Wednesday, May 18, 2011

A long term strategy is imperative to achieve a consistent high export growth, control POL imports and achieve a sound BOP position

‘A long term strategy is imperative to achieve a consistent high export growth, control POL imports and achieve a sound BOP position.’ Critically evaluate this statement in the light of BOP crisis faced by India.

Answer. The balance of payments of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. A country which is faced with exiting or projected balance of payments deficits on combined current and capital accounts has a variety of policy options. It can seek to improve the balance on current account by promoting export expansion/or limiting imports. A second alternative, though often not exclusive of the first, is to improve the balance on their capital account by encouraging more private foreign investment and seeking more public foreign assistance. Finally, a country can also seek to modify the detrimental impact of chronic balance of payments deficits by expanding their stocks of official monetary reserves. Generally, under the workings of the international monetary system, countries with deficits in their balance of payments are required to pay for these deficits by drawing down on their official reserves comprising gold, U.S. Dollars and SDRs. Fiscal imbalances were the root cause of the 1991 balance of payments crisis in India. By the end of the 1980s, deteriorating government finances had resulted in a significant widening of the current account deficit, an accumulation of government and external debt, and rapidly rising debt service. As concerns about the external position mounted, and with a renewal of domestic political tensions, India’s credit rating was downgraded, access to external borrowing dried up, and nonresident deposits were withdrawn. By early 1991, foreign exchange reserves were almost depleted, and India was on the verge of default.

Two sources of external shocks contributed the most to India’s large current account deficit in 1990/91. The first shock came from events in the Middle East in
1990 and the consequent run-up in world oil prices, which helped precipitate the crisis in India. In 1990/91, the value of petroleum imports increased by $2 billion to
$5.7 billion as a result of both the spike in world prices associated with the Middle

East crisis and a surge in oil import volume, as domestic crude oil production was
impaired by supply difficulties. In comparison, non-oil imports rose by only 5 percent in value (1 percent in volume terms). The rise in oil imports led to a sharp deterioration in the trade account, worsened further by a partial loss of export markets (as the Middle East crisis disturbed conditions in the Soviet Union, one of India’s key trading partners). The Gulf crisis also resulted in a decline in workers’ remittances, as well as an additional burden on repatriating and rehabilitating nonresident Indians from the affected zones.

Second, the deterioration of the current account was also induced by slow growth in important trading partners. Export markets were weak in the period leading up to India’s crisis, as world growth declined steadily from 41/2 percent in 1988 to
21/4 percent in 1991. The decline was even greater for U.S. growth, India’s single largest export destination. U.S. growth fell from 3.9 percent in 1988 to 0.8 percent in 1990 and to –1 percent in 1991. Consequently, India’s export volume growth slowed to 4 percent in 1990/91.

In addition to adverse shocks from external factors, there had been rising political uncertainty, which peaked in 1990 and 1991. After a poor performance in the 1989 elections, the previous ruling party (Congress), chaired by Rajiv Gandhi (the son of former Prime Minister Indira Gandhi), refused to form a coalition government. Instead, the next largest party, Janata Dal, formed a coalition government, headed by V.P. Singh. However, the coalition became embroiled in caste and religious disputes and riots spread throughout the country. Singh’s government fell immediately after his forced resignation in December 1990. A caretaker government was set up until the new elections that were scheduled for May 1991. These events heightened political uncertainty, which came to a head when Rajiv Gandhi was assassinated on May 21, 1991, while campaigning for the elections. India’s balance of payments in 1990/91 also suffered from capital account problems due to a loss of investor confidence. The widening current account imbalances and reserve losses contributed to low investor confidence, which was further weakened by political uncertainties and finally by a downgrade of India’s credit rating by the credit rating agencies. Commercial bank financing became hard to obtain, and outflows began to take place on short-term external debt, as creditors became reluctant to roll over maturing loans. Moreover, the previously strong inflows on nonresident Indian deposits shifted to net outflows.

To make the balance of payments viable, the key lies in consistently stepping up exports. On the import front, POL will require special attention if the country has to be protected from external-price hike-shocks. Petro products being the dominant import item, measures be taken to augment domestic production. There is ample scope for locating new petro reserves as only 6 out of 26 basins that have potential for oil and gas in India have been explored and that too only partially. Significant and consistent export growth so as to cover the growing import bill will bring a turn-around by removing vulnerability of India’s balance of payments.

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