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3 Assessing India’s External Position

Editor(s):
Tim Callen, Christopher Towe, and Patricia Reynolds
Published Date:
February 2001
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Tim Callen and Paul Cashin 

Introduction

India has generally followed cautious external sector policies, with trade intervention and capital controls used extensively as instruments of balance of payments control and adjustment. It has nonetheless experienced several balance of payments crises, most recently in 1991. The policy of restricting trade and capital flows may also have entailed costs in terms of forgone resources. Despite recent reforms, India retains one of the world’s most restrictive trade regimes, and the inflow of foreign capital remains well below that of other countries in Asia.

This paper uses a number of methods to assess developments in India’s external position. First, an intertemporal model of the current account and a composite model of external vulnerability indicators, which generates probabilities of the occurrence of a balance of payments crisis, are used to consider the solvency, sustainability, and optimality of the external position. Second, a model of the medium-term saving-investment balance is used to derive estimates of the “equilibrium” current account balance against which the actual balance can be compared. Lastly, the possible sustainable current account deficit over the medium term is examined through conditions for intertemporal solvency under different economic scenarios.

The results indicate that India’s current account deficits have been consistent with intertemporal solvency, but the evidence on whether external borrowing has been optimal, even when allowance is made for capital controls, is mixed. However, the path of the current account prior to 1991 is found not to have been consistent with solvency. The composite model of external vulnerability indicators also raised questions about external sustainability during this period, while estimates of the equilibrium current account deficit were smaller than the actual outcomes during the 1980s. Since 1991, the estimated probabilities of external crisis in India have remained low, and they rose little during the Asia crisis, while the current account deficit is currently around its estimated equilibrium level. Finally, estimates of the sustainable level of the current account deficit over the medium term range from 1½ to 2½ percent of GDP, depending on the growth rate and the cost of external finance. The remainder of the chapter provides a brief overview of external sector developments and policies in India, and a discussion of the methodologies for assessing external sector developments.

Overview of External Sector Developments and Policies

Following independence, economic policies focused on rapid industrialization with the aim of achieving economic self-sufficiency. This goal resulted in a trade system that strictly regulated imports through exchange controls and trade restrictions, which were supplemented by a tariff structure with high and differentiated rates across industries (Joshi and Little, 1994). Little emphasis was placed on promoting exports, and the inefficiency of domestic industry, engendered by extensive protection, resulted in a distinct anti-export bias. The investments in goods essential for industrialization and the continuing need to import many essential consumer items, including food during periods of drought, resulted in strong import growth in the late 1950s and early 1960s. With export performance remaining poor, the trade deficit widened, and the current account deficit increased to around 2½ percent of GDP as the surplus on the invisibles account also narrowed (Figure 3.1, top panel).

Figure 3.1.Current Account Balance, 1950/51–1998/99

(In percent of GDP)

Source: Data provided by the Indian authorities.

Improved export performance in the late 1960s and 1970s, aided by the expansion of world trade and a depreciation of the real exchange rate, led to an improvement in the current account position. While this was temporarily reversed in the aftermath of the oil price shock of 1973, a tightening of import controls and restraint of domestic expenditures brought import growth down. Remittances also increased during the 1970s as the number of Indians employed in the oil-producing nations of the Middle East increased, and the current account position improved, recording a surplus in a number of years during the second half of the 1970s (Figure 3.1, bottom panel).

The current account was largely financed by concessional aid flows prior to the 1980s. Recourse was also made to IMF financing on several occasions. Private capital movements were limited as foreign investment policy was marked by very tight regulation during the late 1960s and 1970s, particularly with the introduction of the Foreign Exchange Regulation Act (FERA) in 1973 (Kapur, 1997).

The 1980s witnessed a gradual deterioration in the current account position and a profound change in its financing. The second oil price shock in 1979 placed considerable pressure on the balance of payments. Imports rose, exports slowed in response to the worldwide recession and the appreciation of the real exchange rate, and the current account moved back into deficit. As reserves fell critically low, India entered into a program with the IMF in 1981. However, unlike after the first oil price shock, no significant current account adjustment followed, and with large macroeconomic imbalances developing in the second half of the 1980s, particularly a deterioration in public finances, the current account deficit rose to a peak of 3 percent of GDP in 1990/91.1

The proportion of concessional debt in total external debt declined from over 80 percent at the beginning of the 1980s to under 45 percent by the end, due to the widening of the current account deficit and constraints on access to concessional funds. The additional financing came from private sources, mainly rupee and foreign currency deposits from nonresident Indians (NRIs) and external commercial borrowing from international banks (Figure 3.2, top panel). Much of the latter was undertaken by public enterprises and used to finance projects in the oil, power, aluminum, steel, and transportation sectors, and for on-lending by official financial institutions. While foreign direct investment (FDI) increased slightly, it remained a marginal source of funds, and portfolio investment was not permitted.

Figure 3.2.Capital Flows and External Liabilities, 1971/72–1998/99

(In percent of GDP)

Sources: Data provided by the Indian authorities: and the World Bank Global Development Finance Database.

1 Not all components of the capital account are shown; hence, components do not sum to total capital flows.

External debt rose rapidly from 11 to 31 percent of GDP between 1980/81 and 1991/92, with short-term debt representing around 10 percent of this total from the mid-1980s compared to negligible amounts pre-1980 (Figure 3.2, bottom panel). The debt servicing ratio also increased to over 30 percent of exports. These problems came to a head with a sovereign debt rating downgrade in October 1990 (subsequent downgrades followed in March and May 1991). The rollover of short-term loans became more difficult, and expectations of a depreciation of the rupee rose, leading to a loss of confidence among investors and a flight of NRI deposits out of the country. With the rise in oil prices and the decline in remittances following the crisis in the Gulf region, the external position became untenable. As reserves declined, India was brought to the brink of default in January 1991 (Jalan, 1992). This was avoided by purchases through the IMF’s Compensatory Financing Facility (in January and July 1991) and by the adoption of an IMF program in October 1991.

The reforms implemented in the wake of the 1991 balance of payments crisis have resulted in a more open external sector (Box 3.1). Exports and imports have both risen as a share of GDP. Exports have responded strongly to the liberalization measures and the decline in the real exchange rate, while imports have grown rapidly in response to strong domestic growth and the reduction in tariffs and quantitative restrictions. The current account deficit has been markedly smaller than in the 1980s, averaging only 1 percent of GDP.

The financing of the deficit has also been much different in the 1990s, with a shift away from short-term debt financing toward equity and longer-term debt flows as restrictions on FDI and portfolio inflows have been eased. Restrictions on debt flows, particularly of a short-term nature, however, have been tightened. Strict controls have been placed on short-term debt, medium-term borrowing from private commercial sources has been made subject to annual caps and minimum maturity requirements, and interest rates or interest rate ceilings have been specified for NRI deposits of different maturities and under different schemes (Acharya, 1999).2 Consequently, between 1991/92 and 1998/99, FDI accounted for 21 percent of total capital inflows, and portfolio investment a further 25 percent. Meanwhile, the outstanding stock of external debt fell to around 23 percent of GDP. By March 1999, short-term debt (on a contracted maturity basis) accounted for only percent of total external debt.

Assessing India’s External Position

Several approaches to assessing India’s external sector developments are discussed in this section. First, issues of external solvency, sustainability, and optimality are examined. Second, estimates of the “equilibrium” current account are presented against which actual developments can be compared. Lastly, the issue of what is likely to be a sustainable current account deficit over the medium term is considered.

Solvency, Sustainability, and Optimality

Three questions are usually asked when evaluating a country’s external position:

  • Is the debtor country solvent? Solvency requires that the present discounted value of future current account surpluses equals the value of its existing net external liabilities. In other words, a country is expected to generate sufficient earnings to repay all its external liabilities.
  • Is the extent of international capital flows optimal? Optimality of capital flows requires that, in the face of shocks to net output, capital flows are used to smooth the path of consumption to ensure there are no avoidable welfare losses.
  • Is the external position sustainable? Even if a debtor country is technically solvent, questions may arise about the sustainability of its current account if lenders perceive that the intertemporal falls in consumption, implied by the path of the current account imbalances, raise doubts about the willingness of the debtor to meet its payment obligations (Milesi-Ferretti and Razin, 1996; Cashin and McDermott, 1998).

Box 3.1.External Sector Liberalization in the 1990s

Some progress was made in liberalizing current account transactions during the 1980s, but it was not until the early 1990s that significant steps were taken. The Export and Import Policy in April 1992 focused on the gradual removal of quantitative restrictions on machinery and equipment and manufactured intermediate goods, reduction in tariff rates, and the modification of export promotion measures. Subsequent policies have continued this trend, and India has committed to remove all quantitative restrictions by April 2001. In August 1994, India accepted the obligations of Article VIII of the IMF’s Articles of Agreement and the rupee was made fully convertible for current account transactions.

On the capital account side, given the experience with the buildup of short-term, high-cost borrowing in the 1980s, policies in the 1990s have focused on encouraging equity and long-term debt flows. Measures include

  • Foreign direct investment (FDI). Liberalization began with the new industrial policy in July 1991. Initially, automatic approval by the Reserve Bank of India (RBI) for FDI of up to 51 percent of equity in 35 priority industries was permitted. Over time it was expanded. In February 2000, the government announced that FDI under Rs 6 billion would be available through the RBI automatic route except for 13 sectors that have been placed on a negative list, areas reserved for the small-scale sector where foreign investment already exceeds 24 percent, and seven sectors where sectoral investment caps apply. To invest in these sectors, or above the investment cups, permission is required from the Foreign Investment Promotion Board.
  • Portfolio investment. In September 1992, approved foreign institutional investors (FIIs) were permitted to invest in primary and secondary markets for listed securities, and foreign brokerage firms were allowed to operate in India the following fiscal year. While there is no restriction on the total volume of inflows, total holdings by FIIs cannot exceed 24 percent (can now be raised to 40 percent by the company’s Board), and total holdings of a single FII cannot exceed 10 percent. Nonresident Indians (NRIs) and overseas corporate bodies can hold an additional 10 percent (this can be raised to 24 percent through a general resolution of the company), with a 5 percent individual limit. To provide an incentive to longer-term investors, the capital gains tax rate is 10 percent if the investment is held for over one year (30 percent otherwise). More recently, foreign investors have been allowed to invest in Treasury bills. In February 1992, Indian companies were allowed to issue Global Depository Receipts on approval of the Ministry of Finance and subject to rules relating to repatriation and end use of funds. Since January 2000, no prior approval has been required.
  • External borrowing. Approval from the Ministry of Finance is required for all external commercial borrowing and is subject to an annual indicative ceiling (borrowing in excess of 8 and 16 years’ maturity is outside the ceiling if the loan amount exceeds $200 million and $400 million, respectively). Borrowing is also subject to minimum average maturities, although, more recently, companies have been given some scope to prepay outstanding borrowing. Terms permitted on NRI deposits have been made considerably less attractive than those available in the late 1980s, and interest rates have been linked to LIBOR/swap rates. In April 1998, the interest rate ceiling on nonresident foreign currency deposits of one year and above was raised, and the ceiling on maturities of less than one year was lowered. In October 1999, the RBI announced that the minimum maturity would be raised from six months to one year.
  • Outward capital flows. Controls on such flows remain quite stringent. Banks have recently been allowed to invest up to 15 percent of their Tier I capital in foreign currency assets, while mutual funds have also been allowed to invest overseas up to certain limits.

Capital Controls and the Consumption-Smoothing Approach to the Current Account

The question of whether a given current account position is appropriate can be answered only within the context of a model that yields predictions about the optimal path of external imbalances and liabilities. The most common such model is the intertemporal model of the current account, in which the current account is used to smooth consumption and maximize welfare in the face of temporary shocks to the net income of an economy—usually defined as output less investment and government consumption. The basic model derives from the permanent income theory of consumption, in the context of a small open economy with access to world capital markets, and under the assumptions of a given world real interest rate, a government that has access to lumpsum taxation to finance expenditure and chooses a spending and taxation path that ensures intertemporal solvency, and output that is determined by exogenously given investment.3

The consumption-smoothing model predicts that the current account will be in deficit when future changes in net income are expected to be positive. Future income is then transferred to the present (by external borrowing) to smooth the path of consumption. For example, a temporary adverse shock to exports implies that expected future net income will be higher, and that the consumption-smoothing component of the current account deficit will widen. Permanent shocks, in contrast, which by implication have no effect on expected changes in net income, will have no impact on the current account.4

A limitation of the standard intertemporal model for analyzing India is the assumption of unfettered access to world capital markets, as controls on capital movements are an important component of India’s external policies.5 Deviations of the current account from an optimal benchmark derived on the assumption of free capital mobility could simply reflect the presence of capital controls. The standard model can, however, be extended to incorporate capital controls by allowing for asymmetric behavior on the part of economic agents in seeking to respond to temporary shocks to net income (Kent, 1997). Specifically, agents are constrained from responding to a temporary reduction in net income (they are unable to borrow externally), but they are able to respond to temporary increases in net income (capital outflows are not restricted).6

India’s external solvency can be tested in this framework by examining the relationship between consumption and net income less payments on the outstanding stock of external liabilities during the sample period (1952/53–1998/99). If these variables are cointegrated, then, over the long run, consumption does not deviate too far from movements in the available resources of the economy and the solvency constraint is satisfied. If the variables are not cointegrated, then consumption may be growing in excess of what is supportable from the resources available to the country. The results of the cointegration test indicated that capital inflows to India were not in breach of the solvency condition. When the regression was run on data up to the 1991 crisis, however, evidence of cointegration could not be found, indicating that during this period private consumption tended to deviate from movements in the available resources of the economy. Accordingly, under unchanged policies, capital inflows during this period were not consistent with the intertemporal budget constraint, and a return to smaller current account deficits during the 1990s was needed to reestablish solvency.

The actual current account and estimates of the unconstrained (assuming no capital controls) and the constrained (assuming controls on inward capital flows) current accounts are shown in Figure 3.3.7 As would be expected, the constrained current account is generally in a smaller deficit than the unconstrained measure. The unconstrained deficit has typically been larger than the actual deficit, indicating that in the absence of constraints on capital flows more external borrowing would have been appropriate to smooth consumption in the presence of net income shocks experienced during the period. During the 1970s, the actual current account position was in a smaller deficit (and even in surplus in some years) than implied by either the constrained or unconstrained models. This probably reflects the tightening of controls on capital flows during this period and the models’ inability to pick this up because of its assumption of no restrictions on capital outflows. During the 1980s, however, the actual deficit was generally larger than the constrained deficit, and toward the end of the decade it also exceeded the unconstrained deficit. This was corrected in the wake of the 1991 crisis, and the difference between the actual and constrained deficits has narrowed substantially in the 1990s.

Figure 3.3.Current Account Balance, 1952/53–1998/99

(In percent of GDP)

Sources: Data provided by the Indian authorities; and staff calculations.

A simple method to examine the relative performance of the two models is to compare the correlation between the actual current account and the unconstrained and constrained current accounts over the sample period. The correlation for the unconstrained model is actually much higher over the whole sample period than for the constrained model (0.7 against 0.23). The ability of the models to track the data, however, varies substantially during different time periods. The correlation of the unconstrained model with the actual deficit is high in the 1950s and 1980s, while the correlation between the actual and constrained current accounts is much higher during the 1960s-70s and the 1990s.

Formal tests of the appropriateness of the two models are mixed. While evidence from Granger causality tests indicates that the constrained model performs better (as a predictor of changes in net income) than the unconstrained model, a Wald test is unable to reject the unconstrained model in favor of the constrained model, possibly due to the lack of precision with which the latter model is estimated.

A Composite Model for Assessing External Sustainability

While the above results indicate that India satisfies its intertemporal budget constraint, questions may still arise as to the sustainability of its current account imbalances if lenders perceive that the intertemporal adjustments to consumption implied by the path of the imbalances raises doubts as to the willingness of a country to meet its external obligations.

A recent approach to assessing external sustainability is to develop an empirical framework for predicting balance of payments crises (a so-called “early warning system”) using economic and financial indicators likely to provide timely indications of a country’s potential vulnerability. This approach attempts to determine if a country is vulnerable to the imposition of liquidity constraints by foreign investors who may become unwilling to continue lending on current terms if economic difficulties are experienced. These limits may be over and above those imposed by intertemporal solvency of the current account, the traditional approach to gauging external sustainability.

The predictability of balance of payments crises has been examined in a number of recent papers (Kaminsky, Lizondo, and Reinhart, 1998; and Berg and Pattillo, 1999). In this section we apply the model developed by Berg and Pattillo to India. The approach is basically a multivariate probit model estimated on monthly data for a panel of 23 developing economies. The dependent variable takes a value of one if there is a balance of payments crisis within the next 24 months and zero otherwise. A crisis occurs when a weighted average of monthly percentage exchange rate depreciations and monthly percentage declines in reserves exceeds the mean by more than three standard deviations. Berg and Pattillo find that the probability of a crisis increases when the bilateral real exchange rate is relatively overvalued, reserve growth and export growth are low, and the ratio of the current account deficit to GDP and short-term debt to reserves are high.

The estimated coefficients from the model can be used to generate predictions in the form of the probability of a crisis occurring in any one country during the next 24 months, given the current values of the explanatory variables in that country. Predicted probabilities above a certain threshold (typically taken as either 25 or 50 percent) indicate that the model is signaling the likelihood of a crisis (assuming unchanged policies) within the next 24 months. The signaling of an imminent crisis is, in effect, tantamount to the model indicating that under unchanged policies the external position is unsustainable. Of course, a crisis may not eventuate if appropriate policy actions are taken to address the underlying problems.

The estimated probability of a crisis in India was high and rising during the second half of the 1980s, and well above the 25 percent threshold (Figure 3.4). Had the threshold level instead been 50 percent, this was crossed on two occasions in mid-1988 and late 1990. The crisis probability reached a peak in May 1991 at over 60 percent, just five months before the commencement of the IMF program. Crises, as defined in the model, occurred in April and July 1991 and also in March 1993 (represented by the bold vertical lines in the figure).8 These results are in line with evidence from the previous section that India breached its solvency constraint prior to 1991 by running excessive current account deficits in the 1980s.

Figure 3.4.24-Month Ahead Crisis Probability and Relative Contributions of Economic Factors, 1986–991

Source: Staff calculations.

1 Calculations are based on the Berg et al. (1999) model. The solid vertical lines represent crisis dates (as defined in the model).

The aggregate crisis probability can be decomposed into the contributions of each of the five variables. As can be seen, the steadily rising probabilities during the second half of the 1980s were largely due to the widening current account deficit and the increase in short-term debt. The crisis probabilities declined quickly following the reform program implemented after the 1991 crisis and have generally remained low since. During 1997 and 1998, when the economy was buffeted by the Asia crisis, sanctions following the nuclear tests in May 1998, and the turmoil in world financial markets following the Russian default in August 1998, the crisis probabilities rose only moderately and remained well below the 25 percent threshold. This suggests that the reforms undertaken since the early 1990s, which have sought to encourage equity and longer-term debt flows while also liberalizing current account transactions, have laid the foundation for a more sustainable external position.

Estimating the “Equilibrium” Current Account Deficit

Several recent studies have applied a medium-term saving-investment balance approach to derive the fundamental or “equilibrium” current account position, although most of this work has focused on industrial countries (see Isard and Faruqee, 1998). A recent exception is the work of Chinn and Prasad (2000) who apply this framework to a large panel of industrial and developing countries. While this approach does not directly address the question of current account sustainability, it provides an indication of the current account level that may be considered “normal” based on the country’s structural and macroeconomic attributes.

Several factors affect saving and investment and the medium-term current account balance:

  • Fiscal policy will affect national saving through changes in public saving unless full Ricardian equivalence holds. Fiscal policy may also affect investment through real interest rates and its impact on business confidence.
  • Demographic factors affect private saving if, as the life cycle hypothesis suggests, older people save less. If a country has a relatively low dependency ratio, it would be expected to have a higher private saving rate than one with a higher dependency ratio. The dependency ratio may also affect public saving through its impact on the fiscal accounts. To the extent that capital-labor ratios are affected by the number of available workers, demographics may also affect investment.
  • The relative stage of a country’s development also matters, as a country starting from a low-income base would be expected to narrow this gap over time. To do this it will need to undertake a higher rate of investment during the catch-up period.
  • Terms of trade volatility may induce countries to save more as a buffer against the variability of their income. Systematic changes in terms of trade volatility could affect saving and the current account balance.
  • Countries with a greater degree of openness to international trade may be able to finance larger current account deficits in the short run, as more open economies can have a greater capacity to generate foreign exchange earnings through exports, and hence be better able to service external debt.
  • Financial deepening can induce greater private saving by providing a vehicle for the accumulation of surplus funds, and thus be positively correlated with current account imbalances.

The following equation (1) from Chinn and Prasad (2000) was used to derive estimates of the fundamental current account balance in India:9

The equation suggests that both the large public sector deficit and the relatively low stage of economic development contribute to a larger current account deficit in India. The relatively low and declining dependency ratio has recently had a positive impact on the current account position through its impact on private saving. In addition, India’s stable terms of trade and its relatively low level of financial development have both worked toward a larger current account deficit, by obviating the need for precautionary saving and by constraining the opportunities for private saving. India’s lack of openness to trade, however, has had a positive impact on the current account by inhibiting its capacity to service (and thus to accumulate) external debt.

While for most of the 1980s the actual current account deficit was close to the estimated equilibrium, in the late 1980s, just prior to the crisis, the actual deficit exceeded the equilibrium (Figure 3.5). The sharp contraction in the deficit during the crisis, however, saw it move closer to equilibrium, and, in general, it has stayed there during the 1990s. Indeed, during the past two years, the actual deficit has been roughly equal to the estimated “equilibrium” of around 1 ¼ percent of GDP.

Figure 3.5.Actual and Fitted Current Account Balance, 1980–99

(In percent of GDP)

Sources: Data provided by the Indian authorities; and staff calculations.

Assessing the Sustainable Current Account Over the Medium Term

While the previous section provided an assessment of historic external sector developments, the methodologies employed generally do not permit an assessment of what current account deficit may be appropriate in the future. This is an important question, however, given that capital inflows have the potential to aid India’s development process, while there is also a need to ensure these inflows are sustainable and used in an efficient manner. Addressing the issue of what is the appropriate current account level is difficult, and the answer will depend on many different factors. The 1993 High Level Committee on the Balance of Payments recommended that the current account deficit be contained to 1.6 percent of GDP “given the level of normal capital flows,”10 while in its 1996/97 Annual Report, the Reserve Bank of India suggested that under the circumstances prevailing at the time, India could sustain a current account deficit of 2 percent of GDP.

A common approach to assessing the sustainability of a given path of the current account is to project into the future the current stance of macroeconomic policy and private sector behavior, and calculate the path of the current account that ensures the country’s intertemporal budget constraint is not breached. This typically involves ensuring that the ratio of net external liabilities (NEL) to GDP remains at its current level (on the assumption that if this level is currently sustainable, then it should remain sustainable into the future).

The dynamics of NEL (and thus the current account balance) can be shown to be determined by the following equation (assuming the “no Ponzi game” constraint is valid):

where ′ indicates that the variable is a ratio to GDP, γ is the growth rate, λ is the fraction of NEL denominated in foreign currency,11r is the real rate of return on foreign liabilities, ∈ is the rate of real appreciation of the domestic currency, bt is NEL, and qt is the current account balance net of payments on foreign liabilities. From equation (2), the qt required to achieve any given level of bt can be calculated given assumptions about economic growth, the exchange rate, and the rate of return on foreign liabilities.

In the first scenario (Table 3.1), the current account deficit that stabilizes the NEL-to-GDP ratio at its end-1998/99 level of 31 percent is calculated, given a constant real exchange rate and varying assumptions about the real growth rate and the real cost of foreign liabilities.12 For example, assuming that real GDP grows at 5 percent a year and the real cost of foreign liabilities is 4 percent, then the deficit on goods, services, and transfers must average 0.3 percent of GDP to maintain the NEL-to-GDP ratio at 31 percent. With the cost of servicing the outstanding stock of external Liabilities at 1.2 percent of GDP, this results in an overall annual current account deficit of 1.5 percent of GDP (compared to the actual deficit of 1.0 percent of GDP in 1998/99). If a higher growth rate of 7 percent per annum is achieved, a current account deficit of around 2.1 percent of GDP could be run. For each 1 percentage point increase in the cost of external liabilities or fall in the growth rate, the required increase in the goods, services, and transfers balance, required to keep the ratio of NEL-to-GDP constant, is about 0.3 percent of GDP. If, instead, a real depreciation of the rupee of 1 percent per year is assumed, a current account deficit of 1.3 percent of GDP would stabilize the NEL-to-GDP ratio at 31 percent of GDP with a growth rate of 5 percent per annum (Scenario 2).

Table 3.1.Scenarios of the Current Account Position(In percent of GDP)
Scenario 1

(Stabilize NEL)
Scenario 2

(Stabilize NEL with depreciation)
Scenario 3

(Reduce NEL)
Scenario 4

(Increase NEL)
Real Interest Rate (percent)Net Investment BalanceGrowth Rate of Real IncomeGrowth Rate of Real IncomeGrowth Rate of Real IncomeGrowth Rate of Real Income
3.005.007.003.005.007.003.005.007.003.005.007.00
Current Account Balance
2-0.62-0.92-1.51-2.07-0.65-1.24-1.800.08-0.51-1.07-1.92-2.51-3.07
3-0.93-0.93-1.52-2.09-0.65-1.25-1.820.07-0.52-1.09-1.93-2.52-3.09
4-1.24-0.94-1.54-2.11-0.66-1.26-1.840.06-0.54-1.11-1.94-2.54-3.11
5-1.55-0.95-1.55-2.13-0.66-1.27-1.860.05-0.55-1.13-1.95-2.55-3.13
6-1.86-0.96-1.56-2.15-0.67-1.28-1.870.04-0.56-1.15-1.96-2.56-3.15
Of which: Goods, Services, and Transfers Balance
-0.30-0.89-1.45-0.03-0.62-1.180.700.11-0.45-1.30-1.89-2.45
0.00-0.59-1.160.28-0.32-0.891.000.41-0.16-1.00-1.59-2.16
0.30-0.30-0.870.58-0.02-0.601.300.700.13-0.70-1.30-1.87
0.600.00-0.580.890.28-0.311.601.000.42-0.40-1.00-1.58
0.900.30-0.291.190.58-0.011.901.300.71-0.10-0.70-1.29
Notes: The entries in the upper panel of the table are the minimum current account balances required to meet certain objectives. The objective under Scenario 1 is to stabilize India’s net external liabilities (NEL) at its current level of 31 percent of GDP, under the assumption of a constant real exchange rate. The objective under Scenario 2 is to stabilize NEL at its current level of 31 percent of GDP, given a real exchange rate depreciation of 1 percent per year. The objective under Scenario 3 is to reduce NEL to 21 percent of GDP by the year 2008/09, under the assumption of a constant real exchange rate. The objective under Scenario 4 is to raise NEL to 41 percent of GDP by the real exchange rate. In Scenario 2, it is assumed that the share of external debt, which is denominated in foreign currency, is 89 percent.
Notes: The entries in the upper panel of the table are the minimum current account balances required to meet certain objectives. The objective under Scenario 1 is to stabilize India’s net external liabilities (NEL) at its current level of 31 percent of GDP, under the assumption of a constant real exchange rate. The objective under Scenario 2 is to stabilize NEL at its current level of 31 percent of GDP, given a real exchange rate depreciation of 1 percent per year. The objective under Scenario 3 is to reduce NEL to 21 percent of GDP by the year 2008/09, under the assumption of a constant real exchange rate. The objective under Scenario 4 is to raise NEL to 41 percent of GDP by the real exchange rate. In Scenario 2, it is assumed that the share of external debt, which is denominated in foreign currency, is 89 percent.

Given that the choice of maintaining a constant NEL-to-GDP ratio is somewhat arbitrary, two other scenarios are presented for comparison. In Scenario 3 the objective is to lower the NEL ratio to 21 percent of GDP over the next ten years. Under the same growth and interest rate assumptions as above, a current account deficit of only 0.5 percent of GDP could be run. If a rise in the NEL ratio to 41 percent of GDP could be accommodated—perhaps through an increase in foreign direct investment—a much larger current account deficit of 2.5 percent of GDP could be run (Scenario 4).

These scenarios are designed only to be illustrative of the size of the current account deficits that could be sustainable into the future. What will actually prove sustainable will also depend on a large number of other factors. For example, if the deficits were to he financed mainly from direct investment flows, a larger outstanding stock of foreign liabilities could be maintained than if they were financed out of short-term debt flows (as was the case in the second half of the 1980s), Further, the sustainable level of capital flows is likely to be dependent on the continuation of structural reforms in the domestic economy, which will influence the return on the investment projects undertaken (represented by the high-growth scenarios in Table 3.1). As previously indicated, what may be a sustainable deficit under certain conditions in world capital markets may prove to be unsustainable under different circumstances. For example, a downturn in international investor confidence in developing markets may result in a reduction in capital inflows to India.

Summary and Conclusions

This paper has applied a number of methodologies to examine India’s external developments. The results indicate that the path of the current account deficit has been consistent with intertemporal solvency as it did not breach the intertemporal budget constraint. There is evidence, however, that the intertemporal budget constraint was not satisfied in the period up to 1990/91, and the return to smaller current account deficits in the 1990s has been needed to reestablish solvency. The composite model of early warning indicators also indicated that the path of the current account deficit in the period preceding the 1991 crisis was not sustainable, while the actual deficit was above its estimated equilibrium for much of the 1980s. The economic reforms undertaken since the early 1990s have brought about a more sustainable external position. The crisis probabilities also remained low during the Asia economic crisis, while the current account deficit appears to be around its equilibrium level at present. Estimates of what could be a sustainable current account deficit for India over the medium term indicate a range of 1½-2½ percent of GDP, although this is dependent on the economic and policy environment.

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1

The fiscal year in India runs from April 1 to March 31.

2

In October 1999, the Reserve Bank of India (RBI) announced that the minimum maturity for foreign-currency-denominated NRI deposits would be raised from six months to one year.

3

Details of the model and its application to India are presented in Callen and Cashin (1999).

4

As noted by Sachs (1982), movements in the current account can be decomposed into a consumption-tilting component, where the country tilts consumption toward the present or future, driven by differences between its discount rate and the world real interest rate, and the consumption-smoothing component.

5

While a number of studies have suggested that the degree of effective capital mobility in developing countries is higher than generally supposed due to widespread evasion of capital controls, Montiel (1994) finds that capital controls in India have been relatively effective.

6

Given that controls on outflows also exist, this is still not an ideal characterization. Further, the degree of controls on inflows has varied over time so that the assumption of no capital inflows in the constrained model is extreme for some time periods.

7

While the Central Statistical Office (CSO) has recently revised and rebased (to 1993/94) national accounts data, the old GDP series was used in the estimation work as, at the time, a comprehensive breakdown on the expenditure side of the accounts in the new data was not available. As the newly revised series raised the estimated level of nominal GDP by around 10 percent relative to the old series, the ratios to GDP present in this section need to be scaled down by about 10 percent. All nominal series were deflated by the implicit GDP deflator.

8

The model’s dating of the third crisis of March 1993 can be explained by that month’s unification of the dual exchange rate system that had been in place since 1991, which resulted in a large effective devaluation of the rupee.

9

This is a restricted version of the equation presented by Chinn and Prasad. The constant term was set so that the average equation error was zero over the period 1980–95. Relative income is defined as per capita income relative to the United States, Dependency is defined as the share of the population under 15 years of age (young) and over 65 years of age (old) as a share of the population between 15–65 years of age, both measured relative to the mean of all developing countries.

10

Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan), Reserve Rank of India Bulletin, August.

11

At end-1998, around 11 percent of India’s external debt was denominated in rupees (Government of India, 1999). In the following sustainability scenarios, we assume that this ratio also applies to total external liabilities.

12

While official estimates of external debt are regularly published, no estimates of equity liabilities are readily available. To derive an estimate of the outstanding stock of NEL, we therefore added the stock of external debt (23 percent of GDP at end-1998/99) to an estimate of the stock of equity liabilities calculated by accumulating (from 1970 onward) the flows of foreign direct and portfolio investment flows in the capital account of the balance of payments. This methodology obviously does not allow for valuation changes that have occurred since the flows were received. Using this method, the outstanding stock of equity liabilities was estimated at about 8 percent of GDP at end-1998/99.

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