Most developing countries carry on current account deficits (CAD) in their balance of payments and get external capital to supplement their domestic savings to attain higher growth rates. Such financing through CAD reflects the accumulation of external liabilities of a country, which have to be cleared in near future. The issue of viability of CAD becomes important in this context. When the payments for such external servicing begin to have an escalating trend, they preempt any growth in current external earnings which would otherwise are useful to meet expenses towards imports. When debt servicing erodes the import purchasing power the growth gets stunted.
Ultimately the growth process itself gets retarded. An unviable current account amounts to a great external constraint on growth. For the World Bank, a debt-service ratio (DSR) of about 30 per cent means a country is ‘severely indebted’.
In India’s case, hefty and persistent CADs were run in the entire decade of 1980s. They were at an untenable level of 3.2 per cent in 1990-91 and were a sign of explosive situation in external indebtedness. The signals of impending doom were apparent in the increasing debt-ratio (DSR) throughout the 1980s, reaching a new of 35.3 per cent in 1990-91. The excessive DSR of Indian economy in the 1980s, was directly the result of reliance on debt creating fund inflows as a. source of financing the CAD instead of non-debt creating inflows like foreign investments and near stagnation in invisible receipts.
The grave economic crisis of 1990-92 taught India many lessons. A High Level Committee on Balance of Payments urged that the CAD ought to be contained at 1.6 per cent of GDP, which was financiable with normal capital flows. A special Committee on Capital Account Convertibility set out the truism of sustainability in the balance of payments in these words: “In view of the growing degree of integration of the Indian economy with the rest of the world, it needs to be recognized that the CAD would need to be varied in the context of the opening of the economy. The size of the CAD, which can be sustained without encountering external constraints, is thus a function of the degree of openness of the economy, which can be defined in terms of the rate of current receipts (CR) to GDP.
The size of this ratio is the crucial determinant of the ability of the economy to make current payments and meet the servicing of external debt. As the CR/GDP ratio rises, it would be possible for the economy to expand the CAD/GP ratio raised without rendering the external debt unsustainable.”
In the wake of the 1991 crisis, government initiated several major structural reforms. The reforms dealt with the issue on two fronts. First, there was a Calculated policy shift towards encouraging non-debt creating. flows to finance the CAD. Secondly, the current receipts both merchandises and services-showed a healthy performance after 1990-91 as a result of the reforms. The ratio of current -receipts to GDP exhibited a visible rise. The combined effect of the two factors resulted in the decline of DSR from 35.3 per cent in 1990-91 to 21.2 per cent in 1997 and 18 per cent in 1998-99. The downward trend in IMF repayment debt also contributed to decline in the DSR.
In the capital account; there was a worth mentioning compositional shift away from debt inflows to non-debt inflows. The compositional change also reflected the effect of conscious policy initiatives spread over trade, exchange rate, foreign investment and industrial policy. There was a renewed endorsement of international confidence in the Indian economy. The economic reforms created a vigorous and Conducive environment for inflow of foreign investment both direct (FDI) and portfolio (FPI). These were almost non existent earlier. The basic benefit of foreign investment is in its risk sharing characteristics, which arc superior to that of debt. Unlike debt, these inflows have to be serviced only to the extent that yields positive returns.
The only form of external investment, which does not have this characteristic, is external portfolio investment in domestic debt. These instruments are not much different from external debts. Their two-fold advantage is that they command the domestic rate of interest as against the international interest and the exchange rate risk is borne by foreign investor and not the domestic borrower. Caution, however, has to be observed in dealing with this form of foreign investment.
A greater inflow of foreign investment particularly the FDI means a higher level of sustainable CAD. The Foreign Direct Investment as percentage of net capital is on the rise for last one and half decades. Along with, the Foreign Portfolio Investment has also gone up. An important aspect of these inflows is the issuance of Global Depository Receipts (GDRs) by Indian companies.
These developments have come as a blessing for the balance of payments with a clear sustainability as shown by decline in the debt service ratio from 35.3 per cent in 1990-91 to 21.2 per cent in 1996-97 and 18 per cent in 1998-99. Moreover, the debt-GDP ratio has also gone down from 30.4 per cent in 1990-91 to 24.7 per cent in 1996-97 and 23.5 per cent in the year 1998-99. The improved balance of payment position since 1991-92 has led to a healthy build-up of foreign exchange reserves. The level of foreign exchange reserves had reached to 31 US dollar billion by end of the year 1999.