ESCAP
SOUTH AND SOUTH-WEST
ASIA OFFICE
TRADE, CAPITAL FLOWS
AND THE BALANCE OF PAYMENTS:
Trends, Challenges and Policy Options for India
Nagesh Kumar
March 2013
DEVELOPMENT PAPERS 1303
South and South West Asia Office
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Disclaimer: The views expressed in this Development Paper are those of the author(s) and
should not necessarily be considered as reflecting the views or carrying the endorsement of
the United Nations. Development Papers describe research in progress by the author(s) and
are published to elicit comments and to further debate. This publication has been issued
without formal editing.
For any further details, please contact:
Dr. Nagesh Kumar, Director
South and South-West Asia Office (SSWA)
Economic and Social Commission for Asia and the Pacific (ESCAP)
C-2 Qutab Institutional Area, New Delhi-110016, India
Email: sswa.escap@un.org
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South and South-West Asia Development Papers 1303
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Table of Contents
Foreword ........................................................................................................................................................ 5
Abstract .......................................................................................................................................................... 7
1.
Introduction ........................................................................................................................................... 9
2.
Merchandise trade ............................................................................................................................... 10
3.
Services in India’s Trade ..................................................................................................................... 17
4.
Current Account Balance .................................................................................................................... 18
5.
Foreign Direct Investment flows and their quality .............................................................................. 22
6.
Regional economic integration............................................................................................................ 28
7.
Concluding remarks ............................................................................................................................ 30
References .................................................................................................................................................... 30
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South and South-West Asia Development Papers 1303
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Foreword
The Development Papers Series of the ESCAP South and South-West Asia Office (ESCAPSSWA) promotes and disseminates policy-relevant research on the development challenges facing
South and South-West Asia. It features policy research conducted at ESCAP-SSWA as well as by
outside experts from within the region and beyond. The objective is to foster an informed debate on
development policy challenges facing the subregion and sharing of development experiences and best
practices.
This paper summarizes the emerging trends, patterns and challenges in India’s external sector
since the reforms of 1991. The reforms have led to a rising share of global trade and an even more
dramatic transformation of services trade and emergence of the country as one of the most attractive
investment destinations as well as an important source of FDI flows. However, opportunities for
product and market diversification could not be fully exploited to sustain growth and create more
jobs. Despite healthy trade surpluses earned by services, the balance of payment situation has again
entered into a period of stress over the past few years with rising current account deficits needing an
immediate policy response. Export competitiveness needs to be strengthened through appropriate
exchange rate management and opportunities for strategic import substitution need to be exploited by
leveraging India’s large domestic market size using industrial policy measures. The paper argues that
revival of manufacturing to substitute lumpy imports of manufactured goods will not only help in
addressing the current account deficits but also create jobs for skilled and unskilled workers helping in
poverty reduction. India has also engaged ASEAN and other East Asian countries over the past two
decades as a part of the Look East Policy and is now a partner in emerging broader regional economic
arrangement. Indian industry however, has been slow in harnessing the opportunities provided by
these engagements.
We hope that this paper will contribute to the ongoing debate on external sector challenges
that the country faces and how they are to be addressed including through regional cooperation and
integration in the aftermath of the global financial crisis.
Nagesh Kumar
Director, ESCAP South and South-West Asia Office
and Chief Economist, ESCAP
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South and South-West Asia Development Papers 1303
March 2013
Trade, Capital Flows and Balance of Payments: trends,
challenges and policy options for India
Nagesh Kumar1
ABSTRACT
The reforms pursued since 1991 have deepened global integration of the Indian economy in terms of a
rising share of trade and an even more dramatic transformation of services trade as well as the
emergence of the country as one of the most attractive destinations for and important source of FDI
flows. Analysis shows however that opportunities for product and market diversification remain to be
fully exploited to sustain growth and create more jobs. Despite healthy trade surpluses earned by
services as India emerged as a global hub for ICT outsourcing, the balance of payment situation has
again entered into a period of stress due to a dramatic widening of the merchandise trade deficit.
While India now has the comfort of sizeable foreign exchange reserves unlike in 1991, this is an
important policy challenge needing an immediate response. Export competitiveness needs to be
strengthened through appropriate exchange rate management and opportunities for strategic import
substitution need to be exploited by leveraging India’s large domestic market size using industrial policy measures. Revival of manufacturing to substitute lumpy imports of manufactured goods will
not only help in addressing the current account deficits but also create jobs for skilled and unskilled
workers helping in poverty reduction. While farsighted policies have led India becoming a part of
emerging broader regional economic arrangement, Indian industry has to learn to exploit the
opportunities provided by preferential access to East Asian markets rather than passively grant market
access.
JEL Code(s): F13, F21, F32
Key words: Trade Policy, International Investment, Current Account Adjustment,
1
Chief Economist, UN-ESCAP and Director UNESCAP South and South-West Asia Office, New Delhi. The
author thanks Ashima Goyal and an anonymous reviewer for comments. The author is grateful to Christopher
Garroway for some computations reported and to Helene Meurisse, Quentin Roblin, Neha Aggarwal, and Vinod
Soman, ESCAP-SSWA interns in 2012 for their competent research assistance. The United Nations or its
Member States are not responsible for the views expressed, which should be attributed to the author alone.
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South and South-West Asia Development Papers 1303
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Trade, Capital Flows and Balance of Payments: trends,
challenges and policy options for India
1. Introduction
A major liberalization of trade and investment regimes has taken place since 1991 as a part of the
package of reforms to deepen integration of the Indian economy with the world economy as a whole.
Peak tariff rates came down from 150 per cent in the early 1990s to just 10 per cent by 2007. The
quantitative restrictions on imports were phased out and the bulk of the tariff lines (over 70%) have
been bound under WTO. Most sectors of the economy are today open to foreign direct investment
(FDI) with up to 100 per cent foreign ownership, although sectoral ownership limits apply in service
sectors. Since 1992, foreign institutional investors (FIIs) have also been allowed to invest in India.
The Indian rupee was made convertible in the current account and the capital account is being opened
gradually, including a gradual liberalization of the regime governing outward FDI from India.
These economic reforms have led to industrial restructuring in the country with a focus on
competitiveness and global economic integration. The growing economic integration of the Indian
economy is reflected in various indicators including the rising share of trade in the economy. The
structure and direction of trade have changed over time along with growing magnitudes. An important
and more dynamic aspect of India’s integration with the world economy is through the growing trade
in services. India has emerged as a hub for outsourcing of IT software and other business services
such as business process outsourcing (BPO). India is also attracting attention from major multinational
enterprises (MNEs) around the world wishing to make India a hub for knowledge-based services to
tap the availability of high-quality low-cost trained human resources as well as scientific and
technological infrastructure. Another aspect of growing global integration is through FDI – both
inward and outward. With a liberal FDI policy regime and a large and growing domestic market
among other advantages, India is attracting increasing attention of MNEs even as Indian enterprises
also develop global ambitions and are undertaking outward investments in increasing numbers and
magnitudes.
India is known for an impressive turnaround of the external sector from a foreign exchange crisis
faced in 1991, when the current account deficit touched 3 per cent of GDP, to a current account
surplus during 2001-04 and the buildup of large foreign exchange reserves. Today, however the
economy has once again entered a period of balance of payment stress in the wake of the global
financial crisis of 2008/09, which still continues to rattle the world economy in 2013. Besides the
urgent attention of policy makers to the balance of payment situation, the global financial crisis has
warranted another major rebalancing in the trade structure away from traditional trade partners in the
West to increasingly greater reliance on fast growing Asia-Pacific economies. These Asia-Pacific
economies are emerging as the centre of gravity of the world economy due to the inability of the
Western advanced economies to act as global growth engines in the medium term (UN-ESCAP 2012).
With a visionary Look East Policy (LEP) pursued since 1992, India is well placed in this respect,
having engaged ASEAN and other East Asian countries through a growing web of free trade
agreements (FTAs). Indeed, India is an important part of an incipient broader regional economic
arrangement bringing together 16 of region’s largest and fastest growing economies. Therefore,
regional economic integration is likely to play an increasingly important role in the global economic
integration of the Indian economy in the coming years.
Against that backdrop, this paper considers the changing trade and investment profile of the Indian
economy highlighting major emerging trends and patterns and concludes with a few policy lessons to
address the challenges that currently face the external sector.
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
2. Merchandise trade
2.1 Growth of Merchandise Trade
The reforms of the 1990s led to a rapid expansion of India’s trade. The growth rates of India’s exports and imports averaged over 10 per cent during the 1990s but stepped up to an average of 22 per cent in
the past decade. Imports have generally grown at faster rates (24%) than exports (20%) as shown in
Table 1. Rapid growth of trade is reflected in the rising share of trade in India’s GDP. The share of
merchandise trade in GDP has more than doubled between 2001-02 to 2011-12 from 21.2 to 43.8 per
cent. In fact, the global integration of the economy crosses 60 per cent if trade in services is also
included (Figure 1).
Table 1. India’s Merchandise Trade Growth Rates and Balance
(Million US$)
2001-02
2011-12
Avg. Annual
Growth Rate
(2001-2011)
43 827
304 624
20%
9.4
16.8
51 413
489 417
11.8
27.0
95 240
794 041
21.2
43.8
-7 586.6
-184 793.9
Exports
Share in GDP
Imports
Share in GDP
Total trade
Share in GDP
Balance of trade
24%
Source: Extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
Figure 1. Growing importance of trade in the economy
70.0
Trade/GDP
Percentage of GDP
60.0
Trade in services/GDP
50.0
Trade in goods and
services/GDP
40.0
30.0
20.0
10.0
2011-12
2010-11
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
1991-92
1990-91
0.0
Source: Author based on RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
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South and South-West Asia Development Papers 1303
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The other noticeable trend is the widening deficit in balance of trade with imports growing at a faster
rate than exports. The trade deficit has snowballed from USD$ 5-6 billion a year in the beginning of
the last decade to USD$ 185 billion in 2011-12, which amounts to over 10 per cent of GDP (Table 1,
Figure 2). The widening trade deficit has created balance of payment challenges for the economy even
after taking care of a substantial surplus in invisibles or services trade, as observed later.
Figure 2. Trends in Balance of Trade, 1991-2012
Millions of US dollars
600,000
500,000
Exports (X)
400,000
Imports (M)
300,000
Trade Balance (X- M)
200,000
100,000
0
-100,000
-200,000
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
-300,000
Source: Author based on RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
2.2 Changing structure of trade
The export structure is expected to change with the level of development from one dominated by
primary products to products with greater value-added. Diversification of export structure also makes
the exporting country less vulnerable to external shocks compared to a country with a more
concentrated export structure. Table 2 summarizes some important shifts in the patterns of India’s export structure over 1995-2012. Firstly, as expected, the share of primary products including
agricultural and mineral products has declined steadily from nearly a quarter of India’s merchandise
exports to just 15 per cent over the 1995-2012 period. However, the declining share of India’s manufactured exports is a matter of concern, with manufactures steadily decreasing from a peak of 77
per cent of merchandise exports in 2000-01 to 60 per cent in 2012. However, this decline can be seen
as a statistical artifact due to the emergence of India as a petroleum refining hub. Exports of refined
petroleum products rose from virtually nothing in 1995-96 to 18 percent of India’s exports by 2012. If
refined petroleum products are considered as value-added products like other manufactured and
processed products, then the share of manufactured goods in exports would be nearly 78 percent in
2011-12, which is roughly at the level of 2000-01.
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Table 2. Structure of India's Exports from 1995 to 2012
Commodity / Year
1995-96
Share
2000-01
Share
2005-06
Share
2008-09
Share
2011-12
Share
I. Primary Products
7257
23%
7126
16%
16377
16%
25335
14%
45574
15%
Agriculture and Allied
Products
Ores and Minerals
6082
19%
5973
13%
10214
10%
17535
10%
37421
12%
1175
4%
1153
3%
6164
6%
7801
4%
8153
3%
II. Manufactured Goods
23747
75%
34335
77%
72563
70%
123149
67%
186784
60%
Leather and Manufactures
1752
6%
1944
4%
2698
3%
3556
2%
4789
2%
Chemicals and Related
Products
Engineering Goods
3597
11%
5886
13%
14770
14%
22708
12%
37191
12%
4391
14%
6819
15%
21719
21%
47286
26%
67093
22%
Textile and Textile
Products
Gems and Jewellery
8032
25%
11285
25%
16402
16%
20016
11%
27998
9%
5275
17%
7384
17%
15529
15%
27955
15%
46901
15%
434
1%
662
1%
462
0%
301
0%
234
0%
267
1%
356
1%
984
1%
1327
1%
2580
1%
454
1%
1870
4%
11640
11%
27547
15%
55604
18%
Handicrafts (excluding
Handmade Carpets)
Other Manufactured
Goods
III. Petroleum Products
IV. Others
TOTAL Exports
(millions USD)
337
1%
1229
3%
2511
2%
6768
4%
16662
5%
31795
100%
44560
100%
103091
100%
182800
100%
309624
100%
Source: Extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
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South and South-West Asia Development Papers 1303
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There is also a slight reorganization of exports of manufactured products as the share of conventional
products like textiles and clothing has come down from a 25 per cent to just 9 per cent since 1995-6
while leather products declined to 2 per cent, which is only a third of what it was in 1995-6. Gems and
Jewellery has also lost its importance slightly from a 17 per cent share to 15 per cent. At the same
time, the share of engineering goods rose steadily from 14 per cent to 22 per cent of all merchandise
exports. Among engineering goods, exports of transport equipment have risen very fast from less than
a billion dollars in 1995 to nearly USD$21 billion in 2011-12.
Besides exporting vehicles and two wheelers, India has emerged as a competitive exporter of auto
parts and a number of procurement groups of auto companies such as Delphi Systems (for General
Motors) and Visteon (of Ford) have set up procurement subsidiaries in India. This emergence owes
itself to a particular strategic intervention by the government in the form of an erstwhile performance
requirement that required foreign-owned companies to balance imports by foreign exchange earnings
(Kumar 2005). Machinery and equipment has been another category that has risen in importance.
Chemicals and related products is another group of manufactured products that has improved its share
in total merchandises exports even if only marginally from 11 to 12 per cent. But among the chemicals
and allied products, chemicals and pharmaceuticals group has gained the most. This is due to India’s emergence as a major exporter of generic medicines in the world, accounting for a third of global
pharmaceuticals exports by volume. A major supplier of cost effective generics to developing
countries and multilateral organizations like the World Health Organization (WHO) for their healthcare programmes in developing countries, India is sometimes referred to as the pharmacy of the
developing world. That success owes itself to another strategic intervention by the government in
terms of the adoption of a patent law abolishing product patents for pharmaceuticals in 1970, which
encouraged development of generics by Indian companies (Kumar 2003).
It is clear that India’s export structure has over time moved from the export of primary and
conventional products such as textiles and clothing, leather products and gems and jewelry towards
products with greater value-added, such as transport equipment, generic pharmaceuticals and refined
petroleum products. However, the share of technology-intensive products in India’s exports is still very low compared to that of East Asian countries. Recent figures suggest that the share of hightechnology exports in India’s export basket was only 7.2 per cent compared to 26.2 per cent for East
Asian countries (UN-ESCAP SSWA, 2012). India has also not been able to make a mark in fastgrowing high value-added segments of manufacturing such as electronic and telecom equipment
(Kumar and Joseph 2007). In fact growing imports of electronic equipment and other hardware are
straining India’s trade balance, as observed below. India has also not been able to exploit the jobcreating potential of exports and has been unable to develop highly labour-intensive export-oriented
industries such as toys and electronic assembly, among others (RIS 2006).
India’s import structure has also changed over the years, as summarized in Table 3. Firstly imports
comprising crude oil, raw materials and certain food imports account for as much as 44 percent of
total merchandise imports in 2011-12 compared to 39 percent in 1995-6. In particular, the share of
petroleum, crude and products has risen rapidly from 21 percent to 32 percent over the same period.
While consumption of petroleum and crude has risen in the country with growth of volumes, a part of
the increase is due to rising fuel prices over the past decade. Considering that the demand of bulk
imports that are mainly raw materials and foods is relatively price inelastic, in the context of rising
trade deficit, one needs to pay attention to rising imports of capital goods and others even though their
overall share in total imports may have come down. Among the capital goods, major categories
include machinery, except electrical accounting, for $30 billion, electronic goods worth $33 billion,
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
transport equipment $14 billion, and project imports $8.7 billion in 2011-12. In particular, imports of
electronic goods are expected to rise to $400 billion by 2020 at current trends.2
The demise of India’s fledgling electronic hardware industry is to be partly explained in terms of India’s premature signing of the WTO’s Information Technology Agreement 2000. It exposed Indian
manufacturers to direct competition with established rivals in the East Asian countries that have
massive scales of production due to their links with multinational supply chains. It is in these
categories of imports that an attempt needs to be made to pursue strategic import substitution to
leverage the sizeable domestic markets to develop domestic supply capabilities that will also generate
value added and jobs while helping to moderate the trade deficit (Aggarwal and Kumar 2012). Gold
(other non-bulk) is yet another item, imports of which are growing and were of the order of $66 billion
in 2011-12. While a part of the gold feeds into the gems and jewelry exports, a large part is for
domestic consumption and investment by households. Expansion of well-rated exchange traded funds
(ETFs) might help in curbing the demand by households especially for investment purposes.
Table 3 Structure of India's Imports from 1995 to 2012
Commodity / Year
1995-96
Share
2000-01
Share
2005-06
Share
2008-09
Share
2011-12
Share
I. Bulk Imports
14314
39%
20816
41%
61086
41%
138791
46%
214755
44%
Petroleum, Crude and
Products
Bulk
Consumption
Goods
Other Bulk Items
7526
21%
15650
31%
43963
29%
93672
31%
154906
32%
970
3%
1443
3%
2767
2%
4975
2%
11614
2%
5819
16%
3722
7%
14356
10%
40144
13%
48234
10%
II. Non-Bulk Imports
22361
61%
29721
59%
88080
59%
160043
54%
274663
56%
Capital Goods
10330
28%
8941
18%
37666
25%
71833
24%
99365
20%
Mainly Export Related
Items
Others
5257
14%
8059
16%
18641
12%
31931
11%
54479
11%
6773
18%
12721
25%
31772
21%
56279
19%
120819
25%
TOTAL Imports
36675
100%
50537
100%
149166
100%
298834
100%
489417
100%
Source: extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
2.3 Changing geography of trade
A major transformation has taken place in the direction of India’s trade in terms of declining dependence on conventional trade partners like the European Union and the United States and
diversification of trade in new and emerging markets. As Table 4 shows, the share of EU in India’s trade in 2010 is less than half of what it was in 1990. Similarly North America’s share has come down from 14 percent to just 8.3 percent over the same period. Japan’s share in India’s trade is now only a fourth of what it was in 1990. The trade structure is gradually diversifying in favour of emerging
countries in Asia-Pacific region and beyond. The most impressive rise is that of China from a
negligible share in 1990 to over 10 percent of India’s trade by 2010, making China the single largest
trade partner of India.
2
http://www.thehindubusinessline.com/industry-and-economy/electronic-goods-import-up-30-to-rs-157-lakh-crin-201112/article4512418.ece?homepage=true&ref=wl_home
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South and South-West Asia Development Papers 1303
March 2013
Table 4 Changing direction of India’s trade, 1990-2010
North America
European Union
ASEAN
South Korea
Japan
China
Australia
ASEAN+6 subtotal
SAARC
Middle East
Africa
Latin
America
Carribean
World
&
% share in
1990
1995
2000
2005
2009
2010
Imports
12.66
10.79
7.17
7.02
7.66
6.33
Exports
Trade
16.14
14.14
18.49
14.41
23.25
14.54
18.21
11.64
12.07
9.38
11.50
8.34
Imports
33.67
26.91
21.32
17.39
14.34
12.10
Exports
Trade
28.87
31.62
27.62
27.24
24.38
22.72
22.43
19.47
21.14
17.00
18.64
14.64
Imports
6.77
7.20
8.70
7.46
9.29
8.46
Exports
Trade
4.27
5.70
7.77
7.47
6.45
7.67
10.10
8.55
10.51
9.77
10.32
9.19
Imports
1.36
2.08
1.96
3.07
3.05
2.83
Exports
Trade
0.92
1.17
1.29
1.71
1.07
1.56
1.66
2.49
2.26
2.74
1.63
2.37
Imports
7.51
6.48
4.00
2.76
2.48
2.36
Exports
Trade
9.30
8.27
6.98
6.71
4.15
4.07
2.44
2.62
1.93
2.26
2.16
2.28
Imports
0.13
2.35
2.88
7.10
11.19
11.78
Exports
Trade
0.10
0.12
0.93
1.68
1.78
2.37
6.59
6.89
6.15
9.22
7.86
10.26
Imports
3.15
2.74
2.12
3.34
4.17
3.44
Exports
Trade
1.03
2.25
1.15
1.99
0.95
1.58
0.81
2.29
0.80
2.85
0.74
2.39
Imports
19.17
21.03
19.84
23.86
30.35
29.07
Exports
Trade
15.73
17.70
18.30
19.75
14.55
17.41
21.73
22.98
21.79
27.01
22.80
26.63
Imports
0.46
0.60
0.94
0.94
0.59
0.59
Exports
Trade
3.06
1.57
5.11
2.72
4.28
2.47
5.41
2.78
4.52
2.13
5.00
2.30
Imports
13.02
18.10
6.43
5.45
17.37
20.20
Exports
4.99
6.72
8.75
11.49
16.30
16.85
Trade
9.60
12.76
7.50
7.94
16.95
18.90
Imports
2.80
4.57
6.07
3.18
7.33
8.36
Exports
1.84
4.38
4.50
5.97
6.79
7.10
Trade
2.39
4.48
5.35
4.33
7.12
7.87
Imports
2.12
1.48
1.53
1.80
3.34
3.88
Exports
0.43
1.14
2.16
2.83
2.96
4.15
Trade
1.40
1.32
1.82
2.22
3.19
3.98
Imports (million $)
23991
34489
50336
139888
257665
350783
Exports in (million $)
17813
30539
42627
98212
165186
222926
Total trade (million
$)
41804
65028
92964
238100
422851
573709
Source: Extracted from IMF, Direction of Trade Statistics 2012, www.imf.org
ASEAN’s share in India’s trade has also gone up from 5.7 per cent to nearly 10 percent in 2009 before declining marginally to 9.2 percent in 2010. This explains the rising share of ASEAN+6 countries in
India’s trade from 17.70 to 26.6 per cent between 1990 to 2010. These include China, Japan, Republic of Korea, Australia and New Zealand that are India’s partners in the East Asia Summit formed in
2005. The shift in the geography of India’s trade from the advanced economies of the west to the East Asian economies did not happen automatically but was a result of conscious and well thought out
strategic policy pursued since 1992 called the Look East Policy, which will be examined later in the
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
paper. Another region rising in prominence as a trade partner is the Middle East with a share in India’s trade nearly doubling between 1990-2010 to 18.9 per cent, mainly on account of India’s high dependence on the region for fuels. But trade with the Middle East is also increasing because of
India’s growing exports of manufactures, sometimes transshipped through the region to other countries like Pakistan. Shares of Africa and Latin America and the Carribean have also risen very fast
from rather low bases.
2.4 Decomposing sources of growth of India’s exports
A country’s exports grow due to the growth of global markets in products it exports (growth effect),
due to improved competitiveness of its exports (competitiveness effect), due to diversification into
new markets (markets effect), or due to diversification into new products (products effect). Constant
Market Share (CMS) analysis is a technique applied to decompose the possible role of these factors in
explaining the export growth of countries (Tyszynski 1951;; in India’s context see Tiwari 1986). In
what follows we examine the results of an exercise made to analyze the factors contributing to India’s export growth over 2000-2010. The exports were grouped into ten 1-digit SITC3 categories and the
time series was divided into two 5 year averages to suppress random yearly fluctuations. Exports to
major markets, namely the EU, USA, Japan, East Asia, ASEAN, China, SAARC, Africa, and Central
and South America and Caribbean, that absorb 80% of India’s exports, are analyzed using UNCTAD data.
Table 5 summarizes the decomposition of different effects in the CMS analysis. The most important
contributor of the exports growth has been the growth effect explaining 44 percent of export growth
indicating the fact India was able to benefit from the expansion of world trade over the past decade.
The next most important effect accounting for 37 percent of export growth has been increased
competitiveness in the products it has been exporting. The contribution of product diversification and
market diversification is positive but is relatively modest. Therefore, the potential of diversification of
export structure and of geography remains to be fully exploited. Although the share of East Asia in
India’s trade has improved, it is more in terms of imports than in exports. Similarly, although the
product structure has changed, the share of conventional products like agricultural and mineral raw
materials and textiles and clothing continues to be quite significant, as observed earlier. Furthermore,
India has not been able to move up the value chains in the export of conventional products—whether
it is export of iron ore, tea or textiles and clothing. One exception includes Tata Tea that acquired
Tetley Brands in the UK and integrated its operations to control the entire value chain in-house. (see
Kumar 2008)
Table 5 Sources of India’s export growth, 2000-2010
Growth effect
Competitiveness effect
Product effect
Market effect
Total change
Size of the effect in million US$
Percentage share
56,700
47,600
13,200
10,500
128,000
44.30
37.19
10.31
8.20
100
Source: ESCAP calculations based on UNCTAD statistics. See UN-ESCAP-SSWA 2012.
3
SITC – Standard International Trade Classification
16
South and South-West Asia Development Papers 1303
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3. Services in India’s Trade
The emergence of the services sector as the most dynamic sector driving India’s growth has been
accompanied by its growing importance in trade. The share of trade in services in India’s GDP has quadrupled from 3.3 percent to 14.3 percent between 1990-2010. Table 6 shows that unlike in goods
trade, the growth rate of service exports has been higher than that of imports. There has been a striking
transformation of India as a net exporter of services from being a net importer at the beginning of the
decade. Exports of $137 billion worth of services in 2011 left a surplus of $12.5 billion after imports.
Growth of trade in services in India has also been faster than in other countries, tripling India’s share in global services trade. The transformation of India’s services trade has attracted attention in a
number of studies (see Chanda 2002, and Gordon and Gupta 2004, Verma 2008 and Raychaoudhuri
and De 2012)).
Table 6 Services Trade Balance
Exports
Share in global exports (%)
Imports
Share in global imports (%)
Balance of services trade
2001
2011
Avg. Annual Growth Rate (2001-2011), %
17337
137149
23%
1.14
3.23
20099
124566
1.31
3.05
-2762
12583
20%
Source: Based on UNCTAD, Online database, accessed 12/09/12
To understand the dynamism of services trade, Table 7. shows the sectoral composition of exports of
commercial services. The bulk of India’s commercial services exports comprise those of computer,
communications and other related services (or ICT services), which increased from 62.8% to 71.5%
over 2000-2011 while commercial services exports of the country expanded from $17 billion to $137
billion. This primarily owes to the emergence of India as a hub for software development and other
IT-enabled services, also referred to as business process outsourcing services (BPO). In these services
India is recognized as the global leader. In the Global Services Location Index, by AT Kearney, a
global consultancy organization, India is rank ranked first globally in 2011 (Table 8), a position it has
consistently retained since the inception of the index in 2004. Among the sources of its strength in the
sector are people skills and their abundance given the large youthful workforce of the country. India’s success in IT services has been attributed to, among other factors, a farsighted government policy to
spot emerging opportunities and create high-end education and training facilities and computing
infrastructure way back in late 1970s (Kumar 2001). In future, this strength in ICT services needs to
be leveraged to build a strong electronic goods industry.
Table 7 Structure of Service Exports
2001
2011
Transport
12%
11%
Travel
19%
11%
Communications, computer and other
services
Insurance, financial and other business
services
65%
71*%
4%
6%
* relates to 2010.
Source: Based on UNCTAD, Online database, accessed 27/09/12
17
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Table 8 Ranks of Asian Countries in Global Services Location Index
Country
2004
2005
2007
2011
India
1
1
1
1
China
2
2
2
2
Malaysia
3
3
3
3
Indonesia
..
13
6
5
Thailand
13
6
4
7
Vietnam
20
26
19
8
Sri Lanka
..
..
29
21
Pakistan
..
..
30
28
Singapore
5
5
11
32
Turkey
..
..
..
48
Source: Based on atkearney.com, accessed 17/09/12
4. Current Account Balance
India faced a major balance of payments crisis in 1991 when the current account deficit crossed 3
percent of GDP and the government had to mortgage its gold reserves to borrow foreign exchange to
stave off a liquidity crisis. However, subsequent reforms and structural adjustment led to a major
turnaround of the external sector with India running current account surpluses during the 2001-02 to
2003-04 period. But since 2004-05 the current account situation has again turned adverse with
widening deficits.
Despite significant surpluses in services trade, current account deficits have been widening due to a
steadily worsening merchandise trade deficit. As Table 9 shows, the merchandise trade deficit of India
widened steadily from 2.1 per cent of GDP in 2002-03 to 10.2 percent in 2011-12, an unprecedented
level in India’s post-Independence history. One of the reasons for this widening is the faster growth
rate of imports compared to that of exports especially during 2002-03 to 2008-09 as is evident from
Figure 3. Rising import intensity of Indian economy in this period, besides trade liberalization, could
be resulting from an appreciating exchange rate during the period as the rupee-dollar exchange rate
touched a new high of Rs 38 to a dollar in 2008. In terms of the real effective exchange rate, the rupee
appreciated by 8.6 percent over 2004-05 to 2007-08 as is evident from Table 10. By making imports
cheaper in relative terms, this trend of appreciation pushed Indian corporations to outsource
manufacturing of a number of their products to cheaper locations such as China in addition to
affecting the competitiveness of India’s exports.
Even though the current account deficit has crossed the 3 percent threshold in 2011-12 for the first
time since 1991, the key difference in 2012 is that India has sizeable foreign exchange reserves.
However, reserves in terms of months of import coverage have steadily come down from 16 months in
2003-04 to 7 months by 2011-12. This situation warrants immediate attention as it will not take much
time for the import coverage offered by India’s reserves to deplete further, especially in view of the
rate at which imports are rising. Another disturbing trend is that the reserves are primarily made up of
highly volatile short-term capital flows.
18
South and South-West Asia Development Papers 1303
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Year
Trade
Exports/
GDP
Imports/
GDP
Trade
balance/G
DP
Payments/
GDP
Receipts/
GDP
Net/ GDP
CAD/ GDP
Foreign
Investment/
GDP
Import
Cover
of
Reserves
(in months)
Table 9 Current Account Balance Indicators, 2000-2012
Invisibles
Current Account
2000-01
9.9
12.6
-2.7
4.9
7.0
2.1
-0.6
1.5
8.8
2001-02
9.4
11.8
-2.4
4.6
7.7
3.1
0.7
1.7
11.5
2002-03
10.6
12.7
-2.1
4.9
8.3
3.4
1.2
1.2
14.2
2003-04
11.0
13.3
-2.3
4.3
8.9
4.6
2.3
2.6
16.9
2004-05
12.1
16.9
-4.8
5.5
9.9
4.4
-0.4
2.2
14.3
2005-06
13.0
19.4
-6.4
5.9
11.1
5.2
-1.2
2.6
11.6
2006-07
13.6
20.1
-6.5
6.6
12.1
5.5
-1.0
3.1
12.5
2007-08
13.4
20.8
-7.4
5.9
12.0
6.1
-1.3
5.0
14.4
2008-09
15.4
25.2
-9.8
6.2
13.7
7.5
-2.3
2.3
9.8
2009-10
13.4
22.1
-8.7
6.1
12.0
5.9
-2.8
4.8
11.1
2010-11
14.9
22.6
-7.7
6.7
11.8
5.0
-2.7
3.4
9.6
2011-12
16.8
27.0
-10.2
5.8
11.9
6.0
-4.2
2.7
7.1
Source: Extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
Figure 3: Growth Rates of Exports and Imports, 1991-2012
50.00%
40.00%
30.00%
20.00%
10.00%
-30.00%
Growth rate of exports
Growth rate of imports
Source: Based on data from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
19
2011-12
2010-11
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
-20.00%
1991-92
-10.00%
1990-91
0.00%
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Table 10 Indices of Real Effective Exchange Rate (REER) of Indian Rupee
(36- Currency Bilateral Weights) (Financial Year - Annual Average)
Year
REER
Export-based
Weights
Trade-based
Weights
1997-98
103.07
100.77
1998-99
94.34
93.04
1999-00
95.28
95.99
2000-01
98.67
100.09
2001-02
98.59
100.86
2002-03
95.99
98.18
2003-04
99.07
99.56
2004-05
98.30
100.09
2005-06
102.74
103.10
2006-07
101.05
101.29
2007-08
108.57
108.52
2008-09
97.77
97.80
2009-10
95.26
94.73
2010-11
103.52
102.34
2011-12
100.68
99.15
(Base:1993-94 = 100)
(Base:2004-05 = 100)
Source: Extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
4.1 FII Inflows and Exchange Rate Instability
What explains the appreciation of the rupee despite the fact that India has been running trade and
current account deficit for so long? The rapid rise in inflows of portfolio investments in India since
2003-04 is summarized in Table 11. Large magnitudes of portfolio investments in the form of shortterm equity investments by foreign institutional investors (FII) have flowed in as the Indian economy
gathered momentum and capital markets started giving attractive returns. The annual net inflows,
however, are highly volatile.
FII inflows rose to a sizeable $ 27 billion in 2007-08 that led to not only stock prices booming, with
BSE Sensex more than doubling from under 10,000 to 20,000, but also the rupee exchange rate
appreciating sharply from 47 Rupees in year in 2006 to 38 Rupees to a US dollar in 2008. In 2008-09,
in the wake of global financial crisis, there was a net outflow of FII to the tune of $14 billion dollars
that brought down the BSE Sensex from nearly 20,000 points to less than 9000 points in the early part
of 2009. Much more importantly it led to a sharp depreciation of rupee by nearly 25 per cent in early
2009. The depreciation would have been greater if the Reserve Bank of India had not intervened in the
market by selling dollars. This depleted the RBI’s foreign exchange reserves by $58 billion to about
$252 billion from $310 billion from 2007-08 to 2008-09 . However as FIIs returned rapidly to the
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South and South-West Asia Development Papers 1303
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market with the onset of recovery and the FII inflows to the country in 2010 were of the order of $ 32
billion bringing the Sensex back above 20,000 points in October 2010. Despite the RBI’s market intervention to offset the subsequent exchange rate pressure, the rupee appreciated by nearly 8 per
cent although foreign exchange reserves were augmented to about $284 billion. FII inflows have
become primary determinants of the movements in the stock exchange indices and the exchange rate
of the rupee (see Kumar 2011). As there are sharp movements in these inflows linked to global
developments, they become channels of transmission of instability to the country’s financial system. As a result, the rupee has been on a roller coaster ride: from Rs 44 per dollar in January 2007 to Rs 39
in January 2008 to increase again to Rs 49 per dollar in January 2009 to Rs 44 in October 2010. The
rupee has been fluctuating around Rs 54 in 2012 as FIIs showed lukewarm response to Indian capital
markets.
Besides the volatility, FII inflows have a very high servicing burden. Among foreign resources such as
FDI, foreign borrowings, non-resident Indian (NRI) deposits, American Depositary Receipts (ADRs/),
global depositary receipts (GDRs), FII investments are most expensive in terms of servicing burden
(Kumar 2011). This is because they come to chase primarily good returns at the stock markets and
exchange rate speculation. In 2007-08, Indian stock markets were giving around 44% return. That
means for every dollar India received in FII flows, it became liable to pay $1.44 in one year. As they
are stock price makers rather than takers, they manage to exit safely before major crashes of markets
thereby precipitating the declines.
One may argue that FII inflows help a country to build foreign exchange reserves. What is not
appreciated very well is the fact that exposure to these inflows also enhances the need to have large
foreign exchange reserves due to their highly volatile nature. Therefore, developing countries such as
India should rely for their foreign resource needs more on FDI inflows and where possible raise
ADRs/GDRs and deposits from nonresident Indians rather than relying on the FIIs. In view of their
high cost and their other deleterious effects such as volatility, a number of emerging economies such
as Brazil, South Korea, and Indonesia have recently imposed capital controls to moderate their
volatility. The unprecedented injection of liquidity by the governments in developed countries in the
wake of global financial crisis is likely to find its way to emerging economies of Asia like India to
take advantage of higher returns. There is now a growing consensus on the relevance of capital
controls as aspects of the policy tool kit for the governments in emerging economies (UN-ESCAP
2010, Ostry et al 2010). The benefits of maintaining open capital accounts, if any, are ambiguous.
4.2 Addressing BOP stresses
Rising current account deficits pose an important challenge for policy makers and need urgent
attention. With widening merchandise trade deficits driving this trend, immediate attention needs to be
paid to reviving export growth and exploiting the opportunities for import substitution. For reviving
exports, whose growth rate in 2012 was negative, attention needs to be paid to strengthening their
competitiveness by addressing exchange rate distortions. For an economy facing growing current
account deficits, exchange rate appreciation can aggravate the situation further. Therefore, it is
important to restrain volatile short-term capital flows. Export competitiveness needs to be
strengthened by maintaining relative exchange rate stability with a slight tendency towards
depreciation rather than appreciation. Besides that, policy distortions such as inverted duty structures
need to be removed and flow of trade finance needs to be strengthened (see Kumar and Joseph 2007
for an inventory of policy support measures).
In a situation of slow down of the global economy as at present, a major expansion of exports can be
challenging given an environment of excess capacities throughout the Asia-Pacific region, the
growing threat of protectionism, and the temptation of dumping by those with deep pockets. In such
circumstances, it might be also critical to look at new opportunities for strategic import substitution
21
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
(Friere 2012). As observed earlier, while large bulk imports of fuels and raw materials may be price
inelastic, attention should be paid to very large and fast growing imports of electronics, non-electrical
machinery, and defence equipment, among others that provide opportunities for strategic import
substitution. An effort needs to be made to start domestic manufacture of these products leveraging
India’s large domestic market size and by targeting MNEs to set up local manufacturing facilities
through creation of incentives for pioneering industries, as has been done in East Asian countries like
Malaysia, besides incentives in public procurement like ‘buy America’ programmes. These policies
are part of industrial policies and infant industry protection that have been widely practiced in
different developed and emerging economies (Kumar and Gallagher 2007). The strategic import
substitution will also lead to a more balanced structural change by creating more manufacturing jobs
(see Aggarwal and Kumar 2012). An ESCAP study analyzing opportunities for building productive
capacities in South and South-West Asia using the product space maps also found opportunities for
strategic import substitution in India (Freire 2012).
Table 11 FDI and Foreign Portfolio Investment Flows to India
Direct
Investment
to India
FDI
India
2000-01
Gross
inflows/
Gross
Investments
4029
4029
2001-02
6130
2002-03
by
Net
Portfolio
Investment
Total
(in million
USD)
759
Net
Foreign
Direct
Investment
3270
2590
5860
6125
1391
4734
1952
6686
5035
4976
1819
3157
944
4101
2003-04
4322
4322
1934
2388
11377
13765
2004-05
6051
5986
2274
3712
9291
13003
2005-06
8961
8900
5867
3033
12492
15525
2006-07
22826
22739
15046
7693
6947
14640
2007-08
34843
34727
18836
15891
27434
43325
2008-09
41873
41707
19364
22343
-14032
8311
2009-10
37745
33108
15143
17965
32396
50361
2010-11
34847
27829
16524
11305
30292
41597
2011-12
46553
32955
10950
22006
17171
39177
Source: Extracted from RBI’s Handbook of Statistics on Indian Economy, 2012. www.rbi.org.in
5. Foreign Direct Investment flows and their quality
Besides the liberalization of trade, 1991 was also the time for substantial liberalization of the FDI
policy regime for both inward as well as outward FDI. The key features of the FDI policy regime of
India include up to 100 per cent foreign ownership in most sectors except those due to sensitivities
and security concerns such as arms and ammunition. Sectoral caps also apply to services sectors, and
to the full repatriation of capital and remittances of profits, dividends, technical fees and royalties.
FDI inflows to India have been growing since 1991 but the big break came in 2006 when annual
inflows to the country nearly tripled in one year from $ 7.6 billion to $ 20 billion and increased from
that level peaking to $ 43 billion in 2008 before declining to $ 24 billion in 2010 in the wake of the
global financial crisis but recovering to $31.5 billion in 2011. India’s share in global FDI inflows
22
South and South-West Asia Development Papers 1303
March 2013
nearly doubled over 2005-2006. and again between 2006-2009 to before declining slightly (Figure
4A) The relative importance of the flows in relation to gross fixed investment, has also risen from 2.9
percent in 2005 to 6.6 percent in 2006. The share of FDI in gross fixed investments in India has been
lower than for other developing countries but was catching up. In 2008 when FDI inflows peaked in
India, this ratio at 10.1 percent was quite close to that for developing Asia at 10.4 percent. Afterwards
it has declined in the wake of financial crisis indicating the potential for a rise in the future (Figure
4B)
Table 12 Inward foreign direct investment flows, annual, 2001-2011, million US$
Inward FDI flows, annual 2001-2011, million USD
India
Share of India
in Developing
Asia
Share of India
in Developing
World
Share of
India in
World
115968
5478
4.72
2.53
0.66
173283
100083
5630
5.62
3.25
0.9
190125
123707
4321
3.49
2.27
0.74
744329
291866
177983
5778
3.25
1.98
0.78
2005
980727
327248
218420
7622
3.49
2.33
0.78
2006
1463351
427163
290907
20328
6.99
4.76
1.39
2007
1975537
574311
349412
25506
7.3
4.44
1.29
2008
1790706
650017
380360
43406
11.41
6.68
2.42
2009
1197824
519225
315238
35596
11.29
6.86
2.97
2010
1309001
616661
384063
24159
6.29
3.92
1.85
2011
1524422
4.61
2.07
World
Developing
economies
Developing
Asia
2001
827617
216865
2002
627975
2003
586956
2004
684399
423157
31554
7.46
FDI Inflows as a per cent of Gross Fixed Capital Formation
2001
2002
2003
2004
2005
India
4.7
4.6
2.8
2.7
2.9
World
12.2
9.1
7.6
8.3
9.9
Developing economies
13.5
10.2
9.8
12.4
11.8
Developing Asia
10.3
8
8.4
9.9
4.5
4.7
3
3.1
South Asia
2006
2007
2008
2009
2010
6.6
6.2
10.1
8.1
4.5
13.3
15.7
12.9
9.5
9.5
12.9
14.1
13.2
10.1
10.1
10.4
11.7
11.5
10.4
7.9
8
3.7
7.3
6.9
10.3
7.8
4.6
Source: Extracted from UNCTAD online data base (2012), www.unctad.org
The recent rise in FDI inflows since 2006 reflects improving investment climate in India with the
acceleration of growth rate since 2003, the rise of a sizeable middle class with purchasing power, and
with the recognition of India’s comparative advantage in knowledge-based industries. This is not only
evident from the rising magnitudes of FDI inflows but also from investor surveys conducted by global
consultancy organizations. In the FDI Confidence Index published by AT Kearney, a global
consultancy organization, covering 25 top destinations for FDI, India has moved up from 6th place in
2003 to 2nd in 2005 and stayed there before swapping the third rank with the United States in 2010. In
2012, it again regained the second position in the global rankings (AT Kearney 2012). Similar
upgrading in India’s ranks has been reported by the surveys of investors conducted by the Japanese
Bank of International Cooperation (JBIC) as well as in UNCTAD’s World Prospects Survey 20122014, where India is ranked as the third most preferred FDI location (UNCTAD 2012). Recent
reforms adopted by the country to allow FDI in multibrand retail and civil aviation are also likely to
help in realizing its potential for FDI inflows. This is in sharp contrast to the World Bank’s studies on 23
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Ease of Doing Business based on perception surveys that tend to put India at a very poor rank of 132.
It is clear therefore that foreign investors get attracted to a country by the potential of benefiting from
its dynamism and are willing to put up with hardships rather than going to countries with easier
business conditions but with poorer prospects of making profits. FDI inflows may also assist in
manufacturing oriented structural transformation of the economy and technological upgrading of
exports that India needs by bringing technologies and other resources working together with local
entrepreneurs.
Figure 4: India’s attractiveness as a destination of FDI inflows
A: India’s share in global inflows
B: Share of FDI in gross fixed capital formation in
developing economies and India
Source: Author’s calculations based on Table 12.
5.1 Quality of FDI inflows
There can be several indicators of quality of FDI inflows (see Kumar 2002). In what follows, we
discuss India’s performance in terms of a few such indicators.
5.1.1
Sectoral composition
One of the indicators of quality is the sectoral composition of FDI inflows. It matters whether FDI is
going to the modern technology intensive sectors and building productive capabilities or to
conventional sectors crowding out domestic investments. In terms of the sectoral composition of FDI
inflows, there is a shift since 1991 in India’s case. Earlier the bulk of FDI inflows used to be directed to manufacturing especially the high technology industries through a selective policy. After the
liberalization, a substantial proportion of FDI inflows has been directed to services. Manufacturing has
accounted for only about 40 per cent of inflows in the post-1991 period with services accounting for
about 35 per cent share. Furthermore, among the manufacturing subsectors, FDI stock in post-1991
period is also more evenly distributed between food and beverages, transport equipment, metals and
metal products, electricals and electronics, chemicals and allied products, and miscellaneous
manufacturing. This stands in contrast to the situation prior to 1990 when there was a very heavy
concentration in relatively technology intensive sectors viz. machinery, chemicals, electricals, and
transport equipment (Kumar 2005a).
In China, on the other hand, the bulk of FDI inflows have been directed by the government policy to
manufacturing (of the export-oriented type) and very little has gone to services (Yongding 2006). Of
the FDI in manufacturing in China, 11 per cent has gone in electronics and telecommunication
equipment helping it emerge as the leading producer and exporter of these products. A policy guiding
FDI inflows to manufacturing has helped in China’s emergence as a global factory. Therefore, FDI inflows in China have been directed to assist in industrial development of the industry that has made
24
South and South-West Asia Development Papers 1303
March 2013
China a global factory generating in the process billions of dollars of output and exports and millions
of jobs.
5.1.2
Impact of FDI on growth and domestic investment
FDI inflows could contribute to growth rate of the host economy by augmenting the capital stock as
well as with infusion of new technology. However, high growth rates may also attract more FDI
inflows by enhancing the investment climate in the country. Therefore, the FDI – growth relationship
is subject to causality bias given the possibility of two-way relationship. What is the nature of the
relationship in India? A recent study has examined the direction of causation between FDI and growth
empirically for a sample of 107 countries for the 1980s and 1990s period. In the case of India, the
study finds a Granger neutral relationship as the direction of causation was not pronounced (see
Kumar and Pradhan 2005, for more details of the methodology and results).
It has also been shown that sometimes FDI projects may actually crowd-out or substitute domestic
investments from the product or capital markets with the market power of their well-known brand
names and other resources and may thus be immiserizing (see Fry 1992, Agosin and Myer 2000, for
evidence). Therefore, it is important to examine the impact of FDI on domestic investment to evaluate
the impact of FDI on growth and welfare in the host economy. An earlier study to examine the effect
of FDI on domestic investment in a dynamic setting, however, did not find a statistically significant
effect of FDI on domestic investment in the case of India (see Kumar and Pradhan 2005). It appears,
therefore, that FDI inflows received by India have been of mixed type combining some inflows
crowding-in domestic investments while others crowding them out, with no predominant pattern
emerging in the case of India. In the case of East Asian countries such as South Korea and Thailand,
the relationship was clearly indicating FDI crowding-in domestic investments. (Kumar and Pradhan,
2005) Therefore, the quality of FDI in India in respect to its impact on growth and on domestic
investment is of mixed type and leaves scope for improvement.
The empirical studies on the nature of the relationship between FDI and domestic investments suggest
that the effect of FDI on domestic investment depends on host government policies. Governments
have extensively employed selective policies and imposed various performance requirements such as
local content requirements (LCRs) to deepen the commitment of MNEs to the host economy. The
Indian government has imposed a condition of phased manufacturing programmes (or local content
requirements) in the auto industry to promote vertical inter-firm linkages and encourage development
of the auto component industry (and crowding-in of domestic investments). A case study of the auto
industry where such a policy was followed shows that these policies (in combination with other
performance requirements viz. foreign exchange neutrality), have succeeded in building an
internationally competitive vertically integrated auto sector in the country (see Kumar 2005). The
Indian experience in this industry, therefore, is in tune with the experiences of Thailand, Brazil and
Mexico as documented by Moran (1998).
5.1.3
FDI and export-platform production
A number of developing countries have used FDI to exploit the resources of MNEs such as globally
recognized brand names, best practice technology or by increasing integration with their global
production networks, among others, for expanding their manufactured exports. In this respect, China
has had a considerable success in exploiting the potential of FDI for export-oriented production. A
very substantial (55%) proportion of manufactured exports of China are undertaken by foreign
invested enterprises, which account for as much as 80 per cent of all technology intensive exports
(UNCTAD 2005). Foreign enterprises while setting up export-oriented production bases created 23
million jobs by 2003 making China a global factory. Export oriented FDI also helps in bringing
world’s best practice technology as the affiliate has to compete globally right from the beginning. It
also enhances the chances of FDI inflows crowding in domestic investments and reducing the chances
of crowd-out as the foreign affiliate would be mainly catering to the outside markets rather than eating
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
into domestic firms’ markets. It would also create fresh possibilities of market information spillovers for domestic firms on export possibilities.
Unlike the East Asian countries, India has not been able to exploit the potential of FDI for exportoriented production. The bulk of FDI inflows in India are market-seeking coming for tapping the
domestic market with the share of foreign affiliates in exports around 10 per cent. Therefore, the
quality of FDI in respect of export-orientation is poorer compared to FDI received by East Asian
countries. In this respect two observations can be made. The first is that recent studies of exportperformance are beginning to indicate a relatively superior performance of foreign enterprises in terms
of export orientation compared to early studies suggesting a poorer performance of foreign companies
(see Kumar and Joseph 2007). Therefore, MNEs are beginning to exploit the potential of India as base
for export-oriented production.
The second observation is about the role of host country policies in exploiting the potential of FDI for
export-oriented production. A quantitative study analyzing the determinants of the patterns of exportorientation of MNE affiliates across 74 countries in seven branches of industry over three points of
time has shown that in host countries with large domestic markets, the export-obligations were
effective for promoting export-orientation of foreign affiliates to third countries (see Kumar 1998).
Export-obligations have also been employed fruitfully by many countries to prompt MNE affiliates to
exploit the host country’s potential for export platform production. For instance, in China which has succeeded in expanding manufactured exports with help of MNE affiliates, regulations stipulate that
wholly owned foreign enterprises must undertake to export more than 50 per cent of their output
(Rosen 1999:63-71). As a result of these policies, the proportion of foreign enterprises in
manufactured exports has steadily increased to over 55 per cent as observed above.
India has not imposed export obligations on MNE affiliates except for those entering the products
reserved for SMEs. However, indirect export obligations in the form of dividend balancing have been
imposed for enterprises producing primarily consumer goods (since phased out in 2000). Under these
policies, a foreign enterprise was obliged to earn the foreign exchange that it wished to remit abroad
as dividend so that there was no adverse impact on host country’s balance of payment. Some times a condition of foreign exchange neutrality has been imposed where the enterprise is required to earn
foreign exchange enough to even cover the outgo on account of imports. Therefore, these regulations
have acted as indirect export obligations prompting foreign enterprises to export to earn the foreign
exchange required by them. The evidence that is available suggests that such regulations have
prompted foreign enterprises to undertake exports. In the case of auto industry, in order to comply
with their export commitments to comply with foreign exchange neutrality condition, foreign auto
majors have undertaken export of auto components from India which have not only opened new
opportunities for Indian component manufacturers but also in that process found profitable
opportunities for business (Kumar 2005). Hence, exports of auto components from India are now
growing rapidly and exceeding the obligations several times over. These regulations have acted to
remove the information asymmetry existing about the availability of quality components in India
among the foreign auto majors. In that respect India’s experience is very similar to that of Thailand
that has emerged as the major auto hub of Southeast Asia (as documented by Moran 1998 and Kumar
2005).
5.1.4
R&D and other knowledge-based activities and local technological capability
A comparison of R&D intensity of foreign firms in India and in other countries has not been possible
due to lack of data. Within the country, foreign firms appear to be spending more on R&D activity in
India than local firms although gap between their R&D intensities has tended to narrow down. A study
analyzing the R&D activity of Indian manufacturing enterprises in the context of liberalization has
found that after controlling for extraneous factors, MNE affiliates reveal a lower R&D intensity
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South and South-West Asia Development Papers 1303
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compared to local firms, presumably on account of their captive access to the laboratories of their
parents and associated companies. The study also observed differences in the nature or motivation of
R&D activity of foreign and local firms. Local firms seem to be directing their R&D activity towards
absorption of imported knowledge and to provide a backup to their outward expansion. MNE
affiliates, on the other hand, focus on customization of their parents’ technology for the local market (Kumar and Agarwal 2005).
An important issue is diffusion and absorption of technology brought by foreign firms in the host
countries. Some governments have imposed technology transfer requirements on foreign enterprises,
e.g. Malaysia. However, such performance requirements do not appear to have been very successful in
achieving their objectives (UNCTAD 2003). Instead other performance requirements such as local
content requirements or domestic equity requirements may be more effective in transfer of
technology. As observed above, local content requirements and export performance requirements have
prompted foreign enterprises to transfer and diffuse some knowledge to domestic enterprises in order
to comply with their obligations. Similarly the domestic equity requirements may facilitate the quick
absorption of the knowledge brought in by foreign enterprises which is an important pre-requisite of
the local technological capability, as is evident from case studies of Indian two-wheelers industry
where Indian joint ventures with foreign firms were able to absorb knowledge brought in by the
foreign partner and eventually become self-reliant not only to continue production but even to develop
their own world class models for domestic market and exports on their own (see Kumar 2005). Some
have expressed the view that domestic equity requirements may adversely affect the extent or quality
of technology transfer (Moran 2001). However, it has been shown that MNEs may not transfer key
technologies even to their wholly owned subsidiaries abroad fearing the risk of dissipation or diffusion
through mobility of employees. Furthermore, even if the content and quality of technology transfer is
superior in the case of a sole venture than in the case of a joint venture, from the host country point of
view, the latter may have more desirable externalities in terms of local learning and diffusion of the
knowledge transferred.
5.2 India as an emerging source of FDI outflows
Another important emerging trend with respect to FDI in India is its emergence as a significant source
of FDI outflows.. Like FDI inflows the major turnaround in their outflows came in 2006 when
outflows more than quadrupled in one year to $ 14 billion and peaked to nearly $ 20 billion in 2007
before declining to around $ 15 billion in subsequent years in the wake of global financial crisis Table
13The big break came with Indian enterprises using their outward investments to acquire larger
companies in the advanced economies as a part of their effort to augment their bundles of strategic
assets including known brand names, proprietary knowledge and global marketing networks in order
to jump start their global orientation. The past few years have seen several multibillion- dollar
acquisitions of western firms by Indian companies including Tata Steel-Corrus, Tata Motors-Jaguar/
Land Rover, Handalco-Novelis among others.
A recent analysis of India’s outward FDI flows has shown that among the emerging markets,the
relative scale of India’s outward FDI was quite significant (Kumar 2008). The emergence of Indian
enterprises on the global scene is striking considering their origin in a lower middle income country.
Their ability to acquire much larger enterprises in the developed world reflects their confidence in
managing the newly acquired entities successfully. It has been argued that the source of their
ownership or competitive advantage lies in their accumulation of skills for managing large multilocation operations across diverse cultures in India and in their ability to deliver value for money with
their ‘frugal engineering skills’ honed up while catering to the larger part of income pyramid in India.
(Kumar 2008)
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Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Considering that nearly all the Indian enterprises undertaking outward investments had their origins in
import substitution based industrialization strategies and the selective FDI policy regime, it would
appear that the policy of infant industry protection with supportive institutional framework can assist
in enterprise development by giving to them access to domestic market to grow and build capabilities.
(Kumar 2008) However, the protection needs to be phased out once the capabilities are built up to
expose the enterprises to international competition and sharpen their competitiveness. In fact the
reforms of 1991 have sparked of a considerable restructuring of Indian industry which emerged from
it leaner, more efficient and competitive. The exposure also gave to the Indian firms global ambitions
and also the confidence to pursue them. In some ways the Indian experience follows in the Japanese
and Korean tradition of enterprise development policies and may have lessons for other developing
countries.
The acquisition based strategy of internationalization adopted by Indian enterprises in the recent years
by acquiring strategic assets such as technology, known brands, access to customers and global
footprints for jump starting their internationalization, is challenging as it involves managing across
diverse cultures and win over the confidence of workforce to successfully exploit the synergies. Indian
enterprises can face this challenge by relying on their experience and their skills in cross-cultural
management honed in India, their emphasis on corporate social responsibility and their sensitivities to
workers rights from the beginning. (Kumar 2008)
Table 13 Foreign direct investment (FDI) outflows originating in India
(millions of USD)
2001
747657
83087
Developing
economies:
Asia
49155
2002
528496
47484
34987
1678
2003
570679
46668
23961
1876
2004
925716
122792
91404
2175
2005
888561
132507
86425
2985
2006
1415094
239336
151400
14285
2007
2198025
316863
228154
19594
2008
1969336
328121
223116
19257
2009
1175108
268476
210925
15927
2010
1451365
400144
273033
13151
2011
1694396
383754
280478
14752
World
Developing
economies
India
1397
Source: Extracted from UNCTAD database 2012.
6. Regional economic integration
India has generally pursued multilateralism faithfully in its trade policy with very few exceptions till
the end of the last century. However, it has begun to pay due respect to regionalism in its trade policy
increasingly since the turn of the century following the emerging trend globally. Among the early
schemes for regional cooperation, India has been a member of one of the earliest preferential trading
arrangements in Asia-Pacific viz. Asia-Pacific Trade Agreement (APTA) earlier known as the
Bangkok Agreement negotiated under the auspices of ESCAP in 1975. India has also been a member
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South and South-West Asia Development Papers 1303
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of the South Asian Association for Regional Cooperation (SAARC) formed in 1985 that has adopted
SAARC Preferential Trading Agreement (SAPTA) in 1993 that eventually evolved in the SAARC
Free Trade Agreement (SAFTA) in 2004, implemented in the decade from 2006. In 1998, India also
signed a bilateral FTA with Sri Lanka that has been operational since 2000. India also has trade and
transit agreements with Bhutan and Nepal that provide to them non-reciprocal free access to the Indian
market.
Since 1992 in the wake of economic reforms, a new thrust was given to India’s approach to regional cooperation as a part of what is called as the Look East Policy. As a part of this policy, India became a
sector dialogue partner of ASEAN. India was made a full dialogue partner by ASEAN in 1995 and
was accorded a membership of the ASEAN Regional Forum in 1996. The ASEAN-India dialogue
partnership was further upgraded to an annual Summit level dialogue from 2002. Therefore, the IndiaASEAN partnership saw a remarkable transformation from a sectoral dialogue partnership to a
Summit-level interaction within a decade of 1992-2002. At their Second Summit in October 2003,
ASEAN and India signed a Framework Agreement on Comprehensive Economic Cooperation (CEC)
providing a Free Trade Arrangement. At the Laos Summit in 2004, they signed a long-term
Partnership for Peace, Progress and Shared Prosperity based on the work done by the think-tanks of
ASEAN and India. CEC is usefully complemented by a Comprehensive Economic Cooperation
Agreement (CECA) signed between India and Singapore in 2005. Since 2004, the early harvest
scheme of the India-Thailand bilateral Free Trade Agreement has been operational. India has also
signed a bilateral FTA with Malaysia and is negotiating one with Indonesia. The India-ASEAN FTA
was also concluded in 2009 and negotiations are currently undergoing for a services agreement. The
India-ASEAN partnership is also complemented by Mekong-Ganga Cooperation (MGC), and
BIMSTEC (Bay of Bengal Initiative for Multisectoral Techno-Economic Cooperation) which
combines seven South and Southeast Asian countries. India has been assisting the new ASEAN
countries namely Cambodia, Laos, Myanmar and Vietnam (CLMV) as a part of the ASEAN’s Initiative for ASEAN Integration (IAI). India is assisting them, particularly with capacity-building by
setting up centres for entrepreneurship development, ICT and English language training, among other
areas. The high-level interactions between India and ASEAN countries have steadily grown in both
the directions. In December 2012, India hosted an India-ASEAN Summit in New Delhi to
commemorate the tenth anniversary of their summit level dialogue.
India’s Look East Policy started with engagement of ASEAN but is not confined to it. As a part of it,
India has also engaged East Asian countries like Republic of Korea and Japan concluding
Comprehensive Economic Partnership Agreements with both of them. Negotiations are on with
Australia and New Zealand. The engagement of ASEAN and the East Asian countries by India led to
her inclusion in the East Asia Summit established in 2005 as an annual Summit level forum between
ASEAN and its six dialogue partners (Kumar et al 2008). In 2011 it was joined by the US and Russia.
Within the framework of EAS, a Comprehensive Economic Partnership of East Asia (CEPEA)
bringing together ASEAN and its six FTA partners into a single trade agreement was proposed and
was accepted in principle in 2009 Hua Hin Summit and four working groups were set up to take the
negotiations forward. In 2011 at the Bali Summit, ASEAN proposed a framework on Regional
Comprehensive Economic Partnership of East Asia (RCEP) with the six partners. RCEP was formally
launched at the Phnom Penh Summit of ASEAN in November 2012.
India, has therefore, become a key partner in the emerging broader regional trading arrangement
RCEP that would be the largest such arrangement in the world. Combining 16 of fastest growing and
largest economies of the Asia-Pacific region, RCEP has the potential of becoming the third and more
dynamic pillar of the world economy besides EU and NAFTA. In new changed post-crisis
international context where the advanced economies of the West will not be able to play their role as
the engines of growth in view of compulsions of unwinding their huge debt accumulations, a
rebalancing of external orientation in favour of regional economic integration is clearly important with
29
Trade, capital flows and the balance of payments: trends, challenges and policy options for India
March 2013
Asia-Pacific region emerging as the centre of gravity of the world economy (ESCAP 2012). In that
respect the Indian Look East Policy of turning attention to East Asia was farsighted. Hopefully the
business enterprises of the country will be able to take advantage of the preferential markets access
made available through the emerging RTAs in some of the fastest growing markets of the world in the
coming years to address the balance of trade concerns.
7. Concluding remarks
The reforms pursued since 1991 have led to much deeper integration of the Indian economy with the
global economy in terms of rising share of merchandise trade and an even more dramatic
transformation of services trade and emergence of the country as one of the most attractive
destinations for FDI, as well as an important source of FDI outflows. The trade structure has changed
in terms of product composition and destinations. However, quantitative analysis using the constant
market share analysis suggests that much of the export growth benefited from expansion of world
trade and enhanced competitiveness while potential of product diversification and market
diversification remains to be fully exploited. Diversification into technology intensive higher value
adding goods or labour-intensive goods could be helpful for sustaining growth of exports while also
creating more industrial jobs.
Despite healthy trade surpluses earned by services as India emerged as a global hub for ICT
outsourcing, the balance of payment situation has again entered into a period of stress due to a
widening merchandise trade deficit. While India now has the comfort of sizeable foreign exchange
reserves unlike in 1991, this is an important policy challenge needing an immediate response before
situation turns difficult. Export competitiveness needs to be strengthened through appropriate
exchange rate management and opportunities for strategic import substitution need to be exploited by
leveraging India’s large domestic market size. This large domestic market has already led to growing
and sizeable imports in several products like electronic goods, non-electrical machinery and other
equipment including defence equipments, among others. To exploit these opportunities a number of
policy measures that are normally grouped as industrial policy, including infant industry protection,
pioneer industry incentives, public procurement preferences and a special targeting of multinational
enterprises to establish local manufacturing facilities, as employed extensively by the developed
countries in the past and emerging countries in more recent times may be fruitful. Revival of
manufacturing to substitute these lumpy imports will not only help in addressing the current account
deficits but also create jobs for skilled and unskilled workers helping in poverty reduction.
Finally, in the context of the dramatically changed international context in the aftermath of global
financial crisis, when advanced economies are not able to provide growth stimulus to Asian
economies, a rebalancing of growth in favour of domestic and regional sources of demand is
imperative. India has already moved towards integration with the East Asian economies with a
number of bilateral and regional FTAs and is a part of Regional Comprehensive Economic Partnership
(RCEP) of East Asia that seeks to create a broader Asia-Pacific regional trade arrangement covering
16 of region’s largest and fastest growing economies. Indian industry should aggressively exploit the
export opportunities provided by preferential access to East Asian markets provided by these
agreements rather than only using these FTAs to import duty free from the partners.
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