Pathways through financial crisis: India.

Author:Ghosh, Arunabha

India survived near-crisis situations twice in the 1990s. How did internal and external constraints shape that country's ability to respond to the crises? This article argues that India's success can be attributed to four sets of decisions taken during the period 1991-1997: devaluation, involvement of the IMF, partial liberalization of the domestic financial sector, and gradual opening up of the external sector. The article analyzes the options, political opposition, and eventual outcomes for each set of decisions. India's ownership of its reform program helped set the pace of reform, while close interaction between technocrats and the IMF added credibility. But the balance between entrenched traditional interest groups and the demands of new interests determined the scope of reform. KEYWORDS: India, financial crisis, economic reform, IMF, interest groups.


India survived near-crisis situations twice in the 1990s, and in 1991 was nearly bankrupt. In response, a reform process began. Engagement with the International Monetary Fund (IMF) had its risks: if India could not deliver on its promises of economic reform, investors would exit again; if the government pushed too hard on reforms, domestic opposition would become unmanageable. In 1997-1998 the Asian financial crisis again threatened India. Macroeconomic fundamentals were vastly different, but political instability and external shocks were common in both episodes. How did internal and external constraints shape India's ability to handle financial crises in the 1990s?

The 1991 Crisis

In 1991, India experienced a classic external payments crisis: high fiscal and current account deficits, external borrowing to finance the deficits, rising debt service obligations, rising inflation, and inadequate exchange rate adjustment. In 1979, the oil shock, agricultural subsidies, and a consumption-driven growth strategy had pushed up the fiscal deficit. It further increased in the mid-1980s as defense expenditure was substantially increased and direct taxes were progressively reduced. (1) The result was that the deficit ballooned from 1985 to reach 9.4 percent by 1990-1991. (2)

India's current account position also worsened. Increasing dependence on foreign oil imports, vulnerability to oil price fluctuations, declining remittances from abroad, strong domestic demand (a result of public sector wage increases in the mid-1980s), and rising debt service payments ensured that the current account deficit averaged 2.2 percent of gross domestic product (GDP) during 1985-1990. Also, export competitiveness was adversely affected by the rupee's steady appreciation: 20 percent between 1979 and 1986. (3) In 1987 it steadily depreciated, but the real exchange rate remained overvalued until 1991.

To finance the twin deficits, India relied on external funds. Foreign investment at 0.1 percent of GDP during 1985-1990 was negligible. (4) During 1980-1985, nearly half of external financing needs were met by external assistance. (5) By the mid-1980s, "aid weariness" forced the government to rely more on commercial borrowing. (6) Soft loans declined in proportion from 89 percent (1980) to 35 percent (1990). (7) Thus, external debt (with a large proportion of short-term debt) started dominating the balance sheet, peaking at 38.7 percent of GDP in 1991-1992, with the debt-export ratio at 563 percent. (8)

Notwithstanding the weakening fundamentals, one key factor that reduced vulnerability was the absence of private sector external debt. Unlike many other countries, individuals and firms could not raise foreign currency-denominated debt, and the banking sector was not allowed to hold financial assets abroad. One effect of this was that the private sector's interests were geared more toward internal deregulation than toward external liberalization. (9)

Two immediate external shocks contributed to the large current account deficit of 3.1 percent in 1990-1991. First, the Gulf crisis in August 1990 exposed the Middle East's strategic relevance for India. Petroleum import costs in 1990-1991 increased by half to US$5.7 billion. (10) The government had to bear the additional burden of airlifting and rehabilitating 112,000 Indian workers from the Middle East as remittances from the region declined. (11) The second shock was global recession: world growth had declined from 4.5 percent in 1988 to 2.25 percent in 1991. (12) Export growth in the United States--India's largest market--turned negative in 1991. Conditions in the Soviet Union, another major export destination, had also worsened. In 1990-1991 India's exports grew only 4 percent.

India was also suffering from internal political instability. The fragile National Front coalition faced a nationwide crisis in the summer of 1990 over its affirmative action policies. By autumn, a campaign by the BJP (an upper caste--dominated coalition partner) to build a Hindu temple at the site of a sixteenth-century mosque in Ayodhya resulted in widespread communal violence. The government collapsed when the BJP pulled out. A new minority government failed to pass the scheduled budget in February 1991 when it lost the Congress Party's external support. In May 1991, while campaigning for the general elections, former prime minister Rajiv Gandhi was assassinated.

In reaction, and in parallel to these developments, the economic situation worsened. By September 1990, net inflows of Non-Resident Indian deposits had turned negative. Access to commercial borrowing had become more costly, and by December even short-term credit was restricted. Foreign exchange reserves fell to $1.2 billion in January 1991. By the time a new government took over in June, reserves could cover only two weeks of imports. India was close to defaulting on its sovereign debt for the first time in its history. (13)

The 1997 Crisis

In 1997, India was much less vulnerable, both relative to 1991 and to most East Asian economies. (14) The fiscal deficit, although still high, had declined since the early 1990s. The current account deficit had fallen to 1.25 percent of GDP in 1996-1997. External debt as a proportion of GDP (24.7 in 1996-1997) was a fraction of that of Indonesia (61.3) or Thailand (62). The debt service ratio had fallen fourteen percentage points since 1990 to 21.2 percent in 1996-1997. The predominantly state-owned banking sector had nonperforming loans that were only 8 percent of total loans. And while many countries were exposed to a common creditor country, this was not the case with India.

The better fundamentals influenced expectations of crisis. In 1996, the IMF calculated that East Asian countries had balance-of-payments (BOP) crisis probabilities ranging from 25 percent for the Philippines to 65 percent for Thailand. India's probability was just 11 percent. (15)

But as in 1990-1991, India was again experiencing political instability. A minority coalition government twice lost parliamentary support of the Congress Party during 1996-1998. In May 1998, the two-month-old BJP-led government engineered nuclear tests, inviting widespread sanctions. Fresh commitments from the World Bank, Asian Development Bank, and bilateral donors ceased. Credit rating agencies downgraded India, and foreign institutional investors withdrew funds.

Against this background, India faced the East Asian crisis, which spread as far afield as Russia and Brazil. Speculative pressures on India persisted from August 1997 to February 1998. The pressure increased in May 1998, when the United States imposed economic sanctions on India for detonating five underground nuclear explosions. The foreign exchange market was particularly volatile. Yet, India emerged relatively unscathed.

The pressures of 1991 and 1997 were managed against a backdrop of international and domestic constraints faced by policymakers. Many in India viewed foreign investment and international financial institutions with great suspicion. A highly regulated economy was considered necessary to keep control over limited economic resources. The experiences of dealing with the IMF and World Bank in the 1960s and 1980s had reinforced the sense that India should be self-reliant. Moreover, in a parliamentary system, executive authority was greatly constrained for minority governments. Powerful interest groups opposed to liberalization--a vast bureaucracy, labor unions representing 20 million public sector employees--not only affected the wage bill but also had immense political clout. (16) These constraints variously shaped the scope and speed of policy changes, as can be seen by examining four key decisions: devaluation in 1991; the IMF program of 1991-1993; partial internal financial liberalization from 1994 onward; and the gradualist change in the exchange rate and external sector.

Devaluation, 1991

In summer 1991, with dwindling foreign exchange reserves, India considered four options. There was a strong temptation to default, but the action would have certainly been self-fulfilling. Since December 1990, India had been borrowing on a daily basis, so market confidence was already eroded; a default would have destroyed any remaining credibility. Policymakers had no intention of souring India's record of repaying debts on time. The second option--seeking private funds--was also unrealistic: Non-Resident Indians withdrew $1.3 billion during April-September 1991. A third strategy was to pawn gold. In April, the then caretaker government had raised $200 million from the Union Bank of Switzerland through a sale of 20 tonnes of gold. In July, another 47 tonnes were shipped to the Bank of England to raise $405 million. The measure had the merit of signaling India's credibility. (17) But India's problem was not temporary; it had to shift away from recurring liquidity squeezes. More unpopular measures were necessary.

The new prime minister, Narasimha Rao, appointed an Oxford-educated former academic/bureaucrat, Manmohan Singh, as...

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