Asian crisis. The IMF recognised the role of capital controls and acknowledged the existence of important preconditions for an orderly liberalisation of capital movements. Since then, the IMF, in general, has favoured a gradual approach to opening the capital account if the preconditions for effective liberalisation are not in place. The World Bank also came out with the suggestion that capital account liberalisation should proceed cautiously, in an orderly and progressive manner in developing countries, given the large risks of financial crises – heightened by international capital market failures.

A series of financial crises in the second half of the 1990s exposed various shortcomings of the international financial architecture in respect of both crisis prevention and crisis management. Accordingly, efforts are underway to strengthen the structure of the existing architecture to reduce the probability of a crisis, contain the severity of crises when they occur, and insulate the global economy from contagion, while providing the desirable level of confidence to the national authorities to sustain the process of globalisation. The emphasis has been on establishing best practices through standards and codes, greater transparency and accountability, early detection, better supervision, stronger prudential requirements, sustainable exchange rate regimes and a greater sharing of the burden of crisis resolution with the private sector.

In the discussion on the international financial infrastructure, increased recognition has been given to three pre-requisites for efficient functioning of the financial sector, viz., a well-designed infrastructure, effective market discipline, and a strong regulatory and supervisory framework. As a member of various international groups such as, the International Monetary and Financial Committee (IMFC) at the International Monetary Fund (IMF), Development Committee of the World Bank, the Bank for International Settlements (BIS), the Group of 20 and the Working Group set up by the Financial Stability Forum and various other organisations, India has been playing an active role in the discussions on the international financial architecture and related issues. India has been closely monitoring the developments on all aspects of the new international financial architecture and has been fine-tuning and strengthening the internal crisis prevention and management frameworks. India was a part of the Task Force on the Implementation of Standards and participated in the Joint Committee Group meeting of the Financial Stability Forum (FSF).

Looking ahead, there is a growing recognition that openness matters and globalisation is an irreversible process entailing both opportunities as well as challenges. With increasing openness, monetary and fiscal policies are expected to play a key role in ensuring macroeconomic stability while facilitating sustained economic growth within the framework of a market economy. In view of increased uncertainty, central banks need to take into account developments in the global economic situation, the international inflationary situation, interest rate situation, exchange rate movements and capital movements while formulating policy responses. The maintenance of financial sector stability has assumed much greater importance with opening up of the economy to the influence of globalisation.

The key challenge for macroeconomic policies would be to ensure that the anticipated expansion in saving in developing countries is productively utilised within the economy and not exported abroad. Accordingly, it is vital to ensure that the investment rate rises in close co-movement with the saving rate. This requires massive investments to close the gaps between demand and supply in key infrastructural areas such as power, roads and highways, ports, telecommunication, cities and urban utilities. More rational user charges have to be levied to finance the restoration of public investment. The future growth strategy will also need to be more labour absorbing to accommodate the projected expansion in the work force. Reforms in the labour market, educational system, pensions and medical care would gather importance within the overall intensification of structural reforms so that an average current account deficit of 1.6 per cent of GDP during the Tenth Plan period (i.e., 2002-03 to 2006-07) could be realised.

Real sector developments have close connection with the process of opening up. In order to reap the fruits of opening up, enabling conditions need to be created by providing a proper incentive structure to encourage private investment in agriculture and infrastructure. The process of opening up of the Indian economy has given birth to a host of new challenges and opportunities. The spirit of the liberalisation process entails a conscious effort on the part of the policy maker(s) to optimise on these trade-offs.