Balance of Payments: Foreign Investment and the Exchange Rate
Balance Of Payments: Foreign Investment and the Exchange Rate
The balance of payments of colonial India was characterized by certain distinctive features that disappeared or weakened after the end of colonial rule in 1947. For example, the economy of India was more open in the nineteenth century than it became later. There was close integration between the world economy and the domestic economy. There was also a close relationship between balance of payments and the currency and exchange system. Further, government remittances abroad made public finance and external transactions mutually dependent, and this was an area of potential conflict between Indian and British economic interests. For this reason, the balance of payments became a politically charged issue, one that figured prominently in nationalist critiques of colonial rule in India. Finally, there was a large transaction in gold and silver in the external accounts. Much of this gold and silver was normally imported for private consumption.
Balance of Payments and Foreign Investment
In the 1920s there were two major types of net inflow: net export of goods and net inflow of foreign investment. These two together were as large as about 4.4 percent of national income. These were balanced by three types of net outflow: private remittances (2.7 percent of national income), government remittance (0.4 percent), and net purchase of gold and silver (1.3 percent).
Estimates available for the middle of the nineteenth century suggest that the pattern was not fundamentally different from the beginning of Crown rule in India in 1858. The five items above were even then the principal items in India's external account, and in most years carried the same signs as these did later. Balance of trade was usually positive, whereas remittances and precious metal transactions were usually negative. The relative magnitudes, however, were different. The total size of external transactions relative to national income was smaller in 1858 than in 1914. And within total payments, the shares of private remittance and gold purchase were smaller as well, while the share of government remittance was larger.
The five principal items—trade, capital flows, factor income flows, government remittance, and gold—need fuller description. Foreign trade (export plus import) increased significantly in value, from 123 million rupees in 1834 to 3.8 billion rupees in 1939, and as a ratio of national income, from possibly 3–4 percent around 1800 to 20 percent in 1914. It did not rise any further in the next thirty years until the end of colonialism in the region. The ratio declined subsequently to 7–8 percent in the early 1970s, rising again to 18–20 percent in the mid-1990s. India's presence in the world economy was small, however. India accounted for no more than 2–3 percent of world trade in 1914. Yet, India played a significant role in the international settlements system. Colonial India usually maintained a trade deficit with Britain, but a trade surplus with the rest of the world. This pattern facilitated Britain to meet its international settlements on the current account. In turn, that enabled Britain to use the income from its investments abroad to make further investments.
The composition of India's exports changed in the long run. In the nineteenth century, semiprocessed natural resources accounted for more than 70 percent of exports, the principal items being raw fibers, seeds, food grains, indigo, opium, and hides and skins. The percentage declined to 30 in the mid-1930s, whereas textiles and tea accounted for another 30 percent. Imports, likewise, underwent a change. Cotton textiles constituted almost half of India's imports in the mid-nineteenth century. Late in the interwar period, the major items were machinery and intermediate goods. The change in composition, in other words, partly reflected the advancement of a textile-based industrialization. This process accelerated in the interwar period, when import tariffs on a range of manufactured goods were raised.
Direction of trade in this period steadily moved away from the dominance of Britain as a market and as a source of imports into India, even though there was a slight reversal in the trend in the 1930s as a result of Britain's attempts to establish preferential trade arrangements within the empire. The two countries that emerged as major trading partners were the United States and Japan. The increasing importance of Japan was a reflection of a relatively new intra-Asian commodity exchange pattern involving Japan, China, Southeast Asia, and India, driven to a large extent by Japan's own rapid industrialization.
India received several types of capital flow, short term and long term. The usual type of short-term flows, which are not adequately captured in the annual accounts, went to meet the seasonal demands of trade. The India Office sold bills in London (called council bills) redeemable in India, which went to meet export transactions that peaked in the harvest seasons. Interest rates in India varied greatly by season, and these capital flows were evidently influenced by the high interest rates that prevailed in the busy season. The business of council bills was mainly conducted by the exchange banks, which were a group of banks licensed to conduct the foreign exchange business. All of them had headquarters outside India. In the 1920s, there was another kind of inflow of short-term foreign capital for investment in the government of India's rupee debt, but as the Great Depression began, the flow reversed.
Long-term capital came in two forms: net private foreign investment, and net increase in public debt. Private foreign investment remains the weakest link in India's balance of payments database. Based on what data are available, net foreign investment was usually positive, but a rather small item (well below 1 percent of national income). Private investment was dominated by railways in the third quarter of the nineteenth century, and toward the century's end, by the formation of tea, jute, and mining companies. Such investment was initially in the form of shares sold in London by companies based in India. In the interwar period, the pattern changed into direct investment in subsidiaries of foreign firms. At least some of these multinational firms were attracted by the substantially higher import tariffs introduced from the 1920s. At independence, foreign capital accounted for between a quarter and a third of capital stock in the private corporate sector, according to different estimates. Plantations, jute textiles, and engineering had 70 percent of the capital stock. Seventy-seven percent of foreign capital was owned by British companies, the bulk of which had come in as portfolio investment. Of the remaining amount, the major part came from the United States, all of it as direct investment.
The government of India sold two types of securities, one denominated in sterling, and the other denominated in rupees. In the nineteenth century, the former exceeded the latter in value. By 1910 the two were of roughly equal magnitude. In the 1930s sterling securities were being retired rapidly, and for new issues, the government relied entirely on the Indian money market. The events of the Great Depression weakened confidence in London in India's sterling bonds. But there was also a long-term factor behind the decline of sterling bonds. Between 1880 and 1930, the average buyers of government securities had changed as well, from "old India hands" in Britain to Indian banks and the Indian public, who accepted rupee debts more easily. Public debt went to finance the railways, irrigation, roads, and buildings in the nineteenth century. In the twentieth century, these productive expenditures declined in importance. On the other hand, World War I led to a significant accumulation of debt.
Net factor income flows were consistently negative. Both private flows and government remittances were individually negative items. The ratio between these was roughly 3:2 in the 1860s, and probably increased marginally toward the end of colonial rule. The largest item in private flows (about half in the 1920s, and increasing) was repatriated income earned on foreign investment. Other items included insurance and freight charges, and dividends of railway companies, which progressively declined as the railways became increasingly state-owned.
In any normal harvest year, a large quantity of gold and silver was imported into India. This bullion was converted into jewelry and ended up as the private hoarded assets of the peasant households. The quantity of non-monetary gold absorption by Indians was so large that the world financial circles, and especially the City of London, were often fearful that a good year in India might interfere with monetary expansion elsewhere in the world. The demand for precious metals can be seen as a response to exceedingly high risks of livelihood in Indian agriculture. Financial assets fluctuated in value given the rather extreme movements in prices and interest rates. Gold and silver were traded the world over, and therefore were more stable assets. This preference for precious metals took a toll on the savings available for productive private investment. By a rough calculation, had the acquisition of precious metals been zero, private investment in interwar India could have risen by as much as 2 to 3 percent as a proportion to national income.
A politically controversial element in the balance of payments was government remittance. Every year, the government in India paid to Britain a sum of money in sterling, which were called the "home charges" in the nineteenth century. About half of the home charges in the prewar years consisted of interest payment on loans raised to finance construction of railways and irrigation works. The second most important item was payment for the maintenance of army and marines. A third major component was pension payments for officials who had served India and retired to Britain. India Office expenses and stores purchased were the other considerably less important items of expenditure.
These payments, it was argued by Indian nationalists, compromised the capacity of the domestic economy to generate savings and investments. In principle, if such payments were financed from taxes, domestic consumption or savings could fall. If such payments were financed out of government's own investment funds, public investment could fall. If such payments were financed out of foreign borrowings, the volume of payments would increase by interest obligations. All three methods were used to meet these charges. For example, the regressive salt tax was used to finance increased government obligations in sterling in the 1890s. However, none of these adverse effects might result if these charges corresponded to factor services that in turn increased national income, or that supplied public goods that the government ought to provide anyhow. The potential adverse effects, in other words, depended on the "quality" of these charges. Whether or not government remittance enhanced national income, and to what extent it did, remains difficult to determine. To take one example, Indian nationalists alleged that the charge on account of the British Indian marines, who normally guarded trade routes, was unproductive because the marines were sometimes deployed for purposes other than the defense of Indian waters. On the other side, it was suggested that the British public, which paid ten times more than their Indian counterpart on average toward the maintenance of the marines, in fact subsidized Indian defense.
A second problem with these payments was that they compromised the government's capacity to follow a stabilization policy independent of British economic interests. This effect was in evidence whenever the Indian currency was under pressure, for example, during the Great Depression. This issue leads to an examination of the currency and exchange system.
The Exchange System
The primary objective of monetary policy in colonial India was to stabilize the exchange rate. The government wished to ensure that the exchange rate remained stable, and did not fluctuate with balance of trade. An appreciation hurt commercial interests exporting from India, and depreciation made it difficult for the budget to meet its sterling obligations.
Between 1835 and 1893, the Indian rupee was a silver coin. The British East India Company in 1806 chose silver as the standard of value, and pushed silver coins into circulation in Madras, where the gold "pagoda" was still in circulation. In 1835 the government declared the silver rupee as the legal tender, and announced an exchange rate (15:1) between the rupee and the pound sterling. There were two ways that money could be transferred between India and the rest of the world. As mentioned before, the India Office sold council bills in London at an announced exchange rate, which the exchange banks purchased, sent to India, redeemed at the Treasury, and financed trade demands for money. The receipts in London were used to meet the home charges. Alternatively, traders could buy silver in London, ship to India, and have these minted into silver coins for a fee. In the last quarter of the nineteenth century, excess supply of silver in the world led to a fall in silver prices, which made the second mode of payment the more profitable. The council bill system came under threat unless the government devalued the rupee. Depreciation did occur, but at considerable cost to the budget. On the recommendations of a committee of inquiry headed by Lord Herschell, the Lord Chancellor, free coinage of silver was abolished in 1893. The next few years saw shipping of silver bullion for payment, and yet, the rupee did appreciate somewhat. In 1898, on the recommendation of another committee under the direction of Sir Henry Fowler, a gold exchange standard was introduced in India.
The gold exchange standard was in force between 1898 and 1916. The rupee was convertible against sterling and not against gold, at a ratio of 16 pence per rupee, or 15 rupees for a pound sterling. These years witnessed an animated discussion on the merits of a full gold standard for India, within India and in London. The desire for a gold standard was strong in India, and the view that the gold exchange standard was adequate for India was strong in London. In effect, the autonomy of Indian monetary policy was at stake here. For many contemporaries, the gold standard represented the freedom for India to settle her obligations directly by means of flows of metals. In any case, World War I suspended these debates on the gold standard.
To support the exchange, the India Office now sold council bills in weekly auctions at the Bank of England. Until 1905 the volume of these sales was limited to the home charges. The limit was removed thereafter, and the sale of these bills effectively became a strategy to stabilize the exchange by preventing the free movement of metals for settlement of balance of trade. An official gold standard reserve was created. It was transferred to the India Office in 1902. The reserve thereafter consisted of mainly British government securities, Treasury bills, Exchequer bonds, and consols, in turn contributing in no small measure to keeping interests rates low in Britain. The India office also used the gold standard reserve of India in the call money market, leading to a closer alliance between the office and the financial world of the City of London. The only occasion in the prewar period when the government needed to draw on the currency reserve occurred in 1907, when a trade deficit threatened a depreciation of the rupee. On this occasion, the government also used the reverse council bills, a counterpart instrument that facilitated supply of sterling.
The gold exchange standard faced its first serious crisis toward the end of World War I. The first years of the war saw a loss of confidence in the rupee, due to inflation in silver prices. From 1916 to 1917, the inflation threatened a disappearance of silver rupee coins from circulation. An appreciation of the rupee seemed inevitable. Between 1917 and 1919, the rupee was allowed to float. By December 1919, the rupee had appreciated by 75 percent. A committee of inquiry was established to study the situation, which recommended an exchange rate at 2 shillings, provoking a strong minority report from the Indian member, who advocated a return to the prewar ratio. Silver prices, however, eventually stabilized, and confidence in paper currency returned in the next two years, with the result that early in the 1920s, the rupee depreciated somewhat. In 1925 another committee of inquiry endorsed the then prevailing ratio, 18 pence, to be the basis for a return to a modified gold exchange standard. From 1926 on, the rupee was again closely controlled to remain near 18 pence, the rate that was to prevail for the next several decades.
The next twelve years, until the outbreak of World War II, saw what has been described in historical scholarship as the "ratio controversy." In the emerging political environment of 1930–1931, Indian commercial and political opinion had united in the belief that the rupee was overvalued at 18 pence. The demand for a full gold standard and autonomy with regard to the exchange rate grew strong again.
The conduct of Indian monetary policy during the Great Depression, which seemed to serve British interests at the expense of Indian ones, worsened the controversy. The beginning of a fall in world commodity prices in the second half of the 1920s turned the terms of trade adverse for India, and weakened the balance of payments. Further, the fear that the rupee might devalue eroded confidence in the rupee. Official and nonofficial opinion in India strongly favored depreciation of the rupee against sterling. But depreciation was neither easy nor acceptable to London, for that step would have changed the volume of home charges measured in rupees, and might lead the government of India to default on its external obligations. None of the options usually available to the India Office for dealing with a financial crisis—fresh borrowings in London, or drawing on the reserves—seemed practicable in the prevailing economic and political climate. The options available to the monetary authorities in India were even more limited and inflexible. A postponement of India's sterling obligations was discussed, but did not materialize.
Eventually, on London's insistence, the government of India carried out monetary contraction, in the hope that this would reduce prices and raise demand for Indian goods. The goal was not easily attainable, for the demand depression was not specific to India but was a global phenomenon. The contraction, therefore, had to be a deep and sustained one. Furthermore, as the contraction continued, and the less it seemed to work, the harder it became to return to devaluation; the expected devaluation would have had to be larger than before, causing larger-than-before adjustments in budget. The government of India feared that the resultant decline in prices would raise real interest rates and rents, causing hard ship. These fears were borne out. The financial situation did cause widespread transfer of assets from debtors to creditors in rural India, and led to rural unrest in some cases.
One principal mechanism used for such transfer was the sale of gold jewelry. As mentioned before, a significant part of rural assets was held in the form of gold and silver jewelry. These now began to be liquidated. At the same time, the British government's decision to leave the gold standard in 1931 depreciated the pound, and with it the rupee, against gold. These circumstances led to a rise in the price of gold in terms of rupees. On the basis of an 18 pence rupee, the price of gold was lower in India than in the international market, causing a great quantity of this gold to be sold abroad. In the next five years, these gold exports reflated the Indian economy, restored balance of payments, and provided the government of India with enough remittance to meet its sterling obligations. Nevertheless, these exports were widely seen as a sign of distress and a lost opportunity to build a currency reserve for India, and thus left Britain-India relations seriously strained.
The establishment of the Reserve Bank of India in 1935 was the first step in the dissociation of monetary policy from balance of payments in India. Balance of trade in World War II was in surplus. At the same time, a massive monetary expansion was allowed to take place to meet the needs of war financing, even as severe shortages of essential commodities developed. The result was massive inflation. On the more positive side, India's contribution to the war effort accumulated in a "sterling balance" account, which became available for liquidation in the late 1940s. For the newly independent nation, the balance came in handy in its efforts to consolidate the balance of payments.
By contrast with the colonial pattern, the general pattern of balance of payments after colonial rule was very different. Restrictions on gold import brought the share of gold transactions close to zero almost immediately after 1947. Government account showed a net receipt due to foreign aid. The relative shares of trade, foreign investment, and private remittance all declined as India withdrew from an open to an autarkic regime from the 1950s onward. Also, balance of trade turned consistently negative, due to the need to import capital goods, oil, and sometimes food. Over the next fifty-odd years, several major changes took place. Two of these are noteworthy. As the number of expatriate workers increased, remittances of the private account turned into a net receipt item. And as India ended its autarkic policies in the 1990s, the shares of trade and investment in national income increased again.
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