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bop crisis

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1 ST. THOMAS COLLEGE, PALAI

1991 Balance of Payments Crisis of India Until the early 1980s, India’s economic policy was dominated by pervasive administrative controls and had a strong inward orientation. The process of gradual decontrol and easing of restrictions began in the mid-1980s. The initial focus of liberalisation was on relaxation of licensing for entry, expansion in industry and on freeing access to imports, particularly of inputs and capital goods for export production. From 1985, there was also an emphasis on promoting exports encompassing some direct measures such as easier access to imports, tax relief, preferential credit, subsidies to compensate for differences between international prices and domestic prices of inputs, and a supportive exchange rate policy. The Reserve Bank on its part also initiated several measures to rationalise interest rates and develop the money and foreign exchange markets, and gave a new orientation to monetary management, following the Chakravarty Committee report. These early reform measures, however, suffered from the lack of an overarching framework to promote competition and efficiency. Consequently, the emergence of several macroeconomic distortions could not be averted. The first half of the 1980s saw a large increase in the central government deficit, primarily on account of high expenditure levels, especially on agricultural subsidies, defence and interest payments. On the external account, higher imports dominated over acceleration in exports. A steady deterioration in the services account resulted in widening of the current account deficit (CAD) and, with the aid inflows not increasing commensurately, the increasing reliance on commercial sources for financing resulted in the debt-service ratio rising to nearly 30 percent in the late 1980s. By 1990, there was a realisation in official circles that the widening of fiscal deficit and the related rise in money growth were contributing to a rise in inflation and exerting pressure on the balance of payments (BoP). The Reserve Bank had evidently been expressing its concern to the Government about the adverse implications of the deteriorating BoP position and the impact of rising fiscal deficit since the late 1989, but timely preventive measures were stalled by the uncertain political situation. India was thus faced with large internal and external financial imbalances and was vulnerable to adverse external shocks around 1990. Previously India had relied almost exclusively on aid on concessional terms. The 1980s saw a growing resort to financing on commercial terms and therefore by the end of the decade its debt-service ratio became relatively high by regional standards. Second, the official reserves, which until then had been

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relatively stable at a high level, were drawn down from about five months of imports in the mid-1980s to only a little over two months of imports at the end of 1989–90. Inflation rose to 12.0 per cent. The consequent fragile economic situation was compounded by the sudden impact of the Iraq war, leading the country deeper into the crisis by the mid-1991. The higher oil prices and loss of workers’ remittances weakened the current account position by US$ 1.5 billion in 1990–91. The impact of the crisis was further exacerbated by policy slippages. A sizeable reduction in fiscal deficit had been planned for 1990–91, but it did not materialise, and bank credit to the Government continued to grow rapidly. Expansionary financial policies continued to put pressure on domestic prices and the external current account deficit (CAD ) widened to 3 percent of GDP. Owing to market concerns about the deteriorating external position and domestic political uncertainty, recourse to external commercial borrowings (ECBs) was not available from the mid-1990. The external liquidity situation remained extremely tight in the first quarter of 1991–92 owing to a number of factors, such as the withdrawal of non-resident Indian (NRI) deposits, outflows of short-term capital from banks, and lacklustre export performance. The withdrawal of NRI deposits, which started in September 1990, intensified and was accompanied by an outflow of short-term capital as commercial banks failed to renew credit lines. Exports stagnated, largely because of slack demand in key markets in the industrial nations and the Middle East, as well as growing disruptions to trade with the USSR. Political events, in particular the resignation of the Government in March, 1991 and the postponement of general elections, prevented major fiscal action, and the burden of adjustment fell mainly on monetary tightening and direct import compression measures. Despite a sharp fall in import volumes, gross official reserves declined further to US$ 1.7 billion (about three weeks of imports) by end-June 1991. By the mid-1991, the BoP crisis turned into a crisis of confidence in the country’s ability to manage the BoP. The loss of confidence undermined the Government’s capability to deal with the crisis by closing off all recourse to external credit. The persistently high levels of fiscal deficit and current account deficit on the balance of payments (BoP) gave rise to a sizeable public debt, both domestic and external. The country was faced with a risk of default on external debt servicing during the early months of the fiscal year 1991–92. 1991 Economic Crisis: Major Contributing Factors or Reasons: The main causes behind the Balance of Payments crisis of 1990-91 were as follows:

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1. Worsening fiscal situation: From 1979 onwards, the second oil shock, agricultural subsidies and consumption-driven growth had pushed up fiscal deficit. It further enlarged in the mid-1980s as defence expenditure was substantially increased and direct taxes were progressively reduced. The result was that fiscal deficit as a percentage of GDP escalated to 9.4 per cent in 1990–91 as against the average of 6.3 per cent in the first half of the 1980s. The high levels of deficit spilled over into the BoP gap, with the resultant drawdown of foreign exchange reserves. 2. Widening current account deficit: The current account deficit increased from Rs. 11,350 crore in 1989-90 to Rs. 17,350 crore in 1990-91. The CAD/GDP ratio increased from 2.3 in 1989-90 to 3.1 percent in 1990-91. There were two instant external shocks contributed to widening of the CAD – Iraq’s invasion of Kuwait in 1990 and Slow Growth in India’s export markets. 3. Gulf War: The Gulf crisis began with the invasion of Kuwait by Iraq in 1990. Crude oil prices rose rapidly thereafter–from USD 15 per barrel in July 1990 to USD 35 per barrel in October 1990. India’s petroleum import bill in 1990–91 increased over 50 percent to US$ 6.0 billion. The gulf crisis clearly impacted the balance of trade situation. During 1990–91, imports were 22.0 per cent higher than that in 1989–90, largely on account of POL imports, while exports rose by 17.5 per cent, as a result of which the trade deficit at US$ 9,437.0 million was 38.0 per cent higher than that in 1989–90. Consequently, there was a rapid drawdown of foreign exchange reserves during 1990–91. Foreign currency assets (FCA) held by the Reserve Bank declined by US$ 3,460.0 million during the year despite the BoP support received from the IMF. The gulf crisis also had an adverse impact on the capital account. The fall in capital inflows compounded the problem of financing the rising level of CAD. Inflows into non-resident accounts and ECBs were the two major components of the capital account, which suffered most under the impact of the gulf crisis. The Gulf war also caused the return and rehabilitation of the Indians working in that region, adversely affecting the inflow of remittances. By September 1990, the net inflow of NRI deposits had turned negative. 4. Slow Growth in India’s export markets: The deterioration of the current account was also induced by slow growth of important trading partners. Growth in the US — India’s largest export destination — fell from 4.1 per cent in 1988 to (–) 0.2 per cent in 1991. Conditions in another major export market — the Soviet Union worsened

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due to the oil shock. Export markets were weak in the period leading up to India’s crisis, as the world growth declined steadily from 4.5 percent in 1988 to 2.25 percent in 1991. 5. Overvaluation of the rupee: Since 1987, the Indian rupee had been depreciating in real terms as compared with many of India’s trade competitors. However, between October 1990 and March 1991, the REER of the rupee appreciated by about 2 per cent as a result of widening inflation differentials between India and the major industrialised countries, and the REER increase was continuing, albeit slower than the nominal depreciation (2.4% against five currencies, over the same period). Further, in the 5-month period between February 1991 and June 1991, the nominal effective exchange rate (NEER) decreased by only 2.5 per cent, while the inflation differentials continued to widen. All this resulted in eroding India’s international competitiveness. 6. Break-up of the Soviet Bloc: Rupee trade (payment for trade was made in rupees) with the Soviet Bloc was an important element of India’s total trade up to the 1980s. However, with the introduction of Glasnost and Perestroika and the breaking away of the Eastern European countries led to termination of Rupee Payment Agreements (RPA) in 1990-91. As a consequence, the flow of new rupee trade credits declined abruptly in 1990-91. Further, there was also a decline in our exports to Eastern Europe—these exports constituted 22 .1 percent of total exports in 1980 and 19.3 percent in 1989; but they declined to 17.9 percent in 1990-91 and further to 10.9 percent in 1991-92. 7. Political Uncertainty and Instability: The country also faced intense political uncertainty during this period. The period from November 1989 to May 1991 was marked with political uncertainty and instability in India. In fact, within a span of one and half years there were three coalition governments and three Prime Ministers. This led to delay in tackling the ongoing balance of payment crisis, and also led to a loss of investor confidence. 8. Loss of Investors’ Confidence: The widening current account deficits and reserve losses contributed to low investor confidence, which was further weakened by political uncertainty. This was aggravated by the downgrade of India’s credit rating by credit rating agencies. By March 1991, the International Credit Rating agencies Standard & Poor’s, and Moody’s, had downgraded India’s long term foreign debt rating to the bottom of investment grade. Due to the loss of investors’ confidence,

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commercial bank financing became hard to obtain, and outflows began to take place on short-term external debt, as creditors became reluctant to roll over maturing loans. 9. Increase in Non-oil Imports: The trends in imports and exports show that imports rose much faster than exports during the eighties. Imports increased by 2.3 percent of GDP, while exports increased by only 0.3 percent of GDP. As a consequence, trade deficit increased from an average of 1.2 percent of GDP in the seventies, to 3.2 percent of GDP in eighties. Oil and Non- Oil Imports (In Rs. Crores)

10. Rise in External Debt: In the second half of the 1980s, the current account deficit was showing a rising trend and was becoming unsustainable. An important issue was the way in which this deficit was being financed. The current account deficit was mainly financed with costly sources of external finance such as external commercial borrowings, NRI deposits, etc. In the context of external debt the following observations are worth considering:  The period of eighties was marked by a reduction in flows of concessional

assistance to India, principally from the World Bank Group. In 1980, disbursements on concessional terms constituted more than 89 percent of assistance to India from multilateral sources; in 1990, this proportion declined to about 35 percent  Due to a decline in concessional assistance there was a rise in average interest

cost of external borrowing  There was a change in the composition of debt as it shifted from official (like

bilateral sources) to private sources like external commercial borrowings (ECBs) and NRI deposits. These private sources were costlier  The external debt was funnelled into financing the government’s deficit

6 ST. THOMAS COLLEGE, PALAI  India’s external debt increased from Rs. 194.70 crore (USD 23.50 billion) in

1980-81 to Rs. 459.61 crore (USD 37.50 billion) in 1985 – 86. It went up to Rs. 1,003.76 crore (USD 58.63 billion) in 1989-90. In 1990-91, it was Rs. 1,229.50 crore (USD 63.40 billion) Conclusion: Thus, the balance of payments situation came to the verge of collapse in 1991, mainly because the current account deficits were mainly financed by borrowing from abroad. The economic situation of India was critical; the government was close to default. With India’s foreign exchange reserves at USD 1.2 billion in January 1991 and depleted by half by June, an amount barely enough to cover roughly three weeks of essential imports, India was only weeks way from defaulting on its external balance of payment obligations. Government of India's immediate response was to secure an emergency loan of USD 2.2 billion from the International Monetary Fund by pledging 67 tons of India's gold reserves as collateral. The Reserve Bank of India had to airlift 47 tons of gold to the Bank of England and 20 tons of gold to the Union Bank of Switzerland to raise USD 600 million. These moves helped tide over the balance of payment crisis temporarily and kick-started P V Narasimha Rao’s economic reform process.