Abstract
This paper discusses the intermediation of financial saving in India and the implications for growth. Recent studies linking financial sector development and growth in India are reviewed. The following statistical data are also provided: employment and labor statistics, agricultural production and yields, index of industrial production, saving and investment, price developments, balance of payments, official reserves, reserve money, monetary survey, central and state government operations, indicators of financial system soundness, financial performance of Indian commercial banks, and selected monetary and exchange rate indicators.
II. India’s Global Integration and The Role of the IT Sector1
A. Introduction
1. In the early 1990s, despite being a relatively closed economy, India suffered a balance of payments crisis (Table II.1).2 At that time, India’s trade openness (imports and exports as a share of GDP) was comparatively low, tariff rates were high, and nontariff barriers (including licensing, quantitative import restrictions, “canalization” of imports,3 and controls on exports) were extensive. Private capital movements (both inflows and outflows) were tightly regulated, with portfolio investment not permitted. Foreign direct investment (FDI) was limited, and capital inflows during the 1980s primarily consisted of aid flows, concessional lending, external commercial borrowing, and nonresident Indian (NRI) deposits. On the domestic side, licensing and controls in industry and agriculture were pervasive, most labor-management relations were covered by government regulations, and many sectors were reserved for the state or if, “nonessential,” for small-scale industries.
Pre-and Post-Reform India 1/
(percent of GDP, unless indicated otherwise)
For 1991 Crisis, 1990/91, except for GDP and inflation, which are 1991/92.
Imports and exports of goods and services as percent of GDP.
From Lane and Milesi-ferretti (1999). Latest available data is for 1997.
End of period.
Residual-maturity basis, including estimated repayment of $5.5 billion for the Resurgent India Bond in August 2003.
Pre-and Post-Reform India 1/
(percent of GDP, unless indicated otherwise)
| 1991 Crisis | 2002/03 | ||
|---|---|---|---|
| Average (unweighted) tariff rate (percent) | 128 | 29 | |
| Trade openness 2/ | 17.2 | 30.5 | |
| Financial integration 3/ | 0.2 | 5.2 | |
| FDI and portfolio investment | 0.0 | 1.0 | |
| Current account balance | -3.1 | 0.8 | |
| Foreign Reserves (US$ billions, excluding gold) 4/ | 2.3 | 71.9 | |
| (in months of imports of goods and services) | 1.1 | 9.1 | |
| External debt 4/ | 26.5 | 19.8 | |
| Short-term external debt 4/5/ | 4.6 | 3.0 | |
| (in percent of reserves, excluding gold) | 630.1 | 21.6 | |
| Real GDP (at factor cost, percent change) | 1.3 | 4.4 | |
| Per-capita real GDP (at factor cost, percent change) | -0.7 | 2.6 | |
| WPI Inflation | 13.7 | 3.5 | |
For 1991 Crisis, 1990/91, except for GDP and inflation, which are 1991/92.
Imports and exports of goods and services as percent of GDP.
From Lane and Milesi-ferretti (1999). Latest available data is for 1997.
End of period.
Residual-maturity basis, including estimated repayment of $5.5 billion for the Resurgent India Bond in August 2003.
Pre-and Post-Reform India 1/
(percent of GDP, unless indicated otherwise)
| 1991 Crisis | 2002/03 | ||
|---|---|---|---|
| Average (unweighted) tariff rate (percent) | 128 | 29 | |
| Trade openness 2/ | 17.2 | 30.5 | |
| Financial integration 3/ | 0.2 | 5.2 | |
| FDI and portfolio investment | 0.0 | 1.0 | |
| Current account balance | -3.1 | 0.8 | |
| Foreign Reserves (US$ billions, excluding gold) 4/ | 2.3 | 71.9 | |
| (in months of imports of goods and services) | 1.1 | 9.1 | |
| External debt 4/ | 26.5 | 19.8 | |
| Short-term external debt 4/5/ | 4.6 | 3.0 | |
| (in percent of reserves, excluding gold) | 630.1 | 21.6 | |
| Real GDP (at factor cost, percent change) | 1.3 | 4.4 | |
| Per-capita real GDP (at factor cost, percent change) | -0.7 | 2.6 | |
| WPI Inflation | 13.7 | 3.5 | |
For 1991 Crisis, 1990/91, except for GDP and inflation, which are 1991/92.
Imports and exports of goods and services as percent of GDP.
From Lane and Milesi-ferretti (1999). Latest available data is for 1997.
End of period.
Residual-maturity basis, including estimated repayment of $5.5 billion for the Resurgent India Bond in August 2003.
2. In response to the crisis, India embarked on an ambitious reform program, which included substantial liberalization of external transactions.4 The exchange rate was unified in 1993, and current account convertibility was achieved with India’s acceptance of Article VIII of the Articles of Agreement of the International Monetary Fund in 1994. On trade, India lowered tariff rates, reduced licensing requirements and canalization, removed most export restrictions, and eliminated quantitative import restrictions (based on balance of payments grounds). The capital account was also gradually liberalized, with a focus on encouraging foreign equity investment while reducing the reliance on short-term and debt-creating flows. In particular, portfolio investments were permitted through approved institutional investors and by NRIs, FDI policies were liberalized, and restrictions on capital outflows—mainly those associated with inflows (for example, from exporters or NRIs) or involving Indian banks or corporates (subject to prudential guidelines)—were reduced. External commercial borrowing remains restricted, but longer-term borrowing was gradually liberalized. Domestic structural reforms—including delicensing and deregulation of the industrial sector, liberalization of private investment, tax reforms, and financial sector reforms—also improved the efficiency of the Indian economy and aided in global integration.
3. With these reforms, India’s trade openness and financial integration increased, while external vulnerabilities diminished (see Table II.1). Both exports and imports surged during the decade following the crisis. Foreign direct and portfolio investments increased by roughly thirty fold as a share of GDP. At the same time, external debt—particularly short-term debt—decreased, while foreign reserves increased substantially.
4. This chapter examines India’s progress with global integration, including in comparison to other Asian economies. One unique aspect of the progress has been the importance of services trade, particularly software and IT-enabled services, in increasing India’s integration. The next section takes stock of where India stands in this process, including relative to other Asian countries. Section C discusses the importance of the IT sector in India’s globalization and also briefly describes the reasons behind the success of India’s IT-related services sector. Section D assesses some of the future implications of India’s integration. Increased global integration could be expected to have a number of economic effects, including on employment growth, poverty, inequality, and interstate disparities. We have chosen, however, to restrict the analysis in this paper to the broad macroeconomic impact from changes in the external accounts and the exchange rate. Section E provides some concluding remarks.
B. Progress with Global Integration
5. After stagnating during the 1980s, India’s trade openness doubled from under 15 percent of GDP in the late 1980s to about 30 percent of GDP in 2002. The increase coincided with substantial trade liberalization. In particular, the average (unweighted) tariff rate fell from 128 percent at the beginning of the decade to under 30 percent in recent years, and nontariff barriers were reduced. While liberalization encouraged rapid growth in imports (averaging about 10 percent per annum in dollar terms during 1991–2002), the impact on the goods and services trade balance was offset by even faster export growth (10¾ percent per annum).
6. Nonetheless, India remains less open to trade than other Asian economies. India’s trade share of GDP is lower than that of China, other South Asian countries (the simple average of Bangladesh, Nepal, Pakistan, and Sri Lanka), the newly industrialized economies (Hong Kong SAR, Korea, Singapore, and Taiwan POC), and the ASEAN-4 countries (Indonesia, Malaysia, the Philippines, and Thailand) (Figure II.1).
Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.
Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.Trade Openness
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: WEO.7. While this partly reflects the size of the Indian economy,5 it also is attributable to India’s more restrictive trade regime. Although trade-weighted average import duty rates (as percent of goods imports) have declined in India, they remain higher than in other Asian economies (Figure II.2). Nontariff barriers are also substantial, and in some cases, have increased during the past decade. In particular, India has become one of the most active users of anti-dumping measures—second only to the United States in initiations in recent years6. Overall, India’s index of trade restrictiveness measured 8 in 2001 (on a scale of 1 to 10) compared to an average of 4.4 for Asian countries, suggesting that India has the potential to gain substantially more from further trade liberalization.
Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.
Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.Import Duties
(In percent of goods imports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: Government Finance Statistics; and WEO.8. Financial integration (or openness) also increased substantially during the 1990s, but remains less than in other Asian economies. Using a similar principle to trade openness—but applied to asset markets—financial integration is defined as the sum of external assets and liabilities of FDI and portfolio investment as a share of GDP (see Lane and Milesi-Ferretti, 1999). Financial integration in India declined secularly during 1970–1990, reaching a nadir in 1991, before rising afterwards (Figure II.3). As with trade, however, India remains less integrated than other Asian economies, partly due to a more restrictive regime on foreign equity ownership (Figure II.4).7
Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).
Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).Financial Integration
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Lane and Milesi-Ferretti (1999).
Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).
Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).Foreign Ownership Restrictions
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Source: Edison and Warnock (2003).9. With increasing trade and financial openness, the Indian economy has become more synchronized with global trading partners. In the late 1980s, Indian GDP growth was negatively correlated with GDP growth of trading partners (Figure II.5). By the 1990s, the correlation had turned positive and has remained generally above 0.5. Notably, Indian growth has been more correlated with trading partners than Chinese or other South Asian growth.8 The correlation of India’s financial markets (stock and interest rates) with global markets also increased in recent years (Figure II.6). In particular, the IT stock indices have been highly correlated.
10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.
10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.10-Year Lagged Growth Correlations with Trading Partners
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.
India: 10-Month Correlation with the U.S. Financial Markets
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
India: 10-Month Correlation with the U.S. Financial Markets
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
India: 10-Month Correlation with the U.S. Financial Markets
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
C. The Importance and Reasons for Success of the IT Sector
A unique aspect of India’s global integration has been the important role played by services exports (Figure II.7). During 1991–2002, services exports surged by 15 percent a year (in dollar terms) on average, compared to goods export growth of 9¼ percent on average. Indeed, while goods exports gained some market share during the 1990s (from 0.5 percent to 0.8 percent of world goods exports), the market share of India’s services exports almost tripled to 1.5 percent of world services exports. By contrast, in the rest of Asia, the market share of goods exports is higher than that of services exports, and market share gains in services were at the same rate or slower than market share gains in goods.
Selected Countries’ Share of World Exports
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Selected Countries’ Share of World Exports
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Selected Countries’ Share of World Exports
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
10. The strength in services exports is attributable largely to IT-related exports, which have surged at about a 45 percent annual growth rate from $0.5 billion in 1994/95 to $9.5 billion in 2002/03, based on preliminary estimates by National Association of Software and Services Companies (NASSCOM) (Figure II.8). Excluding IT services, services exports only grew slightly faster than goods exports during the past decade, and the growth in IT-related services exports accounts for roughly a ½ percentage point of India’s market share gain in total world services trade.
Composition of lndia’s Exports
(In percent of goods and services exports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: NASSCOM and Reserve Bank of India.Composition of lndia’s Exports
(In percent of goods and services exports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: NASSCOM and Reserve Bank of India.Composition of lndia’s Exports
(In percent of goods and services exports)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: NASSCOM and Reserve Bank of India.11. Booming IT-related exports have helped strengthen India’s balance of payments. In 2001/02, India achieved a current account surplus of $1.4 billion (or 0.3 percent of GDP)—its first surplus in 24 years—and the surplus is expected to have grown in 2002/03, despite higher oil prices and non-oil imports. IT-related services exports accounted for about 12 percent of goods and services exports in 2001/02 or more than five times the current account surplus. Moreover, the increase in inward remittances (a component of private transfers) and bank deposits from nonresident Indians and the shift in the sources of these flows from the Middle East to the United States and Europe may reflect the repatriation of savings by overseas Indian IT professionals. Multinational corporations, such as GE Capital, American Express, and Citigroup, have also made significant investments in IT-related services in India.
12. India’s success in the IT-related services field is attributable to a combination of factors.9 These include its large pool of English-speaking university graduates, relatively low wages, a well-placed international diaspora, favorable government policies, and low start-up costs for software firms.
India’s more than 250 universities and engineering colleges graduated over 90,000 IT professionals in 2001/02, and this number is expected to increase to 115,000 by 2004/05, according to NASSCOM. In addition, over 2 million other students—many of whom are fluent in English—graduate from universities and colleges annually, and many of these English-speaking graduates are also employed in a number of IT-related services fields, such as call centers, back office processing, and consultancy services.
Salaries in India are about one-tenth to one-half of those found in the United States. A NASSCOM-McKinsey study estimates that customers of Indian IT companies save from 1 percent to 15 percent of noninterest expenses by outsourcing work to India.10
There are over 20 million Indians living overseas, including about 2½ million in North America and over 1 million in the United Kingdom. A significant number of these overseas residents (including both NRIs and persons of Indian origin) are IT professionals—including, it is estimated, over 200,000 in the United States alone—many of whom are in management positions and some of whom play important roles in outsourcing work to India.
Government policies have benefited the IT industry by minimizing interference in the sector (particularly compared to other industrial and services sectors), providing favorable tax treatment, and emphasizing investments in higher education. In 1998, government and industry began joint initiatives to establish the Indian Institutes of Information Technology (IIITs). The goals of the IIITs are to provide degrees in computer software and engineering as well as teach shorter IT courses. Indian IT firms have also benefited from the establishment of a number of software technology parks that provide infrastructure—particularly reliable communication and power—that are not readily available elsewhere.
13. The structure of India’s IT sector has made it less vulnerable to the global cyclical downturn. Unlike other Asian economies, hardware (including peripherals) accounts for a negligible share of IT exports (about 2 percent in 1999/2000). Moreover, a large share of India’s IT-related services exports are back-office and data processing services or customization of nonmission critical software—areas where low wages bring significant competitive advantages. Indeed, as global firms have cut costs during the recent economic slowdown, more work has been outsourced to Indian companies.
14. However, India’s IT services companies have encountered some challenges in recent months. Rupee profit margins have shrunk due to the weaker dollar11 and lower prices—the latter reflecting increased competition within India from both domestic firms and multinationals, which have been rapidly increasing their presence in India to take advantage of the low wages, and from ongoing pressures from customers to reduce costs. In addition, IT services exports are facing protectionist pressures in some industrial countries, including bills in a number of U.S. state legislatures, which aim to restrict outsourcing of government work to U.S. citizens.
D. The Implications on External Accounts and the Exchange Rate of Ongoing Integration
15. Since September 2001, India has faced upward pressure on the rupee vis-à-vis the U.S. dollar, along with substantial balance of payments inflows. The inflows partly have reflected India’s increasing global integration—including strong export growth in both goods and services (both IT-related and other services), ongoing capital account liberalization, and India’s increasing correlation with global financial markets (particularly, interest rates). In addition, it also reflected downward pressure on the dollar compared to other major currencies (the euro, yen, and sterling) and the widening spread between rupee and dollar interest rates, in particular.
16. The Reserve Bank of India (RBI) has responded to the strong inflows primarily by accumulating reserves and partial sterilization in the domestic money markets (Table II.2). During September 2001–May 2003, foreign reserves increased by $36½ billion.12 The rupee appreciated by 1 ½ percent compared to the dollar during the same period, but it depreciated by 8½ percent in real effective terms largely due the weakness of the dollar. The RBI’s intervention limited volatility in the currency markets and prevented a further appreciation of the dollar against the rupee.
The Recent Reserves Buildup Change Relative to Trend
(In billions of U.S. dollars)
Recent is September 2001-December 2002.
Preceding three-year average.
Includes rupee debt.
The Recent Reserves Buildup Change Relative to Trend
(In billions of U.S. dollars)
| Recent 1/ | Change | Trend 2/ | |||
|---|---|---|---|---|---|
| (1) | (3)=(1)-(2) | (2) | |||
| Foreign reserves increase | 25.6 | 17.1 | 8.4 | ||
| Due to | |||||
| Valuation | 3.1 | 3.8 | -0.8 | ||
| BOP change in reserves | 22.5 | 13.3 | 9.2 | ||
| Current account balance | 5.6 | 9.0 | -3.4 | ||
| Merchandise trade balance | -14.9 | 3.7 | -18.7 | ||
| Services trade balance | 7.2 | 3.0 | 4.1 | ||
| Net investment income | -4.1 | 0.3 | -4.4 | ||
| Net transfers | 17.5 | 1.9 | 15.6 | ||
| Capital account balance | 16.0 | 3.8 | 12.3 | ||
| FDI, net | 3.8 | 1.3 | 2.6 | ||
| Portfolio, net | 1.2 | -1.4 | 2.6 | ||
| External assistance, net | 0.4 | -0.6 | 1.0 | ||
| Commercial borrowing, net | -2.0 | -4.8 | 2.8 | ||
| Short-term credit, net | -0.1 | 0.1 | -0.2 | ||
| NRI deposits, net | 3.7 | 1.0 | 2.7 | ||
| Other capital, net 3/ | 9.0 | 8.2 | 0.8 | ||
| Errors and omissions | 0.9 | 0.4 | 0.5 | ||
Recent is September 2001-December 2002.
Preceding three-year average.
Includes rupee debt.
The Recent Reserves Buildup Change Relative to Trend
(In billions of U.S. dollars)
| Recent 1/ | Change | Trend 2/ | |||
|---|---|---|---|---|---|
| (1) | (3)=(1)-(2) | (2) | |||
| Foreign reserves increase | 25.6 | 17.1 | 8.4 | ||
| Due to | |||||
| Valuation | 3.1 | 3.8 | -0.8 | ||
| BOP change in reserves | 22.5 | 13.3 | 9.2 | ||
| Current account balance | 5.6 | 9.0 | -3.4 | ||
| Merchandise trade balance | -14.9 | 3.7 | -18.7 | ||
| Services trade balance | 7.2 | 3.0 | 4.1 | ||
| Net investment income | -4.1 | 0.3 | -4.4 | ||
| Net transfers | 17.5 | 1.9 | 15.6 | ||
| Capital account balance | 16.0 | 3.8 | 12.3 | ||
| FDI, net | 3.8 | 1.3 | 2.6 | ||
| Portfolio, net | 1.2 | -1.4 | 2.6 | ||
| External assistance, net | 0.4 | -0.6 | 1.0 | ||
| Commercial borrowing, net | -2.0 | -4.8 | 2.8 | ||
| Short-term credit, net | -0.1 | 0.1 | -0.2 | ||
| NRI deposits, net | 3.7 | 1.0 | 2.7 | ||
| Other capital, net 3/ | 9.0 | 8.2 | 0.8 | ||
| Errors and omissions | 0.9 | 0.4 | 0.5 | ||
Recent is September 2001-December 2002.
Preceding three-year average.
Includes rupee debt.
17. With ongoing global integration—particularly the rapid expected growth of IT services exports, substantial balance of payments inflows could continue over the medium term. NASSCOM recently increased its projection for IT services exports to $57 billion by 2008/09 (or roughly an annual growth rate of 35 percent). To put this in context, goods and services exports, excluding IT services, were $57½ billion in 2001/02. If these non-IT services exports were to grow at 10½ percent a year (roughly the growth rate over the last decade), they would amount to almost $115 billion by 2008/09, so that IT-related services would account for about a half of all other exports or one-third of total exports. In addition, further globalization could also encourage increased capital inflows, as India continues to grow faster than the rest of the world, although some of the balance of payments inflows could be offset by higher imports.
18. The rapid growth of services exports has potential implications for the behavior of the equilibrium exchange rate.
First, economists have observed that over the long run, purchasing power parity (PPP) is generally valid for industrial countries, and that deviations from PPP or deviations in real exchange rates are positively correlated with differences in GDP per capita.13 The positive correlation between real exchange rates and per-capita GDP is also evident in cross-country data, including of industrial and developing countries (Figure II.9).14 Balassa (1964) suggested that the correlation reflected differences in the relative price of tradables being consistent with differences in per-capita output, and that with relatively faster growth in per-capita output, the relative productivity of tradables would improve faster than nontradables, leading to higher relative prices of nontradables and real exchange rate appreciation.15
Second, an analysis of the medium-term equilibrium savings and investment balance (S-I norm) for India suggests that a small current account deficit of 1–2 percent of GDP is appropriate and sustainable (Figure II.10).16 The current account balance in India was roughly in this range during the 1990s after the balance of payments crisis early in the decade. However, in recent years, the balance moved into surplus at about the time that IT-related services became a substantial portion of exports. As these current account inflows at least partly reflect higher productivity of tradables, they could accommodate an appreciation in the real exchange rate. In this context, it should be noted that deeper and more far-reaching reductions in tariffs and administrative barriers to trade could act to counter the upward pressure on the equilibrium exchange rate.
Cross-Country Balassa-Samuelson Effect in 1999
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.Cross-Country Balassa-Samuelson Effect in 1999
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.Cross-Country Balassa-Samuelson Effect in 1999
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WEO; and staff estimates.
Current Account Balance
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WHO; NASSCOM; and estimates based on Chinn and Prasad (2000)Current Account Balance
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WHO; NASSCOM; and estimates based on Chinn and Prasad (2000)Current Account Balance
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A002
Sources: WHO; NASSCOM; and estimates based on Chinn and Prasad (2000)19. At the same time, a number of arguments have been made in support of moderating upward pressures on the exchange rate, particularly in the short term, including due to concerns about the competitiveness of exports and maintaining a stimulative macroeconomic environment.
For India, over 20 percent of goods exports and over 70 percent of IT-related services exports are to the United States.17 Moreover, substantial portions of exports to other countries are denominated in U.S. dollars or are to economies where the currency moves closely with the U.S. dollar.
Moreover, in the current setting, the RBI has been attempting to maintain easy monetary conditions, given the slowdown in growth and investment, uncertainty about growth prospects, and limited inflationary pressures.
In addition, studies of currency crises have highlighted the role of an overvalued or appreciating exchange rate-—specifically in real terms—in increasing vulnerability to crisis and of increasing foreign reserves in reducing vulnerability.18 Some observers have also expressed concern about a potential “Dutch disease” type effect over the longer term from increased capital or service receipt inflows that lead to an appreciation of the real exchange rate and a shift of resources from tradable goods.19, 20
These considerations, however, need to be weighed against the potential difficulties of limiting exchange rate appreciation through sterilized intervention. Going forward, the scope for intervention may become technically more difficult because of the declining stock of domestic securities held by the RBI that can be used for open market operations.21 The cost or opportunity cost of limiting exchange rate appreciation through sterilized intervention also could grow over time particularly for a country—such as India—that is growing faster than trading partners due to relatively higher interest rates or expected investment rates of return in the faster-growing country.
E. Concluding Remarks
20. The economic reforms that began in the early 1990s have led to greater openness in India to trade and financial flows, with both trade shares and asset market shares increasing substantially during the past decade. In particular, services exports have grown rapidly, largely owing to IT-related services, where India has a comparative advantage. With increased trade and financial integration, the Indian economy has also become more correlated with those of global partners.
21. However, India remains closed in comparison to other Asian economies. This reflects more restrictive trade and capital account regimes, despite substantially liberalization in recent years. In particular, tariffs remain high and nontariff barriers substantial, while equity investments continue to be partially restricted. Ongoing liberalization of external transactions should prove beneficial to India.
22. Significant balance of payments inflows could continue over the medium term. With India’s comparative advantage in IT-related services, these services are expected to grow rapidly and could amount to roughly one-third of total exports by 2008/09.
23. Increasing globalization and the expected rapid growth of IT-related services have potential implications for the behavior of the equilibrium exchange rate. Relatively faster productivity and per-capita growth, along with India’s comparative advantage in IT services, suggest that the equilibrium exchange rate could appreciate over the longer term, although more far-reaching trade liberalization could counter some of the upward pressure. Exchange rate appreciation may also need to be moderated for other reasons, particularly in the short term, including due to concerns about the competitiveness of exports and maintaining a stimulative macroeconomic environment.
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Prepared by Ranil Salgado. This chapter is based on data that were available on June 15, 2003.
For a discussion of the crisis and subsequent reforms, see, for example, Chopra et al. (1995) and Krueger and Chinoy (2002).
Canalization means that trade is restricted to state agencies.
For details on India’s trade reforms during the 1990s and current trade regime, see Salgado and Hammer (2001), Chauffour (2002), and Reserve Bank of India (2003). For details on India’s capital account liberalization, see Reddy (2000) and Jadhav (2003).
Controlling for other factors, trade in larger economies is typically a lower share of GDP than in smaller economies.
In the year to end-June 2002, India surpassed the United States with 76 initiations, compared to 58 initiations by the United States. At end-June 2002, India had 150 outstanding measures, trailing only the United States with 264 and the European Union with 219.
Foreign ownership restrictions are defined in Edison and Warnock (2003) as one minus the portion of equity market that is available to foreign investors, which is set equal to market capitalization of Standard & Poor’s/International Finance Corporation’s Investable index (IFCI) divided by market capitalization of the Global index (IFCG).
The low correlation for China may reflect its relatively high and stable growth rates compared to partner countries.
For a more extensive discussion of the factors behind the success of Indian IT-related services, see, among others, Arora (2000), Arora and Athreye (2001), and Desai (2002). For a description of the evolution of the Indian IT industry, see Saxenian (2002).
See www.nasscom.org.
In 2002/03, 71 percent of IT-related exports were to North America, and a significant portion of exports to other countries (including in Europe) were also priced in dollars.
The net forward position also increased by $3¼ billion to almost $2½ billion during September 2001–March 2003 (the latest available data).
The real exchange rate is generally defined as the domestic price of a basket of goods relative to the foreign price of that basket or of the relative price of nontradables to tradables.
See De Broeck and Sloek (2001) for definition of the exchange rate gap, a proxy for the real exchange rate.
This is generally known as the Balassa-Samuelson effect. See also Samuelson (1964). Time series studies, however, show mixed support for the Balassa-Samuelson effect. For a review, see Ito et al. (1996).
The figure is based on a restricted version of the equation in Chinn and Prasad (2000), including a constant term to allow for a country-specific fixed effect for India. See Callen and Cashin (2001), including for a summary of factors affecting saving and investment norms.
For goods, the estimate is from the Direction of Trade Statistics for 2002, and for IT services, from NASSCOM for 2002/03.
Among others, see Aziz, Caramazza, and Salgado (2000).
“Dutch disease” is generally used in reference to balance of payments inflows (usually foreign aid or revenues from natural resources) that are spent on nontradables goods and lead to a rise in the price of nontraded goods compared to traded goods, i.e., real exchange rate appreciation. With the real appreciation, resources are shifted to producing nontradables.
Since the real exchange rate in India has actually depreciated during the past 1½ years, this has not occurred in the recent past. Moreover, to the extent that any appreciation occurs due to revenues from services exports, it would mean a shift of resources from tradable goods to tradable services.
There are, of course, a number of ways in which a central bank could continue sterilized intervention, even after fully depleting the stock of domestic securities. These include, among others, issuance of bonds by the central bank, a higher or unremunerated cash reserve requirement, and a shifting of public sector deposits to the central bank.
