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Letter of Transmittal 17th January, 2013 Dr. M. Masud Rahman Professor, Department of Finance. University of Dhaka. Subject: Submission of Term Paper on Balance of payments of India, Balance of payments of India with Bangladesh, IRP, PPP, IFE line of India with USA

Dear Sir, Its our pleasure to prepare and submit this report as a partial requirement of course F526(Foreign exchange and International Risk Management). We have been able to execute our assigned task within the timeframe although the possibility of making mistakes cannot be erased completely. We would like to mention that, we tried our best to prepare the term paper to our greater extent through reading, consulting, discussing the matters among the members of our group. We express our gratitude to you for providing us the opportunity to learn about the Foreign Exchange market, institution and role of different policies taken by that institutions or the country. In spite of various shortcomings, we have devoted our best effort to the Indian trade condition with international market. We hope you will appreciate our endeavor and find the report up to your expectation. We hope that you will pardon us and overlook mistakes considering that we are still learners and you will give us the necessary suggestions that you always give for the improvement of our quality in future. Thanking you.

Sincerely Yours, The members of Group -19 MBA 14th Batch Department of Finance University of Dhaka.

Acknowledgement
The report is on the Balance of payments of India, Balance of payments of India with Bangladesh, IRP, PPP, IFE line of India with USA. At first we want to pay our gratitude to Almighty for letting us prepare the report successfully. We are grateful to our honorable course teacher Dr. M. Masud Rahman, for his painstaking guidance, suggestion and all type of support & supervision in preparing this report. He continuously reminded us for the preparation of this report. We strongly believe works like this one will surely help us to develop & make us better adapted as well as capable to cope with the issues & practical exposures in this field.

Last of all we want to thank the Almighty for making our effort a successful one. We would like to express our heartiest gratitude to all our team members who shared their expertise, struggled with difficulties, passed away many awaked night to design the report, to those who put meaningful effort in accumulation of solid & complete information and analysis. Thanks to all for once again.

Executive Summary

We are assigned the topic about the Balance of Payment condition and Foreign Exchange Risk Management of India which is highly relevant to the student of MBA. The nation had been making an impressive recovery until the global financial crisis hit in late 2008. Ongoing economic and social concerns include low real wages, underemployment for a large segment of the population, inequitable income distribution and few advancement opportunities for the population. Export consist Leather and Manufacturer, chemical products, Engineering Products, RMG products, motor vehicles, industrial and transportation equipment, electronics, chemicals, steel, machine tools, processed foods, non-ferrous metals. This report has been divided into five different parts. Second Part is Composition of Balance of Payment of India. In this part we included data from 2002 to 2011. India are continuously experiencing balance of trade deficit. The highlights of Bop developments during 2011-12 were higher exports, imports, invisibles, trade, CAD and capital flows in absolute terms as compared to fiscal 2010-11. Both exports and imports showed substantial growth of 37.3 per cent and 26.8 percent respectively in 2011-12 over the previous year. Trade deficit increased by 10.5 percent in 2011-12 over 2010-11. However, as a proportion of gross domestic product (GDP), it improved to 7.8 per cent in 201011 (8.7 percent in 2009-10). Net invisible balances showed improvement, registering a 5.8 per cent increase in 2010-11. The CAD widened to US$ 45.9 billion in 2010-11 from US$ 38.2 billion in 2009-10, but improved marginally as a ratio of GDP to 2.7 per cent in 2010-11 vis-avis 2.8 per cent in 2009-10. Net capital flows at US$ 62.0 billion in 2010-11 were higher by 20.1 per cent as against US$ 51.6 billion in 2009-10, mainly due to higher inflows under ECBs, external assistance, short-term trade credit, NRI deposits, and bank capital. In 2010-11, the CAD of US$ 45.9 billion was financed by the capital account surplus of US$ 62.0 billion and it resulted in accretion to foreign exchange reserves to the tune of US$ 13.1 billion (US$ 13.4 billion in 2009-10). In the final part we include Purchasing Power parity and international Fisher Effect.

CHAPTER: 1 INTRODUCTION

Origin of the report This report has been prepared as a part of our course requirement F-526: Foreign Exchange & International Risk Management, under the MBA program. Our course instructor Dr. M Masud Rahman has assigned us this report so to gain some practical knowledge about international export import consequences. This really provides us the opportunity to explore and confront the reality about foreign exchange.

Objective of the study

The basic objective of conducting this report is to apply our theoretical knowledge in practical situation. The objective behind conducting this study is as follows:

To apply theoretical knowledge in practical situation. To analyze the present scenario of export import of India. To analyze actual scenario of Balance of Payments of India. To analyze actual scenario of Balance of Payments of India with Bangladesh. To identify the impact of IRP, PPP and IFE line of India with USA.

Methodology of the Report

To prepare the report we collected all the data from the secondary sources. We have collected export import composition of the respective countries over the recent several periods that includes their balance of payments. We used cross sectional data for regression analysis to give conclusion on IRP, PPP and IFE between India and U.S.

Scope of the Report From the report will be able to know the actual scenario of the balance of payment of India. We have gone through the export import of India thoroughly, analyzed the present condition in these regard to find out the viability and to recommend risk mitigation steps in terms of the foreign exchange. We have also shown the impact of IRP, PPP and IFE line of India with USA.

Limitations of the Report

Despite the diligent efforts given in preparing the report, it succeeded only to skim through the surface of the ocean on this subject. Therefore the views expressed in this report are likely to be restricted by limitations. A number of limitations are associated while preparing the report. They are summarized below The main constrain of the study was insufficiency of information. Some vital information would have made this report more fruitful. But as those data were confidential in nature, it was not provide by the authority. The duration of the study was limited. So it was not possible to reflect all activities in the report in such a short period of time.

CHAPTER: 2 THEORETICAL BACKGROUND

2.1 The Balance of Payments (BOP) Balance of Payments (BOP) is a record of all transactions made between one particular country and all other countries during a specified period of time. Usually, the BOP is calculated every quarter and every calendar year. BOP compares the dollar difference of the amount of exports and imports, including all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa. Balance of payments may be used as an indicator of economic and political stability. For example, if a country has a consistently positive BOP, this could mean that there is significant foreign investment within that country. It may also mean that the country does not export much of its currency. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming. 2.2 Composition of Balance of Payments The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.

2.2.1. The Current Account The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account. Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT).The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports. Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that are directly received.

2.2.2. The Capital Account The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds. The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets. 2.2.3. The Financial Account In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

2.3 The Balancing Act The current account should be balanced against the combined-capital and financial accounts. However, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded. When a country has a current account deficit that is financed by the capital account; the country is actually foregoing capital assets for more goods and services. 2.4 Interest Rate Parity Interest rate parity is an economic concept, in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates. Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from

1 0 purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return. 2.5 Purchasing Power Parity (PPP) An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. In other words, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency. Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918. The concept is founded on the law of one price, the idea that in absence of transaction costs and official barriers to trade, identical goods will have the same price in different markets when the prices are expressed in terms of one currency. In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroadthe difference in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate. 2.6 International Fisher Effect IFE IS an economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Both the Interest Rate Parity theory and the Purchasing Power Parity theory allow us to estimate the future expected exchange rate. The Interest Rate Parity theory relates exchange rate with risk free interest rates while the Purchasing Power Parity theory relates exchange rate with inflation rates. Putting them together basically tell us that risk free interest rates are related to inflation rates. This brings us to the International Fisher Effect. The International Fisher Effect states that the real interest rates are equal across countries. Real interest rates are approximately the risk free rate minus the inflation rate.

2.7 Indian Economy The Indian economy is the third largest in the world in purchasing power parity and ninth largest by nominal GDP criterion. .Goldman Sachs has predicted that by 2035, the Indian economy will be the third largest, behind USA and China. The economy would be as large as 60% of US economy. In 2011, the per capita income was $ 3073, making it relatively a lower middle class economy. The year 1991 is a watershed year in Indian economy. In the budget of 91-92, the then Finance Minister and now the Prime Minister, Dr Manmohan Singh, liberated the economy from the tight controls and finished the era of licensing. Also introduced was economic reforms esp. in the banking sector. The international trade was both liberalized and made very simple to operate.

1 1 This brought out the enterprising spirit of the Indians to the fore and Indian economy began to grow at both high and healthy rates. This made both the country and the Indians attain higher incomes resulting in the countrys foreign exchange reserves reaching to a figure of app.$300 billion presently from a distressing reserve of $ 1 Bn in 1990-91. Today India is one of the fastest growing economies in the world. This growth has led to an increase in the purchasing power of the people and is reflected in the variety of merchandise available at a vast range of prices, unthinkable say in the early nineties. The present growth rate is around 7% down from 8.5% a year ago due to overall dip in the global economic scenario. India is the fourteenth largest exporter and eleventh largest importer in the world. The rise of service industry in India has been a major development and today it forms nearly 60% of the total economy (GDP). The industrial and agricultural sectors contribute app. 27% and 13% resp. nearly 46% of Indians are involved in agriculture, 34% in service sector and 14%in industrial sector. The Indian labor force is nearly 500 million strong. The share of India in world trade has now reached 2%, up from 1.5%, in 2007. The estimated exports in 2011 were around $298.2Bn and est. imports were around $ 451Bn. The main export countries are USA, UAE, China, Hong Kong and major imports are from China, UAE, Saudi Arabia, US and Australia. Petroleum products are a large part of our imports including defense purchases. Indias GDP in 2011 was around $ 1.84 trillion in nominal terms and $4.47 trillion in purchase parity price terms. The current inflation is around 6.95%. Nearly 37% of the population is below poverty level and estimated unemployment rate is 9.8%.Indias public debt is estimated to be around 62.5% of the GDP. The current budget deficit is around 5.9%. India can hope to continue growing at a healthy rate of nearly 8% and more provided leadership is good and corruption is reduced. The Indians have the capability to once again reach the share of nearly 25% of the global trade and more before the Industrial revolution and England did us in the seventeenth century onwards. India is the seventh largest and second most populous country in the world. A new spirit of economic freedom is now stirring in the country, bringing sweeping changes in its wake. A series of ambitious economic reforms aimed at deregulating the country and stimulating foreign investment has moved India firmly into the front ranks of the rapidly growing Asia Pacific region and unleashed the latent strengths of a complex and rapidly changing nation. GE Capital terms the Indian Economy unique, PepsiCo finds it one of the fastest growing and Motorola is sure it will turn into a major sourcing center. Indian operations have occupied center stage in these giants' global networks. India's process of economic reform is firmly rooted in a political consensus that spans her diverse political parties. India's democracy is a known and stable factor, which has taken deep roots over nearly half a century. Importantly, India has no fundamental conflict between its political and economic systems. Its political institutions have fostered an open society with strong collective and individual rights and an environment supportive of free economic enterprise.

1 2 India's time-tested institutions offer foreign investors a transparent environment that guarantees the security of their long-term investments. These include a free and vibrant press, a judiciary that can and does overrule the government, a sophisticated legal and accounting system, and a user-friendly intellectual infrastructure. India's dynamic and highly competitive private sector has long been the backbone of its economic activity. It accounts for over 75 per cent of its Gross Domestic Product and offers considerable scope for joint ventures and collaborations. Today, India is one of the most exciting emerging markets in the world. Skilled managerial and technical manpower that match the best available in the world and a middle class whose size exceeds the population of the USA or the European Union, provide India with a distinct cutting edge in global competition. 2.8 Economic indicators The solidity of the Indian economy is evident from its stability in the backdrop of a recessive Asian market. The latest estimates of the Central Statistical Organization (CSO) project Gross Domestic Product (GDP) growth of 5.4 per cent during 2001-02. India has entered the new millennium with a strong and robust financial outlook. Average annual real GDP accelerated from 5.4 per cent during the 12-year period ending 1991-92 to 6.4 per cent during 1992-1993 through 2000-2001. The overall growth performance of the industrial sector during 2001-02 is expected to be somewhat lower than that of the previous year. However, combined with the continued performance of the services sector, particularly of the information technology sector, the Indian economy is expected to achieve a healthy growth of 6 per cent.

Major macroeconomic indicators: 1990-91 to 2001-02 ITEMS Growth rates (per cent): GDP at constant factor cost GDP at constant factor cost Electricity Agricultural production Food grains production Exports (BOP in terms of US $) Imports (BOP in terms of US $) 5.6 8.2 7.8 3.8 3.1 9 14.4 1.3 0.6 8.5 -2 -4.5 -1.1 -24.5 6.5 4.1 6.5 7.6 5.9 -3.9 -7.1 6.1P 6.7 7.3 -0.9 3 9.5 16.5 4.0Q 5 4 -6.6P -6.6P 19.6 7 5.4 A 2.3 c 2.7 c 6.9 P 6.8 P 0.6 b 0.3 b 1990-91 1991-92 1998-99 1999-00 2000-01 2001-02

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POL Food grains production (Million tons) Electricity generated (million KWH) Average exchange rate (Rs./US$) Growth rate of money supply (M3) Average rate of inflation (per cent) In terms of WPI In terms of CPI As per cent of GDP at current market prices: Gross domestic savings Gross domestic investment Central Government expenditure Central Government receipts Gross fiscal deficit of Central Govt. Exports fob (BOP) Imports cif (BOP) Trade balance Net invisibles Current account balance Total capital flows Total foreign investment net (BOP) Foreign direct investment (FDI) net

60 176.4 264.3 17.94 15.1

-11.7 168.4 287 24.65 19.3

-21.6 203.6 448.5 42.07 19.4

97.1

24.1 -14.6 b

209.8 195.9P 209.2 P 480.7 43.33 14.6 499.6 383.2 c 45.68 47.49 d 16.7 11.2 e

12.1 13.6

13.6 13.9

5.9 13.1

3.3 3.4

7.1 3.7

4.4 f 4.2 g

23.1 26.3 17.3 15.3 6.6 5.8 8.8 -3 -0.1 -3.1 2.7 0.03 0.03

22 22.6 16.2 15.2 4.7 6.9 7.9 -1 0.7 -0.3 1.7 0.05 0.05

21.7 22.7 14.7 14.7 5.1 8.3 11.5 -3.2 2.2 -1 1.9 0.6 0.6

23.2 24.3

23.4 24

15.4 15.3PU 16.4 BE 15.4 15.3PU 16.4 BE 5.4 8.4 12.4 -4 3 -1.1 2.4 1.2 0.5 5.5PU 5.1 BE 9.8 13 -3.1 2.6 -0.5 1.8 1 0.4

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Portfolio investment Parameters for al debt: al debt/GDP ratio (per cent) Debt service ratio (per cent) Debt/ exports ratio Short-term debt to total debt ratio (%) Foreign exch. reserves (US$ bn.) Import cover of foreign exch. Reserves (in no. of months of imports)

Negligib Negligible le

-0.02

0.7

0.6

28.7 35.3 454 10.2 5.8 2.5

38.7 30.2 467 8.3 9.2 5.3

23.6 18 283 4.4 32.5 8.2

22.2 16.2 262 4 38 8.2

22.3 17.1 222 3.5 42.3 8.6

21 h

2.8 h 49.5 * 9.6

"India is clearly becoming a more and more important player on the world stage in G20 context, in terms of its role in the global economy. It is very useful for us to exchange ideas and build the basis for future collaboration," according to Mr. Ben Bernanke, Chairman, US Federal Reserve. India is the fifth best country in the world for dynamic growing businesses, according to the Grant Thornton Global Dynamism Index. The index gives a reflection of how suitable an environment it offers for dynamic businesses. In addition, India's economic confidence registered an increase of 8 points, to reach 68 per cent in August 2012 as compared to the previous month, according to the 'Ipsos Economic Pulse of the World' survey. This makes India the fourth most economically confident country in the world. India ranks fourth on Ernst & Young's (E&Y) renewable attractiveness index. India ranks second on the solar index, and third on the wind index, as per the latest study by E&Y and UBM India Pvt. Ltd. Moreover, Indian firms took pride at the 2012 Platts Top 250 Global Energy Company Rankings. Six of the 12 Indian companies which were in the ranking, also made it to the list of top 50 fastest growing companies.

1 5 2.9 Balance of Payments: CRISIS The lead up to the crisis: 1990-91 i) Breakup of the Soviet Union: The Soviet Union had been one of the largest export markets for India prior to its breakup in India. The Soviet breakup therefore negatively affected Indias precarious trade balance, which slipped further into red. ii) The Gulf war: Current account deficit averaging 2.2% of the GDP hit hard by the Gulf war .The Gulf war began in August 1990 with Iraqs Invasion of Kuwait. Both Iraq and Kuwait were among the largest suppliers of oil to India, especially Iraq with whom India had long term arrangements .Due to the war many of these long term contracts were hit, which forced the government to buy from the spot market at high prices resulting in the oil bill ballooning to $2 billion in the latter half of 1990. iii) Fall in remittances: The Gulf war also caused many Indian workers working in Kuwait and Iraq to return, resulting in a fall in remittances. This was significant since NRI remittances had been an important source of inflows to the country throughout the eighties thus reducing the severity of the balance of payments. The situation was further aggravated further with the government having to airlift Indian residents in Kuwait. iv) Political uncertainty: The period between1990-91 was marked with high political uncertainty at the central level with the country seeing three successive government changes. This reduced the focus of the government on the looming economic crisis as there was no clear policy to deal with the unexpected situation. When a stable majority government did was setup in 1991, it was a little too late as the damage had been done. The Crisis: The rapid loss of foreign exchange reserves had prompted the government to take steps to reduce the trade deficit, by restricting the imports .In October 1990; the RBI imposed a cash margin of 25percent on all imports other than capital goods. Capital goods imports were allowed only with foreign sources of credit. Additionally, a surcharge of 50 percent was imposed on all Petroleum and oil imports except domestic gas. Along with increases in custom duties, the above mentioned policies had the desired impact of controlling the imports, which started falling in the latter half of 1991. By late of 1991, the decline of imports had reached a stage where it was starting to affect the domestic production, which started declining (as shown). Hence any further measured in this direction was ruled out. By the end of 1990 and the beginning of 1991 it was clear that Trade deficit was not the deciding factor ,as it had come down to $382 million in Jan-Feb 1991 and further to $172 million in May 1991. The main reason for such a drastic fall in reserves was due to the withdrawal of foreign currency non-resident deposits (FCNR), which accelerated from $59 million in Oct-Dec 1990, to $76million in Jan-Mar 1991 and finally to 310 million in June 1991.

By the end of 1990 and the beginning of 1991 it was clear that Trade deficit was not the deciding factor ,as it had come down to $382 million in Jan-Feb 1991 and further to $172 million in May 1991 59 76 310 . The main reason for such a drastic fall in reserves was due to the

1 6 withdrawal of foreign currency non-resident deposits (FCNR), which accelerated from $59 million in Oct-Dec 1990, to $76million in Jan-Mar 1991 and finally to 310 million in June 1991 It was clear that the crisis had been clearly due to crisis of confidence in the Indian Government to prevent a default. This is more akin to a sort of speculative attack, in which the foreign investor fears devaluation of the currency (the most likely step for the government to prevent a default) withdraws their deposits from the country. Further, in expectation of devaluation import receipts are forwarded and export receipts are postponed .This together with the downgrading of credit risk pushes the country more towards the default, with the Central Bank under more pressure not to devalue the currency. This situation is pictorially depicted below The Response In June 1991, Foreign exchange reserves fell below $1billion. This was barely enough to cover 2 weeks of imports. Further, the short term debt to foreign currency reserve ratio rose from 2.2 in March 1990 to3.8 in March 1991 putting extraordinary pressure on the reserves (It should be noted that this ratio had increased from 0.9 in 1989 to2.2 in 1990 which was a strong precursor).These short term debts had higher costs and were subject to greater volatility, subjecting the reserves to greater risks. However, during this time the government took a number of steps starting with an agreement with IMF for a withdrawal of $1,025 billion under its Compensatory and Contingency Financing Facility (CCFF).Withdrawals of $789million from the first credit tranche made in Jan, 1991. In May 1991, the government leased 20 tones of confiscated gold to State bank of India to sell it abroad with an option to repurchase it within 6 months. Further in July 1991, the government allowed the RBI to ship 47 tons of Gold to the Bank of England a Bank of Japan which allowed RBI to raise $600 million. This pledged gold was later retrieved in September 1991.It was against this background that a two-step downward adjustment in the exchange rate of rupee was effected on July 1 and 3, 1991, which resulted in devaluation of around 18 per cent against major international currencies. Devaluation at no time was free from controversy. But given the grim situation that the country faced on the external front, a downward adjustment of the exchange rate had become inevitable. The extent of devaluation was determined primarily by the degree of correction that was required in the balance of payments. Another consideration was whether, instead of making a discrete change, small changes in the exchange rate should be made , as had been policy since 1985 . It was decided that a sharp discrete change was needed to quell expectations. These two-stage discrete devaluation processes in the exchange rate also intrigued many observers. After the first announcement, to avoid destabilizing expectations, the required change was completed in the second round. The devaluation of the rupee was complemented with changes in the external trade regime. Perhaps this is what made the devaluation of 1991, different from others. A process of establishing a more liberalized trade regime was set in motion. A realistic exchange rate provided the basis for a credible reform process. Post Crisis: Reforms India adopted a more cautious approach to reforms and liberalization than most of the other emerging economies. The reforms program was undertaken in the face of a balance

1 7 of payments crisis which forced the country to seek IMF financial assistance. To impart inherent competitive strength to the industrial economy, a program of structural reforms of trade, industrial and public sector policies was also initiated. T he objective was to evolve an industrial and trade policy framework would promote efficiency, reduce bias in favor of excessive capital-intensity and encourage an employment-oriented form of industrialization.

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CHAPTER 3 BALANCE OF PAYMENT OF INDIA

1 9 3.1 Indias Export Indias export was worth 1041.52 Billion USD in April of 2011 and it increased throughout the year to march of 2012 with export worth 1421.73 Billion at the end of their FY 2011-2012. Export growth has continued to be a major component supporting India's rapid economic growth. Exports of goods and services constitute 24.64% of its GDP. Indias major exports are: agriculture and allied products, ores and minerals, leather and manufactures, chemicals and related products, engineering goods, textile Products, gems and jewellery, handicrafts (excluding handmade carpets) & petroleum products. Indias largest exports markets are European Union, United States, Hong Kong, Sri-Lanka and Singapore. From the following graph, we can see that Indias exports are increasing from May 2011 and it was highest in March 2012.

Figure 1: Export of India in US$ Billion for year 2011-12

3.1.1 Major Export Items of India: Items I. Primary Products A. Agriculture and Allied Products B. Ores and Minerals II. Manufactured Goods A. Leather and Manufactures B. Chemicals and Related Products C. Engineering Goods D. Textile and Textile Products (Data from 2011-12) 14.96% 12.28% 2.68% 61.32% 1.57% 12.21% 22.02% 9.19%

2 0 E. Gems and Jewellery F. Handicrafts (excluding Handmade Carpets) G. Other Manufactured Goods III. Petroleum Products IV. Others (All Commodities) Total Exports

15.40% 0.08% 0.85% 18.25% 5.47% 100.00%

Indias main exports are engineering goods (22.02 percent of total exports), gems and jewelry (15.40 percent), chemicals (13 percent), agricultural products (12.21 percent), textiles (9.19 percent) and petroleum products (18.25 percent)

Major Export Items (2011-12)

6% 18% Manufactured Goods Petroleum Products Others (All Commodities) 15% Primary Products

61%

Figure 2: Major Export items of India in percentage for year 2011-12

3.1.2 Indias Export Composition Export of India is mainly composed of eight main components or products. To illustrate the composition, we have taken 10 year data from session 2002-03 to session 2010-12.

Commodity / Primary Manufactured Petroleum Year Products Goods Products 8706.1 40244.5 2576.5 2002-03 9901.8 48492.1 3568.4 2003-04 13553.3 60730.7 6989.3 2004-05 16377.4 72562.8 11639.6 2005-06

Others (All Total Commodities) Exports 1192.3 52719.4 1880.3 63842.6 2262.6 83535.9 2510.7 103090.5

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2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

19685.9 27551.9 25335.4 26396.5 32844.7 45574

84920.4 102978.8 123148.9 115180.7 157993.9 186784.2

18634.6 28363.1 27547 28192 41480 55603.5

3173.2 4010.5 9263.7 8982.2 18817.7 16661.7

126414.1 162904.3 185295 178751.4 251136.2 304623.5

Table: Export Composition of India for 10 Financial Years

India is also one of Asias largest refined product exporters with petroleum accounting for around 18 percent of total exports. Indias main export partners are United Arab Emirates (12 percent of total exports) and United States (11 percent). Others include: China, Singapore, Hong Kong and Netherlands. 3.1.3 Export Trend In case of Indias export trend, we can see from the graph that it is increasing from the year FY2003-04 and got a relatively downward move in year FY2009-2010. But after that year it was increasing highly from the previous financial years.

Exports
350000 300000 250000 200000 150000 100000 50000 0 Exports

Figure 3: Export trend of India in US$ million for year 10 years.

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3.2 Indias Imports Indias import was worth 1623.93 Billion USD in April of 2011. Then it increased gradually and made highest import in January 2012. Indias main imports of commodities are: Petroleum, Crude and Products, Consumption Goods and Capital Goods. Indias main imports partners are: Germany, Belgium, USA, South Korea and Asian countries. From the following graph, we can see that India imports are increasing from May 2011 to March 2012.

Figure 4: Import of India in US$ Billion for year 2011-12.

3.2.1 Major Import Items of India: Items I. Bulk Imports A. Petroleum, Crude and Products B. Bulk Consumption Goods C. Other Bulk Items II. Non-Bulk Imports A. Capital Goods B. Mainly Export Related Items C. Others Total Imports (Data from 2011-12) 43.88% 31.65% 2.37% 9.86% 56.12% 20.30% 11.13% 24.69% 100.00%

2 3

India is heavily dependent on coal and foreign oil imports for its energy needs. Other imported products include: machinery, gems, fertilizers and chemicals. Indias main import partners are China (12 percent of total imports), United Arab Emirates, Switzerland, Saudi Arabia, United States, Iraq and Kuwait.

Figure 5: Major Import Items of India in percentage for year 2011-12.

3.2.2 Indias Import Composition Import of India is mainly divided into two categories, such as bulk imports and non-bulk imports. To illustrate the composition, we have taken 10 year data from session 2002-03 to session 2010-12. USD Million Commodity Petroleum Consumption Other /Year and Goods Bulk Crude Items 2002-03 2003-04 2004-05 2005-06 17639.5 20569.5 29844.1 43963.1 2411 3072.8 3104.6 2766.6 4249 5819.2 9452 14356.5 Capital Goods Mainly Others Total Export Imports Related Items 10313.7 13300.7 61412.1 12716.8 17691.9 78149.1 17095.5 26886.2 111517.4 18641 31772.4 149166

13498.2 18278.9 25135 37666.2

2 4 56945.3 79644.5 93671.7 87135.9 105964.4 154905.9 4294.1 4600.3 4975.3 9012.7 8854.8 11614.4 22996.4 28499.9 40144 29166.5 36347.9 48234.3 47069.1 70110.5 71833.1 65865 78546.1 99364.7 17871.7 36558.5 20768.3 47815.7 31930.8 61141.4 31270 65922.8 53608.3 86447.6 54478.9 120819.3 185735.2 251439.2 303696.3 288372.9 369769.1 489417.4

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

Table: Import Composition of India for 10 Financial Years 3.2.3 Import trend India was facing an increasing amount of import every year. From our analysis, we found that without the financial year 2009-10, the growth of import was increasing gradually. It indicates an adverse impact of overall trade balance of India as well as in the economic condition.

Imports(USD MN)
600000 500000 400000 300000 200000 100000 0 Imports

Figure 6: Import trend of India in US$ million for year 10 years

3.3 Balance of trade The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and occurs when value of exports is higher than that of imports; a negative balance of trade is known as a trade deficit or a trade gap. Combing the statistics from imports and exports, trade balance from 2002-03 to 2011-12 is derived. In 2011-12, India has an exceedingly high trade deficit of -184793.9 USD million. Below the chart of India trade balance and its trends from year 2002 - 2012:

2 5

Year 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

Exports ($ in millions) 52719.4 63842.6 83535.9 103091 126414 162904 185295 178751 251136 304624

Imports ($ in millions) 61412.1 78149.1 111517 149166 185735 251439 303696 288373 369769 489417

Trade Balance ($ in millions) -8692.7 -14306.5 -27981.5 -46075.2 -59321.2 -88535 -118401.3 -109621.5 -118632.9 -184793.9

Table: Export, Import and Balance of Trade of India for 10 years India recorded a trade deficit of USD 184793.9 million in December of 2012. Balance of Trade in India is reported by the Directorate General of Commerce. Historically, from 2002 until 2012, India Balance of Trade averaged USD -77,636.2 million. And it is expected from the recent trend with a highest trade deficit of USD 184793.9 million that it will increase in future financial year.
600000 500000 400000 300000 200000 100000 0 -100000 -200000 200203 Exports 52719.4 Imports 61412.1 Trade Balance -8692.7 -300000 2003- 2004- 2005- 2006- 2007- 2008- 2009- 2010- 201104 05 06 07 08 09 10 11 12 63842.6 83535.9 103090.5126414.1162904.2 185295 178751.4251136.2304623.5 78149.1 111517.4149165.7185735.2251439.2303696.3288372.9369769.1489417.4 -14306.5 -27981.5 -46075.2 -59321.2 -88535 -118401 -109622 -118633 -184794

Figure 7: Export, Import and Balance of Trade of India for 10 years

India had been recording sustained trade deficits due to low exports base and high imports of coal and oil for its energy needs. India is leading exporter of petroleum products, gems and

2 6 jewelry, textiles, engineering goods, chemicals and services. Main trading partners are European Union countries, United States, China and UAE. 3.4 Balance of Payment Analysis of India 3.4.1 Current Account Current Account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). This page includes a chart with historical data for India Current Account. The current account includes trade balance, payments for software exports and worker remittances. To analyze the current account and its compositions we used the data from financial year 200607 to 2011-12.

Item/Year Current account (US $ million) 1. Merchandise 2. Invisibles (a+b+c) a) Services i) Travel ii) Transportation iii) Insurance iv) G.n.i.e. v) Miscellaneous of which : Software services Business services Financial services Communication services b) Transfers i) Official ii) Private c) Income i) Investment income ii) Compensation of employees Total Current account (1+2)

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

-61782 52217 29469 2439 -94 553 -150 26721 29033 -1322 115 1466 30079 254 29825 -7331 -6762 -569 -9565

-91467 75731 38853 2091 -1500 595 -45 37712 36942 219 84 1548 41945 239 41706 -5068 -4433 -635 -15737

-119519 91605 53916 1469 -1510 292 -404 54068 43736 3284 1470 1211 44798 232 44567 -7110 -6626 -484 -27915

-118202 80022 36016 2516 -755 306 -84 34033 48237 -6728 -949 -127 52045 254 51791 -8039 -7247 -790 -38180

-130593 84648 48816 4167 391 548 -285 43995 53266 -3715 -975 410 53140 16 53124 -17310 -16398 -912 -45945

-189759 111604 64098 4700 1859 1135 -302 56707 60956 -878 -2017 43 63494 25 63469 -15987 -16465 477 -78155

Table: Current Account Composition of India for Six Financial Years

Merchandise net balance of current account was always negative for India in recent years. The amount of export is increasing but the import is increasing with a more increasing rate than export of India. So it caused a deficit over the year and it is growing year to year with a highest

2 7 deficit of last financial year 2011-12 with USD -189759 million according to the reserve bank of India. The movements of this merchandise over the years are:

Net Balance of Merchandise

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

-61782 -91467 -119519 -118202 -130593

-189759

Figure 8: Balance of Merchandise for Six Financial Years

Invisibles with services, transfers and incomes had been having a positive balance over the years. It shows a fluctuation in the balances of invisible items. Though this balance was always positive the net balance of current account cannot be positive due to the higher amount of trade deficit. For example the amount of invisibles item balance was $ 111604 million in last year of 2011-12, but the negative balance of merchandise USD -189759 million caused the overall balance negative with -78155 million USD. The invisibles items compositions are described below:
70000 60000 50000 40000 30000 20000 10000 0 -10000 -20000 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 Services Transfers Income

Figure 9: Balance of Income items for Six Financial Years

2 8 On the other hand Current Account in India is reported by the Reserve Bank of India. Historically, from 1949 until 2012, India Current Account averaged -1.32 USD Billion reaching an all time high of 7.36 USD Billion in March of 2004 and a record low of -22.30 USD Billion in September of 2012. Other conditions about current account of India are: The current record is $21.7 billion, in the January-March quarter of this year. India imports more than three-fourths of the crude oil it requires, making this the biggest driver of the trade gap. Analysts blame the government's large fuel subsidy for keeping the demand for fuel products artificially high and stoking the trade deficit. The $24.2 billion in foreign investment in the capital market and foreign direct investment during the July-September quarter weren't enough to fill the current-account deficit. Foreign investment was $19.0 billion in the same period a year earlier. The current-account deficitfuelled by a perennial trade gapis seen as the biggest drag on the rupee, which weakened more than 3% against the U.S. dollar in 2012 following a 16% fall last year. India's trade deficit grew to $48.3 billion in the July-September period from $44.50 billion a year earlier. Merchandise exports slumped by 12.2%, while imports fell 4.8% over the same period. Analysts expect the pressure on the current-account deficit to continue, as the trade deficit remained wide in October and November.

3.4.2 Capital Account Capital inflows can be classified by instrument (debt or equity) and maturity (short-term or longterm). The main components of capital account include foreign investment, loans, and banking capital. Foreign investment comprising FDI and portfolio investment represents non-debt liabilities, while loans (external assistance, ECBs, and trade credit) and banking capital including NRI deposits are debt liabilities. In India, FDI is preferred over portfolio flows as the FDI flows tend to be more stable than portfolio and other forms of capital flows. Rupee-denominated debt is preferred over foreign currency debt and medium- and long-term debt is preferred over shortterm. To analyze the capital account and its compositions we used the data from financial year 2006-07 to 2011-12. Item/Year Capital account (US $ million) 1. Foreign investment (a+b) a) Foreign direct investment (i+ii) i) In India Equity Reinvested earnings Other Capital ii) Abroad Equity Reinvested earnings 2006-07 14753 7693 22739 16394 5828 517 -15046 -12604 -1076 2007-08 43326 15893 34728 26757 7679 292 -18835 -14422 -1084 2008-09 8342 22372 41737 31930 9030 777 -19365 -12180 -1084 2009-10 50362 17966 33109 22905 8669 1535 -15143 -9871 -1084 2010-11 39653 9360 25884 13790 11939 154 -16524 -7975 -1084 2011-12 39231 22060 32953 22833 8205 1914 -10892 -3874 -1208

2 9

Other capital b) Portfolio investment i) In India of which: FIIs GDRs/ADRs ii) Abroad 2. Loans (a+b+c) a) External assistance i) By India ii) To India b) Commercial borrowings i) By India ii) To India c) Short term to India i) Suppliers' Credit >180 days & Buyers' Credit ii) Suppliers' credit up to 180 days 3. Banking capital (a+b) a) Commercial Banks i) Assets ii) Liabilities of which: Non-Resident Deposits b) Others 4. Rupee debt service 5. Other capital Total capital account (1 to 5)

-1366 7060 7004 3226 3776 56 24490 1775 -12 1787 16103 -340 16443 6612 3307 3305 1913 1581 -3494 5075 4321 332 -162 4209 45203

-3330 27433 27270 20327 6645 163 40653 2114 -4 2119 22609 -31 22640 15930 10913 5017 11759 12112 6894 5217 179 -353 -122 10969 106585

-6100 -14031 -13853 -15017 1162 -177 8315 2438 -346 2785 7861 1214 6647 -1985 463 -2448 -3246 -2774 -2902 128 4289 -471 -100 -5917 7395

-4188 32396 32376 29049 3328 20 12447 2890 -371 3261 2000 -532 2531 7558 4657 2901 2083 1927 1838 89 2922 157 -97 -13162 51634

-7465 30292 31471 29421 2049 -1179 28437 4941 -26 4966 12507 327 12178 10990 7344 3646 4962 4432 -3297 7729 3238 530 -68 -10995 61989

-5809 17170 17409 16812 597 -239 19307 2296 -156 2452 10343 1204 9140 6667 3835 2832 16226 16049 -593 16641 11917 177 -79 -6928 67756

Table: Capital Account Composition of India for Six Financial Years

In 2011-12, both gross inflows of US$ 478808 million and outflows of US$ 411052 million under the capital account were higher than gross inflows of US$ 499355 million and outflows of US$ 437366 million in the preceding year. Foreign investment Foreign investment of India had a net balance of US$ 39231 million in year 2011-12. It is composed of foreign direct investment of India and abroad and portfolio investment of India and abroad. Both items have inflow and out flow of fund and constitute foreign investment. The trend of this item is shown below:

3 0

Foreign Investment (USD MN)

60000 50000 40000 30000 20000 10000 0 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

Figure 10: Foreign Investment of India for Six Financial Years

Loans Loan had a net balance of US$ 19307 million in the year 2011-12. It is composed of External assistance, Commercial borrowings and Short term loans to India. These all items were positive in the considered financial years in the table and the fluctuations over the years are:

Figure 11: Balance of Loans of India for Six Financial Years

Banking capital Banking capital is the combinations of assets and liabilities in resident and nonresident banks in account for India. This item has also been having positive net balance over the year and contributing to the overall capital account balance in India. It had a positive net balance of US$ 1913 million in year 2006-07 and US$ 16226 million in year 2011-12. But a negative balance net US$ 3246 million.

3 1 On the other hand, according to the Reserve Bank of India some capital account conditions of India over the years are: In net terms, capital inflows increased by 9 percent to US$ 62.0 billion (3.7 per cent of GDP) in 2010-11 vis-a-vis US$ 51.6 billion (3.8 per cent of GDP) in 2009-10 mainly on account of trade credit and loans (ECBs and banking capital).The Non-debt flows or foreign investment comprising FDI and portfolio investment on net basis decreased by 21.4 per cent from US$ 50.4 billion in 2009-10 to US$ 39.7 billion in 2010-11. Decline in foreign investment was offset by the debt flows component of loans and banking capital which increased by 130.3 per cent from US$ 14.5 billion in 2009-10 to US$ 33.4 billion in 2010-11. Inward FDI showed a declining trend while outward FDI showed an increasing trend in 2010-11 vis-a-vis 2009-10. Inward FDI declined from US$ 33.1 billion in 2009-10 to US$ 25.9 billion in 2010-11. Sector wise, deceleration during 2010-11 was mainly on account of lower FDI inflows under manufacturing, financial services, electricity, and construction. Country-wise, investment routed through Mauritius remained the largest component of FDI inflows to India in 2010-11 followed by Singapore and the Netherlands. Outward FDI increased from US$ 15.1 billion in 2009-10 to US$ 16.5 billion in 2010-11. With lower inward FDI and rise in outward FDI, net FDI (inward minus outward) to India stood considerably lower at US$ 9.4 billion during 2010-11 (US$ 18.0 billion a year earlier). Net portfolio investment flow witnessed marginal decline to US$ 30.3 billion during 2010-11 as against US$ 32.4 billion in 2009-10. This was due to decline in ADRs/GDRs to US$ 2.0 billion in 2010-11 from US$ 3.3 billion in 2009-10, even though FII inflows showed marginal increase to US$ 29.4 billion in 2010-11 from US$ 29.0 billion in 200910. 6.30 Other categories of capital flows, namely debt flows of ECBs, banking capital, and short-term credit recorded a significant increase in 2010-11. Net ECB inflow increased significantly to US$ 12.5 billion in 2010-11 as against US$ 2.0 billion in 200910. Similarly, short-term trade credit increased from US$ 7.6 billion in 2009-10 to US$ 11 billion in 2010-11, indicating strong domestic economic performance. Further, external assistance increased from US$ 2.9 billion in 2009-10 to US$ 4.9 billion in 201011.The capital account surplus improved by 20.1 per cent to US$ 62.0 billion during 2010-11 from US$ 51.6 billion in 2009-10. However, as a proportion of GDP, it declined marginally to 3.7 per cent in 2010-11 from 3.8 per cent in 2009-10.

3.5 Overall Balance of Payment The highlights of Bop developments during 2011-12 were higher exports, imports, invisibles, trade, CAD and capital flows in absolute terms as compared to fiscal 2010-11. Both exports and imports showed substantial growth of 37.3 per cent and 26.8 percent respectively in 2011-12 over the previous year. Trade deficit increased by 10.5 percent in 2011-12 over 2010-11. However, as a proportion of gross domestic product (GDP), it improved to 7.8 per cent in 201011 (8.7 percent in 2009-10). Net invisible balances showed improvement, registering a 5.8 per cent increase in 2010-11. The CAD widened to US$ 45.9 billion in 2010-11 from US$ 38.2

3 2 billion in 2009-10, but improved marginally as a ratio of GDP to 2.7 per cent in 2010-11 vis-avis 2.8 per cent in 2009-10. Net capital flows at US$ 62.0 billion in 2010-11 were higher by 20.1 per cent as against US$ 51.6 billion in 2009-10, mainly due to higher inflows under ECBs, external assistance, short-term trade credit, NRI deposits, and bank capital. In 2010-11, the CAD of US$ 45.9 billion was financed by the capital account surplus of US$ 62.0 billion and it resulted in accretion to foreign exchange reserves to the tune of US$ 13.1 billion (US$ 13.4 billion in 2009-10). USD Million Particulars Total Current account Total capital account Errors & omissions Overall balance 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 -9565 -15737 -27915 -38180 -45945 -78155 45203 106585 7395 51634 61989 67756 968 1316 440 -12 -2993 -2432 36606 92164 -20079 13441 13050 -12832

Table: Overall BOP of India for Six Financial Years

India had recorded a balance-of-payments deficit of $ 12832 million in the 2011-2012 period after posting surplus in two successive financial years. The overall net balance of Payment was positive over the years without the year 2008-09 and 2011-12.

Balance of Payment scenerio

150000 100000 50000 0 -50000 -100000 Total Current account Total capital account Errors & omissions Overall balance

2006-07 -9565 45203 968 36606

2007-08 -15737 106585 1316 92164

2008-09 -27915 7395 440 -20079

2009-10 -38180 51634 -12 13441

2010-11 -45945 61989 -2993 13050

2011-12 -78155 67756 -2432 -12832

Figure 12: Overall BOP of India for Six Financial Years

The current account deficit for the first half of 2011 12 stands at USD 32.84 billion according to an economic survey in 2011-12. It can be noted that higher current account deficit can be attributed to declining capital inflows. Foreign Institutional Investment during the first half of

3 3 2011-12 came down to USD 1.346 billion from USD 23.796 billion in the corresponding period of the previous financial year. Other conditions about Balance of payments of India are: Foreign Direct Investments during the first half of 2011-12, however, increased to USD 12.31 billion from USD 7.040 billion in the corresponding period of the previous year. It can also be noted that a further deterioration in the current account deficit situation will put further pressure on the value of rupee. The rupee touched its lowest ever value of Rs 54.23 per US dollar on December 15th, 2011. Indias exports during the first half of the financial year grew by 40.5 per cent while its imports grew by 30.9 per cent. Total value of the exports during the April- January period stood at USD 23.5 billion while total value of imports stood at USD 29.4 billion. The Economic Survey notes that 2011-12 was a tough year for International trade with the fall in global world trade being steeper than the decline in real Gross Domestic Product (GDP). Indias exports felt the heat of this slowdown in international trade. India's balance of payments returned to deficit in the July-September quarter as a surge in foreign investment was insufficient to bridge a record current-account gap, highlighting the fragile state of Asia's third-largest economy even as the government takes steps to curb its spending and boost growth.

Current Account Deficit Has Widened to All-time High as Saving Declined

Figure 13: Current account deficit and saving decline

Post credit crisis, Indias current account deficit has widened: Post credit crisis, Indias current account deficit has been widening steadily as the government continued to

3 4 run its savings due to high revenue deficit. The governments desire to stimulate domestic demand at a time when external demand has been relatively slow has been the most important factor behind the wider current account deficit post credit crisis. In F2012, current account deficit has widened to an all-time high: Indias current account deficit is estimated to reach an all- time high of ~-4% of GDP in F2012 (year ending Mar-12). If the government attempts to increase domestic demand (capex or consumption) in a meaningful manner, it will mean even a wider current account deficit. Widening Deficit Exposes India to Funding Risks

Figure 14: Funding risk because of deficit

India is most exposed to global funding risks in Asia Ex-Japan: During the 12 months ended March 2012, India is estimated to have had a current account deficit of US$73bn (4% of GDP. More important, over two-thirds of this deficit was funded by less-stable sources of capital, including commercial loans, trade credit and portfolio equity and debt inflows. With rising current account deficit over the last few months, capital inflows have not been able to fully match the current account deficit, resulting in a decline in FX reserves. Any sign of risk aversion in the global financial markets and consequent slowdown in capital inflows will result in wider balance of payments deficit exerting pressure on exchange rates as well as domestic cost of capital.

3 5 Higher Current Account Deficit and Slowdown in Capital Flows Affects Reserve Money (M0) Growth

Figure 15: Higher current account deficit and slowdown in capital flows affects reserve money growth Slowdown in capital flows affects reserve money growth: Over the last six months, reserve money (monetary base) growth has decelerated to 6.8% YoY currently from 19.4% YoY as of Sep-11. FX outflows over the last couple of months have meant that reserve money growth has decelerated, thus leading to unintended tightening, although a part of the deceleration in reserve money is due to a reduction in the cash reserve ratio. Indeed, the contribution of net FX assets to reserve money growth has been negative since Nov-11, and FX reserves have reduced by US$21.5bn since then. This has in turn resulted in M3 growth decelerating to 13% YoY as of the fortnight ended April 20, 2012, compared with 16.3% YoY in September 2011.

Findings: India is still categorized under Developing Countries. In 1991 India's industrial system changed from socialism to capitalism. As a result, India's economy started growing at 6% per year double the earlier rate. Later it started growing at 9% per year triple the earlier rate. That is, after adopting capitalism in 1991, India's rate of industrialization/modernization has now tripled. India is now industrializing /modernizing thrice as fast as she was doing during the period 1947 1991. Balance of trade and current account balance Historically India has been running current account deficits. Trade deficit hit a record high of $184.9bn or 9.9 per cent of GDP for the fiscal year 2011 compared to 7.1 percent of GDP in FY 2010 Oil imports soared 46.9 per cent to $155.6bn. Exports grew 21 per cent, to $303.7bn, but imports surged 32.1 per cent over the previous fiscal year, to $488.6bn. Indias current account deficit is estimated to reach an all- time high of ~-4% of GDP

3 6 in F2012 The driver for this rise in current account deficit is savings declining faster than investment. Some investors have argued that gold imports are the key cause for the high current account deficit and therefore the underlying current account deficit is not as bad as it appears. But higher gold imports as a symptom of loose fiscal policy (high revenue deficit and low productivity nature of government capital spending) keeping inflation high relative to growth trend. Foreign investment was insufficient to bridge a record current-account gap, highlighting the fragile state of Asia's third-largest economy even as the government takes steps to curb its spending and boost growth.

Strengths in Balance of Payments Transfer account and services account are the strengths in the BOP, as India expects to receive high remittance than other Asian countries. India has wide natural resources like Coal, Iron, Oil, etc. Experts say that more of these would be found out soon. The country is agriculture based so if it can bring some local investment or FDI in the agriculture processing industry than it can have a more favorable growth. The country is self-sufficient in many areas and was endowed with fertile land, dense forests, and swift rivers.

Risks in Balance of Payments:

The most important balance of payment risk is the dependence on agricultural export products. India imports more than three-fourths of the crude oil it requires, making this the biggest driver of the trade gap. Analysts blame the government's large fuel subsidy for keeping the demand for fuel products artificially high and stoking the trade deficit. Rising inflation can make export costlier and may induce more imports from other countries of consumption goods. Moreover, increasing population and income level will induce more imports which will eventually lead to balance of trade deficit. But, as it is not optimum to reduce consumption in consumer goods and goods for industrialization structural deficit is to be found. Capital Account Although, over 2004-07, when global capital markets were buoyant and capital inflows continued to be higher than Indias current account deficit funding needs, in the current environment, when risk of systemic sudden stop in capital inflows is high, a wider current account deficit means that balance of payment could be under stress. Over the three years, out of total capital inflows of US$120 billion, about 60% have been

3 7 from non-FDI inflows. Over the last 12 months, as the portfolio equity inflows have slowed, dependence on debt- creating inflows has shot up. The share of debt-creating inflows is expected to increase to 65% in F2012 compared to 44% in the 10-year period of F2001-10. Balance of payment stress will keep short-term cost of capital high and hurt growth: The governments desire to stimulate domestic demand with less-productive spending at a time when productive private investment has been declining as % of GDP has been the key driver behind the wider current account deficit. In particular, the current account deficit could widen further, exposing India to even more volatility in global capital inflows. If a slowdown in capital inflows were to occur, it would create significant depreciation pressures on the rupee and increase market-oriented short-term cost of capital and hurt growth.

3 8

CHAPTER 4 BALANCE OF PAYMENTS OF INDIA WITH BANGLADESH

3 9 4.1 BOP of India with Bangladesh: Composition of Balance of Payment differs from country to country. The following graph shows the comparison between four main accounts of Balance of Payment between Bangladesh and India.

BOP of india-Bangladesh
Bangladesh 2010-11 Bangladesh 2011-12 India 2010-11 India 2011-12

US$67756m US$61989m

US$1630m US$885m

US$469m US$642 m

US$-955m US$1920m

US$-650m US$-2432m US$-263m

US$-2993m

1.Current account Balance 2.Capital Accoiunt Balance

3.Financial Acccount

4.Errors and Ommision

US$-45945m

US$-78155m

Figure 16: Balance of Payments of India-Bangladesh

The Graph shows that current account Balance of Bangladesh in year 2010-11 was US$ 885 m, which increased to US$ 1630m whereas, Indias current account Balance was negative which mean they had current account deficit of US$(45,945) m in 2010-11 and it became US$ (78,155)m in FY2011-2012. Current account deficit of a country means that the country is sending more money abroad from its trading activities and factor income it is receiving. Total capital account Balance of Bangladesh was US$ 642m in 2010-11 and it reduced to US$ 469m in 2011-12. In India capital account balance was US$ 61,989 m in 2010-2011 and increased to US$ 67,756 m in 2011-2012. Positive capital account balance means that a country is getting more capital investment than it sends in a foreign country. In case of negative capital account balance the situation is exactly opposite. Financial account Balance of Bangladesh in 2010-11was US$ (1920) m in year 2010-11 and US$ (955) m. negative balance of financial accounts means that there was more negative trade credit, investment, portfolio investment than positive foreign direct investment, long-term and mid-term loans, assets etc. In India financial accounts are included in capital account and they dint show it separately.

4 0 Errors and Omission account is equal to the difference between reserves and related items and the sum of the balances of the current, capital, and financial accounts. The errors may be due to statistical discrepancies & omission may be due to certain transactions may not be recorded. For e.g.: A remittance by an citizen working abroad may not yet recorded, or a payment of dividend abroad by an MNC operating in a country may not yet recorded or so on. The errors and omissions amount equals to the amount necessary to balance both the sides. Net errors and Omission account in Bangladesh in year 2010-2011 was US$ (263) m and in 2011-2012 it was accounted for US$(650) m. In India Errors and Omission account was quite higher than Bangladesh. In year 2010-11 it was US$ (2993) m and US$ (2434) m in year 2011-12. There are also a part named monetary movements which include IMF and Foreign Exchange Reserve in Indias BOP. And in Bangladeshs BOP there are a part named Reserve Assets which includes net balance in Bangladesh Bank. 4.2 Current Account Decomposition of India and Bangladesh The current account includes export of services, interests, profits, dividends and unilateral receipts from abroad, and the import of services, interests, profits, dividends and unilateral Payments to abroad and other service and transfer account. There can be either surplus or deficit in current account. The deficit will take place when the debits are more than credits or when payments are more than receipts and the current account surplus will take place when the credits are more than debits. Current Account of Bangladesh is mainly composed of Trade balance, Service account and Income level. Trade balance consists of export and import of Bangladesh. Service account includes different transportation, insurance and other services. Income is divided into Primary income and Secondary Income in which Secondary income comes from official transfers, private transfer and workers remittance.

Current Account Decomposition of Bangladesh

2010-2011 2011-2012 US$13699m US$12452m

1. trade Balanace

2. services US$-2369US$-2566m m

3. primary income US$-1454m US$-1508 m

4. secondary income

US$-7744m US$-7995m

Figure 17: Current Account Decomposition of Bangladesh

4 1 The above graph shows the current account decomposition of Bangladesh. Trade balance recorded a deficit of US$ 7744 million in FY2010-11 as compared to the deficit of US$ 5155 million in FY2009-10. In this period, growth rates of exports and imports were 41.74 percent and 41.84 percent respectively, but the trade deficit increased due to larger base of imports though the growth rates are very proximate. The current account balance stands at US$ 885 million while it was US$ 3724 million in the previous fiscal year. Services also faced deficit of US$2369 m in 2010-2011and it increased to US$ 2566m in year 2011-12.Primary Income was US$ (1454)m in year2010-2011 and it also increased to US (1508)m among which official interest payment was 345m US$ in 2010-11 and 373m US$ in 2011-12. Secondary income comes from official transfer, private transfer and workers remittance. Secondary income had surplus of US$12,452m in year 2010-11 and it increased to US$ 13699m in year 2011-12. The overall current account balance had a surplus of US$ 885 mil in 2010-11 and US$ 1630mil in 2011-12. Current Account of India is composed of Merchandise (Export-Import), and Invisible account. Invisible account is again composed of Service, Transfer and Income. Service account includes transactions such as Travel, Transportation, Insurance, business services, financial services, communication services etc. Transfer accounts consist of official and private transfer. And Income consists of investment income and compensation of employees.

Current Account Decomposition of India

Merchandise services Transfer Income US$ 64098 m US$63494m

US$ 48816 m US$53140 m

2010-2011

US$-17310 m

2011-2012

US$-15987 m

US$ -130593 m US$-189759 m

Figure 18: Current Account Decomposition of India

The above graph shows the Current Account decomposition of India. Merchandise had negative balance of US$130593m in year 2010-11 and US$ 189759m in year 2011-12 which means that India import more from other countrys than they export to other countries. Services account had positive balance US$ 48816 m in year 2010-11 and it increased 31% in the next year. Transfer account had also positive balance of US$ 53140 m in 2010-11 and 19.48% in the next year.

4 2 Income had deficit of US$ 17310m in 2010-11 and it reduced 7.64% in the next financial year. Overall current account Balance was in deficit of US$ 45945 m in year2010-11 and the deficit increased in the next year to US$ 78155m. 4.3 Capital & Financial Account Decomposition of Bangladesh and India The capital and financial account involves capital transfers and inflows and outflows relating to investments, short-term borrowings/lending, and medium term to long-term borrowing/lending. There can be surplus or deficit in capital account. The surplus will take place when the credits are more than debits and the deficit will take place when the debits are more than credits. Capital and Financial account shown separately in the BOP of Bangladesh. Capital account composed of capital transfer and other transfer and financial account composed of portfolio investment, medium and long term loans, trade credit, FDI, Medium and long term amortization payment, other short term loan, and other assets and liabilities.

Capital and financial account Decomposition of Bangladesh

Capital transfers Portfolio investment (net) Medium and long-term (MLT) loans Other long term loans (net) Trade credit (net) $775m $642m $1032m $739m Foreign direct investment (net) Other investment (net) MLT amortization payments Other short term loans (net) Other assets $1460m $995m $531 m $469m 198 $789m $242m 2011-12 -57 -$661m $-1450m $-2148m $-2667m $-2569m $-1606m

$-28m

2010-11 -101

Figure 19: Capital and Financial Account Decomposition of Bangladesh

Capital account balance of Bangladesh in year 2010-11 was $642m which is composed of capital transfers only; there were no other capital transaction. In FY2011-12 capital transfer reduced to $469 m. financial account was in deficit of $1920 m in FY2010-11 and it reduced to$955 million in the next year. Foreign Direct Investment is accounted for $775 m in FY 2010-11 and increased by 28.38% in the next year. Net Portfolio investment was negative in the year2010-11 and it became positive in year 2011-12. In financial Year 2010-11 Investment other than

4 3 portfolio and FDI and also Trade Credit contributed to the deficit of overall Financial account Balance. Net Balance of Medium and long term loan, other short term loan, medium and longterm amortization payment was positive. In the Financial year 2011-12, Foreign Direct Investment and medium and long term loan increased and helped to reduce the deficit of financial account balance to $955 m. Trade credit and other investment reduced in the year 201112 which also helped to reduce the financial account deficit.

Capital and Financial account of India is mainly divided into 5 parts. They are Foreign Investment, Loans, Banking capital, Rupee debt service and other capital. Foreign Investment is again composed of FDI and Portfolio investment. FDI includes investment India (equity, reinvested earnings and other capital) and in Abroad ((equity, reinvested earnings and other capital). Portfolio investment includes investment in India and abroad and GDRs/ADRs. Loans consist of external assistance by and to India, Commercial borrowings and short term loan to India. Banking Capital consists of commercial banks asset and Liabilities.

Capital and Fianacial account Decomposition of India

1. Foreign investment 39653 28437 19307 4962 2010-11 -68 -10995 2011-12 -79 -6928 16226 2. Loans 3. Banking capital 4. Rupee debt service 5. Other capital 39231

Figure 20: Capital and Financial Account Decomposition of India

Notes: Amounts are in Million Us dollar In Financial Year 2010-11 Foreign Investment and loans contributed more to the overall capital and financial account Balance. Rupee debt service and other capital had negative balance in financial year 2010-11 and 2011-12. Foreign Investment and Banking capital increased in the next year and loans decreased in the next year.

4 4

4.4 Export of India to Bangladesh

UAE has emerged as the top export destination for India during 2012, while the country's shipments to the US are declining. Although the US has maintained its high position in India's top 10 export destinations over the years, its share in the country's total exports has registered a slip from about 21 percent in 2001 to 17 percent in 2006 to 12 percent in 2012. Whereas, UAE's contribution has increased to 12 percent in 2012 from about 6 percent in 2001, it said. "UAE has emerged as the top export destination. Japan's position has been worsening in the list of major export destinations of India, adding Japan is now no more features amongst the top 10 destinations. Similarly, the UK has slipped from the fourth position in 2001 to seventh position in 2012. Whereas Germany and Belgium, which were at number eighth position in 2001, in 2012 stood at ninth position. China and Singapore, which did not even feature in the top ten export destinations of India in 2001, have now captured the third and fourth places. While China contributes six percent, Singapore accounts for 5.5 percent in 2012. According to study of India the rapid diversification of India's export destinations is encouraging. The widely spreading export markets can be noted from the narrowing dependence on selected economies for exports.

"The share captured by the top ten exports destinations have been narrowing from 57.7 percent in 2001, to 57.3 percent in 2006 to 51.6 percent in 2012, indicates the increasing share of a larger number of economies in India's exports market," the study said. India has been rapidly diversifying its exports markets from the traditional partners -- the US and Europe -- towards emerging and developing economies.
Shift in Indias top 10 export destinations over the years (US$Bn)

4 5 The high growth destinations, such as East Asian and SouthEast Asian economies like China, Singapore and Hong Kong have dominated the Indias exports scenario with the third, fourth and fifth positions during 2012. This marks a considerable leap taken by these economies in this respect, as compared to 2001 and 2006. Indonesia, one of these economies has also emerged among the top ten export destinations in 2012. Bangladesh was in the top 10 export destinations countries list of India at number tenth position with 2% share in 2001 but after that Bangladesh slipped out from the list. Indias exports growth has been found to be significantly dependant on the real GDP growth of destination economies. In fact, the degree of correlation, between Indias exports growth and real GDP growth of export destinations has been found to be 0.89 over the last decade. Sluggishly growing economies have been replaced by China and Singapore. China and Singapore, which did not even feature in the top ten export destinations of India in 2001, have now captured high positions at third and fourth places with significant share of around 6% and 5.5% in 2012, respectively. Indias export to Bangladesh is very small. The following graph shows the export of India to Bangladesh over the last 25 years.

Export of India to Bangladesh

4000.0 3500.0 3000.0 2500.0 2000.0 1500.0 1000.0 500.0 0.0 1987-88 1988-89 1989-90 1990-91 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

Figure 21: Indias export to Bangladesh

In spite the absolute value of the export from India to Bangladesh increased over the period. The percentage share of Bangladeshs position of the Indias export increasing but compared to other nations it is not so significant.

4.5 Indias export composition to Bangladesh for recent year

India mainly exports twenty eight type items to Bangladesh. Among them rice, Cotton, (all types) cotton yarn/thread and cotton fabrics, Pharmaceutical products, Spices, Engineering goods are most common.

4 6

India's Export Composition for Bangladesh

60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 50.00%

2010-2011

Figure 22: Indias Export Composition for Bangladesh in 2010-2011

From the graph it is seen that in FY 2010-2011 50% of Indias total export to Bangladesh was Pharmaceuticals products and remaining 50% was for rest of the items. Among the remaining 50%, 33% was for Cotton (all types) cotton yarn/thread and cotton fabrics products. So from this data it can be easily understood that rest of the items are so small in percentage. Whereas Bangladesh is not in the Indias top export destination list, Bangladeshs import is India based. Where India differentiates their export destination, Bangladesh couldnt differentiate their import location. As a result Bangladesh becomes dependent on India for most of the daily used products. But this situation is changing now. Now China is coming forward and replacing Indias position. In terms of the value of total imported commodities, China secured the top position in FY 201011. During this period, 17.58 percent of the total imported commodities came from China. India was the second largest source of import (13.57 percent of total import) while Malaysia, Japan and Singapore held the third, fourth and fifth position (5.23, 3.89 and 3.84 percent to total import) respectively. In FY2010-11, the total import payment rose to US$ 33,658 million from US$ 23,738 million in the previous year. Following Table shows the import payments made for India from FY2000-2001 to 2010-2011.

21.Manmade 22. Essential oils 23.Paperand 24.Ediblefruit 25. 26.Zincand 27. Dairy produce 28. Others

11.Plasticsand 12.Electrical 13.Coffee,tea, 14.Rubberand 15.Salt, 16.Manmade 17.Knittedor 18.Aluminium

1. Cotton 2. Vehicles 3. Cereals 4.Nuclear 5.animal fodder 6. Iron and steel 7.Organic

9.Edible

4 7

Bangladesh Import Payment Year India (In Million US$) 2000-2001 1184 2001-2002 1019 2002-2003 1358 2003-2004 1602 2004-2005 2030 2005-2006 1868 2006-2007 2268 2007-2008 3393 2008-2009 2864 2009-2010 3214 2010-2011 4569
Table: Bangladesh Import Payments Made to India over the periods

From the table it is seen that over the year import payments made to India increased. In FY 2010-2011 this amount was $4569 million which is lower than the payments which is made to China $5918 million. Before FY2010-2011 India was the top import payment receiver from the Bangladesh perspective, but now China replaced the position.

Figure 23: Bangladeshs Import Payments to India in Percentage

4 8 From the graph it is seen that in FY2007-2008 the import payments was at highest point which is 15.69% and after this the highest payment was in FY2004-2005. 4.6 Indias Import from Bangladesh Major Import Sources Indias imports from top twenty countries, based on 2009-10 figures and covering 73.72 % value share of imports. Indias imports from the Peoples Republic of China remained consistently maximum. Although the percentage shares of imports from China was less than 10 % in the initial two years (7.29 % in 2005-06 and 9.40 % in 2006-07), it is around 11 % for the last three years. This indicates the importance of Chinese goods in Indian markets as the shares of imports from the next four major countries are much less the United Arab Emirates (UAE) has a share of 6.73 %, followed by Saudi Arab and USA (both at 5.91 %), and Switzerland (5.08 %). The United Arab Emirates is the second major source of imports for the last two years. Saudi Arab and USA remain at the top three or four countries for the last four years. Bangladesh mainly imports frozen foods, agriculture products, woven garments, knitwear, jute goods, leather goods etc.

Import of India from Bangladesh

700.0 600.0 500.0 400.0 300.0 200.0 100.0 0.0 1987-88 1988-89 1989-90 1990-91 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

Figure 24: Import of India from Bangladesh

For India, trade with Bangladesh is a very small part of its total trade-just over one percent since the mid-1990s, and currently about 3 percent of its total exports and a miniscule share (0.01%) of its total imports. For Bangladesh, however, India has now become the largest single source of its imports (about 15% of the total, ahead of China and Singapore) and accounts for about a tenth of its total trade, despite exports to India which have declined to only slightly above 1 % of total exports.

4 9 The appreciation of the real Taka/Rupee exchange by about 50% between mid-1980s up to about 1999, would have contributed to the expansion of both formal and informal Indian exports to Bangladesh, and retarded the growth of Indias import from Bangladesh. However, recorded Bangladesh imports from India have grown even more rapidly since the exchange rate trend was reversed after 1999, and Bangladesh exports to India have continued to stagnate. Two possibilities arise: (a) faster productivity growth in India increased the difficulty of Bangladesh exports competing there, offsetting the favorable trend in the exchange rate since 1999; (b) significant tariff and non-tariff barriers constraining Bangladeshs major exports (RMG) or minor exports which have experienced rapid growth elsewhere. In Bangladesh it is often argued that the deficit is aggravated by Indias protectionist policies that have hobbled Bangladesh exports to India. However, for the past 8 years Indias imports from the world as a whole have been growing at over 9 percent a year recently, each years increase in imports has been exceeding Bangladeshs total exports. Many of these imports have been coming in over considerably higher tariffs than the tariffs faced by Bangladesh exporters, owing to the extensive tariff preferences given to Bangladesh by India under SAPTA, and to the extent that there are non-tariff and bureaucratic barriers, they are probably more constraining than the ones that Bangladesh would face. This suggests that the low level and slow growth of Bangladeshs exports to India reflect fundamental comparative advantage factors, not discriminatory import policies. 4.7 Performance analysis of international trade of India with Bangladesh: Trend Analysis of Export and Import of India with Bangladesh Export Trend The trend equation Y= + * X Where, Y= Value of Export in US$ X= Time period = Intercept = Slope The equation indicates that in every year the export will increase by
ANOVA df Regression Residual Total 1 8 9 SS 3988667.176 904226.193 4892893.369 MS Significance F 3988667.176 35.28911 0.000346 113028.2741 F

5 0 We see the regression is statistically significant (.000346) as it is below 5% level.

Coefficients Intercept X Variable 1 Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

558.9861 263.0342262 2.125145722 0.066292 219.8806 37.01404715

-47.572 1165.544

-47.572 1165.544

5.94046377 0.000346 134.5261 305.2352 134.5261 305.2352

So the equation is Y= 558.98+ 219.8806* X

Serial 1 2 3 4 5 6 7 8 9 10 11 Year Export with BD Y=558.9861+219.8806*X 2000-2001 935.0 778.8666667 2001-2002 1002.2 998.7472727 2002-2003 1176.0 1218.627879 2003-2004 1740.7 1438.508485 2004-2005 1631.1 1658.389091 2005-2006 1664.4 1878.269697 2006-2007 1627.9 2098.150303 2007-2008 2916.8 2318.030909 2008-2009 2460.9 2537.911515 2009-2010 2424.2 2757.792121 2010-2011 3237.9 2977.672727

Fitted line
3500.0 3000.0 2500.0 2000.0 1500.0 1000.0 500.0 0.0 Export with BD Y=558.9861+219.8806*X

Figure 25: Export of India with Bangladesh

5 1 Import Trend The trend equation Y= + * X Where, Y= Value of Import in US$ X= Time period = Intercept = Slope The equation indicates that in every year the import will increase by
ANOVA df Regression Residual Total 1 8 9 SS 134956.3705 21735.71855 156692.089 MS F 134956.3705 49.67174015 2716.964818 Significance F 0.000107402

We see the regression is statistically significant (0.000107402) as it is below 5% level.

Coefficients Intercept X Variable1 -74.98545455 Standard Error 40.78126773 t Stat P-value Lower 95% Upper 95% 19.0563174 Lower 95.0% Upper 95.0%

-1.83872299 0.103247357 169.0272265

-169.027 19.05632

40.44545455 5.738719969

7.047818113 0.000107402 27.21194258 53.67896651 27.21194 53.67896

So the trend equation is Y= -74.98545+ 40.4454 * X The equation indicates that in every year the import will increase by US $ 40.4454 Serial 1 2 3 4 5 6 7 8 9 10 11 Year 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009 2009-2010 2010-2011 Import 80.4 59.1 62.1 77.6 59.4 127.0 228.5 257.0 308.4 254.1 445.9 Y=-74.985454+40.44545*X 5.414545455 -15.88545455 -12.88545455 2.614545455 -15.58545455 52.01454545 153.5145455 182.0145455 233.4145455 179.1145455 370.9145455

5 2 Fitted line

Import trend
500.0 400.0 300.0 200.0 100.0 0.0 -100.0

Import

Y=-74.985454+40.44545*X

Figure 26: Indias import from Bangladesh

5 3

CHAPTER 5 IRP, PPP, IFE LINE OF INDIA WITH USA

5 4

5.1 Purchasing Power Parity(PPP)

Purchasing Power Parity (PPP) is one of the most powerful and controversial theories of international finance. There are two versions of PPP. Absolute version of PPP, this type of PPP says that, without international barriers, prices of same basket of goods in two different countries will be same when measured in a common currency. The relative form of PPP considers market imperfections like transaction costs, tariffs, and quotas. It says that the rate of changes in the price will be somewhat similar when measured in a common currency as long as transportation costs and trade barriers remain unchanged.

Rationale behind PPP

If two countries products are substitute for each other, the demand for the products should adjust as inflation rates differ. If inflation in India is higher than USA, it should cause Indian consumers to increase imports from USA and cause USA consumers to decrease their import from India. Such forces place upward pressure on the USA dollar value and vice-versa. This shifting in consumption will continue from India to USA will continue until the USA dollar value has appreciate to the extent that (1) the prices paid for USA products by India consumers are no lower than the prices for comparable products made in India and (2) the prices paid for India products by USA consumers are no higher than the prices for comparable products made in USA.

Estimation of exchange rate effects using PPP

According to PPP foreign currency effects can be found by using the formula given below:

Here,

= Effect in foreign currency exchange rate = Inflation in home country = Inflation in foreign country Assume that inflation in home country (India) is 5% and inflation in foreign country (USA) is 3%. So the changes in foreign currency exchange rate will be:

= 0.0194 or 1.94%

5 5 That is, foreign currency (USA dollar) should appreciate by 1.94% against Indian Rupee. Other way, Indian Rupee should depreciate by 1.94 % against USA dollar. A simplified but less precise relationship based on PPP is

Using the data given earlier, the changes in then foreign currency exchange rate will be:

= .02 or 2% That is, USA dollar should appreciate against Indian Rupee by 2% or Indian Rupee should depreciate by 2% against USA dollar.

Graphical analysis of PPP

Ih If (%)
20% PPP Line

Increased purchasing power of foreign goods

.C .A
10% 20% % change in Foreign Currencys spot rate

10%

-20%

-10%

.B .D

-10%

-20%

Decreased purchasing power of foreign goods

Figure 27: Illustration of Purchasing Power Parity (PPP) Using PPP theory, we should able to assess the potential impact of inflation on exchange rates. In the above figure is a graphical representation of PPP theory. The points on the figure suggest that given an inflation differential between the home (India) and the foreign (USA) country of X%, the foreign currency (USA Dollar) should adjust by X% due to that inflation differential.

5 6

Points on the PPP Line

The points of A and B represents that given the inflation differential between home and foreign country of X, the foreign currency should adjust by X% due to that inflation differential. Point A shows that home country inflation rate is 10% higher than foreign country and as PPP says, foreign exchange spot rate also appreciate by 10%. Point B shows opposite situation of point A. Here home foreign country inflation is more than home country by 10%, so foreign exchange spot rate depreciate by 10%. If these situations hold, we can say that PPP line holds.

Points below the PPP Line

Points below the PPP line reflect the decreased purchasing power of foreign goods. In the graph the point D represents a situation where home inflation is 20% lower than that of foreign country, but the foreign currency depreciate only by 10%. All points like D below the PPP line represent more favorable purchasing power of foreign consumers for home country goods than from foreign goods.

Points above the PPP Line

Points above the PPP line reflect the increased purchasing power of foreign goods. In the graph the point C represents a situation where home inflation is 20% higher than that of foreign country, but the foreign currency appreciate only by 10%. All points like C above the PPP line represent more favorable purchasing power of home consumers for foreign country goods than from foreign goods.

Analysis of PPP for India

The PPP theory not only provides an explanation of how relative inflation rates between two countries can influence an exchange rate, but it also provides information that can be used to forecast exchange rates. Testing of PPP can be done through 2 ways: Conceptual tests Statistical tests

Conceptual Tests of PPP

One way to test the PPP theory is to choose two countries and compare the differential in their inflation rates to the % change in the foreign currencys value (due to avoid cross exchange rate we have calculated the value against dollar) during several time periods. Using a graph, we can plot each point to determine whether these points closely resemble the PPP line.

5 7

The table shows the yearly information on change in exchange rate and the inflation rate differential between Bangladesh (home country) and USA (foreign country) from the year of 2002 to 2011.

Year Inflation of India 3.20% 2002 3.72% 2003 3.79% 2004 5.57% 2005 6.53% 2006 5.51% 2007 9.70% 2008 14.97% 2009 9.47% 2010 6.49% 2011

Inflation rate (%) Inflation Ih-If (X) 1+ Ih /1+ If ef=(1+ Ih /1+ If)-1 of USA 2.38% 0.01 1.0080 0.0080 0.019 0.02 1.0181 0.0181 3.26% 0.01 1.0051 0.0051 3.42% 0.02 1.0208 0.0208 2.54% 0.04 1.0389 0.0389 4.08% 0.01 1.0137 0.0137 0.09% 0.10 1.0960 0.0960 2.72% 0.12 1.1192 0.1192 1.50% 0.08 1.0786 0.0786 2.96% 0.04 1.0342 0.0342

Statistical Test for PPP Line:

Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations ANOVA df Regression Residual Total 1 8 9 Coefficients Intercept X Variable 1 -0.044870874 0.972900512 SS 0.014254926 0.016594909 0.030849835 Standard Error 0.02180417 0.371131995 t Stat -2.057903362 2.62144069 P-value 0.07359929 0.030581963 Lower 95% -0.09515138 0.117068598 Upper 95% 0.005409631 1.828732425 Lower 95.0% -0.09515 0.117069 Upper 95.0% 0.00541 1.828732 MS 0.014254926 0.002074364 F 6.871951292 Significance F 0.030581963 0.67976071 0.462074623 0.394833951 0.045545183 10

5 8

The Regression Equation:

The required equation is{ }

Where, ef = percentage change in foreign currencys value a0 = constant/intercept a1 = regression coefficient (slope) = error term From the coefficient table the values of a0 and a1 are taken. The desired equation is-

y = -0.044870874+ 0.972900512x1
Interpretation: The Slope of the Variable Here, a1 = .972900512 indicates that if the inflation rate differential between India and USA increases by one unit (1%), then percentage change in foreign currency spot rate will be increased by Intercept of the variable: Here a0 = -.044870874 means if there is no impact of inflation differential on foreign currencys spot rate (Dollar rate in Rupee) , then there will be -.044870874% change in foreign currencys spot rate. Relationship between the Variables: The relationship among the variables in relative term can be estimated with the help of correlation coefficient (R). From the regression statistics it is found that R = 0.67976071, which indicates that there exists Medium relationship between the variables. The Explanatory Power of the Independent Variable: The explanatory power of the independent variable can be assed with the help of the coefficient of determination (R2). From the regression statistics it is found that R2 = 0.462074623, which indicates that 46.2074% variations in percentage change in USA Dollar can be explained by the variation of the inflation rate differential. Standard error estimate: The standard error 0.045545183means the Y values fall typically 4.554 % from the regression.

5 9 Significance of the Regression From the ANOVA table it is found that, the model is statistically significant, because the F value which is 6.87195 greater than 5.32. It indicates that there is a significant relationship between foreign currencys spot rate changes and inflation differential. So the result is statistically significant. PPP does not hold. Significance of intercept and coefficient of variable

In case of intercept calculated t value is -2.05 which is greater than tabulated t value -2.262 so the hypothesized value is not significantly different from zero. In case of variable the calculated t value is -.073 which is greater than tabulated t value -2.262, so the hypothesized value is not significantly different from 1. So, the PPP theory did hold empirically. Analysis of PPP for India
The percentage changes in spot exchange rates & difference between interest rates of India and USA (ih-if )f or last 10 years are shown in the following table and results of multiple regression are shown in the next table:

6 0

Infaltion Rate Differential (Ih-If)

25%

PPP Line
20%

Increased Purchasing Power of Foreign Goods

15% 10% 5% 0%

-25%

-20%

-15%

-10%

-5% -5%

0%

5%

10%

15%

20%

% Change in Foreign 25% Currency's Spot Rate

D
-10% -15% -20% -25%

Decreased Purchasing Power of Foreign Goods

Figure 28: illustration of Purchasing Power Parity (PPP) Above figure identifies areas of purchasing power disparity. Assume an initial equilibrium situation, then a change in the inflation rates of India and USA. If the exchange rates do not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries. The three situations relating to the PPP line for India: Points on the PPP line Only 4/5 points are on the PPP line indicating that PPP held

Points below the PPP line Point D in the figure represents a situation where India inflation is 4% below USA inflation. Yet, the foreign currency has appreciated by 8%. Again Purchasing power disparity exists. The purchasing power for foreign goods has become more favorable relative to the purchasing power for the home countrys goods. The PPP theory suggests that the foreign currency in this figure should have appreciated by 4% to fully offset 4% inflation differential. All points in the

6 1 below the PPP line represent more favorable purchasing power for home country goods than for foreign goods. Points above the PPP line There is no any point above the PPP Line of India, because we have taken the data only for ten years. Final Conclusion about PPP The conceptual and statistical tests for Purchasing Power Parity indicate that PPP does not hold for India. The historical coordinates of inflation rate differential and exchange rate differential indicates that the points are not on the 45 Degree equilibrium line. Only change in inflation rate differentials is considered in determining exchange rate movements in PPP theory while other factors like interest rate differentials, change in relative income level among countries, government influence in market and international trade, expectations regarding future exchange rates also have influence on exchange rate movements. Most of the points are below the 45 Degree equilibrium line which indicates an increase in purchasing power for USA purchaser of India goods.

5.2 International Fisher Effect (IFE)

The International Fisher effect (IFE) theory specifies a precise relationship between relative interest rates of two countries and their exchange rates. It suggests that an investor who periodically invests in foreign interest-bearing securities will, on average, achieve a return similar to what is possible domestically. According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and an anticipated inflation. If investors of all countries require the same real return, interest rate differentials between countries may be the result of differentials in expected inflation. IFE is closely related to PPP theory because interest rates are highly correlated with inflation rate. If real rates of interest are the same across countries, any difference in nominal interest rates could be attributed to the difference in expected inflation. The IFE theory suggests that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation.

6 2

30%

ih-if(%)

Lower returns from investing in foreign deposits B

IFE Line
20%

10%

E
-25% -15% 0% -5% -10% 5% 15% 25%

% change in FC's spot rate

C F

D Higher returns from investing in foreign deposits

-20%

-30%

Figure 29: Illustration of International Fisher Effect (IFE)

The three situations relating to the IFE line:

1. Points on the IFE Line

All the points along the IFE line reflect exchange rate adjustments to offset the differential in interest rates. Investors will end up achieving the same yield investing home or in a foreign country by adjusting foreign exchange rate fluctuations.

2. Points below the IFE Line

Points below the IFE line reflect the higher returns from investing in foreign deposits. This may occur due to If ih > if and foreign currency appreciates (foreign currency appreciation is greater than interest rate differential- Point E) If if > ih and foreign currency appreciates (Point D) If if > ih and foreign currency depreciates (interest rate differential is greater than foreign currency depreciation Point F)

6 3

3. Points above the IFE Line

Points above the IFE line reflect returns from foreign deposits are lower than the returns from domestic deposits. This may occur due to If ih > if and foreign currency appreciates (interest rate differential is greater than foreign currency appreciation- Point A) If ih > if and foreign currency depreciates (Point B) If if > ih and foreign currency depreciates (foreign currency depreciation is greater than interest rate differential Point C).

Graphical Analysis of IFE for India

Year

Nominal Interest Rate(India)

11.11% 11.01% 8.49% 11.81% 11.01% 12.38% 13.98% 20.84% 9.33% 8.50%

Us(Nominal Interest Rate)

5.38% 3.85% 4.74% 6.19% 7.12% 9.09% 2.90% 4.63% 4.02% 3.96%

Ih-if (X) India With USA

5.73% 7.15% 3.75% 5.62% 3.88% 3.29% 11.07% 16.21% 5.31% 4.54% 48.612 46.544 45.217 44.131 45.303 41.198 43.880 48.440 45.757 46.943

% Change Currency Spot rate (Y)

0.00% -4.25% -2.85% -2.40% 2.65% -9.06% 6.51% 10.39% -5.54% 2.59%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Statistical Test for IFE Line:

Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.760251508 0.577982355 0.525230149 0.040341007 10

ANOVA df SS MS F Significance F

6 4

Regression Residual Total

1 8 9

0.017830661 0.013019175 0.030849835

0.017830661 0.001627397

10.95655333

0.01069712

Coefficients

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Lower 95.0%

Upper 95.0%

Intercept X Variable 1

-0.075334643 1.102500943

0.025576508 0.333074965

-2.94546241 3.310068478

0.018553977 0.01069712

-0.13431418 0.334428696

-0.01635511 1.87057319

-0.134314176 0.334428696

-0.01636 1.870573

The Regression Equation: The required equation isWhere, ef = percentage change in foreign currency a0 = constant/intercept a1 = regression coefficient (slope) = error term From the coefficient table the values of a0 and a1 are taken. The desired equation is{ } { }

Interpretation:
Intercept of the Variable: a0 = indicates that even if the interest rate differential is zero the exchange rate will be depreciated by %. Slope of the Variable: Besides, a1 = indicates that if the interest rate differential between India and USA increased by one percent, exchange rate will be appreciated by %. That means USD will be appreciated and Indian Rupee will be depreciated. Relationship between the variables: The relationship among the variables in relative term can be estimated with the help of correlation coefficient (R). From the regression statistics table it was evident that R=0.760251508which indicated a normal degree of positive relationship between the variables.

6 5 The Explanatory Power of the Independent Variable: The explanatory power of the independent variable can be assed with the help of the coefficient of determination (R2). From the regression statistics it is found that R2 =0.577982355, which indicates that 57.79% of the variations in percentage change in spot exchange rate (ef) can be explained by the independent variable (INTt). Standard error estimate: The standard error 0.040341007means the Y values fall typically 4.0341% from the regression. Significance of the Regression: From the ANOVA table it is found that, the result is statistically significant, because F value which is 10.9565 greater than the Table value 5.32. It indicates that there is a significant relationship between change in spot exchange rate (ef) and interest rate differential. Though the result is statistically significant IFE does not hold.

Significance of the model intercept and coefficient of variable

In case of intercept calculated t value is -2.94 which is less than tabulated t value -2.262 so the hypothesized value is significantly different from zero. In case of variable the calculated t value is .3078 which is less than tabulated t value 2.262, so the hypothesized value is not significantly different from 1. So, the IFE theory did not hold empirically.

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ih-if(%)
25% 20% 15% 10% 5% 0% -30% -20% -10% -5% -10% -15% -20% -25% 0% 10% 20% 30%

IFE Line

Lower returns from investing in USA deposits

B 3.48% % change in FC's spot rate

C 3.29%

Higher returns from investing in USA deposits

Figure 30: Illustration of International Fisher Effect (IFE) of India The three situations relating to the IFE line for India: Points on the IFE line Only one point falls on the IFE line indicating that IFE slightly holds. In the above figure the set of points that conform to the argument behind IFE theory. Point B represents a home interest rate (India) 3.48% above the foreign deposit; they are at a disadvantage regarding the foreign interest rate. However, IFE theory suggests that the currency should appreciate by 3.48% to offset the interest rate disadvantage. Points below the IFE line Points below the IFE line generally reflect the higher return from investing in foreign deposits. In the above figure Point C indicates that the foreign interest rate (USA) exceeds the home interest

6 7 rate (India) by 3.48%. In addition, the foreign currency (USA Dollar) has appreciated by 9.1%. The combination of the higher foreign interest rate plus the appreciation of the foreign currency will cause the foreign yield to be higher than what is possible domestically. In the above figure, the majority points were below the IFE line, this would suggest the investors of the India (home country) could consistently increase their investment returns by establishing foreign bank deposits in USA.

Points above the IFE line Points above the IFE line generally reflect returns from foreign deposits that are lower than the returns possible domestically. In the Point A, The home interest rate (India) is higher than the foreign interest rate (USA). The foreign currency appreciates during the time foreign deposit was held.

5.3 Interest Rate Parity (IRP)

Interest Rate Parity is a theory which states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates. It uses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rate. It relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency. The size of the forward premium or discount on a currency should be equal to the interest rate differential between the countries of concern. For an example if nominal interest rates are higher in country A than country B, the forward rate for country Bs currency should be at a premium sufficient to prevent arbitrage.

Rational Behind IRP

If there is interest rate differential in two countries, the investors of lower interest providing country can earn higher return by investing in higher interest providing country. The only risk in this case is the risk of converting the foreign currency into domestic currency. This risk can very easily be overcome by using forward exchange rate. So here forward is playing a significant role in fund flow between two countries. If forward exchange rate is lower than the interest rate differential, investors can earn a risk free profit which is called Covered Interest Arbitrage. Interest Parity Theorem states that this arbitrage opportunity will not be sustainable for a long time. Forward exchange rate will be adjusted sufficiently to offset the gain from interest rate differential. Making forward contract to sell foreign currency will lower the demand of foreign currency and make the exchange rate higher and vice versa.

6 8 So the implication of IRP is that the forward premium has to be equal to the interest rate differential to make the covered interest rate not feasible.

Forward Rate Premium Using IRP

According to IRP Forward rate premium can be found by using the formula:

Here, = Forward rate premium = Interest Rate of home country = Interest Rate of foreign country Assume that interest rate in home country (India) is 5% and interest rate in foreign country (USA) is 3%. So the forward rate premium will be:

= 0.0194 or 1.94% That is USA Dollar should exhibit a forward premium of about 1.94%.

A simplified but less precise relationship based on IRP is

Using the data given earlier, the changes in then foreign currency exchange rate will be:

= 0.02 or 2% That is, USA Dollar should exhibit a forward premium of about 2%.

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Graphical Analysis of IRP

Ih If (%)
Covered Interest Arbitrage by the investors of foreign countries 20% IRP Line

.G .A
Forward Premium 10% 20%

10% Forward Discount

-20%

-10%

.B .S

-10%

-20%

Covered Interest Arbitrage by the investors of Home countries

Figure 31: Interest Rate Parity (IRP)

Points Representing IRP Line

Points lying on the diagonal line cutting the intersection of the axes represent IRP. As we know, in this line covered interest Arbitrage is not possible. On the graph above, points of A and B represents the IRP line. Here we can see the 10% interest rate differential in points A and B is offset by the forward rate discount or premium.

Points below the IRP Line

Points below the IRP line give the covered interest rate arbitrage opportunity for the investor of home country (India). On the graph, we can see, at point S the interest rate of foreign currency is 20% more than that of home currency (India) but forward rate discount is only 10%. So it gives the investors of home countries arbitrage opportunity of getting approximately 10% of risk free profit.

Points above the IRP Line

7 0 At point G, we see the home countries interest rate is 20% higher than that of the foreign country (USA). But there is only 8% premium of forward rate. So it creates an arbitrage opportunity for the investors of foreign country (USA) to make a profit of 12% approximately.

Conclusion
The Indian economy is the third largest in the world in purchasing power parity and ninth largest by nominal GDP criterion. .Goldman Sachs has predicted that by 2035, the Indian economy will be the third largest, behind USA and China. The economy would be as large as 60% of US economy. In 2011, the per capita income was $ 3073, making it relatively a lower middle class economy. Since independence, India's balance of payments on its current account has been negative. Since economic liberalization in the 1990s, precipitated by a balance of payment crisis, India's exports rose consistently, covering 80.3% of its imports in 200203, up from 66.2% in 199091. However, the global economic slump followed by a general deceleration in world trade saw the exports as a percentage of imports drop to 61.4% in 200809. India's growing oil import bill is seen as the main driver behind the large current account deficit, which rose to $118.7 billion, or 9.7% of GDP, in 200809. Between January and October 2010, India imported $82.1 billion worth of crude oil. Due to the global late-2000s recession, both Indian exports and imports declined by 29.2% and 39.2% respectively in June 2009. The steep decline was because countries hit hardest by the global recession, such as United States and members of the European Union, account for more than 60% of Indian exports. However, since the decline in imports was much sharper compared to the decline in exports, India's trade deficit reduced to 25,250 crore (US$4.6 billion). As of June 2011, exports and imports have both registered impressive growth with monthly exports reaching $25.9 billion for the month of May 2011 and monthly imports reaching $40.9 billion for the same month. This represents a year on year growth of 56.9% for exports and 54.1% for imports. India's reliance on external assistance and concessional debt has decreased since liberalization of the economy, and the debt service ratio decreased from 35.3% in 199091 to 4.4% in 200809. In India, External Commercial Borrowings (ECBs), or commercial loans from non-resident lenders, are being permitted by the Government for providing an additional source of funds to Indian corporate. The Ministry of Finance monitors and regulates them through ECB policy guidelines issued by the Reserve Bank of India under the Foreign Exchange Management Act of 1999. India's foreign exchange reserves have steadily risen from $5.8 billion in March 1991 to $283.5 billion in December 2009.

We have also tested the IFE and PPP for India and USA by using the historical data. The results show that IFE and PPP does not hold in both the countries both the conceptual and the statistical test. Because of the information constraints we could not find out the IRP for India and USA.

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Bibliography
Website www.rbi.org.in www.tradingeconomics.com www.federalreserve.gov www.worldbank.org www.adb.org www.bangaladeshbangk.org www.wikipedia.org

Book:
International Financial Management by Jeff Madura 9th Edition.