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Mid-term Review of Macroeconomic and Monetary Developments in 2002-03

External Developments

27. At the time of the annual policy Statement in April 2002, the prospects for recovery in the world economy, after the September 11 events, had improved. The recovery process, however, now appears to be somewhat slower than that anticipated earlier. The International Monetary Fund (IMF) has also noted some emerging issues that would affect the investment climate adversely. These include: the risk averse behaviour of financial institutions in the current uncertain economic climate; a sharp slowdown of investment into the US; and some signs of contagion from South America to other emerging markets. However, in terms of relative performance, India and China are anticipated to perform better than the global trend.

28. The Indian forex market generally witnessed orderly conditions during the current financial year (April–October 2002) with the Indian rupee exhibiting an appreciating trend against the US dollar on account of moderate demand coupled with a comfortable supply position resulting in large accretion to reserves. Foreign exchange reserves increased by US $ 9.9 billion from US $ 54.1 billion in end-March 2002 to US $ 64.0 billion by October 25, 2002.

29. In recent years, the annual monetary 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, while 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 satisfactory. 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.

30. India’s foreign exchange reserves have increased sharply from US $ 45.2 billion as on October 26, 2001 to US $ 64.0 billion by October 25, 2002, an increase of US $ 18.8 billion. 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 comfortable and consistent with the rate of growth, the share of the external sector in the economy and the size of risk-adjusted capital flows.

31. As a signatory to the Special Data Dissemination Standards (SDDS) of the IMF, the Reserve Bank is making available relevant information on the foreign exchange market and on RBI’s operations in the foreign exchange market as per internationally accepted standards. The data template provides information on international reserves with break-up into various categories (e.g., securities, deposits with central banks and commercial banks etc.) and foreign currency liquidity in respect of countries which have subscribed to SDDS. These data are disseminated at monthly intervals with a lag of one month and are available on the RBI website. The latest such data available are as on August 31, 2002.

32. 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) adding to the comfort of the market participants by demonstrating the backing of domestic currency by external assets. Sharp exchange rate movements can be highly disequilibrating and costly for the economy during periods of uncertainty or adverse expectations, whether real or imaginary. 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.

33. 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.

34. 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 deficits but also ‘liquidity at risk’ arising from unanticipated capital movements;

A judicious policy for management of capital account.

35. In view of the Medium Term Export Strategy (MTES) announced in January 2002 and in order to further liberalise the movement of cross-border capital flows, especially in the area of outward foreign direct investment, inward direct and portfolio investment, non-resident deposits and external commercial borrowings, RBI, inter alia, announced the following important measures relating to current and capital account during the current financial year:

Considerable liberalisation of release of foreign exchange for individual residents, with minimum documentation requirements, for most purposes including travel, education, medical expenses and other current account transactions.

Non-Resident Indians/Persons of Indian Origin (NRIs/PIOs) have been permitted to repatriate assets in India acquired by way of inheritance/legacy, in addition to other facilities. Full repatriation of current income like rent, dividend, pension and interests of NRIs, even without holding a Non-Resident Ordinary (NRO) account in India is also permitted.

Status Holder Exporters may credit upto 100 per cent of their eligible receipts of foreign exchange to their Exchange Earners Foreign Currency (EEFC) account.

Corporates are permitted to prepay External Commercial Borrowings (ECBs) upto US $ 100 million without permission from RBI upto end-March 2003. No prior permission of RBI is required for prepayment of ECBs out of balances held in EEFC accounts or foreign exchange inflow for fresh equity for amounts exceeding US $ 100 million.

Remittances towards premium for general insurance policies taken by units located in Special Economic Zones (SEZs) from insurers outside India are permitted.

Insurance companies registered with Insurance Regulatory and Development Authority (IRDA) are allowed issuance of general insurance policies denominated in foreign currency.

36. Export performance during the current year has been encouraging so far. India’s exports during the first five months of the current financial year at about US $ 19.8 billion, increased by 13.4 per cent over the corresponding period of the previous year. During the same period, imports increased by only 1.7 per cent as against an increase of 3.8 per cent in the corresponding period of last year. As a result, the trade deficit narrowed to US $ 2.7 billion from US $ 4.6 billion in the same period last year. Oil imports increased by 5.3 per cent in US dollar terms as compared with a decline of 5.4 per cent in the corresponding period of the previous year. Non-oil imports increased by 0.3 per cent as against an increase of 8.3 per cent in the corresponding period of the previous year. While the surplus on the non-oil account widened from US $ 1.1 billion to US $ 3.2 billion, the deficit on oil account increased marginally from US $ 5.8 billion to US $ 5.9 billion during April-August 2002. The current account deficit which averaged 1.0 per cent of GDP over the past ten years, recorded a modest surplus in 2001-02. On present reckoning, it is expected that the current account deficit for the year 2002-03 would be below 1.0 per cent of GDP and no significant pressures on balance of payments are expected on this account.

37. The annual policy Statement of April 2002 highlighted the use of the euro as an intervention currency in addition to the US dollar. The Reserve Bank has started making available on its website the reference rate for the euro in addition to the US dollar with effect from January 1, 2002. The euro zone is India’s second largest trading partner, and it is desirable that more and more of our trade to the euro area is also invoiced in the euro.

38. Sustained efforts towards accelerating the growth of exports become imperative for long-term viability of the balance of payments as well as for increasing income and employment opportunities. The recent experience suggests subtle shifts in international comparative advantage with software, business and commercial services exceeding the performance of merchandise exports, and even providing support in phases of contraction in external demand. The Medium Term Export Strategy has set out a road map that is co-terminus with the Tenth Five-Year Plan period. It aims at raising India’s share in world trade to 1.0 per cent by 2006-07 from the present level of 0.67 per cent. This entails doubling of exports from their present level.

39. The Reserve Bank has been making concerted efforts to encourage banks to improve the export credit delivery system. In this context, the annual policy Statement of April 2002 had mentioned a survey on exporters’ satisfaction conducted with the help of the National Council of Applied Economic Research (NCAER). While the survey results indicated a high level of satisfaction by exporters, certain suggestions were made for further improving credit delivery to exporters. The report was forwarded to all banks and was also placed on the RBI website. Banks have to be sensitised about the need for bringing improvements in the credit delivery system as suggested by NCAER. Consequently, a small committee consisting of officers from banks, RBI and the Export Credit Guarantee Corporation of India Ltd. visited 5 centres that account for a large volume of exports and had discussions with bankers. On the basis of the ‘Action Taken Report’ submitted by bankers, it is observed that the banks have complied with most of the suggestions made by NCAER. Banks should continue with their efforts to make the export credit delivery system customer-friendly and efficient at the branch level, particularly, in areas with concentration of small and medium sized exporters.

40. Procedures for financial transactions such as remittances, investments and maintenance of bank account etc., for non-residents have been simplified considerably in the recent past. The policy framework governing inward Foreign Direct Investment (FDI) was substantially liberalised under the automatic route. FDI upto 100 per cent was permitted under the automatic route for manufacture of glass and pharmaceuticals, in the hotel and tourism sector and for mass rapid transport systems in all metropolitan cities. FDI upto 49 per cent from all sources was permitted in private sector banks under the automatic route. Continuing with the policy of progressive liberalisation of the capital account, NRI deposit schemes were also rationalised and are now fully convertible [with the exception of Non-Resident Ordinary (NRO) accounts].

41. The existing limit for Indian direct investment outside India under the automatic route was raised to US $ 100 million. Two-way fungibility of American Depository Receipts (ADRs)/Global Depository Receipts (GDRs) has became operational. Foreign Currency Convertible Bonds (FCCB) upto US $ 50 million were brought under the automatic route. In order to facilitate the external commercial borrowings of corporates, the Reserve Bank allowed corporates, on a case by case basis, to credit even higher proportions of export proceeds to their EEFC accounts so that they can take advantage of lower interest rates and prepay their ECBs. It is, however, observed that sometimes a noticeable portion of the corporate foreign currency commitments tend to remain unhedged by the corporates on the basis of their perceptions of the market and these could severely impact the overall financial status of the corporates in case conditions change. In this context, the mid-term Review of October 2001 had emphasised the need for banks to monitor large exposures to such corporates against unhedged exposures.

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