INTRODUCTION TO EXTERNAL DEBT MANAGEMENT

EXTERNAL
DEBT

(or foreign debt) is that part of the total debt in a country that is owed to

creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the IMF and World Bank.

D EFINITION
IMF defines it as "Gross external debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy." In this definition, IMF defines the key elements as follows: (a) Outstanding and Actual Current Liabilities: For this purpose, the decisive consideration is whether a creditor owns a claim on the debtor. Here debt liabilities include arrears of both principal and interest. (b) Principal and Interest: When this cost is paid periodically, as commonly occurs, it is known as an interest payment. All other payments of economic value by the debtor to the creditor that reduce the principal amount outstanding are known as principal payments. However, the definition of external debt does not distinguish between whether the payments that are required are principal or interest, or both. Also, the definition does not specify that the timing of the future payments of principal and/or interest need be known for a liability to be classified as debt.

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(c) Residence: To qualify as external debt, the debt liabilities must be owed by a resident to a nonresident. Residence is determined by where the debtor and creditor have their centers of economic interest - typically, where they are ordinarily located - and not by their nationality. d) Current and Not Contingent: Contingent liabilities are not included in the definition of external debt. These are defined as arrangements under which one or more conditions must be fulfilled before a financial transaction takes place. However, from the viewpoint of

understanding vulnerability, there is analytical interest in the potential impact of contingent liabilities on an economy and on particular institutional sectors, such as government. Generally external debt is classified into four heads i.e. (1) public and publicly guaranteed debt, (2) private non-guaranteed credits, (3) central bank deposits, and (4) loans due to the IMF. However the exact treatment varies from country to country. For example, while Egypt maintains this four head classification, in India it is classified in seven heads i.e. (a) multilateral, (b) bilateral, (c) IMF loans, (d) Trade Credit, (e) Commercial Borrowings, (f) NRI Deposits, and (g) Rupee Debt.

EXTERNAL DEBT AND MACROECONOMIC CONSIDERATIONS
How foreign borrowing affects macroeconomic stability can be best understood in the context of production, consumption, savings, and investment. In a closed economy (no foreign trade), production comprises goods and services for personal consumption (consumer goods), capital goods (buildings, plant and equipment, inventories used by enterprises), and goods and services used by the government, which can be both for consumption (for current use) and for investment. Where there is foreign trade, production also includes goods for export; imports are a supplement to domestic consumption, for investment, for government use or for exports.

There is a relationship between production and income. Put simply production creates incomes equal to the value of output. The government in taxes takes some income; some is taxed; some is saved by the private sector; the balance is spent on consumption. Foreign borrowing is the excess of imports of goods and services over exports and net borrowing creates debt, which can be repaid if exports exceed imports. In the absence of foreign borrowing (exports and imports are equal), private sector investment plus government spending is limited by the level of private sector savings and taxation. Economic growth, of course, could be accelerated with foreign borrowing, permitting imports to exceed exports and at the same time, investment plus government expenditures to exceed savings plus taxes. There are standard indicators for measuring the burden of external debt: the ratios of the stock of debt to exports and to gross national product, and the ratios of debt service to exports and to government revenue. Although there is widespread acceptance of these ratios as measures of creditworthiness, there are no firm critical levels, which, if exceeded, constitute a danger for the indebted country. However, the World Bank Staff has proposed a set of parameters, which it uses to demarcate “moderately” and “severely” indebted countries. Countries with a rapid export growth can support higher debt relative to exports and output. Heavily indebted, however, are vulnerable to severe macroeconomics shocks-sharply higher interest rates in the lending countries, for instance, or simply lenders cutting back on their commitments. Faced with these pressures, countries must then adjust by cutting private investment, decreasing government expenditures and or increasing government revenues.

IMPORTANT ASPECTS RELATED TO EXTERNAL DEBT MANAGEMENT
A) F INANCING T ECHNIQUES Countries have a limited ability to support external borrowing. At the same time, the supply of finance is also limited. Consequently, borrowers must choose the best combination from the available sources of external finance to suit the needs of individual projects-and of the economy as a whole. The country wishes to minimize the problems in servicing new debt, while making maximum use of grants and foreign loans on concessional terms. These are clearly the cheapest from of financing, but their availability is generally restricted to the poorest developing countries; and even for those countries, they are inadequate to meet needs. A maximum leverage can be obtained from concessional financing by combining it with other types of financing. Other sources of credits are export financing and loans from international commercial banks. Authorities should ensure that credits from financial markets are part of a package that provides the best possible external financing mix for the economy, as well for an individual project. For projects the best mix could mean one with: (1) maximum concessional loans or maximum market finance (2) the maximum capital that can be rolled over easily, or (3) the minimum debt service due in the years before returns materialize. Authorities must also ensure that the aggregate financing package meets national financing priorities, This involves an assessment of such aspects as: the sources of finance ,including the amounts that can be borrowed and the prospects for future supply; the currency composition of foreign borrowing that would minimize

exposure to exchange rate fluctuations; the exposure to interest rate fluctuations over the life of the loan; and the impact of new borrowing on the structure of debt service obligations.

B) H OW

MUCH TO

B ORROW

The amount that any country ought to borrow is governed by two factors: how much foreign capital the economy can absorb efficiently, and how much debt it can service without risking external payment problems. Each factor will depend on the quality of economic management. Borrowings can be on different terms and in different currencies, which complicates the policy decision. There may be uncertainty too about evolving debt-servicing capacity. Interaction between debt servicing capacities, the type of finance, and the borrowing decision increases in complexity as the number of loans increases.

C) M ANAGING R ISK Countries are sometimes exposed to BOP shocks arising from unfavorable changes in the relative prices of exports and imports, suppose that a country’s exports earnings are in dollars and its foreign debts are repayable in yen deterioration in the exchange rate of the dollar vis-a-vis the yen will add to the debt servicing obligation of the borrowing country. Fluctuations in commodity prices, foreign exchange rates and world interest rates are largely beyond the control of countries. It is possible to hedge against this risk. Managing risk is an important part of public debt management.

D) K NOWING T HE D EBT Information on external debt and debt service payments is essential for the day-to-day management of foreign exchange transactions as well as managing debt and for planning foreign borrowing strategies, At the most detailed level, the information enables central authorities to ensure that individual creditors are paid promptly; at more aggregated levels; debt data are needed for assessing current foreign exchange needs, projecting future debt service obligations, evaluating the consequences of further future borrowing and the management of external risk The component of external debt statistics include details of each loan contract and its schedule of future service payments, figures on loan utilization, and the payments of debt service obligations. From these data elements summary figure on foreign borrowing, outstanding debt, and projected debt are assembled. The resulting statistics provide inputs for budget and BOP projections. After this lets have a look at external debt sustainability in detail in Chapter 2.

EXTERNAL DEBT SUSTAINABILITY
Sustainable debt is the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth. (UNCTAD/UNDP, 1996)

External-debt-sustainability analysis is generally conducted in the context of medium-term scenarios. These scenarios are numerical evaluations that take account of expectations of the behavior of economic variables and other factors to determine the conditions under which debt and other indicators would stabilize at reasonable levels, the major risks to the economy, and the need and scope for policy adjustment. In these analysis, macroeconomic uncertainties, such as the outlook for the current account, and policy uncertainties, such as for fiscal policy, tend to dominate the medium-term outlook. World Bank and IMF hold that “a country can be said to achieve external debt sustainability if it can meet its current and future external debt service obligations in full, without recourse to debt rescheduling or the accumulation of arrears and without compromising growth.” According to these two institutions, external debt sustainability can be obtained by a country “by bringing the net present value (NPV) of external public debt down to about 150 percent of a country’s exports or 250 percent of a country’s revenues.”

I NDICATORS

OF

E XTERNAL D EBT S USTAINABILITY

There are various indicators for determining a sustainable level of external debt. While each has its own advantage and peculiarity to deal with particular situations, there is no unanimous opinion amongst economists as to one sole indicator. These indicators are primarily in the nature of ratios i.e. comparison between two heads and the relation thereon and thus facilitate the policy makers in their external debt management exercise.

These indicators can be thought of as measures of the country’s “solvency” in that they consider the stock of debt at certain time in relation to the country’s ability to generate resources to repay the outstanding balance. Examples of debt burden indicators include the (a) debt to GDP ratio, (b) foreign debt to exports ratio, (c) government debt to current fiscal revenue ratio etc. This set of indicators also covers the structure of the outstanding debt including the (d) share of foreign debt, (e) short-term debt, and (f) concessional debt in the total debt stock. A second set of indicators focuses on the short-term liquidity requirements of the country with respect to its debt service obligations. These indicators are not only useful early-warning signs of debt service problems, but also highlight the impact of the inter-temporal trade-offs arising from past borrowing decisions. The final indicators are more forward looking as they point out how the debt burden will evolve over time, given the current stock of data and average interest rate. The dynamic ratios show how the debt burden ratios would change in the absence of repayments or new disbursements, indicating the stability of the debt burden. An example of a dynamic ratio is the ratio of the average interest rate on outstanding debt to the growth rate of nominal GDP. These were certain aspects of external debt in the next chapter we will see how the external debt was managed by various countries of the world at the time of economic crisis.

DEBT MANAGEMENT STRATEGY-A GLOBAL OVERVIEW
The design of an adequate strategy for public debt management should include proper consideration of a number of questions. Among them, several come to mind: (a) how much public debt should be issued in domestic markets and how much in foreign capital markets? (b) What should be the currency denomination of new public debt issues? (c) What is the optimal maturity structure of public debt? (d) Should governments consider redeeming in advance some issues and refinance them on different terms? (e) Should public debt be issued at fixed or variable rates and (f) should public debt issues be directed to a particular segment of the market (financial institutions, other institutional investors, corporate sector, etc).Most of these choices entail a trade-off between the level and the variance of debt costs and are highly dependent on both the domestic macroeconomic context and conditions in international markets.

Nonetheless, the debt management strategy has important implications for the economy as a whole. Good liability management should result in lower borrowing costs and unobstructed access to international capital markets, while minimizing any crowding-out effects on private sector borrowing. The choice of the specific characteristics of the debt portfolio involves difficult decisions. While on a pure cost-based analysis it is tempting to choose short-term over long-term debt, the latter might Brady bond spreads for different emerging market economies have behaved similarly, though at different levels, in the midst of financial crises or increased uncertainty. Thus, the liquidity of emerging markets’ securities and the collective behavior of institutional investors make the financial authorities’ tasks more difficult, particularly since systemic risk may rise swiftly. Over the past decade, capital mobility has increased many times over and its main features have also changed, especially those related to the allocation between foreign investment and traditional lending. Mexico, as a recipient economy, has witnessed those events. Total capital inflows to Mexico grew from a yearly average of US$ 2 billion in 1987–88 to $36 billion in 1993. In the latter year, foreign investment amounted to 920/0 of capital inflow. The 1994 crisis caused an important reduction of these flows, to $23 billion in 1995. Given that foreign investment for that year turned out to be negative, loans from abroad represented more than 1000/0 of total capital inflows. For 1996–97 capital inflows were on average $10 billion per year. However, it should be emphasized that total foreign investment represented more than 2000/0 of that amount. That is, foreign investment more than compensated for the decline in indebtedness. For 1998–99 capital inflows are estimated to have averaged $16 billion per year, with total foreign investment amounting to 770/0 of the inflows. Foreign direct investment grew from $4 billion in 1993 to $11 billion in 1994 and has kept a stable level of around $10 billion per year since then. On the other hand, portfolio investment has shown more erratic behavior. Having reached a peak of $29 billion in 1993, it turned negative in 1995 (–$10 billion) and for 1996–99 has averaged under $1 billion per year. The important reduction in the flows of foreign portfolio investment to Mexico since the crisis of 1994–95 is primarily explained by the adoption of a floating exchange rate regime. This regime has proved to be extremely helpful in inhibiting short-term foreign investments by reducing their expected return, once adjustment is made for exchange rate risk. Without the implicit guarantee to portfolio investment provided by the semi-fixed exchange rate regime, foreign direct investment started to play a more dominant role in financing

Mexico’s current account deficit blurred. The Exchange Stabilization Fund prevented the liquidity crisis from turning into a solvency crisis, whose repercussions would have been far more devastating. Prior to 1994, both debtors and the banking system in general were in a fragile situation. Past due loans had increased substantially, and the lack of proper provisioning started to erode banks’ capital. In addition, some commercial banks faced severe problems that were not revealed in their financial statements, and, in some instances, banks disregarded existing regulations and proper banking practices (Mancera (1997)). In this environment, the effect of the currency depreciation, rising inflation and higher interest rates on the credit service burden seriously jeopardized the Mexican financial system. At that time, the materialization of systemic risk and its impact on the economy were major concerns. Faced with this situation, the government and the central bank implemented a comprehensive programme to deal with the banking sector crisis, without derailing monetary policy from its main task of procuring the reduction of inflation. The successful mix of policies ensured the consistency of Mexico’s macroeconomic framework and allowed the economy to recover and rapidly return to international markets. An important element of the overall strategy was to provide liquidity to commercial banks to comply with their external obligations. To this end, a dollar facility was made available to them by the central bank. Thus, Banco de México played the role of lender of last resort for commercial banks at a time of distress, making foreign exchange available to banks through a specially designed credit window. These dollardenominated loans were channeled through the Fund for the Protection of Savings (FOBAPROA).At the beginning of April 1995, the dollar-denominated credits granted through FOBAPROA reached a maximum of US$ 3.8 billion. However, the high level of interest rates purposely charged on such credits induced a rapid amortization, as banks sought other sources of financing. By 6 September 1995, the 17 commercial banks that had participated in this scheme had already repaid their credits. In this sense, the programme achieved its stated purpose, namely that of providing temporary assistance. Once international markets were reopened to Mexican agents (July 1995), the main objectives for the immediate future included the refinancing of the Exchange Stabilization Fund in the market, have a smaller refunding risk and thus be preferable in the end.

That is, a better schedule of amortizations lowers country risk and finance costs over the medium term, both for the government and for the private sector. Likewise, borrowing domestically may turn out to be more expensive than in external markets. Yet borrowing in domestic markets could trigger a rapid development of these markets and pave the way for a solid corporate domestic market in the future. In sum, a good liability management strategy is one that helps minimize the cost of borrowing over the medium and long term. The objective is certainly not to save the last basis point in each transaction, but rather to bring down the overall borrowing cost. Thus, a smooth debt amortization profile is crucial. There is no doubt that emerging economies have to work hard to ensure desirable characteristics in the debt profile, even if initially costly. At the end of 1994, Mexico faced a liquidity crisis accompanied by a very high refinancing risk. This forced the country to seek support from the international community to confront the heavy short-term debt burden. Economic policy was oriented towards rapidly re-establishing macroeconomic stability. This was the only way to stop capital flight and gradually restore Mexico’s access to international financial markets. To deal with the scenario just described, a comprehensive package of policy measures was put together. The stabilization programme was built upon restrictive fiscal and monetary policies and was reinforced by the financial package (Exchange Stabilization Fund) assembled by the US financial authorities and multilateral organizations. The rescue package amounted to more than US$ 52 billion: $17.8 billion committed by the IMF, $20 billion by the United States government, $10 billion by the Bank for International Settlements, $3 billion by commercial banks and $1.5 billion by the Bank of Canada. It is worth mentioning, however, that in 1995 Mexico’s drawings amounted to only $24.9 billion. A solvent government might still face liquidity problems that limit its ability to service its debt. For instance, an overly pessimistic view about the future of the economy might lead lenders to curtail the amount of financing temporarily even if the country is in fact solvent. Eventually, liquidity problems might escalate, negatively affecting the government’s access to international capital markets. At this particular stage, the distinction between liquidity and solvency problems for a country is. At the same time; the private pension fund system has continued to grow, making long-term resources more widely available. Today, Mexico’s foreign debt amortization schedule is light and well distributed over time. The overall debt burden, including domestic and external debt, diminished from levels above 450/0 of GDP in 1990 to approximately 280/0 in 1998. This trend is thought to have continued in 1999.The country’s solvency and liquidity indicators compare

favorably to those of other countries: external debt as a share of GDP amounted to 170/0 in early 1999, while the ratio of total exports to external debt was 1.7. An example of Mexico’s strategy to ensure external financing when conditions in international capital markets turn adverse is the credit line secured with international financial institutions in November 1997. After having a look at the global scenario of external debt lets understand the debt management in India .

EXTERNAL DEBT DEVELOPMENT AND MANAGEMENT
SOME REFLECTIONS ON INDIA INTRODUCTION
In 1990-91 when India got into a severe foreign exchange crisis her outstanding level of external debt was $ 83. 8 billion. The level of debt was about 40 per cent of Gross Domestic Product and the debt service payment was about 30 per cent of exports of goods and services. Several destabilizing forces acting on the Indian foreign exchange markets were a downgrade of India’s sovereign credit ratings to non-investment grade, reversal of capital flows, exacerbated the foreign exchange crisis and withdrawal of the foreign currency deposits held by non-resident

Indians. One can best describe the severity of the situation by quoting from the then Finance Minister of India Dr Manmohan Singh’s Budget 1992-93 speech to the Parliament: "When the new Government assumed office (June 1991) we inherited an economy on the verge of collapse.Inflation was accelerating rapidly. The balance of payments was in serious trouble. The foreign exchange reserves were barely enough for two weeks of imports. Foreign commercial banks had stopped lending to India. Non-resident Indians were withdrawing their deposits. Shortages of foreign exchange had forced a massive import squeeze, which had halted the rapid industrial growth of earlier years and had produced negative growth rates from May 1991 onwards". With this background a study on India’s external debt would obviously raise certain questions such as: how did India manage historically with a very low volume of external capital inflows; how is that the third world debt crisis of early 80s had a little impact; how is it then that India got into a massive foreign exchange crisis in 1990-91; how was India spared from the contagious currency crisis of 1997; and how did India managed to improve her rank from what was third debtor after Brazil and Mexico in 1991 to eighth in 2002 in the list of the top fifteen debtor countries(as per the Global Development Finance report 2004 published by the World Bank). Still more notable is the fact that India never defaulted to international lenders in her entire credit history (except one or two instances of corporate rescheduling). Although the level of debt has increased to $ 112.1 billion by end-December 2003, the magnitude of debt is no longer an issue at present. The economic reforms and debt management policies pursued since 1991 have helped to bring down the share of external debt in GDP to 20.2 per cent and the debt service ratio to 15.8 percent by end-December 2003. The reforms involving trade and capital account liberalization have changed the nature and composition of capital flows into Indian economy. The gradual opening of the capital account and improved credit standing internationally, supported by the prudent macroeconomic policies, have established investors’ confidence. The above scenario although presupposes several accomplishments underlying the country’s external debt management history, the Indian economy nevertheless displayed several episodes

of imbalances in her debt, capital flows and external sector. India’s external debt management in the light of the development in her overall macroeconomic policies and draws lessons for countries in the region. It needs to be mentioned here that the trends in debt need to be reviewed along with the developments in external sector and capital flows, because the overall trade regime, involving trade restrictions, export subsidisation and exchange controls would govern to a large extent the behaviour of external debt.

B URDEN

OF

E XTERNAL D EBT IN I NDIA

It is a source of some comfort that India's external debt continues to be at a stable level. According to the status paper prepared by the Union Finance Ministry, the stock of foreign debt stood at $98.4 billion at the end of December 2001. After a substantial increase of $16 billion between 1991 and 1995, partly on account of fresh loans and partly on account of exchange rate movements, the total debt has fluctuated between $93 billion and $99 billion since 1995. Going by a number of indicators, India's external debt situation is far better today than it was during the balance of payments (Bop) crisis of 1991. While the absolute size of foreign debt is important, more relevant is the weight this debt imposes on the economy. And, on that count, the burden has become lighter and lighter, even as the stock of outstanding has remained more or less constant. Annual repayments of loans and interest as a percentage of current receipts — the debt service ratio, which was as high as 35 per cent in 1990-91, has fallen to 13 per cent today. Debt as a percentage of the gross domestic product has nearly halved since the early 1990s. And the short-term debt to GDP ratio, which crossed 10 per cent in 1990-91 and precipitated the Bop crisis of that year, has been held under 3 per cent. Overall, India is now classified by the World Bank as a "less" indebted country, which

is two rungs below the extreme category of "severely" indebted countries, which is where Brazil, Argentina and Indonesia now belong. In absolute terms as well, India's position has improved globally. In the mid-1990s, India was the third largest debtor in the world; today it is ranked ninth. All this has taken place in spite of the fact that new loans are increasingly being raised on commercial rather than concessional terms, as was the practice for decades.

E XTERNAL D EBT MANAGEMENT P OLICY
India’s Debt-GDP ratio which shows the magnitude of external debt to domestic output had declined from 38.7 % at the end of March 1992 to 22.3% at end March 2001.Similarly the debt service ratio that measures the ability to serve debt obligations has declined from 35.3% of current receipts in 1990-91 to 16.3% in 2000-01. This improvement in external debt should be attributed both to a cautious policy on foreign borrowings (which includes annual caps on commercial loans which would not have been possible if the rupee was fully convertible) and to the steady growth in current receipts in the Bop. There are, however, enough areas of concern, which should prevent complacency and persuade the Government to go slow on capital account convertibility. The first is that while the short-term debt to GDP ratio was only 2.8 per cent at the end of 2001, the more accurate measure of immediate repayments— total debt of a residual maturity of one year — was 9 per cent of GDP in December 2001. This is still not a very heavy burden, but it is not something to be taken lightly. The second concern should be that the estimate of debt servicing in the years ahead (based on past borrowings) shows that there are going to be two major humps round the corner. In 2003-04 and 2005-06, repayments of the expensive Resurgent India Bonds and India Millennium Deposits fall due. Debt service in both years will then cross $12 billion. This will be the largest since 1995-96, though the Government hopes that not all the repayments will be repatriated. The third concern should be the impact of the Government's decision to make even the existing nonrepatriable bank deposits by non-resident Indians fully payable in foreign exchange. As a

consequence, two such schemes were discontinued last April and outstandings transferred to repatriable accounts where they will be held till maturity. The stock of deposits in one of these schemes was itself over $7 billion. This means that if these deposits are taken out of the country when they mature they will add to India's debt service burden. And if they are renewed they will add substantially to India's external debt burden. Either way, the Government's decision is going to have a negative impact on the Bop.

PROBLEMS OF EXTERNAL DEBT MANAGEMENT IN INDIA
Borrowing costs are not limited to interest costs. First, there is the dependency syndrome, which leads to the development of constituencies at the various levels of government to keep the borrowing momentum in full swing, actively supported by the multilateral development agencies. Second, there is an element of uncertainty in regard to whether the loans will be available when most needed, with the uncertainty increasing in the event of any demonstration of national self-reliance in area unacceptable to the stockholders of the lending agencies. Third, neither the civil servants negotiating the loans nor their political bosses have a direct responsibility for loan repayment, with the result that there is bound to be a relatively high degree of laxity in ensuring the best and most productive use of the borrowed funds. Fourth, there is hardly any evidence to indicate that countries with heavy indebtedness really can ever develop to such an extent that they will be free from such indebtedness. E XTERNAL D EBT D EVELOPMENT U NTIL 1970’ S Looking at historically one observes that external capital played a very insignificant role in India’s development process. The industrialisation strategy adopted since the 1950s emulated an import substituting trade regime, with both imports and exports being strictly regulated through quota and duties. The level of current account deficit was as low as 1.2 per cent in 1970, matching the availability of external finance, most of which were contracted from the official creditors and at concessional interest rates. Private commercial borrowings from the international capital markets were nil. The total external debt outstanding at $ 8.4 billion was just about 13.3 per cent of GDP for the year 1970.

India responded very well to the first oil shock of 1973, with prudent macroeconomic management. The deflationary stance of macroeconomic policies coupled with massive inflows of inward remittances from Gulf led to even a surplus on current account in 1976-77, which helped to build up the reserve level. Imports were virtually restricted to the level of exports, and thus the entire inflows of worker's remittances and net aid inflows (after adjusting the gross flows for debt service) were ploughed back to build up the reserves. It was no surprise, therefore, to find that during this period gross aid inflows were sharply reduced by the donors, as these were only going to swell further the reserves. By 1978-79, the reserve level reached about 9 months of import requirements. There was strong opinion in some quarters as to whether Indiacould take advantage of this comfortable foreign exchange situation to relax the severity of the import control regime. To some extent imports were liberalised in 1976-77 and 1977-78 through the introduction of Open General License (OGL), but the persistence of almost total protection of the Indian industrial sector prevented any significant loosening of import. The second oil shock had a major impact on India’s balance of payments, however, with the prices of POL more than doubling during the course of 1979. The oil imports accounted for almost 58 percent of total imports and 46 percent in terms of export earnings. The primary focus of balance of payment management after the second shock was to finance the deficit, rather to control it through deflationary stance of the first oil shock-type.

D EVELOPMENTS

IN

E XTERNAL S ECTOR D URING 1980’ S

India remained unaffected by the debt crisis of early eighties facing many developing countries, due to her insignificant level of private debt. The foreign exchange constraints in the aftermath of second oil shock could be relieved by drawing substantial amount of loans from the International Monetary Fund: SDR 266 million under Compensatory Financing Facility (CFF) in 1980, SDR 529.01 million under Trust Fund Loan (TFL) in 1980-81 and SDR 5 billion under Extended Fund Facility (EFF) during 1981-84 (of which India used only SDR 3.9 billion). The foreign exchange situation also improved dramatically due to the inflow of remittances from the Gulf. A substantial amount of import savings could be made due to large-scale import substitution in the areas of food, petroleum (after the discovery of Bombay High) and fertilizer. Thus, an improved foreign exchange scenario, which along with the available multilateral concessional assistance helped India to retain her credit-worthiness and avoid a possible liquidity crisis of the Latin American type in early 1980s. In fact taking the advantage of the improved foreign exchange scenario Indian policy makers attempted to relax the severity of the controlled trade regime in the 80s. The liberalization of the import control regime, particularly the category of Open General License (OGL) and export-related licenses, opened up a variety of imports that were required by a wider range of emerging consumer goods industries. Export growth remained sluggish during the eighties, due to the slowdown in the growth of world trade, decline in primary commodity prices in the global market, and the expansionary policy at home, as the later might have reduced the exportable surplus to some extent. Indeed the trade deficits went up from $ 5.9 billion in 1984-85 to $ 7.9 billion in 1990-91 (with $ 9.1 billion in 1988-89) and the current account deficits from $ 2.4 billion to $ 8.9 billion during the same period (based on RBI data).

With the near stability in the inflows of concessional assistance, financing of deficits were made by raising commercial loans from the eurocurrency markets in the form of syndicated loans and eurobondsas well as accepting short term foreign currency deposits from the non-resident Indians.
Table 1: Indicators of Current Account Sustainability for India (Per cent) Indicator 19711975 19761980 19811985 19861990 19911995 1996- 2001-2003 2000

Trade Deficit/ GDP Current Account Deficit/GDP Gross Fiscal Deficit/GDP Private Sector: SI Gap External Debt/GDP Short-term Debt/Total Debt Non-Debt Capital Flows/Total Capital Flows Debt Servicing Changes in REER Import Cover (Months)

-0.9 -0.4 -3.3 2.7 15.3* .. .. .. .. 4.3

-1.4 0.2 -5.0 4.7 12.8* .. .. .. -2.1 7.4

-2.5 -1.5 -6.8 3.8 13.2* .. .. .. 0.8 4.2

-2.1 -2.2 -8.1 4.8 15.8* 10.0 6.0 30.2 -4.9 3.3

-1.2 -1.3 -5.7 7.3 33.9 6.7 27.1 28.9 -2.9 5.9

-2.5 -1.3 -5.1 6.6 24.3 5.3 49.3 19.7 -0.8 7.2

-2.2 0.2 -5.9 9.9 21.2 3.6 94.8 15.3 4.8 11.2

* Comprising of external assistance, commercial borrowings and IMF loans only. Thus, the external debt-GDP ratio for these periods is not comparable with the subsequent period. SI Gap: Saving Investment Gap

Source: Reserve Bank of India.

The imbalances in the external sector coincided with the macroeconomic imbalances in the economy, particularly in the form of increasing domestic money supply and budget deficits (see Table 1). The expansionary monetary and fiscal policies did not take into account the likely repercussion in the form of spill over effects on balance of payments. In fact, the generation of the excess liquidity that accompanied the liberalised import structure swelled the level of current account deficit. The principal mode of balance of payment adjustments in Indiaduring the second half of the eighties was the managed depreciation of the rupee. Between 1985-90, the NEER of the rupee depreciated by almost 50 per cent and the REER by 30 per cent. It is clear that in a situation where the balance of payment problem was basically due to the macroeconomic imbalances, which arose primarily from the expansionary macroeconomic policies and the liberalised import structure, the expenditure switching effects of devaluation did not work. The debt management policies in 1970’s and 1980’s was not helping India develop and there arised a need to make changes in the policies.

C RISIS

AND

R EFORM

IN THE

1990 S

The foreign exchange crisis opened up several internal conflicts of an inward looking economy. The policy makers considered the unsustainable balance of payment situation as the symptom and the disease was inherent in the trade and industrial policy that protected the Indian economy from both internal and external competition. The shrinking share of India's exports in the global trade was considered as the reflection of the receding exports competitiveness and the absence of a right kind of commodity mix in India's export basket. The inefficiency of the trade regime had much to do with the prohibitive tariffs and a pervasive system of import controls. The entire regime of discretionary management of foreign exchange had constrained growth, proliferated black markets in foreign exchange and created avenues for considerable rent-seeking

activities. India’s approach to the 1990-91 crises was not to default on her external obligations, rather to pursue macroeconomic reforms, and remain current on debt servicing by borrowing from multilateral sources. As part of the overall macroeconomic reforms, sweeping changes were introduced in the areas of trade and exchange rate policies. The Congress led government, which assumed office at the Centre in June 1991, accepted the medium term structural adjustment programme of the IMF. An immediate fall out of this programme was the sharp devaluation of the rupee. In July 1991 the rupee was devalued at two stages, from £ 1 Rs.34.36 to Rs.41.59. This was followed by a plethora of trade policy reform measures, beginning August 1991, by slashing cash subsidies for the export sector and relieving the economy from the QR and tariff regimes adopted since fifties. India’s reform efforts since 1990s had led to a resumption of growth, decline in inflation, improved fiscal deficit, and a sustainable balance of payments. As we shall see later this had remarkably reduced the external debt burden and brought several beneficial changes in the composition of capital flows in years to come. D EVELOPMENTS
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1991 F OREIGN E XCHANGE C RISIS

By 1990, there was a marked deterioration in India's balance of payments. Although there was satisfactory growth in exports, it was overshadowed by growth in imports, stagnant flows in invisibles such as tourism and private transfers, and mounting debt service burden. The current account deficits which were sustained mainly by borrowing from commercial sources and NRI deposits, with short maturities and variable interest rates, resulted in a ballooning of repayment burden towards 1990. The size of external debt reached $ 83 billion in March 1991, 45 percent of which was contracted from private creditors and at variable interest rates. The debt service payments had reached 30 percent of export earnings by March 1991, which was close to some of the heavily indebted countries such as Indonesia (31 per cent), Mexico (28 per cent), and Turkey (28 per cent).

Interest components alone were about $ 4 billion, comprising some 50 per cent of the total current account deficits and 21 per cent of the total merchandise exports. The growth of exports in US dollar terms was not sufficient even to pay for the interests for each of the three years to 1990-91 and India had to make for amortization payments by resorting to fresh borrowing. The foreign exchange crisis was exacerbated by the Gulf war that began in August 1990, causing shortfall in exports to West Asia, loss of remittances from Kuwait and Iraq, huge foreign exchange costs of emergency repatriation from the region and, most importantly, additional cost of oil imports due to the oil price increase. The Gulf crisis coincided with recessionary trends in the West that had depressed the demand for India’s exports. Furthermore, the economic decline in Eastern Europeled to a contraction of exports to these markets. The uncertain political climate at home along with the precarious balance of payments situation led to the erosion of India's credit ratings abroad. The Moody's downgraded India's status to BB in 1990, which was the highest speculative grade for long-term debt. There were indications that the net resource transfer on account of official and private credit had become negative in 1990-91 i.e. the fresh inflows were not even adequate to meet the obligations on account of amortization and interest payments. The level of foreign exchange reserves fell to just $ 1 billion in 1990-91. This desperate situation led the Reserve Bank of Indiato sell 20 tonnes of gold in May 1991 and pledge another 46.91 tonnes in July 1991, for meeting the urgent foreign exchange needs and financing current account deficits. An imminent foreign exchange crisis loomed large before the Indian economy, with unsustainable external debt burden.

R ESPONSE

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1991

CRISIS AND ITS EFFECTS

Ten years ago India was in the midst of a full-blown balance of payments crisis. We have come a long way since those dark days of collapsing confidence, thanks mainly to sound economic policy and partly to good luck. It’s a story of successful economic reform. To begin with, it’s worth recalling just how bad our external economic position had had become in 1991. By March the current account deficit in the BoP had cumulated to a record level of nearly 10 billion dollars or over 3 per cent of GDP. Exports were falling. The foreign borrowing spree had taken the ratio of short-term external debt to foreign currency reserves to an astronomical 380 per cent. Foreign currency reserves skated close to a pitiful billion dollars throughout the spring and summer of the year. NRI deposits were bleeding away. Access to commercial external credit was becoming extremely costly and difficult. Even the normally sober government Economic Survey for the year admitted “A default on payments, for the first time in out history had become a serious possibility in June 1991”. Faced with this prospect, the new Government (with Manmohan Singh as finance minister) undertook emergency measures to restore external and domestic confidence in the economy and its management. The rupee was devalued, the fiscal deficit was cut and special balance of payments financing mobilized from the IMF and World Bank. The government also launched an array of long overdue and wide-ranging economic reforms. Aside from various measures of domestic liberalization, the strategy for restoring external sector health embraced six key planks.

First, and most importantly, the exchange rate was made market-dominated after a two year transition. It improved greatly the incentives to exporters and to NRIs remitting funds to India through official channels. Correspondingly the rupee cost of importing became higher. Most important, the price of foreign exchange stopped being fixed by politically apprehensive governments. Second, the heavy anti-export bias (and pro high-cost import substitution bias) was reduced through phased cuts in our extraordinarily high customs tariffs. Third, almost all the economic (and not so economic) evils of the import license-permit raj were gradually phased out. Fourth, there was a decisive opening up to foreign direct and portfolio investment. Fifth, short term foreign debts were reduced and strictly controlled; medium term commercial borrowing was also made subject to prudential caps and minimum maturities. Finally, there was a deliberate policy to build up foreign exchange reserves to provide more insurance against external stresses and uncertainties. The fruits of these policy thrusts soon came in bountiful measure. Export growth zoomed up to 20 per cent in 1993/94 and the two years thereafter. Inward remittances by NRIs quadrupled from two billion dollars in 1990/91 to eight billion in 1994/95 and rose further to exceed twelve billion in 1996/97. The current account deficit in the BoP never again exceeded two per cent of GDP and averaged only about one per cent for the ten years after 1990/91. Foreign investment soared from a negligible hundred million dollars in 1990/91 to over 6 billion dollars in 1996/97. Foreign exchange reserves climbed steeply from the precarious levels of 1991 to over $ 26 billion by the end of 1996/97. The debt service ratio was halved over the decade. The critical ratio of short-term foreign debt to forex reserves (proven critical again in the recent Asian Crisis) plummeted down from the stratospheric heights of 1991 to a very safe 20 per cent in March 1995. It would be hard to find more convincing evidence of success of the external sector reforms. But more evidence was soon forthcoming as the gales of contagion swept through Asia in 1997/98. India’s external policies of flexible exchange rates, strict control of short-term borrowing and ample forex reserves, backed by timely monetary policy, passed this rigorous test with high marks. With many key performance indicators (such as overall economic growth and fiscal deficit), the year 1996/97 seems

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