A REPORTON

PRECARIOUS POSITION OF INDIAS BALANCE OF PAYMENTS

BYTaijas Malpani2008B3A3521G

Report submitted in partial fulfillment of the requirements of courseECON C421: Issues in Indian Economy

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE-PILANI20th Nov, 2011

Table of Contents1ACKNOWLEDGEMENTS33INTRODUCTION44SIGNIFICANCE OF THE STUDY55OBJECTIVE AND PERIOD OF THE STUDY66REVIEW OF LITERATURE77UNDERSTANDING BALANCE OF PAYMENTS88HISTORY OF INDIAS BOP SINCE INDEPENDENCE98.1Period from 1949-1991:98.2Period from 1990-99:98.3Period from 2000-present:109CAUSES OF BOP DISEQUILIBRIA WITH SPECIAL REFERENCE TO INDIA119.1Structural changes in the economy119.2Cyclical changes in the economy119.3Changes in exchange rate119.4Changes in National Income129.5Price changes129.6Capital movements129.7Other factors1210ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE ECONOMY1310.1Merits of CA Deficit1310.1.1Sound Capital Market1310.1.2Current Account financed by foreign investment1410.1.3Benefits of Long term Investment1410.1.4CA deficit as an engine of growth1410.2Demerits of CA Deficit1510.2.1Financing of CA deficit by Borrowing1510.2.2Low Competitiveness1510.2.3Increasing claim on Indian assets by foreigners1510.2.4Drying up of Capital Flows1610.2.5Lower Economic Growth1610.2.6Replacement of Domestic Products with Imported Goods1611POLICY SUGGESTIONS AND RECOMMENDATIONS1712CONCLUSION1913BIBLIOGRAPHY20

ACKNOWLEDGEMENTS

I would like to thank our course instructor, Mr. N. Kubendran, without whose support, this report couldnt have been completed. Id also like to thank our other instructor, Mr. Ashwini Kumar Mishra, whose deep insights into this topic have proven useful to me in the completion of this report.

INTRODUCTION

The international Balance of Payments (BOP) of any country is a measure of its economic performance as compared to the rest of the world. In this regard, it becomes imperative to study the nations Balance of Payments trends, so that necessary corrective policies and actions may be taken to improve the nations economic standing in the world. With respect to India, its BOP situation is quite delicate now. The problem of BOP disequilibrium has been persisting in India right since independence, which led to the BOP crisis of 1990-91. Even though the BOP situation has improved since then, BOP management still remains one of the main concerns for Indian policy makers.This report describes ,firstly, the structure of BOP (the manner in which BOP is calculated) so that it is easier for the reader to appreciate the significance and implications of the BOP trends and it then moves on to describe in detail the trends of BOP in India right from Independence till today. Secondly, a list of all internal and external factors for BOP disequilibria problem have also been listed as well as the impacts of the various policies on Indias BOP, that the Government of India has implemented. Both pros and cons of such policies have been evaluated. Lastly, further policy recommendations have been made to further improve the current BOP scenario and reduce the BOP deficits.

SIGNIFICANCE OF THE STUDY

Since the BOP of a nation is a measure of its economic strengths and weaknesses, the study of BOP trends and its implications is very vital to gauge the growth and development of various trade and financial transactions of the nation with the rest of the world. Naturally, for any nation, its economy will thrive if it has a healthy BOP. Generally, for nations, a healthy BOP indicates surplus in the overall trade balance, as this maintains confidence in the economy and among investors. India right now, is suffering from a Current Account (one of the components of BOP) deficit. The following questions arise: Should Indian policy makers focus on narrowing the Current Account deficit or should they maintain the same amount of deficit so as to ensure long term local productivity and increased exports in the future? What strategies are to be implemented by the policy makers to reduce the Current Account deficit? What should be the optimum amount of Current Account deficit that a developing country like India can handle? These questions clearly indicate that the BOP position plays a significant role in governing the decisions of policy makers, which are crucial for any economy.Also, since credit ratings are based on BOP positions, flows of credit to businesses may be affected because of them. Furthermore, predictions regarding foreign exchange rates can also be made by studying BOP positions.

OBJECTIVE AND PERIOD OF THE STUDY As seen above, the BOP positions of a country can have significant impact on its economy, through the decisions of policy makers. The objective of this study is to investigate the causes of BOP disequilibria prevailing in India and its various consequences on the Indian economy. To accomplish this, the various merits and demerits of the Indian BOP position on the economy are analyzed in detail, along with the BOP trends in India. Based on this analysis, various policies are recommended to strengthen the Indian economy. This has been the primary focus of this study.The period of this study stretches from 1949 till present.

REVIEW OF LITERATURE

The problem regarding the current BOP scenario of India is of significant importance. According to Anita Chanda (Indias Balance of Payments-2010), Indias poor BOP situation during the post independence period right till the 1990s was because of the protectionist policies that India implemented. She also maintains that it was only because of the New Economic Policy (NEP) regime that Indias BOP situation improved. She also says that even though India has maintained a decent BOP position, BOP management still remains an issue of concern for policy makers, as now India is exposed to every change in the global scenario.Manu Gupta (What is Balance of Payments and what does it mean for your business-2009) is of the opinion that healthy BOP position term is relative to every country. While developed countries have surplus in Current Account, developing countries like India place more importance on Capital Account surplus. He also says that BOP position of a country is of prime importance for a countrys trade as it influences the decisions of policy makers.Richard Pettiger (Is a Current Account deficit harmful? 2005) says that a current account deficit can prove to be harmful only if the deficit is financed by borrowing or by running down reserves as this leads to depreciation of the currency. He further says that if however, the deficit is financed by long term investment; it can lead to increased productive capacity and more exports and help in the growth of the economy.

UNDERSTANDING BALANCE OF PAYMENTS

A countrys Balance of Payments (BOP), also referred to as the Statement of International Transactions is basically a summary statement, in which, all the transactions of the residents of the nation with the rest of the world are recorded during a particular period of time, usually a calendar year. The BOP employs the double entry bookkeeping accounting technique.In general, the BOPs comprise of the two main components: Current Account (CA) This includes transactions of goods and services, income on foreign investments and unilateral transfers. It consists of two main subheads Merchandise and Invisibles. The Invisibles can be divided into Services, Transfers and Income.

Capital Account (KA) This measures the change in the domestic countrys assets abroad and foreign assets owned in the domestic country. It includes the following subheads Foreign Investment (FIIs and FDIs), Loans, Banking Capital, Rupee Debt Service and Other Capital.

The Foreign Exchange Reserves of a country can be measured as the negative of the sum of the Current Account and the Capital Account, that is,R = - (CA+KA)

HISTORY OF INDIAS BOP SINCE INDEPENDENCE

Period from 1949-1991:

Throughout this period, the BOP situation of India remained weak, because of the protectionist policies that were implemented by the Indian government. The Current Account was in excess of 3% of GDP during this period. Under Capital Account, foreign aid and commercial borrowings were used to balance the CA deficit. Indias main aim after attaining independence was to achieve self-reliance. This was the main objective of the Second Five-year Plan. It implemented protectionist policies like import substitution, with gross neglect on exports. The capital goods industry remained, to a large extent, import intensive. The Indian economy was put under further strain because of the increasing petroleum products demand, domestic inflation, the two oil shocks and harvest failure. Because of this and also because of the recession in the 1980s, Indias BOP situation deteriorated. This BOP deterioration saw the External Debt situation of India change from bad to worse because the government resorted to large borrowings to rectify the BOP situation in the short run. The constant depreciation of the Rupee to promote exports also raised the amount of External Debt. The country was on the verge of defaulting. Although the process of liberalization began from the mid 1980s, the situation was already very bad, and all this mismanagement ultimately culminated in the 1990-91 BOP crisis.

Period from 1990-99:

The BOP crisis of 1990-91The triggering factors for this crisis were primarily the growing fiscal deficits, rapid accumulation of external debt, the Gulf War and the Oil Price Shock, very low foreign currency reserves and threat of default on external debt repayments. The New Economic Policy (NEP) was implemented to combat this BOP crisis, which focused on liberalization and globalization of the economy. This opened up the Indian economy and lifted the restrictions on free trade, allowed foreign investments and introduced a new Liberalized Exchange Management System to avail the benefits and advantages of a competitive market. Apart from this, other economic restructuring was done to counter the weak BOP position of India. Some of them were float of the Rupee, Industrial delicensing, fiscal adjustment, tight caps on external borrowing and lowering of direct and indirect taxes. The BOP position of India steadily became more stable, after overseeing the initial doubts during the period 1991-99.

Period from 2000-present:

Since 2000, the BOP position of India went through ups and downs until 2008. The Current Account (CA) balance was positive till 2004, after which it started decreasing and the CA balance became negative. The Capital Account (KA) increased gradually till 2008. This was possible because of the liberalized policy that India implemented. The CA balance widened in 2008-09 (-2.4% of GDP) as compared to 2007-08 (-1.3% of GDP). The overall balance went into negative figures, and the KA balance decreased substantially as well. This happened because of the global recession that took place during that period. After the recession, as the economy improved and picked up momentum again, the BOP position improved. Both the overall and KA balance continued to improve. However, the CA balance still continued to deteriorate.

Currently, Indias foreign exchange reserves are quite comfortable, exchange rate is pretty competitive and exports and capital inflow through FDIs are also encouraging. The BOP situation of India is fairly well managed, although it rests on a very precarious position. The main concern for India now, is the increasing Current Account deficit.

CAUSES OF BOP DISEQUILIBRIA WITH SPECIAL REFERENCE TO INDIA

There are many varied reasons for BOP disequilibria in an economy. The major ones are listed below:

Structural changes in the economy

Structural changes in an economy can lead to a BOP deficit or surplus. For example, right after independence, India followed protectionist policies that curbed exports, leading to huge BOP deficits. After the BOP crisis of 1990-91, India opted for a more liberalized and globalized policy. Such a policy improved significantly the previously poor BOP position.

Cyclical changes in the economy

Cyclical changes like the expansion of an economy lead to a BOP surplus, while recession leads to a BOP deficit. The 2008 global recession saw the BOP position of India for 2008-09 deteriorate as compared to the period 2007-08.

Changes in exchange rate

A competitive or floating exchange rate can lead to a better BOP while a fixed exchange rate may lead to a BOP deficit. In Indias case, India had a fixed exchange rate until 1990, and this period saw poor BOP positions. After liberalization, since the exchange rate became floating, the BOP situation became much better.

Changes in National Income

Increase in national income through income earned on investments on foreign goods abroad, strengthens the CA balance and improves the BOP position of a country. After the BOP crisis in India, the CA balances improved because of the increase in the returns on foreign investments.

Price changes

An increase in prices indicates a weak BOP for a nation, while a decrease in prices indicate a healthy BOP for a nation. During the 1980s continued inflation saw the BOP condition in India deteriorate from bad to worse.

Capital movements

An increase in capital inflow leads to a KA surplus thus strengthening the BOP position, while an increase in capital outflow leads to a KA deficit, which in turn weakens the BOP position of a nation. In Indias case, with increasing globalization, the FIIs and the FDIs increased during the mid 1990s, eventually leading to a better BOP.Other factors

Other factors that led to a weak BOP position in Indias case include large population and the ever-increasing consumption, dependence on Petroleum, Oil and Lubricants imports, unfavourable political conditions, ability of domestic investment to absorb large foreign currency inflows, fiscal deficit and increase in public debt.

ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE ECONOMY

As mentioned earlier, BOP of any nation has two components: Current Account (CA) Capital Account (KA)Currently, India has a CA deficit and a KA surplus. Its BOP situation is precarious and unless India treads with caution, it might worsen again.A Current Account deficit can have both favourable and unfavourable impacts on the Indian economy. Both the merits and the demerits of a CA deficit have been presented below, through a detailed analysis.

Merits of CA Deficit

A Current Account deficit is not necessarily harmful to certain economies. For developing countries like India, a CA deficit may prove itself useful to the economy in the long run. Following are the advantages of a CA deficit:

Sound Capital Market

India is emerging as one of the most favoured venues for overseas investments, especially after the global recession of 2008. It has one of the most open and sound capital markets in the world, and since so far, after 2008, financing a trade deficit in goods and services has not led to a sharp decline in the value of the Rupee, there is little need to be concerned about the CA deficit. In such a case, a CA deficit will only serve to strengthen a developing economy like India.

Current Account financed by foreign investment

A Current Account deficit can be considered to be a by-product of Indias rapid economic growth and its appeal as a hot destination for foreign investment.CA = S I, where S = Savings & I = investmentsAccording to this relation, a CA deficit exists when I>S, as a result of which foreign investment occurs. Whenever I>S, the overspending or the investments abroad must be financed by foreign investment. This implies that there will exist a KA surplus, because more and more foreign firms will invest capital in India, thus making up for the CA deficit. India currently has a CA deficit; this simply indicates that India is importing capital from abroad. This can in turn allow India to increase its exports and eventually, reverse its deficit.

Benefits of Long term Investment

CA deficit is financed partly by long term investment. In such a scenario, India stands to gain a lot from the benefits of long term investment, which include: Increased productive capacity Favourable working practices of foreign firms More jobs Increased exports in the distant future

CA deficit as an engine of growth

A Current Account deficit for India indicates a growing demand for imports, and only if Indias economy is growing and expanding as well as creating jobs and Disposable Income can there be an increase in the demand for imports. This clearly shows that there is a direct coherence to Indias CA deficit and its economic growth.

Demerits of CA Deficit There are a number of reasons why a CA deficit can prove detrimental to Indias economy. Some of them are:

Financing of CA deficit by Borrowing

Financing of CA deficit through borrowing or running down reserves will prove unsustainable in the long run. This in turn would lead to depreciation of the Rupee as the supply of the Rupee would exceed it demand. Such a rapid depreciation will in turn lead to problems like inflation and falling confidence in India. Imported good will become more expensive and depreciation of the Rupee will reduce the living standards.

Low Competitiveness

Indias CA deficit has been persisting since 2004 and has been increasing since then. Such a persisting deficit suggests a fundamental weakness in the Indian economy. It may lead to: Decreasing competitiveness Decreasing productive capacity Declining comparative advantage in various manufactured goodsThese factors could have a profound and adverse impact on job creation in India, leading to unemployment, thereby worsening the situation and leading to lower growth and development of the economy.

Increasing claim on Indian assets by foreigners

India has primarily relied upon attracting foreign investment in the form of FDIs and FIIs to finance the CA deficit. This means that foreigners now have an increasing claim on Indian assets. If the foreigners were to withdraw their investment from India due to some economic crisis, it would leave India highly vulnerable.

Drying up of Capital Flows Since the rates of borrowing from other countries is pretty high, Capital flows may dry up and India will no longer be able to finance its CA deficit by attracting capital flows from different countries. This will in turn pile up the external debt burden of India.

Lower Economic Growth

If the Indian CA deficit is due to excessive consumer demand, a recession or slowdown will help to resolve the problem. As consumers cannot go on spending far in excess of their income forever, they have to start saving and controlling their expenditure to improve their own finances. To accomplish this, both high interest rates and significant reductions in consumer spending will be required, and this could ultimately push India into recession or slowdown of the economy, leading to overall lower economic growth.

Replacement of Domestic Products with Imported Goods

Since India faces a CA deficit, most often domestic products are replaced by imported goods, and thus, when the imported goods are growing, it signals a weakening Indian economy.

POLICY SUGGESTIONS AND RECOMMENDATIONS

Based on the merits and demerits of the current BOP situation in which the Current Account deficit has deteriorated since 2004, as a result of the overheating of the Indian economy, and keeping in mind the various factors responsible for the current BOP situation in India, the following policy suggestions have been made: Devalue the Rupee by lowering the interest rates. This will make exports cheaper to foreign buyers; while at the same time make foreign goods more expensive. Such a policy would increase the exports and at the same time lead to a reduction in imports, thus ensuring that CA deficit is reduced. However, such a policy measure can also lead to inflation. So care must be taken as to not lower the interest rates too much that it puts an inflationary pressure on the Indian economy.

Lower aggregate demand by raising taxes or cutting down on spending. This will decrease the demand for imports, thus ensuring that CA deficit is reduced.

Raise import tariffs, import quotas and other non-tariff barriers so as to decrease the demand for imports and keep the foreign goods out. This would also lead to a reduction in Indias CA deficit.

Set up tax-free export processing zones and subsidize capital to exporting sectors. Such policies will channel resources to the exporting sectors and therefore the exports will rise, thus correcting the CA deficit problem in India.

Build an infrastructure that makes it conducive and far easier to export.

Implement policies that attract direct foreign investment into the Indian economy as well as those policies that attract short term flows of money in the Indian banking sector.

Contract the money supply as this will reduce consumption and reduce the demand for imports, thereby improving Indias current BOP situation.

Implement policies that provide subsidies or incentives to export producers. This will ensure large volume of exports and will help in combating the CA deficit.

Adopt import substitution and introduce QRs thereby prohibiting imports and solving Indias current CA deficit.

The CA deficit of India can also be corrected to a large extent by taking loans, attracting FDIs and FIIs and through Tourism and Transportation development as well.

CONCLUSION

The volume of a countrys current account (one of the two main components of BOP) is a good sign of economic activity. By analyzing the current account, one can get a clear picture of the extent of economic activity of a country- including its industries and its capital markets. However, depending on whether the nation is a developed or a developing nation and its goals, the state of the current account decides whether the economy is prospering or not. Since India is a developing country, a Current Account deficit works well for Indias economic progress as long as it is kept in check. However, since 2004, the Current Account deficit of India has been increasing continuously and if it continues to increase, Indias economic growth might become unsustainable. When analyzing the Current Account of India, it is important to know what is fueling the extra deficit and what is being done to counter the effects and whether the actions being taken are providing results or not. The primary aim for India is to control this deficit before it gets out of hand.This report has dealt exclusively with the causal factors of BOP disequilibria in India and various policy measures that reduce the demand for imports and increase exports have been suggested that can combat the Current Account deficit of India.

BIBLIOGRAPHY

Article by Richard Pettinger on the topic Is Current Account Deficit Harmful (2005)

Pierre-Olivier Gourinchas, Olivier Jeanne.2002. On the benefits of Capital Account Liberalization for Emerging Economies June 2002.

Article by Manu Gupta on the topic What is Balance of Payments and What does it mean for your Business? (2009)

Article by Anita Chanda on the topic Indias Balance of Payments (July 2010)

Dominick Salvatore.2004. International Economics 8th edition by John Wiley & Sons, Inc.

http://www.preservearticles.com/2011092013745/what-are-the-methods-of-correcting-disequilibrium-in-the-balance-of-payments.html

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