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India's Trade Policy: The Impact on Growth,

Balance of Payments and Current Account Deficit
Article in SSRN Electronic Journal June 2010
DOI: 10.2139/ssrn.1632341

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Indias Trade Policy: the Impact on Economic Growth, Balance of Payments and
Current Account Deficit
G.Ramakrishna*
I Introduction
The Indian economy has been experiencing a major transformation since 1990s in the
wake of unilateral economic reforms initiated since 1991 and the reorientation of the
economy in accordance with the rules and regulations within the multilateral framework
of GATT/WTO. Accordingly the globalization of production process, market for goods
as well as financial markets has been initiated, though slowly. This has generated debate
on the linkage between trade policy and economic growth along with poverty and income
inequalities. The large quantities of capital inflows and trade liberalization have brought
forefront the debate on the linkages between trade policy and the macro variables. The
World Bank and IMF have endorsed liberalization policies in developing countries such
as India and began to condition funds to the member countries on the basis of
implementation of these policies.
The open trade and capital flows regimes are being supported and advocated on several
theoretical grounds 1. India wedded to economic reforms since 1991 as a consequence of
its serious balance of payments crisis though there were some attempts in this regard in
1980s. Some of the policy measures are homebred and some are initiated as a part of IMF
and World Bank conditions. The unilateral trade policy measures initiated include:
market oriented exchange rate policy, removal of trade restrictions and subsidies, drastic
reduction in tariffs on imports and removal of non- tariff barriers, easing the restrictions
on foreign investments, and measures relating external borrowing and import licensing.
The multilateral aspects of Indias trade policy include its commitments with WTO in
relation to trade in goods and services, trade related investment measures and intellectual
property rights. The present study has the following objective: To assess the impact of
Trade policy on Indias economic growth, balance of payments and current account
deficit. The paper is structured as follows: In the following section we discuss the
features trade policy of India along with the recent trade policy of 2004-2009. In section
3 an empirical analysis of the impact of trade policy has been presented. The final section
is on conclusion.
II the Trade Policy of India
Indias trade policy has been inward looking and based on several regulations and
controls. Huge tariff rates and non- tariff barriers have been the hallmark till recently.
India has been continuing with quantitative restrictions (QRs) on imports since 1957.
1

Enhancing economic growth through the operation of foreign trade multiplier, gains due to specialization
based on comparative advantage, widening market size, availability of cheaper capital goods needed for
development, access to the international capital and technology, availability of skilled manpower,
competition, resource allocation gains and market discipline.
* Professor, Dept. of Economics, Osmania University,India.

Electronic copy available at: http://ssrn.com/abstract=1632341

These restrictions were imposed in the wake of severe foreign exchange crisis that
threatened to disturb the stability of its balance of payments. This crisis has been the
result of an emphasis given to industrial development during the II Five Year Plan in the
name of import substituting industrialization. India continued with inward looking
policies, though, there were efforts to open up the economy for competition during
1980s. Till 1990s, Indias domestic production was highly protected and roughly 93%
of its tradable goods continued to be protected by some type of quantitative restrictions
(Pursell, 1996). The QR coverage was 94% for agricultural and 90% for manufactured
intermediate and capital goods during this year. Import licensing policy was in vogue and
licenses were given to the importers only on the basis of non-availability of domestic
supply. India was one of the most restrictive countries based on import tariff structures.
Tariff revenue was one of the highest and constituted some 21% government revenue in
1990. High tariff structures in India have obviously been the reason for the inefficient
allocation of resources. The impact of such policies was felt in terms of a continuous
decline in the share of India in worlds trade. Its share declined from 2% in 1950-51, 1%
in 1965-66, and 0.55 % in 1973-74 by 0.4% in 1980-81. It continued at this percentage
till the reforms were initiated. It rose to 0.64% in 1995, 0.76% in 2002 and slightly came
down to 0.75% in 2003. At present, it stands at 0.8%.
Indias trade policy regime has been restrictive and complex till the trade reforms have
been initiated in 1990s. There were various methods of licensing, categories of importers
and methods of importing. The later policy documents have been simple in terms of
content, rules and regulations. Though, the inward looking import substitution strategy
pursued vigorously during the Second and third Five Year Plans combining both QRs and
tariffs helped the economy to make significant capacity additions in manufacturing
particularly in the areas like chemicals and pharmaceuticals, light engineering and
transport equipment agriculture sector largely been ignored. The country along with the
devaluation of the rupee in 1966 initiated policies in a systematic way to exploit the
available capacities through export promotion. The country however, continued with the
QRs, as the General Agreement on Tariffs and Trade (GATT), though aims at
multilateral non-discriminatory free trade, permits a member country facing balance of
payments problems to protect its domestic economy relying on QRs. The share of value
added in manufacturing sector under QR protection declined from 90% to 47% by May
1992 and to 36% by May 1995 (Pursell, 1995).
As per the WTO agreement, the member countries should reduce the tariff structures in a
phased manner to facilitate the market accessibility. Imposition of tariffs is considered
inefficient as it leads to deadweight losses. The reductions in tariff rates are expected to
improve trade volumes and balance of payments. As per the agreement, India reduced
customs duties from 475% to 23% on selected items. The customs duties on food
products were also reduced. However, it has been estimated that Indias imports were
restrictive as one-third of its import value was under some NTBs (Mehta, 1998). The
recent trade policies reveal that some 30% of the 10 digit tariff lines are still subject to
NTBs. The import of 40% of agricultural goods is still restricted since these are classified
as consumer goods. Consequent to the recommendations by Chellaiah committee, India
reduced the import weighted average tariff from 87% in 1990-91 to 47% in 1993-94 to
2

Electronic copy available at: http://ssrn.com/abstract=1632341

and 20% in 1997-98. The peak rates also have come down from 355% in 1990-91 to 45%
in 1997-98 to 40% in 1999-2000. However, larger portions of consumer goods imports
remain still protected by QRs. The relaxations were extended to some restricted
commodities through freely transferable import licenses. This coverage has been
extended since 1997 to cover various items in the restricted list. India, considering the
improvement in its balance of payments committed with her major trading partners to
phase out QRs by 2003. However, USA and other developed countries having not been
satisfied with Indias commitment filed a case with the Dispute Settlement Board (DSB)
against these QRs in May 1997. The DSB had ruled against India and had found that
Indias QRs on imports were not justified on balance of payments grounds. It had
recommended that India should bring its import regime in conformity with its obligations
under WTO agreements; Government of India has accordingly decided to phase out QRs
by 2001. The process of removing QRs has started in 1991 and was completed during
2001-02 Export- import policy as the QRs have been eliminated for the remaining 715
products. However, the imports of 27 products were placed in the category of state
trading. The removal of QRs is the end of an era that was providing protection to
domestic production of most of agricultural and industrial products. This obviously was
viewed with suspicion, as the domestic production, prices and producer gains would be
affected adversely. To avoid some of these problems anti- dumping duties and other nontariff barriers were planned. The Export-import policy of 2002-07 came out with several
institutional, infrastructural and fiscal measures to promote exports helping economic
development of the country.
The New Trade Policy (2004-09)
The recent trade policy of India aims at two important objectives: (1) to double Indias
percentage share of global merchandise trade by 2009 and (2) to act as effective
instrument of economic development of rural and semi- urban areas. The strategy
followed would be as follows: (i) Unshackling of controls; (ii) Creating an atmosphere of
trust and transparency; iii) Simplifying procedures and bringing down transaction costs;
(iv) Adopting the fundamental principle that duties and levies should not be exported;
(v) Identifying and nurturing different special focus areas to facilitate development of
India as a global hub for manufacturing, trading and services.
The new trade policy aims at increasing exports through various measures: Sectors
with significant export prospects and employment generation potential in semi-urban and
rural areas have been identified as thrust sectors, and specific sectoral strategies have
been prepared to develop these sectors. Special Focus Initiatives have been prepared for
the priority sectors such as Agriculture, Handicrafts, Handlooms, Gems & Jewellery and
Leather & Footwear sectors. The threshold limit has been reduced from Rs. 1000 crores
to Rs. 250 crores. These sectors constitute 1/3 of our total exports and have good
potential for employment.
A Special scheme for Agriculture called Vishesh Krishi Upaj Yojana has been
introduced to boost exports of fruits, vegetables, flowers, minor forest produce and their
value added products. Duty free facilities are provided to the exports of gems and
3

Electronic copy available at: http://ssrn.com/abstract=1632341

jewellery, handlooms and handicrafts and duty free facilities to leather and footwear have
been provided. Several export promotion schemes have been introduced. A new scheme
to accelerate growth of exports called Target Plus has been introduced. To accelerate
growth in export of services Served from India scheme has been introduced under
which, the Individual service providers who earn foreign exchange of at least Rs.5 lakhs,
and other service providers who earn foreign exchange of at least Rs.10 lakhs will be
eligible for a duty credit entitlement of 10% of total foreign exchange earned by
them. . An important initiative is the introduction of a new scheme called Free Trade and
Warehousing Zone to create trade-related infrastructure to facilitate the import and export
of goods and services with a freedom to carry out trade transactions in free currency.
This is aimed at making India into a global trading-hub. In addition, Services Export
Promotion Council shall be set up in order to map opportunities for key services in key
markets, and develop strategic market access programs including brand building, in coordination with sectoral players and recognized nodal bodies of the services industry.
The new trade policy aims at increasing the country's exports to 1.9 percent of global
trade by 2009 from the current 0.8 percent. This requires an increase in Indias exports by
21 percent every year. During 2003-04, India's exports grew at 13.5 percent over the
previous year, and in the current year the target is 16 percent. Therefore attaining 21
percent growth rate appears to be slightly difficult. The recent foreign trade policies have
been useful in facilitating free and flexible trade with many of the barriers for a number
of exportable and importable items have gone and the cut in import duties being
continued.

The new policy has paved the way of setting up free trade and warehousing zones. These
are aimed at making India a global trading-hub. In these zones foreign direct investment
would be permitted up to 100 percent of the development and establishment costs. The
new thrust on service exports in the form of "Served from India" would add the new
thrust on services exports and broaden the country from the dominance of IT and
software services exports.
During the 1990s, India achieved the fastest average export growth of 17.3 percent per
annum in services' exports leaving China behind at 15.8percent. In fact, it topped the
group of world's 15 largest exporters of services outperforming all neighbors in Southeast
and East Asia and also the US, Canada, Japan and countries of the European Union.
During five years ending 2000, India's services' exports grew by 23.2percent per annum.
A feature that is common to both automobiles and software exports is the openness of
these sectors to foreign competition and FDI and India is now emerging a sourcing
destination in these sectors for global majors. Both in ITES and automobiles, MNCs have
made India a hub for their global production and supply chains and this has inspired
Indian companies too to aggressively enter the global fray. The recent FDI hike in
telecommunications and insurance sectors would also make India a hub for global
production and competition.

III Impact of Trade Policy

The quantification of the impact of the trade policy particularly in terms of tariff
reduction and removal QRs is a complex exercise. One way of doing it is to compare the
pre and post situation from the viewpoint of several variables. The studies available for
India do not show any-definite trend in this regard. Some recent studies have used
econometric models and computable general equilibrium models to discern the impact of
trade policy on macro economic variables 2. The impact of multilateral liberalization on
production, trade and welfare usually studied estimating Computable General
Equilibrium (CGE) models 3. In the following paragraphs, an effort is made to assess the
impact of both unilateral and multilateral liberalization on Indian economy in terms of
some macro economic variables using econometric models.
(a) Trade Policy and Economic Growth: The impact of trade policy on economic
growth has provided some evidence of trade liberalization policy influencing economic
growth positively. Using neo-classical production function, we have estimated the impact
of trade liberalization on economic growth of India. In this model we have introduced
trade liberalization as one of the variables along with other growth determining
fundamentals 4. Using the data for the period 1970-2000 we have found that apart from
domestic variables such as industrial output and capital formation, trade liberalization
played a positive role in influencing economic growth of the country. The model is as
follows:

Some notable efforts in this direction are Mehta, 2000 and Mehta and Mohanty, 1999.
Chadha et al (2000) have used CGE model developed by Michigan University and NCAER to study the
impact of WTO trade negotiations on India. They have used the data from GTAP- 4 database (Mac Dougall
et al, 1998). The study analyzed the economic effects on India and other countries of the Uruguay round
trade liberalization that might be undertaken in a new WTO negotiating round. Indias welfare gain is
expected to be 1.1% of its 2005 GDP; resources will be allocated the labor-intensive sectors such as
textiles, clothing, leather and leather products and food, beverages and tobacco. These sectors are also
expected to experience growth in output exports. Real returns to both labor and capital were also expected
to rise. The say scale effects would be positive and unilateral trade liberalization would benefit but less than
the multilateral liberalization.
4
The first one, which runs roughly from 1950 to 1975, may be called a closed economy regime. It
combines passive export policy of 1950s; export subsidization of 1956-62, an abortive attempt of
liberalization (1966-68) and a more restrictive period of 1968-75. The second regime runs from
1975 to 1991, which may be termed as a period of passive liberalization. This consists of
selective relaxation of controls (1975-85) and an effort towards liberalization (1985-91).
The third regime (1991 onwards) is the paradigm shift towards active liberalization and
globalization in terms of structural adjustment program. The first regime was dominated by
socialist, import substitution oriented and public sector dominated policies. During the second
period, though India could not make a clean break from the past policies, there was
recognition that the policy approach of the-previous decades had failed to deliver the goods
and a change was needed. The period of liberalization and globalization runs from 1991 to the
present. As the name implies, this period saw a major policy shift and a clear, if somewhat
halting, move towards free trade and open investment politics.
3

Y=F (L, K, A, R, T)
Where,
Y = GDP
L = Labor
K = Capital
A = Agricultural output
R = Industrial output
T = Trade Liberalization
Following Salvatore (1983) and Salvatore and Hatcher (1991), we modified the model
by substituting per capita output for total output. The justification for this is unless
population growth is matched by economic growth, development does not materialize.
Labor (L) is dropped as an explanatory variable. This is justified on the ground that in most of
the developing countries labor is abundant. We use Gross Domestic Capital formation (I) as a
proxy for capital. Thus, the modified model is expressed as:
Y = F (K, A, R, T)
Totally differentiating and making certain manipulations and adding an intercept dummy,
gY t = a 0 + a 1 gK t + a 2 gA t + a 3 gR t + a 4 gT t + a 5 D it
Di =

0 for the period 1970-92,

1 for the period 1993-2000

The g indicates rate of growth, aj, aj, a 3 , a 4 and a 5 are the elasticities with
respect to K, A, R, and T respectively and a 5 is the coefficient of policy change. Di
= 0 for the years before 1992-93 and Di =1 for the later period. The objective was to
test the hypothesis that trade liberalization influences the economic growth of a
country positively. The methodology used is to estimate the model to test the validity
of this hypothesis. All the variables included in the model are tested for unit root using
Augmented Dicky Fuller test. The test procedure is as follows:
k

Yt = 0 + Yt 1 + 1k Yt 1 + error
t 1

The study period chosen is 1970-71 to 2000-01 as the relevant data are available
for this period. The data are collected on annual basis from Economic Survey and
International Financial Statistics. The data on exports and imports are the quantum
indices (1978-79=100). GDP, agricultural output and industrial output are at factor
6

cost in constant prices (1980-81=100). Gross Domestic Capital formation is converted

into constant prices by deflating it with the price index of Machinery and Transport
Equipment sector. Before estimation of the model time series properties of the
variables are studied using Augmented Dicky Fuller test. The null hypothesis in the
ADF test is that the time series contains unit root (i.e. is non-stationary). The null
hypothesis is rejected if the value of the test statistic is greater than the Mac Kinnon
critical values. The lag length k is determined on the basis of Schwarz criterion.
As all the series are non-stationary in levels co-integration analysis would
have been the appropriate method of estimation. We have not attempted co
integration, as the number of observations is not sufficient to carry such an
analysis. However, with growth rates, each series clearly indicates rejection of
the null hypothesis of nonstationarity.
TABLE 1:
Effect of Trade Liberalization on Economic Growth of India
Dependent Variable
gY
Method
Least
S
Variable
Coefficient
C
gA
gR
gK
gT
Di

10.72782
-2.050891
3.465393
0.817863
0.45447
47.63719

R-Squared
Adjusted RDW Statistic
ARCH: n*R2
(Prob)

0.768824
069 1766
1.940863
0.232480
0.629691

Std. Error
8.40192
0.706308
1.655013
0.218240
0.120054
12.56299

t-Statistic
1.276484
-2.903679
2.093877
3.747546
3.785362
3.791869

Mean Dependent
Var SD dependent
var Akaike
RESET:F-Statistic
(Prob)
Schwarz
F-Statistic
(prob)

Prob
0.2180
0.0095
0.0507
0.0015
0.0014
0.0004
5.156511
63.49721
10.19447
238.1617
(0.00000)
10.53576
9.977134
0.000065

The results are adjusted for the presence of auto-correlation. The serial
correlation among the error terms is tested using Breech - Godfrey Lagrange Multiplier
(LM) method. The empirical findings underscore that fact the trade liberalization
plays an important role in influencing economic growth of India. The industrial
growth and the growth in capital formation have influenced the growth
performance of India positively. Agricultural growth has a negative sign may be
due to the fluctuations in the growth of real agricultural output. The exclusion of
this variable has not improved the results either. Di variable is positive and
7

statistically significant which implies the positive impact of trade liberalization

policy. The model has behaved properly in terms of other diagnostic tests.
(b) Trade policy and Balance of payments:
The experience of India regarding trade and balance of payments is encouraging. Since
India became the member of WTO in 1995, Indian exports have been doubled in dollar
terms (from US $ 31 billion in 1995-96 to US$ 62 billion in 2003-20004). There is an
evidence of export diversification as the share of exports of agriculture and allied sectors
in total exports came down from 19% in 1990-91 to 12% in 2002-2003. Conversely, the
manufactured exports have increased their share from 73% in 1995-96 to 81% in the
recent period. However, imports have continued to increase in pre and post WTO periods.
The percentage growth in imports stood up at 25% during 2002-2003 and expected to rise
further on account of increasing oil prices. The recent trends reveal an increase in the
share of food and allied products and petroleum in total imports. Indias current account
showed a persistent deficit except in recent years. The surplus in current account recent
years has been mainly due to the growth of invisible exports.
We have studied the trade and balance of payments of India dividing the countrys
experience since independence into three economic regimes 4. A structural shift
anal ysis has been used which involves estimating a semi-log lime trend
equation with intercept and slope dummies. The equation is as follows:

Ln Yt = 0 + 1 t + D1 + D2 + 2 t + 3 t
Where,
L n Y t = natural log of the variable, Y t
D1
= 0 for 1950-51 to 1975-76 and 1992-93 to 199-2000
= 1 for 1976-77 to 1991-92
D2
= 0 for 1950-51 to 1991-92
= 1 for 1992-93 to 1999-2000
= growth rate of variable for the period, 1950-51 to 1975-76
1
2
= change in the growth rate for the period, 1976-77 to 1991-92
3
= change in the growth rate for the period, 1992-93 to 1999-2000
Soon after independence, India put in place central planning and the famous FiveYear plans. The primary goals of the plans included: transformation of an
essentially agricultural economy to an industrial one, attaining selfsufficiency
and building domestic capabilities in key industrial sectors. India chose the
process of planning based on the socialist framework and used the mixed
economy approach. Government played a dominant role in nearly every facet of
the economy and practically every economic and business activity required
permits or licenses. The role of private sector was minimal and it was barred
from many key sectors of the economy. Protecting domestic industry from foreign

Table 2:
Structural Shift Analysis of Indias BOP (1950-51 to 2000-01)
R2

intercept
0

Time
t

EXPO

5.9875
(68.27)

0.0661
(11.65)

-1.4065
(-3.35)

-1.4475
(-1.09)

0.0726
(5.55)

0.0846
(2.96)

0.9886

0.43

IMP

6.3763
(84.49)

0.0591
(12.10)

-1.5972
(-4.43)

-2.1693
(-1.99)

0.0860
(7.65)

0.1052
(4.27)

0.9916

2.29

TB

11.2863
(112.26)

-0.0000
(-0.01)

0.2932
(1.61)

12.7121 -0.0111
(8.38) (-0.75)

-0.2943
(-8.98)

0.8347

2.96

NINV

6.2715
(24.17)

0.0112
(0.67)

3.6125
(2.91)

-9.6269
(-2.46)

-0.0706
(-183)

0.2748
(3.25)

0.8414

2.12

CAB

10.1196
(100.44)

-0.0002
(-0.03)

1.4212
(2.95)

3.2934
(2.17)

-0.0482
(-3.21)

-0.0916
(-2.79)

0.7404

2.28

KAB

7.2293
(37.88)

^0.0020
(-0.16)

-3.9838
(-4.36)

-2.4200
(-0.84)

0.1528
(1.92)

0.1195
(1.71)

0.8835

1.98

FI

3.6304
(14.35)

0.0222
(1.36)

-8.1335
(-6.73)

-3.0200
(-0.79)

0.2343
(6.21)

0.1669
(2.02)

0.9325

1.23

EA

7.3174
(47.82)

0.0037
(0.37)

-1.9249
(-2.63)

4.6814
(2.01)

0.0735
(3.22)

-0.0735
(-1.51)

0.6821

1.98

RES

-10.3137
(65.78)

0.0004
(0.04)

-0.0687
(0.09)

-6.8185
(2.88)

0.0023
(0.10)

0.1690
(3.30)

0.6225

2.08

OAB

8.4987
(35.30)

0.0011
(0.07)

0.9722
(0.84)

-7.8792 -0.0315
(2.17) (-0.88)

0.1907
(2.43)

0.4387

2.80

Variable

intercept dummy
D1
D2

slope dummy
2t
3 t

DW

Competition was a major policy objective and restrictions on imports and high
tariffs were the order of the day. Enormous amounts were invested in large and
small public sector undertakings. Unfortunately these units did not function
efficiently resulting in low productivity for the industrial sector as whole and low
returns on the huge investments made during the period. During this period, until
1971, India followed a fixed exchange rate policy with an exception of the
devaluation of the Rupee in 1966. In 1975, India's exchange rate was placed on
a controlled and floating basis linked to a basket of currencies of its major
trading partners. During The inward looking strategy led to several difficulties
9

along with rising trade and account deficits. The oil shocks of 1973 and 1974
have aggravated the balance of payments situation. During this period, India's
exports and imports have risen by 6.61% and 5.91% respectively however; trade
balance and current account balance have not shown an improvement. The
growth rate of both the variables is negative and almost equal to zero percent.
Except for few years in the 1950s and 1970s, the current account balance has
shown a continuous decline. The improvement in CAB during these years is
mainly due to the growth in invisibles. The average annual growth of
invisibles for this period was 1.12%. The trade balance was negligible in 195051 as the imports and exports were all most of the same magnitude (647 and
650 crores) but due to massive increase in imports by 1955-56, the deficit
rose to 133 crores. Current account balance has become positive due to the
invisible transactions. During 1960-61 and 1965-66, current account
deficit has increased from 392 to 511 crores. During this period invisibles
also fell by 10 crores, India was left with no foreign exchange reserves and
CAD had to be financed through loans. The deteriorating BOP performance
till 1960 was accountable to India's trade policy, which was mainly based
on export pessimism. The policy based on self-sufficiency laid
emphasis only on import substitution ignoring the importance of exports.
The declining terms of trade, deteriorating balance of payments and
stagnant export earnings of 1950s have led India to adopt export
promoting measures in 1960s. And in 1966, the Indian Rupee was devalued
by 57.6%. This has increased exports but imports could not be contained
mainly on account of droughts (1965 and 1966). During these years not
only trade deficit and CAD increased but invisible earnings also came
down. Bhagwati and Srinivasan (1975) feel that the export promotion
policies of this period were inefficiently designed and ineffectively
implemented. The oil shocks of early 1970s had adverse impact as the
import expenditure and trade deficit have risen, but due to significant
increase in invisible earnings the CAD has come down. But by 1980-81
CAD has increased by four times to that of 1975-76. This was mainly due
to the huge trade deficit (6211 crores) in 1980-81, which was triggered by
increase in oil prices. This continued in the later years along with
current account deficits.
The late 1980s saw a change in the thinking in terms of
experimenting with market forces and the need for shifting from inward
looking strategies. The efforts have taken place in the form of deregulating
the restrictions on some of the imports. There was a clear policy shift in
1984 as the government eased many of the controls and restrictions for
the first time in independent India. This produced results as exports have
risen by 13.87% during this period. But imports also have risen by 14.51%
10

mainly due to rise in oil prices in 1980-81. Trade and current account
deficits have continued as they have grown by 1.11';< and 4.847o. The net
earnings from invisible have declined during this period by 5.94%. The
reforms initiated by the government were half-hearted and many of the
promised changes never took place.
The early nineties saw the country run into a major crisis with
foreign currency reserves running out and a possible collapse of the
economy caused by a number of factors: overvalued exchange rate, severe
foreign exchange shortages, high inflation (17% in August 1991, largepublic and current account deficits, decline in credit rating and foreign
lending. The new government in 1991
initiated major structural
reforms with the immediate objective of stabilization of the economy
by lowering inflation, improving the balance of payments situation and
reducing fiscal deficits. The policies have been carried out with the
encouragement and support of the World Bank and the International
Monetary Fund. During this period, exports and imports have started rising
significantly at the rates of 15.07% and 16.43% respectively. Earnings from
invisibles have grown by 27.48%. In spite of this phenomenal growth,
trade deficits and current account deficits have grown by 29.43% and
9.16% respectively. Our analysis on growth rates reveals that barring the
external assistance and non-resident Indian deposits all the variables
exhibit a statistically significant change in growth rates during the reform
period.
C) The Impact on Current account Deficit
To verify whether Open policies had any impact on current account deficits
we have used a model on the lines suggested by Calderon, Chong and Zanforlin
2001. The model may be expressed as follows:
CAD t

0 + 1 GGDP t + 2 GPS t + 3TOT t + 4 REER t + 5 OPEN t + 6

FDI t + 7 MEU + 8 EDT -lt + U t

CAD = current account deficits as a ratio of GDP. CAD>0(<0) indicate a

deficit or surplus
GGDP = growth of real GDP (+)
GPS = gross public sector saving as a ratio of GDP. Alternatively
government expenditure to GDP ratio (GOE) is also tried (-)
TOT = terms of trade, is the ratio of export prices to import prices (+)
REER = real effective exchange rate, is the multilateral real exchange rate (+)
11

EDT

= measured as (export + imports/ GDP) (+)

KDT,

= external debt (lagged one year), measured as a ratio of aggregate

external debt to GDP (-)

MEU =

macro economic uncertainty, computed as the fluctuations

in CPI from i t s t r e n d (- )

We have chosen 1970-2000 as the study period based on the availability of data
for variables included in the model. The data have been collected from various
sources. The data on Gross Domestic Product in 1980-81 have been collected
from Economic Survey of India, 2000-2001. Growth rate of GDP is computed as
the percentage change over the previous year. We expect a positive association
between GDP and CAD in India. This is consistent with domestic-absorption
increasing more than exports. The income elasticity for foreign commodities
could also be low. Gross Public sector savings are introduced into the model to
verify whether fiscal consolidation as one of the tools to correct external
imbalances can work with India. Accordingly we expect a negative association
between GPS and CAD, The data on GPS are collected from the same source. The
terms of trade (TOT) variable is introduced into the model to find the impact of
external shocks on CAD. Obviously, an improvement in terms of trade should reduce
deficits in CAD. A positive change in TOT improving the current account balance
is possible when Marshal-Lerner condition is satisfied. This is consistent with
Haberger-Laursen-Metzler effect. The data on TOT are also culled from Economic
Survey of India, 2000-2001. Based on MundellFleming models, the REER
variable is introduced in to the model. Real effective exchange rate changes may
have a stronger impact on CAD of India, as its exports are price sensitive
because of its primary commodity exports. We expect a positive and significant
relationship between REER and CAD. A decline in REER should lead to a decline
in CAD. The data on REER are collected from 'Basic Statistics of Indian Economy, the
Reserve Bank of India (RBI), 2001. Openness variable is introduced into the
model to reflect the influence of globalization policies. The sum of exports and
imports as a ratio of GDP is considered as the proxy. Globalization of the Indian
economy is expected to increase both exports and imports and have the positive
impact on its CAD. Inflow of foreign capital is another indicator of openness. To
represent this, foreign direct investment as a ratio of gross domestic
product (FDD is introduced. We expect a negative association between FDI and
CAD as capital inflows take place as an adjustment mechanism of BOP. The
data on trade openness and FDI are collected from World Bank database. External
debt (EDT; is introduced into the model to verify the linkage between EDT and
CAD. The impact of External debt as a ratio of GDP lagged one year is used
for this purpose. We expect a negative association between them. The idea is,
high levels of foreign debt today will lead to BOP adjustments in the future. The
data on external debt are collected from RBI. The fluctuations in yearly
12

consumer price index have been used to represent, Macro economic uncertainty
(MEU). The data on yearly CPI arc culled from International Financial Statistics (IPS),
Yearbook, 2000. The macro economic uncertainty is computed as follows:

MEU = ( CPI t -CPIt)/CPI

Where,

CPI t = trend value of CPI

CPI t = mean value of CPI

We have estimated the model using ordinary least squares method

and tested for the presence of auto-correlation using Bresch-Godfrey LM
test. The results are presented in table.
Table 3:
Impact of Open Policies on Current Account Deficits in India
Dependent Variable: CAD
Variable

Coefficient

Std. Error

t-Statistic

Prob.

-6.192357

4.392968

-1.409607

0.1805

GGDP

0.031944

0.049942

0.639614

0.5328

GPS

-0.594573

0.271014

-2.193879

0.0456

TOT

0.004449

0.015915

0.279556

0.7839

REER

0.055759

0.022506

2.477548

0.0266

OPEN

0.404344

0.181939

2.222415

0.0432

FDI

-0.148727

0.142938

-1.040505

0.3157

MEU

-3.009326

1.556775

-1.933051

0.0737

EDT
R-squared

-5.845356 0.697686

5.083935 Jarque-Berra

-1.149770

0.2695 1.126650

Prob

0.569313

Akaike info criterion

2.467614

Schwarz criterion

2.958470

F-statistic

3.589946

Prob (F-statistic)

0.016131

Adjusted R-squared 0.503342

RESET: F

1.107922

Prob

0.315706

ARCH: nr2

Prob

0.505378

0.477147

Durbin-Watson stat 2.275483

13

As empirical literature suggests, the effect of growth in real GDP is

positive statistically not significant. As stated earlier, the inelastic income
demands for foreign goods and at the same time domestic absorption
increasing at a higher rate than exports are may not be true in Indian case.
The sign of the coefficient of public saving variable is negative and
statistically significant. This emphasizes the importance of fiscal
consolidation programs in India for correcting current account deficits.
The impact of terms of trade is positive but statistically not significant
indicating the fact that TOT shocks had a less significant effect on
CAD of India. As per our expectation, REER variable is statistically
significant confirming the efficacy of devaluation improving balance of
payments. The OPEN variable has influenced the current account
balances positively and significantly. This result testifies the relation
between open policies and the improvement in current account balances.
The lagged value of the foreign debt variable (EDT) has a negative sign
but it is statistically not significant. This perhaps may be due to the nonseverity of the debt problem to warrant an adjustment in the balance of
payments in the future.
Macro economic uncertainty, which is
measured in terms of fluctuations in CPI, has led to an increase in the
Current account deficits in India. Though, the FDI variable is not
statistically significant but has expected sign. We have also tried the ratio
of foreign capital to GDP as the variable instead of FDI. The results were
similar. Thus, the empirical findings underscore the fact that open policies
influence current account deficits in India.
IV Conclusion
The Indian economy has been experiencing a major transformation since 1990s in the
wake of unilateral economic reforms initiated since 1991 and the reorientation of the
economy in accordance with the rules and regulations within the multilateral framework
of GATT/WTO. In this paper we have made an attempt to empirically verify the impact
of both unilateral liberalization and multilateral liberalization on some of the macro
variables such as economic growth, trade and balance of payments. The major
conclusions that emerge from the study are:
(1) The empirical findings underscore that fact the trade liberalization played a
positive role in. influencing economic growth of India.
(2) Indian exports have been doubled in dollar terms and there is evidence of export
diversification. Imports are rising continuously and the current account showed a
surplus in recent years.
(3) The structural shift analysis on the growth rates of BOP indicate except for two
variables all the components have shown a statistically significant change during
liberalization period.
(4) The open policies had a positive impact on Indias current account balances.
14

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