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click here to return to main page of Mid-term Review of Annual Policy for the year 2004-05
Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
I. Mid-term Review of Macroeconomic and Monetary Developments in 2004-05
External Developments
39. Managing capital flows is an issue closely related to the level of reserves. The annual policy Statement had listed the important policy responses that could be used to manage large capital inflows. A critical issue in this regard is a view on whether the capital flows are temporary or permanent in nature. The recent episode of large capital flows prompted a debate in the media on the need for exchange rate adjustment. In a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature.
40. India’s exports during April-September 2004 increased by 24.4 per cent in US dollar terms as compared with 8.1 per cent in the corresponding period of the previous year. India’s merchandise export growth surpassed that of most Asian countries during this period. Imports rose faster by 34.3 per cent as against an increase of 21.0 per cent in the corresponding period of last year. Oil imports increased by 57.8 per cent as compared with 6.4 per cent. Non-oil imports increased by 25.8 per cent as against 27.4 per cent. The overall trade deficit widened to US $ 12.7 billion from US $ 7.4 billion in the corresponding period of the previous year. The higher trade deficit this year, in substantial part, reflects the high oil imports bill in the wake of the hardening of international prices and also the growth in import demand emanating from a pick-up in economic activity as reflected in higher capital goods imports.
41. Destination-wise, India’s exports to almost all the major regions/country groups recorded sharp improvement during April-June 2004. Exports to developing countries in Asia increased by about 40 per cent. Among the major partner countries, significant increases in exports were recorded in respect of Belgium, France, the UK, the US, the UAE, China, Hong Kong SAR, South Korea and Singapore.
42. The current account of the BoP had remained in surplus consecutively over the past three years. The first quarter of 2004-05 also posted a current account surplus of US $ 1.9 billion. The trade deficit (on payments basis) of US $ 6.3 billion was more than offset by invisibles, including private transfers, of US $ 8.2 billion. In addition, there was a significant increase of US $ 5.6 billion in net capital inflows comprising mainly foreign direct investment (US $ 1.2 billion), commercial borrowings (US $ 1.2 billion) and short-term credit (US $ 1.6 billion). As a result, the net accretion to foreign exchange reserves, excluding valuation effects, amounted to US $ 7.5 billion during April-June 2004.
43. During the second quarter of 2004-05, however, there are indications that the continuing uptrend in imports may result in the current account being only marginally in surplus assuming continued robust growth of merchandise exports and invisible earnings. Net capital inflows have moderated from the level recorded in the first quarter. While it is difficult to anticipate the behaviour of capital flows in the wake of the global geopolitical uncertainties, the positive sentiment on India should augur well for continued buoyancy, but some moderation should not be ruled out in view of turning of the global interest rate cycle.
44. The distinguishing features of the external sector during 2004-05 could be summed up as follows: First, import growth, both on oil and non-oil accounts, has been higher. While the former is reflective of higher international oil prices, the latter reflects the revival of investment demand as capital goods imports are strong. Second, exports have increased at a stronger pace and could maintain the momentum, given the positive outlook on global trade. Third, the trade deficit, however, may widen essentially on account of higher oil prices. Fourth, invisibles, particularly personal remittances, are expected to maintain the tempo on account of rebound in global growth and expanding activity in oil exporting Middle East countries. Fifth, the current account balance, which has remained in surplus over the last three years, may still show a marginal surplus. Sixth, capital inflows are expected to remain buoyant, albeit with some moderation relative to the previous year. Seventh, there could be a structural shift in capital inflows with more of foreign direct investment and short-term trade credit, the latter reflecting increasing openness and competitiveness of the industrial sector. Eighth, accretion to NRI deposits may slow down responding to alignment of interest rates with international rates. Finally, it is reasonable to expect that accretion to reserves will continue, albeit not at the same pace as last year. Thus, management of liquidity arising out of external flows will continue to be challenging.
45. The annual policy Statements and mid-term Reviews have been continuously expressing concern over the unhedged foreign currency exposures of corporates in view of its implications for financial stability in the event of unforeseen adverse conditions. In the mid-term Review of November 2003, banks were advised to adopt a policy, which explicitly recognises and takes into account risks arising out of foreign currency exposures of their clients. Accordingly, it was advised that all foreign currency loans above US $ 10 million or such lower limits as may be deemed appropriate vis-à-vis the banks’ portfolios of such exposures could be extended by banks on the basis of a well laid out policy of their Boards except in cases of export finance and loans for meeting forex expenditure. A recent study of select banks on the implementation of such prudential norms revealed that though most banks have adopted policies mandated by their Boards, banks often rely on ‘natural hedge’ available with their customers. Further, information on the total exposure of the corporate clients was also not readily available with banks. In view of the systemic risk, banks are encouraged to obtain information from their large borrowers on their unhedged forex exposures, so that the banks, in turn, can assess the risk of their own exposure to such corporates on an on-going basis.
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