The Hindu Business Line : External sector — Growing strengths, emerging challenges

The growing strength of the external sector in recent years has provided the conditions for accelerating the pace of liberalisation. Merchandise and service exports have posted robust growth, global capital has been pouring into the economy, and forex reserves have continued to rise. Nevertheless, there are some challenges relating to external sector management in the context of the growing trade deficit, says S. D. Naik.

THE data released by the Reserve Bank of India in recent times point to the growing strength of the country's external sector. Exports of merchandise and services have posted robust growth. Global capital has been pouring into the economy by way of portfolio and foreign direct investments (FDI), global depository receipts (GDRs), and so on, and foreign exchange reserves have continued to rise. With non-debt flows dominating, the country's stock of foreign debt as a percentage of GDP has declined steeply.

Exports posted a strong growth of 24.9 per cent in dollar terms in 2004-05 on top of the growth rates of 20.4 per cent in 2003-04 and 20.3 per cent in 2002-03. However, the robust exports in 2004-05 were outstripped by a massive expansion of imports, powered by soaring international crude prices and higher non-oil imports. Capital goods and industrial inputs formed a major proportion of non-oil imports, reflecting the increased investment activity in the economy.

Total imports registered a growth of 48.4 per cent in 2004-05. The growth in non-oil imports was even higher at 49.5 per cent during the year, led primarily by imports of capital goods and industrial inputs. In the preceding year, total imports had registered a 25.4 per cent growth with oil imports recording a modest 16.6 per cent growth and non-oil imports a robust 29per cent.

The trade deficit for 2004-05 scaled a historic peak of $38.1 billion, more than double the $16.7 billion the preceding year. The country has never seen the trade deficit of this magnitude. The trade deficit in 2004-05 amounted to 5.5 per cent of GDP compared to an average of a little below 3 per cent in 1990-2004. What is more, going by available indicators, analysts believe that the gap between imports and exports could widen further this fiscal and top the $50-billion mark.

However, no one seems to be worried about the sharp escalation in trade deficit. This is because global capital continues to pour into the economy and the foreign exchange reserves have now gone up more than $140 billion. In 2004-05, invisible receipts grew 45.8 per cent, thanks to significant growth in travel, transportation, software exports and other professional and business services. Software exports at $17.3 billion were up 35 per cent in 2004-05. Private transfers, comprising primarily remittances from Indians working overseas, though lower than in 2003-04, were sizeable at $20.8 billion.

Total net invisible receipts in 2004-05 at $31.7 billion or 4.6 per cent of GDP financed trade deficit to the extent of 83 per cent and, thus, contained the current account deficit at 0.9 per cent of GDP. The re-emergence of a current account deficit in India's balance of payments after three years, when it was in surplus, is viewed by the RBI and analysts as a positive development in that it signals a pick-up in investment activity and cessation of export of domestic savings, as in 2001-04.

Though the trade deficit is set to rise further to about $50 billion this fiscal, the earnings from service exports and other invisibles are also expected to record impressive growth. According to a study by the Federation of Indian Chambers of Commerce and Industry (FICCI), the economy has achieved a fundamental breakthrough in the external sector with service exports recording an astounding 105 per cent growth in 2004-05 to $51.3 billion from $24.9 billion in 2003-04.

This has fuelled the growth in overall external trade with the exports of goods and services zooming to $132.2 billion in 2004-05 from $89.7 billion in the preceding year, up 47.4 per cent. Foreign direct investment (FDI) rose from less than one per cent of total capital flows in the 1980s to 20 per cent in 2004-05. Total portfolio investment flows on account of Foreign Institutional Investors, GDRs and others amounted to $8.9 billion in 2004-05 on top of net inflows of $11.4 billion the preceding year. The Government has indicated that FDI flows will increase more than double in 2005-06 to cross $8 billion from $3.75 billion in 2004-05. The portfolio investment flows are also expected to be higher in 2005-06 than in 2004-05.

As the RBI Annual Report 2004-05 points out, the strong improvement in India's macroeconomic performance has created a preferred habitat for private capital flows led by unprecedented flows of portfolio investment. This was also reflected in an upgradation of India's sovereign rating to investment grade in 2003-04 for the first time since 1997-98.

A major success in external sector management has been the gradual transition from an administered exchange rate regime to a more flexible market-based system.

The growing strength of the external sector in recent years has provided the enabling conditions to accelerate the pace of external liberalisation. The ongoing process of capital account liberalisation is expected to deepen the foreign exchange market further. As a part of this process, outward FDI is receiving increasing policy attention, not merely as a means of contending with rising capital inflows but also as a growing expression of competitiveness and entrepreneurial energy of Indian industry.

Thanks to the policy support, the value of overseas acquisitions by Indian companies more than doubled to $9.30 billion in 2004 from $4.5 billion in the previous year. While the number of deals went up significantly (316 in 2004 compared to 305 in 2003), the huge increase in terms of value indicates how Indian companies are now willing to go for bigger overseas stakes. All indications suggest that this trend is only going to strengthen in 2005 and beyond.

According to the RBI guidelines issued this June, banks have now been allowed to fund overseas acquisitions by Indian companies. Until recently, such financing was possible only through select routes, including the one under the refinance agreement with Exim Bank of India. The RBI, in its Credit Policy announced earlier in the year, had allowed Indian companies to invest up to 200 per cent of their net worth for overseas acquisitions against the earlier level of 100 per cent. Outward FDI may be for seeking resources, penetrating new markets, acquiring domain knowledge or for business synergies. It is well-recognised that a greater integration with the global economy would provide increased competitive strength and resilience to the domestic economy when India not only receives FDI but also promotes outward FDI.

The extent of liberalisation that has taken place in external trade by way of lowering of tariffs, access to low-cost funds and a liberalised exchange rate regime, has already imparted considerable competitive efficiency to the domestic sector. In some sectors, it is almost up to the best international standards. This is reflected in the robust growth in merchandise exports and imports seen in the past few years.

India's merchandise trade (exports and imports) reached $185 billion in 2004-05, comprising exports worth $80 billion and imports of $105 billion. Thus, the total foreign trade during the year was 30 per cent higher than the previous year's level of $142 billion (exports $64 billion and imports $78 billion). The phenomenal growth in exports over the past three years was achieved notwithstanding constraints such as the appreciation of the rupee vis-a-vis the dollar and high fuel prices.

According to the WTO Annual Trade Volume, India's share in world merchandise exports rose from 0.66 per cent in 2000 to 0.82 per cent in 2004. What is particularly noteworthy is that around 80 per cent of the merchandise exports emanate from manufactured products, thanks to the sustained spurt in productivity of the manufacturing sector. This has been made possible by increased investments in modernisation and technology upgradation.

The Foreign Trade Policy announced in 2004 for the first time took a holistic view of integrating foreign trade within the overall framework and development needs of the economy. It has recognised trade as a driver of greater economic activity and incremental employment opportunities rather than just earning foreign exchange.

Of course, there are some challenges relating to the external sector management. In the context of growing trade deficit, efforts are needed to ensure that the growth momentum in both merchandise exports and service exports is maintained. For this, there is a need to remove the existing trade restrictions within the country and strengthen the small- and medium-scale enterprises through policy support. Also, import tariffs must go down further in keeping with the trend in other Asian countries.

Then, there is a question of inflow of hot money on capital account. FII inflows and NRI remittances are far in excess of FDI inflows. The country needs more FDI inflows to sustain the strength of the external sector and provide foreign exchange resources for the growing trend of overseas acquisitions by Indian companies in their effort to become global companies.

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