India has faced severe periods of unstable growth and painful adjustments whenever it developed weaknesses in its external sector. Some examples of externally induced stress are — the early 1980s due to the oil crisis; 1991 because of the balance of payments crisis; and very recently the slowdown because of the global financial crisis, though the impact proved to be mild.

The management of external sector in India saw a paradigm shift after the early 1990s, following the severe impact of the balance of payments crisis of 1991. The policies that were reshaped since then covered trade, foreign investment, exchange rate and reserves management and the management of the capital account. The strategic changes served the country well. But there are, of late, some signs of weakening of the external sector indicators.

Even while fighting inflation as enemy number one, authorities should bestow renewed attention on the external sector, before the incipient signs of weakness become worse and impact the current growth story. There are positives such as buoyant exports that need to be strengthened, and negatives such as widening current account deficit, riskier financing pattern of meeting this deficit and dwindling foreign investment, which need to be reversed.

Trade and Current Accounts

The well-conceived trade policy of the government for 2009-2014 has so far yielded good results. Despite weaknesses in global recovery, India's export/trade performance has been exemplary. The pick-up in exports to $245.56 billion in 2010-11 surpassed the government's target and quelled fears of current account deficit exceeding the prudential limit of around 3 per cent of GDP. Despite the robust growth in imports, the trade deficit narrowed to $105.14 billion, from $116.03 billion in 2008-09.

Trade diversification both in terms of commodities/services and the regional direction shifting from traditional US and Europe to emerging markets including China and Latin America, would serve to insulate India from global shocks emanating from the advanced countries.

Invisible receipts, however, have come down from $91.6 billion in 2008-09 to $79.99 billion in 2009-10 and further down to $63.18 billion during April-December 2010-11. As a result, the current account deficit for the period April-December 2010-11 was larger than the full year level of 2009-10.

Capital Flows

There are some worrisome developments in capital flows. The non-debt creating foreign direct investment came down sharply from $34.17 billion to $27.02 billion and the portfolio flows also decreased marginally from $ 32.38 billion to $ 31.47 billion between 2009-10 and 2010-11. The ECBs/FCCBs flow increased from $18.36 billion in 2007-08 to $25.78 billion in 2010-11. This trend is not consistent with the policy of encouraging non-debt creating flows. One reason for the sluggish trend in capital flows, apart from the weak equity market, is governance both at the government and corporate levels, following a series of scandals. Restoring confidence should be the utmost priority through both institutional and legal reforms.

Another reason is restrictions on entry into the debt market. The Raghuram Rajan Committee on financial sector reforms recommended complete opening up of FII investment into debt market without any annual ceilings. While there could be some restrictions on FII investment in government securities market pending full convertibility, this recommendation should be considered as far as the corporate debt market is concerned.

First, this will allow FIIs to adjust their portfolio between bonds and equity and also expand their investment in debt on an enduring basis. Second, in times of equity market tumbling as in recent times, FIIs will use debt market for parking their funds and as such the volatility in capital flows and its consequent impact on exchange rate could be minimised. FII entry on a large scale could improve trading and settlement practices as a spill over as was the case in the equity market when that market was opened up earlier. These reforms will require coordinated action from regulators and the government.

The public issue of corporate bonds increased multifold from Rs.1,500 crore in 2008-09 to Rs. 9,451 crore in 2010-11, though its share in total issues was still small. The private placement issues, which is the dominant mode, nearly doubled from Rs.1.18 lakh crore in 2007-08 to 2.19 lakh crore in 2010-11. After the introduction of trade reporting, the information on secondary market trading shows that the volume has increased substantially in all the three platforms.

Exchange Rate and Reserves

The policy on exchange rate and reserves management has become increasingly opaque in the recent period. Forex reserves, after falling from pre-crisis level, are yet to be restored even while the current account deficit has more than doubled and the capital flows have become more volatile. Both, the nominal and real effective exchange rate of the rupee show significant appreciation. There has been a real appreciation of rupee by more than 15 per cent in 2010-11.

There are no clear answers to whether the reserves are adequate and whether export competitiveness can be sustained in the face of rupee appreciation. The Reserve Bank is seen as non-interventionist in the forex market. When the road to full convertibility is yet very long, the time is not yet ripe for a hands-off policy on exchange rate and reserves management. The strategy requires re-examination in country's best interests, and should be reviewed in the context of what is happening in competing currencies in Asia and in particular, China.

Overall, what is required is a concerted, integrated and coordinated external sector policy from the regulators and the government.

(The author is Director, EPW Research Foundation. The views are personal. >blfeedback@thehindu.co.in )

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