FOREIGN RESOURCES INFLOW SINCE 1991

FOREIGN RESOURCES INFLOW SINCE 1991 The period from 1990 to 1992 can be regarded as a watershed in the historical profile of external capital flows to India. Prior to that period, external assistance constituted up to 80 percent of net capital flows. Foreign direct investment (FDI) was repressed by an inward-looking regime guided by a socialistic view of India's economic development. Portfolio investment was virtually nonexistent. In the 1980s, shortfalls began to be experienced, as external financing needs expanded in response to an increase in growth. A modest recourse to international financial markets by Indian corporates—mainly public sector enterprises—in the second half of the 1980s was accompanied by a reliance on high-cost deposits by nonresident Indians. The Iraqi invasion of Kuwait in August 1990 would alter this canvas dramatically.

The war in the Persian Gulf precipitated a combination of shocks into an unprecedented balance of payments crisis. Crude oil import costs surged threefold, even as evacuation of expatriates from the war zone and the loss of key export markets in the Gulf region dealt crippling blows. The almost coincident disintegration of the Soviet Union disrupted a fifth of India's exports and a steady source of strategic imports. To add to the acute situation, the application of prudential norms under the Basel Capital Accord of 1987 led to the restriction of lending by international banks to developing countries, including India. Suddenly there was a collapse of capital flows. Credit ratings were downgraded, and this triggered a flight of nonresident deposits and even a moderation in bilateral and multilateral aid. By July 1991 the foreign exchange reserves had run down to a level of less than a week's imports and, for the first time in its history, India approached the brink of default on external obligations.

Stabilization

The response to the crisis was equally spectacular. An orthodox International Monetary Fund (IMF)–style stabilization program was put in place, supported by IMF funding and exceptional finance from donors. Unconventional measures included the sale/pledge of monetary gold, a two-stage devaluation of 18–19 percent, immunity from taxes for inward remittances from nonresident Indians and their investments in India Development Bonds, issued to beat the subinvestment grade credit ratings. By November 1991 came the turnaround. The crisis passed, and with it went the paradigm that had driven India's previous economic development. As stability returned, structural reforms were put in place, including a measured liberalization of the capital account.

Two compulsions weighed upon policy authorities in the choice of a gradualist approach over a "big bang." First was the sheer magnitude of the reform effort—an economy of continental dimensions, housing 15 percent of the world's population. Second, there was the unenviable task of implementing stabilization and structural reforms simultaneously on a crisis-ravaged economy. In addition, the reforms were an article of faith with the international community, and time was running out.

Considerable time was spent in setting up the preconditions for the liberalization of the capital account. Over the years 1991, 1992 and 1993, fiscal compression and tight monetary policy were put in place. Industry and foreign trade were virtually deregulated from licensing, tariffs were lowered sharply, and a dual exchange rate regime was instituted to prepare the evolutionary foreign exchange market for a greater role in determining exchanges rates (earlier the exchange rate was administered by the Reserve Bank of India [RBI] under a trade-weighted peg). FDI, highly restricted hitherto on account of ownership considerations, was allowed into all key areas of Indian industry at international rates of taxation and with free repatriability. Portfolio investment by foreign institutional investors was allowed into Indian stock exchanges under similar considerations. Indian companies were permitted to make both debt (convertible bonds) and equity (global depository receipts) issuances in international stock exchanges. The process of liberalizing exchange control was set in motion, leading up to current account convertibility and India's acceptance of the obligations of Article VIII of the IMF's Articles of Agreement from 1994. At the same time, the brief but traumatic brush with debt default during the crisis laid the foundations of a strategy for external debt management. External commercial borrowings were routed through an approval procedure emphasizing maturity, cost, and enduse, within an overall exposure ceiling. Short-term debt was monitored under a subceiling.

The operating framework of monetary policy was undergoing a silent transformation, as if in anticipation of the deluge of capital flows to follow. Nonresident deposit accounts carrying exchange guarantees from the RBI and instruments of automatic monetization of the fiscal deficit were phased out in a planned manner. There was a progressive shift to indirect instruments of monetary control, and statutory preemptions were lowered to minimum levels prescribed in relevant legislation.

Surges in Capital Flows

Shortly after the progression from dual exchange rates to a unified, market-determined exchange rate system in March 1993, India faced its first encounter with surges in capital flows. Beginning in August 1993 and extending well into 1995, waves of foreign investment inflows dominated the balance of payments, accounting for almost half of net capital flows in 1993–1995. FDI rose from near-negligible levels in 1990–1991 to exceed U.S.$1.3 billion in 1994–1995 (fiscal year). Leading the flood, however, were portfolio investment flows: foreign institutional investors in Indian stock markets, offerings of global depository receipts (GDRs) paper in overseas equity markets, convertible bonds raised abroad by Indian companies, and Indian offshore funds. In each of these years, portfolio investment flows averaged U.S.$3.5 billion. After a hiatus of almost four years, India renewed access to short-term trade credits toward the close of 1994–1995.

The visitations of private capital flows were clearly a response to the strengthening macroeconomic fundamentals. The economy grew by over 7 percent from 1993 to 1996, well above trend. A robust expansion of both merchandise and invisible exports easily accommodated the surge in import demand in response to the liberalization in trade and industrial policies. Despite sizable repayments of bilateral and multilateral aid, repurchases from the IMF, and net outflows under the discontinued nonresident deposit accounts with exchange guarantees, there occurred a hitherto unprecedented buildup of the foreign exchange reserves to a level of over U.S.$25 billion in March 1995, equal to about ten months of imports. In turn, this posed challenges to the conduct of monetary policy. A combination of policy responses—sterilization, external liberalization, retention of funds abroad—could not head off upward pressures on inflation, which rose above 10 percent in 1993–1995. A social resistance to inflation in double digits, entrenched in the Indian polity, manifested itself tellingly in a withdrawal of confidence in the government of the day. A fractured political mandate decisively ended the office of the "original reformers" in 1996 for a period that would last until 2004.

By early 1995, the capital flows ebbed and the downside of the roller-coaster experience with mobile capital flows was about to begin. Persistent surplus conditions in the foreign exchange market throughout 1993–1995 had been assuaged through passive interventions (purchases) by the RBI. Consequently, the nominal exchange rate of the rupee remained fixed over a period when the U.S. dollar was going through a pronounced appreciation against major currencies. Inflation differentials between India and the rest of the world were widening sharply, and the policy authorities themselves indicated discomfort with the building appreciation in the real exchange rate. Burgeoning imports had been comfortably financed all along, but when the capital flows ebbed, signs of incipient pressure became evident by August 1995. A spurt in the demand for domestic bank credit pushed up domestic interest rates, feeding an upward drift in the forward premium. Downward pressures on the exchange rate intensified in October, and India had its first taste of a currency attack. Expectations of a free fall of the rupee ran rife, disrupting the tranquil market conditions. The RBI engaged in exchange market interventions (sales), but this had the effect of withdrawing domestic liquidity and causing short-term interest rates to soar. Accordingly, interventions were soon backed up with money market support and an easing of reserve requirement stipulations on deposits with banks.

Capital flows remained, by and large, impervious to the currency turmoil. Net inflows under nonresident deposits actually increased in 1995–1996 over the preceding year. There was a welcome spurt in inflows of foreign direct investment, which exceeded U.S.$2 billion for the first time. The United States emerged as the largest investor. Engineering and electrical equipment were the preferred industries. Portfolio investment flows, on the other hand, were adversely affected by the disorderly conditions in the domestic financial markets and the restrictions imposed by the authorities on the introduction of funds from GDRs, which remained in force until November 1995. There was a slump in issuances of GDRs in overseas stock exchanges. Low equity prices in domestic stock exchanges combined with the unsettled market conditions to dampen investment by foreign institutional investors. In the first quarter of 1996, however, sentiment improved as the currency attack dissipated and the authorities undertook a series of confidence-building measures, including a rollback of the interest rate increases and a tightening of exchange control undertaken to deal with the "bandwagon" effects that had driven financial markets. Indian companies launched about U.S.$0.5 billion of GDRs in the quarter and foreign institutional investment surged, with perceptions of overcorrection in the equity and foreign exchange markets. The medium- and long-term debt flows—bilateral and multilateral aid and external commercial borrowings—continued to be dominated by large repayments. Access to short-term trade credit was extremely modest. For the first time since 1993, net capital flows fell short of the external financing requirement set by a higher current account deficit. This necessitated a draw down of the foreign exchange reserves on the order of U.S.$1.2 billion.

The currency attack in the second half of 1995–1996 (fiscal year) turned out to be only a temporary disruption in India's tryst with private capital flows. The inflows resumed strongly in the following year. Net inflows under nonresident deposits recorded a threefold increase, marking the return of confidence. The largest inflows were into rupee deposits under the nonrepatriable scheme. FDI maintained its uptrend, benefiting from enhancement in equity holding limits and an expansion of the industries for which approval was automatic. The sluggish domestic capital markets and policy relaxations prompted a large number of GDR issuances. Portfolio investment by foreign institutional investors was maintained, as over-heated international capital markets propelled a diversification of portfolio flows in favor of emerging markets. Debt consolidation was pursued apace with substantial amortization of external aid and commercial borrowings, including the "bullet" redemption of the India Development Bonds issued at the height of the crisis of 1990–1992. Expanding energy requirements resulted in higher short-term trade credits in order to finance imports of petroleum products.

Asian Crisis

The fiscal year 1996–1997 was a turning point of sorts, presaging the cataclysmic Asian crisis that would reverberate across the world. International trade slowed down, and shifts in consumption patterns in mature economies provided early indications of the synchronized global slowdown that would dominate the second half of the 1990s. India's merchandise exports and industrial production were adversely affected. The demand for bank credit remained damped by the tightening of monetary policy during the currency turbulence of the preceding year. As the growth of the economy moderated from the scorching pace set in the period 1993–1995, non-Petroleum, Oil, and Lubricants imports slowed down sharply. Indian industry entered a period of painful restructuring and organizational change, as corrections to the massive capacity expansion in the first flush of liberalization had to be made in a more realistic assessment of demand.

Buoyant capital flows were interrupted in the first half of the fiscal year 1997–1998 by exchange market turbulence generated by the floating of the Thai baht. Sporadic speculative attacks led to a slackening of investment by foreign institutional investors in Indian stocks and even outflows in the period from November 1997 to February 1998. GDRs dropped sharply and were mainly in the form of disinvestment by public sector entities. The rekindled appetite for external commercial borrowings in the first half of the year was choked off in the second half by a sharp rise in the forward premium as monetary policy braced itself to defend against the crisis spreading across Asia. Corporate entities that had raised funds preferred to hold them abroad. Net inflows into nonresident deposits halved over the year, reflecting the generalized sense of uncertainty as well as the imposition of incremental reserve requirements; in fact, net outflows occurred in the period of exchange market volatility. FDI flows were untroubled by the surrounding chaos and exceeded U.S.$3 billion. FDI was allowed into financial services. Mauritius emerged as the most important source of FDI inflows into India as transnational corporations sought exemptions from Indian taxes by exploiting treaties for avoidance of double taxation.

India emerged relatively unscathed from the Asian crisis. Foreign exchange reserves were built up by U.S.$3 billion, and the nominal exchange rate held its own in an environment of domino effects among Asian currencies. In the following year, however, Asian financial markets experienced heightened turbulence and contagion spread to Russia and Brazil amidst fears of the competitive devaluation of currencies. A global slowdown, which began in mid-1997, deepened in 1998, and world trade underwent a substantial contraction. The spectacular increase in private capital flows to developing countries, including India, in the first half of the 1990s collapsed. The domestic financial markets were buffeted by bouts of instability during May–September 1998. The stormy international environment was worsened by sanctions on India imposed by industrial countries in response to nuclear testing. Monetary policy measures were deployed in conjunction with the issue of Resurgent India Bonds (RIBs) of U.S.$4.2 billion for nonresident Indians. Other types of external commercial borrowings and issuances of GDRs registered a sharp decline. Net outflows were recorded by foreign institutional investors, and even FDI was distinctly lower than in the fiscal year 1997–1998. By contrast, net inflows into nonresident deposits rose significantly, impervious to the generalized global uncertainty, and revealed a definite home bias. Net capital inflows taken together were lower by more than U.S.$1 billion. Ultimately, it was the RIBs that shored up the balance of payments in an extremely testing year, enabling a buildup of reserves to a level of U.S.$31.4 billion by March 1999.

Stability returned to international financial markets in early 1999 to mark the close of an eventful decade. The global economy staged a V-shaped recovery. The resumption of growth was particularly strong in the crisis-hit economies of Asia, shaped by successful macroeconomic adjustment and strict financial policies. Net private capital flows to developing countries resumed modestly but were dominated by substantial repayments of bank lending. Hardening crude oil prices emerged as the major risk to an improved global outlook. In India, a broad-based firming of industrial activity ensured that trend growth of over 6 percent was maintained, despite the shadow cast by border tensions in May 1999. The RBI resumed a graduated liberalization of capital flows. Foreign corporate entities and high net worth individuals were allowed to invest in Indian stock markets through foreign institutional investors. All sectors of the economy, except for a short negative list, were opened to FDI on an automatic basis. The policy regime for external commercial borrowings was substantially liberalized with the approval procedures largely moved out of the Ministry of Finance to the RBI. End-use stipulations were relaxed, except for real estate and equity investments in light of the experience gained in the Asian crisis. Outward FDI was encouraged, and Indian companies engaged in knowledge-based activities (information technology [IT], biotech, and entertainment) were allowed enhanced capabilities for the acquisition of companies abroad. Policies for the import of bullion were also liberalized, with banks and financial institutions allowed to freely import gold and silver.

Net capital flows returned to pre-1998 levels on the back of a renewal of portfolio investment by foreign institutional investors, resilient flows to nonresident deposits, and a larger recourse of Indian entities to international equity markets. For the first time, American depository receipts (ADRs) entered the portfolio of capital flows to India. FDI continued to be sluggish, despite a greater focus domestically on the speedy implementation of FDI proposals and the opening up of the insurance sector. The debt flows in the form of external aid and commercial borrowings continued to remain muted, reflecting lackluster domestic investment demand. For the fourth year in a row, there was an accretion to the reserves of over U.S.$ 6 billion in 1999–2000. By June 2000, all liabilities to the IMF incurred in the crisis of 1990–1991 were repaid.

Global Slowdown

The advent of the new millennium began another phase in India's experience with capital flows. A deepening of the global slowdown from mid-2000 to late 2003 was accompanied by large sell-offs in international equity markets, the bursting of the IT bubble, and a receding of private capital flows to emerging markets as risk aversion increased in the aftermath of the currency crises in Turkey and Argentina. Repayments of bank loans continued to be sizable. Beginning with a significant reduction in fiscal year 2000–2001, India's current account deficit turned into a surplus in 2001–2002 after two decades. Surpluses persisted in the ensuing years, powered essentially by the strength of remittances from Indians residing abroad. By 2003 India became the highest recipient of such inward remittances, accounting for 14 percent of global flows. Merchandise exports regained lost momentum, particularly since 2002–2003. The generalized aversion to emerging markets was reflected in a sharp decline in trade credits, syndicated loans, and other types of commercial borrowings in 2000–2001, as well as a fall in investment by foreign institutional investors and FDI over the previous year. Net inflows into nonresident deposits, however, continued their uptrend, reflecting the confidence of nonresident Indians in the Indian economy. Indeed, the invulnerability of nonresident deposits to the vicissitudes of the international financial environment turned out to be a source of strength to India through an extremely difficult decade. The shortfall in various types of external financing in 2000–2001 was bridged by the launching of the India Millennium Deposits of U.S.$5.5 billion, again targeting nonresident Indians.

Fortuitously, this shortfall would prove to be a transient experience, as capital flows became stronger in 2001–2002 and 2002–2003, led initially by FDI and nonresident deposits but dominated in 2002–2003 by large inflows in the form of banking capital as exchange rate movements and interest rate differentials made rupee assets highly attractive. In 2003 and 2004, a massive surge in investments by foreign institutional investors was the most striking feature of capital flows to India, supported by the buoyancy of nonresident deposit inflows and continuing inflows of banking capital. By May 2004, India held the sixth-largest stock of foreign exchange reserves in the world, a far cry from the low point of July 1991. Beginning in 2002, India became a lender to the IMF. The level of the reserves currently exceeds the stock of India's gross external debt.

Capital flows weathered subinvestment grade credit ratings, the general aversion to emerging markets, adversities peculiar to India such as sanctions, terrorist attacks, a terrible drought, and soaring crude oil prices to endorse the underlying strength and resilience of the Indian economy in the decade of the 1990s. In fact, throughout 2004, even after undertaking large prepayments of external debt and bullet repayment of RIBs, policy authorities were actively engaged in strategies to temper the massive influx of capital. Efforts to counter the expansionary impact of the inflows on monetary conditions threatened to deplete the stock of monetary instruments and innovative strategies have had to be combined with orthodox measures of monetary policy to deal with the inflows.

Since the turn of the twenty-first century, there has been a perceptible acceleration in the speed of capital account liberalization. New economy industries—IT, e-commerce, telecommunication, financial services, mass rapid transport, airports, urban infrastructure, even defense—have been opened to foreign direct investment, along with a removal of quantitative restrictions such as dividend balancing through exports imposed on FDI in consumer goods industries. Overseas business acquisitions through ADRs/GDRs have been significantly enhanced, up to several times the size of export earnings, and outward FDI is now allowed up to 200 percent of the net worth of the domestic investor. All approval procedures relating to external commercial borrowings have been delegated to the RBI for proposals beyond U.S.$500 million. Below that amount, approvals are not required.

Since the opening up in 1991, India's experience with capital flows has been marked by episodes of surges and short-lived reversals. The policy regime has emphasized stability and gradualism and a shying away from the more dramatic attempts at liberalization in neighboring Asia. A hierarchy of capital flows has emerged but not entirely in consonance with policy preferences. Inflows into nonresident deposits have turned out to be the most durable flows, in spite of measures to slow them down as part of the overall approach to contending with capital flows. Special bond issues for nonresident Indians have filled in exceptional financing gaps in periods of stress. FDI has, in general, not lived up to policy expectations, held down primarily by implementation gaps in the process of turning proposals into actual inflows. Investment by foreign institutional investors and raising of ADRs/GDRs/FCCBs (foreign currency convertible bonds) have exhibited volatility and sensitivity to shifts in market conditions. Foreign investment, both direct and portfolio, is now entrenched in India's capital account, with a share of more than 50 percent of net capital flows. The reliance on debt flows has declined substantially. While the policy for external commercial borrowings has been modulated in tune with the needs of the economy and the compulsions of prudent external debt management, the appetite of Indian corporate entities has been muted by the slowing down of investment demand since the second half of the 1990s. The reliance on external aid that characterized the period up to the 1980s has dissipated completely. Active efforts are underway to prepay bilateral and multilateral donors and seek, in a redefinition of self-reliance, freedom from aid.

Michael Debabrata Patra

See alsoCommodity Markets ; Debt Markets ; Economic Reforms of 1991 ; Economy since the 1991 Economic Reforms ; Information and Other Technology Development ; International Monetary Fund (IMF), Relations with ; Money and Foreign Exchange Markets

BIBLIOGRAPHY

Patra, Michael Debabrata, and S. Pattanaik. "Exchange Rate Pass through and the trade Balance: The Indian Experience." Reserve Bank of India Occasional Papers, December 1994.

Patra, Michael Debabrata, and S. Pattanaik. "Exchange Rate Management in India: An Empirical Evaluation." Reserve Bank of India Occasional Papers, September 1998.

Rangarajan, C. "Recent Exchange Rate Arrangements: Causes and Consequences." Reserve Bank of India Bulletin, September 1991.

Reserve Bank of India. Annual Reports, 1990–1991 to 2003–2004.