13

External Sector Reforms in India

V. R. Prabhakaran Nair

13.1 Introduction

The domestic financial sector reforms generally necessitate the external sector liberalization, both the current and the capital accounts, to yield the best results. It is generally argued that domestic liberalization can lead to a reflow of the capital flight and improvements in the capital accounts, especially if accompanied by the external sector liberalization. Capital account liberalization can improve a country’s ability to tap global savings (at a lower cost than using only domestic savings); allow economic agents the freedom to choose how and where to borrow, invest or exchange assets; improve the resource allocation through increased competition for financial resources; and increase the availability of resources to support investment, finance trade and boost up the other significant economic sectors (Johnston et al., 1999). The liberalization of capital flows can be viewed as one aspect of a broader programme of the financial sector liberalization. The financial capital has become highly mobile across the countries as a result of the gradual globalization of the financial markets that followed from a widespread deregulation and innovations in the communication and transaction technologies. As the capital mobility increases, the flow of resources to the specific country also increases, making a provision for increased investible resources. In India, the reforms in 1991 injected a new dynamism in the Indian trade through the new industrial policy, import liberalization, removal of exchange rate controls and other measures aimed at improving competition and efficiency. Drawing attention to the historical antecedents, in which the far reaching external sector reforms were initiated, the present chapter traces the policy measures on both the current and the capital accounts of the external sector in India.

13.2 External Sector Reforms: Some Historical Antecedents

Since the advent of the First Five Year Plan in 1950–51, the aspects of the external sector have been debated and policies were chosen. The choice between the import substitution-oriented strategies and the export promotion-oriented strategies, or a combination of both, has been a major element in such a debate. In the early 1950s, the relative advantage of a particular strategy was not recognized or there were no appropriate guidelines to make a choice between them. As a result it was the pragmatism, initiative and urge for the socioeconomic transformation of the leaders and the policy makers which have played an effective role in the choice of the trade policies and strategies.

13.2.1 Import Substitution

It is well known that India started its planned development under the framework of an import-substitution strategy. India pursued a highly inward oriented strategy of development until the 1991 reforms. The Second Five Year Plan emphasized the strategic importance of the manufacturing and the capital goods sectors. Since India had to import capital goods in the early days, the trade policy gave an emphasis to replace these capital goods with the domestic import-substitution production. Generally there are two options for the production strategies. One is to substitute the imports of consumer goods by the domestic production of consumer goods and allocate a large part of the investment to the production of consumer goods. The second strategy is to restrict the availability of the luxury consumer goods to the minimum, either through domestic production or through import substitution, so that the capability of the economy to produce both the consumer and capital goods at a future date could be very high. India adopted the latter strategy on the basis that it would result in sound foundations for development, though it includes considerable sacrifices on the part of people in the early stages of development.

The implementation of import-substitution strategy mainly includes two approaches: the first one is through the fiscal and monetary policies and the second is the adoption of physical interventionist policies, such as tariff, taxes, banning, etc. of imports, and the tariff and non-tariff measures of protection. India’s trade policies during the late 1950s were essentially interventionist in character. The adoption of interventionist policies was necessitated by the severe foreign exchange crisis of 1956–57 and the urgency for adopting strict measures for import control. The interventionist approach of licensing, quotas, etc., intensified in the late 1950s and early 1960s and led to the creation of a number of institutions such as the Chief Controller of Imports and Exports office, the agencies for issuing essential certificates, etc. In a nutshell, the period from 1956 to 1962 stands distinctly as a period where the trade and domestic production was based on import substitution.

13.2.2 Export Promotion

However, at the beginning of the third plan, export orientation was inducted and thereafter export targets were set up and introduced in various plan documents. The period from 1962 to 1966, could be identified as a period of induction of export orientation along with a heavy import-substitution orientation in the strategies. The reliance on physical controls and the restriction on the multiplicity of the policies for import substitution and export promotion had led to a situation of a variety of distortions in the domestic economy. With the decision on the devaluation of Rupee in 1966 and with the changes in the tariff and the export subsidy policies, the approach was shifted towards using fiscal policies to control the imports. However, this exercise was short-lived (only up to 1968), and afterwards the approach of import controls, licensing and restrictions (physical controls) was re-introduced. A variety of export promotion policies were also initiated. From 1971 onwards, a new dimension in terms of creating organizations such as the creation of export promotion councils, the commodity boards to promote export services, etc. was added to the export promotion effort.

However, the period until 1975 was a period of uneasiness with excessive protectionism, control and restriction. Many inadequacies were found in the functioning of the export promotion councils. This was followed by the setting up of a number of committees and task forces to review the trade policies during 1975–79. The Alexander Committee on the import-export policies reviewed various trade policies and recommended a simplification of the export-import policies by stating that the import of goods could be classified into three categories, viz., banned, restricted and Open General List (OGL). The first two categories could be listed in the policy book and the last one could be left as an open-ended list without being fully mentioned in the policy book. The committee also recommended the abolition of licensing and rationalization of the export subsidy schemes. These recommendations were aimed at injecting competition by giving greater weightage to efficiency in the decision-making. There were also other committees like the Sondhi Committee, the Tandon Committee, the Venkataraman Committee, the Arjun Sen Gupta Committee, the G.V.K Rao Committee, the Abid Hussain Committee, etc., which reviewed and recommended various trade policy measures. As a result, some of the broad trends have emerged in the trade policy regime in India.

13.2.3 The 1991 Crisis

The liberalization of the import policy regime started in 1975–76 when the approach of the Open General Licence (OGL) was effectively introduced. In 1978, the earlier approach of the NIL policy—treating all the items not listed in the policy book as banned items—was discontinued and the items listed in the policy book were regarded as OGL items. Thus the 1980s saw some attempts to simplify the licensing system in order to provide an easier access to the intermediate goods imports for domestic production by placing many such items on the readily importable OGL list. To a lesser extent, the capital goods imports were also imposed through a discretionary licensing regime in order to encourage technological upgrading, particularly for the export-oriented industries. However, higher tariffs accompanied the liberalization of Quantitative Restrictions (QRs) in the 1980s.

As many governments in the world switched over to an outward orientation in their policies to exploit the growing trade opportunities, Indian policy makers continued with the import substitution till the end of the 1980s. The export pessimism became a selffulfilling prophecy, as its share of the world exports declined steadily from a small 2 per cent in 1950–51 to a negligible 0.4 per cent in 1989–90. For the five-year period 1985–90, the trade deficit averaged to 3 per cent of the GDP,¹ while the current account deficit averaged to 2.2 per cent of the GDP (Acharya, 2001). To finance these deficits, the government switched over to external borrowings. The dependence on the expensive commercial borrowings and the NRI deposits increased the debt burden and worsened the external debt indicators. The debt service ratio, the external debt stock to the GDP ratio and the debt to exports ratio peaked at 35, 39 and 563, respectively. The proportion of the short-term debt in the total external debt attained its highest level in March 1991 at 10.3 per cent. As a ratio to the foreign currency reserves, the short-term debt soared to a dangerous 382 per cent, signalling the heightened fragility of India’s external finances (Acharya, 2001). The reduction in the remittance inflows and increase in the oil price due to the Gulf War pushed the Indian economy to face an unprecedented macro-economic and balance of payments crisis. This resulted in the introduction of the structural adjustment and macroeconomic stabilization programmes under the World Bank and the International Monetary Fund (IMF) in almost all the sectors of the economy in various degrees.² In the reforms, the external sector was given the focal emphasis since the reforms were aimed at integrating the domestic economy with the world. In a nutshell, until the economic reforms, India maintained a trade policy regime characterized by the pervasive QRs and the high tariffs on the imports and a complex system of the export subsidies. India’s trade policy, thus, shows a transition from the export pessimism in the 1950s to a more realistic assessment of trade prospects in the 1960s and 1970s, the resultant import liberalization strategy in the 1980s and to a more pronounced trade reform measures by eliminating the QRs after the 1991 economic crisis.

13.3 Trade Policy Reforms

The balance of payments crisis of 1991 met with the reforms which have focused on a sea change in India’s trade policy. The recent rapid growth of the developing countries suggests that the trade liberalization measures, both tariff and non-tariff, create incentives for production of exports and thereby increase economic growth at a higher pace. Emphasizing the fact that the inherent limitations of an inward-looking import-substitution strategy results in hampering the efficiency in resource use, low economic growth and disequilibrium in the balance of payments, the trade policy reforms has given emphasis to increased openness through greater imports and exports.

13.3.1 Exchange Rate Reform and Current Account Convertibility

To integrate the Indian economy with the global economic environment, the currency has been made fully convertible so that the exchange rate would be determined in the international market without any official intervention. Along with this, the government started removing the exchange controls in a phased manner. This is in accordance with the IMF insistence on 13 per cent devaluation, as it was felt that India was keeping the value of the Rupee artificially high. As pointed by Swamy (1994), the government fixed the target rate of inflation at 9 per cent so that the nominal devaluation required for appeasing the IMF and the World Bank authorities came out to be 22 per cent. With the devaluation of the Rupee on the 1 and 3 July 1991, five major currencies were appreciated by 22 per cent against the Rupee to pave way for the condition to obtain the IMF financial assistance.

The exchange rate policies went through a series of further changes from 1991. The Rupee was made partially convertible by introducing a dual exchange rate system in the 1992–93 budget. Under this system, called the Liberalized Exchange Rates Management System (LERMS), 40 per cent of the current account transactions will be conducted at the RBI-determined official rate and the remaining 60 per cent at the market-determined rate. In keeping with the policy of the market-determined exchange rates and the abolition of import controls, the government moved to a unified floating exchange rate in 1993–94. Since then, the exchange rates were determined by the demand for and the supply of foreign exchange in the market. Later, on 19 August 1994, India attained full convertibility on the current account accepting the obligation under Article VIII of the IMF (Box 13.1).³ With this the current account transactions have been provided the freedom to buy or sell foreign exchange for international transactions.⁴

The current account is split into two categories, viz., the balance of trade and the balance of invisibles. While the balance of trade takes into account the exports and imports of merchandize or visible items, the balance of invisibles deals with the net receipts on the account of invisibles such as the remittances and net service payments.⁵ Theoretically, the current account balance may either show a deficit or a surplus. The current account surplus means the acquisition of assets or repayment of the earlier debts. On the contrary, the current account deficit implies to the withdrawal of the previously accumulated assets or the borrowings to bridge the deficit.

13.3.2 Capital Account Convertibility

In India, the capital account liberalization received policy attention in the wake of 1991 balance of payments crisis. As a part of the overall structural adjustment programme and restructuring package of the external sector, it aimed at reducing reliance on the debt creating flows—particularly the short term ones, while encouraging foreign investment, both the Foreign Direct Investment (FDI) and the Foreign Portfolio Investment (FPI). While the focus was primarily on attracting adequate private capital of the desired composition, during surges in the capital flows, the policy measures were also directed at regulating the inflows. With a gradual liberalization of the foreign investment, both the FDI and the FPI, the Rupee for all purposes has been made convertible for foreign investors. The attempts to liberalize the capital account in India has been a gradual and cautious approach. Though India has travelled a long way in the capital account liberalization, the policies were adopted in a phased and sequenced manner across the economy. As a part of this exchange, the controls were removed and the Rupee has been made convertible for foreign investors to invite the FDI and FPI in the economy. However, controls were kept in varying degrees for both the foreign and domestic corporates and individuals. The restrictions on the capital outflows involving residents continue. Such controls have indeed served well the needs of the external sector and the overall economy, and many of them can be removed depending on the progress on entrenching the preconditions on a durable basis (Jadhav, 2003).

It was the Tarapore Committee on ‘Capital Account Convertibility’ that defined the framework for forex liberalization in May 1997 (Tarapore, S. S., 1997). The capital account convertibility implies the right to transact in the financial assets with the foreign countries without restrictions. The Tarapore Committee had chalked out three stages, to be completed by 1999–2000. It had indicated certain signposts to be achieved for the introduction of Capital Account Convertibility (CAC). The three most important of them were— fiscal consolidation, a mandated inflation target and strengthening of the financial system. However, the timetable was abandoned in the wake of the 1997–98 Asian financial Crisis. Though the capital account is not fully convertible, in certain respects convertibility exists. For instance convertibility exists for the foreign investors and the Non-Resident Indians (NRIs) for undertaking direct and portfolio investments in India, and Indian investment abroad up to US$ 4 million which is eligible for an automatic approval by the RBI, subject to certain conditions. (Policy initiatives are given in Box 13.2).

In April 2006 a committee was formed again under the chairmanship of the former Deputy Governor of the Reserve Bank of India (RBI) Mr S. S. Tarapore to revisit the issue of CAC and suggest a road map for it. The committee proposed that India shift to Fuller Capital Account Convertibility (FCAC) in five years beginning 2006–07. In its report submitted to the RBI on 31 July 2006, the committee suggested that the proposed regime would be embraced in three phases: 2006–07 (Phase I), 2007–08 and 2008–09 (Phase II) and 2009–10 and 2010–11 (Phase III). The committee has pointed out that the concomitants for the move to a fuller CAC would be fiscal consolidation, setting of the medium-term monetary policy objectives, strengthening of the banking system and maintaining an appropriate level of current account deficit as well as reserve adequacy. The RBI, however, has not been taken a final approval for capital account convertibility in India, though it has initiated measures on an on-going basis.

13.3.3 Import Liberalization

The World Bank (1990) advocated the redesigning of the import policy to allow the imports of all items not listed in the negative (restricted) to be imported, lowering the import tariffs on all goods, import of the capital goods, intermediate goods, raw materials and consumer goods. In April 1992, a single negative list replaced the import licensing and eliminated the scope for discretionary decisions, bureaucratic delays and inefficiencies. The reforms in the very first year largely swept away QRs on the imports. The QR coverage for manufacturing declined from 90 per cent in the pre-reform period to 51 per cent in 1994–95. It dropped to 29 per cent for the capital goods and 35 per cent for raw materials and intermediaries. The customs duties on 35 items were slashed from 255 per cent ad valorem to 150 per cent ad valorem on 9 February 1993. The import duties were also reduced on a number of capital goods by 20–30 percentage points. The maximum duty on all the goods was reduced from 110 per cent to 85 per cent except for a few items including passenger luggage and alcoholic beverages.

After 1995 and the completion of the Uruguay Round, India’s remaining industrial QRs were contested at the World Trade Organization (WTO) by the other WTO members including the United States and the EU. India therefore had to phase out the remaining QRs which were not compatible with the WTO rules.⁶ This was started in 1998 and finished in April 2001 (Goldar and Renganathan, 2008). By April 2007, the conventional QR coverage of manufacturing in the aggregate declined to only about half of 1 per cent of the manufacturing GDP (Pursell et al., 2007). Liberalization for the consumer goods started in 1992, when large exporters received Special Import Licenses (SILs) as an incentive, allowing them to import certain consumer goods specified on a positive list. In March 2000, the QRs on 714 out of 1429 items were removed by shifting them from the SIL list to the Open General License List (OGL). The remaining items would be shifted to the OGL list by 31 March 2001 and the SIL list would be abolished. The import of the second hand capital goods, which are less than 10 years old, are allowed without obtaining any license on the surrender of SILs.

A phased reduction in the tariffs became a central component of the reforms as the tariff rates came down continuously. The tariff reforms have had a centrestage in the process of opening up of the Indian economy, to dismantle systematically the high cost, the inward-oriented industrial regime and to make the Indian industry globally competitive. This policy has had two components—to reduce the rates as well as the dispersion of the tariffs and to shake the Indian capital goods sector out of its lethargy and facilitate its technological renaissance. The unweighted average rate of tariff (excluding countervailing duty (CVD) and specific exemptions) on the imports of the manufactured products was 122 per cent in 1986 and 129 per cent in 1991, which declined to 40 per cent in 1996 and 35 per cent in 1998. Further, it started coming down from 2004 onwards, and the unweighted average tariff rate on the manufactured imports came down to 12 per cent in 2007 (Pursell et al., 2007).

The earlier controls in the industrial sector, through licensing and MRTP, inhibited competition and led to a wasteful misallocation of the resources among the alternative industries and also accentuated the underutilization of the resources with these industries (Bhagawati and Srinivasan, 1975: 191). However, the removal of the licensing policy and the resultant increase in capacity through increased output and investment followed by a substantial opening of the FDI and trade liberalization through the elimination of QRs and reduction in the custom tariffs, resulted in a greater access to the foreign technology and capital after 1991. From a higher level of relative price of the capital goods under the protective trade regime (De Long and Summers, 1993; Jones, 1994), there was a tremendous fall in the relative price of machinery during the 1980s and particularly in the 1990s (Athukorala and Sen, 2002). In the post-reform period, the imports of manufactured goods in India have increased tremendously. As a percentage of the manufacturing GDP, it has increased from 30 per cent in 1990 to nearly 60 per cent in 2006 (Pursell et al., 2007).

13.3.4 Export Liberalization

The export incentives and subsidies were made prominent in the trade reforms. The coverage ratio (coverage of imports by export earnings) was low at 66.2 per cent in 1990–91. The result was a higher trade deficit. However, the coverage ratio, on an average has increased to 79.2 per cent during 1991–92 to 1998–99. This improvement was the result of various export promotion measures introduced since 1991. The devaluation of the Rupee by 18 per cent in July 1991 was intended to help boost up the exports. In May 1993, the Parliamentary Standing Committee on Commerce proposed allocation of the special funds to top the state governments out of the export earnings from the units located in those states to enable the states to develop infrastructure facilities for export promotion.

The Exim Policy 1991, aimed at a progressive reduction in the extent of canalization. It permitted the export houses, trading houses and star trading houses to import a wide range of items. The special growth centres and export promotion industrial park schemes, Export Processing Zones (EPZs), etc. have been implemented to support the state government efforts in export promotion. The EPZ and the Export Oriented Units (EOUs) were granted several concessions.

Besides the systems of Exim scripts and the liberalized exchange rate mechanism, the Exim Policy (1992–97) introduced a number of export promotion measures. The export promotion measures include the incentive schemes, fiscal relief and tax concessions, relaxation of controls or export restrictions, simplification of procedures, price stabilization of the export commodities, compulsory gradation of commodities, granting of the additional inducements and incentives for export to the non-traditional markets, special ship and rail facilities, credit arrangements, signing the trade agreements, setting up of various export institutions, the export-import council, the export promotion council, etc. The export of all items is declared free, except for a negative list of seven items (beef tallow, wildlife, human skeletons, wood and wood products, etc.). The export of 62 items (raw silk, certain minerals, pulses, etc.) is restricted and 10 items have been canalized. The export of 46 other items is permitted with a minimum regulation. Thus about 144 items are removed from the negative list of exports. The modified Exim Policy 1997–2002 has shifted 340 items to the OGL in line with India’s commitment to WTO to phase out the remaining import tariff on over 2000 items. With the introduction of a new Exim Policy, 2002–07, all QRs in exports were removed and a massive thrust was given to the exports to achieve 1 per cent share in the global exports by 2007. Further, in the new foreign trade policy, 2004–09, Target Plus schemes were introduced, in which the exporters achieving a quantum growth in exports are entitled to duty-free credit-based incremental exports substantially higher than the general actual export target fixed. In the recent years, India has undertaken a number of measures for increasing its exports through the Special Economic Zones (SEZs) and the EPZs.

13.3.5 Liberalization of Capital Flows

The reforms in the policy towards foreign investment began with a radically new approach to permit the FDI in virtually every sector of the economy. The capital flows have become prominent with the implementation of structural adjustment programme and financial reforms. In the pre-liberalized period, under successive five-year plans, the foreign capital was held at modest levels. The possibility of exports replacing foreign capital did not receive attention due to the emphasis on import-substitution strategy in the initial decades of planned development.

Recently, the Indian capital market has been rejuvenated with the liberalization of the international capital flows. In 1993, capital markets were opened for Foreign Institutional Investors (FIIs) and allowed Indian companies to raise capital abroad by the issue of equity in the form of Global Depository Receipts (GDRs). The government had opened up the Indian securities market for foreign investment through the FIIs, the GDRs and the Foreign Currency Convertible Bonds (FCCBs). The liberalization of the GDR issues and commercial borrowing offshore by top corporations, albeit under tight control by the RBI, was an important source of additional funds for the private sector, particularly in the mid-1990s. As a part of the financial sector reforms, the economy was opened to the foreign investment, both direct and portfolio investments. With this, the government invited FPI in the Indian securities market through the FIIs, who have been required to register with the Securities and Exchange Board of India (SEBI). The government allowed foreign participation in many areas of financial services through joint ventures. The offshore funding was another source of competition for the banks, particularly for the top firms, though this type of funding declined towards the end of the 1990s. (Hanson, 2004).

The industrial and trade sector policies introduced in the 1990s resulted in a receptive attitude towards the foreign investment and foreign licensing collaboration,⁷ and as a positive response to the changed policy regime, the foreign investment flows in India has picked up sharply from Rs 174 crores in 1990–91 to Rs 28, 258 crores in 2001–02. The FDI, which was Rs 316 crores in 1991–92, went up sharply to Rs 29,235 crores in 2001–02, though declined in the next two years. The FPI on the other hand, has shown wide fluctuations in different years, but increased from Rs 10 crores in 1991–92 to Rs 52,279 crores in 2003–04 (RBI, 2006). In May 2001, the government decided to allow 100 per cent foreign investment in several industrial sectors. The theoretically argued strong complementarity with the domestic investment suggests that the capital flows brighten up the overall investment climate and stimulate it even when a part of the capital flows actually gets absorbed in the form of an accretion to the reserves (RBI, 2001).

However, compared to the policy regimes prevailing in the world markets, India’s regime is still considerably restrictive. The differential restrictions are applied to residents vis-à-vis non-residents and to individuals vis-à-vis corporate and financial institutions. The policy of ensuring a well diversified capital account with the rising share of non-debt liabilities and a low percentage of the short-term debt in total debt liabilities is amply reflected in India’s policies of the FDI, the FPI and the external commercial borrowings. The quantitative annual ceilings on the ECB along with the maturity and end-use restrictions broadly shape up the ECB policy. The NRI deposits have been liberalized while the policy framework imparted stability to such flows. The FDI is encouraged through a liberal but dual route—a progressively expanding automatic route and a case-by-case route. The portfolio investments, which have been progressively liberalized, are restricted to select players, particularly the approved institutional investors and the NRIs. The Indian companies are also permitted to access the international markets through the GDRs/ADRs, subject to approval. The foreign investment in the form of the Indian joint ventures abroad is also permitted through both automatic and case-by-case routes. The restrictions on outflows involving Indian corporates, banks and those who earn foreign exchange (e.g., exporters) have also been liberalized over time, subject to certain prudential guidelines (Jadhav, 2006).

13.4 Conclusion

As a result of various liberalization measures, the performance of the Indian external sector is found to be strong. The immediate effect of the trade reforms was the sharp decline in imports. The trade deficit and the current account deficit have gone down to secured levels. Though the import growth recovered and boosted in the later years of the 1990s, the current account deficit has not gone up to disturbing levels. India could maintain the current account deficit, well below the 2 per cent of the GDP mainly due to an increase in the exports and the net invisible earnings. The surge in net invisibles was partly attributed to the switch over to the market-determined exchange system. Regarding foreign borrowing, the share of the external assistance, the NRI deposits and the IMF financing has declined, while that of the net external commercial borrowings have fluctuated and reached peak levels. It is to be noted that, generally the capital account surplus has been adequate enough in relation to the corresponding current account deficit in the post-reform period. This has led to the accumulation of foreign exchange reserves in many years, amounting to more than eight months of import cover. The external debt indicators in the postreform period are stable reflecting the success of India’s external sector policies. The debt service ratio and external debt to the GDP ratio have come down significantly. Moreover, the proportion of the short-term debt lowered and reached comfortable levels in the postreform period. The transition from a controlled to a market-based exchange rate policy has succeeded in fostering India’s international competitiveness and containing day-to-day market volatility.

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