Thursday 30 August 2012

Balance of Payments (BoP) situation in India

Relevant extracts  from Economic Survey 2012, Chapter 6 "Balance of Payments".

Balance of Payments comprises:
  1. Current account: Under current account of the BoP, transactions are classified into:
    • Merchandise (exports and imports) and 
    • Invisibles- invisible transactions are further classified into three categories. 
      • Services comprising travel, transportation, insurance, government not included elsewhere (GNIE), and miscellaneous. Miscellaneous services include communication, construction, financial, software, news agency, royalties, management, and business services. 
      • Income. 
      • Transfers (grants, gifts, remittances, etc.) which do not have any quid pro quo form the third category of invisibles.
      • During 2011-12 all broad categories of invisibles, namely services, transfers, and income, 
        showed increase
      • The invisibles account of the BoP reflects the combined effect of transactions relating to international trade in services, income associated with non-resident assets and liabilities, labour and property, and cross-border transfers, mainly workers’ remittances.

  2. Capital account: Under capital account, capital inflows can be classified by instrument (debt or equity) and maturity (short- or long-term). The main components of capital account include: 
    • Foreign investment: 
      • foreign direct investment (FDI) and 
      • portfolio investment consisting of foreign institutional investor (FIIs) investment and American depository receipts /global depository receipts (ADRs/GDRs) represents non-debt liabilities.
      • In India, FDI is preferred over portfolio flows as the FDI flows tend to be more stable than portfolio and other forms of capital flows.
        Push and pull factors explain international  capital flows. Push factors are external to an economy and inter alia include parameters like low 
        interest rates, abundant liquidity, slow growth, or 
        lack of investment opportunities in advanced 
        economies. Pull factors like robust economic 
        performance and improved investment climate as a 
        result of economic reforms in emerging economies 
        are internal to an economy.
      • Inward FDI showed a declining trend while 
        outward FDI showed an increasing trend in 2010-11 
        vis-a-vis 2009-10. Sector-wise, deceleration during 2010-11 was 
        mainly on account of lower FDI inflows under 
        manufacturing, financial services, electricity, and

        construction. Country-wise, investment routed 
        through Mauritius remained the largest component 
        of FDI inflows to India in 2010-11 followed by 
        Singapore and the Netherlands. Outward FDI 
        increased from US$ 15.1 billion in 2009-10 to US$

        16.5 billion in 2010-11.

    • Loans (external assistance, external commercial borrowings [ECB], and trade credit) 
      • Rupee-denominated debt is preferred over foreign currency debt and medium- and long-term debt is preferred over short-term.
    • Banking capital:  including nonresident Indian (NRI) deposits are debt liabilities. 
  3. Errors and omissions, and 
  4. Change in foreign exchange reserves. India’s foreign exchange reserves comprise: 
    • Foreign currency assets (FCA): maintained in major currencies like the US dollar, euro, pound sterling, Australian dollar, and Japanese yen. FCAs are the major constituent of India’s foreign exchange reserves.
      • FCAs are maintained with the principles of preserving the long-term value of the reserves in terms of purchasing power, minimizing risk and volatility in returns, and maintaining liquidity.
    • Gold, special drawing rights (SDRs), and 
    • Reserve tranche position (RTP) in the International Monetary Fund (IMF). 
    • The twin objectives of safety and liquidity have been the guiding principles of foreign exchange reserves management in India with return optimization being embedded strategy within this framework.

      India is the sixth largest foreign exchange reserves holder in the world, after China, Japan, Russia, Brazil, and Switzerland at end December 2011.

Growth in Exports: 
  • During 2010-11, exports crossed the US$ 200 billion mark for the first time, increasing by 37.3 per cent from 2009-10. 
  • This increase was largely driven by engineering goods, petroleum products, gems and jewellery, and chemicals and related products. 
  • This increase was accompanied by a structural shift in the composition of the export basket from labour-intensive manufacture to higher value-added engineering and petroleum products
  • A diversification of export destinations with developing countries becoming our largest export market in recent years.
The resilience in export performance appeared to have resulted from a supportive government policy, focusing on diversification in terms of higher value-added products in the engineering and petroleum sectors
and destinations across developing economies. Trade policy is supporting exports through schemes
like the Focus Market Scheme (FMS), Focus Product Scheme (FPS), and Duty Entitlement Passbook Scheme (DEPB).

Rising crude oil prices, along with increase in gold and silver prices, have contributed significantly to the burgeoning import bill during 2011-12.

Foreign Exchange Reserves
The level of foreign exchange reserves is largely the outcome of the RBI’s intervention in the foreign exchange market to smoothen exchange rate volatility and valuation changes due to movement of the US dollar against other major currencies of the world. Foreign exchange reserves are accumulated when there is
absorption of the excess foreign exchange flows by the RBI through intervention in the foreign exchange
market, aid receipts, and interest receipts and funding from the International Bank for Reconstruction and Development (IBRD), Asian Development Bank (ADB), International Development Association (IDA), etc.


FCAs are maintained in major currencies like the US dollar, euro, pound sterling, Australian dollar, and Japanese yen. Both the US dollar and euro are intervention currencies; however, reserves are denominated and expressed in the US dollar only, which is the international numeraire for the purpose. The movement of the US dollar against other currencies in which FCAs are held therefore impacts the level of reserves in US dollar terms. The level of reserves declines when the US dollar appreciates against major international currencies and vice versa. The twin objectives of safety and liquidity have been the guiding principles of foreign exchange reserves management in India with return optimization being embedded strategy within this framework.

FCAs are the major constituent of India’s foreign exchange reserves. FCAs decreased by US$ 11.3 billion between March 2011 and December 2011. In line with the principles of preserving the long-term value of the reserves in terms of purchasing power, minimizing risk and volatility in returns, and maintaining liquidity, the RBI holds FCAs in major convertible currency instruments. These include deposits of other country central banks, the Bank for International Settlements (BIS), and top-rated foreign commercial banks and securities representing debt of sovereigns and supranational institutions with residual maturity not exceeding 10 years, to provide a strong bias towards capital preservation and liquidity.

EXCHANGE RATE
The exchange rate policy is guided by the broad principle of careful monitoring and management of exchange rates with flexibility, while allowing the underlying demand and supply conditions to determine exchange rate movements over a period in an orderly manner. Subject to this predominant objective, RBI intervention in the foreign exchange market is guided by the objectives of:
  • reducing excess volatility, 
  • preventing the emergence of destabilizing speculative activities, 
  • maintaining adequate level of reserves, and 
  • developing an orderly foreign exchange market.

Fall in Rupee
In the current fiscal, there are two distinct phases in the exchange rate of the rupee. The rupee
continued with an appreciating trend till about July 2011, after which the trend reversed and it started declining sharply from September 2011 onwards. A sharp fall in rupee value may be explained by the:
  1. strengthening of the US dollar in the international market due to the safe haven status of the US treasury, and 
  2. supply-demand imbalance in the domestic foreign exchange market on account of slowdown in FII inflows, 
  3. heightened risk aversion and
  4. deleveraging due to the euro area crisis that impacted financial markets across emerging market economies (EMEs). 
  5. increasing CAD and 
  6. high inflation. 
Currency depreciation during 2011-12 was not specific to India. The currencies of other emerging  economies, such as the Brazilian real, Mexican peso, Russian rouble, South Korean won, and South
African rand, also depreciated against the US dollar, reflecting the increased demand for the US dollar as
a safe haven asset in the wake of the sovereign debt crisis in the euro zone.
As the rupee has been under pressure since July 2011, efforts have been made by the RBI to augment supply of foreign exchange and curb speculation in the foreign exchange market to stem rupee decline.

The rupee has experienced high volatility in the last few years. Such volatility impairs investor confidence and has implications for corporate balance sheets and profitability in case of high exposure to ECBs when currency is depreciating. A more aggressive stance to check rupee volatility is therefore necessary.


External Debt
India’s external debt has remained within manageable limits as indicated by the 
  • external debt to GDP ratio of 17.8 per cent, and 
  • debt service ratio of 4.2 per cent in 2010-11. 

This has been possible due to an external debt management policy of the government that emphasizes:
  • monitoring long- and short-term debt, 
  • raising sovereign loans on concessional terms with long maturities, 
  • regulating External Commercial Borrowings through end-use and all-in-cost restrictions, and 
  • rationalizing interest rates on NRI deposits.


CHALLENGES AND OUTLOOK
A trade deficit of more than 8 per cent of GDP and CAD of more than 3 per cent is a sign of growing imbalance in the country’s balance of payments. There is scope therefore to discourage unproductive imports like gold and consumer goods to restore balance. In this respect, some weakening of the rupee is a positive development, as it improves trade balance in the long run by increasing export competitiveness and lowering imports.

High trade and current account deficits, together with high share of volatile FII flows are making India’s BoP vulnerable to external shocks. Greater attention therefore has to be given to improving the composition of capital flows towards FDI.

The rupee has experienced high volatility in the last few years. Such volatility impairs investor confidence and has implications for corporate balance sheets and profitability in case of high exposure to ECBs when currency is depreciating. A more aggressive stance to check rupee volatility is therefore necessary.

The size of foreign exchange reserves could be a constraining factor in checking depreciation of local currency in the event of external shock and reversal of capital. It is therefore imperative that during times of surge in capital flows, when currency is under pressure to appreciate, measures are taken to build up reserve levels.

6 comments:

  1. Major Determinants of BoP Transactions:

    External Demand
    Vibrant markets abroad – favour exports
    Slowdown in external economies – affects exports
    International oil and commodity prices
    Domestic demand – high
    Appreciation in prices – bulky import bill
    Pattern of capital flows
    FII > FDI
    Short – term trade credit > long – term trade credit
    Exchange rate
    Affects the debt value
    Affects cost of imports/exports
    Affects of value of foreign exchange reserves

    ReplyDelete
  2. STRENGTHS:

    Growth largely domestic economic driven
    Calibrated approach to capital account liberalization
    Fuller capital account convertibility than Full capital account convertibility
    Strict supervision of banks
    Credit derivative instruments like credit default swaps yet to be introduced in the financial markets
    Minimal exposure to toxic assets
    Remittances continuing to be robust
    Foreign Exchange Reserves accretion and diversification

    ReplyDelete
  3. WEAKNESSES:
    Adverse Balance of Trade
    Greater dependence on Capital flows – vulnerable to vagaries of the external environment
    Reduction in capital flows may lead to
    Further decline of rupee
    More borrowing
    Additional burden of tax concessions to attract investment
    To continue till good governance is met with
    Low capacity to absorb periodic surge in capital inflows
    Stock market/real estate bubbles
    Appreciation of local currency
    Excess liquidity leading to inflationary pressures
    Rupee’s weakening against the dollar
    Lowered demand for overseas loans from corporate India
    Inflation – tight money policy – Crowding out

    ReplyDelete
  4. OPPORTUNITIES

    Strong recovery of the domestic economy
    Positive sentiments of global investors about India’s growth prospects
    Significant capital inflows in the form of FDIs, FIIs and short-term trade credits favourably offsetting the Current Account Deficits
    Improvement in Balance of Trade
    Improvement in Agriculture sector
    Scope for simplifying and improving taxation system

    ReplyDelete
  5. THREATS to Balance of Payments
    Deadlock in Doha round talks
    High volatility of Currency Markets
    Fragile global recovery and robust domestic growth
    High public debt in several advanced countries
    Deceleration in stable and productive FDIs
    Downgrading of US $, Slowing down of China, Tsunami-ravaged Japan

    ReplyDelete
  6. Current Trends in BoP 2010-11

    Balance of trade – Lowering deficit
    -Robust import demand
    -Faster rate of growth of exports
    Balance of Invisibles – Moderation in net invisibles surplus
    -Decline in investment income and private transfer receipts – owing to persisting lower interest rates abroad;
    -Increases in services payments under travel, transportation, business and financial services
    -Major turnaround in service exports
    Capital Transfers – Inflows short of estimates
    Foreign Exchange Reserves – Moderate or lesser accretion in foreign reserves
    BoP – Greater borrowing may be effected; worst case – may eat into foreign exchange reserves

    ReplyDelete