Part I. Annual Statement on Monetary Policy for the Year 2006-07
I. Review of Macroeconomic and Monetary Developments during 2005-06
Developments in the External Sector
36. Balance of payments (BoP) data released at end-March 2006 indicate that merchandise exports recorded a growth of 27.7 per cent in US dollar terms during the first nine months of 2005-06 as compared with 25.4 per cent a year ago. Manufacturing exports provided the leading edge with transport equipment, machinery and parts, iron and steel, gems and jewellery, chemicals and petroleum products emerging as the key drivers of export growth. Merchandise import growth was 36.9 per cent as against 44.5 per cent during the corresponding period a year ago. Oil import payments rose by 47.1 per cent, mainly reflecting the elevated levels of international crude oil prices since volume growth was barely 0.8 per cent. Non-oil imports expanded by 33.0 per cent, led by export-related items and capital goods which mirrored the growth in domestic industrial activity. Consequently, the trade deficit widened to US $ 41.5 billion during April-December 2005 as compared with US $ 26.5 billion a year ago.
37. Information available for subsequent months from the Directorate General of Commercial Intelligence and Statistics (DGCI&S) indicates that, in US dollar terms, merchandise exports increased by 24.7 per cent during 2005-06 as compared with 26.4 per cent in the previous year. Imports showed an increase of 31.5 per cent as compared with 36.4 per cent in the previous year. While the increase in oil imports was higher at 46.8 per cent as compared with 45.2 per cent in the previous year, non-oil imports showed an increase of 25.6 per cent as compared with 33.3 per cent in the previous year. At a further disaggregated level, imports of gold and silver increased by 15.7 per cent during April-December 2005 on top of a high increase of 46.9 per cent in the corresponding period of the previous year. Non-oil imports excluding gold and silver increased by 35.5 per cent as against 32.7 per cent in April-December 2005. During 2005-06, the trade deficit widened to US $ 39.6 billion which was 52.7 per cent higher than the deficit of US $ 26.0 billion in the corresponding period of the previous year. The trade to GDP ratio, which was 14.1 per cent in 1991-92 increased to
30.2 per cent in 2005-06, indicating increasing openness.
38. Regional co-operation in Asia has strengthened over the years and this is reflected in increasing trade volumes within the region. The share of exports to developing Asia in India’s total exports increased from 14.4 per cent in 1990-91 to 29.8 per cent in 2005-06 (April-December). The corresponding share in India’s imports also increased from 14.0 per cent to 20.8 per cent during this period. In recent years, China has emerged as a major trading partner, accounting for 6.0 per cent of total exports and 7.4 per cent of total imports in 2005-06 (April-December) as compared with 1.9 per cent and 3.0 per cent, respectively, in 2000-01. In recognition of the growing importance of Asian countries in India’s foreign trade, the series on nominal and real effective exchange rate indices (1993-94=100) released by the Reserve Bank in December 2005 has added Chinese Renminbi and Hong Kong Dollar in the weighting diagram.
39. Invisible receipts rose by 28.1 per cent in April-December 2005 mainly led by earnings from transportation, software exports and other professional and business services as well as remittances from overseas Indians. Private transfers, comprising primarily remittances from Indians working overseas, remained sizeable at US $ 17.4 billion as compared with US $ 14.3 billion in April-December 2004. Invisibles payments increased by 22.1 per cent mainly on account of IMD interest payments and payments for transportation services on account of the increase in trade volume and the rise in freight rates. As a result, the current account deficit was placed at US $ 13.5 billion in April-December 2005 as against US $ 5.9 billion in April-December 2004.
40. Net capital inflows at US $ 14.7 billion during April-December 2005 comprised portfolio investment (US $ 8.2 billion), direct investment (US $ 4.7 billion), NRI deposits (US $ 1.1 billion) and short-term credit (US $ 1.7 billion) while external commercial borrowings registered net outflows (US $ 1.5 billion) due to IMD redemption. There was a one-off principal repayment of IMD (US$ 5.5 billion) in the capital account and interest payments (US$ 1.6 billion) under the current account. Excluding the IMD redemption, external commercial borrowings would show an inflow of US $ 4.0 billion as compared with US $ 2.9 billion a year ago and net capital inflow would work out to US $ 20.2 billion. The net accretion to foreign exchange reserves excluding valuation changes amounted to US $ 1.8 billion during April-December 2005. Taking into account the valuation loss of US $ 6.1 billion due to depreciation of major currencies against the US dollar, foreign exchange reserves recorded a decline of US $ 4.3 billion during April-December 2005. In subsequent months, however, India’s foreign exchange reserves increased by US $ 10.1 billion from US $ 141.5 billion at end-March 2005 to US $ 151.6 billion by end-March 2006. As on April 7, 2006 the foreign exchange reserves stood at US $ 154.2 billion.
41. India’s external debt declined by US $ 4.0 billion from end-March 2005 to US $ 119.2 billion at end-December 2005. The reduction was essentially brought about by redemption of IMD in December 2005. The ratio of short-term debt to total debt increased marginally from 6.1 per cent at end-March 2005 to 7.5 per cent at end-December 2005.
42. The foreign exchange market remained orderly in 2005-06 with the exchange rate exhibiting two-way movements. The rupee appreciated by 0.6 per cent against the US dollar from Rs.43.75 per US dollar to Rs.43.49 per US dollar during April-July, 2005 but depreciated by 4.2 per cent against the US dollar from Rs.43.99 per US dollar at end-September 2005 to Rs.45.94 per US dollar at end-November 2005. Subsequently, the rupee recorded an appreciation on the back of strong portfolio inflows and the US dollar’s weakness against other major currencies in the international markets. Between end-November 2005 and end-February 2006, the rupee appreciated by 3.4 per cent against the US dollar. During 2005-06, the rupee depreciated by 1.9 per cent against the US dollar but appreciated by 4.4 per cent against the euro, by 5.5 per cent against the pound sterling and by 7.5 per cent against Japanese yen. During 2006-07 so far (up to April 13, 2006), the rupee depreciated by 1.5 per cent against the US dollar, 1.24 per cent against the euro, 2.1 per cent against the pound sterling and 0.68 per cent against the Japanese yen.
43. The exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene if and when necessary. The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the ‘liquidity risks’ associated with different types of flows and other requirements.
44. India’s approach to financial integration has so far been gradual and cautious. Although capital inflows have been associated with high growth rates in some developing countries, a number of them have also experienced periodic slumps in economic growth and financial crises with substantial macroeconomic and social costs. The cross-country experience suggests that while trade integration is generally beneficial, there exists a threshold in an economy’s resilience in the context of an open capital account. At a more practical policy level, financial integration may be conducive to growth, without its attendant risks and vulnerabilities, when combined with good macroeconomic policies and good quality of domestic governance. Thus, the ability of a developing country to derive benefits from financial globalisation in the presence of volatility in international capital flows can be significantly improved by the quality of its macroeconomic framework and institutions. While a gradual approach to liberalisation of capital account in India has paid dividends so far, continuation of the gradual process may warrant that some hard and basic decisions are taken in regard to macro-economic management, in particular monetary, external and financial sector management.
45. The Reserve Bank of India, in consultation with the Government of India, has appointed on March 20, 2006 a Committee to set out a Roadmap towards Fuller Capital Account Convertibility (Chairman: Shri S.S. Tarapore). The terms of reference of the Committee will be: to review the experience of various measures of capital account liberalisation in India; to examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system; to study the implications of dollarisation in India of domestic assets and liabilities and internationalisation of the Indian rupee; to provide a comprehensive medium-term operational framework with sequencing and timing for fuller capital account convertibility, taking into account the above implications and progress in revenue and fiscal deficit of both Centre and States; to survey the regulatory framework in countries which have advanced towards fuller capital account convertibility; suggest appropriate measures and prudential safeguards to ensure monetary and financial stability; and to make such other recommendations as the Committee may deem relevant to the subject. The Committee will commence its work from May 1, 2006 and is expected to submit its report by July 31, 2006.
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