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Review of Macroeconomic and Monetary Developments during 2002-2003

External Developments

26. According to the latest estimates of the International Monetary Fund (IMF), the growth rate for the world economy in 2002 was slightly higher than estimated earlier (3.0 per cent as against 2.8 per cent). For the current year 2003, IMF has projected a growth rate of 3.2 per cent for the world economy. The growth in volume of world trade is projected to pick up from 2.9 per cent in 2002 to 4.3 per cent in 2003.

27. The uncertainty regarding the economic outlook, however, remains high due to the ongoing geopolitical tensions. Its adverse impact on the oil markets could have a negative impact on economic activity throughout the world, particularly on oil importing emerging markets.

28. An important lesson emerging from the disturbances in the global financial market last year has been the role of sound macroeconomic policies and financial sector reforms in strengthening the resilience of the financial sector to external shocks. In addition to increasing the effectiveness of the system, efficient regulatory environment and good disclosure norms constitute the crucial confidence-building measures for the financial sector. Macroeconomic policies will have to continue to focus on strengthening the fundamentals of the economy, financial stabilisation and promoting good corporate governance to aid the long-run welfare gains.

29. Despite adverse external developments, India’s foreign exchange reserves continued to record healthy growth during 2002-03 on account of improvement in the current account as well as strong capital and other inflows. India’s foreign exchange reserves increased by as much as US $ 21.3 billion from US $ 54.1 billion in end-March 2002 to US $ 75.4 billion by end-March 2003. Of these, foreign currency assets rose by US $ 20.8 billion. This is the highest increase recorded in a single year and has occurred despite substantial increase in the international oil prices and other unfavourable developments, like lower international capital flows to developing countries during the period.

30. It may be noted that major sources of foreign exchange reserves during the current fiscal year have been: (a) surplus in current account, (b) increase in other capital and (c) valuation changes in reserves. A recent study by RBI has revealed that, contrary to popular impression, there is no evidence to show that available arbitrage opportunities have caused the accretion to foreign exchange reserves. Almost the entire addition to reserves, in the last few years, has been made without increasing the overall level of external debt. The cost of accretion to reserves has also not been found to be very significant, as most of the increase is due to non-debt inflows.

31. In recent years, the annual policy Statements as well as mid-term Reviews have attempted to bring into sharper focus the main lessons emerging from our experience in managing the external sector during periods of external and domestic uncertainties. The recent experience has once again highlighted the need for developing countries to keep a continuous vigil on market developments, and the importance of building adequate safety nets that can withstand the effects of unexpected shocks and market uncertainties. In this context, India’s current exchange rate policy seems to have stood the test of time. It has focused on the management of volatility without a fixed rate target and the underlying demand and supply conditions are allowed to determine the exchange rate movements over a period in an orderly way. Despite several unexpected adverse developments on the external and domestic front, India’s external situation has remained strong. The Reserve Bank will continue to follow the approach of watchfulness, caution and flexibility by closely monitoring the developments in the financial markets at home and abroad. It will co-ordinate its market operations carefully, particularly in regard to the forex market with appropriate monetary, regulatory and other measures as considered necessary from time to time. It is heartening to note that recent international research on viable exchange rate strategies in emerging markets has also lent considerable support to the exchange rate policy followed by India.

32. India’s sustained efforts to build an adequate level of foreign exchange reserves in the last few years have also been fully vindicated by recent developments. As pointed out in previous policy Statements, the overall approach to the management of India’s foreign exchange reserves in recent years has reflected the changing composition of balance of payments, and has 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 investment and other types of capital flows; the unanticipated pressures on the balance of payments arising out of external shocks; and movements in the repatriable foreign currency deposits of non-resident Indians (NRIs). Taking these factors into account, India’s foreign exchange reserves are at present more than comfortable.

33. The substantial growth in reserves in the recent period has generated a welcome debate regarding the costs and benefits of holding reserves. In any cost-benefit analysis of holding reserves, it is essential to keep in view the objectives of holding reserves, which, inter alia, cover: (a) maintaining confidence in monetary and exchange rate policies; (b) enhancing the capacity to intervene in forex markets; (c) limiting external vulnerability so as to absorb shocks during times of crisis; (d) providing confidence to the markets that external obligations can always be met; and (e) reducing volatility in foreign exchange markets. Sharp exchange rate movements can be highly disequilibrating and costly for the economy during periods of uncertainty or adverse expectations, whether real or imaginary. For developing countries, these economic costs are likely to be substantially higher than the net financial cost, if any, of holding reserves. In this context, it is important to note that in India, in the last few years, almost the whole addition to reserves has been made without increasing the overall level of external debt. The increase in reserves largely reflects higher remittances, quicker repatriation of export proceeds and non-debt inflows. Even after taking into account foreign currency denominated NRI flows (where interest rates are linked to LIBOR), the financial cost of additional reserve accretion in India in the recent period is quite low, and is likely to be more than offset by the return on additional reserves.

34. It may also be mentioned that most of the increase in reserves in the recent period is through net purchases by RBI in the domestic forex market for which an equivalent amount of domestic currency has been released to the concerned domestic entities, including public sector units, corporates and individuals. The decision on the use of this counterpart domestic currency released by RBI (i.e., for investment, deposits or as liquid assets etc.) is the responsibility of the above mentioned entities and, not that of RBI, or for that matter, the Government. Needless to add that to the extent that this counterpart local currency is used by recipient entities for further investment in the economy, the impact on industrial demand and growth would be favourable.

35. Strong foreign exchange reserves and low interest rates in the domestic markets have helped the Government to prepay certain foreign currency loans from the Asian Development Bank (ADB) amounting to US $ 1.36 billion and from the World Bank amounting to US $ 1.67 billion. These foreign debts were substituted with domestic debt amounting to Rs.13,000 crore by issuing securities on private placement basis to RBI. These external loans were repaid on February 24 and 27, 2003. The above transactions did not have any fiscal or monetary impact as it was a substitution of external sovereign debt with domestic sovereign debt placed with RBI. Corporate bodies have also taken advantage of low international interest rates in prepaying a part of their external commercial borrowings (ECBs). A study by RBI has estimated that during April-December 2002, corporates have prepaid ECBs amounting to US $ 595 million. The total prepayment of ECBs during the last three years by corporates amounted to US $ 1.1 billion and the saving in the interest burden on account of the prepayment was about US $ 90 million.

36. The broad principles that have guided India after the Asian crisis of 1997 are:

· Careful monitoring and management of exchange rates without a fixed target or a pre-announced target or a band. Flexibility in the exchange rate together with ability to intervene, if and when necessary.

· A policy to build a higher level of foreign exchange reserves which takes into account not only anticipated current account deficit but also ‘liquidity at risk’ arising from unanticipated capital movements.

· A judicious policy for management of the capital account.

37. Considerable flexibility has been given to the corporates over a period to hedge their forex exposure in the market. It is, however, observed that a noticeable portion of the corporate foreign currency commitments remain unhedged by the corporates on the basis of their perceptions of the market and these could impact their overall financial status in case of unexpected developments. In earlier policy Statements, RBI has urged banks which have large exposure to such corporates to put in place a system for monitoring such unhedged external liabilities.

38. A related issue that has been raised recently in the media and through expert comments by market participants relates to the movement of forward market premia. The premia have shown considerable downward movement in recent weeks. Thus, as of April 25, 2003, the 6-month forward premia on US dollar was only 2.1 per cent (annualised rate) as compared with 5.9 per cent a year ago and 3.4 per cent at the beginning of January 2003. The sharp downward movement in forward premia has occurred because, at present, there seems to be a rush to sell dollars in the forward market by exporters and other entities in anticipation of further appreciation of the rupee vis-à-vis US dollar. In response to this expectation, there is also a rush to “borrow” dollars (for repayments later) and convert these into rupees now. If the rupee does appreciate, the borrowers of dollars expect to make a financial gain (as fewer rupees would be required to repay the “borrowed” dollars). This phenomenon is also reflected in banks going “short” on dollars during intra-day and inter-day foreign currency trades.

39. While the demand for “borrowing” dollars for repayments later is strong, for the same reason, the demand by corporates and others for “purchasing” dollars in exchange for rupees in the spot and forward markets has become weaker. This has resulted in corporates and other market participants having larger “unhedged” exposures on their future dollar obligations. It has also led to some postponement of forward demand for dollars. These two phenomena, i.e. higher incentive to sell or “borrow” dollars and lower demand for actual purchase of spot or forward dollars have, inter alia, in combination put pressure on the forward premia.

40. The Reserve Bank has received various suggestions from banks and other market participants to meet the demand for “borrowed” dollars, arising from expectations of continued rupee appreciation. It has been suggested that banks should be permitted a higher level of foreign borrowings (over and above the present limit of 25 per cent of unimpaired Tier I capital), and/or higher inflows of foreign currency deposits should be encouraged (by increasing, for example, the ceiling interest rate on FCNR deposits which is, at present, 0.25 percentage point below LIBOR).

41. While RBI will continue to operate in the spot and forward markets as per its foreign exchange management policies, RBI is not in favour of increasing the unhedged borrowings by corporates, and short term forex liabilities of banks in order to meet the demand for “borrowed” dollars that is arising from expectations regarding future movements in dollar-rupee exchange rate. To put at rest market speculations about RBI’s stance in this regard, it is clarified that:

· At present, there is in fact an excess supply of US dollars in both the spot and forward markets to meet all genuine transactions and investment demand by corporates, banks and others. There is no shortage of foreign currency availability in the market.

· One-way expectations of exchange rate or premia may not always be fulfilled. Present unhedged exposures seem to be on account of expectations on unconstrained appreciation of rupee. Movements in respect of exchange rates may not, however, be unidirectional. This can be seen from the movement of the Euro against the US dollar from 0.9606 to 1.1087 between September 17, 2002 and March 11, 2003, from 1.1087 to 1.0501 between March 11 and March 21, 2003 and from 1.0501 to 1.0997 between March 21 and April 25, 2003. Similar movements have also been observed in the case of pound sterling/US dollar rate.

· For these reasons, it is of utmost importance, particularly in relatively thin developing country markets, that foreign currency exposures by corporates and others are largely hedged or covered against anticipated foreign currency earnings. It may be recalled that a part of the problem that many emerging economies have faced in the past has been due to excessive unhedged foreign currency exposures in a country during periods when movement in exchange rate was absent (due to fixed exchange rate policy) or currency was appreciating.

42. The Reserve Bank has been encouraging banks to improve the export credit delivery system in order to provide timely and adequate credit to the export sector. Following the survey on exporters’ satisfaction conducted with the help of National Council of Applied Economic Research (NCAER), a small committee was constituted with officers from RBI, banks and Export Credit Guarantee Corporation of India Ltd. The Committee has so far visited 10 centres in the country from where large scale exports are taking place and had discussions with bankers to sensitise the need for bringing about improvements in the export credit delivery system. Reports received from banks reveal that the suggestions made by NCAER have been largely complied with. Exports being an important sector of the economy, banks should continue to pursue customer-friendly export credit delivery system.

43. The performance of India’s exports during 2002-03 has been encouraging despite the continued global slowdown. Exports in US dollar terms increased by 16.7 per cent during 2002-03 (April-February) as against a decline of 0.7 per cent in the corresponding period of the previous year. Imports showed an increase of 16.3 per cent as compared with a marginal increase of 0.8 per cent in the corresponding period of the previous year. While oil imports registered a significant increase of 26.5 per cent on account of steep increase in the international oil prices as against a decline of 13.0 per cent in the previous year, non-oil imports showed an increase of 12.5 per cent as compared with an increase of 7.3 per cent in the corresponding period of the previous year.

44. At a further disaggregated level, non-oil imports excluding gold and silver increased by 17.6 per cent during 2002-03 (April-December) as compared with a lower increase of 6.0 per cent in the corresponding period of the previous year reflecting improved industrial outlook. As a result of higher imports, the trade deficit widened to US $ 7.8 billion during 2002-03 (April-February) from US $ 6.8 billion in the corresponding period of the previous year despite acceleration in exports. However, higher services exports, such as software and buoyant inward remittances during 2002-03 (April-December), resulted in the current account of the balance of payments showing a surplus of US $ 2.8 billion as against a deficit of US $ 0.7 billion in the corresponding period of the previous year. Going by current indications, India would be showing a current account surplus during 2002-03 for the second year in succession.

45. With a view to liberalising further the movement of cross-border capital flows, especially in the areas of outward foreign direct investment, inward direct and portfolio investment, non-resident deposits and external commercial borrowing, RBI inter alia, announced several important measures relating to current and capital accounts.

46. Pursuant to the announcement made in the Budget 2003-04 and moving further towards liberalisation of capital account, RBI has also implemented the following measures:

· Prepayment of ECBs under automatic route out of local resources/ market purchases allowed without any limit.

· Indian companies with a proven track record permitted to make overseas investment in a foreign entity engaged in any bonafide business activity, up to 100 per cent of their networth, within the overall ceiling of US $ 100 million, by way of market purchases.

47. In recent years, the Reserve Bank has been undertaking extensive consultations with banks, market participants and experts before deciding on major policy issues relating to the financial sector. In addition to periodic discussions, several Working Groups were set up to consider proposed new measures that were likely to have wide impact on the financial sector, especially the banking sector and also for examining various policy issues. Where necessary, the reports of the Working Groups were also put on the RBI website for wider dissemination and for inviting comments.

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