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Scenario 1: Early 90s: Indian economy at the start of 1990s had to face increasing and uncontrollable trade deficit.

A series of high fiscal deficits, excessive regulation of the industry and trade (license raj) and the weakening of the financial sector led to the Balance of Payment crisis in India. Indian foreign reserves fell to a low of $ 1 billion by 1991. Added to this the doubts over sustainability and effectiveness of Indian political system prevented any further flow into the country. Non-oil imports fell by nearly 22 percent. Imminent Gulf war sentiments further reduced the inflow of cash from the Gulf nations and jacked up the oil prices. All these factors contributed to the fall in external sector. Internal growth in India was also hampered by the strong protectionism measures followed by the Indian government. State governments intervened at micro-levels like in businesses, finances and also controlled te functioning of the industrial sector. Labor market, industrialization, business, financial sector all worked under the stringent laws of the state and the central government. This was the period of Licence Raj in India. There was little competition allowed in the industry. Five-Year plans prepared by the Government of india resembled those prepared by the Soviet Unoin in many ways.
Table 1: Fiscal deficits over the years

Government of India decided to move away from its fixed exchange rate system. It decided to reduce the high customs tariff in a phased manner. Most of the trade restrictions were relaxed. Industrial licensing was removed and Monopolies and Restrictive Trade Practices were minimized. Liberalization of the entire economy meant an end to the Licence raj. Years that followed the liberalization saw increased competition in the market, increased international trade and higher consumption. It led to expansion in the direct and portfolio foreign investment, short-term debt getting reduced and annual caps being applied on the medium term borrowings with minimum maturity requirements. NRI deposits norms were made tight. With the increase in FIIs Foreign exchange reserves increased. This helped the country finance its fiscal deficit, the trade deficit and improve the economic sentiments of India. By 1993 foreign currency reserve of US$ 10b had been raised which could cater to three months of imports. Indian government decided on Disinvestment of Public entity to raise more capital. Merchandise export grew at 20 percent a year between 1993/94 to 1995/96. 1991 TO 2000: Reforms made in the Finance and Trade Sector:

Government of India decided to move away from the Fixed exchange rate system. Exchange rate was devalued and the system transformed from the basket-pegged system to a marketdetermined, unified exchange rate. The heavy export duties and the stringent payment regimes were reduced in a phased manner. Government policies moved more towards removal of custom tariffs and quantitative restrictions on export. For some period India adopted a Free Capital Flow policy. This increased the trade with many countries. Indian Net exports showed a steady increase over the following years. Trade deficit and the current account deficit remained under favorable limits. Imports of essential consumer goods such as cotton, edible oil and sugar was liberalized and phasing out of the the Non-Resident Deposits. Trade deficit and Account deficit table Policies were initiated to encourage direct and portfolio foreign investment. The latter grew to a peak of $ 3.8 billion in 1994/95. Direct foreign investment rose more slowly but steadily to a peak of $ 3.6 billion in 1997/98, before falling off significantly thereafter. Short term borrowings were reduced to facilitate better BOP accounts. Expensive NRI accounts deposits were put under tighter regulation and also Exit policies were put into place to prevent sudden backflow of foreign investments. As the FIIs increased, Foreign exchange reserves were accumulated to provide greater insurance against external sector stresses and uncertainties. Short term debt over the years fell and reached level of 4.1 percent. External debt ratio also fell to 22 percent. Indian fiscal plans included Disinvestment policies of selling off publin entity stakes to raise more money. On the monetary front RBI decided to sterilize the foreign asset cummulation and it begin the Open Market (OMO) trading of Government securities to have greater foreign currency reserves. Graph from Table 10 EXCHANGE RATE POLICY: India moved to a Managed Float system in the exchange rate policy. Old system of the basket-pegged system was removed and a unified market-determined system was implemented. Under this system India could achieve the objective of fostering to International competition and at the same time contain the risks from volatility in the market. India adopted the Current Account convertibility norms under the Article VIII of the IMF. This enabled high foreign investments in the Current accounts with easy withdrawal. ROLE OF REVENUE RECEIPTS:

Revenue receipts did not contribute to the fiscal deficit reduction post liberalization. They had very low ratios to GDP. The main factor contributing to the rise in GDP was reduction in the expenditure to GDP ratio. This led to an increase in the revenue expenses in 1999/2000 because of the pay revisions following the Pay commissions. Fiscal deficit graph- Figure 3A Rise in foreign currency As the Indian economy grew at a very fast rate inflation also started to get high. In 1994 RBI increased the Cash reserve Ratio(CRR) by 1 percent. It also performed OMO selling government securities to control the liquidity in market. In 1995 the high level of inflation and high volatility in the market led the Reserve Bank to sell dollars. This was the first time the Foreign Exchange reserve had come post liberalization. This measure helped cool down inflation from double digit levels to 4.5% by March 1996. Year 1997 saw a tremendous decrease in the industrial growth index. Credit squeeze of 1995 to reduce the liquidity and to reduce the inflation is considered as a leading factor for low industrial growth. Another primary reason considered was the infusion of large amount of dollars to contain the exchange rate led to liquidity crush. RBI begin to cut down on the CRR from November 1995 to add back Rs.13,000 Crore of primary liquidity into the economy. Between April 1996 and January 1997, CRR was reduced by 4 percentage point from 14% to 10%. Bank investments in securities rose to Rs. 1,742.22 billion on August 16. According to ICICI Securities & Finance Company, a sum of $4.71 billion held by the central bank was freed in a series of reserve ratio cuts by the RBI between November 11, 1995 and July 6, 1996
http://www.business-standard.com/india/news/cut-in-crr-will-reduce-call-money-rates-sayanalysts/2119/ - Cut

In Crr Will Reduce Call Money Rates, Say Analysts

Government substantially reduced the rates for Corporate taxes and personal income to increase the investment capabilities of non-government entities. East Asian Crisis: 1997 was the year of South Asian crisis. Thai currency Baht depreciated heavily due to the collapse of the real estate sector. International market went on a panic mode and cross border trade became very volatile. Government of India took up various initiatives like preventing sudden appreciation in the real exchange rate, avoiding very high expenditure of Forex reserves. Many reforms in the financial sectors were made. Prudential limits on risk exposures to the real estate and the stock markets.
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In June 1997, Tarapore committee was formed for a phased implementation of capital account convertibility. Sanctions: In March 1998, India successfully conducted to the Pokhran Nuclear test. This provoked many nations to put economic sanctions. Foreign portfolio investments turned negative as the World Bank and IMF decided to impose a cessation on the fresh commitment of loans and credit issues. The reduction in FIIs and volatile situations led to downgrade of credit ratings. RBI took up hands-on initiatives for dollar sales in the market, controlling the forward, spot exchange rates and swap operations in the market to regulate the exchange rates. Circumstances led to the tightening of the monetary policy. CRR value increased to 8.5 percent. By the end of 1999/2000 fiscal deficit was as high as 9.4 percent. Revenue deficits also reached beyond 6 percent. Another factor considered behind the increasing revenue deficit the increase in the employee compensation at state and national level. Finally in December 2000 Fiscal Responsibility and Budget Management (FRBM) Bill was introduced. Overall the economic outlook was gloomy and some pre-liberalization fears could be felt in the market. By 2001/02 revenue deficits had grown to record level as seen in the figure. This caused a problem of high real interest rates and crowding out productive investments. (Figure 2) Government of India began fiscal consolidation from 2002. Over the next few years to 2008 GDP grew at a very fast rate. A remarkable rise in the aggregate savings and investments was observed during this period. Table 8 Key policy changes: Fiscal consolidation was catalyzed by the Fiscal Responsibility and Budget management (FRBM) law in 2003/04. It targeted eradication of the revenue deficit and reduction in the fiscal deficit to 3 percent. Central government also increased the Tax to GDP ratio over the years. Direct tax collection had major contribution towards GDP. Corporate tax rates were fixed at high levels. Table 10 Graph At state level four major factors contributed to reducing the fiscal deficit: 1. 2. 3. 4. Increased tax collection at central level and 30 percent tax devolution to state. Twelfth Finance Commission grants on non-tax revenues receipts Debt relief and debt write off Uniform State value-added taxes (April 2005)

In terms of the monetary market, a surge in the foreign capital was witnessed. RBI decided to conduct sterilized intervention. RBI continued on its Managed Float system and decided to maintain a Realistic exchange rate. RBI also began sale of Market Stabilizing Scheme to continue with its sterilization operation. This was backed by the short term liquidity adjustment facilities like CRR and SLR. Beyond 2008: Over the years the CENVAT was reduced from 16% to 14% as the manufacturing sector grew at a very fast pace from 2003 onwards. Service industry grew at an incredible rate as India opened more centers for the jobs outsourced from US and Europe. Service tax became a source of growing revenue. With the drastic improvements in the Indian economy conditions and positive market sentiments it became mandatory for the Indian government to ensure prudential measures in the banking sector to prevent it from risk exposures.

Banking Sector Reforms A. Prudential Measures Introduction and phased implementation of international best practices and norms on risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure. Measures to strengthen risk management through recognition of different components of risk, assignment of risk-weights to various asset classes, norms on connected lending, risk concentration, application of marked-to-market principle for investment portfolio and limits on deployment of fund in sensitive activities. B. Competition Enhancing Measures Granting of operation autonomy to public sector banks, reduction of public ownership in public sector banks by allowing them to raise capital from equity market up to 49% of paid-up capital. Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities.

C. Measures Enhancing Role of Market Forces Sharp reduction in pre-emption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with a few exception and enhanced transparency and disclosure norms to facilitate market discipline. Introduction of pure inter-bank call money market, auction-based repos-reserve repos for short-term liquidity management, facilitation of improved payments and settlement mechanism D. Institutional and Legal Measures Setting up of Lok Adalats, debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/restructuring. Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act and its subsequent amendment to ensure creditor rights. Setting up of Credit Information Bureau for information sharing on defaulters as also other borrowers. Setting up Credit Information Bureau for information sharing on defaulters as also other borrowers. Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments. E. Supervisory Measures Establishment of the Board for Financial Supervision as the apex supervisory authority for commercial banks, financial institutions and non-banking financial companies. Introduction of CAMELS supervisory rating system, move towards risk-based supervision, consolidated supervision of financial conglomerates, strengthening of offsite surveillance through control returns. Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit. Strengthening corporate enhanced due diligence on important shareholders, fit and proper tests for directors. F. Technology Related Measures Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) system.
Reforms in Governemt Securities market:
Administered interest rates on government securities were replaced by an auction system for price discovery. 1. Automatic monetization of fiscal dfiicit through the issue of ad hocTreasury Bills was phased out.

Primary Dealers (PD) were introduced as market makers in the government securities market. 3. For ensuring transparency in the trading of government securities Delivery versus Pay (DvP) settlement system was introduced. 4. Repurchase agreements (repo) was introduced as a tool of short term liquidity adjustment. Subsequently, the Liquidity Adjustment Facility (LAF) was introduced. LAF operates through repo and reverse auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also signaling device for interest rates in the overnight market. 5. Market Stabilization Scheme (MSS) has been introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system.

2.

Increase in Instruments in Government Securities Market


91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/FRAs were introduced.

Enabling Measures
1. Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits. 2. Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and settlement system in government securities through Clearing Corporation of India Limited (CCIL). 3. Phased introduction of Real Time Gross Settlement System (RTGS). 4. Introduction of trading of government securities on stock exchanges for promoting retailing in such securities, permitting non-banks to participate in repo market.

India was not drastically affected by the Sub-prime crisis. There were negative sentiments in the market. But the Government of India and RBI were able to handle the situation deftly. In 2010 Indian economy had recovered to its optimum. But the year 2011 saw the double whammy to the global economy in terms of the US Debt-Ceiling crisis as well as the Euro Crisis. Though the Indian economy is protected from high volatility in the international market, it had issues to very high inflation, rising oil prices and huge subsidies. Added to this Corruption ran rampant in the central government. This led the Foreign investors to pull out investments. Manufacturing sector contraction. FII begin to flow out by the end of 2011. Rupee value had reached record high of 53.64 Rs/US$. RBI had to intervene by selling US dollars in the market. The Reserve Bank of India joined
central banks in Indonesia and South Korea in selling US dollars to save the local currency from a sharp slide as investors fled for safety amid worsening sovereign crisis in Europe and deteriorating outlook for emerging economies.RBI increased the Repo rate 13 times in 18 months till October 2011.

Governemt of India decided on introducing the scheme of Qualified Foreign Investors (QFIs) who would be allowed to Directly Invest in Indian Equity Market. This scheme is introduced to Help Increase the Depth of the Indian Market and in Combating Volatility Beside Increasing Foreign Inflows into the County.

Goverenment policy of disinvesting their public company shares did not meet the target revenue of Rs. 40,000 Crores. Governrmet decided to partially stop intervention in petroleum prices. Subsidy bill overshot budget estimates and plans of introducing 100% FDI in retail industry failed. Inflation remained stunbbornly high throughout 2011. CRR (24%), SLR (6%) and the Repo rates(8.5%) remained high to lower inflation. GST implementation and DTC was postponed.

The rupee begins to slip


The change of guard at the RBI occurs at a time when Indian foreign exchange markets, which had stood their ground during the South-East Asian currency crisis, are exhibiting intense volatility.

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