1.

Indian Economy: Pre-Crisis Period(1980-89)

Indian Economy was in a growth mode in the 1980s. From FY 1980 to FY 1989, the economy grew at an annual rate of 5.5 percent, or 3.3 percent on a per capita basis. Industry grew at an annual rate of 6.6 percent and agriculture at a rate of 3.6 percent. A high rate of investment was a major factor in improved economic growth. Investment went from about 19 percent of GDP in the early 1970s to nearly 25 percent in the early 1980s. India, however, required a higher rate of investment to attain comparable economic growth than did most other low-income developing countries, indicating a lower rate of return on investments. Private savings financed most of India's investment, but by the mid-1980s further growth in private savings was difficult because they were already at quite a high level. As a result, during the late 1980s India relied increasingly on borrowing from foreign countries. 1.1) Trends in Indian Economy during 1980-89 i) Government Deficit:

As its evident from the graph below, the government deficits have shown a steady increase from the beginning of 1980s and peaks during the 1985-86 period. The further dip in the deficit can be accounted to the various attempts by the government to monetize the deficit with the help of the central bank which eventually created a lot of other macroeconomic pressures whose culmination led to the crisis eventually.

ii)

Current Account:

The graph below shows the position of the current account in the pre crisis period. We can see that the current account balance declined sharply during the end of the decade. The imports rose sharply (for e.g.: the petroleum imports rose by nearly 40% from the period 1986-87 to 1989-90) and the export growth was very disappointing which led to the widening of the trade deficit and deterioration if current account balances. The trade deficits were increasing all through the 1980s as shown in the table below. This indicated the fact that it was highly imperative to resort to some corrective measures failing which this would affect the BoP and lead to a crisis in the near future.

iii)

Capital Account and For-ex reserves:

The capital inflows to India mainly consisted of aid flows, commercial deposits and deposits from Non resident Indians. The heavy restriction on FDIs in almost all sectors was a main limiting factor in the economy to attract enough foreign investments for its development projects in infrastructure sectors. The only ray of hope came from the provision of Institutional investors, but their investments too were

channelized to a few public sector bonds and literally there were no investments from abroad in Indias attempt to catch up to the mainstream of the world. The situation worsened when India was gradually losing out its forex reserves (see table) due to constant devaluations of the rupee against dollar and widening trade deficit. The forex reserves fell from a comfortable $8151 mm in 1987 to $ 5331mm in 1990 and further to $ 1877mm by 1991.

iv)

External Debt

The external debt of India doubled from 1984-85 ($35 bn) to 1990-91 ($69 bn). It is also evident from the graph below that the external debt kept on rising from the early 1980s towards the end of the decade. The investor confidence declined rapidly due to the economic situation of India and hence it resulted in the outflows being increasingly dependent on short term external debts. The gulf crisis which occurred in the early 1990 along with the existence of an unstable government at the centre further aggravated the situation. There was increasingly an adverse impression globally about Indias creditworthiness.

v)

Exchange Rates

The exchange rates kept on falling owing to the changes in the world market. The world economy had an increasing effect on Indian currency due to heavy dependence on foreign funds and capital goods imports. This, as already explained, had many adverse effects including the multiplying effect on the external debt and trade deficit. The graphs below show the trends in exchange rates, both real and nominal.

2. Balance of Payments: CRISIS

3.1) The lead up to the crisis: 1990-91 i) Break up of the Soviet Union The Soviet Union had been one of the largest export markets for India prior to its breakup in India. The Soviet breakup therefore negatively affected Indias precarious trade balance, which slipped further into red.
ii) The Gulf war

Current account deficit averaging 2.2% of the GDP hit hard by the Gulf war .The Gulf war began in August 1990 with Iraqs Invasion of Kuwait. Both Iraq and Kuwait were among the largest suppliers of oil to India, especially Iraq with whom India had long term arrangements .Due to the war many of these long term contracts were hit, which forced the government to buy from the spot market at high prices resulting in the oil bill ballooning to $2 billion in the latter half of 1990.
iii) Fall in remittances

The Gulf war also caused many Indian workers working in Kuwait and Iraq to return, resulting in a fall in remittances. This was significant since NRI remittances had been an important source of inflows to the country throughout the eighties thus reducing the severity of the balance of payments. The situation was further aggravated further with the government having to airlift Indian residents in Kuwait.
iv) Political uncertainty

The period between1990-91 was marked with high political uncertainty at the central level with the country seeing three successive government changes. This reduced the focus of the government on the looming economic crisis as there was no clear policy to deal with the unexpected situation. When a stable majority government did was setup in 1991, it was a little too late as the damage had been done. 3.2) THE CRISIS The rapid loss of foreign exchange reserves had prompted the government to take steps to reduce the trade deficit, by restricting the imports .In October 1990; the RBI imposed a cash margin of 25percent on all imports other than capital goods. Capital goods imports were allowed only with foreign sources of credit. Additionally, a surcharge of 50 percent was imposed on all Petroleum and oil imports except domestic gas. Along with increases in custom duties, the above mentioned policies had the desired impact of controlling the imports, which started falling in the latter half of 1991. By late of 1991, the decline of imports had reached a stage where it was starting to affect the domestic production, which started declining (as shown). Hence any further measured in this direction was ruled out.

Import Trends
30 20 10 0 -10 -20
Fig1.7: Import Trends

% change

Bulk imports Capital goods

Fig1.8: IIP and Imports By the end of 1990 and the beginning of 1991 it was clear that Trade deficit was not the deciding factor , as it had come down to $382 million in Jan-Feb 1991 and further to $172 million in May 1991( Source :RBI) 59 76 310 . The main reason for such a drastic fall in reserves was due to the withdrawal of foreign currency non-resident deposits (FCNR), which accelerated from $59 million in Oct-Dec 1990, to $76 million in Jan-Mar 1991 and finally to 310 million in June 1991.

Fig1.9: Reserves It was clear that the crisis had been clearly due to crisis of confidence in the Indian Government to prevent a default. This is more akin to a sort of speculative attack, in which the foreign investors fearing devaluation of the currency (the most likely step for the government to prevent a default) withdraw their deposits from the country. Further, in expectation of devaluation import receipts are forwarded and export receipts are postponed .This together with the downgrading of credit risk pushes the country more towards the default, with the Central Bank under more pressure not to devalue the currency. This situation

is pictorially depicted below

Expectati on of default

expected devaluati on

Further drop in reserves withdraw al by foreigners

payments of imports & exports

4. THE RESPONSE
In June 1991, Foreign exchange reserves fell below $1billion. This was barely enough to cover 2 weeks of imports. Further, the short term debt to foreign currency reserve ratio rose from 2.2 in March 1990 to 3.8 in March 1991 putting extraordinary pressure on the reserves (It should be noted that this ratio had increased from 0.9 in 1989 to2.2 in 1990 which was a strong precursor).These short term debts had higher costs and were subject to greater volatility, subjecting the reserves to greater risks. However, during this time the government took a number of steps starting with an agreement with IMF for a withdrawal of $1,025 billion under its Compensatory and Contingency Financing Facility (CCFF).Withdrawals of $789 million from the first credit tranche made in Jan, 1991. In May 1991, the government leased 20 tones of confiscated gold to State bank of India to sell it abroad with an option to repurchase it within 6 months. Further in July 1991, the government allowed the RBI to ship 47 tons of Gold to the Bank of England and Bank of Japan which allowed RBI to raise $600 million. This pledged gold was later retrieved in September 1991. It was against this background that a two-step downward adjustment in the exchange rate of rupee was effected on July 1 and 3, 1991, which resulted in devaluation of around 18 per cent against major international currencies. Devaluation at no time was free from controversy. But given the grim situation that the country faced on the external front, a downward adjustment of the exchange rate had become

inevitable. The extent of devaluation was determined primarily by the degree of correction that was required in the balance of payments.

Another consideration was whether, instead of making a discrete change, small changes in the exchange rate should be made , as had been policy since 1985 . It was decided that a sharp discrete change was needed to quell expectations. This two-stage discrete devaluation process in the exchange rate also intrigued many observers. An explanation for this is that it was done partly to test the waters and gauge the reaction to the first change before making the next. After the first announcement, to avoid destabilizing expectations, the required change was completed in the second round.

The devaluation of the rupee was complemented with changes in the external trade regime. Perhaps this is what made the devaluation of 1991, different from others. A process of establishing a more liberalized trade regime was set in motion. A realistic exchange rate provided the basis for a credible reform process.

5. Post Crisis: Impacts

5.1) i) Impacts Balance of Payments: 1992-93 Foreign exchange reserves had been building up to respectable level of $5.63 billion from a low of $1.29 billion at the end of July 2001. Introduction to LERMS( Liberalized exchange rate management system) Mobilization of external assistance from IMF, World Bank , ADB and Bilateral donors to support the BOP Despite the increase in imports to more normal levels during 1992-93, it has been possible to manage the BOP with the stable exchange rate and comfortable foreign exchange reserves throughout the year.