19

Small-scale Industrialisation

Small Industry

Rationale for supporting Small-scale Enterprises:

THE arguments advanced in the literature for promotion of small-scale enterprises
involve both certain desirable characteristics of such enterprises and also a common
belief that under normal market conditions many such enterprises would not be able
to survive in the economy. A list of such desirable characteristics of such enterprises
include, inter alia, higher labour intensity and related positive income distribution
effects, their potential for balanced regional development through greater
decentralisation, their contribution to the promotion of entrepreneurship, their
flexibility in operation, and their ability to export. If these positive characteristics are
seen to be important and if there is reason to believe that market failures inhibit the
growth of small-scale enterprises, then it would be appropriate to frame policies that
attack these market imperfections.
It is believed that small-scale enterprises are hampered in their growth because of
imperfections in factor markets, in labour, capital and land. Typically, the factor
market most focussed on is the capital market, distortions in which are seen to
especially discriminate against small-scale enterprises. Similarly, imperfections in the
labour market lead to factor price distortions causing larger than justifiable wage
differences between large and small enterprises. It can be argued, however, that the
higher wages facing large firms can generally be compensated by higher efficiency of
the workforce so that the wage cost difference per efficiency unit of labour is much
less than the observed difference in the prices of capital. Thus, it can be argued that
distortions in the capital market are much more important than those in the labour
market. Large firms are able to compensate the higher wages through higher
efficiency, but small firms are not able to compensate for the high cost of capital
through higher efficiency of the capital used. Similarly in the land market small
enterprises could face greater regulatory hurdles in achieving appropriate access to
land.
The economic argument would then be that in the face of factor market distortions
special support policies for small-scale industries would tackle the problems at their
source. The best solution would be to enact policies that remove the various factor
market distortions that are observed at their source. In practice, it is found that it is
difficult to remove such factor market distortions through direct interventions. The
result is that a whole plethora of other supportive policies for small-scale enterprises
are observed. India has differed from other countries in its degree of concern for
supporting small scale enterprises. In fact, amongst developing countries, India was
the first to display special concern for small-scale enterprises, before it became
fashionable to do so. A basic focus of Indian government thinking has been that
employment generations are of paramount importance in a labour surplus economy.
Small enterprises manufacturing labour intensive products make economical use of
capital and absorb abundant labour supply which characterises an under developed
economy. The belief has been that large enterprises are capital intensive and reward
only a small minority of labour which is skilled and urban. Indian concern and
support for small scale enterprises has focussed excessively on small-scale industries
as distinguished from small-scale enterprises in general. This can perhaps be tracked
back to Mahatma Gandhis special concern for handicrafts and village-based
industries. In the nineteenth century, there was a widespread perception in India that
the import of handloom textile workers and other craftspeople, and this experience
also contributed to the special concern for protecting SSIs.
All industrial policy Statements since Independence have provided some special
attention to the problem of small-scale industries.
The basic structure of institutional promotion of small-scale industries was put in
place in the 1950s. The institutional structure had aimed to provide for a development
programme for small-scale industries through the establishment of organisations for
providing technical assistance and industrial extension.
The basic idea then was promotion of small-scale enterprises through positive
technical and marketing support.
A policy of reserving items for the exclusive manufacture in the small-scale sector
began in 1967 when 47 items were reserved. This number rose gradually to 180 by
1976. With the 1977 Industrial Policy Statement a major expansion took place in the
number of items reserved for small-scale sector. A major shift in small-scale industry
policy took place with the promulgation of the Industrial Policy Statement of 1977. It
was then decided that the sole criterion for reservation of products in the small-scale
sector would be merely its ability to physically manufacture them. It was stated in the
policy that whatever can be produced on a small scale must be so produced. The
regime for small-scale industry developed has remained virtually unchanged after
that.
The key elements of Indias policy for the support of small-scale industries have
been small-scale industry reservations, fiscal concessions by way of lower excise
duties, preferential allocation of and subsidisation of bank credit, extension of bank
services by the government, and preferential procurement by the government. Thus,
small scale industry has been sought to be protected from the competition of large
companies both through reservations as well as fiscal concessions. Extension of
business services by the government was considered necessary in the absence of
equivalent services being available in the private sector.
In his study, Rakesh Mohan has argued that this support structure may have
reflected well the needs of the 1950s, 1960s and 1970s. The argument is that these
policies have now become obsolete and are now likely to be harmful to the
development of small scale industries and of industrial development in general. There
has been vast growth of small units over the years. Thus, the governmental structure
for technical support of small-scale industries has become both obsolete and
inadequate. There is now much greater availability of private sector business and
technological support service which should be fostered. Second with the opening of
the economy the reservation policy has become counterproductive. Third, fiscal
concessions can also be operating so as to discourage growth into large units. Thus, it
is argued that a whole new approach for supporting small-scale industries has to be
adopted in India to serve the changing needs of the new open economy.

Definition of Small-scale Industries:

Most countries define small-scale industries or enterprises in terms of employment
levels. Usually small-scale industries are taken to be those units which employ more
than 5 but less than 50 or 100 workers. India is among the few countries that has used
investment ceilings to define small-scale industries. Further, in India itself, different
definitions are used for different purposes. The Factories Act defines a factory as one
which employs 10 workers or more if the unit uses power, or 20 workers or more if it
does not use power. All such units have to be registered under the Factories Act and
are subject to various labour laws including the provision of medical insurance and
some social security. This is known as the registered sector. Within, this definition
those units which employ more than 50 workers (if using power) or more than 100 (if
not using power) have to compulsorily register themselves with the state governments
in order to operate. The main source of data for manufacturing is the Annual Survey
of Industries (ASI). The coverage of this survey is limited to those factories which are
registered under the Factories Act. The third definition is that used for giving fiscal
concessions. At present units which has less than Rs. 3 million turn over are fully
exempted from the excise taxes and there is a sliding scale of concessions available
for small-scale enterprises which have turnover of up to Rs. 30 million.
In 1950, the investment limits was up to Rs. 0.5 million in fixes assets employing
less than 50/100 persons with or without power. From 1960 onwards, there are no
conditions regarding employment but investment limits has been raised to keep up
with the inflation and hence to preserve the real value of investment limits. In 1966
Investment limit was raised to 0.75 million in plant and machinery then 1 million in
1975, 2 million in 1980, 3.5 million in 1985, up to 6 million in 1991 and up to 30
million in 1997. A curious development took place in 1999 when, for the first time, a
reversal in investment limit was put into effect by lowering the investment limit to 10
million. The current definition is therefore more restrictive in real terms relative to
1991.
The current status of the investment ceilings for small-scale industries is provided
in the following statement.
STATEMENT

Investment Ceiling for Small-scale Industry(December 1999)

Type of small- Investment Limit Remarks

scale Industry

Small-scale Industry Rs. 10 million Historical cost of plant and machinery

Ancillary Rs. 10 million At least 50 per cent of its output should go to other industrial
undertakings
Export Oriented Rs.2.5 million Obligation to export 30 per cent of production
Tiny Enterprise Rs.0.5 million No location limits
Service and Rs. 10 million No location limits
Business Enterprise
Women Enterprise Rs. 10 million 51 per cent equity holding by women

Small Scale Reservation Policy:

The policy of small-scale reservations was initiated in 1967 as a promotional and
protective measure for the small-scale sector vis--vis the large-scale sector. Under
this policy selected products are identified for exclusive production in the small-scale
sector. The overwhelming consideration for reservation is whether it is technically
feasible to produce that item in the small-scale sector, the manufacturing process is of
a simple nature i.e. is essentially labour intensive, and whether the small scale units
can meet the requirements of consumers both in terms of quality and quantity. The
rationale for reservation was based on the advantages of the small-scale sector like
labour intensity and adaptability to a semi-urban and rural environment. Another
objective was to make SSI products competitive with those of the large scale by
offsetting the disadvantage of mass scale production, economies of scale, wider
marketing network, better credit availability and publicity through mass media and
advertisements.
 In April 1967 there were only 47 items in the reserved category which increased to
504 by April 1978. In 1978 it was decided to recast the reserved list by following
codes adopted in the NIC and in this process, the list of reserved items expanded from
504 to 804. The number had increased to 873 in October 1984 and in 1989 after some
dereservation it came down to 836.
Throughout this whole period of reservation there has been little analysis of the
effects of this policy. The government has conducted two small-scale industries
censuses so far; one in 1972 and the other in 1987-88. The share of production in the
reserved categories was 25 per cent in total small-scale industry production in 1972
and 28 per cent in 1997-98. This small increase in the share was surprising given the
large-scale expansion of products under reservation that took place in 1977. In both
cases capacity utilisation in units producing reserved items was 47 to 48 per cent on
average, whereas the average level of capacity utilisation was over 50 per cent in units
producing unreserved items. It was also found in 1987-88 that a large number of
reserved items were not produced at all in any unit.
The second census of small scale industries provides persuasive evidence of the
misplaced importance given the policy of reservation. Out of a total of 200 products
leading in value of output produced by the small scale sector, it was found that
reserved products accounted for only 21 per cent. Only 21,000 small scale units, less
than half out of a total of 5,82,000 units, manufactured the reserved products at all.
No less than 233 reserved items out of a total of 1,076 (when expanded at a lower
level of aggregation in the NIC code) were found not be manufactured at all according
to the census. Although further inquiries have revealed that many of these products
are found to be manufactured by some units, the fact remains that their production is
in negligible quantities.
Conversely, very few of the reserved products attracted significant levels of
participation from small-scale units. As many as 90 products were found to be
manufactured by one company each. The sum total of the value of production of all
small-scale companies in as many as 692 items was a low of Rs. 100 million or less.
Just 68 reserved items accounted for 81 per cent of the total value of the production of
reserved products and 83 per cent of the units.
In recent years, with opening of Indian trade almost 75 per cent of all reserved
items are now already importable with the removal of quantitative restrictions (QRs)
in the last few years. India is also committed to remove the remaining of QRs by April
2001. We, therefore, now have a curious situation that reserved items can be produced
by large foreign enterprises and imported into India whereas Indian large enterprises
are not allowed to produce the same items! Even this change in the external
environment has so far not persuaded the authorities to change this policy of small-
scale industry reservation.
Reviewing the framework of Indian policies protecting and supporting small-scale
industries, Rakesh Mohan remarks, That these policies and programmes are thinly
spread thereby leading to relative ineffectiveness. Many of the policies are such that
discourage growth of small scale units into larger ones and thereby are likely to have a
stunting effect on manufacturing employment and output growth. Some of these
policies may have been useful in the earlier stage of Indian industrialisation and in the
context of a highly controlled and closed economy. With all the changes in economic
environment that have taken place in the 1990s the indication is that future policies
for the promotion of small-scale industries must be more growth oriented and more
general rather than being sector oriented. It would be more useful if such policies are
designed to promote entrepreneurial entry, growth of enterprises technology up
gradation and labour productivity in a pervasive manner regardless of specific
sectors.

Spatial Distribution of SSEs:

One of the aims of Indias SSI policy was the dispersed development of units in
rural areas and its less developed backward areas. There has been only limited
success in attaining this objective.
The SIDO figures suggest that 85 districts with more than 2,000units in each
account for 51 per cent of the total. More than 81 per cent of SSEs are concentrated in
204 districts, and more than 50 per cent of the districts do not have any significant
number of enterprises (NCAER, 1993 3.7.6, p.81).
Rakesh Mohan argues, the objective of dispersal might be in conflict with the
dynamic growth of modern and efficient growth. There has been important spatial
concentration of SSEs in clusters in particular product lines. The external economies
which these clusters generate in terms of easy availability of raw materials, skilled
labour, markets, etc. have been known to have been instrumental in the growth of
SSEs in many countries, including Italy and Germany. India is providing no exception
to this basic economic impulse. It is appropriate that these trends might be more
emphatically encouraged in official policies and objectives. A closer look needs to be
taken at the methods for fostering development in backward areas through such
methods as tax concessions and special allotment of scarce materials.

Impact of SSI Reservation on Exports:

According to Rakesh Mohan, the policy of small-scale industry reservations has
had a very deleterious effect on the growth of both manufacturing employment and
exports. An important feature of industrialisation of the fast growing East Asian
countries during the last three decades or so has been high growth in manufactured
exports accompanied by high growth in manufacturing employment. The Indian
experience has been different. Our record of growth in manufacturing employment
has been poor and so has our export growth. The share of exports in Indian GDP has
barely reached 10 per cent now. Although this is a significant improvement over the 3
per cent share of 1970 and 5 per cent in 1980, the Indian economy remains the least
open among major countries in Asia, including China. The volume of Indian exports
in 1970 was the third highest among the 10 Asian countries. Today it is the second
lowest. While Chinese exports grew from US$ 18 billion in 1980 to about US $ 120
billion in 1994 Indian exports during that period grew from US $ 8.6 billion to US $
25 billion. Given that the composition of exports of industrialising countries is largely
labour intensive, one of the reasons behind slow employment growth in
manufacturing in India is clearly related to the slow growth in exports.
It is possible that the damage caused by such policies was not very high in the
1970s, when competition in exports of low technology was not high as it is now.
Furthermore, changing industry structure and demand patterns in the developed world
now place a much higher premium on product quality and service quality with the
inexorably rising incomes there. The average quality demanded for products such as
clothing, footwear, toys and sports equipment and the like is getting higher and
higher. Furthermore, the integration of the information technology in even these
industries also requires greater investment and greater labour sophistication. Such
products are no longer seen as free standing products but are increasingly becoming
parts of long value chains with the share of value added in plain manufacturing
perhaps falling. Higher quality requires high level designing upstream even for simple
 products. Downstream marketing involves linkages with large organisations which
buy such products in bulk. Small enterprises sandwiched between such high level
organisations find it increasingly difficult to operate and be competitive. Thus, apart
from the loss that India has suffered over the last 2-3 decades it is likely that the
future scenario will become even more difficult for Indian small enterprises to
survive, particularly in the reserved sector. Another issue of note is the prospective
dismantling of the Multi-Fibre Agreement. Paradoxically, although it may have
seemed that textile quotas were inhibiting Indian exports, it is likely that we are
actually protected through the MFA mechanism. This is shown in Somnath Chatterjee
and Rakesh Mohan (1993) who documented the fact that Indian clothing exports went
primarily to quota countries and were almost absent in the markets of non-quota
countries. Thus, the removal of small-scale reservation is especially necessary in the
item affected by the removal of MFA.
Looking at the record of Indian exports in comparison with East Asian countries,
it is difficult to avoid the conclusion that Indian exports have been constrained by the
policy of SSI product reservation.
The major conclusions of Rakesh Mohans study are given below:
We may distinguish the small scale modern sector-consisting of units employing 6 or
more workers and the tiny sector including household enterprises. In terms of
employment around 1990, the former accounted for roughly 20 per cent of all
manufacturing employment, but nearly a half of employment in the modern
manufacturing sector. The tiny and household sector is 2.5 to 3 times as large,
depending on whether or not we include secondary workers in the labour force. The
contribution of SSI in terms of value added is, of course, much smaller-only a third as
far as the modern manufacturing sub-sector is concerned and no more than 40 per cent
of all manufacturing value added. The last point emphasises the enormous difference
in labour productivity between the different sub-sectors of manufacturing.
As in other countries, the household sub-sector has declined slowly over the last two
or three decades. A more surprising finding is that in spite of the vigorous policy of
protecting the small scale industry, this decline has not been fully compensated for by
the growth of non-household production in the small-scale sector. The SIDO figures
of high growth rates of SSIs under their purview seem to be grossly exaggerated.
In spite of the vast increase in the number of reserved items, much of the growth in
the SSI sector seems to have been in product lines outside the reserved list. It is
possible that the policy of reservation might be merely protecting inefficient units in
stagnant industries.
A finding of some concern is the unequal distribution of units of small and large sizes
within the SSI sector. There seems to be an increase in the concentration of output in
larger units over the last two decades. A comparison of the data from the two SIDO
censuses of 1972 and 1987-88 show a sharp fall in the mean employment size but an
increase in capital-intensity of the SIDO units-which is consistent with a more skewed
distribution of enterprises, and increased contribution of the more productive units.
The claim that there has been substantial dispersal of units to backward and rural
areas under the SSI policy might be exaggerated. As far as the modern SSIs are
concerned there is considerable evidence of spatial concentration of SSEs in
clusters in specific product groups. We have already emphasises in earlier chapters
that there is a need for policies of de-centralisation to come to terms with the
economic logic of external economies which clusters provide.
 All the evidence suggests that the Indian manufacturing sector is likely to have been
constrained by the various, anti-growth policies promoting the small-scale sector,
particularly that of product reservation. Indian manufacturing employment growth has
been the lowest among large Asian countries over the past three or four decades.
A particular casualty of SSI product reservations has been growth in Indian
manufacturing exports. A large number of categories in which exhibits comparative
advantage have been reserved for SSI. Consequently, Indian industry is unable to
upgrade quality on a continuous basis and is also not able to diversify to higher
technology and higher value added item, thereby stunting export growth.

New Small Enterprise Policy

The document on the new small enterprise policy (NSEP) titles policy measures
for promoting and strengthening small, tiny and village enterprises was tabled in the
Parliament on August 6, 1991. The NSEP is presented under the major heads of (a)
small and tiny enterprises, and (b) village industries. Since the emphasis on objectives
in the NSEP of these two groups is not the same, as also because the measures
proposed for them are substantially different, it is best to examine the NSEP
separately under these heads.

Small and Tiny Enterprises:

The primary objective of the NSEP as mentioned under the above head is to
impart more vitality and growth impetus. In as much-as vitality is founded basically
on cost-efficiency, and is prone to promote growth, the NSEP may be said to have for
this sub-sector, the objective of increase in efficiency, and through it to promote
growth of output, employment and exports. In this context, a number of changes are
proposed, but four, according to Sandesara, are path-breaking. They are discussed in
detail below.
First the definition of a tiny unit is changed, and this change is two-fold. It may be
recalled that the industrial policy of May 19990 had announced an increase in the
investment limit of tiny units from Rs. 2 lakh to Rs. 5 lakh. However, it had retained
the location requirement to villages and smaller towns (limit of 50,000 populations).
The NSEP has done away with this requirement. The population of tiny units will,
thus, increase, as all units within the investment limit of Rs. 5 lakh and located in
bigger towns (population of 50,000 plus) will now become a part of the tiny group.
The other definitional change is more basic. Earlier, industry meant, by and
large, manufacturing industry. The NSEP has widened the scope to include industry-
related services and business enterprises also. All such enterprises, irrespective of
their location are now recognised as small-scale industries, but their investment
ceiling corresponds to those of tiny enterprises. What we really have now, is, thus, a
tiny enterprise/business policy instead of a tiny industry (manufacturing) policy as
earlier. Thus, this change also increases the number of enterprises in the small sector,
more than in the tiny group.
This is to be welcomed for three reasons. First, service and business activities are
more labour-intensive than manufacturing activities. Thus, state assistance to these
activities will sub serve the employment objective. Second, of late, a number of large,
high wage/salary paying companies in the manufacturing sector have been getting
considerable auxiliary, serving work done from outside-from smaller, low wage/salary
enterprises to reduce the cost of such services. Among such activities are: cleaning,
security, typing, transportation and distribution, catering, etc. Partly because of this as
also because of other developments, over the years the tertiary sector has grown
greatly in relative terms, following the growth of the secondary sector. To illustrate,
the formers share in gross domestic product increased from 28 per cent in 1950-51 to
39 per cent in 1989-90 and the latters from 15 per cent to 27 per cent, with a
corresponding decline in the share of the primary sector from 56-24 per cent over the
same period. With its share of nearly two-fifths, the tertiary sector has now become
the largest, and cannot be neglected by the state. Third, in the US, in the UK and in a
number of other countries, for the small sector. It has been really a small business
policy and not an industry policy. It is, thus, in the fitness of things that the NSEP
includes non-manufacturing service enterprises.
The third major change relates to equity participation. The NSEP provides for
equity participation by other industrial units in the small industrial units not exceeding
24 per cent of the total shareholding. This provision should prove mutually beneficial
to both large units and the small units, especially ancillary units, and cement further
the economic bonds between the two sectors. Marketing is one of the most difficult
problems of small industry, and ancillarisation takes care of this problem in varying
measures. Large units are also known to take care of the working capital and quality
problems of small units, by giving them advances and by making available their
testing facilities. The provision of equity participation not only relieves the small units
of the burden of full equity funding, but it also builds up the stakes of large units in
the survival and growth of small units.
The fourth special feature of the NSEP is the introduction of a new legal form of
organisation of business, namely, restricted or limited partnership. In this form,
liability of at least one partner is unlimited, whereas other partners have their liability
limited to invested capital. Following the example of US and Japan, the A.R. Bhatt
committee had recommended the introduction of this form of organisation in the 70s,
but no follow-up action seems to have been initiated until the NSEP. This is a
welcome provision. It will attract equity capital especially from friends and relatives
of the entrepreneurs of small nits, who may like to help their kith and kin, but who
fight shy because of unlimited liability in the partnership firm (under which a large
number of small units are organised). On the other hand, small units short of funds but
wishing to avoid sharing of decision-making will welcome argumentation of risk
capital from such silent partners.

Village Industries:
Although the objectives and policy measures for village industries are presented
separately for handlooms, handicrafts and other village industries, there is a lot that is
common for them in the NSEP as regards both objectives and measures. To avoid
repetition, it may therefore be best to examine first the proposals of the NSEP for
these industries together and then draw attention to their special features individually.
A main objective for the group of village industries seems to be, as the word
village suggests, to promote rural industrialisation. The other major objective is to
promote employment, with a view especially to help the weaker sections of society.
Thus, here, employment is more welfare-oriented than efficiency -oriented.
A number of measures are proposed to serve these objectives. Almost all the
measures of routine type, and relate to supply of raw materials, sale of products, up
gradation of production methods and improvement in the quality of products,
expansion of training facilities, strengthening of the existing organisations, etc.
The NSEP has broadened the definition of tiny and women enterprises. It has
also introduced a new form of legal organisation-restricted partnership-to enable small
units to raise equity from private sources. It also permits limited equity participation
by other industrial enterprises. It also envisages greater role of non-government
agencies like co-operatives, industry associations, voluntary agencies and the like in
administering some assistance programme. It also speaks of simplifying rules and
procedures.

Performance of Small-scale industries

The performance of small-scale industries sector in terms of critical parameters

like number of units (both registered and unregistered), production, employment and
exports is given in the table 19.1.
According to economic survey 2006-0, the micro and small enterprises (MSEs)
constitute an important segment of the Indian economy, contributing around 39 per
cent of the countrys manufacturing output and 34 per cent of its exports in 2004-05.
It provides employment to around 29.5 million people in the rural and urban areas of
the country (table 19.1).

TABLE-19.1

Performance of Micro and Small-scale Enterprises

No. of units(lakh) production (Rs. Crore) Employment Exports

Year (in lakh) (Rs.
Regd. Unregd. Total (at current (at constant crore)
prices) prices)

2002-03 15.91 93.58 104.49 3,11,993 2,10,636 260.21 86,013

(4.1) (10.5) (7.7) (4.4) (20.7)

2003-04 16.97 96.98 113.95 3,57,733 2,28,730 271.42 97,644

(4.1) (14.7) (8.6) (4.3) (13.5)

2004-05 17.53 101.06 118.59 4,18,263 2,51,511 282.57 1,24,417

(4.1) (16.9) (10.0) (4.1) (27.4)

2005-06 18.71 104.71 123.42 4,76,201 2,77,668 294.91 N.A

(4.1) (13.9) (10.4) (4.4)

Note: figures in parentheses indicate percentage growth over previous years

Source: Development Commissioner (SSI)

This sector has the second largest share of employment after agriculture and spans
a wide range, including small-scale, khadi, village and coir industries, handlooms,
handicrafts, sericulture, wool, power looms, food processing, and other agro and rural
industry segments. It touches the lives of the weaker and unorganised sections of the
society with more than half of these employed being women, minorities, and the
marginalized. Fifty seven per cent of the MSE units are owner-run enterprises with
one person. They account for 32 per cent of the workforce and 29 per cent of the
value added in non-agricultural private unincorporated enterprises. Infusion of
appropriate technology, design skills, modern marketing capacity building and easier
access to credit can make this segment an expanding base of self-sustaining
employment and wealth generation and also foster a culture of creative and
competitive industry. Agro-food processing, sericulture and other village enterprises
can check rural-urban migration by gainfully employing people in villages. This will
also take pressure off agriculture. The MSE sector can open up a window of
opportunities in regions like the North East where large industries cannot be set up
due to infrastructure and environmental concerns.
Several ministries/departments/institutions deal with activities falling within the
domain of the MSE sector, and have a variety of schemes to support the MSEs.
However, the benefits accrue to only a small fraction of MSEs as only 13 per cent are
registered. In the 11th plan we need to adopt a dual strategy to ensure that the
unregistered micro and small enterprises and units outside the cooperative fold are
encouraged to get them registered and are also able to benefit from government
schemes, pending registration. In fact, the provision of voluntary filing of enterprise
memoranda by micro and small enterprises in the new micro, Small and Medium
Enterprises Development Act, 2006 is a step in that direction and should be
implemented energetically.
The approach paper to the 11th plan states there is need to change the approach
from emphasis on loosely targeted subsidies to creating an enabling environment. A
cluster approach can increase viability by providing these units with infrastructure,
information, credit, and support services of better quality at lower costs, while also
promoting their capacity for effective management of their own collectives. The 11th
five-year plan should restrict subsidies to those needed to create a level playing field
and to reflect the cost or benefits to others in the society. It should incentivize
innovation and creativity. It should remove all entry barriers and migrate business
risks for start-ups, the latter, inter-alia, through a large number of well managed
business incubators in the identified thrust areas of manufacturing. It should provide
infrastructure and liberate MSEs from the inspector raj. Further, in order to improve
the competitiveness of these micro, small and medium enterprises, schemes for
establishment of mini tool rooms, setting up design clinics, providing marketing
support, sensitization to IPR requirements and tools, etc., should be evolved on a PPP
basis. Brand building can be used as an effective strategy to promote their products in
national and international markets.
After due consultation with the stakeholders, 180 items reserved for exclusive
manufacture in micro ad small enterprises have been de-reserved on May 16, 2006
and 87 such items have been deserved on January 22, 2007.
The logic of deserving items for domestic production exclusively in the small-
scale sector, particularly when such products can be freely imported from large-scale
production units abroad and when such a policy prevents the small from growing
and benefiting from the economies of scale, has progressively come under serious
questioning. However, the question that needs to be addressed is whether the
reservation in the small-scale sector is based on any objective policy parameter. The
process of reservation of items for production exclusively by the small-scale sector
started in 1967 and reached its peak in 1984 with 873 items reserved for small-scale.
There has been a gradual relaxation of the reservation policy over time, and the
number of items reserved for the small-scale sector was 239 on January 22, 2007.

20
 Role of Foreign Capital

Introduction

THE growth-augmenting role of external trade and foreign capital flows has
assumed critical importance in India in recent years. The overall shift in the policy
stance in India from export pessimism and foreign exchange conservation to one that
assigns an important role to export of goods and services in the growth process has
primarily been guided by the perception that an open trade regime could offer a
dynamic vehicle for attaining higher economic growth.
Structural reforms and external financial liberalisation measures introduced in the
1990s in India bought in their wake surges in capital flows as well as episodes of
volatility associated with the capital account dictating the balance of payments
outcome. Large capital inflows enabled an easing of resource constraints and an
acceleration of growth in the mid -1990s. In the second half, the foreign exchange
market developments as well as the rapid transmission of international sell-offs
facilitated by cross border integration equity markets via capital flows have provoked
a reassessment of the benefits and cost of employing capital flows as a lever of
growth. Throughout the 1990s, the role assigned to foreign capital in India has been
guided by the considerations of financing a level of current account deficit that is
sustainable and consistent with the absorptive capacity of the economy (Rangarajan,
1993; Tarapore, 1995; Reddy, 2000). In the aftermath of South-East Asian crisis,
however, the need for further strengthening the capacity to withstand vulnerabilities
has necessitated a shift in policy that assigns greater weightage to stability (Reddy,
2000).
The experience of developing countries with harnessing capital flows for growth
over the last two decades has been mixed. The actual impact of capital flows on
economic growth varied widely across countries, depending on country-specific
conditions and the nature of policies for external capital. Accordingly, it becomes
necessary to empirically evaluate each countrys experience in terms of the specific
role assigned to foreign capital in the process of development. This includes an
assessment, however subjective, of the negative externalities associated with capital
flows. Negative externalities could emanate both during periods of surges and sudden
reversals. Besides real appreciation of the exchange rate, surges in capital flows could
facilitate imprudent lending and overheating associated excessive capacity addition,
which may give rise to banking crises. Sudden reversals of capital flows, particularly
in cases of short-term banking flows and portfolio flows, could trigger sudden
collapse of asset prices and exchange rate and thereby adversely affect growth.
This chapter undertakes an empirical assessment of the contribution of foreign
capital to the growth process in India. Macroeconomic analysis weighing the role
foreign capital vis--vis exports (of goods and services) as a growth accelerator in a
developing country context is presented in section I. section II encapsulates the
important features of the role of foreign capital by drawing on the theoretical and
empirical literature on the subject. Different viewpoints on the role of alternative
forms of foreign capital and the changing importance of each form of capital over
time are also discussed. A brief overview of the Indian policy framework for attracting
foreign capital during the period of planned development is set out in section III, with
specific empirical findings presented in the context of the shifts in the policy regime.
Section IV suggests a realistic FDI policy. This is followed by concluding
observations.
 I
FOREIGN CAPITAL VERSUS EXPORT-LED GROWTH

The standard analysis of growth accounting in an open economy encounters an

apparent contradiction between export led growth on the one hand, and capital-flow
included growth on the other, even though in reality both strategies could be
operationalised simultaneously to strengthen the growth process. The apparent
contradiction arises from the macroeconomic identity [Y=C+I+G+(X-M)] which
suggests that while a surplus in the external goods and services account- reflecting the
result of an export-led growth strategy- could increase GDP, that would tantamount to
no role for net external financing as the country must necessarily save more than it
can invest, leading to net capital outflows. The underlying assumption behind this
assessment is that an export-led growth strategy can stimulate growth only by
generating a surplus in the external goods and services account. The actual external
resource transfer process and the stages over which the importance of each form of
transfer changes can explain how a developing country could simultaneously benefit
from both export-led and capital-flow-induced growth strategies.
In a developing country, the consumption level lags behind the consumption
standards of advanced economies and the marginal productivity of investment is
higher. A deficit in the goods and services account and the associated net capital
inflows cannot only enable the economy to bridge its consumption gap but also help
in achieving output convergence with the advanced economies. An export-led growth
strategy could enhance the ability of a developing country to achieve this goal faster
by allowing higher levels of sustainable imports. Sustainable capital inflows to
finance the gap so created would be growth enhancing. In small open economies, a
surplus generated in the trade (for goods and services) account could raise GDP.
Residents would increase their external financial assets, acquired in exchange of real
resources through the trade surplus. Financial assets, in turn, represent command over
future goods and services. An open capital account in such economies helps in
freedom of portfolio adjustment and consumption smoothing to each resident. Small
open economies, however, depend largely on external demand conditions for
sustaining the export-led growth. A slowdown in external demand conditions can give
rise to a large-scale deceleration in domestic GDP growth in such economies. For
example, Singapores external current account exhibited large surplus in recent years
(in excess of 20 per cent of GDP) indicating the role of net exports in growth (IMF,
2001).
There are three possible types of resource transfers in the external account, viz,
real against real, financial against real, and financial against financial. Priority is
greatly assigned to real against real form of resource transfers in the initial years of
development. As a result, exports are regarded essentially as the means to pay for
imports. Since the demand for certain critical real resources may exceed what could
be made available domestically or what could be financed through export earnings, a
bridging role emerges for financial transfers in the form of capital flows. With modest
and gradually increasing recourse to real against financial form of transfer, a role for
foreign capital is envisaged. Only over time, financial against financial form of
transfers-representing an open capital account-can occur. Even though country-
specific approaches to timing and sequencing often widely differ, three phases for
debt related capital flows could be conceived. In the first phase, the country operates
with a resource gap that is financed by inflows of debt capital. During this phase, debt
 grows faster than debt servicing. In the second phase, the country generates a positive
resource balance (in the goods and services account) in the current account, but the
debt servicing exceeds the positive resource balance, giving rise to further addition to
debt stock. In phase three, the positive resource balance position becomes more than
sufficient to finance the debt servicing obligations. As a result, residents accumulate
external assets and the need for debt flows to finance the resource gap disappears
(Simonsen, 1985).
India could conceptually be placed at present in phase-1 of this cycle. An export-
led growth strategy -that ensures export growth to continuously exceed the interest
rate on debt-would enable India to raise its per capita GDP to the threshold level
beyond which generation of a surplus balance in the current account could enable the
residents to accumulate foreign assets. A possible threshold level of per capita GDP
for the developing countries in general could be about US $ 1,000. Effective use of
trade as an engine of growth could help India in achieving a faster transition to the
next phase of the cycle while at the same time internalising the benefits of growth
impulses associated with a more open trade regime.

II
THE DEBATE ON THE ROLE OF FOREIGN CAPITAL

Theoretical and empirical research on the role of foreign capital in the growth
process has generally yielded conflicting results. Conventionally, the two-gap
approach justifies the role of foreign capital for relaxing the two major constraints to
growth-the saving constraint or gap and the foreign-exchange constraint or
gap.(Chenery and Bruno, 1962; Mckinnon, 1964). In the neo-classical framework,
however, capital neither explains differences in the levels and rates of growth across
countries nor can large capital flows make any significant difference to the growth
rate that a country could achieve (Krugman, 1993). In the subsequent resurrection of
the two-gap approach, the emphasis was generally laid on the preconditions that could
make foreign capital more productive in developing countries. The important
preconditions comprised presence of surplus labour and excess productive demand for
foreign exchange. With the growing influence of the new growth theories in the
second half of the 1980s that recognised the effects of positive externalities associated
with capital accumulation on growth, the role of foreign capital in the growth process
assumed renewed importance. In the endogenous growth framework, the sources of
growth attributed to capital flows comprise:
The spill over associated with foreign capital in the form of technology, skills, and
introduction of new products;
The positive externalities in terms of higher efficiency of domestic financial markets;
Improved resource allocation and efficient financial intermediation by domestic
financial institutions (de Mello and Thea, 1995; Bailliu, 2000).
The marginal productivity of capital in India was 58 times that of the United
States as obtained through the standard estimation of Cobb-Douglas production
functions (Lucas, 1990; Taylor, 1994). India, however, could never attract enough
foreign capital to take advantage of the productivity differentials. Unlike the wide
differences in estimated productivity of capital, however, real interest rates-a measure
of real return received by the investors-turned out to be much less divergent across
countries in reality. Capital markets could be imperfect, preventing capital flows from
being driven by productive differentials. Incremental investment would be more
productive in countries with skilled workforce and well developed physical
infrastructure. Thus, the presence of internal growth supportive factors appear
important, not only for attracting higher private foreign capital but also for enhancing
the growth inducing effects of such foreign capital (Lucas, op.cit).
In the recent period, studying the growth augmentation role of various forms of
foreign capital has gained prominence over the general analysis. The findings of these
studies can be conveniently grouped under the classification adopted in the analysis of
the balance of payments in India. This would also reflect the current ordering of
capital flows by type from the point of view of the policy stance (Reddy, 1998).

Foreign Direct Investment:

Capital flows in the form of FDI have been widely believed to be an important
source of growth in recent years. Since the 1970s, imperfections in goods and factor
markets, presence of scale economies and government restrictions on output, trade
and entry have come to be recognised as creating market structures where foreign
capital in the form of FDI contributes to growth (KindleBerger, 1969; Hymer, 1976).
It is eminently plausible that FDI flows might not have existed but for the presence of
these imperfections. The theories of international resource allocation based upon the
spatial distribution of factor endowments suggest the importance of locational
advantages as a key driver of FDI flows while the theories of organisation point to
the role of ownership advantage and the advantage of internalising intangible
assets (like technology, brand name and marketing skills). Competitive policies of
nations to attract FDI often work towards reducing the cost of production in a host
country. Favourable tax treatment, protected domestic market and low labour costs
represent the primary pull factors for FDI. Sound control norms also help in creating
the congenial environment for augmented inflows under FDI.
Growth impulses originating from FDI are primarily ascribed to superior
technology and greater competition that generally accompany FDI. Local firms of
many developing host countries also do not invest enough on R&D to offer and
sustain competition with Transnational Corporations (TNCs). Investment on R&D by
TNCs in foreign affiliates is, however, found to be low, accounting for as little as 1
per cent of the total R&D investment even though TNCs are generally viewed as
R&D intensive (UNCTAD, 1999). Despite the usual concerns that inappropriate
technology is generally transferred to the foreign affiliates, empirical assessments
suggest that technology -both public and private-that accompany FDI are
complementary and inter-firm collaboration helps in augmentation growth. In such
cases, also FDI may augment growth in a country if its initial technology gap is higher
and openness to FDI is significant.
Whether FDI promotes competition or facilitates development of oligopolistic
structures depends upon whether FDI crowds-out or crowds-in domestic investment.
FDI can potentially displace domestic producers by pre-empting their investment
opportunities. It is possible; however, that the adverse growth effect emanating from
crowding-out could be more than offset by the increase in productivity resulting from
advanced technology that often accompanies FDI.
Since trade is an important vehicle for growth, FDI could also contribute to
growth by promoting exports. For sustaining an export-led growth strategy, it
becomes important to attain dynamic shifts in comparative advantage and FDI can
play a major role in imparting the desired dynamism on account of its global
marketing network.
Portfolio Capital:
Portfolio capital has emerged as the key channel for integrating capital markets
worldwide. For developing countries, the growth process in the initial phase is often
characterised by self-financed capital investment, which is replaced by gradually by
bank-intermediated debt finance and supplemented over time by both debt and equity
from the capital market. Portfolio capital flows can ease the constraint on growth
imposed by illiquid and small sized capital markets in the early and intermediate
stages of the growth process. Countries that reduced barriers to portfolio flows exhibit
significant improvements in the functioning of their stock markets. Greater liquidity
in the capital market makes it possible to take up investment projects in developing
countries that require lumpy and long-term capital. Equity, unlike debt, allows a
permanent access to capital.
Surges in portfolio flows can, however, adversely affect growth. Greater liquidity
and opportunities for risk diversification may reduce household saving and excess
volatility in the stock market may hinder investment. The problem of market
imperfection and asymmetric information amplifies the volatility resulting from
sudden shifts in the pattern of portfolio flows. Portfolio flows can hinder export
promotion by exerting upward pressures on the exchange rate and also sustain an
import-cum investment boom to overheat the economy. Unlike FDI, for the portfolio
flows there is no one-to-one relationship with real investment. When portfolio
activities are entirely concentrated in the secondary market, there is no direct link with
real investment in the economy. At the macro level, portfolio flows finance the current
account gap when alternative forms of foreign capital prove inadequate. Otherwise, it
is only by enhancing the efficiency and liquidity of capital markets that portfolio
flows can propel growth.

External Aid:
The role of external aid in enhancing growth has waned in recent years. In several
developing countries, including India, public and publicly guaranteed capital flows
have been supplanted by a growing recourse to private capital flows. In some
countries, the problem of negative resource transfer associated with aid has emerged
as an additional balance of payments/growth constraint. Except for the poorest
countries and those with very limited access to commercial capital, a general sense of
aid fatigue has set in. donors have also gradually de-emphasised the role of aid in
international economic relations resulting in a significant decline in aid flows as
percentage of GDP of the donors since the 1960s.
External aid was initially equated with the need for resource transfer to ease the
financing constraint to growth. The major contradiction that surfaced soon was that
while the poorest countries had the greatest need for external aid, their capacity to
absorb foreign aid was highly unsatisfactory. In the 1980s, structural reforms were
seen as the key to promote growth and the earlier project-linked aid strategy was
supplemented by non-project linked structural adjustment lending as an additional
instrument to augment growth. Lack of sound policy environment in the aid receiving
countries has operated as a major factor in eroding aid effectiveness (World Bank,
1998). Despite the general dissatisfaction with aid effectiveness, factors such as lower
cost and higher maturity of aid in relation to commercial loans has encouraged many
developing countries to maintain their access to aid flows.
An orderly transition from aid dependence to market access for foreign capital is
being pursued by several developing countries. A number of countries have
successfully accessed international markets and raised adequate levels of private
capital to meet the financing gap. It is also being increasingly highlighted that more
aid policy should give way to more trade, requiring a change in the policy stance of
the donors to liberalise their extant restrictions on exports from aid-receivers so as to
allow them to reap the benefits of true competitive advantage and in that process to
reduce their dependence on aid.

Commercial Debt Capital:

Commercial debt capital includes a whole range of sources of foreign capital
where the overriding consideration is commercial, i.e. risk adjusted rate of return.
External commercial loans could include bank loans, buyers credit, and suppliers
credit, securitised instruments such as Floating Rate Notes and Fixed Rate Bonds, and
commercial borrowings from the private sector window of multilateral financial
institutions.
It is generally believed that the potential of banking capital in augmenting growth
would be largely realised in a strong and resilient domestic financial system with
effective supervision and regulation. Despite the diversification in the 1990s in favour
of commercial borrowings from the market, loans from banks continue to dominate
the commercial debt segment for the developing countries.

III
CAPITAL FLOWS AND GROWTH IN INDIA: THE RECENT
EXPERIENCE

Capital flows into India have been predominantly influenced by the policy
environment. Recognising the availability constraint and reflecting the emphasis on
self-reliance, planned levels of dependence on foreign capital in successive plans were
deliberately held at modest levels. Economy in the recourse to foreign capital was
achieved through import-substitution industrialisation in the initial years of planned
development. The possibility of exports replacing foreign capital was generally not
explored until the 1980s. It is only in the 1990s that elements of an export-led growth
strategy became clearly evident alongside compositional shifts in the capital flows in
favour of commercial debt capital in the 1980s and in favour of non-debt flows in
th1990s. The approach to liberalisation or restrictions on specific capital account
transactions, however, has all along been against any big-bang (Box 20.1)
A large part of the net capital flows to India in the capital account is being offset
by the debt servicing burden. As a consequence, net resource transfers have fluctuated
quite significantly in the 1990s, turning negative in 1995-96.
Till the early 1980s, the capital account of the balance of payments had essentially
a financing function (Rangarajan, 1996). Nearly 80 per cent of the financing
requirement was met through external assistance. Aid financed imports were largely
ineffectual in increasing the rate of growth and were responsible for bloating the
inefficient public sector (Kamath, 1992). Due to the tied nature of bilateral aid, India
had to pay 20 to 30 per cent higher prices in relation to what it could have got through
international bidding (Ridell, 1987). The real resource transfer associated with aid to
India, therefore, was much lower. There were occasions when India accepted
bilateral aid almost reluctantly and without enthusiasm because of the combination of
low priority of the project and the inflate price of the goods. The Report of the High
Level committee on Balanced Payments (1993) identified a number of factors
constraining effective aid utilisation in India and underscored the need to initiate
urgent action on both reducing the overhang of unutilised aid and according priority
to externally aided projects in terms of plan allocations and budgetary provisions. Net
resource transfer under aid to India, however, turned negative in the second half of the
1990s.

Box 20.1
Role of Capital Controls in Stabilising the Growth Process
The Indian Approach
India considers liberalisation of capita account as a process and not as a single
event. While relaxing capital controls, India makes a clear distinction between
inflows and outflows with asymmetrical treatment between inflows (less
restricted), outflows associated with inflows (free) and other outflows (more
restricted). Differential restrictions are also applied to residents vis--vis non-
residents and to individuals vis--vis corporate and financial institutions. A
combination of direct and market-based instruments control is used, meeting the
requirements of a prudent approach to management of the capital account. The
control regime also aims at ensuring a well-diversified capital account including
portfolio investments and at changing the composition of capital flows in favour
of non-debt liabilities and a higher share of long-term debt in total debt liabilities.
Thus, quantitative annual ceilings on external commercial borrowings (ECB)
along with maturity and end use restrictions broadly shape the ECB policy.
Foreign direct investment (FDI) is encouraged through a progressively expanding
automatic route and a shrinking case-by-case route. Portfolio investments are
restricted to select players, particularly approved institutional investors and the
NRIs. Short-term capital gains are taxed at a higher rate than longer-term capital
gains. Indian companies are also permitted to access international markets through
GDRs/ADRs, subject to specific guidelines. Capital outflows (FDI) in the form of
Indian joint ventures abroad are also permitted through both automatic and case-
by-case routes. The Committee on Capital Account Convertibility (Chairman: Shri
S.S Tarapore) which submitted its Report in1997 highlighted the benefits of a
more open capital account but at the same time cautioned that capital account
convertibility (CAC) could cause tremendous pressures on the financial system.
To ensure a more stable transition to CAC, the Report recommended certain
signposts and preconditions of which the three crucial ones relate to fiscal
consolidation, mandated inflation target and strengthened financial system.
International developments, particularly the initiatives to strengthen the
international architecture for dealing with the problems arising in the capital
account of a countrys balance of payments, would also influence the timing and
sequence of CAC in India.

In the 1980s, India increased its reliance on commercial loans as external

assistance increasingly fell short of the growing financing needs. The significant
pressures on the balance of payments as the international oil prices more than doubled
in 1979-80 and the world trade volume growth decelerated sharply during 1980-82,
triggered an expansion in Indias portfolio of capital inflows to include IMF facilities,
greater reliance on the two deposit schemes for non-resident Indians-the Non-
Resident External Rupee Accounts (NRERA) (that started in 1970) and Foreign
Currency Non-Resident Account (FCNRA) (that started in 1975)- and commercial
borrowings on a moderate scale. A few select banks, all-India financial institutions,
leading public sector undertakings and certain private corporate were allowed to raise
commercial capital from the international market in the form of loans, bonds and Euro
notes.
The policy approach to ECB has undergone fundamental shifts since then with the
institution of reforms and external sector consolidation in the 1990s. Ceilings are
operated on commitment of ECB with sub-ceilings for short-term debt. The ceilings
on annual approvals have been raised gradually. The focus of ECB policy continues to
place emphasis on low borrowing cost, lengthened maturity profile (liberal norms for
above 8 years of maturity), and end-use restrictions.
Given the projected need for financing infrastructure projects, 15 per cent of the
total manufacture financing may have to come from foreign sources. Since the ratio of
infrastructure investment to GDP is projected to increase from 5.5 per cent in 1995-96
to about 8 per cent by 2006, with a foreign financing of about 15 percent, foreign
capital of about 1.2 per cent of GDP has to be earmarked only for the infrastructure
sector to achieve a GDP growth rate of about 8 per cent.
NRI deposits represent an important avenue to access foreign capital. The policy
framework for NRI deposits during 1990s has offered increased options to the NRIs
through different deposit schemes and by modulation of rate of return, maturities and
the application of Cash Reserve Ratio (CRR). In the 1990s, FCNR (B) has been
linked to LIBOR (London Inter-Bank Offer Rate) and short-term deposits are
discouraged. For NRERA, the interest rates are determined by banks themselves. The
Non-Resident (Non-Repatriable) Rupee Deposit [NR (NR) RD] introduced in June
1992 is non-repatriable, although interest earned is fully repatriable under the
obligation of current account convertibility subscribed to in 1994. In the 1990s, NRI
deposits remained an important source of foreign capital with the outstanding balance
sunder the various schemes taken together rising from about US $ 10 billion at the
close of 1980s to US $23 billion at the close of 2001. Capital flows from NRIs have
occasionally taken the form of large investments in specific bonds, i.e., the India
Development Bond (IDB) in1991, the Resurgent India Bond (RIB) in1998 and India
Millennium Deposits (IMD) in 2000.
The liberalisation process started with automatic approval up to 51 per cent for
investment in select areas. Subsequently, the areas covered under the automatic routes
and the limits of investment were raised gradually culminating in permission for 100
per cent participation in certain areas (particularly oil refining, telecommunications,
and manufacturing activities in Special Economic Zones).
Foreign investment responded favourably to the liberalised policy environment
and the generalised improvement in macroeconomic conditions. By 1993-94, FDI and
portfolio flows taken together emerged as the most important source of external
finance and non-debt flows in the form of NRI deposits, external commercial
borrowings and external assistance. Since then, foreign investment has remained as
the most important form of external financing in India.
It is difficult to assess the direct contribution of these flows, particularly FDI, to
the growth process. Anecdotal evidence suggests that foreign-controlled firms often
use third-party exports to meet their export obligations (Athreye and Kapur, 2001).
Another factor that contributes to widening the technology gap in FDI in India is the
inappropriate Intellectual Property (IP) regime of India. Survey results for 100 US
multinationals indicate that about 44 per cent of highlighted the weak IP protection in
India as a constraining factor for transfer to new technology to Indian subsidiaries for
investment in sector like chemicals and pharmaceuticals, almost 80 per cent of the
 firms viewed Indian IP regime as the key constraining factor for technology transfer
(Lee and Mansfield, 1996). It appears that the lure of the large size of the domestic
market continues to be one of the primary factors causing FDI flows to India.
Spill-over of positive externalities associated with FDI in the form of transfer of
technology is also highlighted as another factor that could contribute to growth. The
relationship between technology imports (comprising import of capital goods and
payments for royalty and technical know-how fees) and domestic technology efforts
in terms of R&D expenditure does not exhibit any complementarities. Foreign
exchange spent on technology import as percentage of domestic expenses on R&D
rather increased significantly in the 1990s I relation to 1980s, suggesting the use of
transfer pricing mechanism to create a gap between the visible and invisible patterns
of resource transfer. The share of imported raw materials used by FDI/FCRC firms
has, more or less, hovered around only 20 per cent. FDI firms, however, outperformed
the overall growth in industrial production in the 1990s.

FDI Policy: A Historical Perspective

Over the last five decades, there have been significant changes in approaches and
policies relating to FDI in India in tune with the developments in the industrial
policies and also foreign exchange situation, from time to time. There is a view in the
literature that the attitude and approach to FDI reflected under the current of balance
of payments crisis in the respective periods. Depending upon the thrust and direction
of the policies at different time period, one can identify four distinct phases in the
evolution of the policies:
i. First phase from 1950 to 1967- characterised by receptive attitude or cautious
welcome;
ii. Second phase from 1967 to 1980- marked by restrictive and selective policies;
iii. Third phase from 1980 to 1990- gradual liberalisation; and
iv. Fourth phase from 1991 till date- paradigm shift to open door policy (Jain, 1994,
Subrahmanian, et al., 1996 and Kumar, 1998). Major features of FDI policies during
the above four phases are reviewed below. Exhibit 1 provides the major features of
FDI policies during the four phases.

First Phase 1950-1967:

After independence, especially with the second Five-Year Plan, Indias
development strategy focused on import substituting industrialisation. At that point of
time, the availability of capital, technology, skills, entrepreneurship, etc., was very
limited. Hence, the attitude towards FDI was increasingly receptive (Kumar, 1998).
During this period, FDI was sought on mutually advantageous terms, though the
majority local ownership was preferred. As foreign investment was considered
necessary, foreign investors were assured of non-discriminatory treatment on par with
domestic enterprises. There were no restrictions on the remittances of profits and
dividends. Foreign investors were assured of fair compensation in the event of
acquisition. However, it was provided that, as a rule, the major interest in ownership
and effective control would always be in Indian hands. With the foreign exchange
crisis in 1957-58, FDI policies were further liberalised and offered a host of incentives
and concessions. During this phase, market seeking FDIs have been specially
encouraged by the locational advantage in production as there was protection to local
manufacture in the domestic market. Thus, during this phase, the country had given
cautious welcome to the foreign capital.
 Second Phase 1967-1980:
By the middle of sixties, there was considerable investment in various industries.
Besides, Indias scientific and technological knowledge and infrastructure were
developing and manpower was getting more skilled and constraints on local supply of
capital and entrepreneurship have begun to ease somewhat. On the other hand,
outflow on account of servicing of FDI and technology imports from the earlier
period has begun to rise in the form of dividends, profits, royalties, and technical fees,
etc. These factors forced the government to adopt a more restrictive attitude towards
FDI (Kumar, 1998). Major features of the policies followed during the phase are:
i. Restrictions were imposed on proposals of FDIs without technology transfer and
those seeking more than 40 per cent foreign ownership;
ii. The government listed industries in which FDI was not considered in view of local
capabilities;
iii. Foreign collaborations required exclusive use of Indian consultancy services wherever
available;
iv. The renewals of foreign collaboration agreements were restricted.
v. From 1973 onwards the further activities of foreign companies along with those of
local large industrial houses were restricted to select group of core or high priority
industries. The enactment of Foreign Exchange Regulation Act (FERA), 1973 became
the key to guiding and controlling FDI inflows. The phase of tight regulation and
selective policy was implemented by an administrative system based on discretionary
power.

Third Phase 1980-89:

There was a gradual liberalisation of FDI policies in the eighties due to the
deterioration of foreign exchange position in the wake of second oil crisis and Indias
failure to boost her manufactured exports. Hence, eighties witnessed a gradual but
discernible sign of easing of restrictions on foreign investment inflows with the
liberalisation of industrial and trade policies. Policies were framed to attract more
FDIs and foreign licensing collaborations. During this phase policies were specially
designed to encourage higher foreign equity holding in export-oriented units and
investments from Oil Exporting Developing Countries. Approval systems were
streamlined. A degree of flexibility was introduced in the policy concerning foreign
ownership, and exceptions from the general ceiling of 40 per cent on foreign equity
were allowed on the merit of individual investment proposals. The rules and
procedures concerning payments of royalties and lump sum technical fees were
relaxed and withholding taxes were reduced. The approvals for opening liaison offices
by foreign companies in India were liberalised. New procedures were introduced
enabling direct application by a foreign investor even before choosing an Indian
partner. A fast channel was set up in 1998 for expediting clearances of FDI proposals
from major investing countries, viz. Japan, Germany, the US and the UK. Thus, the
third phase witnessed a concrete move towards liberalisation of FDI policies.

Fourth Phase- 1991 Onward:

There has been a paradigm shift in the policies on FDI from the early nineties with
the adoption of the Industrial Policy Statement of July 1991. One of the objectives of
Industrial Policy Statement was that foreign investment and technology collaboration
will be welcomed to obtain higher technology, to increase exports and to expand the
production base. The Industrial Policy Statement of 1991 has followed an open-
door policy on foreign investment and technology transfer. The policy since then has
been aimed at encouraging foreign investment particularly in the core and
infrastructure structures. During the fourth phase, favourable policy environment
consisting of the liberalisation policies on foreign investment, foreign technology
collaboration, foreign trade and foreign exchange, have been exerting influence on
foreign firms decisions on investment and business operations in the country.
During this period, the FERS, 1973 has been amended and restrictions placed on
foreign companies by the FERA have been lifted. In 1999, FERA has been replaced
with Foreign Exchange Management Act. Government has permitted, except for a
small negative list, access to the automatic route for FDI. Hence, foreign investors
only need to inform the RBI within 30 days of bringing in their investment.
Companies with more than 40 per cent of foreign equity are now treated on par with
fully Indian owned companies. New sectors such as mining, banking,
telecommunications, highways, construction, airports, hotel and tourism, courier
service and management have been thrown open for FDI. Even the defence industry is
opened up to 100 per cent for Indian private sector participation with 26 per cent FDI,
subject to licensing. (FDI is not permitted in the following industrial sectors: 1) arms
and ammunition, 2) atomic energy, 3) railway transport, 4) coal and lignite, and 5)
mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper and
zinc). The liberal policies have been accompanied by active courting of foreign
investors at the highest level. The international trade policy regime has been
considerably liberalised too with removal of quantitative restrictions lowering of peak
traffics to 30 per cent and sharp pruning of negative list for imports. The rupee was
made convertible on current account and gradually to capital account.
EXHIBIT- 20.1
Major Features of FDI Policies during the Four Phases

Phase 1 Phase 2 Phase 3 Phase 4

1950-67 1967-80 1980-90 1991 onwards

Receptive Attitude or Restrictive Gradual Open Door

Cautious Welcome Attitude Liberalisation Policy

Non- Restriction on FDI Higher foreign Liberal policies

discriminatory without technology equity in export- relating to technology
treatment to oriented units collaboration, foreign
FDI. allowed. trade and foreign
exchange.

No restrictions Above 40% stake Procedure for Encouraging FDI in

on remittance of not allowed. remittance of core and infrastructure
profits and Allowed only in royalty and industries
dividends. priority area. technical fees FERA replaced with
liberalised FEMA

Ownership and FDI controlled by Fast channel for Procedures transparent

control with FERA. FDI clearance Liberal approach for
Indians Discretionary power NRI investments
in sanctioning the FDI need not be
projects. accompanied by
technology
FDI through merges
and acquisitions
FDI in services and
financial sector-banks,
NBFCs, insurance.
 Now FDI is permitted under the following four forms of investments: 1) through
financial collaboration, 2) through joint ventures and technical collaborations, 3)
through capital markets via Global Depository Receipts (GDRs) (Euro issues), and 4)
through private placements or preferential allotments.
Transparency and openness have been the most significant features of FDI
policies in the fourth phase. The degree of openness is reflected in 1) the sectors open
to FDI, 2) higher level of foreign equity participation, and 3) transparency in approval
procedures. One striking aspect of the present liberalisation policy is that unlike the
previous phases, it is not necessary that FDI is accompanied by foreign technology
agreements. There is a liberal approach towards investment by non-resident Indian
(NRIs): NRIs and overseas corporate bodies can invest up to 100 per cent in high
priority industries. Another distinctive feature of the policy is the simplification
procedures.
Thus, the ongoing measures taken since 1991 are focused towards a virtual
elimination of the both direct and indirect barriers to foreign direct investment
[indirect barriers in the form of investor protection, differences in accounting
standards, legal and regulatory structure]. In short, the evolution of FDI policies in
India are characterised by receptive attitude till the mid-sixties to a policy of
restrictions and controls till 1980 and then to gradual liberalisation till 1990 and
finally to a policy of full-fledged liberalisation since 1991.

Trends in FDIIn The 1990s

TABLE- 20.1

FDI- Amount Approved, Actual Inflows and Per cent of Capital Formation
(Rs. Crore)

Year Amount Approval Actual Inflow Inflow % of Approval

Inflow % of GCF
1191 534 351 65.8 0.2
1992 3888 675 17.4 0.4
1993 8859 1787 20.2 1.0
1994 14187 3289 23.2 1.4
1995 32072 6820 21.3 2.2
1996 36147 10389 28.7 3.4
1997 54891 16425 29.9 4.7
1998 30814 13340 43.3 3.6
1999 28367 16868 59.5 3.8
2000 37039 19342 52.2 -
2000* 32631 13810 42.3 -
2001* 23266 16127 69.3 -

Note*: January-October, GCF: Gross Capital Formation

Source: Economic Survey 2001-02, Government of India

From a closer look at the data, one can identify two distinct phases in the growth
of FDI during the nineties. The four-year period from 1994 to 1997 is characterised by
high growth of approvals and lower inflows and realisation rate. During this period,
there was a significant rise in the number of projects and amount approved for FDI-
the average annual growth of FDI amount approved was 63 per cent. However,
inflows as a per cent of amount approved were lower: 26 per cent during 1994-97.
Phase I: 1994 to 1997high growth of approval and low growth of inflow and
realisation rate.
Phase II: 1998 to 2001low growth of approvals and high growth of inflow and
realisation rate.
 On the other hand, during the next four-year period from 1998 to 2001 (till
October) there was a slow-down in both number and amount of approvals but growth
of inflows and realisation rate was higher. During this low growth phase, the yearly
average number of approvals declined to 1,998 from 2,205 during the high growth
phase. Further, the average annual growth of amount approved during this period was
lower at 12 per cent as against 63 per cent during the previous phase. Though there
was a lower growth of approvals during this period, the actual inflow has been higher
in terms of absolute amount and realisation rate. Average amount of inflow during this
period was Rs. 16,419 crore as against Rs. 9,231 crore during 1994 to 1997. Actual
inflows as a per cent of amount approved rose from 26 per cent to 56 per cent.
Since inflows in particular year need not be entirely related to the approvals given
in that year, it is possible to infer that higher inflows during the second phase may be
on account of lag involved in the realisation of projects for which approvals were
given in the earlier phase. If that is the case, it can also be inferred that lower
approvals during the second phase may lead to lower inflows in the coming years.
The reasons for the reduction in the number of approvals can be traced to: 1) the
effect of restrictions on India following nuclear tests, 2) political uncertainty, and 3)
very slow progress in second generation reforms, particularly relating to real sector
and privatisation of public enterprise.

Changes in Sectoral Composition

In tune with the governments priorities with respect to FDI, sectoral composition
of FDI has undergone significant changes during the last two decades. Till 1990, the
government policy was to channel FDI inflow in technology-intensive branches of
manufacturing. Thus, more than four-fifth of FDI stock in 1990 was in the
manufacturing industries. The share of petroleum and power and service sectors was
only marginal. However, with the changes in the FDI policies in the nineties, the
share of manufacturing has been more than halved to 40.1 per cent. Within the
manufacturing industries, FDI is shifting away from heavy capital goods industries to
light industries. With the opening, up of the infrastructure industries, on the other
hand, the share of petroleum and power sector rose substantially to 30.6 per cent in
1999 from just 0.1 per cent of FDI stock in 1990. Similarly, the share of service sector
rose to 27.8 per cent from just 5.2 per cent, respectively, during the above period.
Three high priority industries, namely, power, telecommunication and oil refinery
accounted for nearly half of the total amount of FDI approvals during 1991 to 1999.
Among the different industries, power and telecommunication accounted for the
highest share (17.5 per cent each) of FDI approvals during the nineties. They are
closely followed by oil refinery, which accounted for 13.1 per cent of FDI approvals.
Transportation industry and financial sector were the other two prominent sectors
accounting for larger share of FDI approvals. Thus, what is noticeable in the nineties
in the rise of FDI inflows in the priority infrastructure sectors like power,
telecommunication, oil refinery, transportation, finance and banking? Perhaps, this is
on account of the opening up of these industries for FDI in recent times.
 Changes in the Sources of FDI

Over the years, there has been diversification of sources of FDI. Until 1990,
European countries have been the major sources of FDI inflow sin India. They
accounted for nearly two-third of total stock of FDI in 1990. However, their share
drastically declined to around one-fifth during the nineties. Among the European
countries, the decline was significantly high in the case of UK from 48.8 per cent in
1990 to just 7.6 per cent during the nineties. The share of European countries,
America and Japan taken together accounted for nearly 90 per cent of total stock of
FDI in 1990; however, it has declined to 46.6 per cent during the nineties. The
decline in the share of the above group is essentially due to the rise in the inflows
from other countries. What is more striking is the fact that after USA, Mauritius is the
second largest source of FDI in India. Because of lower taxes in Mauritius, they are
able to attract foreign capital from different parts of the world, which is in turn
invested in countries like India.
Country-wise, the number of approvals of FDI during the nineties shows that USA
accounts for nearly one-fifth of the total approvals. Four countries, namely, USA,
Germany, United Kingdom and Japan, together share around half of the approvals.
Around 95 per cent of foreign collaboration approvals from Mauritius and NRIs are
financial in nature. However, in case of Japan and Italy, technical collaborations are
more than financial collaborations.

Pattern of FDI by Type of Approvals

There are two major routes, namely, Governmentthrough Foreign Investment

Promotion Board (FIPB) and Secretariat for Industrial Assistance (SIA)and the
Reserve Bank, through which FDI approvals are given. An analysis of institution-wise
approval of the amount of inflows reveals that the share of government through
FIPB/SIA has been on the decline and it formed around three-fifth of the approvals in
2001-02. The share of RBIs automatic approval, on the other hand, has increased to
19.4 per cent in 2000-01 from 13.3 per cent in 1992-93. NRI direct investments
constituted around one-third of total FDI inflows in 1995-96. However, of late, their
share has declined and it formed only to 2.9 per cent in 2000-01 as NRI investments
are increasingly taking place in the form of acquisitions of shares of domestic
companies. The share of acquisition of shares by Non-residents rose significantly
from 0.5 per cent in 1995-96 to 15.5 per cent in 2000-01 (Table 20.2).
TABLE 20.2
Share of Different Approval Sources in Actual Flow of FDI

Sources of Approval 1992-93 1995-96 1998-99 2000-01

1. Government (FIPB/SIA) 70.5 58.3 74.0 62.2

2. Reserve Bank (automatic route) 13.3 7.9 7.3 19.4

3. NRIs (40% and 100% scheme) 16.2 33.3 2.5 2.9

4. Acquisition of shares by Non-Residents* 0.0 0.5 16.2 15.5

Total 100.0 100.0 100.0 100.0

Note: * : acquisition of shares of Indian companies by non-residents under Section 5 of FEMS, 1999
Source: Economic Survey 2001-02, Ministry of Finance, Government of India, New Delhi.
 Comparative Performance of India and China

While discussing about FDI in India, often a comparison is made with China, as it
is the major recipient of FDI among the developing countries. According to the World
Investment Report 2001, Indias inward FDI in 2000 stood at US$ 2.3 billion as
against US$ 40.8 billion in China, nearly 18-fold higher than India. Further, the
accumulated stock of FDI in India was US$ 19.0 billion in 2000 as against US$ 346.7
billion in China, nearly 18-fold higher than India. India compares very poorly with
China in terms of inflow of FDI during the last two decades. During the nineties from
1991 to 2000, China accounted for 27.0 per cent of total flow of FDI to developing
countries as against Indias share at 1.0 per cent.
As a result of higher FDI inflows, in China the number of foreign-invested firms
constituted 16 per cent of all companies in 1998, which contributed 24.7 per cent of
total industrial output, 17.6 per cent of total assets and 18.8 per cent of total revenue.
Further, FDI inflows in India as per cent of her gross fixed capital formation and GDP
were very much lower than that of China. In 1990, FDI inflows in India as per cent of
gross fixed capital formation were just 2.4 per cent as against 11.3 per cent in case of
China (Table 20.3). Similarly, FDI inflows in India as per cent of GDP were as low as
3.6 per cent as against 30.9 per cent in case of China (Table 20.4). These facts indicate
that India is relatively slow in restructuring growth and orienting policies to
encourage FDI. The comparison shows that there is considerable scope for attracting
more FDI in India as the country has the potential to absorb it.
TABLE- 20.3

Inward FDI Flows as per cent of Gross Fixed Capital Formation in India and China

Country 1986- 1997 1998 1999

1995

India 0.6 3.80 2.9 2.4

China 6.4 14.6 12.9 11.3
Developing countries 4.7 10.9 11.7 13.8
minus China

World 4.0 7.5 10.9 16.3

Source: UNCTAD, 2001

TABLE 20.4

Inward FDI Flows as Per Cent of Gross Domestic Product in India and China

Country 1985 1990 1995 1999

India 0.5 0.6 1.7 3.6
China 3.4 7.0 19.6 30.9
Developing countries 14.1 13.4 15.6 28.0
minus China

World 7.8 9.2 10.3 17.3

Source: UNCTAD, 2001

Here it is worthwhile to examine why China is able to get more FDI than India
despite het many relative advantages like prevalent English fluency, top-notch
engineers, a well-developed IT industry and low wages. One significant factor cited
for the difference is the contrasting discretion in adopting policies of openness by the
 respective governments. Chinese governments pragmatic reform and policy of
openness is exemplified through their Prime Ministers famous remark, ...it doesnt
matter if a cat is black or white, so long as it catches mice. However, Indias
openness policy is applied to relatively restricted sectors, mainly social overhead
projects such as roads, ports, telecommunication, electricity, etc., where capital
requirement is very large with low profitability.
Another factor is the differences in the structure of local governments and their
authority. In China, local governments play an important role in attracting FDI
because they have a great deal of autonomy in issuing permits as well as offering
various administrative services. Since China is still a highly-planned economy, the
Central governments openness policy tends to be executed easily and efficiently
throughout the economy. In contrast, in India under democratic setup, the sovereignty
of the local governments is well guaranteed, and hence, some of the local
governments are still passive with regard to attracting FDI.
Another inhibiting factor in India is the uncertainty of policy decisions which
obscures predictable future profits and establishment of well-guided management
plans. Factors like lack of well-established investment procedures, unpredictable costs
for factory construction and operation and corrupt bureaucracy aggravates the level of
uncertainty in the eyes of potential foreign investors. The India-China comparison
shows that a governments firm determination to pursue a policy of openness and
capability to ensure efficient coordinated implementation systems can outweigh the
inherent advantages of another government (Kim, 2002).
Another major reason for chinas success is that they are able to attract more
investment from their own people who are doing business in America, Hong Kong,
Macao and in other countries. Further, the level of infrastructure in China is better
than India. On the policy front, in case of India, the initial reform measures were
mostly in the area of financial sector. Only recently reform measures were
contemplated for the real sector. In fact, for attracting FDI, real sector reforms are
essential as the investment essentially takes place in sectors like manufacturing,
infrastructure and services.

Impact of FDI

Impact of FDI can be felt on a number of areas and it varies depending upon the
nature of the projects and the degree of integration with the rest of the economy.

Impact of FDI: Performance of FDI-Companies in India:

The Reserve Banks regular surveys on Foreign Collaboration in Indian Industry
provide valuable information on the status of industries which are having foreign
collaboration. The latest survey (the sixth in the series) pertains to the period 1986-87
to 1993-94 and it covered 1,108 companies in the private sector (132 subsidiaries, 572
minority capital participation companies and 404 purely technical collaboration
companies). Major relevant findings of the survey are:
i. There was significant concentration of foreign capital in the manufacturing sectors
like chemicals and chemical products, machinery and machine tools, electrical
machinery and apparatus and transport equipment.
ii. As compared with the previous survey period (1981-86), there has been an
improvement in the profitability of the companies during 1986-87 to 1993-94,
especially in case of companies with minority capital participation and pure technical
collaborations.
iii. Production of the surveyed companies rose at an average annual rate of 20.3 per cent;
the leading contributors to production were chemicals and chemical products,
transport equipment, machinery and machine tools and the diversified groups.
iv. During the survey period (1986-87 to 1993-94), on an average, exports accounted for
63.3 per cent of imports by the companies; trade deficit was more pronounced in the
case of pure technical collaboration companies.
v. Import intensity of production increased during the survey period; value of imports
formed 11.6 per cent of total production of technical collaboration companies, 11.5
per cent production of minority capital participation companies and 8.6 per cent in
case of subsidiaries.
vi. Dividend remittance was high in case of chemicals and chemical products, followed
by machinery and machine tools (Reserve Bank, 1999).

IV
TOWARDS A REALISTIC FDI POLICY

If history is any guide, foreign investment in infrastructure is potentially

problematic. Latin America witnessed a wave of foreign infrastructure in investment
from the US in the 1930s, only to leave with the bitter experience of nationalisations
in a couple of decades. It bears repetition that infrastructure is inherently capital-
intensive with long gestation lags, and low (but stable) returns over a long period.
Market failures are ubiquitous in these industries, with considerable network
economies necessarily inviting wide and deep state intervention. In a world consisting
of politically independent nations with a growing number of democracies, the pricing
of infrastructure is bound to be a political decision. Foreign firms with short pay-back
periods invariably, find it hard to stay on, as it conflicts with the goals of developing
economies caught in an increasingly uncertain world economy.
There are also perhaps some India specific factors for the relatively small foreign
capital inflow. It seems worth reiterating that India is still largely an agrarian
economy, with land productivity being a third of Chinas, where the average
disposable income after meeting food and clothing (wage goods) requirement is still
relatively small. Price-income ratio of most consumer goods that foreign firms usually
sell is high by domestic standards, accentuated perhaps by cultural factors and
regional heterogeneity of markets (Financial Times, April 25, 2002).
In infrastructure industries, the rupee cost of electricity supply by foreign firms
seems high. Given Indias fairly diversified industrial capability, and low labour costs,
foreign firms may not have a cost advantage over the domestic producersespecially
with the currency depreciating in nominal terms. This is perhaps best illustrated,
again, by the Enrons DPC. With imported capital goods and fuel, and high operating
cost due to international norms of costing, Enrons cost of production was found to be
higher than the comparable new plants using domestic capital equipment (Morris,
1996).
At the same time, Hyundais large investment with consciously built-in high
domestic content secured through economies of scale has succeeded in producing a
small car that seems competitive both in price and quality. Reportedly, Hyundai
proposes to use its Indian plant as a global hub for its small car (The Economic Times,
January 2, 2003). Thus, the key to increasing FDI inflow seems to lie in industries
(and products) with relatively high technology that has large economies of scale, with
substantial domestic content.
 However, the foregoing reasoning still does not explain why foreign investment
does not come to use cheap labour and skills for export of labour-intensive
manufacturesas it has happened in China. We are inclined to believe that the foreign
investment policy lacks a clear focus. Unlike China, India has not invested in export
infrastructure. In fact, as is widely accepted now, the share of infrastructure in fixed
capital formation has declined sharply for nearly one and half decade now (Nagaraj,
1997). Further, what is needed is not perhaps large investment but suitable
inducement to international marketerstrading houses and retail chainsto set up
purchase offices and testing facilities to tap the potential of the domestic
manufacturers. It is widely acknowledged that Chinas export success largely lies in
marrying its low-cost manufacturing capability in Town and Village Enterprises
(TVEs) with Hong Kongs highly developed trading houses and other long-
established commercial organisations catering to international trade. While it is out of
question for India to replicate the locational and historical advantage of Hong-Kong
for China, investment in export infrastructure in strategic locations and carefully
tailored incentives to international trading houses (and retailers) merit a serious
consideration. Similarly, such investments are perhaps equally necessary to tap the
growing potential for using Indias labour cost advantage for doing back office jobs
business processes outsourcingfor international firms (The Economist, May 5,
2001).
Realistically, what is it that India expects from foreign investment, and how to
secure it? In principle, openness to foreign investment should be strategic, not passive
(or unilateral). History does not seem to support such an uncritical international
integration as a proven route to growth and efficiency. If the recent experience is any
guide, foreign capital is far from a major provider of external savings for rapid
industrialisation of any large economy. It can only supplement the domestic resources,
wherever they necessarily come bundled with technology and access to international
production and distribution networks. The terms of foreign investment will depend on
the relative bargaining power of the foreign firm vis--vis domestic firms, backed by
the state. Indian advantages are the availability of the skilled workforce, cheap labour,
and the size of the domestic market, which it should leverage as most successful
countries have done. A telling instance of it is perhaps Koreas big leap in
semiconductor and telecom equipment manufacturing in the recent years, as it seems
to have tied liberalisation of domestic market to sharing of production technology.
If this view has any value, then how should we go about inviting FDI that is
consistent with the economys long-term interests? Foreign investment should be
allowed mainly in manufacturing to acquire technology, and to establish international
trading channels for promoting labour-intensive exports.

V
SUMMARY AND CONCLUSION

Ending is long held restrictive foreign investment policy in 1991, India sought to
compete with the successful Asian economies to get a greater share of the worlds
FDI. Cumulative approved foreign investment since then is about $67bn, but the
realised amount is about a third of itthe ratio roughly comparable to Chinas. While
the foreign investment inflow represents a substantial jump over the 1980s, it is
modest compared to many rapidly growing Asian economies, and minuscule
compared to China. While the bulk of the approved FDI is for infrastructure, the
realised investment is largely in manufacture of consumer durable goods and the
automotive industry seeking Indias seemingly large and growing domestic market.
Foreign investment in telecom and software industries has also been significant.
Approved FDI has largely gone to a few developed statessimilar to its
concentration in the southern coastal provinces in China. A sizable part of the foreign
investment seems to represent a gradual increase in foreign firms equity holding
(hence managerial control) in the existing firms, and acquisition of industrial assets
(and brand names).
Chinas ability to attract a phenomenal amount of foreign investment is a puzzle
for many. About 40-40 per cent of Chinas FDI represents its domestic saving
recycled as foreign investment via Hong Kong to take advantage of economic
incentives---popularly called the round tripping. Another 25 per cent or so, seems to
represent investment in real estate by overseas Chinese that is potentially problematic,
as such investments could easily give rise to property bubbles. Thus, the quantum of
foreign investment from the advanced economies that could improve domestic
production capability is perhaps not very different from that in India. In relation to its
domestic output. Contrary to the popular belief, Chinas foreign investment regime is
said to be more restrictive than Indias. Therefore, what India should be concerned
about is not so much the absolute quantum of the inflow, but how effectively it uses
its external openness to augment the domestic capability, and access foreign markets
for its labour-intensive manufactures.
As the 1990s experience shows, quite contrary to the popular perception, the size
of Indias domestic market is relatively small, given the low levels of per capita
income. After meeting the needs of food and clothing (wage goods), income left for
spending on products that most foreign firms offer seems small; their price-income
ratio too high for Indian consumers. Therefore, many of them seem to be making
efforts to indigenise production to reduce costs and secure economies of scale. In this
process, many foreign firms are discovering the potential of low cost of ma
manufacturing for exports.
Much of the approved FDI in infrastructure did not fructify, as the rupee cost of
electricity supply by foreign firms is too much high for Indian consumers. This seems
true for two reasons: one, prices of goods like electricity are widely subsidised, and
cannot be increased without inviting public opposition; second, India produces much
of these services at lower cost using domestic raw material and capital equipment.
Foreign investment in consumer goods industries has increased domestic
competition, resulting in greater choice and quality improvement. While FDI inflow
displaced some domestic firms (and brand name), the bulk of them haveat least yet
largely been able to withstand the competition by making large capital investment,
and in expanding distribution networks.
What should be done to increase foreign investment? It is popularly believed that
a more liberal policy regime, industrial labour market reforms, and infrastructure
investment are needed. While infrastructure improvement surely merits a close
attention, one is not so sure if the extent of the reforms and the quantum of foreign
investment inflow are positively related. Moreover, there is little evidence that greater
FDI inflow ensures faster output and export growth. Such simplistic associations,
usually based on cross-country analysis, seem to have support neither in principle nor
in comparative experience.
What is needed is a strategic view of foreign investment as a means of enhancing
domestic production and technological capability, and so also to access the external
market for labour-intensive manufacturesas China has precisely done. It seems
valuable to reiterate what K.N. Raj, a perceptive observer of comparative economic
development, noted early in Chinas liberalisation drive. It is certainly not without
good reason that China has chosen to be hospitable even to multinationals with
worldwide ramifications like IBM, evidently in the expectation of securing the know-
how for building up semi-conductor industry of its own. Those who do not realise the
implications of all this for India are living in a dream of their own (Raj, 1985).
Such interventions need selectively, and strategic intent. Comparative experience
seems to clearly favour such a policy stance.

21
Services in the Indian Growth Process

THE phenomenal expansion of services world-wide led to services being regarded

as an engine of the growth even as a necessary concomitant of economic growth.
Development economics suggests that development is a three-stage process. The
dominance of the services sector in the growth process is usually associated with the
third stage of growth. During the 1980s and 1990s, services accounted for a share of
about 70 per cent of GDP in industrialised countries and about 50 per cent in
developing countries.
In India growth of services picked up in the 1980s, and accelerated in the 1990s,
when it averaged 7.5 per cent per annum, thus providing an impetus to industry and
agriculture, which grew on average by 5.8 per cent and 3.1 per cent respectively?
Growth in the services sector has also been less cyclical and more stable than the
growth of industry and agriculture (in the sense of having the smallest coefficient of
variation).
TABLE- 21.1

Sectoral Growth Rates

Average growth (In per cent per annum)

1951-1980 1981- 1991-

1990 2000

Agriculture 2.1 4.4 3.1

Industry 5.3 6.8 5.8

Services 4.5 6.6 7.5

GDP 3.5 5.8 5.8

Source: Gordon and Gupta, 2003

A notable feature of the structural transformation of the services sector has been
the growth of skill intensive and high value added sectors, i.e., software,
communication and financial services. The rapid growth of services can be attributed,
inter alia, to the advent of information technology (IT) and the knowledge economy.
This has enhanced the growth of the high productivity segment of the services sector
as well as variety of service activities involving low productivity activities catering to
a large mass of people. The phenomenal growth of low skilled service activities has
occurred due to reduced opportunities in the manufacturing sector, particularly in the
unorganised sectors.
Some of the activities in the service sector are multidimensional, being part of
industry as well as services, such as information technology and construction. Service
statistics in most countries including India provide information on value-addition of
various activities of business services, hotels, trade, financial services, etc. For an
empirical analysis, sub-sectors including trade, transport and communication,
financing, insurance, real estate and business services can be categorised as producer
services with hotels and restaurants and other services as consumer services.
Government services comprise public administration and defence services. During
1999-2000, producer services accounted for about 70 per cent of the total services
followed by consumer services (17 per cent) and government services (13 per cent).
The high share of producer services reflects the strong inter-linkages between services
and goods producing sectors of the economy.
The emergence of services as the most dynamic sector in the Indian economy has
in many ways been a revolution. The most visible and well-known dimension of the
take-off in services has been in software and IT-enabled services (including call
centres, design, and business process outsourcing). However, growth in services in
India has been much more broad-based than IT. In fact, although, IT exports have led
a profound impact on the balance of payments, the sector remains a small component
of GDP. As of 2001, business services (which include IT) contributed only about 1 per
cent of GDP or 1/50 to the size of total services output (Table 21.1).
Rapid growth of the service sector is not unique to India. The existing literature
shows that as an economy matures the share of services in output increases
consistently. To begin with, the increase occurs along with an increase in the share of
industry. Thereafter, the service share grows more rapidly, accompanied by a stagnant
or declining share of the industrial sector. Cross-country experience suggests that the
first stage occurs until the country reaches lower middle income status, while the
second stage commences once it becomes an upper middle income country.
Consistent with the trend observed in other countries, Indias growth experience
has been characterised by a decline in the share of agriculture in GDP and an increase
in the share of industry and services. Between 1951 and 2000, the share of agriculture
in GDP fell from 58 to 25 per cent, while the share of industry and the share of
services increased from 15 to 27 per cent and from 27 to 48 per cent, respectively. In
the 1990s, however, the share of services in Indias GDP climbed by about 8
percentage points, as compared to a cumulative increase of 13 percentage points
during 1951-1990. The share of the industrial sector, on the other hand, has been
stagnant since the 1990s. As a result, the sectoral composition of output in India has
come to resemble that of a middle-income country, even though its per capita income
remains that of a low-income country.

Growth and Sectoral Shares, Cross Country Evidence and Indian

Experience

The evolution of sectoral shares in output, consumption and employment as

economies grow has been studied by economists for well over fifty years. During the
1950s and 1960s, research by Kuznets and Chenery suggested that development
would be associated with a sharp decline in the proportion of GDP generated by the
primary sector, counterbalanced by a significant increase in industry, and by a more
modest increase in the service sector. Sectoral shares in employment were predicted to
follow a similar pattern.
With the benefit of more data on development than was available to Kuznets and
Chenery, recent literature has tended to emphasise the growing importance of service
sector activity (Inman 1985, Kongsamut, Rebelo and Xie, 2001). For example,
Kongsamut, et al, (2001) analyse a sample of 123 countries for 1970-1989 and show
that rising per-capita GDP is associated with an increase in services and a decline in
agriculture both in terms of share in GDP and employment. In other words, the
sectoral share given up agriculture as the economy matures goes more to the services
sector and less to industry than the Kuznets-Chenery work had suggested. The
modern view is that as an economy matures, the share of services (in output,
consumption, and employment) grows along with a decline in agriculture. By
contrast, the share of industry first increases modestly, and then stabilises or declines.
(Gordon and Gupta, 2003)

Share of Services in GDP:

Such a pattern of growth is visible in the cross-country data on shares in GDP
(Table 21.2). These data suggest two stages of development. In the first, both industry
and services shares increase as countries move from low income to lower middle
income status, while in the second, the share of industry and that of services increases
as the economy moves to upper middle and higher income levels.
TABLE 21.2

Sectoral Shares in GDP in 2001, Global Averages (Per cent of GDP)

Agriculture Industry Services

Low Income 24 32 45 Stage I

Lower middle income 12 40 48

Upper middle income 7 33 60 Stage II

High income 2 29 70

Source: World Banks WDI,2003, Table 4.2. Definition: Low income: per capita GDP<$745;
Lower middle-$746-2975; Upper middle-$2976-9205; and high > $9206

How does the Indian experience fit in with this patter? In the four-decade period,
1950-1990, agricultures share in GDP declined by about 25 percentage points, while
industry and services gained equally. The share of industry has stabilised since 1990,
and the entire subsequent decline in the share of agriculture has been picked up by the
services sector. Thus, while over the four decades, 1950=1990, the services sector
gained a 13 per cent share, the gain in the 1990s alone was 8 percentage points.
Consequently, at current levels, Indias services share of GDP is higher than the
average for other low income countries.
According to Gordon and Gupta, if different sectors in India grow at the average
growth rates experienced in 1996-2000, then by 2010, the share of services would
increase to 58 per cent, which would bring the size of the Indias services sector,
relative to GDP, closer to that of an upper middle income country, while still
belonging to the low-income group.
 TABLE- 21.3

India, Sectoral Shares in GDP, 1950-2006

(Per Cent of GDP)

Agriculture Industry Services

1950 58 15 28

1980 38 24 38 Stage I

1990 33 27 41

2000 24 27 49 Stage II

2003-04 22 26 53

2004-05 (P) 20 26 54

2005-6 (Q) 20 26 54

2006-07 (R) 19 27 55

Source: Central Statistical Organisation

Share of Services in Employment:

Even though India has experienced profound changes in output shares, the same is
not true for employment shares (Table 21.4). A striking feature of Indias development
is that in contrast to the substantial decline in the share of agriculture in GDP, there
has been rather little change in the share of employment in agriculture (Bhattacharya
and Mitra, 1990). Similarly, although services rose from 42 per cent of GDP during
the 1990s, the employment share of services actually declined by about one
percentage point during the decade. Thus, while activity has shifted to services,
employment creation in services has lagged far behind.
Indias relatively jobless service sector growth is unlike the experience of other
countries, where the service sector has tended to gain a larger share of employment
over time. When compared with other countries India has an exceptionally large share
of services employment.
TABLE 21.4

India, Share of Service Sector in Employment and Capital Formation (In per cent of total)

Employment Gross Capital Formation

1965-66 18.1 46.1

1970-71 20.0 43.7

1980-81 18.9 44.0

1990-91 24.4 41.2

1999-2000 23.5 39.6

Source: Hansda (2002)

 Which Services Have Grown Rapidly?

The acceleration in services growth in the 1980s and 1990s was not uniform
across different activities (Table 21.5). Some segments grew at a rate much faster than
their past average growth rates, while for other sub-sectors, growth rates were similar
to the past trend. To identify the growth-drivers within the services sector, Gordon and
Gupta have compared the growth rates of various activities in the 1990s with their
previous trend growth rates. The trend growth rates have been estimated using the
three-year moving average of the rate and the period through 1990 is included in
estimating the trend (except for banking for which the trend is estimated using the
data until 1980).
Comparison of the actual and the trend growth rates shows that growth in several
service sub-sectors accelerated sharply in the 1990s (and 1980s for banking);
indicating some sort of a structural break in their growth series. According to Gordon
and Gupta these activities are fast growers. The remaining grew more or less at a
trend rate, these they call trend growers.
Based on the above criterion, fast growers include business services (which
include IT), communication services, and trade (distribution) services. The trend
growers include real estate, legal services, transport, storage, personal services, and
public administration and defence (PAD).

Fast Growers:
Business services were the fastest growing sector in the 1990s, with growth
averaging nearly 20 per cent a year. Though disaggregated data for this category are
not available, however export and software industry data show that the growth was
mainly on account of the IT sector. Despite being the fastest growing sector, business
services, particularly IT activity, was growing off a low base and its contribution to
service sector and GDP growth was quite modest in the nineties. This segment is
expected to continue growing at a very high rate and is likely to contribute more
significantly to services growth in the future.
Communication services, which registered growth of 14 per cent a year during the
1990s, made a significant contribution to services growth. The growth in
communication was mostly due to telecom, which accounts for 80 per cent of output
and grew at 17 per cent a year on average during the 1990s.
In the banking sector, growth jumped from about 7 per cent over the period 1950-
1980, to 12 per cent in the 1980s, and to 13 per cent in the 1990s. Growth was most
rapid in NBFIs (which grew by 24 per cent in the 1980s and 19 per cent in the 1990s),
followed by growth in the banks (10 per cent and 9 per cent respectively in the 1980s
and 1990s). The contribution of banking services sector growth was larger than that of
the communication sector.
Community services and hotels and restaurants increased at the trend growth rate
through the early 1990s, and a pick-up in growth in the latter part of the decade. In
community services, this was due to both education and health services (accounting
for about 70 per cent and 23 per cent of the value added, respectively) growing at an
average rate of 8 per cent in 1990s.

Trend Growers:
The growth rate of distribution services (the largest service subsector in India),
averaged about 6 per cent in the 1980s, higher than in previous decades, and
accelerated further to about 7 per cent in the 1990s. This sub-sector qualifies as a
trend grower. While growth of distribution services picked up strongly in the second
half of the 1990s, growth was not much above trend for the decade as a whole.
The rate of growth of PAD in the 1990s averaged 6 per cent, which was similar to
the growth experienced in previous decades. Growth spiked upwards in response to
the Fifth Pay Commission awards to government employees in the late 1990s, but this
did not shift average PAD growth upwards for the decade as a whole. Acharya
(2002a) estimates that imperfect deflation of the Fifth Pay Commission in the
National Accounts led to an overstatement of the growth of government services
(PAD) in the late 1990s. Hansda (2002) and RBI (2002) concede that there may have
been some upward distortion in the estimates for a few years as a result of the Pay
Commission, but note that it was not of sufficient magnitude to affect the trend in
services growth, which increased in the 1990s, even if PAD is excluded altogether.
The growth rate of personal services almost doubled in the 1990s, as compared to
the 1990s, but at 5 per cent average it remained below the growth in most of the
service activities. As a result, personal services declined as a percentage of GDP
through the 1990s. The other sub-sectors such as transport, dwellings, and storage did
not grow more rapidly than the average of the previous decades in either the 1980s or
1990s.

Contribution of Fast and Trend Growers to Services Growth:

The fast-growing activities accounted for about a quarter of services output in the
1980s, but because of their relatively fast growth, these activities represented one-
third of these services output by 2000. (Gordon and Gupta, 2003)
The high services growth in the 1980s was primarily due to the trend growing sub-
sectors (these activities added about 1 percentage point of extra growth in the 1980s),
while the contribution made by the fast growing activities was only about half the
size. In the 1990s, by contrast, fast growing activities made about the same
contribution to services growth as the trend growing sectors. In fact, since the trend
growing sectors grew at about the same rate in both decades, the fast growers
collectively accounted for almost all of the higher growth in the 1990s. This is
consistent with new activities and industries having sprung up in the fast growth sub-
sectors, but not in the trend growth ones. (Gordon and Gupta, 2003)

Factors Underlying the Services Growth

What are the factors behind the dynamism of the services sector in India? One
explanation suggested in the literature for fast growth in services is that the income
elasticity of demand for services is greater than one. Hence, the final demand for
services grows faster than the demand and commodities as income rises.
A rising share of services in GDP is regarded as an outcome of higher income
elasticity of demand services. The empirical studies have shown that the income
elasticity of demand for services could be greater than or equal to unity (Gemmell,
1982; Summers, 1985; Bergstand, 1991; Falvey and Gemmell, 1991). Income
elasticity of demand for services increases with rising income which favours the
fulfilment of more sophisticated desires. During the development process, distribution
of GDP and employment register sectoral shifts. Such shifts may occur on account of
the hierarchy of needs, distinguished into basic needs for food and shelter and needs
for other material and non-material goods including services (Maslow, 1970).
According to this view, income elasticity of demand depends on per capita income
and differs across various sectors.
The empirical estimates of price and income elasticity for various categories of
services in India are summarised in Table 21.6. it is important to mention that the
actual behaviour of the services sector in real GDP depends on the relative strength of
the coefficients of the income and price elasticity.
TABLE 21.6

Income and Price Elasticities for the Services Sector

Sector Income Elasticity Price Elasticity

1 2 3

Services 1.20* -0.68*

Producer Services 1.22* -0.78*

Consumer Services 1.00* -0.10

Government Services 1.41* -1.05*

Note: *: Statistically significant at 1 per cent

The income elasticity of demand is greater than unity and price elasticity is
negative and significant for the total services, produces services and government
services. In other words, demand for overall services rises with increase in per capita
GDP and decreases with increase in prices of services. The higher income elasticity of
demand in the case of producer services underscores its forward linkages. This is
corroborated by the emergence of producer services comprising advertising, publicity,
marketing and other IT-related activities in the recent period as important service
industries in India. Therefore, producer services can be regarded as a major source of
economic growth.
Another explanation is that technical and structural changes in an economy make
it more efficient to contract out services that were once produced in the industry. This
type of outsourcing has been called the splintering of industrial activity. Splintering
results in an increase in net input demand for services from the industrial sector, as
well as the services sector growing proportionately faster than other sectors.
The empirical evidence presented in Gordon and Gupta (2003) shows that while
splintering and high income elasticity of demand for services have served to stimulate
services growth in India, it is necessary to look beyond these factors to fully explain
the growth acceleration since the 1990s. In particular, important roles also seem to
have been played by economic reforms, the advent of the IT era, and growing external
demand for services exports. Industrial sector reforms have also been carried out in
India and the question arises why the industrial sector has not experienced the same
sustained high level of growth that the service sector has experienced. This could be
because industrial growth is more dependent on infrastructure development (such as
roads and ports), which have acted as bottleneck to growth. Labour restrictions and
small-scale reservations may also have disadvantaged industry more than services. In
addition, the faster growing services activities seem to be more intensive in skilled
labour, with which India is well endowed.
A number of studies have attempted to explain the fast growth in the share of
service activity observed in cross country data. The literature draws a distinction
between demand and supply factors.
 On the supply side, the share of services can be boosted by a switch to a more
service-input intensive method of organizing production. Such a change in production
methods can arise as a result of increasing specialization as the economy matures. For
example, over time, industrial firms may make greater use of specialist sub-
contractors to provide services that were previously provided by the firms themselves.
Legal, accounting, a security services are obvious candidates to be contracted out.
Bhagwati (1994) calls this process of specialization splintering. Kravis (1982) points
out that splintering will lead to growth in the share of services in GDP, even when
GDP itself is not growing.
On the demand side, an increase in the output share of services can arise from
rapid growth in the demand for services. This could be from domestic consumers with
a high-income elasticity of demand for services, or from foreign consumers with a
growing demand for the countrys service exports. Demand-led growth of this type is
likely to result, at least initially, in higher prices of services, as well as a shift of
resources into the production of services.
With the advent of the IT revolution, it has become possible to deliver services
over long distances at a reasonable cost, thus trade in services has increased world-
wide. India has been a particular beneficiary of this trend. In India, the exports in
services (in dollar) grew in average at 15 per cent a year in the 1990s, compared with
9 per cent in the 1980s, and at 21 per cent a year in the second half of the 1990s.
Cumulatively, services exports increased four-fold in the 1990s and reached US$ 25
billion in 2002.
The increase in exports has been most dramatic in software and other business
services (included in the miscellaneous category), but there has also been growth in
the export of transport, and travel services. As a result, the composition of services
has changed dramatically in favour of miscellaneous services, which includes
software exports.
Service activity can also be stimulated by technological advances, whereby new
activities or products emerge as a result of technological breakthroughsuch
advances are likely to be particularly relevant in the case of the IT sector (e.g. the
internet), telecommunication (cellular phone services) and to some extent in financial
services (credit cards, ATM etc.).
Liberalisation can also provide a boost to services. In India, important policy
reforms were made in the 1990s which were conductive to the growth of services
sector, such as deregulation, privatisation and opening up to FDI. If the growth of
services was previously inhibited by government controls, then policy may provide a
positive shock that unleashes new activity and growth.
An example would be the telecom industry where inefficient government
provision led to a situation of effective rationing of services up until the early 1990s.
As seen earlier, communications has been one of the fastest growing services
subsectors in the 1990s and liberalisation undoubtedly a major role.
Thus, the set of economic reform measures initiated since 1991 also impacted on
the performance of the services sector. First, reforms in the domestic industrial
environment which resulted in rising manufacturing growth provided synergies to the
services sector in the form of increased demand for producer services. Second, the
liberalisation of the financial sector provided an environment for faster growth of the
financial services. Third, reforms in certain segments of infrastructure services also
contributed to the growth of services. Consequently, the services sector posted a much
higher growth during the reform period as compared with the pre-reform period with
its share touching nearly the 50 per cent mark.
External Demand for Services:
The growing role of tradable services in international trade and exchange has
come to be recognised with the General Agreement on Trade in Services (GATS).
Indias share in world export of commercial services has doubled from 0.6 per cent in
1990 to 1.2 per cent in 2000, while the share in world merchandise exports has gone
up marginally from 0.5 per cent to 0.7 per cent during the same period. Interestingly,
there has been a consistent surplus on account of trade in services. The compositional
shifts in foreign trade in favour of services in the reform period have helped in the
emergence of new sources of earnings in Indias balance of payments. Earnings from
software exports have increased from negligible levels in early 1990s to a level of
US$ 7.5 billion in 2001-02. Thus, while the 1980s was dominated by tourism
earnings, the second half of 1990s witnessed an unprecedented jump in Indias
earnings from new economic activities like software services exports and other
information technology related skill intensive exports. The services exports thus,
provided some element of stability to the external balance of the country and also
positively impacted on the overall demand in the services sector.
Services exports during 2005-06 continued to be led by rapid growth in software
services exports, other business and professional services (Table 21.7). Within the
services exports, rising prominence of business services reflects high skill intensity of
the Indian workforce. There has also been a strong revival in international tourist
interest in India since 2003-04.

Structure of Indias Services Exports

TABLE 21.7

Structure of Indias Services Exports

Share in Total Services Exports (per cent)

Year Amount
(US $
million) Travel Transporta- Insur- G.N.I. Softwa Miscella-
tion ance E -re neous*

1 2 3 4 5 6 7 8

1970-71 292 16.8 49.7 5.5 13.7 - 14.4

1980-81 2,804 43.5 16.3 2.3 4.0 - 33.9

1990-91 4,551 32.0 21.6 2.4 0.3 - 43.6

2000-01 16,268 21.5 12.6 1.7 4.0 39.0 21.3

2003-04 26,868 18.7 11.9 1.6 0.9 47.6 19.2

2004-05 46,031 14.1 10.4 2.0 0.7 37.4 35.4

2005-06 60,610 12.9 10.4 1.7 0.5 38.9 35.6

Note *: Excluding software services

G.N.I.E: Government not included elsewhere
Source: RBI Annual Report 2005-06

Services Trade:
 India has been recording high growth in the export of services during the last few
years. Such exports have increased threefold during the last three years; in 2005-06,
with a growth of 42.0 per cent, it reached US$ 61.4 billion. Growth has been
particularly rapid in the miscellaneous service category, which comprises of software
services, business services, financial services and communication services. In 2005,
while Indias share and ranking in world merchandise exports were 1 per cent and 29
respectively, its share and ranking in world commercial services exports was 2.3 per
cent and 11, respectively. By growing faster than merchandise exports, services
exports constituted almost 60 per cent of merchandise exports in 2005-06.
Reflecting these positive developments and continued buoyancy of Indias
services exports, the share of Indias services exports in world exports has recorded a
significant increase from 0.6 per cent in 1995 to 2.3 per cent in 2005. India was the
18th largest service exporter in the world in 2004 became no 11 in 2005. The gains
recorded by the exports have far exceeded those recorded by exports of goods.
Impressive growth in receipts from business services continued during 2005-06.,
indicating Indias rising advantage in commercial services. Earnings from exports of
software and IT-enabled services remained the key driver of services earnings during
2005-06, recording a growth of 33 per cent. Globally, India ranks second to Ireland in
exports of computer and information services. Notwithstanding increasing
competitive pressured, India remains an attractive source because of its low-cost
operations, high quality of products and services and availability of skilled manpower.
Favourable time zone difference also helps organisations run around the clock internal
operations and render better customer service. In order to withstand growing global
competition, the Indian IT companies have started moving up the value chain by
exploring untapped potential in IT consulting and system integration, hardware
support and installation and processing services.
The enormous opportunities for further growth of these services make WTO
negotiations in services all the more important for India (Box 21.1).
While India is negotiating for greater market access in developed country markets,
domestic regulations create barriers for Indian service providers even when trading
partners have taken firm commitments. Quick domestic policy reforms are needed,
especially in qualification and licensing requirements and procedures, to impart
effective market access for our service providers. Some of the ways of promoting
services could include facilitation to become known suppliers of quality services,
providing relevant export market information, providing appropriate export financing
with reduced transaction costs by reviewing the common practice of collateral
backing, good marketing of services by energizing Indian embassies and industry
associations, anchoring brand ambassadors for promoting services, and leveraging the
countrys potential services purchasing power in multilateral and bilateral negotiations
and in the CECAs.
 BOX- 21.1

Services, GATS and Strategies for India

Services account for more than 60 per cent of world GDP, and trade in services has grown
more rapidly than merchandise trade since 1985. In 2004, while Indias share in world
merchandise exports was 0.8 per cent, the corresponding share in world commercial services
was 1.9 per cent. Services, accounting for 54.1 per cent of GDP in 2005-06, are a sector of
critical interest in India.
In the ongoing negotiations at WTO under the General Agreement on Trade in Services
(GATS), the offers of most countries do not provide any significant new openings for trade,
especially in areas of interest for developing countries. Given its strong competitive edge in IT
and ITES, and competence of its professionals, Indias efforts have been to get binding
commitments in cross-border supply of services (Mode 1) and movement of natural persons
(Mode 4). In mode 4, India has been pushing for clear prescription of the duration of stay and
removal of the Economic Needs Test (ENT). Though the services negotiations have been
salvaged at the Hong Kong Ministerial, quick and detailed work id needed in the form of
examining the detailed requests and offers and arriving at concrete proposals in each of the 12
main categories and 156 sub-categories of services.
Besides software in which India has already made an impact, there is good potential for
export of many other professional services, like super-speciality hospital; satellite mapping;
printing and publishing; accounting, auditing and book-keeping services. Besides greater
efforts at marketing, there is a need to negotiate both multilaterally and bilaterally, issues like
the National Health Service Systems in European countries like UK which virtually deny
market access; lack of coverage of medical expenditure incurred abroad by US medical
insurance companies; need based quantitative limits; need to be natural persons; and
accreditation rules. Similarly, in the case of accounting, auditing and book-keeping services,
market access limitations, which are mainly in the form of licensing, accreditation, in-state
residency and state level restrictions in countries like US, have to be negotiated. Some liberal
sectoral commitments by developed countries get automatically negated by the restrictive
horizontal limitations of entry for speciality occupations which needs to be addressed in WTO
negotiations.

Source: Economic Survey 2005-06

Summing Up

The services sector has exhibited a strong trend component that has provided an
element of stability to the growth process. The sector seems to have grown in the
reform period, sustained by an increasing demand for producer and consumer services
coupled with the external demand. The role of public administration and defence
appears to have been limited in the growth process. The emergence of producer
services as an important source of services growth reflects strong interlinkage with
commodity producing sectors of the economy. Apart from providing inputs, services
contribute to the outward shift of the industrial sectors production frontier by
enhancing productivity growth. Conversely, services growth could be sustained
provided adequate demand impulses are generated in industry or agriculture. Given
Indias comparative advantage in information technology, services growth momentum
can be sustained by exploiting new opportunities in international trade in services,
particularly, in the area of communication and information services, technology
transfer and software.
 Gordon and Gupta (2003) suggest a bright future for the Indian services sector.
The effects of high income elasticity of demand and increased input usage in industry
are likely to continue for some time, before tapering off. But extra impetus to services
growth is also likely to come from exports and from liberalisation. New markets for
Indian service exports are just beginning to be tapped and there is substantial scope
for considerable growth from liberalisation and the associated productivity gains in
some of the services subsectors where growth has lagged behind in the 1990s.

22
The Financial Sector

Structure, Performance and Reforms

THE financial sector plays a major role in the mobilisation and allocation of
savings. Financial institutions, instruments and markets which constitute the financial
sector act as a conduit for the transfer of financial resources from net savers to net
borrowers, i.e., from those who spend less than they earn to those who earn less than
they spend. The gains to the real sector, therefore, depend on how efficiently the
financial sector performs this function of intermediation.

Financial Sector Development in India

The Indian financial sector today comprises an impressive network of banks and
financial institutions and a wide range of financial instruments.

Institutional Structure:
At present, the institutional structure of the financial system is characterised by (a)
banks, either owned by the government, RBI, or the private sector (domestic or
foreign) and regulated by the RBI; (b) development financial institutions and
refinancing institutions, set up by a separate statute or owned by the Government,
RBI, private, or other development financial institutions under the Companies Act and
regulated by the RBI; and (c) non-bank financial companies (NBFCs), owned
privately and regulated by the RBI.
Provision of short-term credit is entrusted primarily to commercial and
cooperative banks. Of late, commercial banks have diversified into several new areas
of business such as merchant banking, mutual funds, leasing, venture capital,
factoring and other financial services. In addition, there is a wide network of
cooperative banks and cooperative land development banks at state, district and sub
district levels. Together, commercial and cooperative banks hold around two-thirds of
the total assets of the Indian system (Rangarajan and Jadhav, 1992).
Medium-term and long-term finance is provided primarily by a few large all India
development banks together with a spectrum of state level financial institutions.
While the Industrial Development Bank of India (IDBI), the National Bank for
Agriculture and Rural Development (NABARD), the Export-Import Bank of India
(EXIM Bank) and the National Housing Bank (NHB) serve as apex agencies in their
respective areas of concern, there are also other financial institutions which specialise
in areas like tourism and the small-scale industry.
 Besides these, there are investment institutions, which include the Unit Trust of
India (UTI), the Life Insurance Corporation (LIC) and the General Insurance
Corporation (GIC). In recent years, a number of public sector mutual funds have been
set up by banks and financial institutions. In addition, a large number of private sector
non-bank financial companies undertake Para-banking activity mainly in the area of
hire-purchase and leasing.
The capital market has witnessed a remarkable growth in the paid-up capital of
listed companies and market capitalisation in recent years. With a network of 23 stock
exchanges and as many as 9,413 listed companies in 2003, it has emerged as one of
the important markets in the developing world. The Securities and Exchange Board of
India (SEBI) has been established to regularise the capital market.

Capital Markets:
The 1990s have been remarkable for the Indian equity market. The market has
grown exponentially in terms of resource mobilisation, number of stock exchanges,
and number of listed stocks, market capitalisation, trading volumes, turn over and
investors base (Table 22.1). Along with this growth, the profile of the investors,
issuers and intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction costs and
significant improvement in efficiency, transparency and safety (NSE, 2002). In the
1990s, reform measures initiated by SEBI, market determined allocation of resources,
rolling settlement, sophisticated risk management and derivatives trading have greatly
improve the framework and efficiency of trading and settlement.
Almost all equity settlements take place at the depository. As a result, the Indian
capital market has become qualitatively comparable to many developed and emerging
markets.
TABLE- 22.1

Select Stock Market Indicators in India Year

(end-March) 1961* 1971* 1980* 1991 2000 2002 2003

Number of Stock Exchanges 7 8 9 22 23 23 23

Number of listed companies 1,203 1,599 2,265 6,229 9,871 9,871 9,413

Market Capitalisation 1,200 2,700 6,800 1,10,279 11,92,630 7,49,248 6,31,921

(Rs. Crore)

Note: *: end-December, BSE only.

Sources: The Stock Exchange, Mumbai and National Stock Exchange.
Rakesh Mohan (2004), Economic Development in India, vol. 74, Academic Foundation, New Delhi

Although the Indian capital market has grown in size and depth in the post-reform
period, the magnitude of activities is still negligible compared to those prevalent
internationally? India accounted for 0.40 per cent in terms of market capitalisation
and 0.59 in terms of global turnover in the equity market in 2001. The liberalisation
and consequent reform measures have drawn attention of foreign investors and led to
rise in the FIIs investment in India. During the first half of the 1990s, India accounted
for a large volume of international equity issues than any other emerging market (IMF
Survey, 1995). Presently, there are nearly 500 registered FIIs in India, which include
asset management companies, pension funds, investment trusts and incorporated
institutional portfolio managers. FIIs are eligible to invest in listed as well as unlisted
securities.
The short-term money market which has links with the entire spectrum of the
financial system comprises five segments:
The call money market,
The inter-bank term deposit market,
The bills re-discount market, and
The Treasury bill market
The inter-corporate funds market
In recent years, new money market instruments such as Certificates of Deposits
(CDs), Commercial Paper (CP) and 182 days treasury bills have been introduced so as
to impart liquidity and depth to the money market. Moreover, a specialised money
market institution, named the Discount and Finance House of India (DFHI), has been
established with the objective of providing liquidity to money market instruments,
thereby helping to develop an active secondary market.

Strategy of Development:
The role of central banking and financial system in the process of economic
development was recognised at an early stage. The first Five Year Plan stated that:
Central banking in a planned economy can hardly be confined to the regulation
of overall supply of credit or to somewhat negative regulation of the flow of bank
credit. It would have to take on a direct and active role, firstly in creating or helping to
create the machinery needed for financing developmental activities all over the
country and secondly, ensuring that the finances available flow in the directions
intended.
During the 1950s and 1960s, the major concern was to create the necessary
legislative framework to relate reorganisation and consolidation of the banking
system. The year 1969 was a major turning point in the Indian Financial System when
14 large commercial banks were nationalised. The main objectives of bank
nationalisation were:
Re-orientation of credit flows so as to benefit the hitherto neglected sector
such as agriculture, small-scale industries and small borrowings.
Widening of branch network of banks, particularly in the rural and semi-
urban areas.
Greater mobilisation of savings through bank deposits.
Between June 1969 and March 1991, the total number of commercial bank offices
rose from 8,262 to as much as 60,570. The number of rural branches increased from
1,833 to 35,187 during the same period, accounting for 58.4 per cent of the total as
compared with barely 22 per cent in 1969. Accordingly, the average population served
per bank office declined from 64,000 in 1969 to about 14,000 in March 1991.
As a ratio of the GDP at current prices, bank deposits expanded during the period
from 16 per cent in 1969-70 to around 48 per cent in 1990-91, thus indicating the
banking industrys importance in the mobilisation of savings. In respect of advances,
the expansion during the same period was from 10 per cent o around 25 per cent of
the GDP, thus providing increasing support to expanding agricultural, industrial and
commercial activities.
The ratio of priority sector services (i.e. advances to agriculture, small-scale
industries and small borrowers) to net bank credit rose from 15 per cent in June 1969
to nearly 39.1 per cent in June 1991. The role of indigenous bankers and
moneylenders has declined considerably over the years. Studies based on surveys
indicate the dependence of rural households for cash debt from non-institutional
agencies has come down from about 93 per cent in 1950-51 to as low as 39 per cent in
1981. Thus, the benefits of banking are no longer confined to a narrow segment of the
population. Banking has acquired a broad base and has also emerged as an important
instrument of socioeconomic change. The other components of the financial system
such as the term lending institutions have also recorded a similar quantitative and
qualitative change.
TABLE 22.2

Progress of Commercial Banking in India

(Amount in Rs. Crore, Unless Mentioned Otherwise)

Indicators June June March March March March

1969 1980 1991 1995 2000 2003

1. No of commercial 73 154 272 284 298 292

banks
2. No of bank offices of 8,262 3,4594 60,570 64,234 67,868 68,561
which:
Rural and semi-urban 5,172 23,227 46,550 46,602 47,693 47,496
bank offices
3. Population per office 64 16 14 15 15 16
(000s)
4. Deposits of SCBs 4,646 40,436 2,01,199 3,86,859 8,51,593 12,80,853
5. Per Capita Deposit 88 738 2,368 4,242 8,542 12,253
(Rs.)
6. Credit of SCBs 3,599 25,078 1,21,865 2,11,560 4,54,069 7,29,214
7. Per capita Credit (Rs. ) 68 457 1,434 2,320 4,555 7,275
8. Share of Priority 15.0 37.0 39.2 33.7 35.4 33.7*
Sector Advances in
Total Non-Food Credit
of SCBs (per cent)
9. Deposits (per cent of 15.5 36.0 48.1 48.0 53.5 51.8*
national income)
Note: * : As at end-March 2002
Source: Reserve Bank of India
The mid-1980s saw some movement away from this regulated regime.
Commercial banks were permitted to enter new activities. Apart from the introduction
of new money market instruments, interest rates in the money market were freed from
control. Great flexibility was introduced in the administered structure of the interest
rate. While deposit rates were made attractive to savers by making the rate positive in
real terms, the structure of leading rates was simplified by linking the rate of interests
largely to the size if loans.
While the progress made by the financial system in general and the banking and
other financial facilities to a larger cross-section of the people and the country is well
recognised, there is a growing concern over the operational efficiency of the system.
There has been a perceptible decline in the productivity and profitability of
commercial banks. It is estimated that in 1989-90, gross profits before provisions
were no more than 1.10 per cent of working funds. In 1990, the spread between
interest paid and earned as a proportion of working funds in the same year was 2.05
per cent. With the decline in the quality of loan assets, (the sticky advances account
for more than 20 per cent of the credit outstanding) the need for provisioning has
become more urgent and several banks are not in a position to make adequate
provisions for doubtful debts. The financial position of the Regional Rural Banks is
far worse with the accumulated losses completely wiping out the capital in most
banks. The balance sheet of the performance of the financial sector is thus mixed,
strong in achieving certain socioeconomic goals and in general, widening the credit
coverage but weal as far as viability is concerned (Rangarajan and Jadhav, 1992).

Directions of Reforms

The financial markets in the industrially advanced countries have undergone far-
reaching changes in the 1980s. Innovations spurred by deregulation and liberalisation
have been a marked feature of this transformation. Rapid strides in technology in the
areas of telecommunication and electronic data processing have helped to speed the
changes. A major consequence of these changes is the blurring of the financial
frontiers in terms of instruments, institutions and markets. The distinction between
banks and non-banking financial institutions has become thin. Restrictions imposed
earlier on banks regarding the activities that they can undertake have been removed
one by one. Effectively, universal banking has now become the trend. Another feature
of the market is the interlinking of different national markets. With the dismantling of
exchange controls and the rapid developments in communication systems, funds have
started moving rapidly from one country to another.
It is the interlinking of different national markets which has come to be known as
globalisation. Important financial institutions are present in all the leading market
centres and markets are in operation on a 24 hour basis. Deregulation has thus meant
the dismantling of regulations relating to entry and expansion; it has also meant the
removal of all direct controls over interest rate wherever they existed. The integration
of markets, both financially and spatially, has led to a more unified market for the
allocation of savings and investment among the participating countries. The
functioning of the financial markets in the decade of 1980s has, however, raised some
serious concerns. There is a fear that the state of the financial markets is now
inherently more risky than in the past. In technologically integrated financial world,
the chances of systemic risk increase. The potential damage to the system arising out
of the failure of a large globally active banking or non-banking financial institution
can be immense. Because of the intense competition which banks have come to face,
both as a consequence of the growth of non-banking financial institutions as well as
securitisation, it is feared that the quality of the bank loans has suffered. With the
spectacular growth of non-bank financial institutions, the question of adequate
supervision of these institutions has also gained urgency. It is for these reasons that
increasing attention is paid in these countries towards evolving a common code of
prudential regulations applicable to all countries. Several significant steps have
already been taken in this direction. The new approach is somewhat loosely
summarised in the phrase with as much freedom as possible and with much
supervision as necessary (Rangarajan and Jadhav, 1992).
The issues in financial sector reform, as far as India is concerned, are in some
ways similar to the issues that have surfaced in the advanced countries. However,
there are concerns that are specific to the Indian situation. The ultimate objective of
financial sector reform in India should be to improve the operational and allocation
efficiency of the system. Even from the point of view of meeting some of the
socioeconomic concerns, it is necessary that the viability of the system is maintained.
It is in this context that a fresh look at the administered structure of interest rates is
called for. The reform of the Indian financial system must really begin here.
Administered Structure of Interest Rate:
The fundamental reason for introducing administered structure of interest rates in
our country is to provide funds to certain sectors at concessional rates. While there
may be ample justification for concessional credit to be provided to finance certain
activities, a highly regulated interest rate system has a number of weaknesses.
Government borrowing at concessional rate of interest has become possible only
because of the compulsion imposed on the financial institutions. This also results in
the monetisation of public debt if the Reserve Bank of India (RBI) is to pick up what
cannot be absorbed by banks and other institutions. Such restrictions, limit the ability
of these institutions to raise resources at market rates. In the case of credit to other
priority and preferred sectors, the burden of the financial institutions can be tolerable
so long as the quantum of such credit is limited, as there is a limit to cross-
subsidisation. The regulated interest rate structure has, therefore, implications for the
viability of the financial institutions. The reform of the interest rate structure is thuds
linked to the system of directed credit as it is practiced now.
In the case of commercial banks, directed credit takes the form of prescription of
Cash Reserve Requirement (CRR), statutory liquidity requirements (SLR) and the
allocation of credit for priority sectors. The CLR and SLR taken together now pre-
empt a significant proportion of the deposit liabilities. Banks are now required to
provide 40 per cent of net bank credit to priority sectors which include agriculture,
small-scale industry, etc. CRR has to be distinguished from SLR. The former is an
instrument of monetary control and its level has to be determined by monetary
authorities taking into account the overall economic situation. However, statutory
liquidity ratio is of a different character and has become basically an instrument for
providing credit to the government by the commercial banks.
In relation to direct credit for priority sectors the real problem is not so much the
proportion of credit allocated for priority sectors as much as the concessional rates of
interest enjoyed by the borrowers. Clearly there is a case for re-examination of those
who are entitled to borrow at concessional rates from the banking system. One
immediate way of doing this is to eliminate large borrowers from the credit to the
priority sector. No more than two concessional rates of interest should be prescribed
so as to keep the burden on the banking system within limits.
The financial system must clearly move towards an interest regime which is free
from direct controls. Obviously, interest rate is an important policy instrument.
Monetary authorities the world over try to influence the level of interest rate through
the various instruments that are available to them. It is not, therefore, argued that
monetary authorities should abdicate an important function of theirs. The general
level of interest rate should be influenced by the monetary authorities taking into
account the overall economic environment. The issue is whether a structure should be
imposed by the monetary authorities. In moving towards a more deregulated structure
of interest rate, there is considerable historical evidence to such experiments succeed
only when the inflationary pressures are under control. Sharp increase in nominal and
real rates of interest can result in adverse economic consequences. However, the
broad outlines of the reform agenda in terms of the interest rate as far as India is
concerned are quite clear. At least initially from an elaborate administered structure of
interest rate we should move towards a more simplified system where only a few rates
are determined (Rangarajan and Jadhav, 1992).
Autonomy, Prudential Regulations and Supervision:
Even as the external constraints such as administered structure of interest rate and
pre-empted credit are eased, the financial institutions must act as business units with
full autonomy and the same token become fully responsible for their performance.
There are instances of countries like France where the major banks are in the public
sector but are allowed to operate with a high degree of autonomy without any
interference from the government. In the Indian context, adverse selection and
moral hazard which have been discussed in recent literature arise more because of
outside interference with decision making than as a consequence of interest rate
policy. In fact, decisions such as waiver of loans also have an adverse effect on the
performance of financial institutions as they vitiate the recovery climate. In short, the
operational efficiency of the system will improve only if we restore functional
freedom to the financial institutions.
The need for stringent prudential regulations in a more deregulated environment
has become apparent in many countries. The elements of prudential regulation which
have assumed greater importance in the recent period relate to capital adequacy and
provisioning. The Indian system has so far been slack in relation to both these aspects.
Capital adequacy did not perhaps receive adequate emphasis because of the false
assumption that banks and financial institutions owned by the government cannot fail
or cannot run into problems.
With major Indian banks now having branches operating in important money
market centres of the world, this question can no longer be ignored. This apart, even
banks operating in domestically needs to build an adequate capital base. The Bank for
International Settlements ha prescribed the norm for capital efficiency at 8 per cent of
the risk weighted assets. As the Narasimham Committee (Government of India, 1991)
has recommended, banks which have a consistent record of profitability may be
allowed to tap the capital market for meeting this additional requirement. This would
involve a dilution of ownership which cannot be avoided and which may also serve a
useful purpose. What has been told about banks holds good in relation to term lending
institutions as well as other financial institutions. Whether they are leasing companies
or hire purchase companies or investment companies, prescription of appropriate
capital requirements is a must since capital is the last line of protection for all
depositors.
Closely related to prudential guidelines is supervision. A strong system of
supervision becomes necessary in order to ensure that the prudential regulations are
followed faithfully by financial institutions. As the financial sector grows, it is quite
possible to have different agencies supervising different segments of the market and
institutions. In this background two issues arise. One relates to the coordination
among supervisory agencies and other regarding consolidated supervision. Financial
institutions no longer operate in one segment of the market. Under the circumstances,
the segmentation of the market for regulatory purposes can run into a number of
difficulties. Apart from multiple authorities exercising control over one institution,
differing prescriptions by different authorities can also lead to inconsistencies and
conflicts. It is in this context that the concept of lead regulator has emerged under
which one authority is recognised as a primary regulator in relation to one type of
institution.

1991 and After: The Reform Years:

The reform in the financial sector was attuned to the reform of the economy,
which now signified opening up. Greater opening up underscores the importance of
international best practice quickly since investors tend to benchmark against such best
practices and standards. Since 1991, the Indian financial system has undergone radical
transformation. Reforms have altered the organisational structure, ownership pattern
and domain of operation of banks, DFIs and Non-Banking Financial Companies
(NBFCs). The main thrust of reforms in the financial sector was the creation of
efficient and stable financial institutions and markets. Reforms in the banking and
non-banking sectors focused on creating a deregulated environment, strengthening the
prudential norms and the supervisory system, changing the ownership pattern, and
increasing competition.
The policy environment was stanced to enable greater flexibility in the use of
resources by banks through reduced statutory pre-emption. Interest rates deregulation
rendered greater freedom to banks to price their deposits and loans and the Reserve
Bank moved away from micromanaging the banks on both the asset and liability-
sides. The idea was to impart operational flexibility and functional autonomy with a
view to enhancing efficiency, productivity and profitability. The objective was also to
create an enabling environment where existing banks could respond to changing
circumstances and compete with domestic private and foreign institutions that were
permitted to operate. The Reserve Bank focused on tighter prudential norms in the
form of capital adequacy ratio, asset classification norms, provisioning requirements,
exposure norms and improved level of transparency and disclosure standards. As the
market opens up, the need for monitoring and supervising become more important
systematically. The greater flexibility and prudential regulation were fortified by on-
site inspection and off-site surveillance. Furthermore, moving away from the closed
economy objectives of ensuring appropriate credit planning and credit allocation, the
inspection objectives and procedures,, have been redefined to evaluate the banks
safety and soundness; to appraise the quality of the Board and Management; to ensure
compliance with bank rules and regulations; to provide an appraisal of soundness of
the banks assets; to analyse the financial sectors which determine the banks solvency
and to identify areas where corrective action is needed to strengthen the institution
and improve its performance. A high-powered Board for Financial Supervision (BFS)
was constituted in 1994, with the mandate to exercise the powers of supervision and
inspection in relation to the banking companies, financial institutions and non-
banking companies. Currently, given the developing state of the financial system, the
function of supervision of banks, financial institutions and NBFCs rests with the
Reserve Bank.

Role of Competition:
It is generally argued that competition increases efficiency. Competition has been
infused into the financial system by licensing new private banks since 1993. Foreign
banks have also been given more liberal entry. New private sector banks constituted
11 per cent of the assets and 10 per cent of the net profits of scheduled commercial
banks (except regional rural banks) as at end-March 2003. The respective shares of
foreign banks were 6.7 per cent and 10.7 per cent, respectively. In February 2002, the
Government announced guidelines for foreign direct investment in the banking sector
up to a maximum of 49 per cent (since raised to 74 per cent in 2004). The Union
Budget 2002-03 announced the intention to permit foreign banks, depending on their
size, strategies and objectives, to choose to operate either as branches of their
overseas parent, or, as subsidiaries in India. The latter would impart greater flexibility
to their operations and provide them with a level-playing field vis-a-vis their domestic
counterparts. While these banks have increased their share in the financial system,
their presence has improved the efficiency of the financial system through their
technology and risk management practices and provides demonstration effect on the
rest of the financial system.

Capital Adequacy and Government Ownership in the Banking Sector:

In a globalised system, banks tend to get rated if they have to enter the market to
raise debt or equity. Internationally, banks follow the Basel norms for capital
adequacy. Banks were required to adopt these norms for maintaining capital in a
phased manner in order to avoid any disruption. However, as a result of past bad
lending, a few banks found it difficult to maintain adequate capital. The Government
had contributed Rs. 4,000 crore to paid-up capital of banks between 1985-86 and
1992-93. Subsequently, over the period 1992-93 to 2002-03, the Government
contributed over Rs. 22,000 crore towards recapitalisation of nationalised banks. In
view of the limited resources and many competing demands on the fisc, it became
increasingly difficult for the Government to contribute any substantial required by
nationalised banks for augmenting their capital base. In this context, Government
permitted banks that were in a position to raise fresh equity to do so in order to meet
their shortfall in capital requirements; the additional capital would enable banks to
expand their lending.
Since the onset of reforms, there has been a change in the ownership pattern of
banks. The legislative framework governing public-sector banks (PSBs) was amended
in 1994 to enable them to raise capital funds from the market by way of public issue
of shares. Many public-sector banks have accessed the markets since then to meet the
increasing capital requirements, and until 2001-02, the government made capital
injections out of the budget to public-sector banks, totalling about 2 per cent of GDP.
The government has initiated a legislative process to reduce the minimum government
ownership in nationalised banks from 51 to 33 per cent, without altering their public-
sector character. The underlying rationale of proposal appears to be that the salutary
features of public-sector banking are not lost in the transformation process.

Some Perspectives for the Future

The basic emphasis of the Indian approach remains the creation of enabling
environment so as to foster deep, competitive, efficient and vibrant financial
institutions and markets, with emphasis on stability. A number of measures have been
initiated to achieve convergence with international bet practices. Keeping in view the
fast pace of technological innovations in the financial sector and product development
at the international level, the focus has been to bring the Indian financial system at par
with such standards. However, while adapting to international standards and trends,
special attention is being devoted so as to customise norms and standards keeping in
view various country-specific, including institution-specific considerations.
As the economy begins to grow rapidly, the process of financial intermediation is
likely to increase. However, in the Indian case, the ratio of bank assets to GDP is low
among developing countries (Barth et al., 2001). By comparable international
standards, although the financial research of the system is high, the extent of financial
widening is much lower. This would mean that there is a lot of room for credit
expansion to take place, which, in turn, envisages enhanced credit appraisal and risk
management skills, which is an important challenge.
At present, around 76 per cent of the banking sector assets are accounted for by
public-sector banks, with the remaining being accounted for by private and foreign
bank categories. The share of non-public sector banks has been increasing
continuously over the last few years, with a sizeable rise in the market share (in terms
of assets) being evident for new private banks. It is not difficult to imagine that the
new private banks, with no legacy of economic structure and with their ability
leverage technology to produce highly competitive types of banking, are
comparatively better placed to outperform their public sector counterparts. This would
imply a rise in their market share along with the foreign bank group and accordingly,
a concomitant decline in the market share for public sector banks. The scope for this
expansion obviously depends on the expansion of the total banking system. As it
stands, the intermediation process has been taking place parallel with the development
of the capital market. Therefore, the issue remains for public-sector banks as to how
to adjust the loss of relative market share in an environment where the absolute size of
the pie is not expanding rapidly. Moreover, the ability of different public-sector banks
to cope up with this challenge is likely to be quite different, which is an important
issue that would need to be addressed.
An important issue relates to the manner in which public sector banks would cope
when Government ownership is reduced to 33 per cent, which is likely to be fructified
once the Banking Companies (Acquisition and Transfer of Undertakings) and
Financial Institutions (Amendment) Bill, 2000 is passed by the Parliament. In fact,
international evidence tends to suggest a significant scaling down of Government
ownership in the banking system in most countries (Barth et al., 2001). In such a
scenario, banks will have to embrace modern management and corporate governance
practices and acquire higher quality of human capital.
Another major concern for the banking system is the high cost and low
productivity as reflected in relatively high spreads and cost of intermediation. Both
spreads and operating costs, measured as percentage of total assets of banks have
generally been higher vis-a-vis developed countries. An important challenge for the
banking sector, therefore, remains its transformation from a high cost, low
productivity structure to a more efficient, productive and competitive set up.
The capital requirement of banks is likely to increase in the coming years with the
pickup in credit demand and the implementation of Basel II norms around 2006,
which has accorded greater emphasis on risk-sensitivity in credit allocation. Banks
would need to increase their profitability to generate sufficient capital funds
internally, since maintaining the additional capital position in line with the prescribed
norms could pose a major challenge.
Commercial banks continue to face the problem of overhang of NPLs,
attributable, inter alia, to systemic factors such as weak debt recovery mechanism,
non-realisability of collateral and poor credit appraisal techniques. The recent
enactment of the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act has increased the momentum for
the recovery of NPLs. Banks need to intensify their efforts to recover their over dues
and prevent generation of fresh NPLs.
A major challenge facing the banking and financial community emanates from the
high growth in volumes of financial transactions and the impact of todays
globalisation efforts the world over. Traditional geographical boundaries are getting
blurred and greater challenges are confronting banks owing to the explosion of
technology. It is in context that there is an imperative need for not mere technology up
gradation but also integration of technology with the general way of functioning of
banks.
 Internationally, deposit insurance has been recognised as an important component
of the financial safety net for a country. A risk- based deposit insurance premium
system has been identified as a measure that can reduce negative externalities of the
deposit insurance system. Introduction of such a system is currently under
consideration of the Government.
In view of the gradual withdrawal of DFIs from longer-term financing, an issue
remains about how to fill the void created by such restructuring. There is a need to
develop the private corporate debt market and introduce appropriate instruments to
reduce the risk arising out of long-term financing by other players such as banks.
In recent times, attempts have been made to achieve regulatory and supervisory
convergence between commercial and cooperative banks in certain key areas
including prudential regulations. These steps are in the interest of the stability of the
overall financial system as well as the healthy development of the cooperative credit
institutions. However, in view of the impaired capital position of many cooperatives
and their large overhang of NPLs, achieving such convergence would prove to be
difficult. It is, however, for the cooperative banks themselves to build on the synergy
9inherent in the cooperative structure and stand up for their unique qualities. In this
context it is encouraging to note that during the recent years in the face of the
restructuring process, cooperative banks are making efforts to reduce their operating
cost.
The issue of corporate governance has assumed prominence in recent times, more
so in view of the recent accounting irregularities in the US. The quality of corporate
governance would become critical as competition intensifies, ownership is diversified
and bank and cooperatives strive to retain their client base. This would necessitate
significant improvements in areas such as housekeeping, audit practices, asset-
liability management, systems management and internal controls in order to ensure
the healthy growth of the financial sector.
Prior to enactment of legislative reforms for NBFCs, they mobilised a significant
portion of their fund in the form of public deposits, often at high interest rates. This,
coupled with relaxed regulatory and supervisory arrangements for NBFCs, created
negative externalities including moral hazard. Introduction of moral measures for
NBFCs has, however, substantially eliminated such problems and the share of public
deposits in the total liability of NBFCs has declined substantially. Notwithstanding
this, protection of the depositors interest remains paramount. Towards this objective,
the RBI continues to pursue with various State Governments the state for enacting the
legislation for protection of interest of depositors in financial establishments. Creating
public awareness about activities and risk-profile of NBFCs along with improvement
in corporate governance practices and financial disclosures need to be focused upon in
future.
The entry of private sector players in the insurance sector is yet to make a
significant dent in the market share of the public sector entities. Recent evidence,
however, suggests that the state-of-the-art services provided by private players have
begun to make an impact on the existing insurance industry. Accordingly, promoting
the role competitive forces in the process of insurance liberalisation is essential, not
only for customer choice, but also raising resources for long-term infrastructure
finance.
In the securities market, instituting enabling legal reform poses an important
challenge for its orderly growth. A number of reforms in the financial system have
been held back pending legal changes.
 There is lack of transparency in the corporate debt market, which is operating
predominantly on a private placement basis. A wholesome view has to be taken by the
different regulators to develop a corporate debt market.

Lessons from the Indian Experience

The process of globalisation has important implications for the financial sector
and the institutions comprising it. In an increasingly globalised environment, the role
of the policy-maker in the domestic institutional building process can be envisaged in
the form of providing a stable macroeconomic environment, increasing competition,
establishing a strong regulatory and supervisory framework, evolving an enabling
legal system and strengthening technological infrastructure. A well-knit institutional
set up facilitates the growth and development process of an economy. Effective
institutions can make the difference in the success of market reforms. If the financial
system is well diversified and the markets are liquid and deep, effective mobilisation
and allocation of resources will be ensured. Many broad generalisations can be
discerned from the Indian experience.
Development of the Indian financial system is premised on the conviction that
financial development makes fundamental contributions to economic growth. At the
time of independence, the financial system was fairly liberal. By the 1960s, controls
over the financial system were tightened and aligned in accordance to the centralised
and centralised Plan Priorities. The priority was to set up institutions to mobilise
saving and allocate the saving to specified sectors. The RBI was vested with the
responsibility of developing the institutional infrastructure in the country. Towards
this end, controls on lending and deposit rates were introduced and specialised
development banks, catering to varied segments of the economy were established.
This institutional design did not achieve the desired results. The process culminated
with the two-stage nationalisation process of banks, first in 1969 and thereafter in
1980. Around the same time, the insurance business was also brought under the
domain of government control in phases. The process of nationalisation expanded the
reach of financial services to remote parts of the country. However, the basic principle
of mobilising savings and channelling resources to certain sectors at a price not
related to the market remained. Notwithstanding the numerous achievements of
social banking, such as branch expansion and diversion of credit to rural sectors, the
high degree of controls on the financial system also manifested itself in several
inefficiencies.
In order to address these shortcomings, gradual liberalisation of the financial
system was initiated in the late 1980s, which received greater momentum in the
1990s. The closed-economy framework gradually gave way to greater externally
oriented and liberal financial system. The 1990s witnessed the advent of economic
reforms in the country encompassing trade, industry and the real sectors. The external
sector was liberalised. The country adopted a flexible exchange rate regime early in
the reform period and encouraged non-debt creating flows in the form of foreign
direct investment and foreign institutional investment. Liberalisation of the external
current account was also undertaken early in the reform cycle. The macroeconomic
environment then influences institutional building. As the economy opens up, the
financial system can no longer afford to remain repressed. The financial system also
has to undertake reforms in the form of interest rate deregulation, prudential
regulation, good supervisory standards, legal changes and technological up gradation.
New institutions operating on market principles have to emerge and old institutions
would either have to change to cope with the 0emerging changes or close. Thus,
macroeconomic reforms and reforms in the financial system have to progress
simultaneously. In the early 1990s, a wide-ranging set of reforms were undertaken,
encompassing both financial institutions and markets. These reforms paved the way
for more market-driven allocation and pricing of resources. The process of
globalisation has tended to exhibit itself, both domestically; in terms of greater
integration of domestic financial markets with global ones and internationally, in
terms of the adoption of a process of gradual convergence with international best
practices.
The pre-reform experience suggests that government that suppress their financial
systems in order to financial spending, end up with underdeveloped, inefficient and
repressed financial systems. Prior to reforms, Indian institutions were typically set up
to mobilise savings and allocate resources at administered rates. Initially, the
authorities concentrated on regulating both the quantity and cost of credit. This
undermined the efficiency of the financial system and ultimately led to financial
repression. The post-reform institutional structure recognised the need for institutions
to be market based. The major elements of adequate development of the financial
sector in India constituted a stable macroeconomic environment, competition,
effective prudential regulation, sound supervision, enabling legal framework and
modern technological infrastructure.
The driving forces for important innovations in the financial system can come
from within or external forces. In fact, in the Indian case, although the trigger of the
economic reform process was the balance of payments crisis resulting from the Gulf
War of 1990, the reforms in the financial sector were the result of a well-crafted
internal strategy.
The early part of macroeconomic reform saw changes in the exchange rate
system, the opening up of the economy to foreign investors and adoption of current
account convertibility. This necessitated the financial system to undertake reform to
keep pace with the changes in the other sectors of the economy. The Indian experience
suggests that it was slightly ahead of the learning curve insofar as the implementation
of reforms in the financial sector was concerned. The process was initiated through
high Level Committees that provided road maps for implementation of reforms so as
to progressively reach international best standards while taking the unique country
circumstances into consideration. For instance, in the first phase, greater emphasis
was placed on policy deregulation (interest rate deregulation, easing of statutory pre-
emption, etc.), improving prudential norms (imposing capital adequacy ratio, asset
classification, exposure norms, etc.), infusing competition (permitting entry of new
private sector banks), diversifying ownership, developing money, debt and foreign
exchange markets (for risk-free yield curve and monetary policy transmission as well
as global integration), establishing regulatory and supervisory standards (Board for
Financial Supervision) and insisting on greater transparency and disclosures. It was
only in the second stage that many legal amendments (Securities Contract Regulation
Act, Government Securities Bill, SARFAESI Act, etc.) and diversification of
ownership of public-sector banks, etc., were undertaken.
The Indian experience also shows that there is no optimal sequencing in respect of
either policies or institutions, both within and across countries. For instance, some
countries that reformed after a crisis did so with a big bang, while others such as
India followed a gradualist approach. In fact, reforms in the financial and external
sectors were not treated as a discrete event, but as continuous and complementary
process. For instance, in the Indian context, reforms in the financial sector were
undertaken in the early part of the economic reform cycle and embraced the banking
sector in view of its dominance in the financial sector and the money and Government
securities markets initially in view of their inexorable linkages with the rest of the
financial system. Reform of development financial institutions, cooperative banking
institutions and non-banking financial companies followed. Further, in India
prudential reforms were implemented first and the structural and legal changes
followed whereas in some countries, legal changes have preceded prudential and
structural reforms.
It is very critical that reforms maintain a balance between efficiency and stability,
especially in an emerging market economy like India.
Greater competition modifies the effectiveness of existing institutions. It improves
efficiency, increases incentives for innovation and promotes wider access. There is,
therefore, a need to modify existing institutions to complement the new and better
institutions. It is important that the transition is managed without disruption to the
market and the economy. The Indian approach of cautious liberalisation vindicates
this position, since the balance between markets and the State is delicate. The Indian
experience shows those consultations with market practitioners, and the
announcement of a time table for reforms designed to give time for market players to
adjust goes a long way in ensuring stability.
The interventions of government and the central bank in institution building
depend on specific country circumstance. In India, the government and central bank
were directly involved in institution building from the time of independence.
However, the main difference was that the pre-reform period was characterised by
micro management of institutions by government and central bank whereas in the
post-1991 period, institutions have had greater autonomy and flexibility in operations
and monitoring while regulations were more market based and incentive driven.
Effective institutions are those that are incentive compatible. An important issue in the
design of institutions is in ensuring that the incentives that are created actually led to
the desired behaviour. Greater competition modifies the effectiveness of existing
institutions. It improves efficiency, increases incentives for innovation and promotes
wider access. There is, therefore, a need to modify existing institutions to complement
the new and better institutions.
A well architecture financial system mitigates and diversifies risks, but a badly
designed system can lead to magnification of risks. The challenge to policy-makers is
to build a financial system that assists in risk mitigation. It is well recognised by now,
especially after the Asian crisis, that a multi-institutional financial structure mitigates
the risk to the financial system. The Indian experience vindicates this stance. Banks,
DFIs, and capital markets have co-existed from the post-independence era; only that
the character of these institutions has changed depending on the evolutionary stage of
the economy. In this context, development of domestic debt market becomes
important. The motivation for development of a debt market can arise from different
reasons viz., to develop corporate debt market, overall financial market development,
existence of a dominant Government securities market (like in India), part of pension
reform, etc. Globalisation can be a driving force in this regard. In a simplistic sense,
as market opens up and forex reserves accumulate, the need for sterilisation itself
would motivate development of financial markets. As foreign investors and foreign
direct investment comes in, the need for transparency, institutional mechanism, good
settlement and payment systems, etc. will predominate. The Government securities
market is the most dominant component of the debt market in India. Among others,
the key elements of development of Government securities market have been
institutional development, infrastructure development, technological infrastructure,
and legal changes.
A salient feature of the move towards globalisation has been the intention of the
regulators and the responsiveness of the authorities to progress towards international
best practices. An institutional process in the form of several Advisory groups set
upon the task of benchmarking Indian practices with international standards in areas
relating to monetary policy, banking supervision, data dissemination, corporate
governance and the like. Although the standards have evolved in the context of
international stability, they have enormous efficiency-enhancing value by themselves.
Standards by themselves may be presumed to be, prima facie, desirable, and it is,
therefore, in the national interest to develop institutional mechanisms for
consideration of international standards. Thus, the implementation of standards needs
to be given a domestic focus with the objectives of market development and
enhancing domestic market efficiency (Reddy, 2002).

Conclusion

The Indian financial system today has a wide network of institutions. The
commercial banks have their presence in the most remote parts of the country. The
development of the different segments of the financial system is, however, uneven.
The cooperative credit system is effective only in certain parts of the country. But new
institutions have come on the scene. The capital market has also become more active,
with more primary and secondary markets showing strong upward movement.
The Indian financial development is a classic illustration of the supply leading
phenomenon under which financial institutions come into existence first and then
create the demand for their services. The geographical spread of the Indian banking
system was a conscious policy decision. Regional disparities in the provision of
financial services have come down even though some states do complain of
inadequate provision of credit in relation to deposits mobilised in their states. The
involvement of banks and financial institutions in the schemes for providing credit to
select segments of the society is very active. Banks are also closely associated with
credit linked poverty alleviation programmes such as the Integrated Rural
Development Programme (IRDP), the self-Employment Programme for urban poor
(SEPUP) and Self-Employment Scheme for Educated Unemployed Youth (SEEUY).
The experience with the poverty alleviation programmes has been mixed, as revealed
by many studies. Even where such programmes have succeeded in raising the
incomes of the beneficiaries, the recovery performance has not been that good.
Reform efforts in terms of strengthening of prudential norms, enhancing
transparency standards and positioning best management practices are an ongoing
process. Efforts are also on for furtherance of efficiency and productivity within an
overall framework of financial stability. Organised banking has made its presence felt
in remote parts of the country. Insurance, hitherto a public sector monopoly, has since
been transformed into a competitive market in both life and non-life segments.
Strengthening corporate governance in cooperative banks has been making headway.
Disclosures standards have been strengthened for non-banking financial companies.
DFIs are also restructuring themselves in an era of global competition. A great deal of
reforms has been undertaken in most areas of financial sector, reflected in the growing
sophistication of the financial system. The resilience of the system is reflected in
terms of absence of any major crisis in the financial system, a sustainable and broad-
based growth environment, lower levels of inflation and strong external sector
position. No doubt, the institutional framework in the financial sector had a major role
to play in this process and the globalisation process in the financial sector has been
beneficial for the economy. At the same time, the stance of the authorities has been
proactive, reacting to the macroeconomic policy stance, global challenges and
constantly endeavouring towards international best practices. One can do no better
than observe as to what Jalan (2001) reminds us, in a similar ...India of 2025 will be
a very different place, and a much more dominant force in the world economy, than
was the case twenty-five years ago or at the beginning of the new millennium.

23
Foreign Trade

Constraints Arising from Foreign Trade and Import Substitution

based Policies

INDIAN economic development strategy, particularly relating to industrialisation

has been driven by perceived foreign exchange scarcities and the desire to ensure that
scarce foreign exchange is used only for purposes deemed essential from the
perspective of development. Industrialisation and self-sufficiency in essential
commodities have been important objectives of policy because of the fear that
dependence on other, more powerful countries, for imports of essential commodities
would lead to political dependence on them as well. Nearly a decade before
independence, in 1938, the National Planning Committee was set up by the Indian
National Congress (the political party that led the struggle for independence) under
the chairmanship of the future prime minister Jawaharlal Nehru. This committee
viewed, ...the objective of the country as a whole was the attainment, as far as
possible, of national self-sufficiency, International trade was certainly not excluded,
but we are anxious to avoid being drawn into the whirlpool of economic imperialism.
Later the First-Year Plan went further:
Control and regulation of exports and imports, and in the case of certain select
commodities state trading, are necessary not only from the point of view of utilising
to the best advantage the limited foreign exchange resources available but also for
securing an allocation of the productive resources of the country in line with the
targets defined in the Plan.

Inward Looking Strategy

India adopted an inward looking strategy of industrialisation. This strategy relied

on encouraging domestic production for the domestic market behind high tariffs and
high degree of effective protection to the domestic industry. This resulted in an
uncompetitive domestic industrial structure. T.N. Srinivasan has argued that the
development strategy based on import substituting industrialisation and the system of
controls that were implemented failed to produce rapid growth, self-reliance, and
eradication of poverty, but instead led to lacklustre growth, an internationally
uncompetitive industrial structure, a perpetually precarious balance of payments, and,
above all, rampant rent seeking and the corruption of social, economic and political
systems.
 Far from viewing foreign trade as an engine of growth, Indian planners sought to
minimise import demand and viewed exports more or less as a necessary evil mainly
to generate the foreign exchange earnings to meet that part of the import bill not
covered by external assistance. They created elaborate administrative regulatory
machinery in an attempt to control investment and resource allocation in the economy
and ensure their consistency with five-year plan targets. Controls over imports and
exports were also part of this regulatory system.

Broad Trends: Exports and Imports

Exports:
1. 1950s to early 70s- import substitution became the keystone of development
strategy in the late 1950s. Consequently, exports were neglected by the
Government. The value of exports as a value of percentage of GDP at market
prices declined from an average of over 6 per cent (1950-51 to 55-56) to less
than 4 per cent in the period following. This declining trend in the value of
exports continues till 1971-72 (Table 23.1). The decline is in spite of the
introduction of many incentive schemes for the exporters in the sixties. The
sixties can be seen as the period of induction of export orientation through
incentive schemes for exports along with import substitution. With the
decision to devalue the rupee in 1966, changes in tariffs and export subsidy
policy, it was evident that the policy-makers were trying to use fiscal measures
to set up exports and curb imports. But, the incentives given to exporters could
not offset the bias against exports which was implicit in the overvalued
exchange rate (except for 1996 devaluation) and the prevalent level of import
restrictions.
TABLE 23.1

Current Account Transactions as Per Cent of GSP at Market Prices

(1950-1990)

M X Trade X+M Net Current

Imports Exports Balance Invisibles Account
Balance

1950-51 6.9 6.9 - 13.8 0.4 +0.4

1960-61 6.8 3.9 -2.9 10.7 0.5 -2.4
1970-71 4.2 3.3 -0.9 7.5 -0.1 -1.0
1980-81 9.5 4.9 -4.6 14.4 2.9 -1.6
1990-91 9.1 6.3 -2.9 15.4 0.1 -2.5

Note: figures of 1991 are provisional

Source: Indias balance of payments = 1948-49 to 1988-89. Department of Economic Analysis and Policy, Reserve Bank of
India, Bombay, published in July 1993.

2. Early 70s to late 80s The value of exports as a percentage of GDP at market
prices picked up after 1971-72 and increased till end of seventies. Eighties
again shows a declining trend in value of exports with a recovery to over 6 per
cent level only in the last couple of years in eighties (Table 23.2). it was
realised after the first oil shock of 1973 that India had to step up exports
simply to finance the rising import bill on account of an increase in oil prices.
 Eighties can be viewed as a period of growing uneasiness with the policies of
excessive protectionism. The Abid Hussain Committee on import and export
policies (1985-1988) recommended more liberal access to imports by
exporters. The second major recommendations of the committee were that the
real exchange rate of the rupee should not be allowed to appreciate and it
should be maintained at a level considered appropriate for ensuring the
competitiveness of exports.
TABLE 23.2

Value of Imports and Exports in the Planning Period

(US $ Million)

Year Exports Imports Trade Rate of Change

Balance
Exports Imports
1950-51 1269 1273 -4 24.9 -1.5
1960-61 1346 2353 -1007 0.3 16.7
1970-71 2031 2162 -131 8.8 3.5
1980-81 8486 15869 -7383 6.8 40.2
1990-91 18143 24075 -5932 9.2 13.5
1993-94 22238 23306 -1068 20.0 6.5
1994-95 26330 28654 -2324 18.4 22.9
1995-96 31797 36678 -4881 20.8 28.0
1996-97 33470 39133 -5663 5.3 6.7
1997-98 35006 41484 -6478 4.6 6.0
1998-99 33218 42389 -9171 -5.1 2.2
1999-2000 36822 49671 -12849 10.8 17.2
2000-01 44560 50536 -5976 21.0 1.7
2001-02 43827 51413 -7586 -1.6 1.7
2002-03 52719 61412 -8693 20.3 19.4
2003-04 63843 78149 -14306 21.1 27.3
2004-05 80540 109173 -28633 26.2 39.7
2005-06
(April.-Dec.) 66431 96238 -29807 18.1 27.3

Source: Government of India, Economic Survey, 1998-99, Statement 7.1 (B) p. S-81 and Economic Survey, 2000-
01, 2001-02, 2004-05, 2005-06, p. S-79

3. 1990s The 1990s have witnessed an increase in the value of exports as a

percentage of GDP at market price to over 8 per cent from over 6 per cent
level (Table 23.3). After the payment crisis of 1990-91, when the foreign
exchange reserves had fallen drastically and were enough to pay for two
weeks of imports, the process of economic reform was started in 1991. The
chief elements of reforms are devaluation of rupee, liberalisation of import
licensing, reduction in tariffs, abolition of cash subsidies for exports,
introduction of partial convertibility of the rupee on the current account and
later full convertibility of the rupee on the current account.
After three successive years of robust growth at an annual average of 19.7 per cent
(in US Dollars) during 1993-94 to 1995-96, export momentum slowed down since
1996-97, with exports registering a modest growth of 5.3 per cent and decelerating
further to 1.5 per cent in 1997-98. Both global and domestic factors have contributed
to the slowdown in export growth in India since 1996-97. The share of East Asian
countries in Indias exports was around one-sixth before the crisis, India could not
escape from the fallout from the import compression in these countries. The slump in
global trade and continued recessionary phase has caused not only import contraction,
but has also triggered protectionist measures. Amongst the domestic factors that
continue to hamper exports infrastructure constraints, high transaction costs, SSI
reservations, labour inflexibility, quality problems and quantitative ceilings on
agricultural exports remain problematic. The growth of exports picked up in 1999-
2000 and 2000-01.
TABLE 23.3

Current Account Transactions as a Percentage of GDP at Current Market Prices 90s

Exports Imports Trade X* Current X+M

X M Balance M (%) Account
Balance

1990-91 5.8 8.8 -3.0 66.2 -3.1 14.6

1991-92 6.7 7.7 -1.0 86.7 -0.3 14.1

1992-93 7.1 9.4 -2.2 77.6 -1.7 16.5

1993-94 8.3 9.8 -1.5 84.8 -0.4 18.1

1994-95 8.3 11.1 -2.8 74.8 -1.0 19.4

1995-96 9.1 12.3 -3.2 74.8 -1.7 21.4

1996-97 8.9 12.7 -3.8 69.7 -1.2 21.6

1997-98 8.7 12.5 -3.8 69.7 -1.4 21.2

1998-99 8.3 11.5 -3.2 72.1 -1.0 19.8

1999-00 8.4 12.4 -4.0 67.8 -1.1 20.8

2000-01 9.8 13.0 -3.1 75.8 -0.5 22.8

2001-02 9.4 12.0 -2.6 85.2 0.2 21.4

2002-03 10.6 12.7 -2.1 85.8 1.2 23.3

2003-04 10.8 13.3 -2.5 81.6 1.8 24.1

Note: *Export-Import ratio is not given as a percentage of GDP at current market prices
Source: Economic Surveys

Indias merchandise exports (in dollar terms and customs basis), by continuing to
grow at over 20 per cent per year in the last three years since 2002-03, have surpassed
targets. In 2004-05, export growth was a record of 26.2 per cent, the highest since
1975-76 and the second highest since 1950-51. Supported by a buoyant world
economy (5.1 per cent). The good performance of exports (growth of 18.9 per cent)
continued in April-January 2005-06, despite the slightly subdued growth of global
demand, and floods and transport disruptions in the export nerve centres of Mumbai
and Chennai.
 TABLE 23.4

Performance of the Foreign Trade Sector

(Annual Percentage Change)

Year Export Value in Import Value

US Dollar US Dollar

1990-2000 7.7 8.3

1990-95 8.1 4.6

1995-2000 7.3 12.0

2000-01 21.0 1.7

2001-02 -1.6 1.7

2002-03 20.3 19.4

2003-04 21.1 27.3

2004-05 26.2 39.7

2005-06 18.9 26.7

(April-January)

Source: Economic Survey, 2005-06

Factors for Export Growth since 2002-03

Both external and domestic factors have contributed to the satisfactory

performance of exports since 2002-03. While improved global growth and recovery in
world trade aided the strengthening of Indian exports, firming up of domestic
economic activity, especially in the manufacturing sector, also provided a supporting
base for strong sector-specific exports. Various policy initiatives for export promotion
and market diversification seem to have contributed as well. The opening up of the
economy and corporate restructuring have enhanced the competitiveness of Indian
industry. In fact Indias impressive export growth has exceeded world export growth
in most of the years since 1995; but, since 2003, it has lagged behind the export
growth of developing countries taken together, mainly because of Chinas explosive
export growth. Indias share in world merchandise exports, after rising from 0.5 per
cent in 1990 to 0.8 per cent in 2003, has been stagnating at that level since then with
marginal variation at the second decimal place (Table 23.5). This is a cause for
concern. Foreign Trade Policy (FTP) 2004-09 envisages a doubling of Indias share in
world exports from 0.75 per cent to 1.5 per cent by 2009. To achieve this target,
Indian exports may need to exceed US$ 150 billion by 2009 as world exports are also
growing fast.
While high growth in global output and demand, especially in the major trading
partners of India, helped, it was the pickup in domestic economic activity, especially
the consistent near double-digit growth in manufacturing, that constituted the main
driver of the recent export surge. In 2004-05, Indias manufacturing exports grew by
21 per cent and had a share of around 74 per cent in total exports.
 TABLE 23.5

Export Growth and Share in World Exports of Selected Countries

Percentage Growth Rate Share in World Exports

2004
Value
Country ($ bn)

1995-01 2003 2004 2005* 2001 2003 2004 2005

*

China 12.4 34.5 35.4 32.1 4.3 5.9 6.6 7.2 593.0

Hong Kong 3.6 11.9 15.6 11.4 3.1 3.0 2.9 2.8 259.0

Malaysia 6.6 6.5 26.5 12.1 1.4 1.3 1.4 1.4 125.7

Indonesia 5.7 5.1 11.2 44.6 0.9 0.9 0.8 0.8 71.3

Singapore 4.1 15.2 24.5 14.8 2.0 1.9 2.0 2.0 179.6

Thailand 5.9 17.1 20.0 12.9 1.1 1.1 1.1 1.1 96.0

India 8.5 15.8 25.7 21.0 0.7 0.8 0.8 0.8 71.8

Korea 7.4 19.3 30.9 18.1 2.5 2.6 2.8 2.8 254.0

Developing countries 7.9 18.4 27.1 21.2 36.8 38.8 40.7 42.4 3686.1

World 5.5 15.9 21.2 14.9 100.0 100.0 100.0 100.0 9049.8

Source: Economic Survey, 2005-06

Further productivity gains in the export sector require a deepening of domestic

reforms, and an accelerated removal of infrastructure bottlenecks, including export
infrastructure. Infrastructure remains the single most important constraint to export
growth. Achievement of the ambitious export target set in Foreign Trade Policy
(2004-09) requires a projected augmentation of the installed capacity of ports by 140
per cent. Indian ports, which handle 70 per cent of Indias foreign trade even in value
terms, have a turnaround time of 3-5 days as against only 4-6 hours at international
ports like Singapore and Hong Kong. As for internal transport, while there has been a
perceptible improvement in the national highways, secondary roads need to be
improved and the issue of delays caused at inter-state checkpoints need to be
addressed. Exporters need to place more emphasis on non-price factors like product
quality, brand image, packaging, delivery and after-sales service. A more aggressive
push to FDI in export industries will not only increase the rate of investment in the
economy but also infuse new technologies and management in these industries.
The strengthening of Indian exports has been aided by positive trends in global
demand, which was also reflected in global trade. After a sharp downturn in 2001,
volume growth of world merchandise trade rebounded to 3.0 per cent in 2002 and
further increased by 4.5 per cent in 2003. According to World Trade Organization
(WTO), real merchandise trade accelerated by nearly 10 per cent in the first half of
2004, and is estimated to have grown in 2004 by 8.5 per cent, or nearly twice as fast
as in the preceding year.

Imports:
1. 1950 to early 1970s- the value of imports as a proportion of GDP at market
prices, fluctuated through the 1950s (around to 6 to 9.8 per cent) and thereafter
declined slowly till the early 1970s (from 6.8 per cent in 1960-61 to 4.2 per
cent in 1972-73, Table 23.1).
The severe foreign exchange crisis of 1956-57 led to the adoption of strict
measures for import controls. The import licensing system was intensified in
the late fifties and early sixties. After a brief attempt at using fiscal measures
instead of physical controls in mid-sixties, the import licensing was
intensified. Import policy became increasingly restrictive and complex. The
quantitative restrictions were used to provide protection to any domestic
activity that substituted for imports. The decline in public investment and
industrial growth after the mid-1960s also contributed to reducing the pressure
on imports.

2. Early 1970s to late 1980s- After 1972-73, the value of imports as a

production of GDP showed a distinct increase. The import needs became
stronger as the industrial growth recovered in mid-seventies and showed an
accelerating trend in the 1980s. The eighties are marked with a clear shift in
the trade strategy towards reduction of quantitative restrictions on imports.
The number of items in the category of OGL- that is, a license to import but
with no quantitative restrictionsincreased substantially in this period. The
rise in the value of imports as a proportion of GDP increased from a level of
4.6 per cent (1973-74) to over 6 per cent in the remaining years of seventies. It
was around 8 to 9 per cent in the decade of eighties (Table 23.1).

3. 1990s- The value of imports as a proportion of GDP at market prices shows a

distinct increase in the 1990s except for 1991-92. The decline in 1991-92 was
due to severe import curbs introduced after the payment crisis of 1990-91. The
value of imports as a proportion of GDP increased from 8.8 per cent in 1990-
91 to 12.5 per cent in 1997-98 and 13 per cent in 2000-01 (Table 23.3).

Merchandise imports displayed strong growth in 2003-04, and rose faster than
exports. Lower tariffs, a cheaper US Dollar and a buoyant domestic economy boosted
imports. Imports, in US Dollar terms and on customs basis, increased by 27.3 per cent
in 23-04, on top of a rise of 19.4 per cent the previous fiscal.
Growth in Indias merchandise imports in 2004-05 at 40 per cent in dollar terms
was the highest since 1980-81. This surge in growth in 2004-05 was mainly due to the
steep rise in price of crude petroleum and other commodities with value of POL
imports increasing by 45.1 per cent. While volume growth in import of POL was
subdued at 6.4 per cent, largely in response to the price increase, larger imports filled
the gap between growing demand and stagnant domestic crude oil production. In
2004-05, lower tariffs, a cheaper US dollar, a buoyant manufacturing sector and high
export growth boosted non-oil imports by 39 per cent, particularly capital goods,
intermediates, raw materials and imports needed for exports. Buoyant growth of
imports of capital goods at 21 per cent, on top of the 40 per cent growth in 2003-04,
reflected the higher domestic investment and firming up of manufacturing growth. A
significant contributor to the rise in non-POL imports was the 5.9 per cent growth of
gold and silver on the back of a 59.9 per cent growth in 2003-04, due to high
international gold prices. The duty reduction on the imported gold from Rs.250 to
Rs.100 per 10 gram and liberalisation of such imports as per facilitation measures
announced in January, 2004 could also have provided a fillip. Non-oil, non-bullion
imports increased by 31 per cent in 2004-05, compared to a rise of 28.5 per cent in
2003-04.
Unlike in 2003-04, the surge in POL imports in 2004-05 and 2005-06 (April-
November) was dominated by the price impact. International crude oil (Brent variety,
per barrel) prices, trending upwards since 2002, on average, rose from US$ 27.6 in
2002-03 to US$ 28.9 in 2003-04, US$ 42.1 in 2004-05, and further to US$ 56.4 per
barrel in April-November 2005 with a peak of US$ 67.33 on August 12, 2005. The
stiffening of global crude oil prices was contributed by a combination of heightened
demand, limited spare capacity and geopolitical threats to the existing capacity. The
surge in crude oil prices has sharpened the focus of the adverse impact of such
volatility on domestic prices and the need to minimise such impact. Given Indias
relatively high oil intensity and increasing dependence on imported crude oil, efforts
are being made to diversify sourcing of such imports away from the geopolitically
sensitive regions. Another development has been the decision to build up strategic oil
reserves, equivalent of about 15 days requirement, to minimise the impact of crude
price volatility in the short term. In a related initiative, India is coordinating with large
oil importing countries in Asia, in exploring possibilities for evolving an Asian
products marker, in place of an Asian premium, which would reduce the premium
paid by Asian countries and thus, to some extent help in controlling the countrys oil
import bill.
Bulk of the increase was contributed by the growth in non-oil imports, which shot
up from 17.0 per cent in 2002-03 to 31.5 per cent in 2003-04. The acceleration of
such imports was mainly due to higher imports of capital goods, industrial raw
materials and intermediate goods. It reflected the higher domestic demand and firming
up of industrial growth.

Factors for Imports Growth

Imports continued to rise at a rate faster than that of exports in the current
financial year, rising by 34.7 per cent in April-January, 2004-05 on back of gold
industrial performance and rising international crude oil prices. The rise has been
contributed by a continuing robust growth in non-POL imports of 32.7 per cent and
acceleration in POL imports by 40.1 per cent. The higher non-POL non-bullion
imports are indicative of the economys growing absorptive capacity for imports.
These along with rising trends in domestic production of capital goods and strong
growth in non-food credit indicate a quickening pace of investment activity during the
current fiscal.
India moved one notch up the rankings in both exports and imports in 2004 to
become the 30th leading merchandise exporter and 23rd leading merchandise importer
of the world.
 Changing Structure of Indias Foreign Trade

In order to study the structure of Indias foreign trade we have to analyse the
changing pattern of imports and exports.
Since the purpose of the import control regime was to confine imports to essential
consumer goods, raw materials and investment goods needed for domestic production
and exports, it is not surprising that changes in the commodity composition of Indias
imports reflected this. For example, food grains and edible oil accounted for about 16
per cent of total imports in 1960-61, and about 1 per cent in 1990-91. Imports of
gems, which were negligible in 1960-61, accounted for US$ 2.079 million or nearly 8
per cent of imports in 1990-91, reflected the fact that gems and jewellery exports at
$1.667 million comprised nearly a sixth of total exports. The share of crude petroleum
oils, and lubricants in total imports rose from about 6 per cent in 1960-61 to a high of
roughly 40 per cent in 1980-81. However, it fell to about 23 per cent partly on account
on fall of crude petroleum prices and partly also to rapid growth of domestic crude
output from the Bombay High Field.
Turning to exports, Indias share of world exports has fallen steadily from about 2
per cent in 1950 to less than 0.5 per cent in 1990. Since world export grew rapidly
between 1950 and 1973 and somewhat more slowly thereafter, Indias exports grew in
absolute terms in spite of a declining share. But the dramatic fall in share reflects the
fact that other countries were able to take greater advantage of growing world trade.
The composition of Indias exports has, as expected, shifted moderately away
from primary products to manufactured goods, whose share rose from 45 per cent in
1950-51 to 79 per cent in 1990-91. However, primary exports have been virtually
stagnant, and manufactured products have accounted for almost the entire growth in
total exports (Table 23.7). Among manufactured products, just four items leather,
gems, garments, and textilesaccounted for most of the growth in recent years. In
contrast, the export of engineering goods, which rose by over 20 per cent per year in
value terms between 1950-51 and 1975-76 and between 1970-71 and 1978-79,
declined between 1980-81 and 1985-86.
The export of gems has grown rapidly since the early 1970s. This export is
heavily dependent, however, on the import of uncut small gems, the cost for which is
determined in large part by the South African monopoly De Beers. The export of
garments and textiles are governed by Indias quotas under the Multi-Fibre
Arrangement (MFA). Bhalla (1989) points out that until the 1980s, India did not fully
use quotas, and Indias competitors did better in quota, as well as, non-quota
countries. It is possible that the spurt in Indias garment and textile exports reflects
better use of quotas and higher prices realised on the average. Whether India will be
able to compete in the textile and apparel market in the absence of the MFA is
debatable, particularly in view of the fact that the Indian textile industry has fallen
behind technologically in the past four decades primarily because of the governments
textile policy.
During the high-growth phase of Indias exports, that is, between 1993-94 and
1995-96, major export items which had contributed significantly to the growth
process included engineering goods, cotton yarn, fabrics, chemicals and allied
products, rice, coffee, processed fruits, juices and miscellaneous processed items and
marine products. The growth rate of export of all these items have dropped
considerably during 1996-98. Among the manufactured exports, the deceleration of
growth rate has been most marked for engineering goods. Within the agricultural and
allied products group, export levels of both rice and coffee declined between 1995-96
and 1997-98.

Comparison between 90s and 80s

For the purpose of analysis at the aggregate level, Indias trade performance
during 1992-93 to 1998-99 (referred to here as the nineties) has been compared with
that during 1980-81 to 1990-91 (the eighties). The year 1991-92 witnessed
considerable strain on the balance-of-payments. To meet the crisis, severe restrictions
were placed on imports and the Rupee was adjusted downward in July 1991. Being an
exceptional year, 1991-92 should be excluded in any time series based analysis of
trade developments. The periodisation of the analysis captures the structural shifts in
the growth of exports and imports during the sub-periods. For instance, on an average
annual basis, export growth during 1992-92 to 1998-99 at 9.8 per cent was higher than
that of 8.2 per cent registered during 1980-81 to 1990-91. Similarly, the average
import growth observed during the nineties at 12.0 per cent remained substantially
higher than that of 7.8 per cent recorded during the eighties (1980-81 to 1990-91).
The world trade has undergone significant changes since 1996 due to a host of
developments including a sharp fall in international prices for manufactured products
and the emergence of economic crises in certain parts of the world. In addition,
protectionist policies and practices adopted by various industrialised countries during
the recent years and perhaps most importantly anti-dumping and countervailing
measures seriously affected the export efforts of the developing countries (Stiglitz,
1999). These unfavourable factors have had their impact on the developing countries
including Indias trade performance.
In the light of the above factors, it would be appropriate to examine the trade
performance of India during the two sub-periods of the nineties; the first sub-period
covering the first four years following the introduction of reforms (i.e., 1992-93 to
1995-96) and the second sub-period consisting of the subsequent three years (i.e.,
1996-97 to 1998-99). During the first sub-period, on an average basis, Indias exports
and imports increased by 15.7 and 17.5 per cent, respectively, which were
significantly higher than the growth rates during the eighties. Broadly in line with the
unfavourable external developments, between 1996-97 and 1998-99, growth in Indias
exports and imports, on an average basis, decelerated to 2.0 per cent and 4.5 per cent,
respectively. Indias share in world exports, which had declined from 0.52 per cent to
0.47 per cent between 1984 and 1987, improved to 0.53 per cent in 1992.
Notwithstanding the slowdown in Indias export growth since 1996, reflecting the
relatively better performance by India vis-a-vis rest-of-the-world, its share in global
exports reached 0.62 per cent during 1997 (IMF,1998).

Trade GDP Ratio

Indias trade GDP ratio showed substantial improvements during the nineties as
compared with the eighties. The export-GDP ratio declined from 4.9 per cent in 1980-
81 to 4.2 per cent in 1985-86 and thereafter it gradually improved and reached 6.1 per
cent in 1990-91. During the nineties, the ratio reached its highest level at 8.7 per cent
in 1995-96. The ratio declined, marginally, during the next three years and was at 8.1
per cent in 1998-99. On an average basis, export-GDP ratio increased from 5.0 per
cent to 8.2 per cent between the eighties and the nineties. Between these two periods,
on an average basis, Indias import-GDP ratio increased from 7.7 per cent to 9.4 per
cent. The noticeable improvements in the export-GDP and import-GDP ratios point to
the increasing openness of Indias foreign trade regime to global trade.
TABLE 23.8

Indias Foreign Trade Ratios

(Per Cent)

Period Average X/GDP M/GDP T/GDP X/M

1 2 3 4

1980-81 to 1989-90 4.6 7.2 11.8 64.0

1990-91 to 1999-00* 8.0 9.5 17.4 84.1

1990-91 to 1994-95* 7.3 8.4 15.7 86.9

1995-96 to 1999-00 8.5 10.4 18.9 81.8

2000-01 to 2001-02 9.4 10.8 20.2 86.7

Notes: * Excluding 1991-92

X= Exports, M-imports, T=Exports + Imports, GDP=Gross Domestic Product at current market prices in rupees.
Sources: 1. Directorate General of Commercial Intelligence & Statistics
2. Economic Survey, (various years) Government of India

Trade Deficit-GDP Ratio

Along with the increase in trade-GDP ratio, there has been a decline in Indias
trade deficit-GDP ratio between the two periods. This is borne out by the fact that the
difference between export and import-GDP ratio on an average basis, declined from
2.7 per cent in the eighties to 1.2 per cent in the nineties. This indicates the divergence
between export and import performance was more pronounced during the eighties
than in the nineties. Similarly, the export-import ratio (on an average basis) increased
substantially from 65.1 per cent during the eighties to 87.0 per cent during the nineties
reflecting thereby the increasing alignment between Indias export and import
performance during the nineties as compared with the eighties.

Structural Change in Exports

Changes in Terms of Broad Categories:

Reflecting the development of a large and diversified industrial sector, during the
post-independence period, India has gradually transformed from a predominantly
primary product exporting country into an exporter of manufactured products. In the
mid-eighties, manufactured exports accounted for about two-thirds of Indias total
exports while the rest comprised of primary products. During the years preceding the
introduction of economic reforms, i.e., between 1987-88 and 1991-92, while the
share of manufactured goods increased from 67.8 per cent to 73.8 per cent, that of
primary products declined from 26.1 per cent to 23.1 per cent. These trends were
reinforced during the subsequent period (i.e., 1992-93 to 1998-99). On an average
basis, the share of manufactured products increased by 4 percentage points while that
of primary commodities declined by 2 percentage points between the eighties and the
nineties. The share of residual exports including petroleum products declined almost
continuously between 1987-88 and 1998-99.
An analysis of the commodity composition of Indias export shows that the
combined share of the top six export categories, namely, gems, and jewellery,
readymade garments, engineering goods, textile yarn, fabrics, made-ups, etc., leather
and manufacturers and chemicals and allied products increased steadily from 59.4 per
cent in 1987-88 to 65.7 per cent in 1991-92. On an average basis, the combined share
of these exports at 66.8 per cent during the period 1992-93 to 1998-99 was 3
percentage points higher than that during eighties.
The increase in the share of the top six categories of exports in the total exports by
9 per cent between 1987-88 and 1998-99 reflects a rise in the concentration of Indias
exports in terms of broad export categories. It may, however, be mentioned that each
of these top export categories consists of a large number of individual items. Even if
the export shares of traditional items within a broad category decline, the share of the
whole product category in total exports can increase due to appearance of newer
products within that group. The emergence of newer export items, however, indicates
export diversification and in order to get a clear picture about the change in the
concentration of exports, it is essential to examine the issue at a more disaggregated
level.

Commodity Composition: Exports:

The changes in the structure of Indias exports is more noticeable at the
disaggregated level, items that registered considerable improvements in relative
export performance between the eighties and nineties include coffee, processed fruits,
juices and miscellaneous processed items, rice, spices, works of art excluding floor
coverings and other items like sugar and molasses and raw cotton (not elsewhere
included). Om an average basis, the total export earnings from these six items taken
together declined by 2.9 per cent in the eighties, while they registered an impressive
20.5 per cent growth rate in the nineties. Items, which have exhibited steady relative
export performance through the two periods include drugs, pharmaceuticals and the
fine chemicals, other agricultural and allied items, cotton yarn, fabrics, made-ups, etc.
on an average basis, the total export earnings from these three items taken together
increased by 16.1 per cent and 12.8 per cent during the eighties and the nineties,
respectively. The relative export performance of items such as oil meal, hand-made
carpets excluding silk carpets, other ores and minerals and rubber, glass, paints,
enamels and products worsened considerably during the nineties as compared to
eighties. As against an average growth of 1801 per cent during the first period, the
average rate of export earnings by these four items taken together decelerated sharply
to 6.5 per cent during the nineties. Items which registered relatively low growth rates
during the both periods include cashew, gems and jewellery, iron ore, leather and
manufacturers, natural silk yarn, fabrics, made-ups, etc., petroleum products and tea.
The combined export earnings of these seven items taken together, on an average
basis, increased by 6.3 per cent and 6.7 per cent, during the pre-1992 and post-1992
periods, respectively.
The change in the relative performance of individual export items between the two
periods indicates that the change in the structure of agriculture and allied exports has
been more marked than manufactured exports. Items such as rice, coffee, processed
fruits, juices and miscellaneous processed items remained relatively less important
export items during the eighties. These items, however, can be identified as crucial
emerging exports during the nineties. In terms of average growth rate, these exports
had declined by 3.2 per cent in the eighties, while they increased by an impressive
29.7 per cent in the nineties. The combined share of these three exports in Indias total
agricultural and allied products declined from 23.3 per cent in 1987-88 to 15.4 per
cent in 1990-91. Their share more than doubled to reach 34.2 per cent in 1998-99.
Alongside the emergence of newer products, the relative importance of some of
Indias traditional agricultural and allied export items such as cashew, oil meal, tea
and tobacco declined considerably as between the two periods. On an average, the
growth rate of these exports decelerated from 7.9 per cent in the eighties to 4.2 per
cent in the nineties. More importantly, their combined share in total agricultural and
allied exports, which increased from 38.1 per cent in 1987-88 to 43.6 per cent in
1989-90, declined sharply to 26.2 per cent in 1998-99.

Move Towards Value-addition:

There are indications that during the nineties, some of the Indian exports have
moved upwards in the value-addition chain whereby instead of exporting raw
materials, the country has switched over to the export of processed items. For
example, while the value of iron ore exports declined, that of primary and semi-
finished iron and steel increased many fold between the two periods. Reflecting this
trend, the share of ores and minerals in total exports declined, on an average basis,
from 5.5 per cent to 3.5 per cent between the eighties and nineties.
There were also significant compositional shifts within the major manufactured
product groups such as engineering goods, chemicals and allied products, etc. as
between the two periods. On an average basis, the share of basic chemicals,
pharmaceuticals and cosmetics within the chemicals and allied group, declined from
71.4 per cent to 62.4 per cent between the eighties and nineties. In particular, the
average export share of cosmetics, toiletries, etc. within the group declined sharply
from 12.4 per cent to 4.7 per cent between these two periods. Within the same group,
the average export share of plastic linoleum increased from 6.4 per cent during the
eighties to 13.2 per cent in the nineties. Among the components of engineering goods,
the average share of machinery and equipment in total engineering exports declined
from 30.6 per cent to 21.7 per cent while that of primary and semi-finished iron and
steel increased from 2.9 per cent to 11.9 per cent as between the two periods. Among
the textile products, while the importance of man-made yarn, fabrics, and made-ups,
increased as between two periods that of jute manufacturers declined sharply. The
internal export composition of leather and leather manufacturers and readymade
garments remained stable before and after the initiation of economic reforms.

Moving Away from Traditional Exports Towards New Manufactured Products:

Indias manufacturing exports are showing tendencies of shifting away from
traditional exports towards relatively new manufactured products. Another interesting
point about the compositional change in the manufactured exports is that, by and
large, major export items within the category for which internal composition remained
unchanged between the eighties and nineties (e.g., leather and leather products, ready-
made garments) recorded relatively poor performance as compared to groups which
recorded changes in their internal composition (e.g., chemicals and allied products,
engineering goods). This indicates the existence of a close link between export
performance and structural change in the case of Indias manufactured exports.
As mentioned earlier, since 1996-97 there has been a marked deceleration in the
growth of Indias manufactured exports. Apart from its negative impact on the overall
export growth, a fall in the growth of manufactured exports also likely to have
constrained structural transformation within the category of manufactured exports. A
number of external as well as domestic factors contributed to the process of slowdown
in Indias exports in general and manufactured exports in particular. These included:
decline in international manufactured prices, increased protectionism by the
industrialised countries coupled with non-implementation of the transitional
agreements on integration of trade in textiles and clothing with the WTO by the
industrialised countries. While these factors had adverse implications for Indian
manufacturing exports, particularly exports of engineering goods, chemicals and
allied products and textiles and clothing, the sharp price fluctuation in the
international market for raw diamonds and gold between 1996 and 1998, had
contributed to the decline in gems and jewellery exports, the single largest export item
of India.

Indias Share in Global Exports: Compositional Change

The foregoing discussion focuses solely on the internal change in the commodity
composition of Indias exports. It is also important to study whether there has been
any change in Indias share in global trade. It may be noted that commodities for
which Indias share in global exports have increased considerably as between the two
periods include rice, coffee and substitutes, feeding stuff for animals, textile yarn (in
particular, cotton yarn), pearls, precious and semi-precious stones and gold and silver
jewellery. Items for which Indias global export share declined as between the two
periods include shellfish, tea and mate, spices, iron ore concentrate, leather, leather
manufacturers and certain categories of textile and garment articles.
It is interesting to note that during eighties, there were many export items for
which Indias global market shares were high while growth in world trade for those
products was low. It is argued that lack of alignment between the composition of
Indias export basket and the demand structure in foreign markets has been a major
constraint for expansion of Indias exports. Reversing such trends, during the nineties,
by and large, Indias global shares have improved for those commodities for which
growth in world trade decelerated. In other words, the alignment between the structure
of world demand and the composition of Indias exports has improved during the
nineties as compared to the eighties. This is likely to have major impact on the future
behaviour of Indias exports.
Indias export share in world trade has increased perceptibly during the recent
period. Indias exports as a percentage of world exports improved to 0.56 per cent
during 1991-96 and further to 0.65 per cent during 1996-2002 from 0.48 per cent in
the 1980s. The ratio was 0.71 per cent in 2000-01, the highest achieved so far since
1970s. Nonetheless, Indias share in world exports is still very low and appears
unimpressive when compared with the other major trading Asian countries, such as,
China and other East Asian economies like Malaysia, Thailand, Singapore, Korea and
Indonesia (Table 23.9). China demonstrated the most dramatic change as its share in
world exports more than doubled in a decade from 2.0 per cent in 1991 to 4.4 per cent
in 2001. Group-wise, Indias share in the imports of industrialised countries in the
1990s declined as compared to that in 1986. In respect of the developing countries as
a group, however, it has increased from 0.5 per cent in 1986 to 1.1 per cent during
1996-2000.
The Ministry of Commerce and Industry, Government of India has set an export
target of 1 per cent share of world exports by 2006-07 for the medium-term which
would be co-terminus with the Tenth Five Year Plan. This target is based on historical
trends, current prospects and the requirement of a compound annual growth rate of
about 12 per cent for exports till the year 2006-07 (Government of India, 2002a). The
export performance is known to depend on price competitiveness of Indias exports.
In India, large exchange rate misalignment has not occurred in the last one decade as
the market itself has corrected the misalignment gradually over different episodes.
TABLE- 23.9

Share of Select East Asian Countries in World Exports

(Per Cent)
Annual Average
Country
1991 1995 1999 2000 2001 1991- 1996-
1995 2000

1 2 3 4 5 6 7

India 0.5 0.6 0.6 0.7 0.7 0.6 0.6

China 2.0 2.9 3.5 4.0 4.4 2.5 3.4

Indonesia 0.8 0.9 0.9 1.0 0.9 0.9 0.9

Korea 2.0 2.4 2.6 2.7 2.5 3.0 2.5

Malaysia 1.0 1.4 1.5 1.6 1.4 1.2 1.5

Singapore 1.7 2.3 2.0 2.8 2.0 2.0 2.3

Thailand 0.8 1.1 1.0 1.0 2.0 1.0 1.0

Source: International Financial Statistics, February 2003

Indias export performance is affected by domestic as well as external

impediments. The domestic factors inhibiting Indias export growth are infrastructure
constraints, high transaction costs, small-scale industry reservations, and
inflexibilities in labour laws, lack of quality consciousness and constraints in
attracting FDI in the export sector. High levels of protection in relation to other
countries also explain why FDI in India has been much more oriented to the protected
domestic market, rather than as a base for exports. The exports of developing
countries like India are facing increasing difficulties by emerging protectionist
sentiments in some sectors in the form of technical standards, environmental and
social concerns besides non-trade barriers like anti-dumping duties, countervailing
duties, safeguard measures and sanitary and phyto-sanitary measures. Indian products
which have been affected by such barriers include floriculture products, textiles,
pharmaceuticals, marine products and basmati rice exports to the European Union and
mushroom and steel exports to USA and also grapes, gherkins, egg products, honey,
meat products, milk products, tea, and spices. Differential tariffs against developing
countries have also adversely affected market access into these countries
(Government of India, 2002b; WTO, 2002). According to the WTO, exports from
India are currently subject to 40 anti-dumping and 13 countervailing measures mainly
for agricultural products, textiles and clothing products and chemicals and related
products. This brings into focus the importance of non-price factors like quality,
packaging and the like mentioned earlier, where India still seems to be lacking as
compared to the international standards. This has adversely affected Indias export
performance vis-a-vies other developing countries which may have an improved
standing in these non-price factors.
 Commodity Composition of Imports

In the discussion on the structural change in Indias imports in this sub-section, the
relative shares of the major commodities/groups in total imports should generally be
exclusive of gold and silver imports. This has been done keeping in view the sharp
increase in silver and gold imports in the recent years, which obscures the changes in
the relative shares of other items. The import of gold and silver rose from US$ 4
million in 1990-91 to US$ 4,876 million in 1998-99 and formed as much as 11.6 per
cent of Indias total imports during that year.
The relative share of capital goods in Indias total imports net of gold and silver
improved, marginally, from 25.6 per cent during 1987-91 to 26.0 per cent during
1992-99. Within the capital goods group, the rise in import was more pronounced in
the case of manufacture of metals, machine tools, and electrical machinery (including
electronic and computer goods), while that of non-electrical machinery and transport
equipment recorded a relatively low order of increase. While the overall increase in
the import of industrial raw materials and intermediate goods was less pronounced,
certain individual items mainly catering to export activities such as cashew nuts,
textile yarn, fabrics, made-ups etc., and chemicals (organic and inorganic), however,
recorded sharper rise.
Among other items, the imports of petroleum (crude and products) showed wide
fluctuations, reflecting inter alia, the movements in international prices. There was a
sharp increase in its imports during 1989-90 (25.2 per cent) and 1990-91 (60.0 per
cent) and the average annual growth rate during 1988-1991 was considerably higher
at 27.2 per cent as compared with the 12.0 per cent growth in total imports. After
attaining a high base in 1990-91, the oil imports declined during 1991-92 by 11.7 per
cent. During the period 1992-1993 to 1998-1999, the growth rate in oil imports
ranged between 33.4 per cent in 1996-97 and a negative of 21.2 per cent in 1998-99.
Although the average annual growth rate of this item during 1992-99 was low (4.6 per
cent), the average value at US$ 7,134 million stood 79.2 per cent higher than US$
3,981 million during 1987-1991. Consequently, the relative share of oil imports
moved up to 22.5 per cent during 1992-1999 from 19.4 per cent during 1987-1991.
Similarly, the average level of import of manufactured fertilisers during 1992-
1999 also stood 77.7 per cent higher than that during 1987-1991, although the average
annual growth rate remained considerably lower at 9.5 per cent during 1992-1999
than that of 79.5 per cent during 1988-1991. The increase in the imports of
consumption goods was relatively less pronounced (27.3 per cent), with its share
dropping from 4.3 per cent during 1987-1991 to 3.6 per cent during 1992-1999.
Within this category, the import of edible oils, however, increased by 55.9 per cent
and that of sugar increased by 269.3 per cent.
The changes in the structure of Indias imports are reflective of the influence of
three factors:
1. Movements in international prices;
2. Changes in trade policy; and
3. Pattern of domestic demand.
The role of international prices in shaping the trends in the import of petroleum,
crude and products has already been discussed earlier. This apart, it may be indicated
that the international prices of manufactured goods have declined considerably during
the recent years, keeping their import value depressed.
The surge in the imports of gold and silver, edible oils and manufactured fertilisers
were to some extend policy driven. Similarly, reflecting the impact of further easing
of the restrictions on the import of capital goods, these items recorded higher import
growth during 1992-1999. Since a sizable part of Indias imports cater to the needs of
the industrial sector, the trends in the demand for imports may be judged from the
overall growth in industrial production.

Direction of Foreign Trade

Prior to independence, a large part of Indias trade was either directly with Great
Britain or its colonies or allies. This pattern continued for some years after
independence as well since India had not till then explored the possibilities of
developing trade relations with other countries of the world. For example, the
combined share of UK and USA in Indias export earnings was 42 per cent in 1950-
51. Their share in Indias import expenditure was as much as 39.1 per cent in the same
year. With other capitalist countries like France, Germany, Italy, Japan, etc. India
either did not have trade relations at all or they were very insignificant. As political
and diplomatic contacts developed with other countries, economic relations also made
headway. Thus new vistas for developing trade relations with other countries opened
up. The situation has change very much since, and now after four and a half decades
of planning, the trading relations exhibit marked changes. The diversification in trade
relations has reduced the vulnerability of the economy to outside political pressures.
In the year 1950-51, the share of UK in Indias import was 20.8 per cent and that
of USA was 18.3 per cent. Thus, the combined share of these two countries was 39.1
per cent. This reflected the colonial heritage of the country. Within a decade, the
picture started showing some changes. New trading partners like West Germany,
Canada and USSR emerged. There was a change in the relative position of UK and
USA as well, with the latter pushing down the former to the second place. Expecting a
year or two, USA has continuously maintained the first position thereafter. During the
planning period as a whole, India has obtained maximum imports from USA, the
reason being that India has imported large scale quantities of capital goods,
intermediate products and food grains (under P.L.480 agreement) from that country.
With the expansion of trading relations with Japan, West Germany and USSR, the
dependence on the UK declined considerably. Thus the share of UK in Indian imports
declined from 19.4 per cent in 1960-61 to 5.7 per cent in 1997-98. On the other hand,
the share of Japan increased from 1.5 per cent in 1950-51 to 5.4 per cent in 1960-61
and further to 7.5 per cent in 1990-91. However, thereafter, it decreased the
percentage terms to 6.5 per cent in 1995-96 and 5.2 per cent in 1997-98.
Another significant development was the expansion in trading relations with the
socialist countries especially the erstwhile USSR. Imports from USSR were negligible
in 1950-51. In 1960-61 they amounted to a meagre Rs. 16 crore. However, thereafter,
they increased rapidly increasing the share of USSR in Indias imports from 1.4 per
cent in 1960-61 to 6.5 per cent in 1970-71. For a number of years it occupied the
second place after USA. For instance, during 1980-81 to 1983-82, USA occupied the
first place in Indias imports and USSR was second. In 1984-85, the share of USSR
was 10.4 per cent and it displaced USA from the first place. The picture changed
thereafter. In 1985-86, USA was first, Japan second and USSR third. In 1990-91, with
a share of 12.1 per cent, USA occupied the first place. It was followed by Germany
with a share of 8.0 per cent (the figure is for unified Germany). Japan had the third
position (share 7.5 per cent). UK and Saudi Arabia shared the fourth position with a
share of 6.7 per cent each, Belgium had the fifth position (share 6.3 per cent) while
USSR had the sixth position (share 5.9 per cent). With the disintegration of USSR the
direction of imports has now changed markedly. For instance, in 1997-98, USA
occupied the first position in Indias imports (share 8.9 per cent), followed by Saudi
Arabia (share 6.2 per cent), Germany (share 6.1 per cent), Belgium (share 6.0 per
cent), Kuwait and UK (share 5.7 per cent each) in that order.

Direction of Exports:
As is clear from Table 23.10, OCED group accounts for a major portion of Indias
exports. The hare of this group in 1960-61 was 66.1 per cent and in 1997-98 was 55.7
per cent. Almost 46 per cent of these exports were accounted for by the EU countries
in 1997-98. The OPEC group accounted for 4.1 per cent of exports in 1960-61 and its
share in 1997-98 rose to 10.0 per cent. Most significant was the rapid increase in
exports to the countries of Eastern Europe particularly USSR for instance, Eastern
Europe accounted for 7.0 per cent of export earnings in 1960-61 and its share shot up
to 22.1 per cent in 1980-81. During recent years, exports to this group suffered a
setback due to marked political upheavals in these countries and the disintegration of
the USSR. In 1997-98 the share of Eastern Europe in total exports had slumped to a
mere 3.1 per cent. Developing nations of Africa, Asia and Latin America accounted
for more than one-fourth of Indias export earnings in 1997-98. Most important in this
group have been the countries of Asia. In fact, exports to Asian countries accounted
for 21.3 per cent of Indias total export earnings in 1997-98. Thus, countries of Asia
now account for more than one-fourth of Indias export earnings.
Direction of exports in 1999-2000 show significant increases in Indias exports to
its major destinations like OECD, Asia and OPEC regions. Exports in US Dollar grew
by 12.8 per cent to OECD, 20.1 per cent to Asia (other than OPEC countries) and 12.3
per cent to OPEC in 1999-2000 as compared with declines of 1.5 per cent, 14.4 per
cent and low growth of 0.8 per cent respectively in 1998-99. Other regions recording
robust growth in exports included Eastern Europe (due mainly to turnaround in
exports to Russia) and Latin America and Caribbean region with Mexico, Peru, Chile,
Barbados and Panama accounting for major increases. Exports to developing
countries in Africa, however, declined by 5.4 per cent in 1999-00 as against a rise of
9.9 per cent in the previous year. In terms of region-wise share in total exports, while
the share of OECD, OPEC and developing countries from Africa declined in 1999-
2000, those of Eastern Europe and Asian developing countries increased during this
period. The share of developing countries from the Latin America and Caribbean
region was, however, maintained at 1.7 developing. Although the share in total
exports to OECD countries, as a group, registered a marginal decline from 57.8
developing in 1998-99 to 57.6 developing in 1999-2000, exports to many developed
countries like Canada (25.8 per cent), UK (21.1 per cent), USA (18.5 per cent),
Netherlands (16.1 per cent), France (10.9 per cent) and Belgium (7.2 per cent), in this
region recorded significant increases during the year. The sharp rise in share of
exports to developing countries of Asia was largely on account of the recovery from
the crisis by East Asian countries as a result of which the share of our exports to
selected East Asian countries rebounded from 11.6 per cent in 1998-99 to 13.7 per
cent in 1999-2000.

Direction of Imports:
 Sources of imports reveal a sharp decline in share of imports in total imports from
OECD countries from 51.6 per cent in 1998-99 to 44.8 per cent in 1999-2000 as
imports from these countries declined by 3.2 per cent in 1999-2000. Bulk of this
decline in share was appropriated by imports from the OPEC region whose share rose
to 23.8 per cent in 1999-00 (as compared to 18.3 per cent in 1998-99) mainly because
of increase in international petroleum crude oil prices. Similarly, the share of imports
sourced from non-OPEC developing countries (of Africa, Asia, Latin America and
Caribbean) improved from 21.1 per cent in 1998-99 to 22.6 per cent in 1999-2000.
The share of imports from Eastern Europe was broadly maintained in 1999-2000 due
mainly to recovery in imports from Russia. Imports from developing countries of
Africa and Latin America and Caribbean regions grew by 21.9 per cent and 20.3 per
cent respectively in 1999-2000 and was contributed among others, by countries like
Egypt, Ghana, Brazil, Chile and South Africa. Imports from developing countries
from Asia also recorded a high increase of 18.5 per cent with robust growth from
countries like China, Hong Kong, Malaysia and Thailand. The share of selected East
Asian countries in total imports increased from 14.9 per cent in 1998-99 to 15.5 per
cent in 1999-2000 due partly to the share depreciation of currencies of these countries
during the Asian crisis.
A sharp increase in imports from other residual destinations, coupled with decline
in share of OPEC region, may suggest a change in sourcing of oil imports away from
the OPEC region during the current financial year.
Structural changes are also discernible from the data on sources of Indias imports.
While there has been a sharp increase in the relative share of developing countries that
of the industrialised countries declined. Between 1987-1991 and 1992-1999, the
relative share of the developing countries as a group moved up from 18.0 per cent to
23.0 per cent. This was largely on account of the increase in the imports from the
newly industrialised countries in South East Asia. Among the commodities that
contributed to the import growth, petroleum (crude and products) from Malaysia and
Singapore, vegetable oils from Malaysia, chemicals from Republic of Korea and
Singapore, and electronic goods from Hong Kong, Republic of Korea, Malaysia and
Thailand were prominent. Between the two periods, the relative shares of the
countries belonging to the OPEC group also increased from 14.5 per cent to 21.9 per
cent. This is mainly reflective of the surge in the oil import bill on account of higher
prices.
The share of OECD as a group in Indias import dropped considerably from 59.4
per cent during 1987-1991 to 52.1 per cent during 1992-1999. Within this group, the
relative share of the EU countries fell from 31.8 per cent during 1987-1991 to 26.9
per cent during 1992-1999. The import shares of some of the individual EU countries
such as Denmark, Greece, Ireland and Italy, however, recorded relatively high growth,
while those from traditionally important countries such as Germany, Netherlands,
Sweden and UK showed lower rise. The relative share of the UK fell to 5.8 per cent
during 1992-1999 during from 7.9 per cent during 1987-1991. Among other OECD
countries, the imports from Australia, New Zealand and Switzerland recorded
relatively large growth. The relative share of Switzerland moved up from 1.1 per cent
during 1987-1991 to 4.0 per cent during 1992-1999. This was largely on account of
the import of gold and silver and non-electrical machinery. It may be indicated that
during 1991-1999, the import of gold and silver formed as such as 69.2 per cent of
Indias total import from Switzerland, while Switzerland alone accounted for 58.1 per
cent of Indias total import of gold and silver during this period. The relative share of
the East European countries declined from 8.1 per cent during 1987-1991 to just 2.9
per cent during 1992-1999 with absolute decline in the imports from most of the
countries belonging to this group.

Summing Up

Notwithstanding the earlier policy initiatives aimed at liberalisation of Indias

foreign trade, the outward-looking trade policy measures announced in 1991 marks
the initiation of a new era in Indias foreign trade. Indias foreign trade performance
improved significantly during the recent years and there has been a perceptible change
in the structure of Indias foreign trade between the eighties and nineties.
The share of manufactured products has increased in Indias total exports. At the
same time, since the introduction of reforms, the proportions of high-value and
differentiated products have increased in Indias export basket.
Along with the increase in Indias aggregate share in world trade, the alignment
between the countrys export basket and world demand has increased during the
nineties.
The relative share of certain capital goods in Indias total imports has also
increased in this period. Imports of manufactured fertilizers and edible oils also
recorded higher growth during the post-1991 period.
In line with the policy changes, imports of gold and silver have increased sharply
during the nineties.
Reflecting the increased link between exports and imports, the shares of certain
export-related imports have also increased during the recent years.
The most remarkable change in the country-wise composition of Indias exports
and imports since 1991 has been the increase in the share of developing countries in
Indias overall trade.
While the share of the East European countries has declined in Indias total trade,
that of the OECD countries has declined in the case of imports.
Indias foreign trade has, however, been adversely affected by certain
unfavourable external developments since 1996.
Notwithstanding these negative developments, Indias trade performance during
the nineties as a whole has been better than that during the eighties.

Balance of Trade

Balance of Trade, simply defined is the difference between the value of export of
goods and the value of import of goods or more generally between exports and
imports or (X-M) where X denotes value of exports and M, value of imports.
When value of exports is more than value of imports (X>M) balance of Trade
(BoT) is said to be favourable or positive. On the other hand when the exports are less
than imports (X<M) or imports more than exports (M>X), the balance of trade (BoT)
is said to be unfavourable, or negative or there is said to be a deficit in the balance of
trade.
Since goods are also called merchandise, the balance of trade or trade balance is
also called balance of merchandise account.

Indias Balance of Trade

Ever since the beginning of planning era in 1951, India has continued to suffer
from an unfavourable balance of trade. The only exceptions to this trend have been
the years 1972-73 and 1976-77 when the country had a positive trade balance of Rs.
104 crore and Rs. 68 crore, respectively.
In the early years after independence, the values of Indias exports as well as
imports were low and the difference between them was small. This resulted in
comparatively lower magnitude of deficit in trade balance. From Rs. 163 crore
average annual deficits it rose to an annual average of Rs. 36,363 crore during 1997
and 2002. The early years of Tenth Plan; it was Rs. 42,069 crore in 2002-03 which
increased to Rs. 62,870 crore in 2003-04. Thus, the trade deficit has not only persisted
since 1951 but has increased widely over the years to reach alarming levels by the end
of the century as is shown in Table 23.11.
TABLE - 23.11

Indias Balance of Trade

(Rs Crore)

Plans Average Annual Trade Balance

Exports Imports
First Plan (1951-56) 605 735 -130
Second Plan (1956-61) 606 973 -367
Third Plan (1961-66) 753 1,240 -487
Annual plans (1966-69) 1,238 1,998 -760
Fourth Plan (1969-74) 1,810 1,973 -163
Fifth Plan (1974-79) 4,728 5,538 -810
Annual Plans (1979-80) 6,418 9,143 -2,725
Sixth Plan (1980-85) 8,697 14,683 -5,716
Seventh Plan (1985-90) 17,382 25,112 -7,730
Annual Plans (1991-92) 38,297 45,525 -7,278
Eighth Plan (1992-97) 86,557 97,609 -11,352
Ninth Plan (1997-02) 1,68,400 2,04,763 -36,363
Tenth Plan (2002-07)
(2002-03) 2,55,137 2,97,206 -42,069
(2003-04) 2,93,367 3,59,108 -65,741
(2004-05) 3,61,879 4,90,532 -1,28,653
(2005-06) 2,93,829 4,25,667 -1,31,837
(Apr.-Dec.)

Source: Compiled from Economic Survey, 2003-04, 2005-06

Causes of Unfavourable Balance of Trade

Continued excess of imports over exports has perpetuated the unfavourable

balance of trade since 1950-51. To begin with, the trade deficit was small, but it
widened over time, more particularly from the Sixth Plan onwards, it rose sharply to
assume serious dimensions during and after the Eighth Five-Year Plan. This has
happened because exports from India have not been able to keep pace with the high
growth rate of imports.

Large Increase in Imports:

In terms of value, Indias imports have increased sharply between 1950-51 and
2005-06 from a level of Rs. 608 crore to estimated Rs. 4,90,532 crore in 2004-05.
Some of the factors that have contributed to this massive import growth are as below:
 1. Large Increase in Developmental Imports: Under planned economic
development of the country starting with the First Plan, there has been a
continuous expansion in the imports of capital goods, machinery equipment,
etc. the value of capital goods imports (including transport equipment)
increased from Rs. 366 crore in 1960-61 to Rs. 1,910 crore in 1980-81, Rs.
10,486 crore in 1990-91 and Rs. 63,175 crore in 2004-2005. Similarly there
was increase in raw materials and maintenance imports such as equipment
needed to replace the worn-out machinery and maintain it in working order.
2. Large Increase in Import of Petroleum: Petroleum, oils and lubricants
(POL) have registered more than 500-fold increase between 1960-61 and 1991
as the value of POL imports increased from Rs. 69 crore to Rs. 10,816 crore,
which further rose to Rs. 1,34,094 crore in 2004-05. Petroleum is a major
source of energy used in industry and in surface as well as air transport. It is
also used for domestic fuel in the form of kerosene and cooking gas. Personal
transportation modes comprising motor cars and scooters, motorcycles, etc.,
depend on petroleum. Petroleum is also used in industry as raw material for
many synthetic products. Therefore, a massive increase in demand for and
import of POL is inevitable.
3. Fertiliser Imports: In spite of increased domestic production, fertilisers are
imported to meet their fast growing consumption requirements. Thus, between
1960-61 and 2000-01, import of fertilisers has gone up from Rs. 13 crore to
Rs. 3,034 crore in 2000-01 and Rs. 5,143 crore in 2004-05.
4. Import of Pearls and Precious Stones: The import of unfinished and
finished/worked precious and semi-precious stones has increased from Rs. 1
crore in 1960-61 to Rs. 42,336 crore in 2004-05.

Modest Growth in Imports:

Growth of exports was quite low and insignificant till the Third Five-Year Plan.
The total value of exports increased from Rs. 642 crore in 1960-61 to Rs. 32,553 in
1991, Rs. 2,03,571 in 2000-01 and Rs. 3,61,879 in 2004-05. Both external and
internal factors are responsible for this modest growth.

External Factors:
1. Low World Demand: The world demand for many goods has remained low
due to continuing recession and economic downturn in many countries.
2. Low Income and Price Elasticity of Goods Exported: Many of the goods
exported by India are primary products such as cereal preparations, fish and
marine products, etc. the demand for these goods is generally less elastic, i.e.,
the demand does not change much with change in income or prices. Thus,
when we make efforts to sell more and increase supply, prices fall but demand
does not increase much. Hence, we end up earning lower value even for larger
quantity sold and our export earnings either do not increase much or
sometimes may even decline.
3. Import Restriction on Our Goods Entering Foreign Countries: Many
countries have imposed restrictions on goods imported by them and this
adversely affects our exports. These restrictions may be in the form of quotas,
(not more than a certain given quantity of a given product is to be imported
from outside), tariff restrictions (imposing of import duty on goods entering
the country and thus making them costlier for purchasers in the home market
of the importing country) or non-tariff restrictions such as health laws that do
 not permit import of agricultural goods from underdeveloped countries in
USA and some other countries on grounds of posing health hazard to the
people. Such physical restrictions and tariff as well as non-tariff barriers by
USA and countries of European Union have contributed to slow growth of
exports from India.
4. Disintegration of the Soviet Union: The soviet union/USSR was among our
largest trading partners and a big market for Indian goods. Its disintegration
caused a major setback to our exports.

Internal Factors:
1. Increasing Domestic Demand: increase in income of people due to growth of
the economy has contributed to higher domestic demand. The supply side has
however not been able to match this increased demand due to slow growth in
agricultural and industrial output. Not much is thus left for exports as
producers sell bulk of output at home quite profitably. This reduction in
surplus of goods (over domestic consumption) for exports has contributed to
their slow growth.
2. Low Quality and High Cost of Production: India emerged as high cost
quality production country which could not face foreign competition either at
home or abroad. Hence, Indian goods were not favoured by foreign buyers
and, therefore, our exports remained low.

Measures to Correct Deficit in Balance of Trade:

The Government of India has been adopting and implementing various policies
for restricting imports and promoting exports to reduce trade deficit.

Restrictions on Imports:
Following measures have been taken to regulate imports:

1. Licensing of Imports: for quite a long time, the import of non-essential

consumer goods was not permitted while the importers of capital goods
essentially for countrys development were given import licences. However,
now under the liberalised trade policy, licensing requirements for most of the
goods have been abolished; only a small negative list of imports remains under
licensing system.
2. Tariff Restrictions: For the goods that are permitted to be imported under
licence from the Government, further restrictions are imposed by way of
custom duties or import duties also called import tariffs. This means a tax is
imposed on the goods that arrive at the Indian ports and thus the price of such
goods become higher for the Indian buyers. The higher the rate of custom
duty, the greater is the price that Indian buyers need to pay for imported goods.
These high prices of imported goods are expected to reduce their demand in
the domestic market and thereby to restrict imports.
3. Quantitative Restrictions: The Government may determine the total import
quota of goods, i.e., the total amount of goods that can be imported and allot
this quota to various importers. Nothing beyond the quota is allowed to be
imported. This naturally limits the quantity of imports. However, under an
agreement with the World Trade Organization (WTO), such quantitative
restrictions have been removed on many goods, while for others they are to be
removed in near future.
 Export Promotion

With the continuing large deficits in Indias balance of trade and limited scope for
imports reduction, the only long-term solution to the problem lies in promotion of
exports to earn sufficient foreign exchange to pay for our growing imports. Export
promotion measures opening up wider international market for our entrepreneurs will
simulate industrial development in the country under the incentive of larger world
demand for our goods.

Export Promotion Measures:

The export promotion measures adopted by the Government of India include
monetary and non-monetary incentives, fiscal reliefs, credit facilities, establishment of
institutions to help exporters as well as strict quality controls and inspection of goods
meant from export. Some of the major steps in the direction are as below:
1. Devaluation: in July 1991, the rupee was devalued by about 20 per cent in
terms of major world currencies. This was expected to cheapen our goods to
foreign buyers thus encouraging our exports.
2. Cash Assistance: Under this scheme cash assistance is given to exporters to
compensate them for indirect taxes (e.g., custom duties) levied on the
imported inputs that are used in the production of goods for exports.
3. Income Tax Concessions: Income from exports is given several concessions
under the income tax laws. For example profits from exports are totally
exempted from income tax.
4. Import Concessions: Several concessions in imports of machinery,
technology and equipment are given to export production units. Export
oriented units are allowed duty free imports of machines, raw materials and
technology. Exporters are also allocated foreign exchange for import of raw
materials used in production of export goods.
5. Concessional Bank Credit to Exporters: For financing production meant for
exports and also for financing exports themselves, banks give credit to
exporters at concessional terms.
6. Import Licences to Exporters: since imported goods fetched very high prices
in the domestic market as their imports were highly restricted, the exporters
were granted licences for import of goods up to a certain percentage of value
of goods exported by them. This was expected to provide added incentive for
exports.
7. Issue of Exim Scrips: the system of granting import licences to exporters was
later replaced by exim scrips. The exporters were given exim scrips equivalent
to 30 per cent of value of their exports. These exim scrips could be used to
import a large variety of items. The exim scrips could also be sold in the
market. Since these enjoyed a premium, the exporters could make additional
profits from their sale. This could act as a great incentive to exporters.
8. Convertibility of the Rupee: the system of exim scrips was also replaced by
partial convertibility of rupee in March 1992. Under this scheme, exporters,
who earlier had to surrender their entire foreign exchange earnings to the
Reserve Bank of India (RBI) at a rate fixed by it, were now obliged to sell
 only 40 per cent of their exchange earnings at the official rate to the RBI. The
rest they were free to sell in the market at the market determined rate, which
was obviously higher than the official rate. This indeed was a great
liberalisation measure and a bigger incentive. In March 1997 even this was
replaced by a system of full convertibility of rupee on the trade account.
9. System of Advanced Licensing: Exporters are given advance licences for
duty free import of goods used in production of export items.
10. Relaxation of Controls on Exports and Simplification of Procedures:
Controls on exports have been relaxed. Exports of many items have been
decontrolled while export procedures and formalities have been simplified.
11. Export Processing Zones: Many export processing zones have been set up.
The units operating there are allowed free trading with other countries. They
also enjoy various concessions like five-year tax holiday.
12. Export Promotion Organisations: Some such organisations are Export
Advisory Council, Export Promotion Councils, Directorate of Export
Promotion, etc.
13. Export Import Bank: The EXIM bank provides financial services to
exporters and importers and coordinates the work of other institutions engaged
in financing export trade. It pays a special attention to export of capital goods.

24
Balance of Payments and Trade Policy

Concepts

BALANCE of Payments (BoP) is a systematic record of all economic transactions

between the residents of a country and the rest of the world. Like all double-entry
book keeping accounts it always balances i.e., sum of credit entries=sum of debit
entries.
There are two types of accounts in BoP namely, (1) Current Account and (2)
Capital Account.
Current Account records transfers of goods and services i.e., merchandise trade
and net invisibles which includes services like travel, transportation, insurance, etc.
and transfer payments.
Capital Account shows transfers of claims to money or titles to investment
between a country and the rest of the world. It includes foreign investment inflow
minus the foreign investment outflow, loans including external assistance and external
commercial borrowings (inflow-outflow) and other capital which includes rupee debt
service, IMF transaction and SDR allocation.
A Current Account deficit is finance through the net inflow of capital on the
capital account and the change in the Governments foreign exchange reserve
position.

Trade Policy: An Overview

As we embarked on a period of planning, during the fifties, import substitution

came to constitute a major element of Indias trade and industrial policies. Planners
more or less chose to ignore the option of foreign trade as an engine of Indias
economic growth. This was primarily due to the highly pessimistic view taken on the
potential for export earnings. A further impetus to the inward orientation was provided
by the existence of a vast domestic market. In retrospect, it is now abundantly clear
that the policy-makers not only under-estimated the export possibilities but also the
import intensity of the import substitution process itself. It has been as a consequence
that Indias share of total world exports declined from 1.91 per cent in 1950 to about
0.53 per cent in 1992.
The inward looking industrialisation process did result in high rates of industrial
growth between 1956 and 1966. However, several weaknesses of such a process of
industrialisation soon became evident, as inefficiencies crept into the system and the
economy turned into an increasingly high-cost one. Over a period of time this led to
a technological lag and also resulted in poor export performance.
In the meantime, some change in the attitude towards export became perceptible.
Several export promotion measures were put in place from the early 1960s. The 1966
devaluation, while not resulting in the expected improvement in trade deficit due to a
combination of circumstances, brought out the problems stemming from an
overvalued exchange rate. Nevertheless, it will be correct to say that until the end of
the 1970s, exports were primarily regarded as a source of foreign exchange rather
than as an efficient means of allocating resources. Import substitution over a wide
area remained the basic premise of the development strategy.

The Political Economy of the Foreign Exchange Regimes

The political economy of Indias foreign trade and exchange control regimes
before reforms were initiated in 1991 can be understood from the implications of its
selective, discretionary and non-market-oriented character. First, macroeconomic
instruments, including most importantly the exchange rate of the rupee, were never
used to address balance of payments problems except for the rupee devaluation of
1966. Given that QRs on imports were substantially below market demand, the
domestic price of an imported commodity far exceeded its landed cost inclusive of
tariff duties and other taxes. As such there were rents associated with a licence to
import. It hardly requires much imagination to realise that if rents could be created
and allocated, individuals and groups could spend resources in influencing their
creation and allocation in their favour.
It should be evident even to a casual observer of the Indian scene that a significant
amount of scarce talents and material resources that could have been used for
producing goods and services were spent instead of seeking and dispensing rents.
Senior bureaucrats who wielded power spent much of their time in meetings that
decided individual cases rather than set broad policies. Of course, if adoption of
favourable decisions and prevention of unfavourable decisions had to be bought, so to
speak, only those who could afford to pay the price would enter the market. Clearly
entrepreneurs with relatively few material resources and contacts t crucial decision-
making agencies were unlikely to enter the market.
Foreign trade policy issues became the subject of intensive discussion in early
eighties. It came to be realised that a scheme of import licensing under which imports
were permitted only to the extent that domestic production fell short of domestic
demand irrespective of difference in cost and prices, could only lead to inefficiency.
The view gained ground that a more liberal policy of imports of capital goods and
technology could enable India to reap the benefits of international division of labour.
The attempt therefore was to move away from import substitution per se towards
efficient import substitution, so that considerations relating to cost and efficiency were
incorporated in the overall policy framework. It also became increasingly clear that
production for export could not be isolated from the production for home market and
that trade policy had to be integrated with the policy for domestic industrialisation.
While the signs of liberalised trade policy became visible in the latter half of
eighties, it was only in 1991 that the country embarked on a truly liberalised trade
policy with a short negative list of exports and imports and with quantitative controls
over imports withdrawn for all, except consumer goods. It was recognised that trade,
exchange rate and industrial policies must form an integral policy framework if the
aim was to improve the productivity and efficiency of the economic system.

Trade Policy since 1991

The trade policy changes in the post 1991 period sought to minimise the role of
quantitative restrictions and substantially reduce the tariff rates on the lines suggested
by the Tax Reforms Committee (Chairman: Raja J Chelliah). The developments in
Indias trade policy during this period need to be viewed in conjunction with policy
reforms initiated in other spheres of the economy. The devaluation of the Rupee in
July 1991 and the transition to the market-based exchange rate regime deserve
mention in this regard. These measures were aimed at enhancing the price
competitiveness of exports. The policies governing foreign investments and foreign
collaboration also have undergone significant change, which have a bearing on trade
performance. Apart from unilateral measures, the liberalisation of Indias trade
policies also reflects the multilateral commitments for the country to the World Trade
Organization (WTO).
The focus of these reforms has been on liberalisation, openness, transparency and
globalisation with a basic thrust on outward orientation focusing on export promotion
activity and improving competitiveness of Indian industry to meet global market
requirements. In early 2002, the Government presented a Medium-Term Export
Strategy (MTES) for 2002-07 providing a vision for creating a stable policy
environment with indicative sector-wise targets, with a mission to achieve one per
cent of global trade by 2007. The new Export and Import (EXIM) Policy framed for
the period 2002-07 and unveiled on 31 March, 2002 also seeks to usher in an
environment free of restrictions and controls (Box 24.1). Synergy between these
policies/strategies is expected to realise Indias strong export potential and enhance
the overall competitiveness of its exports.
BOX 24.1
Export Import (EXIM) Policy 2002-07
The special Economic Zone (SEZ) scheme has been strengthened by
permitting the setting up of offshore Banking Units, hedging of commodity price
risks and sourcing of short-term External Commercial Borrowings. Supplies by
domestic units to SEZs would entitle the former to avail of Duty Entitlement
Passbook Scheme benefit. The policy has also ensured procedural simplification
in the process of subcontracting carried out by the SEZ units. To ease the power
situation in and around SEZs, units for generation and distribution of power have
been permitted to be set up in the SEZs.
The Policy gives a major thrust to agricultural exports by removing export
restrictions on designated items. The efforts to promote exports of agro and agro-
based products in the floriculture and horticulture sector have been sustained with
the notification of 32 Agri-Export Zones across the country. Non-actionable
subsidies such as transport subsidy have been provided for the export of fruits,
vegetables, floriculture, poultry and dairy products.
Contd...
 All Quantitative restrictions on exports (except a few sensitive items) have been
removed with only a few items being retained for export through Export Trading
Enterprises. To improve the productivity and export competitiveness of small-scale,
cottage and handicrafts sector, the Policy provides a package of incentives, including
exemption from maintaining the average export obligation under the Export Promotio0n
Capital Goods (EPCG) scheme, permission to achieve a lower threshold level for
achieving the Export House status, preferential access to Market Access Initiative funds
and duty free access to trimming and embellishment for achieving value added exports.
The towns of export excellence (such as Tirupur for hosiery, Panipat for woollen blanket
and Ludhiana for woollen knitwear) are intended to be regional rural motors of economic
development for small-scale sector., focusing on plugging critical infrastructural
bottlenecks and enhancing quality of support services for industrial development.
To provide the necessary impetus to star achievers, EXIM Policy provides a strategic
package for status holders comprising new/special facilities like issuance of Licence on
self-declaration basis, fixation of input-output norms on priority, exemption from
compulsory negotiation of documents through banks, cent per cent retention of foreign
exchange in Exchange Earners Foreign Currency Account, enhancement in normal
repatriation from 180 days to 360 days and not mandating exports in each of the three
licensing years for achieving the status. The Policy has operationalised the procedure for
duty free import of fuel under the Advance Licensing Scheme, provided the licence
holder has a captive power plant.
In view of phasing out of all restrictions on textile products by 2005 under the
Agreement on Textile and Clothing (ATC), the EXIM Policy has focused on measures to
encourage value added exports in the garment sector. Electronic Hardware Technology
Park (EHTP) scheme has been modified to enable hardware sector to face the zero duty
regime under Information Technology Agreement (ITA-1), mandating only a positive net
foreign exchange as a percentage of exports criteria and obviating any other export
obligation for units in Electronic Hardware Technology Parks. The changes carried out in
the gems & jewellery scheme include abolition of the licensing regime for the import of
rough diamonds, reduction in the value addition norms for export of jewellery and
permitting personal carriage of jewellery.
The medium-term policy continues with all the duty exemption/remission schemes,
along with existing dispensation of not having any value caps. Procedural simplifications
introduced in the policy include abolition of DEEC book and withdrawal of Annual
Advance Licence under the Advance Licence Scheme, dispensation with technical
characteristics for audit purposes under the Duty Free Replenishment Certificate
Scheme, 12 years export obligation period with 5 years moratorium for Export
Promotion Capital Goods licences of Rs. 100 crore or more and supplies under deemed
exports to be eligible for export obligation fulfilment along with the demand export
benefits.
Procedural simplification has been made in the EXIM policy to further reduce
transaction costs covering Directorate General of Foreign Trade, customs and banks.
These include adoption of 8 digit commodity classification for imports which would
eliminate the classification disputes, reduction of maximum fee limit for electronic filing
from Rs. 1.5 lakh to Rs. 1 lakh, introduction of same day licensing, new norms for
reduction in percentage of physical examination of export cargo, introduction of the
simplified brand rate of drawback scheme and permitting direct negotiation of export
documents.
Contd..
 Other salient features of the EXIM policy 2002-07 include: widening of the
scope of the Market Access Initiative Scheme to include activities considered
necessary for a focused market promotion of exports, setting up of Business
Centre in India missions abroad for visiting Indian exporters/businessmen for
ensuring a facilitatory environment for exporters, transport subsidy for exports to
units located in North East, Sikkim and J&K and introduction of Focus Africa
with Focus CIS to follow, to diversify markets.

Trade policy reforms in the recent past, with their focus on liberalisation, openness,
transparency and globalisation, have provided an export friendly environment with
simplified procedures for trade facilitation. Such continued trade promotion and trade
facilitation efforts of the Government have also aided the current strengthening of
export growth. The Union Budget 2004-05 reiterated the policy approach of lowering
custom duties in a measured way to align Indias tariff structure to those of the
ASEAN countries. It underlined the need for a special fiscal and regulatory regime for
the Special Economic Zones (SEZs), given their role as growth engines that can boost
manufacturing, exports and employment. Towards this, a Bill for regulating SEZs, to
make India a major hub for manufacturing and exports, is proposed. Other proposals
announced in the Budget included: identification of another 85 items to be taken out
from the SSI reservation list to provide space to these units to grow into medium
enterprises; proposal to set up a Fund for regeneration of traditional employment
generating industries (like coir, handloom, handicrafts, sericulture, leather, pottery and
other cottage industries) for development of their export potential; abolition of the
mandatory Cenvat duty regime and introduction of a new tax regime for the textile
sector to make the sector more efficient and competitive; and a proposal to set up a
National Manufacturing Competitiveness Council as a continuing forum for policy
dialogue to energise and sustain the growth of manufacturing industries and to
enhance competitiveness in the manufacturing sector. Various trade facilitation
measures announced in the review of credit policy by the RBI in October 2004
included liberalisation of guarantee by Authorised Dealers (Ads) for trade credit,
relaxation of trade limit for export realisation for Export Oriented Units (EOUs).
Government also announced, on August 31, 2004, a new Foreign Trade Policy for the
period 2004-2009, replacing the hitherto nomenclature of EXIM policy by Foreign
Trade Policy (FTP). A vigorous export-led growth strategy of doubling Indias share
in global merchandise trade in the next five years, with a focus on the sectors having
prospects for export expansion and potential for employment generation, constitute
the main plank of the policy (Box 24.2). These measures are expected to enhance
international competitiveness and aid in further increasing the acceptability of Indian
exports.

BOX 24.2

Highlights of Foreign Trade Policy 2004-2009

Objectives and Strategy:

The new Foreign Trade Policy (FTP) takes an integrated view of the overall
development of Indias foreign trade and essentially provides a roadmap for the
development of this sector. It is built around two major objectives of doubling
Indias share of global merchandise trade by 2009 and using trade policy as an
effective instrument of economic growth with a thrust on employment generation.
Contd...
Key strategies to achieve these objectives, inter alia, include: unshackling of
controls and creating an atmosphere of trust and transparency; simplifying
procedures and bringing down transaction costs; neutralizing incidence of all levies
on inputs used in export products; facilitating development of India as a global hub
for manufacturing, trading and services; identifying and nurturing special focus
areas to generate additional employment opportunities, particularly in semi-urban
and rural areas; facilitating technological and infrastructural upgradation of the
Indian economy, especially through import of capital goods and equipment;
avoiding inverted duty structure and ensuring that domestic sectors are not
disadvantaged in trade agreements; upgrading the infrastructure network related to
the entire foreign trade chain to international standards; revitalising the Board of
Trade by redefining its role and inducing into it experts on trade policy; and
activating Indian Embassies as key players in the export strategy.

Special Focus Initiatives

The FTP 2004 has identified certain thrust sectors having prospects for export
expansion and potential for employment generation. These thrust sectors include
agriculture, handlooms and handicrafts, gems & jewellery and leather and footwear
sectors.
Sector specific policy initiative for the thrust sectors include, for agriculture
sector, introduction of a new scheme called Vishesh Krishi Upaj Yojana (Special
Agricultural Procedure Scheme) to boost exports of fruits, vegetables, flowers,
minor forest produce and their value added products.
Under the scheme, exports of these products qualify for duty free credit
entitlement (5 per cent of f.o.b value of exports) for importing inputs and other
goods. Other components for agriculture sector include duty free import of capita;
goods under Export Promotion Capital Goods (EPCG) scheme, permitting the
installation of capital goods imported under EPCG for agriculture anywhere in the
Agri-Export Zone (AEZ), utilising funds from the Assistance to States for
Infrastructure Development of Exports (ASIDE) scheme for development of AEZs,
liberalisation of import of seeds, bulbs, tubers and planting material, and
liberalisation of the export of plant portions, derivatives and extracts to promote
export of medical plants and herbal products.
The special focus initiative for handlooms and handicraft sectors include
extension of facilities like enhancing (to 5 per cent of f.o.b value of exports) duty
free import of trimmings and embellishments for handlooms and handicrafts,
exemption of samples from countervailing duty (CVD), authorising Handicraft
Export Promotion Council to import trimmings, embellishments and samples for
small manufacturers, and establishment of a new Handicraft Special Economic
Zone. Major policy announcements under gems and jewellery sector encompass:
permission for duty free import of consumables for metals other than gold and
platinum up to 2 per cent of f.o.b value of exports; duty free re-import entitlement
for rejected jewellery allowed up to 2 per cent of f.o.b value of exports; increase in
duty free import of commercial samples of jewellery to Rs. 1 lakh, and permission
to import of gold of 18 carat and above under the replenishment scheme. Specific
policy initiatives in leather and footwear sector are mainly in the form of reduction
in the incidence of customs duties on the inputs and plants and machinery.
Contd..
 The major policy announcements for this sector include: increase in the limit for
duty free entitlements of import trimmings, embellishments and footwear
components of leather industry to 3 per cent of f.o.b value of exports and that for
duty free import of specialised items for leather sector to 5 per cent of f.o.b value of
exports; import of machinery and equipment for Effluent Treatment Plants for
leather industry exempted from customs duty; and re-export of unsuitable imported
materials (such as raw hides and skin and wet blue leathers) has been permitted.
The threshold limit of designated Towns of Export Excellence has also been
reduced from Rs. 1,000 crore to Rs. 250 crore in the above thrust sectors.

New Export Promotion Schemes

A new scheme to accelerate growth of exports called Target Plus has been
introduced. Under the scheme, exporters achieving a quantum growth in exports are
entitled to duty free credit based on incremental exports substantially higher than
the general actual export fixed. Rewards are granted based on a tiered approach. For
incremental growth of over 20 per cent, 25 per cent and 100 per cent, the duty free
credits are 5 per cent, 10 per cent and 15 per cent of f.o.b value of incremental
exports. Another new scheme called Vishesh Krishi Upaj Yojana has been
introduced to boost exports of fruits, vegetables, flowers, minor forest produce and
their value added products. Exports of these products qualify for duty free credit
entitlement equivalent to 5 per cent of f.o.b value of exports. The entitlement is
freely transferable and can be used for import of a variety of inputs and goods.
To accelerate growth in export of services so as to create a powerful and unique
Served from India brand instantly recognised and respected the world over, the
earlier duty free export credit (DFEC) scheme for services has been revamped and
re-cast into the Served from India scheme. Individual service providers who earn
foreign exchange of at least Rs. 5 lakh, and other service providers who earn foreign
exchange of at least Rs. 10 lakh are eligible for a duty-credit entitlement of 10 per
cent of total foreign exchange earned by them. In the case of stand-alone
restaurants, the entitlement is 20 per cent, whereas in the case of hotels, it is 5
percent. Hotels and restaurants can use their duty credit entitlement for import of
food items and alcoholic beverages.
To make India into a global trading-hub, a new scheme to establish Free Trade
and Warehousing Zone (FTWZs) has been introduced to create trade-related
infrastructure to facilitate the import and export of goods and services with freedom
to carry out trade transactions in convertible currencies. Besides permitting FDI up
to 100 per cent in the development and establishment of these zones, each zone
would have minimum outlay of Rs. 100 crore and 5 lakh sq.mts. built up area. Units
in the FTWZs qualify for all other benefits as applicable for SEZ units.

Further Simplification/Rationalisation/Modifications of Ongoing Schemes

EPCG scheme has been further improved upon by providing additional
flexibility for fulfilment of export obligation, facilitating and providing incentives
for technological upgradation, permitting transfer of capital goods to group
companies and managed hotels, doing away with the requirement of certificate from
Central Excise (in the case of movable capital goods in the service sector) and
improving the viability of specified projects by calculating their export obligation
based on concessional duty permitted to them.
Contd...
Import of second hand capital goods without any restriction on age has been
permitted and the minimum depreciated value for plant and machinery to be re-
located into India has been reduced from Rs. 50 crore to Rs. 25 crore. The new
policy has allowed transfer of the import entitlement under Duty Free
Replenishment Certificate (DFRC) scheme in respect of fuel to the marketing
agencies authorised by the Ministry of Petroleum and natural Gas to facilitate
sourcing of such imports by individual exporters. The Duty Entitlement Passbook
(DEPB) scheme will continue until replaced by a new scheme to be drawn up in
consultation with exporters. Additional benefits have been provided to export
oriented units (EOU), including exemption from service tax in proportion to their
exported goods and services, permission to retain 100 per cent of export earnings in
Export Earners Foreign Currency (EEFC) accounts, extension of income tax
benefits on plant and machinery to DTA units which convert to EOU/Electronic
Hardware Technology Park (EHTP)/Software Technology Park
(STP)/Biotechnology Park (BTP) units, allowing import of capital goods on self-
certification basis and permission to dispose of (for EOU in textile and garment
manufacture) leftover materials and fabrics up to 2 per cent of c.i.f value or quantity
of import on payment of duty on transaction value only. A minimum investment
criterion has also been waived for brass hardware and hand-made jewellery EOUs
(this facility already exists for handicrafts, agriculture, floriculture, aquaculture,
animal husbandry, IT and services). The FTP proposes setting up of BTPs by
granting all facilities of 100 per cent EOUs. The FTP 2004 has introduced a new
rationalised scheme of categorisation of status holders as Star Export Houses, with
benchmark for export performance (during the current and previous three years)
varying from Rs. 15 crore (for one Star Export House) to Rs. 5000 crore (for five
Star Export House). The new scheme is likely to bestow status on a large number of
hitherto unrecognised small exporters. Such Star Export Houses will be eligible for
a number of privileges including fast-track clearance procedures, exemption from
furnishing of bank guarantee, eligibility for consideration under Target Plus Scheme,
etc.

Simplification of Rules and Procedures and Institutional Measures

Policy measures announced to further rationalise/simplify the rules and
procedures include exemption of exporters with minimum turnover of Rs. 5 crore
and good track record from furnishing bank guarantee in any of the schemes, service
tax exemption for export of all goods and services, increase in validity of all
licences/entitlements issued under various schemes uniformly to 24 months,
reduction in number of returns and forms to be filed, delegation of more power to
zonal and regional offices, and time-bound introduction of electronic data interface
(EDI). Institutional measures proposed in the FTP 2004 include revamping and
revitalising the Board of Trade, setting up of an exclusive Services Export
Promotion council to map opportunities for key services in key markets and setting
up of Common Facility Centres for use of professional home-based service
providers in state and district level towns. Pragati Maidan in Delhi is proposed to be
transformed to a world class complex, with state-of-the-art, environmentally
controlled, visitor friendly exhibition areas and marts. The FTP 2004 also proposes
provision to deserving exporters, on the recommendation of the Export Promotion
Councils, of financial assistance for meeting the costs of legal expenses connected
with trade related matters.
Source: Economic Survey 2004-05
 Indias Balance of Payment Trends 1950-2000

The Decades of Fifties and Sixties:

Prior to 1956-57, for most years in the fifties, India had a current account surplus.
But the position changed in 1956-57 when India faced BoP crisis. The trade deficit
increased from 3.8 per cent of GDP at market prices to 4.5 per cent. The BoP crisis of
1956-57 precipitated the imposition of exchange controls which then became endemic
to the import substitution regime.
The BoP substitution deteriorated once again in 1966-67. In 1965, the United
States suspended its aid in response to the Indo-Pakistan war and later refused to
renew the PL 480 agreement on a long-term basis. There was a concerted effort by the
United States, the World Bank and the IMF to use external assistance as an instrument
to induce India (a) to adopt a new agricultural strategy, and (b) to devalue the rupee.
The rupee was devalued by 36.5 per cent in June 1966, and tariffs and export
subsidies were simultaneously rationalised, on the understanding that the inflow of aid
would be substantially increased.
The BoP improved after 1966-67 but largely because of the decline in imports.
Exports performed indifferently despite the devaluation.

Balance of Payments in the Seventies:

A Decade of Comfort:
Indias balance of payments remained comfortable during the Seventies. The
adjustment to the first oil shock of 1973-74 was rendered smooth by a happy
combination of buoyant exports, spurt in private transfer receipts and increased inflow
of aid. Exports, benefited by the expansion in global trade, rose at an annual rate of
6.8 per cent in volume terms and 15.6 per cent in US dollar terms during the decade.
An effective depreciation of the rupee occurred due to the link with Pound Sterling
until 1973 and later, because of the lower growth of prices in India relative to other
countries. Private transfers rose seven-fold from $296 million in 1974-75 to $2175
million in 1979-80 and in fact, in the post first oil shock period, financed roughly 80
per cent of the trade deficit. Within two years of the shock, the current account
balance turned into surplus and it was only in 1978-79 that a deficit of about 0.2 per
cent of GDP appeared. The utilisation of aid was significant and was substantially
higher than the financing requirement for the decade, allowing for a build up of
reserves. At the close of the decade the foreign exchange reserves stood at $7361
million providing cover for over 7 months of imports.

Balance of Payments up to 1981-82:

The Period of Difficulties:
During the eighties, issues relating to the balance of payments came to occupy the
centre stage in terms of Indias macroeconomic management. The impact of the
second oil shock of 1979, the full effect of which spilled over into the eighties, was
more severe than of the 1973-74. Between 1978-79 and 1981-82, imports almost
doubled. The increase in POL imports accounted for a little over half the increase in
overall imports. This was followed by second-round effects on non-POL imports.
Export performance was depressed by the severe international recession of 1980-83
and recorded a volume growth of just a little over 3 per cent. Net invisible receipts
continued to provide support to the balance of payments, largely in the form of
earnings from tourism and the sustained buoyancy of private transfers. However, the
sharp widening in the merchandise trade deficit resulted in a turnaround in the current
account balance from a surplus in 1977-78 to a deficit in 1981-82 of the order of US$
3,166 million or 1.8 per cent of GDP. Adjustment efforts consisted essentially of an
Extended Fund Facility (EFF) negotiated with the IMF, although there were also
intensified efforts to improve domestic production of crude petroleum.

Balance of Payments during 1982-83 to 1984-85:

Easing of Pressure:
A reprieve came during the period 1982-83 to 1984-85, with the easing of pressure
on the balance of payments mainly due to a decline in the volume growth of imports
from an average rate of 11.0 per cent during 1978-82 to a little over 2 per cent. Net oil
imports (net of crude oil exports which commenced in 1981-82 after the discovery of
crude oil in Bombay High), declined substantially as domestic production spurted to
29.0 million tonnes by 1984-85. This indeed was the main reason for the easing of the
balance of payments. Non-POL imports rose at an average rate of 3.6 per cent in
dollar terms. Exports however, grew only at an average rate of 3.2 per cent, in volume
terms, due to a combination of adverse internal and external conditions. The invisibles
account deteriorated as the interest payments to service external borrowing acquired a
steady rising trend. Private transfers stagnated with the arrest in the labour migration
boom. As a result, invisibles including private transfers and other surpluses, which
had financed 89 per cent of the trade deficit in 1978-79 could meet only 57 per cent of
the trade deficit in 1984-85. The current account deficit fell to US$ 2,416 million or
1.2 per cent of GDP in 1984-85 and reserves, which were US$ 5,592 million at the
end of the year, stood to cover a little over 4 months of imports. Twenty nine per cent
of the financing requirement of the first half of the eighties was met by the EFF.
Commercial borrowings and non-resident deposits emerged as important sources of
finance, meeting 21 per cent and 15 per cent respectively of the financing need.
However, external assistance remained the major source of foreign capital inflows,
accounting for 39 per cent of the financing requirement.

Balance of Payments during 1985-1990:

The Build-up to the Crisis:
The second half of the eighties witnessed the building up of strains on the balance
of payments. Current account deficits acquired a structural character, remaining at
high levels throughout. Large trade deficits occurred year after year despite a robust
growth in exports. Recovering from the stagnation in 1985-86, the volume growth of
exports in the succeeding four years ranged between 10 to 12 per cent per annum on
an average. The share of manufactured exports rose from 56 per cent in 1980-81 to 75
per cent in 1989-90. Imports in US dollar terms rose in every year of the period. The
volume of net POL imports increased from 12.4 million tonnes in 1984-85 to 23.5
million tonnes in 1989-90. However, the fall in crude oil prices during the period
helped to contain the oil import bill. On the other hand, non-oil imports rose sharply
by an average of 13.4 per cent in US dollar terms partly due to large import of food
grains in 1988-89. Imports of capital goods rose by an average of 16.2 per cent during
the period. Export-related imports as well as other miscellaneous imports also rose
significantly. The category of non-DGCIS imports, comprising defence imports and
imports of ships and aircrafts etc., also rose significantly from about US$ 1.2 billion
in 1985-86 to US$ 3.1 billion by 1989-90. The support from invisible receipts fell in
the face of steadily growing interest payments and the outgo on account of profits,
dividends, royalty, technical fees and professional fees. The current account deficit
averaged $ 5.8 billion or 2.4 per cent of GDP during the period as against the
Planning Commissions estimate of 1.6 per cent. The period also marked deterioration
in fiscal imbalances as the ratio of gross fiscal deficit to GDP rose from 6.3 per cent in
the first half of the eighties to 8.2 per cent during 1985-90. Repurchases from the IMF
under the EFF exacerbated the deterioration in the balance of payments. External
assistance, commercial borrowing and non-resident deposits shared
equiproportionally in the financing need. The result was a doubling of external debt
and a rise in the debt service ratio from 13.6 per cent in 1984-85 to 30.9 per cent in
1989-90.

The Crisis: 1990-92:

In 1991, India found itself in its worst balance of payments crisis since 1947. That
there was a crisis in the making during the second half of 1980s had been evident for
a long time. The inflow of foreign borrowing had increased at a rapid rate during the
late 1980s. This was due to the excess domestic expenditure over incomethe fiscal
deficit of the Central and State soared to over 11 per cent in 1991. During this period
total public debt as a proportion of GNP doubled reaching the level of 60 per cent and
foreign currency reserves were depleted rapidly.
Matters were made worse by an accompanying double-digit inflation in 1990-91.
The oil price increase resulting from Iraqs invasion of Kuwait in August 1990
reinforced the crisis-like situation in India.
Indias credit rating got downgraded as, for the first time in its history; India was
on the verge of defaulting on its international commitments and was denied access to
external commercial credit markets. A net outflow of Non-Resident Indian (NRI)
deposits commenced in October 1990 and continued during 1991. The only way left
for India was to borrow against the security of its gold reserves transported abroad.
But something good emerged out of the Bop crisis of 1991the long overdue
economic reforms. Apart from an immediate programme of macroeconomic
stabilisation, structural reforms were also introduced in the industrial and trade
policy regimes with a view to improving the efficiency, productivity and international
competitiveness of Indias economy.
The overvalued exchange rate was corrected by devaluation in 1991, followed by
partial convertibility of rupee in 1992-93 and then making the rupee fully convertible
on trade account in 1993-94. Tariffs were also cut steeply to open Indian industry to
foreign competition. The focus of import realisation has been on intermediate and
capitals goods industries with the imports of consumer goods remaining, by and large,
regulated.

Balance of Payments during 1993-94 to 2005-06:

The initial response of the economy, especially exports was very good. The years
1993-94 to 1995-96 were years of excellent economic performance with GDP having
grown at 6.2 per cent in 1993-94 and by more than 7.5 per cent during 1994-95 and
1996-97. Exports grew by 19.7 per cent during 1993-94 to 1995-96.
The major reasons for such a high growth rate in exports were:
World GDP grew by an average rate of 4.1 per cent per annum during
1994-97 compared with 2.4 per cent during 1990-93.
World trade (dollar terms) grew by an average rate of 9.8 per cent per
annum during 1994-97 compared with 6.0 per cent during 1990-93.
Imports of advanced countries (dollar terms) grew by an average rate of
11.5 per cent during 1994-97 compared with 2.1 per cent during 1990-93.
 Increase in Indias share in world exports of its three major commodity
groups namely textiles, yarn and fabrics; pearls, precious and semi-
precious stones; and clothing and accessories during 1994-96.
Increase in the Index of Comparative Advantage (ICA) of the above.
Other export commodity groups in which India gained in terms of ICA
during 1994-96 include fish and fish preparations; rice; coffee and
substitutes; organic chemicals; footwear; and gold and silver jewellery.
However, the boom was short-lived. Since 1996, Indias export performance has
been poor.
There could be several explanations for this. Firstly, there has been a major
downturn in world trade since 1996, which has affected Indias trade as well. Export
growth has been further hampered by an appreciation of the real effective exchange
rate in 1996-97 and 1997-98. This trend has, however, been reversed since 1998-99.
There has also been a adverse movement in terms of trade, which appears to have
affected exports. Finally, there are the host of domestic factorsboth policy related
and administrativewhich continue to hamper imports. These include infrastructure
constraints, high transaction costs, SSI reservations, labour inflexibility, quality
problems and quantitative restrictions on export of agricultural commodities.
However the surplus on invisibles has helped to reduce the deficit on the current
account. Earnings from invisibles have helped particularly during the critical years of
1996-97 and 1997-98 when the deficit on the trade account touched alarming levels
close to $1.5 to 1.6 billion.
A current account surplus for the third successive year, coupled with an expanding
capital account, further strengthened Indias balance of payments in 2003-04. The
year witnessed accumulation of reserves of US$ 31.4 billion (excluding valuation
changes, gold, Special Drawing Rights and Reserve Tranche at the IMF). Almost one-
third of the reserves were contributed by the surplus in the current account (Table
24.1). Rising surpluses in the current account have been one of the distinguishing
features of Indias balance of payments in the current decade, as it has been for most
other major Asian economies (e.g. China, Hong Kong, Japan, Korea, Malaysia,
Philippines, Singapore, Taiwan and Thailand). While for the predominantly export-
oriented South East Asian economies (e.g. Korea, Malaysia, Philippines, Singapore,
Taiwan, and Thailand), strong growth in merchandise exports has been main driver
behind the current account surpluses, buoyant invisible inflows, particularly private
transfers comprising remittance, along with software services exports, have been
instrumental in creating and sustaining current account surpluses in India.
The strength provided by the surplus in the current account was reinforced by
robust capital inflows in 2003-04. During the year, capital account surplus was almost
double its previous years level (Table 24.1). While major components of loans (e.g.
external assistance and commercial borrowings) recorded net outflows, foreign
investment flows increased more than three-fold. Heavy portfolio inflows, comprising
essentially FII investment, shored up total foreign investment and the overall capital
account surplus. Banking capital inflows, particularly expatriate deposits, also
contributed to the expanding surplus.
Balance of payments estimates for April-September, 2004-05, and 2005-06
indicate the emergence of a current account deficit (Table 24.1). The year 2004-05
marked a significant departure in the structural composition of Indias balance of
payments (BOP), with the current account, after three consecutive years of surplus,
turning into a deficit. In a significant transformation, the current account deficit,
observed for 24 years since 1977-78, had started shrinking from 1999-00. The
contraction gave way to a surplus in 2001-02, which continued until 2003-04.
However, from a surplus of US$ 14.1 billion in 2003-04, the current account turned
into a deficit of US$ 5.4 billion in 2004-05.
The turnaround in the current account during 2004-05 was accompanied by a
significant strengthening of more than 80 per cent in the capital account resulting in
continued reserve accretion. Compared with 2003-04, when loan inflows had turned
into net outflows, such inflows shot up rapidly during 2004-05 and bolstered the size
of the capital account surplus with good support from robust foreign investment
inflows. Reserve accumulation during 2004-05, at around four-fifths of such
accumulation during 2003-04, maintained Indias status as one of the largest reserve-
holding economies in the world.
The broad trends observed in the current and capital accounts in 2004-05 have
been maintained during 2005-06. The current account continues to be in deficit with
the size of the deficit during the first half of the current year (April-September 2005)
almost twenty seven times that of the deficit in the corresponding previous period.
Indeed, the current account deficit of US$ 5.3 billion during the first quarter (April-
June 2005) itself was almost equivalent to the deficit for the whole of 2004-05.
During the second quarter (July-September 2005), the deficit became even larger
(US$ 7.7 billion) after growing at almost 45 per cent over and above that of the
previous quarter. The rapidly enlarging trade deficit, buoyed by remarkable import
growth, has been pushing the current account deficit. During the period 2001-02 to
2003-04, the invisibles (net) always overcame the trade deficit to maintain the current
account in surplus. However, the trend was reversed in 2004-05 and appears to be
continuing in 2005-06. At present, India is one of the few leading economies in the
South East Asian region to have a fairly large current account deficit.
The widening of the current account deficit has been accompanied by a similar
widening of the capital account surplus. The capital account surplus during the first
half of the current year has been more than one and a half times the surplus in the
corresponding period of the previous year. Moreover, between the first and second
quarters, while the current account deficit increased by 45 per cent, the capital
account surplus almost doubled in size (US$ 12.9 billion in July-September 2005 vis-
a-vis US$ 6.5 billion in April-June 2005). Since 2002-03, much of the strengthening
of Indias capital account has emanated from augmentation of non-debt creating
foreign investment (net) inflows, particularly Foreign Institutional Investor (FII)
inflows. During the current year, robust FII inflows were more than eleven times
higher than such inflows during April-September 2004. The bulk of this increase
occurred during July-September 2005, in response to the rising buoyancy in the stock
markets. The period also witnessed an increase in inflows of commercial borrowings
and short-term credits on account of lower interest rates spreads on external
borrowings and higher import financing requirements. The cumulative impact of
higher debt and non-debt creating flows was a notable expansion in the size of the
capital account surplus. The expansion succeeded in retaining an overall surplus in the
balance of payments and resulted in a net reserve accretion of US$ 6.5 billion during
April-September 2005, which was only marginally lower than the accretion of US$
6.9 billion during April-September 2004.

Invisibles:
In the three successive years of capital account surpluses ending in 2003-04,
buoyant net earnings from invisibles more than compensated for the trade deficits. In
2004-05, with growth of more than 12 per cent, earnings from invisibles crossed US$
30 billion; but with the trade deficit growing by a much larger 167 per cent to over
US$ 36 billion, the current account balance turned into a deficit. In the first half of
2005-06 as well, while invisibles grew by 31 per cent, the trade deficit grew much
faster by 114 per cent, and resulted in a sharp widening of the current account deficit.
Within invisibles, the contribution of different categories to overall invisible
earnings has changed significantly since the early 1990s. Traditionally, private
transfers, comprising mainly remittances from Indians working abroad, had been the
main source of invisible earnings. Over time, however, non-factor services have
emerged as another key component of invisibles. Indeed, beginning from 1991-92 till
2001-02 (except 1999-2000), private transfers always exceeded invisibles (net).
However, since 2002-03, overall invisibles have been higher than private transfers,
mainly due to rising contribution of non-factor services. As a proportion of total
invisibles (net), the share of private transfers has declined from 121 per cent in 1996-
97 to around 65 per cent in 2004-05, while that of non-factor services has improved
from 7 per cent to 45.5 per cent during this period.
The increasing share of non-factor services in invisibles can be traced to the
buoyancy in export of software services. Net earnings from software services
increased by 34.1 per cent from US$ 12.3 billion in 2003-04 to US$ 16.5 billion in
2004-05. The rate of growth was more or less maintained during the first half of 2005-
6 with such receipts growing by 30 per cent from US$ 7.6 billion in April-September
2004 to US$ 9.8 billion. Indeed, the robust growth in export of software services has
been responsible for an overall growth of 59 per cent in net non-factor services
receipts in April-September 2005 vis-a-vis April-September 2004, since the other
leading components of non-factor services travel and transportation, became net
outflows during April-September 2005. While higher outbound tourist traffic has
resulted in net travel outflows, such development in transportation also reflect higher
outgo related to rising volume of imports and mounting freight rates.
India continues to remain the highest remittance receiving country in the world
(Box 24.3). Buoyant private transfers have imparted strength and stability to net
invisibles receipts. Between 1990-91 and 2003-04, private transfers increased every
year except in 1997-98 and 1998-99. In 2004-05, however, private transfers declined
by 6.3 per cent. Developments in the first half of the current year, with growth of 20.8
per cent in private transfers, probably indicate a return to the earlier secular trend.

BOX 24.3

Trade in Services

Services account for more than 60 per cent of world GDP, and trade in
services has grown more rapidly than merchandise trade since 1985. In 2004,
while Indias share in world merchandise exports was 0.8 per cent, the
corresponding share in world commercial services was 1.9 per cent. Services,
accounting for 54.1 per cent of GDP in 2005-06, are a sector of critical interest in
India.
Contd..
 In terms of annual average rate of growth, world exports of commercial
services, i.e. non-factor services (services henceforth), not only increased faster (7
per cent) than such exports of merchandise (5 per cent) between 2000 and 2003, but
also accelerated from 7 per cent in 2002 to 13 per cent in 2003. Reflecting the
importance of services in their overall economic activities, industrial countries
dominate global exports of services. Nearly two-thirds of the global trade in services
is contributed by the EU, Us and Japan. While the share of US and Spain continue
to rise, that of UK, France, Italy, Japan and the Netherlands have registered declines
over the years. India accounted for 1.4 per cent of total exports and 1.2 per cent of
world imports of services in 2003. China, Ireland, Korea and India have emerged as
important service exporters. Between 1992 and 2003, Chinas and Indias export of
services increased from US$ 9.1 billion to US$ 46.4 billion, and from US$ 4.9
billion to US$ 25.0 billion, respectively. A sharp rise in earnings from tourism and
increased earnings from IT and ITES, including software exports were the reasons
for the enhanced services exports in China and India, respectively. India was the 20 th
leading exporter of services in 2003.

Table
Export of Major Services as per cent of Total Services Exports

Year Travel 27.4Transportatio Software Misce22.9llaneous

n *
1995-96 36.9 27.4 10.2 22.9
2000-01 21.5 12.6 39.0 21.3
2001-02 18.3 12.6 44.1 20.3
2002-03 16.0 12.2 46.2 22.4
2003-04 16.5 13.1 48.9 18.7
Apr.-Sep., 9.9 11.7 36.9 37.2
04
Note: * Miscellaneous services excluding software

The potential for growth, however, continues to be large. There was an upward
shift in the trend growth of services exports (in US dollar terms) from 7.9 per cent in
the first half of the decade of the 1990s to 15.3 per cent during 2000-01 to 2003-04.
Software and other miscellaneous services (including professional, technical and
business services) have emerged as the main categories in Indias export of services.
The relative shares of travel and transportation in Indias service exports have
declined over the years, while the share of software exports has gone up to 49 per
cent in 2003-04. The buoyant growth of professional, technical and business
services has provided a cushion against the slowdown in traditional services such as
travel and transportation. The share of other miscellaneous services, which was
around 20 per cent until 2003-04, registered a sudden rise to 37 per cent in April-
September, 2004. The comparative advantage of India in software, telecom and
other business services is well-documented in several studies.
Services exports grew by 20.2 per cent in 2003-04, 71 per cent in 2004-05 and
75 per cent in April-September, 2005. In 2004-05, software service exports grew by
34.4 per cent and 32 per cent in the first half of 2005-06. Indias share in the world
Contd...
world market for IT and software and services including (BPO) increased from
around 1.7 per cent in 2003-04 to 2.3 per cent in 2004-05 and an estimated 2.8
per cent in 2005-06. A new development in services export is the explosive
growth of business services, including professional services. This is reflected in
the growth of miscellaneous services excluding software, which grew by 216 per
cent to US$ 16.3 billion in 2004-05, 181 per cent in the first half of the current
year to reach a level of US$ 15.4 billion and surpass even the value of software
services exports. The enormous opportunities for the further growth of these
services make WTO negotiations in services all the more important for India.
With the liberalisation of exchange restrictions on current account, services
imports have also increased over time. Travel payments, for example, rose on
account of outward movement of workers and professionals, and a spurt in
outbound tourist traffic from India and exceeded travel receipts in April-
September, 2004. However, overall faster growth of services receipts over
payments resulted in the net surplus from services trade increasing from US$
980 million in 1990-91 to US$ 6,591 million in 2003-04.
Software exports have grown at an annual compound growth rate of around
36 per cent between 1995-96 and 2003-04. While the market share of India in
global IT spending has increased, yet its low level of an estimated 3.4 per cent in
2003-04 indicates a large scope for future expansion, particularly in payment
services, administration and finance. It is estimated that outsourcing has been
resulting in cost saving in the range of 40 to 60 per cent of trans-national
corporations. The IT industry is projected to grow to 7 per cent of GDP (2.64 in
2003-04) and account for 35 per cent of total exports (21.3 per cent in 2003-04)
by 2008. An export potential of US$ 57-65 billion for the software and services
sector can be realised, with ITES-BPO sector contributing $ 21-24 billion by
2008.
The constraints on potential opportunities in services trade include lack of set
up like export promotion councils other than for computer software, various
visible and invisible barriers to services trade, for example visa restrictions;
economic needs test, sector specific restriction and selective preferential market
access through regional initiatives. These need careful examination in the
context of the requests and offers of different countries in WTO. Despite the
constraints, there is scope for increasing diversification into a variety of areas
such as consultancy and R&D services, healthcare, entertainment services, ship
repair services, satellite mapping services, telecom, educational services,
accounting services and hospitality services and also beyond the major markets
of EU, Us and Japan. The policy measures announced in the Foreign Trade
Policy 2004-09 to promote services exports should help along with proper
synergy between economic policies and trade strategies.
In the ongoing negotiations at WTO under the General Agreement of Trade
in Services (GATS), the offers of most countries do not provide any significant
new openings for trade, especially in areas of interest for developing countries.
Given its strong competitive edge in IT and ITES, and competence of its
professionals, Indias efforts have been to get binding commitments in cross-
border supply of services (Mode 1) and movement of natural persons (Mode 4).
Contd...
 In mode 4, India has been pushing for clear prescription of the duration of stay
and removal of the Economic Needs Test (ENT). Though the services
negotiations have been salvaged at the Hong Kong Ministerial, quick and
detailed work is needed in the form of examining the detailed requests and offers
and arriving at concrete proposals in each of the 12 main categories and 156 sub-
categories of services.
Besides software in which India has already made an impact, there is good
potential for export of many other professional services, like super-speciality
hospital; satellite mapping; printing and publishing; accounting, auditing and
book-keeping services. Besides greater efforts at marketing, there is a need to
negotiate both multilaterally and bilaterally, issues like the National Health
Service Systems in European countries like UK which virtually deny market
access; lack of coverage of medical expenditure incurred abroad by US medical
insurance companies; need based quantitative limits; need to be natural persons;
and accreditation rules. Similarly, in the case of accounting, auditing and book-
keeping services, market access limitations, which are mainly in the form of
licensing, accreditation, in-state residency and state level restrictions in countries
like US, have to be negotiated. Some liberal sectoral commitments by developed
countries get automatically negated by the restrictive horizontal limitations of
entry for speciality occupations which needs to be addressed in WTO
negotiations.

Source: Economic Survey 2004-05 and 2005-06

Capital Account, External Debt and Exchange Rate

Approach, Developments and issues:

Reflecting the inward oriented economic policies in pursuit of self-reliance
through export bias and import substitution; the role of the capital account during the
1980s was basically that of financing the current account deficits (RBI, 1999). The
widening of the current account deficit during 1980s coupled with the drying up of
traditional source of official concessional flows necessitated recourse to additional
sources of financing in the form of debt creating commercial borrowings, non-resident
deposits and exceptional financing in the form of IMF loans.
The external payment crisis of 1991 brought to the fore of the weaknesses of the
debt-dominated capital account financing. Recognising this, structural reforms and
external financial liberalisation measures were introduced during the 1990s. The
policy shift underscored the need for gradually liberalising capital account
recognising that this is a process rather than a single event (Jalan, 1999). Throughout
the 1990s the role assigned to foreign capital in India has been guided by the
consideration of financing a level of current account deficit that is sustainable and
consistent with absorptive capacities of the economy (Rangarajan, 1993; Tarapore,
1995; Reddy, 2000). In India, the move towards full capital account liberalisation has
been approached with extreme caution. Taking lessons from the international
experience, the Committee on Capital Account Convertibility, 1997 (Chairman:
S.S.Tarapore) suggested a number of pre-conditions, attainment of which was
considered necessary for the success of the capital account liberalisation programme
in India (Box 24.4). the High Level Committee on BoP had recommended the need
for achieving this compositional shift. Keeping in line with the policy thrust, capital
flows have undergone a major compositional change in the 1990s in favour of non-
debt flows.

BOX- 24.4

Committee on Capital Account Liberalisation (Chairman: S.S.Tarapore)

With growing role of private capital flows and the possibility of occasional
sharp reversals, the issue of capital account liberalisation and convertibility has
spurred extensive debate since 1992the period which witnessed a series of
currency crises; in Europe (1992-93), Mexico (1994-95), East Asia (1997-98),
Russia (1998), Brazil (1999), Turkey (2000), and Argentina (2001-02). These
crises have raised the question of desirability of liberalisation and whether it is
advisable to vest the IMF with the responsibility for promoting the orderly
liberalisation of capital flows. The IMF in its study (1998) stated that As
liberalised systems afford opportunities for individuals, enterprises, and financial
institutions to undertake sometimes imprudent risks, they create the potential for
systematic disturbances. There is no way to completely suppress these dangers
other than through draconian financial repression, which is more damaging. The
view of IMF itself has changed over time (RBI, 2001). While opening up of the
capital account may be conducive to economic growth as it could make available
larger stocks of capital at a lower cost for a capital-deficient country, the actual
performance of the economy, however, typically depends on a host of other
factors. For a successful liberalised capital account, emerging market countries
could: (i) pursue sound macroeconomic policies; (ii) strengthen the domestic
financial system; (iii) phase account capital liberalisation appropriately, and (iv)
provide information to the market. At the international level, there is also the role
of surveillance to consider, including the provision of information and the potential
need for financing (Fischer, 1997).
In India, the move towards full capital account liberalisation has been
approached with extreme caution. The Report of the Committee on Capital
Account Convertibility, 1997 (Chairman: S.S.Tarapore) taking into account lessons
from international experience suggested a number of signposts, the attainment of
which are a necessary concomitant in the move towards capital account
convertibility. Fiscal consolidation, lower inflation and a stronger financial
system were seen as crucial signposts for India.

India followed a gradualist approach to liberalisation of its capital account. India

did not experience a reversal of its policies towards the capital account as was the
case with some emerging market economies that had followed a relatively rapid
liberalisation without entrenching the necessary preconditions. This is particularly
important since cross-country studies do not provide clear evidence of increase in
capital flows resulting from capital account openness across all developing countries,
with only 14 developing countries accounting for about 95 per cent of net private
flows to developing countries in the 1990s. Besides, empirical evidence on the
positive effects of financial capital flows on economic growth is not yet conclusive
(Edison et al., 2002).
Foreign Investment:
During the first three decades after independence, foreign investment in India was
highly regulated. In the 1980s, there was some easing in foreign investment policy in
line with the industrial policy regime of the time. The major policy thrust towards
attracting foreign Direct Investment (FDI) was outlined in the New Industrial Policy
Statement of 1991. Since then, continuous efforts have been made to liberalise and
simplify the norms and procedures pertaining to FDI. At present, FDI is permitted
under automatic route subject to specific guidelines except for a small negative list. In
the recent period, a number of measures have been taken to further promote FDI.
These include: raising the foreign ownership cap to 100 per cent in most of the
sectors, ending state monopoly in insurance and telecommunications, opening up of
banking and manufacturing to competition and disinvestment of state ownership in
Public Sector Undertakings (PSUs). Though the FDI companies have generally
performed better than the domestic companies, FDI to India has been attracted mainly
by the lure of the large market.

Magnitude:
Responding to the policy efforts, foreign investment inflows to India (direct and
portfolio investments taken together) picked up sharply in 1993-94 and have been
sustained at a higher level with an aberration in 1998-99, when global capital flows
were affected by contagion from the East Asian crisis. Total foreign investment has
averaged at US$ 5.4 billion during the three year period 1999-2000 to 2001-2002 as
against negligible levels of the 1980s.

Foreign Portfolio Investment:

Like FDI, the environment for FPI was also made more congenial through
procedural changes for investment and offering more facilities for investment in
equity securities as well as in debt securities to a select category of portfolio investors,
viz., the Foreign Institutional Investors (FII). Furthermore, the sectoral limits for FIIs
in the Indian companies were progressively increased over time; these limits have
been done away with altogether, except in select specified sectors. The NRIs,
Overseas Corporate Bodies (OCBs) and Persons of Indian Origin (PIOs) are also
permitted to invest in shares and debentures of Indian companies, government
securities, commercial papers, company deposits and mutual funds floated by public
sector banks and financial institutions.

NRI Deposits:
NRI deposits in the form of Non-Resident (External) Rupee Account (NR(E)RA)
and Foreign Currency Non-Resident Account (FCNR(A)) emerged as a steady flow of
foreign capital in India from the 1970s, following the labour migration boom in West
Asia in the wake of the first oil shock. The onset of the 1990s saw the introduction of
as many as five NRI deposit schemes [Foreign Currency Bank and Ordinary
(FC(B&O)), Foreign Currency Ordinary Non-Resident (FC(ON)), Non-Resident Non-
Repatriable Rupee Deposit (NR(NR)RD), Non-Resident Special Rupee Account
(NR(S)RA) and Foreign Currency Non-Resident Bank (FCNR(B))] between 1990 and
1993 designed to attract foreign exchange in the face of external payments crisis of
1991. The policies with regard to NRI deposits during the 1990s have been aimed at
attracting stable deposits. This has been achieved through: (i) a policy induced shift in
favour of local currency dominated deposits; (ii) rationalisation of interest rates on
rupee dominated NRI deposits; (iii) linking of the interest rates to LIBOR for foreign
currency dominated deposits; (iv) de-emphasising short-term deposits (up to 12
months) in case of foreign currency dominated deposits; and (v) withdrawal of
exchange rate guarantees on various deposits. The Reserve Bank has also made an
active use of reserve requirements on these deposits as an instrument to influence
monetary and exchange rate management and to regulate the size of the inflows
depending on the countrys requirements.

External Commercial Borrowings

Commercial debt capital includes a whole range of sources of foreign capital

where the overriding consideration is commercial. External commercial loans include
bank loans, buyers credit, suppliers credit, securitised instruments such as Floating
Rate Notes and Fixed Rate Bonds, commercial borrowings and the private sector
window of multilateral financial institutions.
The policies towards External Commercial Borrowings (ECBs) since the reform
programme have been guided by the overall consideration of prudent external debt
management by keeping the maturities long and cost low. ECBs are approved within
an overall annual ceiling. Over time, the policy has been guided by a priority for
projects in the infrastructure and core sectors such as power, oil exploration, telecom,
railways, roads and bridges, ports, industrial parks, urban infrastructure and for 100
per cent Export Oriented Units (EOUs). To allow further flexibility to borrowers, end-
use and maturity prescriptions have been substantially liberalised. Moreover,
corporate have been allowed to borrow up to a certain limit under the automatic
route. Apart from these, special bonds (India Development Bonds (IDBs), resurgent
India Bonds (RIBs) and India Millennium Deposits (IMDs) were issued by the State
Bank of India aimed at NRIs. The success in mobilising foreign exchange resources
through such exceptional schemes reflected the confidence of the global investor
community in the Indian economy and imparted an element of stability to the external
sector and the overall balance of payments position.
At times, the rationale behind raising such high cost debt capital has been
questioned. Experience, however, would suggest that each time this option was
resorted to, it helped in strengthening the confidence in the Rupee and the ability of
the country to honour its obligations. The costs of an exchange rate crisis are too
severe in relation to cost of debt capital. In a situation of moderate debt-service ratio,
such debt capital makes more sense than allowing the exchange rate to fall under
pressure.

Decline in Foreign Aid

Over the same period, official aid has waned in importance. This reflected mainly
growing amortisation payments in the face of sluggish disbursements of external
assistance as also availability of alternative private capital flows. Unlike aid, the share
of ECBs in total capital flows has increased from around 31 per cent in 1990-91 to
around 40 per cent in 1997-98. This has been mainly on account of the higher appetite
for ECBs in view of the strong import demand and industrial growth.
 Impact of Reforms on BoP

The impact of the continuum of reforms initiated in the aftermath of the balance of
payments crisis of 1991 on Indias current account and capital account resulted in an
accumulation of foreign exchange reserves of over US$ 141 billion as at end-March
2005. Capital account surplus increased from US$ 3.9 billion during the 1980s to US$
8.6 billion during 1992-2002 with a steadily rising foreign investment. As a
proportion of GDP, capital flows increased from 1.6 per cent during 1980s to 2.3 per
cent during 1992-2002. The significant increase in capital flows during the 1990s
raises the issue of their determinants as well as their impact on growth.
Since 1990-91, Indias capital account has experienced several increasing changes
in terms of the relative roles played by different varieties of the capital flows in
augmenting the overall balance. Between 1998-99 and 2001-02, the share of foreign
investment in the overall capital account balance increased steadily from 29 per cent
to 80 per cent. Thereafter, however, the proportion has followed an oscillating pattern
within a band of 39 to 79 per cent. It appears that the importance of debt-creating
flows in the overall balance of payments increased with the emergence of a current
account deficit in 2004-05. Debt-creating flows comprising external assistance,
commercial borrowings and non-resident deposits, after being negative for two
successive years, were 19 per cent of the capital account surplus in 2004-05. This
trend in debt-flows appears to have continued in 2005-06.
The evolution of capital flows over the 1990s reveals a shift in emphasis from
debt to non-debt flows with the declining importance of external assistance and EVBs
and the increased share of foreign investmentboth direct and portfolio. Apart from
financing the current account gap, capital flows have played a significant role in
Indias growth performance.
Evidence of strong complementarily with domestic investment suggests that
capital flows brighten the overall investment climate and stimulate domestic
investment even when a part of the capital flows actually gets absorbed in the form of
accretion to reserves. The growth-augmenting role of foreign capital, particularly FDI,
however, seems to have been constrained by the low levels of actual and planned
absorption of foreign capital in India (RB!, 2001). The key indicators of balance of
payments as explained in Table 24.3 (also Table A-23.1 in ch. 23) show considerable
improvement in Indias balance of payments since 1991.
 TABLE 24.3

Balance of Payments Key Indicators

(Per Cent)

Item 1990-91 1995-96 1999-00 2000-01 2001-

02

1 2 3 4 5

(1) Trade
i. Exports/GDP 5.8 9.1 8.4 9.8 9.3
ii. Imports/GDP 8.8 12.3 12.4 12.9 12.0
iii. Trade Balance/GDP -3.0 -3.2 -4.0 -3.1 -2.7

(2) Invisibles Account

i. Invisible Receipts/GDP 2.4 5.0 6.8 7.5 7.4
ii. Invisible Payments/GDP 2.4 3.5 3.8 4.9 4.5
iii. Invisibles (Net)/GDP -0.1 1.6 3.0 2.6 2.9

(3) Current Account

i. Current Receipts@/ GDP 8.0 14.0 15.1 17.2 16.7
ii. Current Receipts Growth@ 6.6 18.2 12.9 17.1 1.4
iii. Current Receipts@/ Current Payments 71.5 88.8 93.0 96.4 101.2
iv. CAD/GDP -3.1 -1.7 -1.0 -0.5 0.3

(4) Capital Account

i. Foreign Investment/GDP - 1.4 1.2 1.1 1.2
ii. Foreign Investment/Exports 0.6 14.9 13.8 11.4 13.2

(5) Others
i. Debt-GDP Ratio 28.7 27.0 22.2 22.3 20.8
ii. Debt Service Ratio 35.3 24.3 16.2 17.3 14.1
iii. Liability Service Ratio 35.6 24.7 17.0 18.3 15.3
iv. Import Cover of Reserves (in months) 2.5 6.0 8.2 8.6 11.3

Note: @ : Excluding official transfers, :- Negligible

External Debt Management

Key indicators of debt sustainability point to the continuing consolidation and

improved solvency in the 1990s. Although, in nominal terms, Indias total outstanding
external debt increased from US$ 83.8 billion at end-March 1991 to US$ 98.5 billion
at end-March 2002, external debt to GDP ratio declined sharply from 28.7 per cent at
end-March 1991 to 20.9 per cent at end-March 2002. Prudent external debt
management is also reflected in the proportion of short-term debt to total debt
declining from 10.2 per cent in 1991 to 2.8 per cent in 2002 and in the ratio of short-
term debt to foreign exchange reserves from a high of 146.5 per cent in the crisis
period of 1991 to only 5.1 per cent in 2001-02. Debt service ratio declined from 35.3
per cent in 1990-91 to 14.1 per cent in 2001-02 (Table 24.4). Interest payments to
current receipts ratio declined from 15.5 per cent in 1990-91 to 5.4 per cent in 2001-
02.
 TABLE 24.4

Major Indicators of External Debt (as at end-March)

(Per Cent)

Items 1991 1996 2000 2001 2002

1 2 3 4 5

1. Total Debt to GDP 28.7 27.0 22.1 22.4 20.9

2. Short-Term Debt (Original Maturity) to GDP 2.9 1.4 0.9 0.8 0.6

3. Concessional Debt to Total Debt 45.9 44.7 38.9 35.5 36.0

4. Short-Term Debt (Original Maturity) to Foreign Exchange 146.5 23.2 10.3 8.6 5.1
Reserves

5. Short-Term Debt (Original Maturity) to Foreign Currency 382.1 29.5 11.2 9.2 5.4
Assets

6. Non-Debt Liabilities and Short-Term Debt to Reserves 148.2 92.3 99.9 100.8 88.4

7. Short-Term Debt and Non-Debt Reversible Liabilities to 146.6 71.1 59.0 58.5 48.1
Reserves

8. Debt Service Ratio 35.3 24.3 16.2 17.5 14.1

9. Debt to Current Receipts 328.9 188.9 145.6 126.2 122.5

10. Liability Service Ratio 35.6 24.7 17.0 18.3 15.3

The decade of 1990s witnessed a steady move towards consolidation of Indias

external debt statistics in terms of size, composition and indicators of solvency and
liquidity. Containing the increase in the size of external debt to a modest level in the
face of tremendous growth in foreign exchange reserves during the decade definitely
point towards the success of Indias debt management strategy. Reflecting this, in
terms of indebtedness classification, the World Bank has categorised India as a less
indebted country since 1999. Among the top 15 debtor countries of the world, India
improved its rank from third debtor after Brazil and Mexico in 1991 to ninth in 2000
after Brazil, Russian Federation, Mexico, China, Argentina, Indonesia, Korean
Republic and Turkey. Moreover, among them, key external debt indicators such as
short-term debt to total debt and short-term debt to forex reserve ratios at the lowest
for India; the concessional to total debt ratio is the highest, while debt of GNP ratio is
the second lowest after china.

Exchange Rate Management

In the context of globalisation and currency crises, recent years, particularly, have
seen a renewed interest on the issues relating to exchange rate regime, which is
evident in the large and growing body of theoretical and empirical literature on the
subject. Nevertheless, both in theory as well as in practice, the state of the debate is
unsettled. A world wide consensus is still evolving in search of an appropriate and
credible exchange rate regime. In India also, discussion and debate on issues relating
to the appropriate exchange rate system, policies on intervention, capital control and
foreign exchange reserves figure very prominently. This is especially relevant with the
introduction of a market-based exchange rate system in March 1993 and in the
context of global currency crises, particularly the East Asian Crisis.
In India the exchange rate system has undergone a paradigm shift from a system
of fixed exchange rate (until March 1992) to a market determined regime in March
1993. Since the switchover to a market determined exchange rate regime in March
1993, the behaviour of the exchange rate has remained largely olderly, interspersed by
occasional episodes of pressures, which were relieved through appropriate
intervention operations consistent with the stated policy of avoiding undue volatility
in the exchange rate without reference to any target, whether explicit or implicit. The
financial crises encountered by the emerging markets in the last decade have brought
to the fore the importance of an appropriate exchange rate policy. The present Indian
regime of managed flexibility that focuses on managing volatility without reference to
any target has gained increasing international acceptance and well served the
requirements of the country in the face of significant liberalisation of external sector
transactions. This is particularly so in the context of the series of exchange rate crises
experienced by several emerging economies undertaking similar macroeconomic
reforms.
In the post-Bretton Woods period, the Rupee was effectively pegged to a basket of
currencies of Indias major trading partners from September 1975. This system
continued through the 1980s; though the exchange rate was allowed to fluctuate in a
wider margin and to depreciate modestly with a view to maintain competitiveness.
However, the need for adjusting exchange rate became precipitous in the face of the
external payments crisis of 1991.

Transition to Market Determined Exchange Rate System:

As a part of the overall macroeconomic stabilisation programme, the exchange
rate of the Rupee was devalued in two stages by 18 per cent in terms of the US dollar
in July 1991. The transition to market determined exchange rate system took place in
two stages and the sequencing was based on the Report of the High Level Committee
on Balance of Payments, 1993 (Chairman: C.Rangarajan). The Liberalised Exchange
Rate Management System (LERMS) instituted in March 1992 was a dual exchange
rate arrangement under which 40 per cent of the current receipts were required to be
surrendered to the Reserve Bank at the official exchange rate while the rest 60 per
cent could be converted at the market rate. The 40 per cent portion surrendered at the
official rate was for meeting the essential imports at a lower cost. Although the
experience with the dual exchange rate system in terms of volatility in the market
determined segment of the forex market was satisfactory, it involved an implicit tax
on exports and other invisibles receipts and thereby emerged as a source of distortion.
As a system in transition, the LERMS performed well in terms of creating the
conditions for transferring an augmented volume of foreign exchange transactions on
to the market.
The unified market determined exchange rate regime replaced the dual regime on
March 1, 1993 and since then the objective of exchange rate management has been
to ensure that the external value of the Rupee is realistic and credible as evidenced by
a sustainable current account deficit and manageable foreign exchange situation.
Subject to this predominant objective, the exchange rate policy is guided by the need
to reduce excess volatility, prevent the emergence of destabilising speculative
activities, help maintain adequate level of reserves, and develop an orderly foreign
exchange market (Jalan, 1999). In order to reduce the excess volatility in the foreign
exchange market, the reserve Bank has undertaken market clearing sale and purchase
operations in the foreign exchange market to moderate the impact on exchange arising
from lumpy demand and supply as well as leads and lags merchant transactions. Such
interventions, however, are not governed by any predetermined target or band the
exchange rate.
The experience with the market determined exchange rate regime has been
satisfactory, although the exchange rate management had to occasionally contend with
a few episodes of volatility. The period from March 1993 till August 1995 was a
phase of significant stability. Capital inflows coupled with robust export growth
exerted upward pressure on the exchange rate. However, the Reserve Bank absorbed
the excess supplies of foreign exchange. In the process, the nominal exchange rate of
the Rupee vis-a-vis the US dollar remained virtually unchanged at around Rs. 31.37
per US Dollar over the extended period March 1993 to August 1995. The real
appreciation that resulted from the positive inflation differentials prevailing during
this period triggered off market expectations and resulted in a market led correction of
the exchange rate of the Rupee during September 1995-February 1996. In response to
the upheavals, the Reserve Bank intervened in the market and also resorted to
monetary tightening so as to restore orderly conditions in the market after a phase of
orderly correction for perceived misalignment.
The period since 1997 has witnessed a number of adverse internal as well as
external developments. The important internal developments include the economic
sanctions imposed in the aftermath of nuclear tests conducted during May 1998 and
the border conflict during May-June 1999. The external developments included, inter
alia, the contagion from the Asian crisis, the Russian crisis during 1997-98, sharp
increases international crude oil prices in the period beginning with 1999, especially
May 2000 onwards, and the post-September 11, 2001 developments in the US. These
developments created a large degree of uncertainty in the foreign exchange market at
various points of time, leading to excess demand conditions in the market. The
Reserve Bank responded through appropriate intervention supported by monetary and
other administrative measures like variations in the bank rate, repo rate, cash reserve
requirements, refinance to banks, surcharge on import finance and minimum interest
rates on overdue export bills. These measures helped in curbing destabilising
speculation, while at the same time allowing an orderly correction in the value of the
Rupee.

FOREIGN EXCHANGE RESERVES: APPROACH,

DEVELOPMENTS AND ISSUES

The subject of foreign exchange reserves has received renewed interest in recent
times in the context of increasing globalisation, acceleration of capital flows and
integration of financial markets. The debt-banking-financial crises in several countries
have also necessitated the need for an international financial architecture in which the
management of foreign exchange reserves has emerged as one of the critical issues.
Contextually, the subject of foreign exchange reserves may be broadly classified
into two inter-linked areas namely the theory of reserves and the management of
reserves. The theory of reserves encompasses issues relating to institutional and legal
arrangements for holding reserve assets, conceptual and definitional aspects, and
objectives for holding reserve assets, exchange rate regime and conceptualisation of
the appropriate level of foreign reserves. In essence, a theoretical framework for
reserves provides the rationale for holding foreign exchange reserves. Reserve
management is mainly guided by the portfolio management consideration, i.e., how
best to deploy foreign reserve assets subject to statutory stipulations? The portfolio
considerations take into account inter alia, safety, liquidity and yield on reserves as
the principal objectives of reserve management. The institutional and legal
arrangements are largely country specific and these differences should be recognised
in approaching the critical issues relating to both reserve management practices and
policy-making (Reddy, 2002).
The motives for holding reserves may be broadly classified under three categories
namely transaction, speculative and precautionary,. International trade gives rise to
currency flows, which are assumed to be handled by banks driven by the transaction
motive. Similarly, speculative motive is left to individuals or corporate. Central Bank
reserve, however, are characterised primarily as a last resort stock of foreign currency
for unpredictable flows, which is consistent with precautionary motive for holding
foreign assets. Precautionary motive for holding foreign currency, like the demand for
money, can be positively related to wealth and the cost of covering unplanned deficit,
and negatively related to the return from alternative assets. Furthermore, foreign
exchange reserves are instruments to maintain or manage the exchange rate, while
enabling orderly absorption of international capital flows. Official reserves are mainly
held for precautionary and transaction motives keeping in view the aggregate of
national interests, to achieve balance between demand for and supply of foreign
currencies, for intervention, and to preserve confidence in the countrys ability to
carry out external transactions.
The objectives for maintaining reserves are:
i. Maintaining confidence in monetary and exchange rate policies;
ii. Enhancing capacity to intervene in foreign exchange markets;
iii. Limiting external vulnerability by maintaining foreign currency
liquidity to absorb shocks during times of crisis including national
disasters or emergencies;
iv. Providing confidence to the markets, including credit rating agencies,
that external obligations can always be met (thus reducing the overall
costs at which foreign exchange resources are available to all the
market participants); and
v. Adding to the comfort of the market participants, by demonstrating the
backing of domestic currency by external assets.
Indias approach to reserve management, until the balance of payments crisis of
1991 was essentially base on the traditional approach, i.e., to maintain an appropriate
level of import cover defined in terms of number of months of imports equivalent to
reserves. For example, the import cover of reserves shrank to three weeks of imports
by the end of December 1990, and the emphasis on import cover constituted the
primary concern say, till 1993-94. The approach to reserve management, as part of
exchange rate management, and indeed the overall external sector policy underwent a
paradigm shift with the adoption of the recommendations of the High Level
Committee on Balance of Payments, 1993 (Chairman: C.Rangarajan). the committee
had recommended that the foreign exchange reserve targets be fixed in such a way
that they are generally in a position to accommodate the imports of three months. In
the view of the committee, the factors that are to be taken into consideration in
determining the desirable level of reserves are:
 i. The need to ensure a reasonable level of confidence in the international
financing and trading communities about the capacity of the country to
honour its obligations and maintain trade and financial flows;
ii. The need to take care of the seasonal factors in any balance of payments
transaction with reference to the possible uncertainties in the monsoon
conditions of India;
iii. The amount of foreign currency reserves required to counter speculative
tendencies or anticipatory actions amongst players in the foreign exchange
market; and,
iv. The capacity to maintain the reserves so that the cost of carrying liquidity
is minimal.
With the introduction of market determined exchange rate, a change in the
approach to reserve management was warranted and the emphasis on import cover
had to be supplemented with the objective of smoothening out the volatility in the
exchange rate, which has been reflective of the underlying market condition. Against
the backdrop of currency crises in East-Asian countries and in the light of country
experiences of volatile cross-border capital flows, there emerged a need to take into
consideration a host of factors. The shift in the pattern of leads and lags in
payments/receipts during exchange market uncertainties brought to the fore the fact
that besides the size of reserves the quality of reserves also assumes importance.
Unencumbered reserve assets (defined as reserve assets net of encumbrances such as
forward commitments, lines of credit to domestic entities, guarantees and other
contingent liabilities) must be available at any point of time to the authorities for
fulfilling various objectives assigned to reserves. As a part of prudent management of
external liabilities, the policy is to keep forward liabilities at a relatively low level as a
proportion of gross reserves.
An important issue which has figured prominently in the current debate on foreign
exchange management is the question of appropriate policy for management of
foreign exchange reserves. In a regime of free float, it can be argued that there is no
need for reserves. In the light of volatility induced by capital flows and self-fulfilling
expectations that this can generate, there is now a growing consensus among
emerging market economies to maintain adequate reserves (Jalan, 2002). Therefore,
while focusing on prudent management of foreign exchange reserves in recent years,
the liquidity at risk associated with different types of flows has come to the fore.
With the changing profile of capital flows, the traditional approach to assessing
reserve adequacy in terms of import cover has been broadened to include a number of
parameters which take into account the size, composition, and risk profiles of various
types of capital flows as well as the types of external shocks to which the economy is
vulnerable. A sufficient high level of reserves is necessary to ensure that even if there
is a prolonged uncertainty; reserves can cover the liquidity at risk on all accounts over
a fairly long period. Taking these considerations into account, Indias foreign
exchange reserves have reached a very comfortable level. The current thinking in this
regard has been clearly articulated: The prevalent national security environment
further underscores the need for strong reserves. We must continue to ensure that,
leaving aside short-term variations in reserve level, the quantum of reserves in the
long-run is in line with the growth of the economy, the size of risk-adjusted capital
flows and national security requirements. This will provide us with greater security
against unfavourable or unanticipated developments, which can occur quite suddenly
(RBI, 2002c). In the context of the uncertain ramifications of the current
developments in Iraq, the relevance of a comfortable reserve level appears particularly
important. Unlike 1990-91, implications of such developments in the Gulf region for
the external sector appear modest and manageable, mainly due to the comfortable
reserve level.
The foregoing discussion points to the evolving considerations and a paradigm
shift in Indias approach to reserve management. The shift has occurred from a single
indicator to a menu or multiple indicators approach. Furthermore, the policy of
reserve management is built upon a host of factors, some of which are not
quantifiable, and in any case, weights attached to each of them do change from time
to time.
Developments: In India, reserves have been steadily built up by encouraging non-
debt creating flows and de-emphasising debt creating flows, particularly short-term
debt. This strategy, coupled with the maintenance of an acceptable level of current
account deficit and market determined exchange rate regime was the cornerstone of
the policy of external sector management. In the context of the changing interface
with the external sector and the importance of the capital account, reserve adequacy is
now evaluated by the Reserve Bank in terms of several indicators and not merely
through conventional norms, such as, the import cover. As a matter of policy, as far as
possible, foreign exchange reserves are kept at a level which is adequate to withstand
both cyclical and unanticipated shocks.
India is amongst the top 10 reserve holding emerging market nations. Indias
foreign exchange reserves increased from US$ 4.7 billion in June 1991 to US$ 163.7
billion as on May 12, 2006. (US$ 151.6 billion in 2005-06) The predominant
component of foreign exchange reserves is in the form of foreign currency assets that
increased from US$ 1.1 billion to US$ 156.6 billion during the same period. The
movement in Indias foreign exchange reserves since 1993-94 can be divided into
three phases: (i) the period March 1993 to March 1995, when reserves increased
sharply from US$ 9.8 billion to US$ 25.2 billion, (ii) the period March 1995 to March
1999, when reserves increased moderately to US$ 32.5 billion, and (iii) finally since
1999-2000, when there was a phenomenal increase in reserves reaching the peak
figure of US$ 163.7 billion.
While the significant accretion to foreign exchange reserves has provided comfort
on external sector management, two contentious issues have come to the fore. These
are the trade-off between costs and benefits accruing from the reserves accretion and
the associated monetary impact that emanates from it.

Summing Up

The external sector reform programme initiated in the wake of the balance of
payments crisis of 1991 was all encompassing. Even though the reforms were largely
crisis led, the policy initiatives were unique in terms of their gradual, cautious and
country specific approach. As against balance of payments problems of varying
intensities experienced during 1956-1991, Indias balance of payments position
strengthened over the 1990s even as the <W> coincided with the liberalisation of
external account, external currency crises and domestic political uncertainties.
Prudent exchange rate management, low current account deficit, steady flow of
non-debt creating capital flows, particularly in the form of FDI, a significant
reduction in the external debt to GDP ratio and containment of short-term debt to
manageable and prudent limits have been some of the positive outcomes of policy
reform in the external sector. Resilience of the external sector has helped India
successfully avert the contagion effects of the East Asian crisis.
 There are, however, a few areas, which require further efforts. Indias
competitiveness in exports would require to be strengthened to achieve a sustained
export growth of at least 12 per cent per annum in order to achieve the medium-term
goal of increasing Indias share in world exports to 1 per cent by 2006-07. India also
needs to make the transition from export of labour-intensive low technology goods to
a wider variety of goods, including technology intensive goods. Indias tariff levels
continue to be high; accelerated pace of reduction of tariffs and removing the
constraints on the small-scale industries would be conducive to industrial growth and
exports. Rapid growth in exports would also require addressing the domestic
constraints of supply bottlenecks and inadequate infrastructure.
A sustained surge in capital flows in the recent past has implications for monetary
and inflation management although, the Reserve Bank has so far been able to sterilise
the monetary impact of foreign exchange reserve through large open market sales of
government securities. The financial cost of additional reserve accretion in the recent
period is low.
The external debt management policy of the government continued to focus on
raising loans from least expensive sources with longer maturities, monitoring of short-
term debt, keeping commercial debts under manageable limits with end-use
stipulations and potion to convert external commercial borrowings into equity,
restriction on trade credits, encouraging non-debt creating capital flows and
accelerating the growth of exports.
There has been a debate that high accretion to forex reserves has resulted in a
substantial output loss in the 1990s. It needs to be recognised, however, that the
steady growth path is functionally related more to the macroeconomic constraints of
saving and investment than to the reserve management policy per se. The reserve
management policy, coupled with the exchange rate management and monetary policy
pursued by the Reserve Bank has created an atmosphere of softer interest rate regime,
which is conducive to higher economic growth. In addition, the recent policy
initiatives have created an investment atmosphere where foreign investment
supplements domestic investment, which in a medium-term perspective would ensure
a higher growth trajectory.

25
India and the WTO

World Trade Organization

THE World Trade Organization (WTO) is an international organization that

oversees the operation of the rules-based multilateral trading system. The WTO is
based on a series of trade agreements negotiated during the Uruguay Round (1986-
1994), the eighth and the final trade round conducted under the General Agreement on
Tariffs and Trade (GATT). The Treaty of Marrakesh established the WTO at the close
of the Uruguay Round in 1994. The WTO began operations on January 1, 1995. The
WTO was comprised of 148 members. The WTO is one of the Big Three International
Organizations that oversee economic relations among nations, joining the
International Monetary fund (IMF) and the World Bank. The WTOs headquarters is
located in Geneva, Switzerland. Pascal Lamy of France, current WTO Director-
General, began a four-year, renewable term of office on September 1, 2005.
 The WTOs main function is to monitor and enforce trade rules in the global
economy. The WTO administers the complex trade agreements listed in the WTO
agreement. Article 1 of the WTO agreement, the General Agreement on Tariffs and
Trade, deals with rules of merchandise trade. The General Agreement on Tariffs and
Trade in Article 1 is often called the GATT 1994 to distinguish it from the original
GATT agreement of 1947. Article 2, the General Agreement on Trade in Services
(GATS), pertains to the trade of commercial services. Article 4, the Agreement on
Trade-Related Aspect of Intellectual Property (TRIPS), provides uniform legal
protections for scientific, technological, and artistic achievements. In addition, the
WTO is a forum for trade negotiations, a dispute settlement mechanism, a source of
technical expertise on trade and development for the worlds poorer countries and a
sister organization to the World Bank and IMF. Unlike the World Bank and IMF, the
WTO does not make loans to countries.
The WTO inherited many of GATTs guiding principles. These fundamental
principles are incorporated in the numerous agreements that comprise the Agreement
Establishing the World Trade Organization. In its Understanding the WTO (2003), the
World Trade Organization identifies five core principles.
The first principle is trade without discrimination, which involves most-
favoured-nation (MFN) status and national treatment. MFN states that a trade
concession granted to one WTO member automatically applies to all members.
National treatment guarantees equal treatment of imported goods with domestically
produced output in nations markets.
The second principle is freer trade through the progressive liberalisation of trade
regimes.
The third principle is the predictability of trade rules. Predictability, in this
context, prevents governments from arbitrarily raising existing tariffs or non-tariff
trade barriers.
The fourth principle is fair competition. Fair competition attempts to level the
playing field in international trade and minimise the market distortions caused by
export subsidy, dumping, and other disruptive trade practices.
The fifth principle is economic development through trade. Economic
development for the worlds poorer countries should be enhanced by trade assistance
and increased market access through preferential trade arrangements.
The WTOs dispute settlement process is the enforcement arm of the organization.
The WTOs apparatus for dispute settlement is stronger and more defined than
GATTs dispute settlement procedures. The WTOs dispute settlement process is the
essence of multilateralism. That is, a country or a group of countries can air trade
grievances in a global forum. A trade complaint is made to the WTOs Dispute
Settlement Body (DSB), which consists of the entire WTO membership. The DSB, in
turn, establishes a panel of three or five experts to hear the evidence and render a
ruling. The panels ruling can only be reversed by a unanimous vote of the DSB.
Under normal conditions, the entire process takes one year or less to complete. One or
both sides in the dispute can appeal the panels decision. A seven member Appellate
Body considers an appeal and renders a decision. Again, only a unanimous vote of the
DSB can reverse the Appellate Bodys ruling. The appellate process could add as
much as three months to the dispute settlement process. A member country found
guilty breaking WTO trade rules is required to correct the violation with due speed.
The DSB is empowered to initiate retaliatory tariffs or other trade sanctions for non-
compliance with a WTO ruling.
 India and the WTO

India was one of the 23 founding Contracting Parties to the General Agreement on
tariffs and Trade (GATT) that was concluded in October 1947. India has often led
groups of less developed countries in subsequent rounds of multilateral trade
negotiations (MTNs) under the auspices of the GATT.
In the last round (8th) of the multinational trade negotiation under the auspices of
the GATT, the World Trade Organization was created to subsume the GATT in 1995.
Even after the inception of WTO in 1995, till the Doha Ministerial (2001), the
developing countries were not very active at the negotiating table. It is indeed ironic,
as free trade is much more favourable for a developing country than its developed
counterparts. However, a new trend emerged from Cancun (2003) onwards, and since
then the former group has become much more vocal at the multilateral trade forums
on the protectionist policies of the latter.
Despite being a founder member of GATT, India was never very active in various
negotiating rounds until late eighties. Since the Indian economy followed the import-
substitution led growth strategy during sixties and seventies, gaining from the import
liberalisation at principal export markets (the EU and US) was never a prime
objective. In addition, a considerable proportion of Indias trade was directed to the
Soviet bloc countries, and the presence of this assured market weakened the incentive
to search for newer outlets. On the other hand, opening the domestic market to foreign
competition through progressive tariff cuts was perceived harmful for the local
industries. Instead, the country was more willing to discuss trade and development
related issues at UNCTAD forums in collaboration with other developing countries
like Brazil (primarily through the G-77 network). Despite adoption of a proactive
approach at WTO, India still feels comfortable to discuss trade-related issues at
UNCTAD forums for coalition building among developing countries on areas
pertaining to mutual interest. Table 25.1 illustrates Indias participation in WTO
meetings.
The first two ministerial meetings were held at Singapore (1996) and Geneva
(1998) respectively, while various provisions of the agreement were discussed and the
state of their implementation was reviewed. In addition, two new agreements, namely
Information Technology Agreement and Global E-Commerce agreement were signed
in these meetings. This was at a time when Indias IT exports started to take off!
Fortunately the agreements inked on these issues have actually helped e-commerce
and not gone contrary to Indias interests. The Singapore Ministerial was particularly
important as it agreed to discuss in future on four issues, (1) Government
Procurement, (2) Trade and Investment, (3) Trade and Competition Policy, and (4)
Trade Facilitationcollectively known as Singapore issues.
 TABLE 25.1

India at the WTO Meetings

No. Of Place of Year Outcome Indias Role

Ministerial Occurrence

1. Singapore 1996 Information Technology Agreement was Mere Presence

signed. In addition four new issues were
discussed. Trade and Investment, Competition
Policy, Transparency in Government
Procurement, and Trade Facilitation.

2. Geneva 1998 Global E-commerce Agreement was signed. Mere Presence

Also, the implementation issues were
discussed.

3. Seattle 1999 The negotiations failed as several developed Was vocal

countries wanted to incorporate environmental against
and labour-standard related issues under the introduction of
wings of WTO. The move was strongly environmental
opposed by developing countries. and labour-
standard related
issues under
WTO.

4. Doha A new round was launched and the concerns Mostly singled
for developing countries like India (e.g. TRIPS out in its protest.
and Public Health) were attended. The market However, made
access and implementation issues were also its presence and
given due notice. position felt for
the first time.

5. Cancun The members could not arrive at a common Actively

viewpoint even on the last date of the protested against
conference. The ministerial decided to take EU-US draft on
stock of progress in negotiations and other agriculture
work under the Doha Development Agenda. jointly with
The developing country solidarity at the other developing
ministerial was formed for the first time. countries.

6. Geneva Five member countries came forward to create Played a

an atmosphere for initiating multilateral constructive role
negotiations once again. in the process
while protecting
developing
countries
interests.

Source: Compiled from WTO Ministerial Declarations and other documents.

 The road between Singapore and Seattle was not a rosy one for India owing to a
number of reasons. First of all, the export growth rate decelerated in the second part
of the nineties. The disadvantages faced by the export sector were intensified after the
East Asian crisis, when the exchange rate of a number of countries in that region was
devalued. On the other hand, the service sector fast emerged as a major foreign
currency earner, and the urgency to ensure free trade in this arena (or, at least in Mode
4, i.e., movement of professionals) was intensely felt. It was noticed while tariff
barriers decreased to some extend in the post-WTO period; several WTO-compatible
non-tariff barriers through usage of higher standards (e.g., SPS-TBT measures) and
contingency provisions (e.g., anti-dumping measures, safeguard provisions) have
sprung up, limiting the impact of elimination of traditional NTBs (e.g., import quota).
Non-realisation of proposed level of market access in developed countries emerged as
a main source of dissatisfaction. In addition, the developed countries wanted to
incorporate labour and environmental issues under the wings of WTO, much to the
annoyance of their developing counterparts.
However, the most important factor responsible for enhancing Indias
participation in WTO negotiations was the outcome of the dispute settlement cases
involving her. In general, the period between 1995 and 1998 witnessed a substantial
rise in the number of cases in WTOs dispute settlement mechanism. India was among
one of the victims of this provision as a number of developed countries moved to the
dispute settlement body complaining about the WTO-compatibility of Indian policies.
In the Seattle Ministerial (1999), India was vocal at the multilateral forum for the
first time, protesting against a developed country initiative to incorporate labour and
environmental standards under the aegis of the WTO. Due to the protest of the
developing countries, the developed countries were not successful in incorporating
this element in the agenda. The Ministerial meeting ultimately ended in failure as the
members could not arrive at a mutually agreeable solution. The then Commerce
Minister Mr. Maran viewed the Seattle outcome as a success for India as for the first
time, developing and poorer countries were united in mutual interest.
During the Seattle-Doha period, India, for the first time, started communicating its
dissatisfaction over several issues and sharing its position with other countries at
various appropriate forums of WTO and other international bodies. Broadly speaking,
a clearly distinguishable and proactive stand emerged before the Doha Ministerial,
and India became particularly concerned with (i) non-realisation of anticipated
benefits (e.g., Agreement on Textiles and Clothing and Agreement on agriculture), (ii)
inequities and imbalances in WTO (TRIPSs, subsidies, Anti-dumping, etc.), and (iii)
non-binding nature of special and differential provisions (market access, DSB, etc.).
In short, India strongly objected to the inclusion of any new issue in the negotiating
agenda before realisation of Uruguay round promises, the non-implementation of
which was costly to developing countries.
Buoyed by the success achieved at Doha, India tried to utilise the two-year period
before Cancun in much a productive manner and coalition-formation experience with
other developing countries were fruitful not only for general agreements that affected
merchandise and services trade, but also in case of institutional arrangements like
dispute settlement. The movement towards a proactive strategy at the WTO was
accompanied towards implementing an increasingly WTO compatible regime at home
and frustration mounted at not obtaining the desired level of market access in
principal export destinations. In Cancun, India principally negotiated over
liberalisation of agricultural trade and trade in services.
In addition, the intensity of proactive approach was further noticed in the sharp
increase in the number of joint submissions at WTO, ranging from agriculture to
services. Interestingly, the Indian submissions to WTO, both joint and individual,
stressed both export promotion (enhancement of market access) and domestic
protection (e.g. provision of special products, special safeguard mechanism in
agriculture) much vigorously. On the other hand, domestic reforms have been
regularly undertaken in order to enhance compliance with WTO. The adoption of the
2005 Patents Ordinance and its subsequent tabling in the Parliament, in spite of the
domestic opposition, is the best example of it.
However, if we are to measure the trajectory of Indias learning curve by a sector-
by-sector basis, two areas stand out immediately. The first is anti-dumping, where
India has transformed itself from the major affected country to an aggressor becoming
quick to initiate investigations. While in the mid-nineties, it was one of the major
affected countries, during the last two years it has topped the list by being the initiator
of the maximum number of anti-dumping investigations.
The second area where India has evolved is with regard to its outlook towards
regional trading arrangements. Not too long back, India was unhappy with the growth
of regional trade agreements, which was constraining its market access. However,
from 2003 onwards, i.e., from Cancun days, it has initiated negotiations on
preferential access with a number of developing countries, which would clearly help it
in guaranteeing an assured export market on the hand, and an ally in future
negotiations on the other.
It is pertinent to point out what the WTO does for Indiaby supplementing
Indias internal market with global market it offers India the opportunity to utilise its
most abundant factor labour, both skilled as well as not so skilled. It also:
Offers India the opportunity to supplement its meagre capital with
investment from rest of the world to enhance growth, and
Allows Indian entrepreneurs to plan for global markets given the fact that
their export destinations have to be governed by laws that are WTO
compatible and thus are rule based and not run by administrative fiat.
How India utilises this opportunity is a separate matter. For example, Indias
export performance depends a great deal on what the state delivers on the
infrastructure front. Indias infrastructure is woefully inadequate to cater to industry as
well as agriculture, and erodes competitiveness in both sectors. This can either be
remedied by investment by the state and/or by instituting reforms to let the market
participate in the solution of this problem.
To summarise, the problem areas on freeing international trade are yet to be
resolved although the 10 year transitory phase of WTO came to an end on December
31, 2004. While tariff barriers have declined over the last 10 years, newer standard-
related and procedural non-tariff barriers have been devised to protect the market.
Even the effectiveness of tariff reduction in strategic areas has been subjected to
questions. In agriculture, the debate over subsidisation issue is far from over, and the
tussle between developed and developing countries is likely to intensify in coming
days. In industry, the increasing use of contingency and safeguard measures has
turned out to be another major source of dispute. Within industry, two sectors need
special attention, where post-transitory phase scenario has a significant implication on
developing countriesPharmaceutical and Textile sector. While the public health
related concern in case of TRIPS is quite high in developing countries like India,
especially in a product patent regime, the MFA phase-out might turn out to be a boon
(if India responds swiftly enough). In case of services, the conflict of interests
between developed and developing countries in liberalisation of various modes are
playing the key role with no global agreement in sight. Finally, the effectiveness of
WTO rules like special and differential treatment and dispute settlement procedures in
protecting the interest of developing country members has often been questioned.

The Sixth WTO Ministerial Conference

At Hong Kong, (December 13-18, 2005)

While the discussions held at Hong Kong resulted in a much more acceptable
Ministerial Declaration as compared to the Derbez Draft circulated at Cancun, the
developing countries are yet to reach their goal (especially over the last two years)
reduction in agricultural subsidisation level in developed countries. Similarly, there
exists enough scope for expanding market access in other areas in the developed
country markets (e.g. Mode 4 of services trade for India). At best, it could be argued
that some deal is probably better than a Cancun-type no-deal, thereby portraying the
result of the ministerial as a second-best outcome.
Debroy and Chakraborty remark, Rather than blaming the negotiators at Hong
Kong for the moderate outcome, the focus should be on the determinants of the
negotiating position of a country at a multilateral level. It is a well known fact that
free trade ensures market access. However, from an independent perspective, tapping
market access opportunities requires supply-side adjustments and improved
governance. That cannot be ensured in ministerial meetings, be it Hong Kong, Geneva
or Cancun. Furthermore, the selection of right partners in negotiating groups for
pursuing a goal, given the national interest of a particular member, is of extreme
importance. Stated alternatively, whenever surrounded by partners with a diverse
interest pattern, a country might need to downplay some of its focus areas to keep
everyone in the group happy.
Now developing countries are in no way homogeneous; nor are their developed
counterparts, for that matter. But disparities are visibly greater in the former group,
which consists of advanced developing economies, small and vulnerable economies,
landlocked countries and least developed countries (LDCs) thrown in together. As a
matter of fact, only 31 out of the 40 LDCs are members of the WTO. The developing
countries and LDCs are scattered in various groups. There are the 77 ACP (African,
Caribbean and Pacific) countries, beneficiaries of preferential trade with EU, whose
interest revolves around preference erosion in items like sugar and bananas. The 41-
member strong African group, APEC (Asia-Pacific Economic Corporation) and
ASEAN could also be mentioned in this regard. The Cancun Ministerial witnessed the
evolution of G-20, with Brazil, China, India and South Africa constituting the core.
There is also the G-33 with a defensive interest in agriculture through special product
and special safeguard mechanism (SSM). There is the G-90, a coalition of the African
group, the ACP countries and member LDCs. In addition, the Hong Kong Ministerial
witnessed the emergence of the NAMA-11, focusing on non-agricultural market
access. Some developing countries are also members of the agro-exporting Cairns
group.
Despite the lack of homogeneity within the south, the fourth day of the Hong
Kong Ministerial witnessed a North-South divide, with G-20 and G-90 coming
together as G-110. This was partly to push the development agenda of the Doha Work
Programme, sometimes interpreted as additional aid.
 Debroy and Chakraborty observe, Had the developed countries not dithered over
the LDC package, the G-110 solidarity might not have materialised.
The G-20 has gained recognition as credible negotiating entity in the negotiations.
The Ministerial declaration adopted at Hong Kong addresses some of the concerns of
developing countries related to agriculture. It has been agreed that development
programmes of developing countries that have minimal distorting effects will be
incorporated into the green box. It has further been agreed that the three heaviest
subsidisers, namely, the EC, the US and Japan, will attract the highest levels of cut in
their trade-distorting domestic support entitlements, and these cuts must be effective.
Among other decisions taken in the Hong Kong Ministerial, it was agreed that all
developed country members, and those developing countries declaring themselves in
a position to do so, shall provide duty-free and quota-free market access on a lasting
basis to all products originating from all LDCs. Agreement was also reached on some
other outstanding S&DT (Special and Differential Treatment) proposals by LDCs. On
the issue of relationship between Trade Related Intellectual Property Rights (TRIPS)
and Convention and Biological Diversity (CBD) and protection of traditional
knowledge, the Declaration calls for intensification of the consultation process. On
implementation issues, Ministers agreed to redouble their efforts to find appropriate
solutions to them and it was agreed that Council shall review progress and take
appropriate action no later than July 31, 2006. The fresh time line for reaching results
on S&D cluster in December 2006.

And After (July 24, 2006)

However, the Doha round of free-trade talks collapsed on July 24, 2006 after
nearly 5 years of haggling. It has been reported The suspension of WTOs Doha
round came after a 14-hour marathon meeting of the group of 6 failed in a last-ditch
attempt to overcome differences on farm trade. The G 6 comprises the US, the EU,
Japan, Brazil, India and Australia. The EU and India accused US of Stone-walling
by demanding too high a price for cutting the $20-billion it spends on farm subsidies.
EU trade commissioner Peter Mandelson said, Surely, the richest and strongest
nation in the world, with the highest standards of living, can afford to give as well as
take. But the Us was adamant and neither the EU nor India were prepared to offer the
sort of access to their markets that Washington needed to make a deal on subsidies
worthwhile. The commerce minister (Kamal Nath) remarked, Developing countries
could not permit their farmers to lose their livelihoods and food security to provide
market access to subsidised agriculture products from developed countries.
To conclude, while India, so far, may not have been able to gain a lot from the
negotiations, it clearly came out of seclusion during the Doha Ministerial (2001) and
is currently leading the developing country coalitions at WTO. Furthermore,
expansion of the negotiating agenda (e.g. environmental services) in recent years
depicts an evolving learning curve, which is no less important. A similar learning
through trading is observed in case of several other developing countries as well. On
the other hand, the aversion of several developed countries towards ensuring free
trade is becoming quite obvious in recent years.
 BOX 25.1

Key Outcomes and Timelines of Hong Kong Ministerial Declaration

Resolve to complete the Doha Work Programme fully, and to

conclude negotiations in 2006.
To establish modalities in agriculture and non-agricultural market
access (NAMA) by April 30, 2006 and prepare draft Schedules by
July 31, 2006.
To eliminate export subsidies in agriculture by 2013, with a
substantial part in the first half of the implementation period.
Developing countries without Aggregate Measurement of Support
(AMS), such as India, will be exempt from reductions in de minimis
and the overall cut in trade-distorting domestic support consisting of
AMS, the Blue Box and de minimis that is entitlement to provide
Amber Box subsidies up to 10 per cent of value.
To submit a second round of revised services offers by July 31,
2006 and submit final draft schedules by October 31, 2006.
Amendments to TRIPS Agreement reaffirmed to address public
health concerns of developing countries.
Duty-free, quota-free market access for all LDCs products to all
developed countries. Developing country declaring itself to be in a
position to do so, to also provide such access, through flexibility in
coverage and in the phase in of their commitments is provided.
In cotton, export subsidies to be eliminated by developed countries
in 2006 and trade-distorting domestic subsidies to be reduced more
ambitiously and over a shorter period of time.

Source: Economic survey 2005-06