Gry

6M e*

The Finan cial Sector

Structure, Performance and Reforms

THE financial sector plays a major role in the mobilisation and

allocation of savings. Financial institutions, instruments and markets
which constitute the financial sector act as a conduit for the transfer of
financial resources from net savers to net borrowers, i.e., from those
who spend less than they earn to those who earn less than they spend.
The gains to the real sector, therefore, depend on how efficiently the
financial sector performs this function of intermediation.r

Financial Sector Development in India

The Indian financial sector today comprises an impressive network
of banks and financial institutions and a wide range of financial
instruments.

Institutional Structure
At present, the institutional structure of the financial system is
characterised by (a) banks, either owned by the government, the RBI,
or the private sector (domestic or foreign) and regulated by the RBI;
(b) development financial institutions and refinancing institutions, set
up by a separate statute or owned by the Government, RBI, private, or
other development financial institutions under the Companies Act and
regulated by the RBI; and (c) non-bank financial companies (NBFCs),
owned privately and regulated by the RBI.
Provision of short-term credit is entrusted primarily to commercial
and cooperative banks. Of late, commercial banks have diversified into
several new areas of business such as merchant banking, mutual funds,

in Financial Sector Reforms", in Bimal

1. Rangarajan, C. and Narendra Jadhav (1992). "Issues
Jalan (ed.), The Indian Economy: Problems and Prospects, Viking, New Delhi.
462 Indian Econonl: Perfornance and Policiet

leasing, venture capital, factoring and other financial services. In

addition, there is a wide network of cooperative banks and cooperative
land development banks at state, district and subdistrict levels. Together,
commercial and cooperative banks hold around two-thirds of the total
assets of the Indian financial system (Rangarajan and Jadhav, 1992).

Medium-term and long-term finance is provided primarily by a few

large all India development banks together with a spectrum of state level
financial institutions. While the Industrial Development Bank of India
(IDBI), the National Bank for Agriculture and Rural Development
(NABARD), the Export-Import Bank of India (EXIM Bank) and the
National Housing Bank (NHB) serve as apex agencies in their respective
areas of concern, there are also other financial institutions which
specialise in areas like tourism and the small-scale industry.
Besides these, there are investment institutions, which include the
Unit Trust of India (UTI), the Life Insurance Corporation (LIC) and
the General Insurance Corporation (GIC). In recent years, a number of
public sector mutual funds have been set up by banks and financial
institutions. In addition, a large number of private sector non-bank
financial companies undertake para-banking activity mainly in the area
of hire-purchase and leasing.
The capital market has witnessed a remarkable growth in the paid-
up capital of listed companies and market capitalisation in recent years.
With a network of 23 stock exchanges and as many as 9,413 listed
companies in 2003, it has emerged as one of the important markets in
the developing world. The Securities and Exchange Board of India
(SEBI) has been established to regulate the capital market.

Capital Markets
The 1990s have been remarkable for the Indian equity market. The
market has grown exponentially in terms of resource mobilisation,
number of stock exchanges, number of listed stocks, market
capitalisation, trading volumes, turnover and investors' base (Table
22.1). Along with this growth, the profile of the investors, issuers and
intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in
transaction costs and significant improvement in efficiency, transparency
and safety (NSE, 2002). In the 1990s, reform measures initiated by
SEBI, market determined allocation of resources, rolling settlement,
sophisticated risk management and derivatives trading have greatly
improved the framework and efficiency of trading and settlement.
Tbe Financial Sector: Stracttre, Performance and Reforms 463

Almost all equity settlements take place at the depository. As a result,

the Indian capital market has become qualitatively comparable to many
developed and emerging markets.

TABLE _ Z2.L
Select Stock Market Indicators in India Year
(end-March) t961* 1971* 1980* 1991 2000 2002 2003

Number of
stock exchanges '789 A2 23 23 23

Number of
listed companies |,203 ,599
1 2,26s 6,229 s,871 9,644
Market capitalisation
(Rs. crore) I,200 2,700 6,800 1,10,2'19 11,92,630 7,49,248 6,31,921
Note : *: end-December, BSE only.
Sources : The Stock Excbange, Mumbai and National Stock Exchange'
Rakesh Mohan (2004). Economic Developments in India, Vol' ?4. Academic Founda-
tion, New Delhi.

Although the Indian capital market has grown in size and depth in
the post-reform period, the magnitude of activities is still negligible
compared to those prevalent internationally. India accounted for 0.40
per cent in terms of market capitalisation and 0.59 per cent in terms of
global turnover in the equity market in 2001. The liberalisation and
consequent reform measures have drawn attention of foreign investors
and led to rise in the FIIs investment in India. During the first half of
the 1990s, India accounted for a larger volume of international equity
issues than any other emerging market (IMF Survey, 1995). Presently,
there are nearly 500 registered FIIs in India, which include asset
management companies, pension funds, investment trusts and
incorporated institutional portfolio managers. FIIs are eligible to invest
in listed as well as unlisted securities.
The short-term money market which has links with the entire
spectrum of the financial system, comprises five segments:
. the call money market,
. the inter-bank term deposit market,
. the bills re-discount market, and
. the Treasury bill market
. the inter-corporate funds market
464 Indiar Ecamnl,: Pe(ornante and Policiet

In recent years, new money market instruments such as Certificates

of Deposits (CDs), Commercial Paper (CP) and I82 days Treasury bills
have been introduced so as to impart liquidity and depth to the money
market. Moreover, a specialised money market institution, named the
Discount and Finance House of India (DFHI), has been established with
the objective of providing liquidity to money market instruments,
thereby helping to develop an active secondary market.

Strategy of Developrnent
The role of central banking and the financial system in the process
of economic development was recognised at an early stage. The First
Five Year Plan stated that:
"Central banking in a planned economy can hardly be confined to
the regulation of overall supply of credit or to a somewhat negative
regulation of the flow of bank credit. It would have to take on a direct
and active role, firstly in creating or helping to create the machinery
needed for financing developmental activities all ovbr-Qe country and
secondly, ensuring that the finances available flow in ihb.directions
intended."
During the 1950s and 1960s, the major concern was to create the
necessary legislative framework to facilitate reorganisation and
consolidation of the banking system. The year 1969 was a major turning
point in the Indian financial system when 14 large commercial banks
were nationalised. The main objectives of bank nationalisation were:
o Re-orientation of credit flows so as to benefit the hitherto
neglected sector such as agriculture, small-scale industries and
small borrowings.
. Widening of branch network of banks, particularly in the rural
and semi-urban areas.
. Greater mobilisation of savings through bank deposits.
Between June 1969 and March 1991, the total number of
commercial bank offices rose from 8,262 to as much as 60,570. The
number of rural branches increased from 1,833 to 35,187 during the
same period, accounting for 58.4 per cent of the total as compared with
barely 22 per cent in 1969. Accordingly, the average population served
per bank office declined from 64,000 in 1969 to about 14,000 in March
r99t.
As a ratio of the GDP at current prices, bank deposits expanded
during the period from 15 per cent in 1969-70 to around 48 per cent in
The Financial Scctor: Stxcture, Performance and Reform 465

1990-9I, thus indicating the banking industry's importance in the

mobilisation of savings. In respect of advances, the expansion during
the same period was from 10 per cent to around 25 per cent of the GDR
thus providing increasing support to expanding agricultural, industrial
and commercial activities.
The ratio of priority sector advances (i.e. advances to agriculture,
small-scale industries and small borrowers) to net bank credit rose from
15 per cent in June 1969 to nearly 39.1 per cent in June 1991. The role
of indigenous bankers and moneylenders has declined considerably over
the years. Studies based on surveys indicate that the dependence ofrural
households for cash debt from non-institutional agencies has come down
from about 93 per cent in 1950-51 to as low as 39 per cent in 1981.
Thus, the benefits of banking are no longer confined to a narrow
segment of the population. Banking has acquired a broad base and has
also emerged as an important instrument of socioeconomic change. The
other components of the financial system such as the term lending
institutions have also recorded a similar quantitative and qualitative
change.

TABLE _ 22.2
Progress of Commercial Banking in India
(Amount in Rs. Crore, Unless Mentioned Otherwise)

1. No. of Commercial Banks 73 t54 272 284 298 292

2. No. of Bank Offices 8,262 3,4s94 60,570 64,234 67,868 68,561
Of which:
Rural and semi-urban
Bank Offices 5,172 23,227 46,5s0 46,602 ' 47,693 47,496
3. Population per Office ('000s) 64 16 14 15 15 t6
4. Deposits SCBs
of 4,646 40,436 2,0t,199 3,86,859 8,s1,593 12,80,853
5 Per capita Deposit (Rs.) 88 738 2,368 4,242 8,s42 t2,2s3
6. Credit of SCBs 3,599 25,078 t,21,865 2,1t,560 4,54,069 7,29,214
7. Per Capita Credit (Rs.) 68 457 |,434 2,320 4,555 ',1
,2',1 5
8. Share of Priority Sector
Advances in Total Non-Food
Credit of SCBs (per cent) 15.0 37 0 39.2 33 7 35.4 13.7+
9. Deposits (per cent of
National Income) 15.5 36.0 48.1 48 0 535 51.8*

Note : *: As at end-March 2002.

Source : Reserve Bank of India.
466 Indian Ecoroal: Perlornance ad Policiet

The mid-1980s saw some movement away from this regulated

regime. Commercial banks were permitted to enter new activities. Apart
from the introduction of new money market instruments, interest rates
in the money market were freed from control. Great flexibility was
introduced in the administered structure of the interest rate. While
deposit rates were made attractive to savers by making the rate positive
in real terms, the structure of lending rates was simplified by linking
the rate of interest largely to the size of loans.
While the progress made by the financial system in general and the
banking and other financial facilities to a larger cross-section of the
people and the country is well recognised, there is a growing concern
over the operational efficiency of the system. There has been a
perceptible decline in the productivity and profitability of commercial
banks. It is estimated that in 1989-90, gross profits before provisions
were no more than 1.10 per cent of working funds. In 1990, the spread
between interest earned and paid as a proportion of working funds was
3.2 per cent. The establishment expenses as a proportion of working
funds in the same year was 2.05 per cent. With the decline in the quality
of loan assets, (the sticky advances account for more than 20 per cent
of the credit outstanding) the need for provisioning has become more
urgent and several banks are not in a position to make adequate
provisions for doubtful debts. The financial position of the Regional
Rural Banks is far worse with the accumulated losses completely wiping
out the capital in most banks. The balance sheet of the performance of
the financial sector is thus mixed, strong in achieving certain
socioeconomic goals and in general, widening the credit coverage but
weak as far as viability is concerned (Rangarajan and Jadhav, 1992).

Directions of Reforms
The financial markets in the industrially advanced countries have
undergone far-reaching changes in the 1980s. Innovations spurred by
deregulation and liberalisation have been a marked feature of this
transformation. Rapid strides in technology in the areas of
telecommunication and electronic data processing have helped to speed
the changes. A major consequence of these changes is the blurring of
the financial frontiers in terms of instruments, institutions and markets.
The distinction between banks and non-banking financial institutions
has become thin. Restrictions imposed earlier on banks regarding the
activities that they can undertake have been removed one by one.
Effectively, universal banking has become the trend. Another feature of
the market is the interlinking of different national markets. With the
The Financial Sector: Stracture, Performance and Reformt
467

dismantling of exchange controls and the rapid developments in

communications systems, funds have started moving rapidly from one
country to another.
It is the interlinking of different national markets which has come
to be known as globalisation. Important financial institutions are present
in all the leading market centres and markets are in operation on a 24
hour basis. Deregulation has thus meant the dismantling of regulations
relating to entry and expansion; it has also meant the removal of all
direct controls over interest rate wherever they existed. The integration
of markets, both financially and spatially, has led to a more unified
market for the allocation of savings and investment among the
participating countries. The functioning of the financial markets in the
decade of 1980s has, however, raised some serious concerns. There is
a fear that the state of the financial markets is now inherently more risky
than in the past. In a technologically integrated financial world, the
chances of systemic risk increase. The potential damage to the system
arising out of the failure of a large globally active banking or non-
banking financial institution can be immense. Because of the intense
competition which banks have come to face, both as a consequence of
the growth of non-banking financial institutions as well as securitisation,
it is feared that the quality of bank loans has suffered. With the
spectacular growth of non-bank financial institutions, the question of
adequate supervision of these institutions has also gained urgency. It is
for these reasons that increasing attention is being paid in these
countries towards evolving a common code of prudential regulations
applicable to all countries. Several significant steps have already been
taken in this direction. The new approach is somewhat loosely
summarised in the phrase "with as much freedom as possible and with
as much supervision as necessary" (Rangarajan and Jadhav,1992).
The issues in financial sector reform, as far as India is concerned,
are in some ways similar to the issues that have surfaced in the advanced
countries. However, there are concerns which are specific to the Indian
situation. The ultimate objective of financial sector reform in India
should be to improve the operational and allocational efficiency of the
system. Even from the point of view of meeting some of the
socioeconomic concerns, it is necessary that the viability of the system
is maintained. It is in this context that a fresh look at the administered
structure of interest rates is called for. The reform of the Indian financial
system must really begin here.
468 Indian Econanl: Petlormance and Policiet

Adrninistered Structure of Interest Rate

The fundamental reason for introducing an administered structure
of interest rates in our country is to provide funds to certain sectors at
concessional rates. While there may be ample justification for
concessional credit to be provided to finance certain activities, a highly
regulated interest rate system has a number of weaknesses. Government
borrowing at concessional rates of interest has become possible only
because of the compulsion imposed on the financial institutions. This
also results in the monetisation of public debt if the Reserve Bank of
India (RBI) is to pick up what cannot be absorbed by banks and other
institutions. Such restrictions, limit the ability of these institutions to
raise resources at market rates. In the case of credit to other priority
and preferred sectors, the burden on the financial institutions can be
tolerable so long as the quantum of such credit is limited, as there is a
limit to cross-subsidisation. The regulated interest rate structure has,
therefore, implications for the viability of the financial institutions. The
reform of the interest rate structure is thus linked to the system of
directed credit as it is practiced now.
In the case of commercial banks, directed credit takes the forms of
prescription of cash reserve requirement (CRR), statutory liquidity
requirements (SLR) and the allocation of credit for priority sectors. The
CRR and SLR taken together now pre-empt a significant proportion of
the deposit liabilities. Banks are now required to provide 40 per cent
of net bank credit to priority sectors which include agriculture, small-
scale industry, etc. CRR has to be distinguished from SLR. The former
is an instrument of monetary control and its level has to be determined
by monetary authorities taking into account the overall economic
situation. However, statutory liquidity ratio is of a different character
and has become basically an instrument for providing credit to the
government by the commercial banks.
In relation to directed credit for priority sectors the real problem is
not so much the proportion of credit allocated for priority sectors as
much as the concessional rates of interest enjoyed by the borrowers.
Clearly there is a case for re-examination of those who are entitled to
borrow at concessional rates from the banking system. One immediate
way of doing this is to eliminate large borrowers from the credit to the
priority sector. No more than two concessional rates of interest should
be prescribed so as to keep the burden on the banking system within
limits.
The Fimncidl Sector: Structure, Performance and Reforms 469

The financial system must clearly move towards an interest rate

regime which is free from direct controls. Obviously, interest rate is
an important policy instrument. Monetary authorities the world over
try to influence the level of interest rate through the various
instruments that are available to them. It is not, therefore, argued that
monetary authorities should abdicate an important function of theirs.
The general level ofinterest rate should be influenced by the monetary
authorities taking into account the overall economic environment. The
issue is whether a structure should be imposed by the monetary
authorities. In moving towards a more deregulated structure of interest
rate, there is considerable historical evidence to show that such
experiments succeed only when the inflationary pressures are under
control. Sharp increases in nominal and real rates of interest can result
in adverse economic consequences. However, the broad outlines of
the reform agenda in terms of the interest rate as far as India is
concerned are quite clear. At least initially from an elaborate
administered structure of interest rate we should move towards a more
simplified system where only a few rates are determined (Rangarajan
and Jadhav, 1992).

Autonomy, Prudential Regulations and Supervision

Even as the external constraints such as administered structure of
interest rate and pre-empted credit are eased, the financial institutions
must act as business units with full autonomy and by the same token
become fully responsible for their performance. There are instances of
countries like France where the major banks are in the public sector
but are allowed to operate with a high degree of autonomy without any
interference from the government. In the Indian context, 'adverse
selection' and 'moral hazard' which have been discussed in recent
literature arise more because of outside interference with decision
making than as a consequence of interest rate policy. In fact, decisions
such as waiver of loans also have an adverse effect on the performance
of financial institutions as they vitiate the recovery climate. In short,
the operational efficiency of the system will improve only if we restore
functional freedom to the financial institutions.
The need for stringent prudential regulations in a more deregulated
environment has become apparent in many countries. The elements of
prudential regulation which have assumed greater importance in the
recent period relate to capital adequacy and provisioning. The Indian
system has so far been slack in relation to both these aspects. Capital
adequacy did not perhaps receive adequate emphasis because of the
470 Itdian Econoal: Pe(ormance and Policiet

false assumption that banks and financial institutions owned by the

government cannot fail or cannot run into problems.
With major Indian banks now having branches operating in
important money market centres of the world, this question can no
longer be ignored. This apart, even banks operating domestically need
to build an adequate capital base. The Bank for International Settlements
has prescribed the norm for capital adequacy at 8 per cent of the risk
weighted assets. As the Narasimham Committee (Government of India,
1991) has recommended, banks which have had a consistent record of
profitability may be allowed to tap the capital market for meeting this
additional requirement. This would involve a dilution of ownership
which cannot be avoided and which may also serve a useful purpose.
What has been said about banks holds good in relation to term lending
institutions as well as other financial institutions. Whether they be
leasing companies or hire purchase companies or investment companies,
prescription of appropriate capital requirements is a must since capital
is the last line of protection for all depositors.
Closely related to prudential guidelines is supervision. A strong
system of supervision becomes necessary in order to ensure that the
prudential regulations are followed faithfully by financial institutions.
As the financial sector grows, it is quite possible to have different
agencies supervising different segments of the market and institutions.
In this background two issues arise. One relates to the coordination
among supervisory agencies and the other regarding consolidated
supervision. Financial institutions no longer operate in one segment of
the market. Under the circumstances, the segmentation of the market
for regulatory purposes can run into a number of difficulties. Apart from
multiple authorities exercising control over one institution, differing
prescriptions by different authorities can also lead to inconsistencies
and conflicts. It is in this context that the concept of 'lead regulator'
has emerged under which one authority is recognised as a primary
regulator in relation to one type of institution.

1991 and After: The Reform Years2

The reform in the financial sector was attuned to the reform of the
economy, which now signified opening up. Greater opening up
underscores the importance of moving to international best practice
quickly since investors tend to benchmark against such best practices

2. Tbis section has been drawn extensively from Rakesh Mohan (2004). "Globalisation: The
Role of Institution Building in the Financial Sector: The Indian Case", in Uma Kapila (ed.),
Economic Developments in Indis, Vol. 74, Acaderuic Foundation, New Delhi
The Financial Sector: Structure, Performance and Reforms 471

and standards. Since 1991, the Indian financial system has undergone
radical transformation. Reforms have altered the organisational
structure, ownership pattern and domain of operation of banks, DFIs
and Non-Banking Financial Companies (NBFCs). The main thrust of
reforms in the financial sector was the creation of efficient and stable
financial institutions and markets. Reforms in the banking and non-
banking sectors focused on creating a deregulated environment,
strengthening the prudential norms and the supervisory system, changing
the ownership pattern, and increasing competition.
The policy environment was stanced to enable greater flexibility in
the use of resources by banks through reduced statutory pre-emptions.
Interest rate deregulation rendered greater freedom to banks to price
their deposits and loans and the Reserve Bank moved away from
micromanaging the banks on both the asset and liability-sides. The idea
was to impart operational flexibility and functional autonomy with a
view to enhancing efficiency, productivity and profitability. The
objective was also to create an enabling environment where existing
banks could respond to changing circumstances and compete with new
domestic private and foreign institutions that were permitted to operate.
The Reserve Bank focused on tighter prudential norms in the form of
capital adequacy ratio, asset classification norms, provisioning
requirements, exposure norms and improved level of transparency and
disclosure standards. As the market opens up, the need for monitoring
and supervising becomes even more important systemically. The greater
flexibility and the prudential regulation were fortified by 'on-site
inspections' and 'off-site surveillance'. Furthermore, moving away from
the closed economy objectives of ensuring appropriate credit planning
and credit allocation, the inspection objectives and procedures, have
been redefined to evaluate the bank's safety and soundness; to appraise
the quality of the Board and management; to ensure compliance with
banking laws and regulation; to provide an appraisal of soundness of
the bank's assets; to analyse the financial factors which determine bank's
solvency and to identify areas where corrective action is needed to
strengthen the institution and improve its performance. A high-powered
Board for Financial Supervision (BFS) was constituted in 1994, with
the mandate to exercise the powers of supervision and inspection in
relation to the banking companies, financial institutions and non-
banking companies. Currently, given the developing state of the
financial system, the function of supervision of banks, financial
institutions and NBFCs rests with the Reserve Bank.
472 Itdiar Econonl: Perfornance and Poliriet

Role of Competition
It is generally argued that competition increases efficiency.
Competition has been infused into the financial system by licensing new
private banks since 1993. Foreign banks have also been given more
liberal entry. New private sector banks constituted 11 per cent of the
assets and 10 per cent of the net profits of scheduled commercial banks
(except regional rural banks) as at end-March 2003. The respective
shares of foreign banks were 6.9 per cent and I0.7 per cent, respectively.
In February 2002, the Government announced guidelines for foreign
direct investment in the banking sector up to a maximum of 49 per cent
(since raised to 74 per cent in 2004). The Union Budget 2002-03
announced the intention to permit foreign banks, depending on their
size, strategies and objectives, to choose to operate either as branches
of their overseas parent, or, as subsidiaries in India. The latter would
impart greater flexibility to their operations and provide them with a
level-playing field vis-d-vis their domestic counterparts. While these
banks have increased their share in the financial system, their presence
has improved the efficiency of the financial system through their
technology and risk management practices and provided a demonstration
effect on the rest of the financial system.

Capital Adequacy and Government Ownership in the

Banking Sector
In a globalised system, banks tend to get rated if they have to enter
the market to raise debt or equity. Internationally, banks follow the Basel
norms for capital adequacy. Banks were required to adopt these norms
for maintaining capital in a phased manner in order to avoid any
disruption. However, as a result of past bad lending, a few banks found
it difficult to maintain adequate capital. The Government had
contributed Rs.4,000 crore to the paid-up capital of banks between
1985-86 and 1992-93. Subsequently, over the period 1992-93 to 2002-
03, the Government contributed over Rs.22,000 crore towards
recapitalisation of nationalised banks. In view of the limited resources
and the many competing demands on the fisc, it became increasingly
difficult for the Government to contribute any substantial amount
required by nationalised banks for augmenting their capital base. In this
context, Government permitted banks that were in a position to raise
fresh equity to do so in order to meet their shortfall in capital
requirements; the additional capital would enable banks to expand their
lending.
The Fiuncial Sector: Stxcture, Performance and Refotms 473

Since the onset of reforms, there has been a change in the ownership
pattern of banks. The legislative framework governing public-sector
banks (PSBs) was amended in 1994 to enable them to raise capital funds
from the market by way of public issue of shares. Many public-sector
banks have accessed the markets since then to meet the increasing
capital requirements, and until 2001-02, the government made capital
injections out of the budget to public-sector banks, totalling about 2
per cent of GDP. The government has initiated a legislative process to
reduce the minimum government ownership in nationalised banks from
51 to 33 per cent, without altering their public-sector character. The
underlying rationale of the proposal appears to be that the salutary
features of public-sector banking are not lost in the transformation
process.

Some Perspectives for the Future

of the Indian Financial System
The basic emphasis of the Indian approach remains the creation of
an enabling environment so as to foster deep, competitive, efficient and
vibrant financial institutions and markets, with emphasis on stability' A
number of measures have been initiated to achieve convergence with
international best practices. Keeping in view the fast pace of
technological innovations in the financial sector and product
development at the international level, the focus has been to bring the
Indian financial system at par with such standards. However, while
adapting to international standards and trends, special attention is being
devoted so as to customise norms and standards keeping in view various
country-specific, including institution-specific considerations'
As the economy begins to grow rapidly, the process of financial
intermediation is likely to increase. However, in the Indian case, the
ratio of bank assets to GDP is low among developing countries (Barth
et al.,2001). By comparable international standards, although the
financial reach of the system is high, the extent of financial widening is
much lower. This would mean that there is a lot of room for credit
expansion to take place, which, in turn, envisages enhanced credit
appraisal and risk management skills, which is an important challenge'
At present, around 76 per cent of the banking sector assets are
accounted for by public sector banks, with the remaining being
accounted for by private and foreign bank categories. The share of non-
public sector banks has been increasing continuously over the l'ast few
years, with a sizeable rise in the market share (in terms of assets) being
474 Indier Econonl: Performazte ail Paliciet

evident for new private banks. It is not difficult to imagine that the new
private banks, with no legacy of economic structure and with their
ability to leverage technology to produce highly competitive types of
banking, are comparatively better placed to outperform their public
sector counterparts. This would imply a rise in their market share along
with the foreign bank group and accordingly, a concomitant decline in
the market share for public sector banks. The scope for this expansion
obviously depends on the expansion of the total banking system. As it
stands, the intermediation process has been taking place parallel with
the development of the capital market. Therefore, the issue remains for
public sector banks as to how to adjust the loss of relative market share
in an environment where the absolute size of the pie is not expanding
rapidly. Moreover, the ability of different public sector banks to cope
up with this challenge is likely to be quite different, which is an
important issue that would need to be addressed.
An important issue relates to the manner in which public sector
banks would cope when Government ownership is reduced to 33 per
cent, which is likely to be fructified once the Banking Companies
(Acquisition and Transfer of Undertakings) and Financial Institutions
(Amendment) Bill, 2000 is passed by the Parliament. In facr,
international evidence tends to suggest a significant scaling down of
Government ownership in the banking system in most countries (Barth
et al., 2001). In such a scenario, banks will have to embrace modern
management and corporate governance practices and acquire higher
quality of human capital.
Another major concern for the banking system is the high cost and
low productivity as reflected in relatively high spreads and cost of
intermediation. Both spreads and operating costs, measured as
percentage of total assets of banks have generally been higher
vis-d-vis developed countries. An important challenge for the banking
sector, therefore, remains its transformation from a high cost, low
productivity structure to a more efficient, productive and competitive
set up.
The capital requirement of banks is likely to increase in the coming
years with the pick up in credit demand and the implementation of Basel
IInorms around 2006, which has accorded greater emphasis on risk-
sensitivity in credit allocation. Banks would need to increase their
profitability to generate sufficient capital funds internally, since
maintaining the additional capital position in line with the prescribed
norms could pose a major challenge.
The Finarcial Sectol: Stuctarc, Performance and Reformt 475

Commercial banks continue to face the problem of the overhang of

NPLs, attributable, inter alia, to systemic factors such as weak debt
recovery mechanism, non-realisability of collateral and poor credit
appraisal techniques. The recent enactment of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act has increased the momentum for the recovery of NPLs.
Banks need to intensify their efforts to recover their overdues and
prevent generation of fresh NPLs.
A major challenge facing the banking and financial community
emanates from the high growth in volumes of financial transactions and
the impact of today's globalisation efforts the world over. Traditional
geographical boundaries are getting blurred and greater challenges are
confronting banks owing to the explosion of technology. It is in this
context that there is an imperative need for not mere technology
upgradation but also integration of technology with the general way of
functioning of banks.
Internationally, deposit insurancei has been recognised as an
important component of the financial safety net for a country. A risk-
based deposit insurance premium system has been identified as a
measure that can reduce negative externalities of the deposit insurance
system. Introduction of such a system is currently under consideration
of the Government.
In view of the gradual withdrawal of DFIs from longer-term
fill the void being created by
financing, an issue remains about how to
such restructuring. There is a need to develop the private corporate debt
market and introduce appropriate instruments to reduce the risk arising
out of long-term financing by other players such as banks.
In recent times, attempts have been made to achieve regulatory and
supervisory convergence between commercial and cooperative banks in
certain key areas including prudential regulations. These steps are in
the interest of the stability of the overall financial system as well as
healthy development of the cooperative credit institutions. However, in
view of the impaired capital position of many cooperatives and their
large overhang of NPLs, achieving such convergence would prove to
bedifficult. It is, however, for the cooperative banks themselves to build
on the synergy inherent in the cooperative structure and stand up for
their unique qualities. In this context it is encouraging to note that during
the recent years in the face of the restructuring process, cooperative
banks are making efforts to reduce their operating cost.
476 Indian Econonl: Perlornance and Policiet

The issue of corporate governance has assumed prominence in

recent times, more so in view of the recent accounting irregularities in
the US. The quality of corporate governance would become critical as
competition intensifies, ownership is diversified and banks and
cooperatives strive to retain their client base. This would necessitate
significant improvements in areas such as housekeeping, audit practices,
asset-liability management, systems management and internal controls
in order to ensure the healthy growth of the financial sector.
Prior to enactment of legislative reforms for NBFCs, they mobilised
a significant portion of their fund in the form of public deposits, often
at high interest rates. This, coupled with relaxed regulatory and
supervisory arrangements for NBFCs, created negative externalities
including moral hazard. Introduction of reform measures for NBFCs has,
however, substantially eliminated such problems and the share of public
deposits in the total liability of NBFCs has declined substantially.
Notwithstanding this, protection of the depositors' interests remains
paramount. Towards this objective, the RBI continues to pursue with
various State Governments the case for enacting legislation for
protection of interest of depositors in financial establishments. Creating
public awareness about activities and risk-profile of NBFCs along with
improvement in corporate governance practices and financial
disclosures needs to be focused upon in future.
The entry of private sector players in the insurance sector is yet to
make a significant dent in the market share of the public sector entities.
Recent evidence, however, suggests that the state-of-the-art services
provided by private players have begun to make an impact on the
existing insurance industry. Accordingly, promoting the role of
competitive forces in the process of insurance liberalisation is essential,
not only for customer choice, but also for raising resources for long-
term infrastructure finance.
In the securities market, instituting enabling legal reform poses an
important challenge for its orderly growth. A number of reforms in the
financial system have been held back pending legal changes.
There is lack of transparency in the corporate debt market, which
is operating predominantly on a private placement basis. A wholesome
view has to be taken by the different regulators to develop a vibrant
corporate debt market.
The Financial Sector: Structure, Performance and Reforms 477

Lessons from the Indian Experience

The process of globalisation has important implications for the
financial sector and the institutions comprising it. In an increasingly
globalised environment, the role of the policy-maker in the domestic
institutional building process can be envisaged in the form of providing
a stable macroeconomic environment, increasing competition,
establishing a strong regulatory and supervisory framework, evolving
an enabling legal system and strengthening technological infrastructure.
A well-knit institutional set up facilitates the growth and development
process of an economy. Effective institutions can make the difference
in the success of market reforms. If the financial system is well
diversified and the markets are liquid and deep, effective mobilisation
and allocation of resources will be ensured. Many broad generalisations
can be discerned from the Indian experience.
Development of the Indian financial system is premised on the
conviction that financial development makes fundamental contributions
to economic growth. At the time of Independence, the financial system
was fairly liberal. By the 1960s, controls over the financial system were
tightened and aligned in accordance to the centralised Plan priorities.
The priority was to set up institutions to mobilise saving and allocate
the saving to specified sectors. The RBI was vested with the
responsibility of developing the institutional infrastructure in the
country. Towards this end, controls on lending and deposit rates were
introduced and specialised development banks, catering to varied
segments of the economy were established. This institutional design did
not achieve the desired results. The process culminated with the two-
stage nationalisation process of banks, first in 1969 and thereafter in
1980. Around the same time, the insurance business was also brought
under the domain of Government control in phases. The process of
nationalisation expanded the reach of financial services to remote parts
of the country. However, the basic principle of mobilising savings and
channeling resources to certain sectors at a price not related to the
market remained. Notwithstanding the numerous achievements of 'social
banking', such as branch expansion and diversion of credit to rural
sectors, the high degree of controls on the financial system also
manifested itself in several inefficiencies.
In order to address these shortcomings, gradual liberalisation of the
financial system was initiated in the late 1980s, which received greater
momentum in the 1990s. The closed-economy framework gradually gave
way to greater externally oriented and liberal financial system. The
478 Indiau Economl: Performatce and Policiet

1990s witnessed the advent of economic reforms in the country

encompassing trade, industry and the real sectors. The external sector
was liberalised. The country adopted a flexible exchange rate regime
early in the reform period and encouraged non-debt creating flows in
the form of foreign direct investment and foreign institutional
investment. Liberalisation of the external current account was also
undertaken early in the reform cycle. The macroeconomic environment
then influences institutional building. As the economy opens up, the
financial system can no longer afford to remain repressed. The financial
system also has to undertake reforms in the form of interest rate
deregulation, prudential regulation, good supervisory standards, legal
changes and technological upgradation. New institutions operating on
market principles have to emerge and old institutions would either have
to change to cope with the emerging changes or close. Thus,
in the financial system have to
macroeconomic reform and reforms
progress simultaneously. In the early 1990s, a wide-ranging set of
reforms were undertaken, encompassing both financial institutions and
markets. These reforms paved the way for more market-driven allocation
and pricing of resources. The process of globalisation has tended to
exhibit itself, both domestically, in terms of greater integration of
domestic financial markets with global ones and internationally, in terms
of the adoption of a process of gradual convergence with international
best practices.
The pre-reform experience suggests that governments that suppress
their financial systems in order to finance spending, end up with
underdeveloped, inefficient and repressed financial systems. Prior to
reforms, Indian institutions were typically set up to mobilise savings
and allocate resources at administered rates. Initially, the authorities
concentrated on regulating both the quantity and cost of credit. This
undermined the efficiency of the financial system and ultimately led to
financial repression. The post- reform institutional structure recognised
the need for institutions to be market based. The major elements for
adequate development of the financial sector in India constituted a
stable macro-economic environment, competition, effective prudential
regulation, sound supervision, enabling legal framework and modern
technological infrastructure.
The driving forces for important innovations in the financial system
can come from within or from external forces. In fact, in the Indian case,
although the trigger for the economic reform process was the balance
of payments crisis resulting from the Gulf War of 1990, the reforms in
the financial sector were the result of a well-crafted internal strategy.
The Financial Sector: Strvcture, Performance and Reforms 479

The early part of macroeconomic reform saw changes in the exchange

rate system, the opening up of the economy to foreign investors and
adoption of current account convertibility. This necessitated the
financial system to undertake reform to keep pace with the changes in
the other sectors of the economy. The Indian experience suggests that
it was slightly ahead of the learning curve insofar as the implementation
of reforms in the financial sector was concerned. The process was
initiated through High-Level Committees that provided road maps for
implementation of reforms so as to progressively reach international best
standards while taking the unique country circumstances into
consideration. For instance, in the first phase, greater emphasis was
placed on policy deregulation (interest rate deregulation, easing of
statutory preemptions, etc.), improving prudential norms (imposing
capital adequacy ratio, asset classification, exposure norms, etc.),
infusing competition (permitting entry of new private sector banks),
diversifying ownership, developing money, debt and foreign exchange
markets (for risk-free yield curve and monetary policy transmission as
well as global integration), establishing regulatory and superviSory
standards (Board for Financial Supervision) and insisting on greater
transparency and disclosures. It was only in the second stage that many
legal amendments (Securities Contract Regulation Act, Government
Securities Bill, SARFAESI Act, etc.) and diversification of ownership
of public sector banks, etc., were undertaken.
The Indian experience also shows that there is no optimal
sequencing in respect of either policies or institutions, both within and
across countries. For instance, some countries that reformed after a
crisis did so with a'big bang', while others such as India followed a
'gradualist' approach. In fact, reforms in the financial and external
sectors were not treated as a discrete event, but as a continuous and
complementary process. For instance, in the Indian context, reforms in
the financial sector were undertaken in the early part of the economic
reform cycle and embraced the banking sector in view of its dominance
in the financial sector and the money and Government securities markets
initially in view of their inexorable linkages with the rest of the financial
system. Reform of development financial institutions, cooperative
banking institutions and non-banking financial companies followed.
Further, in India, prudential reforms were implemented first and the
structural and legal changes followed whereas in some countries, legal
changes have preceded prudential and structural reforms.
It is very critical that reforms maintain a balance between efficiency
and stability, especially in an emerging market economy like India.
4ao Irdian Ecorum1: Performance and Pzlicie[

Greater competition modifies the effectiveness of existing institutions.

It improves efficiency, increases incentives for innovation and promotes
wider access. There is, therefore, a need to modify existing institutions
to complement the new and better institutions. It is important that the
transition is managed without disruption to the market and the economy.
The Indian approach of cautious liberalisation vindicates this position,
since the balance between markets and the State is delicate. The Indian
experience shows that consultations with market practitioners, and the
announcement of a time table for reforms designed to give time for
market players to adjust goes a long way in ensuring stability.
The intervention of governments and the central bank in institution
building depends on specific country circumstance. In India, the
government and central bank were directly involved in institution
building from the time of Independence. However, the main difference
was that the pre-reform period was characterised by micro management
of institutions by government and central bank whereas in the post- 1991
period, institutions have had greater autonomy and flexibility in
operations and monitoring while regulations were more market based
and incentive driven. Effective institutions are those that are incentive
compatible. An important issue in the design of institutions is in ensuring
that the incentives that are created actually lead to the desired behaviour.
Greater competition modifies the effectiveness of existing institutions.
It improves efficiency, increases incentives for innovation and promotes
wider access. There is, therefore, a need to modify existing institutions
to complement the new and better institutions.
A well architectured financial system mitigates and diversifies risks,
but a badly designed system can lead to magnification of risks. The
challenge to policy-makers is to build a financial system that assists in
risk mitigation. It is well recognised by now, especially after the Asian
crisis, that a multi-institutional financial structure mitigates the risk to
the financial system. The Indian experience vindicates this stance.
Banks, DFIs, and capital markets have co-existed from the post-
Independence era; only that the character of these institutions has
changed depending on the evolutionary stage of the economy. In this
context, development of a domestic debt market becomes important. The
motivation for development of a debt market can arise from different
reasons viz., to develop corporate debt market, overall financial market
development, existence of a dominant Government securities market
(like in India), part of pension reform, etc. Globalisation can be a
driving force in this regard. In a simplistic sense, as market opens up
and forex reserves accumulate, the need for sterilisation itself would
 The Financial Sector: Structure, Performance and Reforms
4E1

motivate development of financial markets. As foreign investors and

foreign direct investment comes in, the need for transparency,
institutional mechanism, good settlement and payment systems, etc. will
predominate. The Government securities market is the most dominant
component of the debt market in India. Among others, the key elements
of development of Government securities market have been institutional
development, infrastructure development, technological infrastructure,
and legal changes.
A salient feature of the move towards globalisation has been the
intention of the regulators and the responsiveness of the authorities to
progress towards international best practices. An institutional process
in the form of several Advisory Groups set upon the task of
benchmarking Indian practices with international standards in areas
relating to monetary policy, banking supervision, data dissemination,
corporate governance and the like. Although the standards have evolved
in the context of international stability, they have enormous efficiency-
enhancing value by themselves. Standards by themselves may be
presumed to be, prima facie, desirable, and it is, therefore, in the
national interest to develop institutional mechanisms for consideration
of international standards. Thus, the implementation of standards needs
to be given a domestic focus with the objectives of market development
and enhancing domestic market efficiency (Reddy, 2002).

Conclusion
The Indian financial system today has a wide network of
institutions. The commercial banks have their presence in the most
remote parts of the country. The development of the different segments
of the financial system is, however, uneven. The cooperative credit
system is effective only in certain parts of the country. But new
institutions have come on the scene. The capital market has also become
more active, with both primary and secondary markets showing strong
upward movement.
The Indian financial development is a classic illustration of the
'supply leading' phenomenon under which financial institutions come
into existence first and then create the demand for their services. The
geographical spread of the Indian banking system was a conscious
policy decision. Regional disparities in the provision of financial
services have come down even though some states do complain of
inadequate provision of credit in relation to deposits mobilis'ed in their
states. The involvement of banks and financial institutions in the
4a2 Indiar Etonoarl: Perforttaace ail Policiet

schemes for providing creditto select segments of the society is very

active. Banks are also closely associated with credit linked poverty
alleviation programmes such as the Integrated Rural Development
Programme (IRDP), the Self-Employment Programme for Urban Poor
(SEPUP) and Self-Employment Scheme for Educated Unemployed
Youth (SEEUY). The experience with the poverty alleviation
programmes has been mixed, as revealed by many studies. Even where
such programmes have succeeded in raising the incomes of the
beneficiaries, the recovery performance has not been that good.
Reform efforts in terms of strengthening of prudential norms,
enhancing transparency standards and positioning best management
practices are an ongoing process. Efforts are also on for furtherance of
efficiency and productivity within an overall framework of financial
stability. Organised banking has made its presence felt in remote parts
of the country. Insurance, hitherto a public sector monopoly, has since
been transformed into a competitive market in both life and non-life
segments. Strengthening corporate governance in cooperative banks has
been making headway. Disclosures standards have been strengthened
for non-banking financial companies. DFIs are also restructuring
themselves in an era of global competition. A great deal of reforms has
been undertaken in most areas of financial sector, reflected in the
growing sophistication of the financial system. The resilience of the
system is reflected in terms of absence of any major crisis in the
financial system, a sustainable and broadbased growth environment,
lower levels of inflation and strong external sector position. No doubt,
the institutional framework in the financial sector had a major role to
play in this process and the globalisation process in the financial sector
has been beneficial for the economy. At the same time, the stance of
the authorities has been proactive, reacting to the macroeconomic policy
stance, global challenges and constantly endeavouring towards
international best practices. One can do no better than observe as to
what Jalan (2001) reminds us, in a similar veir'. "'..India of 2025 will
be a very different place, and a much more dominant force in the world
economy, than was the case twenty-five years ago or at the beginning
of the new millennium."
 " T,2

Foreign Tnde

Constraints Arising from Foreign Trade and

Import Substitution based Policies
INDIAN economic development strategy, particularly relating to
industrialisation has been driven by perceived foreign exchange
scarcities and the desire to ensure that scarce foreign exchange is used
only for purposes deemed 'essential' from the perspective of
development. Industrialisation and self-sufficiency in essential
commodities have been important objectives of policy because of the
fear that dependence on other, more powerful countries, for imports of
essential commodities would lead to political dependence on them as
well. Nearly a decade before Independence, in 1938, the National
Planning Committee was set up by the Indian National Congress (the
political party that led the struggle for Independence) under the
chairmanship of the future prime minister Jawaharlal Nehru. This
committee viewed, "... the objective for the country as a whole was the
attainment, as far as possible, of national self-sufficiency, International
trade was certainly not excluded, but we were anxious to avoid being
drawn into the whirlpool of economic imperialism."
Later the First-Year Plan went further:
"Control and regulation of exports and imports, and in the case of
certain select commodities state trading, are necessary not only from
the point of view of utilising to the best advantage the limited foreign
exchange resources available but also for securing an allocation of the
productive resources of the country in line with the targets defined in
the Plan."t

1. Planning Commission (1950). First Five Year Plan, p. 42.

 Intliar Economl: Perfornance and Polieiet
484

Inward Looking Strategy

India adopted an 'inward looking' strategy of industrialisation. This
strategy relied on encouraging domestic production for the domestic
market behind high tariffs and high degree of effective protection to
the domestic industry. This resulted in an uncompetitive domestic
industrial structure. T.N. Srinivasan has argued that the development
strategy based on import substituting industrialisation and the system
of controls that were implemented failed to produce rapid growth, self-
reliance, and eradication ofpoverty, but instead led to lacklustre growth,
an internationally uncompetitive industrial structure, a perpetually
precarious balance of payments, and, above all, rampant rent seeking
and the corruption of social, economic and political systems.2
Far from viewing foreign trade as an engine of growth, Indian
planners sought to minimise import demand and viewed exports more
or less as a necessary evil mainly to generate the foreign exchange
earnings to meet that part of the import bill not covered by external
assistance. They created an elaborate administrative regulatory
machinery in an attempt to control investment and resource allocation
in the economy and ensure their consistency with five-year plan targets.
Controls over imports and exports were also part of this regulatory
system.

Broad Tlends: Exports and ImPorts

Exports
1. 1950 to early 70s - Import substitution became the keystone
of development strategy in the late 1950s' Consequently,
exports were neglected by the Government' The value of
exports as a percentage of GDP at market prices declined from
an average ofover 6 per cent (1950-51 to 1955-56) to less than
4 per cent in the period following. This declining trend in the
value of exports continues till I97l-12 (Table 23.1). The
decline is in spite of the introduction of many incentive scheme
for the exporters in the sixties. The sixties can be seen as the
period of induction of export orientation through incentive
schemes for exports along with import substitution. With the
decision to devalue the rupee in 1966, changes in tariffs and
export subsidy policy, it was evident that the policy-makers
,.Foreign Trade Policies and India's Development", in Uma Kapila (ed.)'
2. Srinivasan, T.N.
Indian Economy Since Independence, ch.25 (2003-04 edition)'
Forcign Trade
4E5

were trying to use fiscal measures to step up exports and curb

imports. But, the incentives given to exporters could not offset
the bias against exports which was implicit in the over valued
exchange rate (except for 1966 devaluation) and the prevalent
level of import restrictions.

TABLE _ 23.1
Current Account Ttansactions as Per Cent of GDp at Market prices
(19s0-1990)

M X Trade X+M Net Current

Imports Exports Balance Invisibles Account
Balance

1 950-5 I 6.9 6.9 13.8 0.4 +0.4

1 960-6 I 6.8 3.9 -2.9 10.7 0.5 -2.4
1970-77 4.2 -J--1 -0.9 7.5 -0.1 - 1.0
I 980-8 I 9.5 4.9 -4.6 14.4 2.9 -r.5
I 990-9 1 9.1 6.3 -2.9 t5.4 0.1 -2.5
ifot? : Figures for 1990-91 are provisional.
source: lndia's Balance of Payments = l94B-49 to 1989-99. Department of Economic
Analysis and Policy, Reserve Bank of India, Bonbay, puUtiJhed in July 1993.

2. Early 70s to late 80s - The value of exports as a percentage

of GDP at market prices picked up after l97l-72 and increased
till end of seventies. Eighties again shows a declining trend in
value of exports with a recovery to over 6 per cent level only
in the last couple of years in eighties (Table 23.2).It was
realised after fhe first oil shock of 1973 that India had to step
up exports simply to finance the rising import bill on account
of an increase in oil prices.
Eighties can be viewed as a period of growing uneasiness with
the policies of excessive protectionism. The Abid Hussain
Committee on import and export policies (1995-1939)
recommended more liberal access to imports by exporters. The
second major recommendations of the Committee was that the
real exchange rate of the rupee should not be allowed to
appreciate and it should be maintained at a level considered
appropriate for ensuring the competitiveness of exports.
486 Irdian Econony: PerJormance and Policies

TABLE - 23.2
Value of Exports and Imports in the Planning Period
(US $ Million)
Year Exports Imports Trade Rate of Change
Balance Exports Imports

l 950-5 I 1269 t2'13 -4 24.9 -1.5

t960-6t 1346 23s3 -1007 0.3 t6.1
r910-7 I 2031 2162 - 131 8.8 3.5
1980-8 1 8486 15869 -73 83 6.8 40.2
1990-9 I 18143 24075 -5932 9.2 13.5
t993-94 22238 23306 -1068 20.0 6.5
1994-95 26330 286s4 -2324 18.4 22.9
1995-96 31797 36618 -48 8l 20.8 2 8.0
t996-97 33470 39133 -5663 5.3 6.7
1997 -98 35006 4t484 -6478 4.6 6.0
1 998-99 332t8 42389 -9111 -5.1 2.2
1999-2000 36822 49671 -r2849 10.8 17.2
2000-0 I 44560 50536 -597 6 2r.0 t.'7
200t-02 43827 51413 -75 86 -1.6 1.7
2002-03 52719 61412 -8693 20.3 t9.4
2003-04 63843 '78t49 -14306 2t.1 27.3
2004-os 80s40 109173 -28633 26.2 39.'7
2005-06

Source: Government of India, Economic Survey, 1998-99, Statement 7.1 (B) p. S-81 and
E c onomi c Su rv ey, 2O0O -0 1, 200 1 -02, 2OO3 -04, 2OO4-05, 2005-06, p. S-79.

3. 1990s - The 1990s have witnessed an increase in the value of

exports as a percentage of GDP at market price to over 8 per
cent from over 6 per cent level (Table 23.3). After the payment
crisis of 1990-91, when the foreign exchange reserves had
fallen drastically and were enough to pay for two weeks of
imports, the process of economic reforms was started in 1991.
The chief elements of reforms are devaluation of the rupee,
liberalisation of import licensing, reduction in tariffs, abolition
of cash subsidies for exports, introduction of partial
convertibility of the rupee on the current account and later full
convertibility of the rupee on the current account.
Foreign Tiade 487

TABLE _ 23.3
Current Account Tlansactions as a Percentage of GDP
at Current Market Prices 90s

Exports Imports Trade X, Current X+M

X M Balance M(Vo) Account
Balance

1990-91 5.8 8.8 -3.0 66.2 -3.1 14.6

t991-92 6.7 7.7 - 1.0 86.1 -0.3 r4.4
1992-93 7.r 9.4 )1 71 .6 -r .7 I 6.5
1993-94 8.3 9.8 -i.5 84.8 -0.4 18.1
t994-95 8.3 11.1 -2.8 748 -1.0 19.4
199s-96 9.1 12.3 -5.1 74.8 -t .7 2t .4
1996-97 8.9 t2.1 -3.8 69.7 -t.2 2t.6
1997 -98 8.7 12.5 -3.8 69.7 -t.4 2t.2
1998-99 8.3 11.5 -3.2 72.t -1.0 r9.8
1999-00 8.4 12.4 -4.0 67,8 -1.1 208
2000-01 9.8 r 3.0 -3. I 75.8 -0.5 22.8
200r-02 9.4 12.0 -2.6 85.2 0.2 21.4
2002-03 10.6 t2.1 )1 85.8 1 .2 23.3
2003-04 10.8 13.3 -2.5 81 6 1.8 24.1

Note : * Export-Import ratio is not given as a percentage of GDP at cunent market prices
Source: Economic Suneys.

After three successive years of robust growth at an annual average

of I9.7 per cent (in US Dollars) during 1993-94 to 1995-96, export
momentum slowed down since 1996-9'7, with exports registering a
modest growth of 5.3 per cent and decelerating further to 1.5 per cent
in 1997-98. Both global and domestic factors have contributed to the
slowdown in export growth in India since 1996-97. The share of East
Asian Countries in India's exports was around one-sixth before the
crisis, India could not escape the fall out from the import compression
in these countries. The slump in global trade and continued recessionary
phase has caused not only import contraction, but has also triggered
protectionist measures. Amongst the domestic factors that continue to
hamper exports infrastructure constraints, high transaction costs, SSI
reservations, labour inflexibility, quality problems and quantitative
ceilings on agricultural exports rernain problematic. The $rowth of
exports picked up in 1999-2000 and 2000-2001.
488 Indian Econonl: Perfornance ail Policiet

India's merchandise exports (in dollar terms and customs basis),

by continuing to grow at over 2O per cent per year in the last 3 years
since 2002-03, have surpassed targets. In 2004-05, export growth was
a record of 26.2 per cent, the highest since 1975-76 and the second
highest since 1950-51. Supported by a buoyant world economy (5.1 per
cent). The good performance of exports (growth of 18.9 per cent)
continued in April-January 2005-06, despite the slightly subdued growth
of global demand, and floods and transport disruptions in the export
nerve centres of Mumbai and Chennai.

TABLE _ 23.4
Performance of the Foreign Trade Sector
(Annual Percentage Change)

Year Export Value in Import Value

US Dollar in US Dollar

1 990-2000 1 .'I 8.3

I 990-95 8.t 4.6

1 995-2000 t.J 12.0

2000-0 1 21 .0 1.1

200t-02 -1.6 r.7

2002-03 20.3 194
2003-04 2t.r 27.3

2004-05 26.2 39.7

2005-06 (April-January) 18.9 26.7

Source : Economic Survey,2005-06.

Factors for Export Growth since 2002-03

Both external and domestic factors have contributed to the
satisfactory performance of exports since 2002-03. While improved
global growth and recovery in world trade aided the strengthening of
Indian exports, firming up of domestic economic activity, especially in
the manufacturing sector, also provided a supporting base for strong
sector-specific exports. Various policy initiatives for export promotion
and market diversification seem to have contributed as well. The
opening up of the economy and corporate restructuring have enhanced
the competitiveness of Indian industry. Infact India's impressive export
growth has exceeded world export growth in most of the years since
 Foreign Tiade
489

1995; but, since 2003, it has lagged behind the export growth of
developing countries taken together, mainly because of China,s
explosive export growth. India's share in world merchandise exports,
after rising from 0.5 per cent in 1990 to 0.8 per cent in 2003, haJbeen
stagnating at that level since then with marginal variation at the second
decimal place (Table 23.5). This is a cause for concern. Foreign Trade
Policy (FTP) 2004-2009 envisages a doubling of India's share in world
exports from 0.75 per cent to 1.5 per cent by 2009. To achieve this
target, Indian exports may need to exceed US$ 150 billion by 2009 as
world exports are also growing fast.

TABLE - 23,5

Export Growth and Share in World Exports of Selected Countries

Percentage Growth Rate Share in World Exports 2004

Value
Country 1995-01 2003 2004 2005* 2001 2003 2004 2005* ($ bn)

China 12.4 34.5 35.4 32.1 4.3 59 6.6 7.2 593.0

Hong Kong 3.6 lt.9 15.6 11 4 3. I 3.0 2.9 2.8 259.0
Malaysia 6.6 6 5 26.5 12.1 1.4 1.3 t.4 1.4 r2s.7
Indonesia 5.1 5.1 t1 .2 44.6 0.9 0.9 0.8 0.8 7 t.3
Singapore 4.t 15.2 24.5 14 8 2.0 1.9 2.0 2.0 179.6
Thailand 5.9 r7 .l 20.0 r2.9 1.1 1.1 1.1 1.1 96.0
India 8.s 15.8 25.1 2l .0 0.7 0.8 0.8 0.8 7 1 .8
Korea 7,4 19.3 30.9 18 1. 2.s 2.6 2.8 2.8 254.0
Developing
countries 7.9 18.4 27.1 2t.2 36.8 38.8 40.7 42.4 3685.1
World 5.5 1s.9 2t.2 14.9 100.0 100.0 100.0 100.0 9049.8

Source: Economic Survey, 2005-06.

While high growth in global output and demand, especially in the

major trading partners of India, helped, it was the pick up in domestic
economic activity, especially the consistent near double-digit growth in
manufacturing, that constituted the main driver of the recent export
surge. In 2004-05, India's manufacturing exports grew by 2l per cent
and had a share of around 74 per cent in total exports.
Further productivity gains in the export sector require a deepening
of domestic reforms, and an accelerated removal of infrastructure
 Indian Economl: Perfornarce ard Paliciet
490

bottlenecks, including export infrastructure. Infrastructure remains the

single most important constraint to export growth. Achievement of the
ambitious export target set in Foreign Trade Policy (2004-2009) requires
a projected augmentation of the installed capacity of ports by 140 per
cent. Indian ports, which handle over 70 per cent of India's foreign trade
even in value terms, have a turnaround time of 3-5 days as against only
4-6 hours at international ports like Singapore and Hong Kong. As for
internal transport, while there has been a perceptible improvement in
the national highways, secondary roads need to be improved and the
issue of delays caused at inter-state checkpoints need to be addressed.
Exporters need to place more emphasis on non-price factors like product
quality, brand image, packaging, delivery and after-sales service. A more
aggressive push to FDI in export industries will not only increase the
rate of investment in the economy but also infuse new technologies and
management practices in these industries.
The strengthening of Indian exports has been aided by positive
trends in global demand, which was also reflected in world trade. After
a sharp downturn in 2001, volume growth of world merchandise trade
rebounded to 3.0 per cent in 2002 and further increased by 4.5 per cent
in 2003. According to World Trade Organization (WTO), real
merchandise trade accelerated by nearly l0 per cent in the first half of
2004, and is estimated to have grown in 2004 by 8'5 per cent, or nearly
twice as fast as in the preceding year.
Imports
1. 1950 to early 1970s - The value of imports as a proportion of
GDP at market prices, fluctuated through the 1950s (around 6
to 9.8 per cent) and thereafter declined slowly till the early
1970s (from 6.8 per cent in 1960-61 to 4.2 per cent in 1972-
73, Table 23.1).
The severe foreign exchange crisis of 1956-57 led to the
adoption of strict measures for import controls. The import
licensing system was intensified in the late fifties and early
sixties. After a brief attempt at using fiscal measures instead
of physical controls in mid-sixties, the import licensing was
intensified. Import policy became increasingly restrictive and
complex. The quantitative restrictions were used to provide
protection to any domestic activity that substituted for imports'
The decline in public investment and industrial growth after the
mid-1960s also contributed to reducing the pressure on imports'
Foreign Trade 49r
2. Early 1970s to late 1980s - After 1972-73, the value of
imports as a proportion of GDP showed a distinct increase. The
import needs became stronger as the industrial growth
recovered in mid-seventies and showed an accelerating trend
in the 1980s. The eighties is marked with a clear shift in the
trade strategy towards reduction of quantitative restrictions on
imports. The number of items in the category of OGL-that
is, a licence to import but with no quantitative restrictions-
increased substantially in this period. The rise in the value of
imports as a proportion of GDP at market prices is in spite of
the sharp increase in tariffs in eighties. The value of imports
as a proportion of GDP increased from a level of 4.6 per cent
(I973-74) to over 6 per cent in the remaining years of
seventies. It was around 8 to 9 per cent in the decade of eighties
(Table 23.1).
3. 19903 - The value of imports as a proportion of GDP at market
prices show a distinct increase in the 1990s except for 1991-
92. The decline in l99l-92 was due to severe import curbs
introduced after the payment crisis of 1990-91. The value of
imports as a proportion of GDP increased from 8.8 per cent in
1990-91 to 12.5 per cent in 1997-98 and 13 per cent in 2000-
01 (Table 23.3).
Merchandise imports displayed strong growth in 2OO3-04, and rose
faster than exports. Lower tariffs, a cheaper US dollar and a buoyant
domestic economy boosted imports. Imports, in US dollar terms and on
customs basis, increased by 27.3 per cent in 2OO3-04, on top of a rise
of 19.4 per cent in the previous fiscal.
Growth in India's merchandise imports in 2004-05 at 40 per cent
in dollar terms was the highest since 1980-81. This surge in growth in
2004-05 was mainly due to the steep rise in price of crude petroleum
and other commodities with value of POL imports increasing by 45.1
per cent. While volume growth in import of POL was subdued at 6.4
per cent, largely in response to the price increase, larger imports filled
the gap between growing demand and stagnant domestic crude oil
production. In 2004-05, lower tariffs, a cheaper US dollar, a buoyant
manufacturing sector and high export growth boosted non-oil imports
by 39 per cent, particularly capital goods, intermediates, raw materials
and imports needed for exports. Buoyant growth of imports of capital
goods at 2I per cent, on top of the 40 per cent growlh in 2003-04,
reflected the higher domestic investment and firming up of
manufacturing growth. A significant contributor to the rise in non-POL
492 Indiau Ecoronl: Performance ail Policles

imports was the 59.6 per cent growth of gold and silver on the back of
a 59.9 per cent growth in 2003-04, due to the high international gold
prices. The duty reduction on imported gold from Rs.250 to Rs.100 per
10 gram and liberalisation of such imports as per trade facilitation
measures announced in January, 2004 could also have provided a fillip.
Non-oil, non-bullion imports increased by 31 per cent in 2OO4-05,
compared to a rise of 28.5 per cent in 2003-04.
Unlike in 2003-04, the surge in POL imports in 2004-05 and 2005-
06 (April-November) was dominated by the price impact. International
crude oil (Brent variety, per barrel) prices, trending upwards since 2002,
on average, rose from US$ 27.6 in 2002-03 to US$ 28.9 in 2003-04,
US$ 42.1 in 2004-05, and further to US$ 56.64 per barrel in April-
November 2005 with a peak of US$ 67.33 on August 12,2005'The
stiffening of global crude oil prices was contributed by a combination
of heightened demand, limited spare capacity and geopolitical threats
to the existing capacity. The surge in crude oil prices has sharpened the
focus on the adverse impact of such volatility on domestic prices and
the need to minimise such impact. Given India's relatively high oil
intensity and increasing dependence on imported crude oil, efforts are
being made to diversify sourcing of such imports away from the
geopolitically sensitive regions. Another development has been the
decision to build up strategic oil reserves, equivalent of about 15 days
requirement, to minimise the impact of crude price volatility in the short
term. In a related initiative, India is coordinating with large oil importing
countries in Asia, in exploring possibilities for evolving an Asian
products marker, in place of an Asian premium, which would reduce
the premium paid by Asian countries and thus, to some extent help in
controlling the country's oil import bill.
Bulk of the increase was contributed by growth in non-oil imports,
which shot up from 17.0 per cent in2002-03 to 31.5 per cent in2003-04.
The acceleration of such imports was mainly due to higher imports of
capital goods, industrial raw materials and intermediate goods. It reflected
the higher domestic demand and firming up of industrial growth'

Factors for Imports Growth

Imports continued to rise at a rate faster than that of exports in
the current financial year, rising by 34.7 per cent in April-January'
2OO4-05 on back of good industrial performance and rising international
crude oil prices. The rise has been contributed by a continuing robust
growth in non-POL imports of 32.7 per cent and acceleration in POL
 Foreign Tiede
493

India moved one notch up the rankings in both exports and imports
in 2004 to become the 30th leading merchandise exporter and 23rd
leading merchandise importer of the world.

Changing Structure of India,s Foreign Tbade

In order to study the structure of India's foreign trade we have to
analyse the changing pattern of imports and exports.
Since the purpose of the import control regime was to confine
imports to essential consumer goods, raw materials, and investment
goods needed for domestic production and exports, it is not surprising
that changes in the commodity composition of India's imports reflected
this. For example, foodgrains and edible oils accounted for about 16
per cent oftotal imports in 1960-61, and about I per cent in lgg0-gl.
Imports of gems, which were negligible in 1960-61, accounted for US
$ 2'079 million or nearly 8 per cent of imports in 1990-91, reflecred
the fact that gems and jewellery exports at $1.667 million comprised
nearly a sixth of total exports. The share of crude petroleum, oils, and
lubricants in total imports rose from about 6 per cent in 1960-61 to a
high of roughly 40 per cent in 1980-81. However, it fell to about 23 per
cent partly on account offall of crude petroleum prices and partly also to
rapid growth of domestic crude output from the Bombay High Field.
Turning to exports, India's share of world exports has fallen steadily
from about 2per cent in 1950 to less than 0.5 per cent in 1990. Since
world export grew rapidly between 1950 and 1973 and somewhat more
slowly thereafter, India's exports grew in absolute terms in spite of a
declining share. But the dramatic fall in share reflects the fact tlat other
countries were able to take greater advantage of growing world trade.
The composition of India's exports has, as expected, shifted
moderately away from primary products to manufactured goods, whose
share rose from about 45 pu cent in 1950-5 1 to 79 per cent in 1990-
91. However, primary exports have been virtually stagnant, and
manufactured products have accounted for almost the entire growth in
total exports (Table 23.7). Among manufactured products, just four
items leather, gems, garments, and textiles-accounted for most of the
Foreign Trade
495

growth in recent years. In contrast, the export of engineering goods,

which rose by over 20 per cent per year in value terms between 1950-
51 and 1975-76 and between l97O-71 and 1978-79, declined between
1980-81 and 1985-86.
The export of gems has grown rapidly since the early 1970s. This
export is heavily dependent, however, on the import of uncut small
gems, the cost of which is determined in large part by the South African
monopoly De Beers. The exports of garments and textiles are governed
by India's quotas under the Multi-Fibre Arrangement (MFA). Bhalla
(1989) points out that until the 1980s, India did not fully use quotas,
and India's competitors did better in quota, as well as, non-quota
countries. It is possible that the spurt in India's garment and textile
exports reflects better use of quotas and higher prices realised on the
average. Whether India will be able to compete in the textile and apparel
market in the absence of the MFA is debatable, particularly in view of
the fact that the Indian textile industry has fallen behind technologically
in the past four decades primarily because of the government's textile
policy.
During the high-growth phase of India's exports, that is, between
1993-94 and 1995-96, major export items which had contributed
significantly to the growth process included engineering goods, cotton
yarn, fabrics, chemicals and allied products, rice, coffee, processed
fruits, juices and miscellaneous processed items and marine products.
The growth rates of export of all these items have dropped considerably
during 1996-1998. Among the manufactured exports, the deceleration
of growth rate has been most marked for engineering goods. Within the
agricultural and allied products group, export levels of both rice and
coffee declined between 1995-96 and 1997-98.3

Comparison between 90s and 80s

For the purpose of analysis at the aggregate level, India's trade
performance during 1992-93 to 1998-99 (referred to here as the nineties)
has been compared with that during 1980-81 to 1990-91 (the eighties).
The year l99l-92 witnessed considerable strain on the balance-of-
payments. To meet the crisis, severe restrictions were placed on imports
and the Rupee was adjusted downward in July 1991. Being an
exceptional ycal l99I-92 should be excluded in any time series based
analysis of trade developments. The periodisation of the analysis
captures the structural shifts in the growth of exports and imports during

3. Reserve Bank of India (1997-98). Report on Currency and Finance, Yol. 1

Foreign Trade 497

the sub-periods. For instance, on an average annual basis, export growth

during 1992-93 to 1998-99 at 9.8 per cent was higher than that of 8.2
per cent registered during 1980-81 to 1990-91. Similarly, the average
import growth observed during the nineties at 12.0 per cent remained
substantially higher than that of 7.8 per cent recorded during the eighties
(1980-81 to 1990-91).
The world trade has undergone significant changes since 1996 due
to a host of developments including a sharp fall in international prices
for manufactured products and the emergence of economic crises in
certain parts of the world. In addition, protectionist policies and
practices adopted by various industrialised countries during the recent
years and perhaps most importantly anti-dumping and countervailing
measures seriously affected the export efforts of the developing
countries (Stiglitz, 1999). These unfavourable factors have had their
impact on the developing countries including India's trade performance.
In the light of the above factors, it would be appropriate to examine
the trade performance of India during the two sub-periods of the
nineties; the first sub-period covering the first four years following the
introduction of reforms (i.e., 1992-93 to 1995-96) and the second sub-
period consisting of the subsequent three years (i.e., 1996-97 to 1998-
99). During the first sub-period, on an average basis, India's exports
and imports increased by 15.7 and 17.5 per cent, respectively, which
were significantly higher than the growth rates during the eighties.
Broadly in line with the unfavourable external developments, between
1996-91 and 1998-99, growth in India's exports and imports, on an
average basis, decelerated to 2.0 per cent and 4.5 per cent, respectively.
India's share in world exports, which had declined from 0.52 per cent
to0.47 per cent between 1984 and 1987, improved to 0.53 per cent in
1992. Notwithstanding the slowdown in India's export growth since
1996, reflecting the relatively better performance by India yis-ti-yis rest-
of-the-world, its share in global exports reached 0.62 per cent during
1997 (rMF, 1998).

Trade GDP Ratio

India's trade-GDP ratio showed substantial improvements during the
nineties as compared with the eighties. The export-GDP ratio declined
from 4.9 per cent in 1980-81 to 4.2per cent in 1985-86 and thereafter
it gradually improved and reached 6.1 per cent in 1990-91. During the
nineties, the ratio reached its highest level at 8.7 per cent in. 1995-96.
The ratio declined, marginally, during the next three years and was at
498 Irdian Economl: Petlormance and Policiet

8.1 per cent in 1998-99. On an average basis, export-GDP ratio

increased from 5.0 per cent to 8.2 per cent between the eighties and the
nineties. Between these two periods, on an average basis, India's import-
GDP ratio increased from 7.7 per cent to 9.4 per cent. The noticeable
improvements in the export-GDP and import-GDP ratios point to the
increasing openness of India's foreign trade regime to global trade.

TABLE - 23.8

India's Foreign Trade Ratios

(Per Cent)
Period Average X/GDP M/GDP T/GDP X/M

1980-81 to 1989-90 4.6 7.2 I1.8 64.0

1990-91 to 1999-00* 8.0 9.5 t7.4 84.1
1990-91 ro 1994-95* '7.3 8.4 15.7 86.9
1995-96 to 1999-00 8.5 lo.4 18.9 81.8
2000-01 to 2001-02 9.4 10.8 20.2 86.7

Notes : * Excluding l99l-92.

X =Exports, M-Imports, T=Exports+Imports, GDP=Gross Domestic Product at cur
rent market prices in rupees.
Sources :1. Directorate General of Commercial Intelligence & Statistics.
2. Economic Szney, (various years) Govemment of India.

Ihade Deficit-GDP Ratio

Along with the increase in trade-GDP ratio, there has been a decline
in India's trade deficit-GDP ratio between the two periods. This is borne
out by the fact that the difference between export and import-GDP ratio
on an average basis, declined from 2.7 per cent in the eighties to 1.2
per cent in the nineties. This indicates that the divergence between
export and import performance was more pronounced during the eighties
than in the nineties. Similarly, the export-import ratio (on an average
basis) increased substantially from 65.1 per cent during the eighties
to 87.0 per cent during the nineties reflecting thereby the increasing
alignment between India's export and import performance during the
nineties as compared with the eighties.
Foreign Tiade 499

Structural Change in Exports

Changes in of Broad Categories
Terms
Reflecting the development of a large
and diversified industrial
sector, during the post-Independence period, India has gradually
transformed from a predominantly primary product exporting country
into an exporter of manufactured products. In the mid-eighties,
manufactured exports accounted for about two-thirds of India's total
exports while the rest comprised of primary products. During the years
preceding the introduction of economic reforms, i.e., between 1987-88
and l99l-92, while the share of manufactured goods increased from
67.8 per cent to 73.8 per cent, that of primary products declined from
26.1 per cent to 23.1 per cent. These trends were reinforced during the
subsequent period (i.e.,1992-93 to 1998-99). On an average basis, the
share of manufactured products increased by 4 percentage points while
that of primary commodities declined by 2 percentage points between
the eighties and the nineties. The share of residual exports including
petroleum products declined almost continuously between 1987-88 and
1998-99.
An analysis of the commodity composition of India's exports shows
that the combined share of the top six export categories, namely, gems
and jewellery, readymade garments, engineering goods, textile yarn,
fabrics, made-ups, etc., leather and manufactures and chemicals and
allied products increased steadily r^'om 59.4 per cent in 1987-88 to 65.7
per cent it l99l-92. On an average basis, the combined share of these
exports at 66.8 per cent during the period 1992-93 to 1998-99 was
3 percentage points higher than that during the eighties.
The increase in the share of the top six categories of exports in the
total exports by 9 per cent between 1987-88 and 1998-99 reflects a rise
in the concentration of India's exports in terms of broad export
categories. It may, however, be mentioned that each of these top export
categories consists of a large number of individual items. Even if the
expilrt shares of traditional items within a broad category decline, the
share of the whole product category in total exports can increase due to
appearance of newer products within that group. The emergence of
newer export items, however, indicate export diversification and in order
to get a clear picture about the change in the concentration of exports,
it is essential to examine the issue at a more disaggregated level.
Commodity Camposition: Exports
The changes in the structure of India's exports is more noticeable
500 Indian Ecanany: Perfarttance aud Policies

at the disaggregated level. Items that registered considerable

improvements in relative export performance between the eighties and
the nineties include coffee, processed fruits, juices and miscellaneous
processed items, rice, spices, works of art excluding floor coverings and
other items like sugar and mollases and raw cotton (not elsewhere
included). On an average basis, the total export earning from these six
items taken together declined by 2.9 per cent in the eighties, while they
registered an impressive 20.5 per cent growth rate in the nineties. Items,
which have exhibited steady relative export performance through the
two periods include drugs, pharmaceuticals and fine chemicals, other
agricultural and allied items, cotton yarn, fabrics, made-ups, etc. On an
average basis, the total export earning from these three items taken
together increased by 16.1 per cent and 12.8 per cent during the eighties
and the nineties, respectively. The relative export performance of items
such as oil meal, hand-made carpets excluding silk carpets, other ores
and minerals and rubber, glass, paints, enamels and products worsened
considerably during the nineties as compared to the eighties. As against
an average growth of 18.1 per cent during the first period, the average
growth rate of export earnings by these four items taken together
decelerated sharply to 6.5 per cent during the nineties. Items which
registered relatively low growth rates during the both periods include
cashew, gems and jewellery, iron ore, leather and manufactures, natural
silk yarn, fabrics, made-ups, etc., petroleum products and tea. The
combined export earnings of these seven items taken together, on an
average basis, increased by 6.3 per cent and 6.7 per cent, during the
pre-I992 and post-1992 periods, respectively.
The change in the relative performance of individual export items
between the two periods indicates that the change in the structure of
agriculture and allied exports has been more marked than manufactured
exports. Items such as coffee, rice, processed fruits, juices and
miscellaneous processed items remained relatively less important export
items during the eighties. These items, however, can be identified as
crucial emerging exports during the nineties. In terms of average growth
rate, these exports had declined by 3.2 per cent in the eighties, while
they increased by an impressive 29.7 per cent in the nineties. The
combined share of these three exports in India's total agricultural and
allied exports had declined ftom23.3 per cent in 1987-88 to 15.4 per
cent in 1990-91. Their share more than doubled to reach 34.2per cent
in 1998-99. Alongside the emergence of newer products, the relative
importance of some of India's traditional agricultural and allied export
items such as cashew, oil meal, tea and tobacco declined considerably
Foreign Tiade
501

as between the two periods. On an average, the growth rate of these

exports decelerated from 7.9 per cent in the eighties to 4.2 per cent in
the nineties. More importantly, their combined share in total agricultural
and allied exports, which increased from 38.1 per cent in 1987-88 to
43.6 per cent in 1989-90, declined sharply to 26.2 per cent in 1998-99.

Mov e Towards Value -addition

There are indications that during the nineties, some of the Indian
exports have moved upwards in the value-addition chain whereby
instead of exporting raw materials, the country has switched over to the
export of processed items. For example, while the value of iron ore
exports declined, that of primary and semi-finished iron and steel
increased many fold between the two periods. Reflecting this trend, the
share of ores and minerals in total exports declined, on an average basis,
from 5.5 per cent to 3.5 per cent between the eighties and the nineties.
There were also significant compositional shifts within the major
manufactured product groups such as engineering goods, chemicals and
allied products, etc. as between the two periods. On an average basis,
the share of basic chemicals, pharmaceuticals and cosmetics within the
chemicals and allied group, declined from 7 I .4 per cent to 62.4 per cent
between the eighties and the nineties. In particular, the average export
share of cosmetics, toiletries, etc. within this group declined sharply
from 12.4 per cent to 4.7 per cent between these two periods. Within
the same group, the average export share of plastic and linoleum
increased from 6.4 per cent during the eighties to I3.2 per cent in the
nineties. Among the components of engineering goods, the average share
of machinery and equipment in total engineering exports declined from
30.6 per cent to 2I.7 per cent while that of primary and semi-finished
iron and steel increased from 2.9 per cent to 11.9 per cent as between
the two periods. Among the textile products, while the importance of
man-made yarn, fabrics, made-ups increased as between two periods,
that of jute manufactures declined sharply. The internal export
composition of leather and leather manufactures and readymade
garments remained stable before and after the initiation of economic
reforms.

Moving Away from Traditional Exports Towards

New Manufactured Products
India's manufacturing exports are showing tendencies of shifting
away from traditional exports towards relatively new manufactured
products. Another interesting point about the compositional change in the
502 Indian Ecozottl: Petfotnance anl Policies

manufactured exports is that, by and large, major export items within the
category for which internal composition remained unchanged between
the eighties and the nineties (e.g., leather and leather products, ready-
made garments) recorded relatively poor export performance as
compared with groups which recorded changes in their internal
composition (e.g., chemicals and allied products, engineering goods).
This indicates the existence of a close link between export performance
and structural change in the case of India's manufactured exports.
As mentioned earlier, since 1996-97 therc has been a marked
deceleration in the growth of India's manufactured exports. Apart from
its negative impact on the overall export growth, a fall in the growth of
manufactured exports also likely to have constrained structural
transformation within the category of manufactured exports. A number
of external as well as domestic factors contributed to the process of
slowdown in India's exports in general and manufactured exports in
particular. These included: decline in international manufactured prices,
increased protectionism by the industrialised countries coupled with
non-implementation of the transitional agreements on integration of
trade in textiles and clothing with the WTO by the industrialised
countries. While these factors had adverse implications for Indian
manufacturing exports, particularly exports of engineering goods,
chemicals and allied products and textiles and clothing, the sharp price
fluctuation in the international market for raw diamonds and gold
between 1996 and 1998, had contributed to the decline in gems and
jewellery exports, the single largest export item of India.

India's Share in Global Exports:

Compositional Change
The foregoing discussion focuses solely on the internal change in
the commodity composition of India's exports. It is also important to
study whether there has been any change in India's share in global trade.
It may be noted that commodities for which India's share in global
exports have increased considerably as between the two periods include
rice, coffee and substitutes, feeding stuff for animals, textile yarn (in
particular, cotton yarn), pearls, precious and semi-precious stones and
gold and silver jewellery. Items for which India's global export share
declined as between the two periods include shellfish, tea and mate,
spices, iron ore concentrate, leather, leather manufactures and certain
categories of textile and garment articles.
It is interesting to note that during the eighties, there were many
Foreign Trade
503

export items for which India's global market shares were high while
growth in world trade for those products was low. It is argued that
lack of alignment between the composition of India's export basket
and the demand structure in foreign markets has been a major
constraint for expansion of India's exports. Reversing such trends,
during the nineties, by and large, India's global shares have improved
for those commodities for which world trade showed relatively high
growth potential and India's global shares declined for those
commodities for which growth in world trade decelerated. In other
words, the alignment between the structure of world demand and the
composition of India's exports has improved during the nineties as
compared to the eighties. This is likely to have major impact on the
future behaviour of India's exports.
India's export share in world trade has increased perceptibly during
the recent period. India's exports as a percentage of world exports
improved to 0.56 per cent during 199l-1996 and further to 0.65 per
cent during 1996-2002 from 0.48 per cent in the 1980s. The ratio was
0.71 per cent in 2000-01, the highest achieved so far since the 1970s.
Nonetheless, India's share in world exports is still very low and appears
unimpressive when compared with the other major trading Asian
countries, such as, China and other East Asian economies like Malaysia,
Thailand, Singapore, Korea and Indonesia (Table 23.9). China
demonstrated the most dramatic change as its share in world exports
more than doubled in a decade from 2.0 per cent in 1991 to 4.4 per
cent in 2001. Group-wise, India's share in the imports of industrialised
countries in the 1990s declined as compared to that in 1986. Inrespect
of the developing countries as a group, however, it has increased from
0.5 per cent in 1986 to 1.1 per cent during 1996-2000.
The Ministry of Commerce and Industry, Government of India has
set an export target of I per cent share of world exports by 2006-07 for
the medium-term which would be co-terminus with the Tenth Five year
Plan. This target is based on historical trends, current prospects and
the requirement of a compound annual growth rate of about 12 per cent
for exports till the year 2006-07 (Government of India, 2002a). The
export performance is known to depend on price competitiveness, as
well as non-price factors. As regards the price competitiveness, a
number of earlier studies have emphasised that real exchange rate may
be an important variable influencing the price competitiveness of India's
exports. In India, large exchange rate misalignment has not oCcured in
the last one decade as the market itself has corrected the misalignment
gradually over different episodes.
504 Inlian Econanl: Prfornance and Po/icies

TABLE _ 23.9
Share of Select East Asian Countries in World Exports
(Per Cenr)

Average
Country I99I 1995 1999 2001 I99r- 1996-
1995 2000

India 0.5 0.6 0.6 0.7 0.7 0.6 0.6

China 2.0 2.9 3.5 4.0 4.4 2.5 3.4
Indonesia 0.8 0.9 0.9 1.0 0.9 0.9 0.9
Korea 2.0 2.4 2.6 2.7 2.5 3.0 2.5
Malaysia 1.0 1.4 1.5 1.6 t.4 1.2 1.5
Singapore 1.7 2.3 2.0 2.8 2.0 2.0 2.3
Thailand 0.8 1.1 1.0 1.0 2.0 1.0 1.0

Source : Intemational Financial Sratistics, February 2003.

India's export performance is affected by domestic as well as

external impediments. The domestic factors inhibiting India's export
growth are infrastructure constraints, high transactions cost, small-scale
industry reservations, inflexibilities in labour laws, lack of quality
consciousness and constraints in attracting FDI in the export sector.
High levels of protection in relation to other countries also explain why
FDI in India has been much more oriented to the protected domestic
market, rather than as a base for exports. The exports of developing
countries like India are facing increasing difficulties by emerging
protectionist sentiments in some sectors in the form of technical
standards, environmental and social concerns besides non-trade barriers
like anti-dumping duties, countervailing duties, safeguard measures and
sanitary and phyto-sanitary measures. Indian products which have been
affected by such barriers include floriculture products, textiles,
pharmaceuticals, marine products and basmatl rice exports to the
European Union and mushroom and steel exports to USA and also
grapes, egg products, gherkins, honey, meat products, milk products,
tea, and spices. Differential tariffs against developing countries have
also adversely affected market access into these countries (Government
of India, 2002b; WTO, 2002). According to the WTO, exporrs from
India are currently subject to 40 anti-dumping and l3 countervailing
measures mainly for agricultural products, textiles and clothing products
Foreign Trade 505

and chemicals and related products. This brings into focus the
importance of non-price factors like quality, packaging and the like
mentioned earlier, where India still seems to be lacking as compared to
the international standards. This has adversely affected India's export
performance vis-d-vis other developing countries which may have an
improved standing in these non-price factors.

Commodity Composition of Imports

In the discussion on the structural change in India's imports in this
sub-section, the relative shares of the major commodities/groups in total
imports should generally be exclusive of gold and silver imports. This
has been done keeping in view the sharp increase in gold and silver
imports in the recent years, which obscures the changes in the relative
shares of other items. The import of gold and silver rose from US $ 4
million in 1990-91 to US $ 4,876 million in 1998-99 and formed as
much as ll.6 per cent of India's total imports during that year.
The relative share of capital goods in India's total imports net of
gold and silver improved, marginally, from 25.6 per cent during 1987-
9l to 26.0 per cent during 1992-1999. Within the capital goods group,
the rise in import was more pronounced in the case of manufacture of
metals, machine tools, and electrical machinery (including electronic
and computer goods), while that of non-electrical machinery and
transport equipment recorded a relatively low order of increase. While
the overall increase in the import of industrial raw materials and
intermediate goods was less pronounced, certain individual items mainly
catering to export activities such as cashew nuts, textile yarn, fabrics,
made-ups etc., and chemicals (organic and inorganic), however,
recorded sharper rise.
Among other items, the imports of petroleum (crude and products)
showed wide fluctuations, reflecting inter alia, the movements in
international prices. There was a sharp increase in its import during
1989-90 (25.2 per cent) and 1990-91 (60.0 per cent) and the average
annual growth rate during 1988-1991 was considerably higher at27.2
per cent as compared with the 12.0 per cent growth in total imports.
After attaining a high base in 1990-91, the oil imports declined during
1991-92 by ll.7 per cent. During the period 1992-93 to 1998-99, the
growth rate in oil imports ranged between 33.4 per cent in 1996-97 and
a negative of 21.2 per cent in 1998-99. Although the average annual
growth rate of this item during 1992-1999 was low (4.6 per'cent), the
average value at US $ 7,134 million stood79.2 per cent higher than
506 Indian Econonlt: Performance and Policiet

US $ 3,981 million during 1987-199I. Consequently, the relative share

of oil imports moved vp to 22.5 per cent during 1992-1999 from 19.4
per cent during 1987-1991.
Similarly, the average level of import of manufactured fertilisers
during 1992-1999 also stood 77 .7 pet cent higher than that during 1987-
1991, although the average annual growth rate remained considerably
lower at 9.5 per cent during 1992-1999 than that of79.5 per cent during
1988-1991. The increase in the imports of consumption goods was
relatively less pronounced (27 .3 per cent), with its share dropping from
4.3 per cent during 1987-199I to 3.6 per cent during 1992-1999. Within
this category, the import of edible oils, however, increased by 55.9 per
cent and that of sugar increased by 269.3 per cent.
The changes in the structure of India's imports are reflective of the
influence of three factors:
(1) movements in international prices;
(2) changes in trade policy; and
(3) pattern of domestic demand.
The role of international prices in shaping the trends in the import
of petroleum, crude and products has already been discussed earlier.
This apart, it may be indicated that the international prices of
manufactured goods have declined considerably during the recent years,
keeping their import value depressed.
The surge in the imports of gold and silver, edible oils and
manufactured fertilisers were to some extent policy driven. Similarly,
reflecting the impact of further easing of the restrictions on the import
of capital goods, these items recorded higher import growth during
1992-1999. Since a sizable part of India's imports cater to the needs of
the industrial sector, the trends in the demand for imports may be judged
from the overall growth in industrial production.

Direction of Foreign TFade

Prior to Independence, a large part of India's trade was either
directly with Great Britain or its colonies or allies. This pattern
continued for some years after Independence as well since India had
not till then explored the possibilities of developing trade relations with
other countries of the world. For example, the combined share of UK
and USA in India's export earnings was 42 per cent in 1950-5 l. Their
share in India's import expenditure was as much as 39.1 per cent in the
Foreign Tiade 507

same year. With other capitalist countries like France, Germany, Italy,
Japan, etc. India either did not have trade relations at all or they were
very insignificant. As political and diplomatic contacts developed with
other countries, economic relations also made a headway. Thus new
vistas for developing trade relations with other countries opened up.
The situation has changed very much since, and now after four and a
half decades of planning, the trading relations exhibit marked changes.
The diversification in trade relations has reduced the vulnerability of
the economy to outside political pressures.
In the year 1950-51, the share of UK in India's imports was 20.8
per cent and that of USA was 18.3 per cent. Thus, the combined share
of these two countries was 39.1 per cent. This reflected the colonial
heritage of the country. Within a decade, the picture started showing
some changes. New trading partners like West Germany, Canada and
USSR emerged. There was a change in the relative position of UK and
USA as well, with the latter pushing down the former to the second
place. Excepting a year or two, USA has continuously maintained the
first position thereafter. During the planning period as a whole, India
has obtained maximum imports from USA, the reason being that India
has imported large scale quantities of capital goods, intermediate
products and foodgrains (under P.L.480 agreement) from that country.
With the expansion of trading relations with Japan, West Germany and
USSR, the dependence on the UK declined considerably. Thus the share
of UK in Indian imports declined from 19.4 per cent in 1960-61 to 5.7
per cent in 1997-98. On the other hand, the share of Japan increased
from 1.5 per cent in 1950-51 to 5.4 per cent in 1960-61 and further to
7 .5 per cent in 1990-9 1 . However, thereafter, it decreased in percentage
terms to 6.5 per cent in 1995-96 and 5.2 per cent in 1997-98.
Another significant development was the expansion in trading
relations with the socialist countries especially the erstwhile USSR.
Imports from USSR were negligible in 1950-51. In 1960-61 they
amounted to a meagre Rs. 16 crore. However, thereafter, they
increased rapidly increasing the share of USSR in India's imports from
l.4per cent in 1960-61 to 6.5 per cent in 1970-71. For a number of
years it occupied the second place after USA. For instance, during
1980-81 to 1983-84, USA occupied the first place in India's imports
and USSR was second. In 1984-85, the share of USSR was 10.4 per
cent and it displaced USA from the first place. The picture changed
thereafter. In 1985-86, USA was first, Japan second and USSR third.
In 1990-91, with a share of l2.l per cent, USA occupied the first
place. It was followed by Germany with a share of 8.0 per cent (the
508 Indiau Econnl: Perfornarce aul Policiet

figure is for unified Germany). Japan had the third position (share 7.5
per cent). UK and Saudi Arabia shared the fourth position with a share
of 6.7 per cent each, Belgium had the fifth position (share 6.3 per cent)
while USSR had the sixth position (share 5.9 per cent). With the
disintegration of USSR the direction of imports has now changed
markedly. For instance, in 1997-98, USA occupied the first position
in India's imports (share 8.9 per cent), followed by Saudi Arabia (share
6,2 per cent), Germany (share 6.1 per cent), Belgium (share 6.0 per
cent), Kuwait and UK (share 5.7 pet cent each) in that order.

Direction of Exports
As is clear from Table 23.10, OECD group accounts for a major
portion of India's exports. The share of this group in 1960-61 was 66.1
per cent and in 1997 -98 was 55.7 per cent. Almost 46 per cent of these
exports were accounted for by the EU countries in 1997-98. The OPEC
group accounted for 4.1 per cent of exports in 1960-61 and its share in
1997-98 rose to 10.0 per cent. Most significant was the rapid increase
in exports to the countries of Eastern Europe particularly USSR For
instance, Eastern Europe accounted for 7.0 per cent of export earnings
in 1960-61 and its share shot up to 22.1per cent in 1980-81. During
recent years, exports to this group have suffered a setback due to marked
political upheavals in these countries and the disintegration of the
USSR. In 1997-98 the share of Eastern Europe in total exports had
slumped to a mere 3.1 per cent. Developing nations of Africa, Asia
and Latin America accounted for more than one-fourth of India's
export earnings in 1997-98. Most important in this group have been
the countries of Asia. In fact, exports to Asian countries accounted
for 21.3 per cent of India's total export earnings in 1997-98. Thus,
countries of Asia now account for more than one-fourth of India's export
earnlngs.
Direction of exports in 1999-2000 show significant increases in
India's exports to its major destinations like OECD, Asia and OPEC
regions. Exports in US Dollar value, grew by 12.8 per cent to OECD,
20.1 per cent to Asia (other than OPEC countries) ar,d I2.3 per cent
to OPEC in 1999-2000 as compared with declines of 1.5 per cent,l4.4
per cent and low growth of 0.8 per cent respectively in 1998-99. Other
regions recording robust growth in exports included Eastern Europe
(due mainly to turnaround in exports to Russia) and Latin America
and Carribbean region with Mexico, Peru, Chile, Barbados and Panama
accounting for major increases. Exports to developing countries in
Africa, however, declined by 5.4 per cent in 1999-00 as against a rise
 Indian Ecoroml: Perlornance ad Policiet
510

of 9.9 per cent in the previous year. In terms of region-wise share in

total exports, while the share of OECD, OPEC and developing
countries from Africa declined in 1999-2000, those of Eastern Europe
and Asian developing countries from Africa declined in 1999-2000,
those of Eastern Europe and Asian developing countries increased
during this period. The share of developing countries from the Latin
America and Carribean region was, however, maintained at 1.7 per
cent. Although the share in total exports to OECD countries, as a
group, registered a marginal decline from 57.8 per cent in 1998-99 to
57 .6 per cent in 1999-2000, exports to many developed countries like
Canada (25.8 per cent), UK (21.I pu cent), USA (18.5 per cent),
Netherlands (16.1 per cent), France (10.9 per cent) and Belgium (7.2
per cent), in this region recorded sign.ficant increases during the year.
The share rise in share of exports to developing countries of Asia was
largely on account of the recovery from the crisis by East Asian
countries as a result of which the share of our exports to selected East
Asian countries rebounded from 11.6 per cent in 1998-99 to 13.7 per
cent in 1999-2000.

Direction of Imports
Sources of imports reveal a sharp decline in share of imports in
total imports from OECD countries from 51.6 per cent in 1998-99 to
44.8 per cent in 1999-2000 as imports from these countries declined by
3.2pu cent in 1999-2000. Bulk of this decline in share was appropriated
by imports from the OPEC region whose share rose to 23.8 per cent in
1999-00 (as compared to 18.3 per cent in 1998-99) mainly because of
increase in international petroleum crude oil prices. Similarly, the share
of imports sourced from non-OPEC developing countries (of Africa,
Asia and Latin America and Carribbean) improved from 21.1 per cent
in 1998-99 to 22.6 per cent in 1999-2000. The share of imports from
Eastern Europe was broadly maintained in 1999-2000 due mainly to
recovery in imports from Russia. Imports from developing countries of
Africa and Latin America and Carribbean regions grew by 21.9 per cent
afi,20.3 per cent respectively in 1999-2000 and was contributed among
others, by countries like Egypt, Ghana, Brazil, Chile and South Africa.
Imports from developing countries from Asia also recorded a high
increase of 18.5 per cent with robust growth from countries like China,
Hong Kong, Malaysia and Thailand. The share of selected East Asian
countries in total imports increased from 14.9 per cent in 1998-99 to
15.5 per cent in 1999-2000 due partly to the share depreciation of
currencies of these countries during the Asian crisis.
Foreign Trade
5tt
A sharp increase in imports from other residual destinations,
coupled with decline in share of OPEC region, may suggest a change in
sourcing of oil imports away from the OPEC region during the current
financial year.
Structural changes are also discernible from the data on sources of
India's imports. While there has been a sharp increase in the relative
share of the developing countries, that of the industrialised countries
declined. Between 1987-1991 and 1992-1999, the relative share of the
developing countries as a group moved up from 18.0 per cent to 23.0
per cent. This was largely on account of the increase in the imports from
the newly industrialised countries in South East Asia. Among the
commodities that contributed to the import growth, petroleum (crude
and products) from Malaysia and Singapore, vegetable oils from
Malaysia, chemicals from Republic of Korea and Singapore, and
electronic goods from Hong Kong, Republic of Korea, Malaysia and
Thailand were prominent. Between the two periods, the relative shares
of the countries belonging to the OPEC group also increased from 14.5
per cent to 2l .9 per cent. This is mainly reflective of the surge in the
oil import bill on account of higher prices.
The share of the OECD as a group in India's imports dropped
considerably from 59.4 per cent during 1987-199I to 52.1 per cent
during 1992-1999. Within this group, the relative share of the EU
countries fell from 31.8 per cent during 1987-199I to 26.9 per cent
during 1992-1999. The import shares of some of the individual EU
countries such as Denmark, Greece, Ireland and Italy, however,
recorded relatively high growth, while those from traditionally
important countries such as Germany, Netherlands, Sweden and UK
showed lower rise. The relative share of the UK fell to 5.8 per cent
during 1992-1999 from 7.9 per cent during 1987-199I. Among other
OECD countries, the imports from Australia, New Zealand and
Switzerland recorded relatively large growth. The relative share of
Switzerland moved up from 1.1 per cent during 1987-I99I to 4.0 per
cent during 1992-1999. This was largely on account of the import of
gold and silver and non-electrical machinery. It may be indicated that
during 1992-1999, the import of gold and silver formed as much as 69.2
per cent of India's total import from Switzerland, while Switzerland
along accounted for 58.1 per cent of India's total import of gold and
silver during this period. The relative share of the East European
countries declined from 8.1 per cant during 1987-1991 to just 2.9 per
cent during 1992-1999 with absolute decline in the imports from most
of the countries belonging to this group.