Examine India’s balance of payments in the last two decades. What have been the trends in terms of merchandise trade, invisibles and capital flows?

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

DIVISION OF BALANCE OF PAYMENTS
The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Financial Account

In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented.

Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

Balance of payments in last 20 years
In the muted celebration earlier this year to mark the completion of two decades of reform, one statistic often referred to was the size of India's foreign exchange reserves. With foreign reserves having crossed the $300-billion mark, India is seen as having convincingly left behind the fragility that led to the collapse of reserves in July 1991 to levels equal to just two weeks worth of imports. Today, reserves can finance close to a year's imports.
While the resulting confidence regarding India's external position is understandable, there are trends and indicators that call for an element of caution. To recall, the 1991 crisis was the result of a loss of lender confidence in India's ability to meet its debt service commitments. A rising external debt-to-GDP ratio and persisting current account deficits in the balance of payments were seen as responsible for that loss of confidence. This led, in the first instance, to a growing reticence to provide long-term debt to India, resulting in a rise in the share of short-term debt in the total.
What was surprising, however, was that this occurred in a context where the country's external debt-to- GDP ratio was by no means alarming. In 1990-91, the external debt-to-GDP ratio was just 29 per cent, which was moderate when compared to the levels that indicator had reached in Latin America at the time of the debt crises of the 1980s. The difficulty was that international banks had already burnt their fingers in Latin America, and therefore were far more wary. From their point of view, what seemed to matter was not the level of external debt relative to national income, but relative to indicators of balance of payments strength. A country recording a combination of persistent current account deficits and a rising debt-to-GDP ratio was suspect, and was likely to lose the confidence of investors.
It is in this light of that experience that recent trends in India's external debt position need to be assessed. Gross external debt has been rising significantly in recent times. Having risen at a slow pace from $83.8 billion on 1990-91 to $104.9 billion in 2002-03, the magnitude of outstanding external debt has more than tripled to $316.9 billion at the end of June 2011.There has been a substantial increase in the external debt.
Five factors have been responsible for this trend. 1. During the period since 2003-04 has been one in which there has been a supply-side driven surge in capital flows to emerging markets worldwide, and India has been one of the beneficiaries. A part of that flow has been in the form of debt, as opposed to portfolio and direct investment. 2. During this time the government has been raising the ceiling on the volume of external commercial borrowing the country can resort to in a year, and has been lax in implementing that ceiling. Moreover, the extent to which any single corporate can resort to external commercial borrowing has also been raised over time. 3. The rate of interest in India has been significantly higher than in the international market, encouraging “carry-trade” investments, or borrowing in foreign markets where rates are lower and lending in India were the rates are higher to benefit from the differential. 4. With the onset of the financial crisis, international banks and financial institutions obtained access to large volumes of cheap liquidity at near-zero interest rates. These funds were pumped into the system by the Federal Reserve of the US and other central banks to bail out the financial system. A part of this liquidity was used by financial firms to indulge in carry trades in emerging markets. 5. In India, this period of global excess liquidity was one in which inflation was ruling high, forcing the Reserve Bank of India to hike interest rates 12 times in a little more than a year. This made India an attractive destination for such flows looking to carry-trade opportunities for easy profits.
India has still immensely benefitted from the by the borrowings and it continues to attract foreign money but there have been few concerns in the economy specifically concerning the merchandise trade which has been very poor for the country as India is entirely dependant on oil exporting countries as it does not have any oil reserves back home. This is the reason India has been continuously been struggling to reduce its trade deficit and at the same time , Indian currency is also a little bit overvalued which affects the exports even more.

TRENDS IN NET CAPITAL FLOWS TO INDIA

Graph 1
Net capital flows to India

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Net capital inflows, which increased from 2.2% of GDP in 1990/91 to around 9% in 2007/08, do not, however, reflect the true magnitude of capital flows to India. Gross capital inflows, as a percentage of GDP, have undergone a more than fivefold increase from 7.2% in 1990/91 to 36.6% in 2007/08. Much of this increase has been offset by corresponding capital outflows, largely on account of foreign institutional investors’ (FIIs) portfolio investment transactions, Indian investment abroad and repayment of external borrowings. Capital outflows increased from 5.0% of GDP in 1990/91 to 27.4% of GDP in 2007/08. The gross volume of capital inflows amounted to $428.7 billion in 2007/08 as against an outflow of $320.7 billion.

Strong capital flows to India in the recent period reflect the sustained momentum in domestic economic activity, better corporate performance, the positive investment climate, the long- term view of India as an investment destination, and favourable liquidity conditions and interest rates in the global market. Apart from this, the prevailing higher domestic interest rate along with a higher and stable growth rate have created a lower risk perception, which has attracted higher capital inflows.

The large excess of capital flows over and above those required to finance the current account deficit (which is currently around 1.5% of GDP) resulted in reserve accretion of $110.5 billion during 2007/08. India’s total foreign exchange reserves were $308.4 billion as of 4 July 2008.

TRENDS IN MERCHANDISE TRADE AND CURRENT ACCOUNT

Net capital flows ($ billions, lhs)
Net capital flows/GDP (in per cent, rhs)

With GDP figures pointing to a return of the era of 9 per cent growth, little attention is being paid to a disconcerting feature of India’s external payments position. Taking a long view, we find that the current account deficit on the balance of payments which fell from 3.4 per cent of GDP in crisis year 1990-91 to 0.6 per cent in 2000-01 (and even turned to surplus in the subsequent three years) has now widened from a marginal 0.4 per cent of GDP in 2004-05 to 3.3 per cent in 2009-10. This widening of the current deficit is on account of two factors. First, the merchandise trade deficit in India’s external account has risen from 2.3 per cent of GDP in 2002-03 to 10 per cent in 2009-10. And, second the year 2009-10 has seen a sudden decline in revenues from services, which fell from 4.6 per cent of GDP to 2.9 per cent of GDP. Matters would have been much worse if remittances as reflected in the Private Transfers figure had not remained at high levels.
The figures do point to a long term syndrome that must colour the otherwise bright picture of the country’s economic performance. Ever since India opted for its first big IMF loan in 1981 in the aftermath of the second oil shock, increased dependence on foreign capital inflows has been justified on the grounds that they provide India the wherewithal to transform its economic structure and redress what is its long-term weakness: poor export performance. Capital flows it was argued would: (i) allow the country to liberalise trade and subject domestic economic agents to efficiency-enhancing international competition; (ii) permit Indian firms to access the foreign exchange needed to import the capital and technology required to modernise their equipment and establish internationally competitive capacities that would allow them to compete in export markets; (iii) bring with them international producers intent on using India as a base and source for production for the world market; and (iv) finance any “interim” deficit that may result from an import surge that follows trade liberalisation but precedes India’s transformation into a successful exporter.
As the accompanying Chart shows, the period from 2004-05 when India has moved on to a high growth trajectory of between 8 and 9 per cent is a period when the merchandise trade deficit has widened quite sharply. This did not matter too much till recently since remittance incomes were sustained, while incomes from the exports of miscellaneous services (including, IT, IT-enabled and business services) were rising significantly. It was when the latter dipped in 2009-10 that the current deficit widened to levels that could be a cause for concern.

FOREIGN INVESTMENT INFLOWS TO INDIA

Graph 2
Foreign investment inflows to India

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FDI Foreign portfolio investment

Source: Reserve Bank of India.

Equity flows under foreign direct investment (FDI) and foreign portfolio investments constitute the major forms of non-debt-creating capital flows to India. There has been a marked increase in the magnitude of FDI inflows to India since the early 1990s, reflecting the liberal policy regime and growing investor confidence. India’s share in global FDI flows increased from 2.3% in 2005 to 4.5% in 2006. Inflows under FDI were particularly high during the last two years, though a large part was offset by significant outflows on account of overseas investment by Indian corporates.

In a major break from the past, the spurt in FDI flows to India in the recent period has been accompanied by a jump in outward equity investment as Indian firms establish production, marketing and distribution networks overseas to achieve global scale along with access to new technology and natural resources. Investment in joint ventures (JV) and wholly owned subsidiaries (WOS) abroad has emerged as an important vehicle for facilitating global expansion by Indian companies. Overseas direct equity investment from India jumped from $3.8 billion in 2005/06 to $11.3 billion in 2006/07, and rose further to $12.5 billion during 2007/08. Overseas investment, which started with the acquisition of foreign companies in the IT and related services sector, has now spread to other areas such as non-financial services.

INVISIBLES TRADE BALANCE

The import and export of services, income and government transfers between countries for which a balance of trade is maintained. Examples of services include tourism , technology exchange , transportation , banking and insurance. Income is derived from interest on foreign currency exchange and other capital movements.

Net invisible earnings have underpinned the dramatic strengthening of India’s external position through the 1990s and the first quinquennium of the 2000s. Rising surpluses on account of invisible transactions have financed a significant portion of the merchandise trade deficit that has traditionally characterised India’s balance of payments. This has been the key factor that has contained the current account deficit at 1.0 per cent of GDP over the period 1993-2001. Through 2001-04, sizeable invisible surpluses have comfortably filled the merchandise trade gap and spilled over into a continuous run of current account surplus (Table). It is only in 2004-05 that a small current account deficit has re-emerged, powered by a massive expansion in merchandise imports. The robust growth of net invisible earnings has, however, become entrenched during the current year. Lead indicators of underlying activity suggest that the invisible surplus of US $ 14.2 billion recorded in the first half of the year would be built up further over the rest of the year.
In recent years, attention has been drawn to this silent transformation in India’s external transactions whereby invisibles comprising services, income from financial assets, labour and property and current transfers are rapidly catching up with merchandise exports as the principal foreign exchange earners for the country. Several forces are at work - the structural shifts in the economy in which services have assumed a dominant position in the production structure and as the key driver of growth; structural reforms and external liberalisation which have released new growth impulses and enabled productivity and cost efficiency to set a cutting edge to

Table: Selected Indicators on Invisibles | | | | | | | | (Per cent) | | | | | | | | | | | 1990-91 | 1995-96 | 2000-01 | 2001-02 | 2002-03 | 2003-04 | | | | | | | | | Net Invisibles | | | | | | | | (US $ billion) | | -0.2 | 5.4 | 9.8 | 15.0 | 17.0 | 26.0 | | | | | | | | | Net Invisible/ | | | | | | | | Trade Balance | | -2.6 | 48 | 78.6 | 129.4 | 159.4 | 168.3 | | | | | | | | | Invisible Receipts/ | | | | | | | Invisible Payments | 96.9 | 144.6 | 143.6 | 168.8 | 168.4 | 196.5 | | | | | | | | | Invisible Receipts/GDP | 2.4 | 5.0 | 7.1 | 7.7 | 8.2 | 8.8 | | | | | | | | | Invisible Payments/GDP | 2.4 | 3.5 | 4.9 | 4.6 | 4.9 | 4.5 |

international competitiveness; the information technology revolution; the modes of delivery of services opened up by advances in communication technology which have enabled the reaping of the returns to knowledge advantage. The interaction of these forces with the changes underway in the domestic macroeconomic environment has enabled India to emerge as the preferred habitat for the financial savings of its expatriate diasporas.
Inward remittances from Indians located overseas have surged in response to the reforms carried out since 1993. India’s traditional advantage in exports of labour has benefited in recent years from a distinct shift in the destination pattern of the outflow of natural persons away from the Middle East in favour of Europe and America. In 2003-04, India was the world’s leading recipient of remittances, accounting for about 20 per cent of global flows. This position is expected to be maintained in 2004-05. According to the IMF’s Balance of Payments Statistics Yearbook, India ranked 18th among the world’s leading exporters of services, with a share of 1.3 per cent in world exports, having moved up from the 27th position in 1990 when its share was 0.6 per cent. Among these commercial services, India is fast emerging among the top ten tourism-exporting countries of the world. According to the World Travel and Tourism Council, India became the second fastest growing tourism economy in the world.
The information technology industry in India has fortified its position as a world leader. In the Business Process Outsourcing segment, India has maintained its lead as the best outsourcing destination, particularly for the US and European companies. India accounted for 3.4 per cent of global IT spending in 2003-04. As regards IT enabled services, India renders two-thirds of all offshored services worldwide. Indian companies have also made rapid strides in securing shares in the world markets for communication and management services.

Although India has been suffering with negative rate of balance of trace but India has been able to sustain itself because of continuous surplus in Invisibles and India needs to explore its resources and find out solutions to its long standing requirements of oil and other related products which have been major reasons for the India’s negative trade balance.