Indian Economy, 5th edition (75 page)

•
Similarly, FDI limit in
public sector banks
could be increased to 26 per cent.

•
There is also a need to review existing approval mechanisms, operational restrictions and conditions in other sectors to attract foreign investment.

India’s Forex Reserves

The distinction between convertible and non-convertible currencies is important for emerging economies, as most transactions with the rest of the world are in convertible currencies like US Dollar, Euro, Pound Sterling, Yen, Swiss Franc, etc. The need for increasing the availability of convertible currency for self-insurance has also been behind the race to build-up foreign exchange reserves (FER) in emerging economies after the Asian Crisis of 1997. Such FER accumulation, however, is constrained by the fact that it is possible only in times of currency appreciation. India’s attempts at building up the Forex Reserve may be seen as given below (as has been summed up by the
Economic Survey 2012-13
) –

•
Following the BoP crisis of 1990-91 that was essentially due to depletion of foreign exchange reserves, there was a conscious effort by the RBI to build up FER. This was done through buying foreign currency in the market during periods of surge in capital flows. As a result, FER levels increased from US$ 5.8 billion in 1990-91 to US$ 314.6 billion at end May 2008.

•
The RBI is however following a hands-off policy in foreign exchange market after the 2008 global crisis, with intervention limited to curbing excess rupee volatility. As a result, during 2009-10 and 2010-11, when rupee was appreciating due to increase in capital flows, there was virtually no intervention to build up FER. The sharp decline in rupee in 2011-12, however, led the RBI to inject foreign exchange to the extent of US$ 20.1 billion to stem the rupee slide. The pressure on currency has continued in the financial year
2012-13
because of the ongoing euro-zone crisis.

•
The import cover of FER, as a result, has declined from 14.4 months of imports in 2007-08 to 7.1 months in 2011-12. There are costs to intervention. The main cost is the release of corresponding rupee liquidity, when RBI intervenes in the market to buy foreign exchange. This may stoke
inflation
, which may not appeal in the current inflationary situation.

•
Past experience, however, shows that measures like
Market Stabilization Scheme
(MSS) have been effective in draining excess liquidity from the system. Countries like China and Turkey use cash reserve ratio (CRR) for the same purpose. The cost of a particular policy, however, has to be weighed against the benefits, which are manifold –

(i)
Intervention to buy FER during surge in capital leads to build-up of reserves, which provides self-insurance against external vulnerability.

(ii)
The higher reserve levels restore investor confidence and may lead to an increase in foreign direct and portfolio investment flows that spurs growth and helps bridge the current account deficit.

(iii)
In a scenario of high trade and CAD, as in India, allowing the currency to appreciate through non-intervention during times of surge in capital, could have further negative fallout for the BoP by making exports less competitive and imports cheaper.

(iv)
Lastly, buying foreign exchange provides more ammunition or intervention when the currency is declining, which could potentially lower currency volatility.

Risks in Foreign Currency
Borrowings

Corporate borrowers in India and other emerging economies are keen to borrow in foreign currency to benefit from lower interest and longer terms of credit. Such borrowings however, are not always helpful, especially in times of high currency volatility. During good times, domestic borrowers could enjoy triple benefits of –

(i)
lower interest rates,

(ii)
longer maturity, and

(iii)
capital gains

– due to domestic currency appreciation. This would happen when the local currency is appreciating due to surge in capital flows and the debt service liability is falling in domestic currency terms. The opposite would happen when the domestic currency is depreciating due to reversal of capital flows during crisis situations,
as happened during the 2008 global crisis
.

A sharp depreciation in local currency would mean corresponding
increase in debt service liability
, as more domestic currency would be required to buy the same amount of foreign exchange for debt service payments. This would lead to
erosion in profit
margin and have ‘mark-to-market’ implications for the corporate. There would also be ‘debt overhang’ problem, as the volume of debt would rise in local currency terms. Together, these factors could create corporate distress, especially because the rupee tends to depreciate precisely when the Indian economy is also under stress, and corporate revenues and margins are under pressure.

In this context, it is felt that one of the factors contributing to faster recovery of the Indian economy after the 2008 global crisis was the low level of corporate external debt. As a result, the significant decline in the value of rupee did not have a major fallout for the corporate balance-sheets. Foreign currency borrowings, therefore, have to be contracted carefully, especially when no ‘natural hedge’ is available. Such natural hedge would happen when a foreign currency borrower also has an export market for its products. As a result, export receivables would offset, at least to some extent, the currency risk inherent in debt service payments. This happens because fall in the value of the rupee that leads to higher debt service payments is partly compensated by the increase in the value of rupee receivables through exports.

When export receivables and the currency of borrowings is different, the
prudent approach
is for corporations to enter
currency swaps
to re-denominate asset and liability in the same currency to create natural hedge. Unfortunately, too many Indian corporations with little foreign currency earnings leave foreign currency borrowings unhedged, so as to profit from low international interest rates. This is a dangerous gamble for reasons described above and should be avoided – as the
Economic Survey 2012-13
suggests.

Gold Imports – A Menace!

Rising gold imports has been among the major external sector concerns
18
for India in the
recent times
. India is one of the largest importers of gold in the world, with import growth of
11.2
per cent in terms of quantity and
39.0
per cent in terms of value during 2011-12. Gold is the
second
major import item of India
after POL
and constitutes
11.3
of its imports in 2011-12 in value terms.

The rise in imports of gold is one of the factors contributing to India’s high trade deficit and CAD in 2011-12, forming
30
per cent of its trade deficit. The RBI in its draft report of the
Working Group to Study ‘Issues Related to Gold Imports and Gold Loans by NBFCs in India’
has stated that if gold imports in India had grown by 24 per cent (an average of growth in world gold demand during past three years) instead of 39 per cent in 2011-12, the CAD would have been lower by approximately US$ 6 billion and the CAD-GDP ratio would have been 3.9 per cent instead of 4.2 per cent.

Globally, the demand for gold is rising, mainly due to demand from emerging economies like
China
and
India
. The major source countries for import of gold include Switzerland, responsible for
52
per cent of the total imports by India of raw gold during 2011-12 (which has led to an unfavourable bilateral balance of trade for India), followed by the UAE (17.6 per cent), and South Africa (11.5 per cent). The rise in gold imports is due to many factors:

•
The love of Indians for the yellow metal is well known – India is one of the largest consumers of gold in the world with consumption increasing from 721.9 tonnes in 2006 to 933.4 tonnes in 2011 and 612 tonnes in the first three quarters of 2012, accounting for around 27 per cent of world gold consumption in 2011, and 26.4 per cent in 2012 (total of first three quarters).

•
As per the
Annual Report 2011-12
of the Ministry of Mines,
domestic production
of gold is estimated at only 2.8 tonnes in 2011-12 and can meet around
0.3
per cent of the demand. This has inevitably led to its import.

•
Gold is also used for trading/investment. Net retail investment constitutes 39.2 per cent of India’s total gold consumption in 2011 and 32.5 per cent during the first three quarters of 2012 in terms of quantity. As stated in the RBI report, one of the major components of gold demand in recent years has been investment demand at global level.

•
Rising gold prices in recent years have not deterred the acquisition of gold in India, implying that investment in gold is becoming
price inelastic
and its price was about to fall any time
(as India saw a 30 per cent fall in gold prices within one week – the 2nd week of
April, 2013
)
.

•
India also imports gold for manufacturing purposes and exports a portion of it as jewellery. In the case of export of gold jewellery, the major export destinations include the UAE (57.9 per cent), Hong Kong (14.1 per cent), and the USA (12.0 per cent).

International gold price movements which have been volatile in recent years also have a bearing on the value of the country’s gold imports. During 2000-12, international gold prices have grown at a CAGR (Compound Annual Growth Rate) of 16.2 per cent. In 2011–12 they increased by 23.4 per cent though they moderated to 4.3 per cent during April–November 2012 over the corresponding period in the previous year. Even with this moderation, gold prices were at a high level of US $1721 per troy ounce in November 2012 and at US $ 1672.3 per troy ounce (as on
February 15, 2013
).

•
As stated by the
RBI Report
, volatility in international gold prices in recent quarters is
positively
skewed
, implying that it provides fewer large losses and a greater number of larger gains. The worsening global situation has also led to a rise in purchase of gold as a
safety metal
and a further rise in its price.

•
Fluctuations in international gold prices get automatically reflected in India’s gold prices along with the markup due to duties and taxes. Substantial increase in gold prices seems to have fuelled positive price expectations also contributing to sharp rise in the value of gold imports in recent years.

To restrict the rising trend in gold imports which is adversely affecting India’s balance of payments, measures were and are being taken by the government:

•
In Budget 2012-13, import duty on standard gold and platinum was raised from 2 per cent to 4 per cent and non–standard gold from 5 per cent to 10 per cent.

•
On January 21, 2013, the Import duty on gold and platinum was increased from 4 per cent to 6 per cent.

•
It has also been proposed to provide a link between the
Gold ETF
(Exchange Traded Fund) and
Gold Deposit Scheme
with the objective of ‘
unfreezing’
or
‘releasing’
a part of the gold physically held by mutual funds under Gold ETFs and enabling them to deposit the gold with banks under the Gold Deposit Scheme.

The value of gold imports during
April
–
December 2012
declined by 14.7 per cent to US $ 38.02 billion and quantity of imports fell by 11.8 per cent compared to same period of previous year. Total gold consumption has also declined by 23 per cent during the first three quarters of 2012. While the supply of gold through organized channels can be constricted, there is need to be vigilant regarding gold inflows through unauthorized channels. Ultimately, the best way to reduce gold imports in a sustainable way will be to offer the public financial investment opportunities that generate attractive returns. This means bringing down
inflation
as well as expanding the range of investments investors have easy access to.

Recent RTA
s
by India

Since India became one of the founding members of the WTO, its attention has grown towards the regional trade groupings. These groupings give regional competitveness to the economy and strengthens it to compete at the global level in a more organised way. Recent developments with regard to India’s regional trade agreements (RTAs) have been given below
19
–

SAFTA

The SAFTA (South Asia Free Trade Area ) Agreement came into force on January 1, 2006 – under it, India has granted
zero basic custom
duty to all LDCs, viz. Afghanistan, Bangladesh, Bhutan, and Maldives, on all items except 25 items relating to alcohol and tobacco. Under the SAFTA Agreement, India has reduced the SAFTA Sensitive List for non-LDCs from 878 to 614 by reduction of 264 tariff lines from 6 September 2012. As per the schedule of Tariff Liberalisation Programme (TLP) under SAFTA, India has brought down its peak tariff rates to
5 per cent from January 1, 2013
.

EHS

India-Thailand FTA,
Early Harvest Scheme
(EHS) under the Framework Agreement for establishing India-Thailand FTA was signed
on 9th October 2003, which includes trade in goods, trade in services, investment, and other areas of economic cooperation, to be concluded as a single undertaking. Under EHS, tariff has gradually been eliminated on a list of 82 common items simultaneously by both sides between September 1, 2004 and August 31, 2006. Under the India-Thailand FTA, it is proposed to provide ASEAN plus tariff concessions. So far 26 rounds of the India-Thailand Trade Negotiation Committee (ITTNC) meetings have been held. The last round was held on November 26–27, 2012 in New Delhi.