BOP Trends and Current Account Deficits, 1991 BOP Crisis INDIA

BOP

• A systematic record of all economic transactionsbetween the residents of a country and the rest of the worldin a particular period

• Quarter of a year or over a year

• Transactions made by individuals, firms and government bodies

• Includes all external visible and non-visible transactions of a country during a given period

• Represents a summation of country's current demand and supply of the claims on foreign currencies and of foreign claims on its currency

• All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country

• Country has received money – credit, Country paid money –debit

• Theoretically, BOP should be zero (assets and liabilities should balance )

• Practically rare. Thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

• Divided into 3 main categories

CURRENT ACCOUNT• The current account is used to mark the inflow and outflow of

goods and services into a country

• Earnings on investments – both public and private

• Within the current account are credits and debits on the trade of merchandise

• Includes goods such as raw materials and manufactured goods that are bought, sold or given away

• Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights.

Cond…• When combined, goods and services together make up a country’s

balance of trade (BOT)

• BOT is typically the biggest bulk of a country’s balance of payments as it makes up total imports and exports

• BOT deficits – Country imports more than it exports, BOT surplus –vice versa

• Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account

• Unilateral transfers – one of the components - credits that are mostly worker’s remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received

CAPITAL ACCOUNT• Capital account is where all international capital transfers are

recorded• This refers to the acquisition or disposal of non-financial assets (Say

land) and non-produced assets, which are needed for production but have not been produced

• Monetary flows like Debt forgiveness Transfer of goods and financial assets by migrants leaving or

entering a country Transfer of ownership on fixed assets (Equipments used in

production process to generate income ) Transfer of funds due to sale or acquisition of fixed assets Gift and inheritance taxes Death levies Uninsured damage to fixed assets

FINANCIAL ACCOUNT• International monetary flows related to investment in

business, real estate, bonds and stocks are documented

• Also included are government-owned assets such as

Foreign reserves

Gold

Special drawing rights (SDRs) held with the International Monetary Fund

private assets held abroad

Foreign direct investment

• Assets owned by foreigners (private and official)also recorded

RISING DEFICITS

• Deficits have been most serious in respect of current account

• Started in 1950s and rose with no interruption, and at accelerated rate, culminating into a crisis in 1990s

• Plan wise – This trend strained the economy in various degrees

• First year plan – Deficits were small, easily managed, little burden on economy

• Second year plan (with emphasis on industrialisation under Mahalanobis strategy )- deficits rose 10 times bigger

Reversing trend

• In subsequent 3 plans (3rd to 5th), deficits rose two to three times bigger than second plan

• In the 3 annual plans (1966-1969), deficit crossed the big figure of Rs One thousand crores in each year

• But sharp increase took place in 6th and 7th plan

• Same feature continued to mark the 2 annual plans after 7th plan (1990-91 and 1991-92), the eighth plan and the first 3 years of 9th

plan

• Then, situation started improving, surplus of Rs. 16426 crore in 2001-02 of the 9th plan

Contribution of each component• Deficits in BOPs have originated in all its 3 components

Trade in goods or merchandise

Trade in invisibles

Normal capital movements ( Transactions on private & government account )

• Biggest contributor was BOT (Difference between exports and imports on merchandise account)

• BOT - Remained negative almost throughout the period, risen massively in the recent years

Contd…• Net invisibles (receipts – payments) also added to overall deficits

but only for a few years

• Middle 1990s- net invisibles has been a net surplus

• 1990s, it was a helpful factor in reducing the deficits in BOP

• Due to this, balance on current account showed smaller deficits

• But for plus net invisibles, the balance on current account would have shown bigger deficits

• Movement of non-monetary gold-little/nil impact

• Capital transactions at times been helpful, sizeable in reducing deficits

Big trade deficits• Since 1951, deficits in trade balance have increased

substantially with the passage of time

• Thus the strains on overall BOP situation are the making of the deficits in the trade balance

• Same has been the case plan wise (Except 4th year )

• The same trend (Proportional to BOP ) in each plan continued till 9th plan where trade deficit turned out to be double of the average deficit during the eighth plan period

• Early 1950s, India was reasonably open• 1951-52 – Merchandise trade accounted for 16% gdp• The share of external sector in India’s GDP gradually declined with the inward

looking policy of import substitution• Policy emphasis on import saving rather than export promotion• Import-substituting strategies were expected to gradually increase export

competitiveness through efficiency-gains achieved in the domestic economy. But this did not happen

CAUSES

• SHARP RISE IN IMPORTS

• SLOW RISE IN EXPORT EARNINGS

• DEFICITS ON CAPITAL TRANSACTIONS

• RISE IN OIL PRICE DUE TO GULF CRISIS(1990).

Sharp Rise in Imports

In1950’s, High import of capital goods due to Industrial development- MahanalobisScheme

In 1960’s, High import of Intermediate goods-for repairs and maintenance.(after establishment of industries producing machine, tools etc.

In 1985, Import of latest technologies for support domestic economy(to reduce cost and improve quality of export products.

Other imports cereals and edible oils during drought.

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Sharp Rise in Imports

Petroleum oil and lubricants at times are 1/3 of total imports(1970’s).

Devaluation of rupee in 1966 and 1991 –raised the money value of goods bought.

Rise in price of certain imports in particular petroleum and fertilizers

Deliberate increase in prices by most of the petroleum producing countries(beginning from 1973-74), Gulf War – Rise in import bills.

Slow rise in exports

Fluctuation in agricultural production(Bumper agricultural crops in the first plan boosted exports, fail in the second plan).

Growth in exports during devaluation in 1966 and 1966, during Korean war but not substantial, govt assisted.

Financial crisis in East Asian countries, July 1977

Earnings from invisibles used to offset interest payments from foreign debts(in 6 plan period net invisibles had offset over 60% of trade deficit, came down to 32% in 1987-88)- Not used to neutralize the trade deficit.

Current account surplus in 1973-74 because exports growth was significant and Invisible receipts also showed a sharp turnaround ( on account of official transfers which largely represented grants under the agreement of February 1974 with the USGovernment on the disposition of PL 480 and other rupee funds)

• Sharp rise in international oil prices was evident in higher imports growth in 1973-74 and 1974-75

• The share of crude oil in India's import bill rose from 11 per cent in 1972-73 to 26 percent by 1974-75• As exports improved, particularly to oil producing Middle-East countries, BoP recoveredquickly from the first oil shock• By this time, the Indian rupee, which was linked to a multi-currency basket with pound

sterling as intervention currency, depreciated against the US dollar• Exports grew and so did invisible receipts (worker’s remittances from middle east )

• The private transfers added a new positive dimension to India’s BoP after the first oil shock• The rapid growth of private transfers reinforced the trade account adjustment to make thecurrent account situation much more comfortable

Other Causes – 1980’s

• BoP again came under stress

• The second oil shock led to a rapid increase in imports in early 1980s

• Oil imports increased to about two-fifths of India’s imports during 1980-83

• Measures were undertaken to promote exports and liberalise imports

• Subdued growth conditions in the world economy constrained exports growth

• The surplus on account of invisibles also deteriorated due to moderation in private transfers

Deficits in capital transactions

Private capital transactions(Deficits in late 1970’s and surpluses in 1980).

Government capital transactions.

Amortization payments(Large sums on the return of loans which became due and large interest payments thereon)

Purchase of rupees from IMF

Banking capital

Crisis Situation – 1990s

• While the problem was long standing one, it took a serious turn in the early 1990’s, and continued

• Although there some easing of the situation

o Two factors have contributed to the worsening of the BoPscenario.

• Large Imbalances.

• Loss of confidence.

Large Imbalances• The continuing deficits became massive around the second half of

1990, because of the Gulf crisis

• The oil prices rose sharply, resulting in an equally steep rise in value of imports of oil, which in turn greatly expanded the size of deficit

• Rs.499 cr per month in June- August 1990, the value of oil imports rose massively to Rs. 1221 cr per month in the following six months

• The following scenarios largely accounted for doubling of BoPdeficit from an average of Rs.619 cr per month in June-August 1990 to Rs.1229 cr per month in the six months that followed

Worsening the situation

• Indian workers employed in Kuwait had to be airlifted back to India, as a result their remittances(money transfer) ceased to flow

• Further the UN trade embargo on Iraq let to cessation of exports to Iraq and Kuwait, and a rapid depletion of reserves on account of rising BoP deficits.

Effectiveness of Measures

• The govt. took several measures to compress imports.

• The deficit got reduced from Rs.1412cr per month in Oct-Dec 1990 to Rs.710cr per month and further to Rs.361cr per month in Apr-June 1991.

Loss of Confidence

• Despite the reduction in the deficit, the payments crisis did not disappear.

• It appeared as if the world outside had lost confidence in the country’s ability to manage the crisis.

• There was the expectation that the country would default on debts, and the Rupee would fall in the market heavily.

Effect of Expectations

• Created longer leads in the payments for imports and lags in the realisation of export proceeds.

• Drying up of short term credits from a level of about $2 Billion in 1989-90 to over a half billion in 1990-91, the interest on these credits too went sharply.

Loans and Borrowings

• Commercial borrowings abroad with maturity of over a year or medium term loans also went down (from Rs.5479cr in 1989-90 to Rs.3414cr in 1990-91).

• The drying up of commercial loans was accompanied by a net outflow of NRI deposits which began in Oct 1990 and continued in 1991.

• All this culminated in a payments crisis of unprecedented dimension in the first quarter of 1991-92.

• It manifested itself into the following two ways:-

1. Difficulty in financing current imports an in meeting debt-service obligation

2. Erosion of confidence of short-term lenders and NRI depositors.

A Serious Problem(Deficit)

• The deficit in trade balance is a big figure.

• As a proportion of GDP, it has remained as high around 3% for most years, and the value is larger than projected.

Strains on foreign exchange resources

• Another serious facet of the large deficit in balance of payments is the large pressures which exert on foreign exchange of the country

• These reserves comprises of foreign assets of RBI and SBI of the IMF

• These reserves which are the maximum a country can draw upon freely

• But it is considered to be prudent to keep an amount of these reserves equivalent of minimum 3 months’ merchandise imports

• Importantly, it should be remembered that sources like

1. SDR’s – which are loans of special category fromthe IMF

2. Drawings from the IMF – technical name forloans under normal rules of the IMF

are not self-owned reserves• Despite these limitations, the balance of

payments situation strained the foreign exchangereserves

• Quite often, the reserves become too small to provide cushion for a reasonable amount of imports

• And in some years, the possition become precarious because of reductions in them

• However, in recent years the foreign exchange reserve position has got strengthened substantially from a reserve of US $ 5834 million in 1990-91 to a reserve build-up of US $ 151.62 billion in 2005-06

Large increase in debt burden

• Large debt – more deficits in balance of payments – heavy burden of return on loans and payment of interest

• These loans are drawn from mainly – foreign aid, IMF credits, commercial borrowing’s and supplier’s credit

• Total external debt – US $ was 23.5 billion in 1980-81

• This increased by 4x times in the year 2005

• At this high level of debt service, the economy is faced with a liability of big magnitude

• Apart from large size, it needs to be added that the debt burden is all the more serious because, unlike the internal debt, this had to be repaid in foreign currency

Government Policy

1. To over come the serious problems of deficits the government undertook

several measures

2. In response, Prime Minister Narasimha Rao, along with finance

minister Manmohan Singh, initiated the economic liberalization of 1991

• Use of gold to acquire foreign currency

• Downward adjustments of exchange rates

• Compress imports

• Government schemes

• New trade policy - 1991

Controlling the crisis

(A)Crisis Management • Set of measures adopted in the early years of the 1990’s

• Which could produce immediate impact on BOP situation, in this category fall four operations

1. Gold was made use for acquiring foreign currency to meet the payment obligations which had made due

• In 1991 Twenty tones of gold out of the confiscated gold lying under the ownership of government was sold to a bank in Switzerland, with condition that it would be repurchased after six months

• Another 40 tones of gold, out of the Reserve Bank of India , was shipped to the Bank of England in July in 1991

• Above two transactions enables the government to raise about $600 million

2) Measure consisted of downward adjustment of the exchange rates of the Rupee i.e. devaluation

• Reduction in the exchange rates of the Rupee to a sizeable extent of around 18 to 20% in terms of major currencies like US Dollar, UK POUND, German Deutsche Mark and Yen

• Intended to boost exports and to discourage imports

3) Line of action was to compress imports so as to reduce

immediately the need for foreign exchange

• In 1990, RBI imposed cash margin of 50% on imports other than those of capital goods

• Cash margin subsequently raised up to 133.3% to 200% in March and April 1991

• In December 1990 a surcharge of 25% was imposed on the prices of petroleum products except domestic gas

• RBI imposed a 25% surcharge on interest on bank credit for imports

4) Measure was to seek foreign exchange to meet the immediate and the future BOP needs and also to relax the curbs on imports

• Government formulated two schemes

India Development Bond Scheme

Immunity Scheme for repatriation of funds held abroad in October 1991

(B)Reform of the economy

• Objective was to ensure a broad based, rapid and sustained growth of exports and an efficient import-substitution

• Several measures for reducing growth in expenditure and raising revenues to reduce fiscal deficit

• Aim was to reduce the demand for imports to stabilize economy for proper alignment of domestic prices with international prices

• New trade policy introduced in July 1991

• To remove obstacles to export associated, exchange control and also custom procedures

• They introduced full convertibility of rupee on trade account from March 1992 to 1993

• Also, exporters started selling their foreign exchange in the free market

• Government introduced a new industrial policy to provide greater competitive stimulus to the domestic industry

• Several steps were taken to facilitate larger inflow of direct foreign investment

• Public sector enterprises too were subjected to change with view of making them self-dependent

• Gold sold and mortgaged were brought back

• But position were till fragile

• Because of large proportion of increase in reserves consists of loans

Post Crisis

• The broad approach to reform in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: C. Rangarajan, 1993)

• Trade policies, exchange rate policies and industrial policies were recognised as part of an integrated policy framework.

Exchange Rates and Policy

• The exchange rate of rupee was adjusted downwards in two stages on July 1 and July 3, 1991 by 9 per cent and 11 per cent, respectively.

• A dual exchange rate system was introduced in March 1992.

• India moved to current account convertibility in August 1994 by liberalising various transactions relating to merchandise trade and invisibles.

Impact of policy changes

• lower CAD(current account deficit) and its comfortable financing in subsequent years.

• India could manage the external shocks that emanated from the East Asian crisis in 1997.

• The rise in international oil prices and bursting of dotcom bubble in 1999-2000.

• Te Indian economy remained relatively insulated from the East Asian crisis.

• Timely policy measures initiated by the Reserve Bank to minimise the contagion effect

• issuance of Resurgent India Bonds (RIBs) helped in stabilizing the BoP.

BoP Stress 2000-01

• BoP came under stress due to sharp rise in oil prices and increase in interest rates in advanced countries.

• This also encouraged Brain Drain. (software engineer)

• As a result, the surplus in the services exports and remittance account of the BoP increased sharply which more than offset the deficit in the trade account.

• Software exports rose from 0.9 per cent of GDP in 1999-2000 to a peak of 3.8 per cent of GDP by 2008-09.

Global Financial crisis

• India’s BoP came under stress in 2008-09 reflecting the impact of global financial crisis

• Capital flows plummeted - India had to draw down its foreign currency assets by US $ 20 billion during 2008-09

• Decline in India’s merchandise exports and deceleration in growth in services exports

• 2010-11 – Pick up in exports mainly led by diversification of trade in terms of composition as well as direction

• 2011-12 - slowdown in advanced economies spilled over to emerging and developing economies

• Sharp increase in oil and gold imports

• India’s openness, both in terms of trade flows and capital flows which increased in the1990s accelerated in the 2000s

• possible due to substantial liberalisation of the capital account and greater openness to private capital.

• The limitations of financing CAD through debt creating flows were exposed in the 1991 crisis• Subsequent reforms and opening up the capital account to non-debt creating flows of foreign direct investment (FDI) – financing BOPs- addition to reserves

Suggested solution1)Changing import-structure

• Elimination of imports of agricultural raw materials can be helpful in reducing quantum of imports

Replacement of certain imports partly or wholly by domestic production

Import-substitution

Provision of imports which will fulfill the objective of rapid growth of country

2) Expanding exports:

• Need at least to maintain traditional exports in absolute terms

• It requires promotion of the export of non-traditional items on a large scale like engineering goods

• Domestic consumption of certain items which have great export potential must be kept within check to make available surplus to export

3) Increasing efficiency:

• Keeping under check inflationary tendencies

• A suitable exchange rate policy, including devaluation of the rupee

4) Raising earnings from invisibles:

• Potential for tourism industry with many attractions of the country

• Consultancy services are also acquiring importance

• IT industries and KPO’s

Using counter trade mechanism

• By enlarging the quantum of counter trade

• Used commonly by the developed countries

• The principle is at the basis of bilateral trade agreements

• Short-term trade as it goes against principle of multilateral trading

• Multilateral trading – where deficits/surplus between two countries are offset through surpluses/deficits with the third/other countries

• Developed countries posses difficulty in using this type of trading

• But it is any day, a second best solution than no trade at all

• Number of measures are helpful in overcoming the problem of deficits

• But majorly, the solution lies in stepping up exports

• To be on the rising curve of exports and imports and with little or no deficits – the trade policies must be conceived in terms of both domestic needs and capabilities as which are global requirements

• To be minuscule, Indian economy will have to be an outward looking economy

CONCLUSION• The Indian economy is much more open and globalised now than ever

before

• The periodic pressures on BOP have been addressed through policy changes

• While the BOP has again come under stress since 2011-12 as the situation is not as serious as it was in 1991

• Because the structure of the economy has changed in a fundamental way with flexible exchange rate and greater depth in financial markets, besides much larger foreign exchange reserves than those in 1991

• However, there is a need to bring the CAD to sustainable levels in the short run to boost our competitiveness, raise growth potential and bring in more stable flows into the economy.

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