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Review of Macroeconomic and Monetary Developments in 2001-02

External Developments

20. While the world economy had slowed down considerably during the first half of the year 2001, the expectation of revival was modest for the second half. The recessionary trends were compounded by the adverse impact of September 11 events on services and trade. In addition, all segments of the financial market, particularly the equity markets, were badly affected. The impact was also felt in the financial markets of the emerging market economies, as there was a shift away from risky assets. These uncertainties prompted the IMF to sharply scale down its growth projection for the global economy to 2.4 per cent, which is almost half of the level of growth recorded in 2000. Fortunately, in recent weeks, the outlook for a recovery in the world economy, particularly in the US, has become much better. This has now prompted the IMF to upgrade its growth projection for the global economy for 2002 to 2.8 per cent from the earlier projection of 2.4 per cent in December 2001. The volume growth in world trade is also likely to be better in 2002 than that in 2001. Coupled with the positive effects of decline in global inflation and interest rates, the prospects for turnaround in world economic growth now appear distinctly more favourable than was the case a couple of months ago. With easing of uncertainties, stabilisation of confidence and improvements in financing conditions, the risks to global economic outlook is now more balanced barring the recent volatility in international oil prices which continues to be a matter of concern.

21. International developments, consequent to the events of September 11, had their destabilising impact on Indian financial markets with a sharp decline in the equity prices and net capital outflows of foreign institutional investors. Foreign exchange market also became volatile with the rupee depreciating vis-à-vis US dollar and consequent uncertainties also affected the government securities market. However, RBI promptly announced its intention to provide appropriate liquidity and initiated several measures so as to stabilise domestic financial markets. These actions by RBI restored stability and confidence in financial markets, which were reflected in the quick return of these markets to normal conditions.

22. Despite adverse external developments, India’s foreign exchange reserves continued to record a healthy growth during 2001-02 due to moderation in trade deficit and strong capital and other inflows. Foreign exchange reserves increased by as much as US $ 11.8 billion from US $ 42.3 billion in end-March 2001 to US $ 54.1 billion by end-March 2002. Of these, foreign currency assets increased by US $ 11.5 billion. This is the highest increase recorded in a single year and is an evidence of strong domestic and international confidence in India’s management of its balance of payments in the post-1991 period. Reflecting this confidence, in the last four years since the East Asian crisis of 1997-98, India’s foreign exchange reserves have more than doubled despite substantial increase in oil imports during the period and several other unfavourable developments affecting the prospects of developing countries.

23. India’s sustained efforts to build an adequate level of foreign exchange reserves have been vindicated by global uncertainties. It is now widely agreed that in judging the adequacy of reserves in emerging economies, it is not enough to relate the size of reserves to the quantum of merchandise imports or the size of the current account deficit. The overall approach to the management of India’s foreign exchange reserves in recent years has, therefore, reflected the changing composition of balance of payments. In addition to the likely developments in the current account, the reserve management has also endeavoured to reflect the liquidity risks associated with different types of flows and other requirements. The policy for reserve management is thus judiciously built upon a host of identifiable factors and other contingencies. Such factors, inter alia, include: the size of the current account deficit; the size of short-term liabilities (including current repayment obligations on long-term loans); the possible variability in portfolio investments and other types of capital flows; the unanticipated pressures on the balance of payments arising out of external shocks (such as the impact of the East Asian crisis of 1997-98 or increase in oil prices during 1999-2001); and movements in the repatriable foreign currency deposits of non-resident Indians. A sufficiently high level of reserves is necessary to ensure that even if there is prolonged uncertainty, reserves can cover the "liquidity at risk" on all accounts over a fairly long period. Taking these considerations into account, India’s foreign exchange reserves are now very comfortable.

24. The prevalent national security environment further underscores the need for strong reserves. We must continue to ensure that, leaving aside short-term variations in reserves 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. 25. India’s exports have not done well last year largely on account of global slowdown exacerbated by the September 11 events which affected export of services. The growth rate of exports in US dollar terms decelerated to 0.05 per cent during 2001-02 (April-February) as compared with 20.6 per cent in the corresponding period of the previous year. In view of enlargement in domestic refining capacity, increase in oil exports (by 12.7 per cent) have emerged as a significant item of export growth. Non-oil exports, on the other hand, declined by 0.5 per cent as against an increase of 15.7 per cent in the previous year. The growth of imports showed an increase of 2.1 per cent as compared with 1.6 per cent in the corresponding period of the previous year reflecting lower oil imports emanating from moderation in international oil prices. While oil imports registered a decline of 11.9 per cent as against an increase of 55.0 per cent in the previous year, non-oil imports increased by 8.7 per cent as compared with a decline of 12.6 per cent in the corresponding period of the previous year. At a further disaggregated level, non-oil imports excluding gold and silver increased by 6.3 per cent during 2001-02 (April-December) in contrast to a decline of 6.4 per cent in the corresponding period of the previous year. As a result of deceleration in exports, the trade deficit widened to US $ 6.7 billion during 2001-02 (April-February) from US $ 5.8 billion in the corresponding period of the previous year.

26. It was announced in the annual policy Statement of April 2001 that a survey would be conducted through an independent outside agency in order to have a feedback on simplification of procedures by RBI for export credit delivery as also the level of exporters’ satisfaction with bank services. Accordingly, the work of the survey was entrusted to National Council of Applied Economic Research (NCAER), New Delhi. NCAER has since submitted its report. The results of the survey reflect positive responses to RBI’s initiatives in improving the credit delivery system to exporters. More than three-fourths of exporters were satisfied with overall bank services relating to export credit delivery. Nearly one-fourth of exporters perceived them as "excellent" and more than half as "good". The only exception is the eastern region where only 12 per cent perceived them as "excellent" and less than half as "good". The report also made some suggestions for improving the credit delivery to exporters which are being examined by RBI. Summary of the report will be sent to banks for consideration and necessary action. It is also proposed to release the report for public information. The results of this survey will be useful for bringing about further improvements in bank services to exporters.

27. Reflecting comfortable supply position, the foreign exchange market generally exhibited stable conditions during 2001-02 barring some instances of volatility arising out of occasional uncertainties in market sentiments. The foreign exchange market witnessed brief periods of uncertainty in May 2001 on account of pressure on oil prices and downgrading of sovereign outlook; deceleration in capital inflows following September 11 events; and again in December 2001 due to terrorist attack on Indian Parliament and border tension. While the rupee depreciated against the US dollar during the year, it showed a mixed trend against other major currencies such as, Japanese Yen, Euro and Pound Sterling.

28. In the European Monetary Union, Euro, as a single currency, came into being with effect from January 1, 1999. As a preparatory measure, RBI, on November 20, 1998 had notified Euro as a permissible transaction currency under FERA and advised banks to accept FCNR (B) deposits in euro and convert existing deposits to euro freely besides balances in Exchange Earners’ Foreign Currency (EEFC) and Resident Foreign Currency accounts. Banks were given freedom to use Euribor and Eurolibor as benchmarks for pricing their foreign exchange transactions. At the instance of RBI, FEDAI conducted a training programme for bankers to familiarise them with the procedure of handling euro notes/coins. In the wake of smooth transition to euro notes and coins from January 1, 2002, RBI instructed Authorised Dealers (ADs) and full-fledged money changers to make arrangements to display euro exchange rates for travellers’ cheques and currency notes and extend facilities to residents for conversion of legacy currencies to euro till January 31, 2002 and even after this date by banks and money changers having the necessary arrangements in place for realising the value of legacy currencies. RBI also provided necessary information on euro on its website and started announcing reference rate for euro in addition to US dollar.

29. Another major development in this area is that the Government of India has since given the option to RBI to use euro as intervention currency in addition to US dollar. Furthermore, Hyderabad and Nagpur have been included as new centres for sale and purchase of US dollar and euro.

30. It may be recalled that in the annual policy Statement of April 1998, soon after the Asian crisis, RBI had highlighted the need for caution in the management of the exchange rate in emerging economies. It was observed that: "all countries, and developing countries in particular, have to be constantly watchful of developments that may adversely affect exchange markets. There can be no room for complacency in this regard". It was further reiterated in the Mid-term Review of October 1998 that: "RBI will continue to closely monitor developments in the financial markets at home and abroad, and take such monetary and administrative actions as may be considered necessary from time to time. RBI will not hesitate to use its reserves, when warranted, to meet sharp day-to-day supply-demand imbalances in the market. As before, it will ensure that lumpy and uneven demand, particularly for oil imports and debt servicing obligations of the Government, does not cause any disturbance in the orderly functioning of foreign exchange market".

31. Subsequent international developments have further underscored the need for careful management of the exchange rate in order to maintain orderly conditions in the markets (without, however, targeting a specific level). An important reason for this conclusion was highlighted in the Mid-term Review of October 2000 which observed that: " in the very short-run, "expectations" about the likely behaviour of a currency next day or over a week or fortnight can play a major role in determining its movement against foreign currencies, particularly the US dollar. Given the "bandwagon" effect of any adverse movements, and the herd behaviour of market participants, expectations can often become self-fulfilling. This is particularly true of thin developing country markets, where net volumes are relatively small. The day-to-day movement in currency markets is further complicated by volatility in private capital flows, which are highly sensitive to short-term domestic and international developments as well as future expectations".

32. Another important reason for a vigil on exchange rate is the likely effect of adverse developments in forex market on the real economy, as has been seen in several East Asian and Latin American countries a couple of years ago, and in Turkey and Argentina recently. The "contagion" effect is quick, and a sharp change in the currency value can affect the real economy more than proportionately. Exporters may suffer if there is unanticipated sharp appreciation and debtors or other corporates may be affected badly if there is a sharp depreciation, which can also lead to bank failures and bankruptcies.

33. Against the above background, India’s exchange rate policy of focusing on managing volatility with no fixed rate target, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way, has stood the test of time. Despite several unexpected external and domestic developments, India’s external situation continues to remain highly satisfactory. RBI will continue to follow the same approach of watchfulness, caution and flexibility while dealing with the forex market. It is a matter of satisfaction that the recent international research on viable exchange rate strategies in emerging markets has lent considerable support to the exchange rate policy followed by India. A number of countries (including those in East Asia) are now following similar policies.

34. In the past two years, a number of changes have been introduced in various schemes for remittances, investment and maintenance of bank accounts by non-resident Indians (NRIs). Continuing with the policy of liberalisation of the capital account, following the announcement made in the Budget 2002-03, the Reserve Bank has implemented the following measures:

With a view to providing full convertibility on non-resident deposit schemes, non-resident non-repatriable (NRNR) account and non-resident special rupee (NRSR) account schemes were discontinued with effect from April 1, 2002. Banks would not accept any deposit, whether by way of renewal of existing deposits or otherwise under these two schemes with effect from April 1, 2002. Existing accounts under NRNR scheme, however, may be continued up to the date of maturity. On maturity of the existing deposits under the NRNR scheme, the maturity proceeds shall be credited to the account holder’s non-resident (external) account (NRE account), after giving notice to the account holder. Similarly, the existing accounts in the form of term deposits under NRSR scheme may be continued till the date of maturity. On maturity, the maturity proceeds shall be credited to the account holder’s non-resident (ordinary) account (NRO account). Existing NRSR accounts, other than term deposits, would not be continued after September 30, 2002 and may, at the option of the account holders, be closed or the balance therein credited to their NRO accounts on or before that date.

Existing limits for Indian direct investment outside India under automatic route has been raised from US $ 50 million in a financial year to US $ 100 million. Such Indian investors could now purchase foreign exchange up to 50 per cent of their net worth as on the date of last audited balance sheet as against the existing limit of 25 per cent.

Corporate borrowers are allowed to prepay ECBs to the extent of the balances in their EEFC accounts, with the approval of RBI. Corporates which are export-oriented units and others can credit up to 70 per cent and 50 per cent, respectively, of their foreign exchange earnings to their EEFC accounts. RBI has since decided to allow the corporates to credit higher than the above percentage of export proceeds to their EEFC accounts on a case-by-case basis to enable them to take advantage of lower interest rates and prepay their ECBs.

It has been decided to allow Indian corporates with proven track record to contribute funds from their foreign exchange earnings for setting up Chairs in educational institutions abroad, and for similar such purposes. Such cases will be considered by RBI on a case-by-case basis.

RBI had issued a notification in September 2001 permitting Indian companies to raise the 24 per cent limit on Foreign Institutional Investors’ (FIIs) investment to the sectoral cap/statutory ceiling as applicable. As announced by the Finance Minister in his Budget speech for 2002-03, FII portfolio investments will not be subject to sectoral limits for foreign direct investment except in specified sectors. The details of sectors and the limits applicable will be specified by the Government in due course.

NRIs will be able to repatriate their current income in India such as rent, dividend, pension, interest, etc. by submitting a certificate from their chartered accountant certifying that the amount proposed to be remitted is eligible for remittance and that applicable taxes have been paid/provided for.

Indian mutual funds will be allowed to invest in rated securities in countries with fully convertible currencies, within the existing limits. Earlier such investment was only permitted in ADRs/GDRs issued by Indian companies in overseas markets.

With a view to further liberalise capital account transactions, it has been decided to put the limit for Foreign Currency Convertible Bond (FCCB) scheme under the automatic route up to US $ 50 million.

35. The Reserve Bank, as a part of the consultative process, constituted various working groups on relevant policy subjects with the participation of bankers, market participants and experts. Working groups were also set up for suggesting road maps for implementation of international best systems and practices in the financial system in general and banking sector in particular. The reports of the working groups were examined internally and, as necessary, these were also put on the RBI website for wider dissemination and comments. The details of the progress made in respect of certain working groups constituted recently are given in the Annexure to this Statement.

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