Medi-caps University

Indore

“A Contrary view on Indian Economic Crisis of 1991”

Submitted as Partial Fulfilment for

Degree of Master of Business Administration to
Medi-Caps University, Indore
2022

Submitted To Submitted By
ANKIT SHARMA
Dr. HALDAR SHARMA ANKIT CHOUDHARY
Assistant Professor AKSHAY PANCHAL
Department of Management and Commerce AAYUSHI VERMA
Medi-Caps Unversity, Indore ALKA GADI
ANJALI CHATURVEDI

1
 PREFACE

This project report has been prepared in partial fulfilment of requirement for the subject:
Contemporary Issues in Management MBA (Sem II) in the academic year 2021-22. The research
Report on the topic India’s economic crisis of 1991 was mainly because of Balance of Payment
difficulties, which was a result of scarce foreign exchange reserves for making payments. Across
the literature this crisis is attributed to various things like, higher Fiscal Deficit, higher debt
component, higher interest rates, higher inflation, devaluation of Rupee, Invasion of Kuwait by Iraq,
USA’s invasion in Iraq, resultant rise in oil prices, political instability in communist economies,
political instability in India etc. India had lesser need of hard currencies because of rupee payment
terms with Eastern European Countries and USSR. India USSR trade significantly rose post 1975.
Less attention was payed towards reserves of other hard currencies and there were increase in
imports from western countries and as a result foreign exchange reserves depleted in 1980s. In 1991,
situation was such that India had to pledge Gold reserves for raising foreign exchange. India had
devaluate rupee and had to amend economic policies as terms and conditions to get funding from
IMF. In this paper our attempt is to study possible reasons for such disgraceful situation and could
it have been avoided.

NAME OF STUDENTS
ANKIT SHARMA
ANKIT CHOUDHARY
AKSHAY PANCHAL
AAYUSHI VERMA
ALKA GADI
ANJALI CHATURVEDI

2
 ACKNOWLEDGEMENT

The success and final outcome of this project required a lot of guidance and assistance from many
people and we are extremely privileged to have got this all along the completion of our project. All
that we have done is only due to such supervision and assistance and we would not forget to
thank them.

We respect and thank Dr. Harish Bapat, Dean, Medi-caps University, Indore for providing usan
opportunity to do the project work here at Medi-Caps and giving us all support and guidance,
which made us complete the project duly.

We owe our deep gratitude to our project guide Dr. Gunjan baheti, Assistant Professor, Medi- caps
University, Indore who took keen interest on our project work and guided us all along, till the
completion of our project work by providing all the necessary information for developing a good
project. We are very thankful to and fortunate enough to get constant encouragement, support and
guidance that helped us in successfully completing the project work.

NAME OF STUDENTS
ANKIT SHARMA
ANKIT CHOUDHARY
AKSHAY PANCHAL
AAYUSHI VERMA
ALKA GADI
ANJALI CHATURVEDI
INDEX

S. No. Contents Page No.

1 Preface 2

2 Acknowledgement 3

3 Abstract: 5

4 Introduction: 5

5 Literature Review: 5-6

6 Analysis and observation: 6-15

6.1 Political uncertainity in the country:

6.2 Economic Structure:
6.3 India’s Trade and Balance of payments:
6.4 Instability in USSR and communist contries:
6.5 Gulf Crisis:
6.6 Balance of Payment Crisis of 1991:

7 Causes and consequences: 15

8 Recovery: 15-16

9 The Balance of Payment Crisis of 1991 16-29

10 Conclusion 29

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 Abstract

India was passing through difficult times on various fronts like Economic, Political and External sector in late
1980’s. Rupee was pegged with a basket of currencies and exchange rate of rupee with foreign currencies was
highly regulated by RBI. Rupee was devaluated several times on the guidelines of IMF in 1990 and 1991. As it
was always earlier, India’s current account balance was negative and country was facing Balance of Payment
difficulties in 1991. India’s foreign exchange reserves had depleted and IMF and world community was not
willing to help India unless it brings in economic reforms. This situation though emerged in few months;
economists consider various factors responsible for the situation, which were results of policies of government
and chronological events occurred for several years. In this paper author will review the available literature and
will present his contrary view on the said economic crisis.

Keywords : Balance of Payment, Causes of Currency crisis of 1991, Foreign Exchange Reserves, India USSR
relations, India’s Foreign Trade, Gulf Crisis.

Introduction:

India’s economic crisis of 1991 was mainly because of Balance of Payment difficulties, which was a result of
scarce foreign exchange reserves for making payments. Across the literature this crisis is attributed to various
things like, higher Fiscal Deficit, higher debt component, higher interest rates, higher inflation, devaluation of
Rupee, Invasion of Kuwait by Iraq, USA’s invasion in Iraq, resultant rise in oil prices, political instability in
communist economies, political instability in India etc. India had lesser need of hard currencies because of
rupee payment terms with Eastern European Countries and USSR. India USSR trade significantly rose post
1975. Less attention was payed towards reserves of other hard currencies and there were increase in imports
from western countries and as a result foreign exchange reserves depleted in 1980s. In 1991, situation was
such that India had to pledge Gold reserves for raising foreign exchange. India had devaluate rupee and had
to amend economic policies as terms and conditions to get funding from IMF. In this paper our attempt is to
study possible reasons for such disgraceful situation and could it have been avoided.

Literature Reveiw:

Ahluwalia in his paper talked about economic reforms in India post 1991, but still it gives it his opinion about
crisis and probable events pre 1991. He is of opinion that changes in policies was required much earlier.
Many Asian countries in Asia achieved high growth and poverty reduction through improving policies to
promote Private sector and exports. India took steps for modernization of economy in 1980, but no significant
steps were taken until economic policy of 1991 (Ahluwalia, 2002).

Cerra & Sweta have tried to find out what caused currency crisis of 1991 in India. They observed that rupee
appreciates with improvement in trade, technological progress, and a relaxation of capital controls and real
exchange rate depreciates when government spending (on tradable goods) increases, the economy opens up
and investment increases. They are of opinion that the current account deficits played a significant role in the
crisis. They also concluded that sentiments of investors, excessive debt and debt servicing also led to
currency crisis (Cerra & Sweta, 2002).

Ghosh discussed about crisis of 1991 and reforms thereafter and tried to touch on possible reasons of
currency crisis of 1991. He also discussed about funding from IMF, conditions put by IMF, currency
devaluation. He has also discussed various economic factors prevailing in 1990s and discussed various things
like growth of GDP, government spending, fiscal deficit, foreign investments and implications of Gulf crisis.
(Ghosh, 2006)

Singh said in his speech, “International confidence in our economy was strong until November 1989 when
our Party was in office. However, due to the combined impact of political instability witnessed thereafter, the
accentuation of fiscal imbalances and the Gulf crisis, there was a great weakening of international
5
 confidence. There has been a sharp decline in capital inflows through commercial borrowing and non-
resident deposits. As a result, despite large borrowings from the International Monetary Fund in July 1990
and January 1991, there was a sharp reduction in our foreign exchange reserves.” He said that crisis is
because of internal and external uncertainties and country have never experienced anything so severe in the
past. He also said that low productivity was responsible for a weak economy. He also pointed out that, fiscal
deficit was 4% of GDP in mid 1970’s, which increased to 6% in the beginning of 1980’s to 8% of GDP in
1990-91. This fiscal deposit has to be financed by borrowing and it puts an interest burden in subsequent
years. He pointed out that current account deficit was about 2 per cent of GDP for many previous years and it
is estimated at 2.5 in 1990-91. This deficit is financed by loans from abroad and as a result, foreign loans
have substantially increased. He also said that debt service burden is around 21 per cent of current account
receipts in 1990-91. Gulf crisis has also contributed to adverse balance of payments. (Singh, 1991).

Research Questions and Research Methodology:

We have done review of literature on balance of Payment Crisis of 1991 and have arrived at following
questions:
1. What were the main reasons of Payment Crisis of 1991?
2. What role political and economic uncertainties in Eastern Europe and USSR played in crisis of 1991?
3. Was weakness in Indian economy the only reason for payment crisis of 1991? Research methodology will
involve analyzing the available literature, trade, foreign exchange data and trying to present a view on the
crisis and previous explanations of the said crisis.

Analysis and observations:

1.1 Political uncertainty in the country:

Indian Government had a policy of Socialism with government control on economy by controlling businesses
by imposing license requirements and controlling prices of commodities. Government started its own
enterprises and invested lot of money in Industrialization of India. Policies discouraged private investments and
fair competition. Foreign capital flow was also discouraged. Importing goods was difficult by private
businesses. Indian private sector has lot of potential but government discouraged it by putting control of free
business. However, government initiatives contributed positively in Indian economy, but private sector could
have done better than public sector.

In 1970’s India USSR political and Economic relations started growing. India signed a treaty with USSR,
which is also known as India USSR friendship treaty. In 1971, Pakistan attacked India and war broke out in two
major countries in south Asia. Defense technology and training provided by USSR proved to be very effective.
USSR backing to India in case of enemy attack on India was thought very critical by US president Richard
Nixon. He considered it critical for peace in Asia from US point of view.

CIA was critically analyzing India USSR relations post 1970’s. CIA released various secret documents, which
are available on its website, is a proof of United States’ interest in USSR-India relations. However, most of the
data released look factual but there are few things, which does not have any relation with the reality in India or
India-USSR relationship. India was always more inclined towards western European and North American
technology, economy, politics and culture, but USSR proved to be India’s best friend in its need and this trust
grew over the period of time. India and USSR had rupee payment agreement for paying in balance of trade
adversities. These terms of rupee payments facilitated India to acquire Russian technology related to defense,
space as it was easier for making payments and this technology was cheaper than North America and Europe.

As Indian population and economy was growing, India’s Petroleum/Oil needs were growing. USSR was major
supplier of petroleum products in 1980’s. As per CIA, in 1st half of 1980’s almost 70% of imports from USSR
was petroleum products (CIA, 1986).

Throughout 1980’s, USSR faced economic and political turbulence. India too faced political turbulence post
assassination of Mrs. Indira Gandhi. From 1988 until 1991, India had four different Prime Ministers and four
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different union cabinet of ministers. Mrs. Indira Gandhi had extremely good relations with politicians and
bureaucracy in USSR. These relations helped country in procurement of defense equipment, technology and
petroleum at favorable terms for the country. Post assassination of Mrs. Indira Gandhi, her son Rajiv Gandhi, a
pilot, became Prime Minister. Prime Minister Rajiv Gandhi had to spend lot of his time strengthening his
political career and his party and tried to bring in economic reforms. During his regime, India witnessed
modernization, acquisition of western technology, reforms in trade, which resulted in rise in fiscal deficit and
Balance of Trade.

It was during Prime Minister Rajiv Gandhi’s government when army was sent as ‘peace keeping force’ to Sri
Lanka in 1987. Army acted against interests of LTTE, who were freedom fighters in Jaffna region of Sri Lanka.
His assassination was attempted in 1987, which was a failed attempt. There were issues like terrorism in
Punjab, Bofors Scandal etc. These issues diverted government’s attention towards noncore and lesser important
issues.

In 1989 elections, congress could not get required majority to form a government. Janata Dal acquired required
majority by forming national front as coalition of small parties to form government, and Mr. V P Singh became
Prime Minister, but his government lasted for a little less than a year. Economic instability like slow growth,
depleting foreign exchange, rising fiscal deficit, widening balance of payments gap were visible, but V P Singh
Government could not take steps to handle these issues. Mr. Chandra Shekhar with his supporter left Janata Dal
to form his own party and Janata Dal lost its majority. Mr. Chandra Shekhar formed a government with the
support of congress in November 1990 and became prime minister, but shortly congress withdrew its support
and fresh elections were called in 1991. Due to political uncertainty in the country, government was unable to
concentrate in core activities as they were engaged in protecting their government. Post assassination of Indira
Gandhi, no other government could have similar warmth with USSR’s politicians. Due to economic and
political instability in USSR, India-USSR relations were not growing as desired.

In 1991 during election campaign in Tamil Nadu, Rajiv Gandhi was assassinated. It is said that Indian Army’s
and Indian Government’s moves against LTTE made LTTE chief Prabhakaran angry. LTTE did not want Rajiv
Gandhi to form a government or to become Prime Minister again, therefore it is widely said that on the
guidance of Prabhakaran LTTE assassinated Mr. Rajiv Gandhi. After elections of 1991, congress led alliance
formed a government and Mr. P V Narasimha Rao became Prime Minister. P V Narasimha Rao government
carried out major trade and economic reforms in the country. In these four years India had four different
governments. Due to lack of majority and political uncertainties, no government was able to take concrete steps
for economic reforms. These political uncertainties in the past resulted in lesser attention towards economy and
making it vulnerable.

1.2 Economic Structure:

India always felt proud since its independence for maintaining its economic self reliance in many aspects. But
there were fundamental flaws in the economy, like low productivity, lack of encouragement to private sector in
commerce and trade, excessive government control over economy. Due to low productivity, low employment,
heavy cost of capital, inferior indigenous technology, poor environment for doing business and lack of
innovation, economy could not grow as it should have been grown post independence period, which made
Indian economy vulnerable to external shocks.

India had a socialistic structure of economy and many businesses were run by government to meet needs of
goods and services in the country. Prices were regulated so that it can serve masses with goods and services,
which is the principal of socialism. Private sector was subject to strict licensing, which resulted in slow and
inefficient growth of private sector. Many public sector companies could not perform well to fulfill economic
interests of the nation. Government was fearful that encouragement to private sector could lead to capitalism
and government may fail to serve people as desired. Doors were kept closed for foreign companies by
restricting FDI. It was felt that if doors are opened for the foreign companies, Indian companies would not be
able to compete with foreign companies. But after liberalization exactly opposite happened, many Indian
companies in Software, Technology, Pharmaceuticals emerged as global giants and many Indian manufacturing

7
companies could perform better than few of their global competitors post implementation of LPG model by Rao
government post 1991. Most of the reforms were conditions imposed by IMF for providing future line of credit.
These reforms helped India to grow economically. We strongly agree that structure of economy was not good
and reforms were required. But still these economic reforms post 1991 were not sufficient to deal with future
uncertainties. Some major structural changes are required with a long foresight which will protect economy
from unforeseen events. Though flaws in economy is considered as factor responsible for Balance of Payment
Crisis of 1991 many economists, but we are of a opinion that Crisis was not a direct result of flaws in Indian
economy. Crisis could have been avoided with economic vigilance with the same economic structure.

1.3 India’s Trade and Balance of Payments:

In 1980s and 1990s destination of largest India’s export was USA. Significant exports was made to USSR,
Japan Germany and UK after USA. USSR was facing political and economic problems throughout 1980’s and
these problem became severe in 1991 and USSR broke into 15 countries. As a result many rupee trading
agreements were terminated. This resulted in fall of India’s exports to USSR 1991-92 which kept on continuing
thereafter. In 1990-91 India exported more commodities to USSR than USA. India was not prepared for
international political and economic uncertainties due to inherent weakness in the economy. After fall of USSR,
India had to rely on other countries for supply of necessities where payment had to be made in hard currencies.
Post 1991, India witnessed steady increase in exports to UK, USA, Hong Kong, Germany etc.

Direction of Exports ( US $ million)

Country 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95
USA 2,252.10 2,574.00 2,686.20 2,673.20 2,921.10 3,515.90 3,998.50 5,020.70
U S S R / Russia 1,513.70 1,801.80 2,678.00 2,928.60 1,640.00 607.2 794 901.2
Japan 1,244.50 1,487.70 1,638.90 1,693.70 1,651.50 1,436.50 1,740.90 2,026.60
Germany 816.8 853.7 1,064.00 1,420.50 1,269.90 1,427.00 1,539.20 1,747.70
UK 783.1 796.3 961.1 1,185.70 1,138.10 1,213.40 1,379.10 1,689.70
Belgium 373.7 611.4 723 701.9 666.9 683.4 843 988.4
Hong Kong 344 564.5 537.3 596.5 614.3 765 1,249.60 1,517.40
France 292.4 295.1 383.4 427.1 425.5 471.5 504.4 582.1
UAE 238.8 293.4 426.5 438.9 738.5 814.3 1,157.90 1,265.90
Saudi Arabia 214.2 223.4 257.6 233.2 351.3 407.5 510.8 435.7
Singapore 210.5 222.6 280.1 379.4 388.8 588.5 752 770.3
South Korea 112.4 126.3 160.9 182.7 238.7 174.9 206.4 332.4
Iran 107.4 61.7 79.4 78.5 122.5 114.4 159.7 156.8
Kuwait 81.8 99.4 118.9 41.1 52.3 108.3 106 133.9
Malaysia 69.6 90.9 105.8 151 202.4 189.8 247.3 286.6
Iraq 13.5 36.5 75.2 24.2 - 5.9 3.9 0.2

Total Trade 12,088.50 13,970.40 16,612.50 18,145.20 17,865.80 18,537.20 22,238.30 26,330.50
Note: Exports of Petroleum Products are taken into account in total exports, but are not included in country-wise
details.

Table 1 - Direction of Exports by Countries (RBI, 2017)

In 1980’s major destinations of India’s export were Germany, Japan, USA and USSR. Post fall of USSR in
1991, imports from USSR started reducing. USSR was major supplier of Defence Technology and Oil to India
and payment were made in convenient rupee terms. India saw significant rise in imports from Saudi Arabia,
UAE and Iran post 1991 due to a combined effect to Gulf War, Oil Price rise. Shock of Gulf War and Oil Price
rise became severe because of rupee devaluation. All these payments for oil imports were to be made in hard
currency. Post gulf was there was steady rise in imports from Kuwait. By mid-1990’s trade started shifting
southwards. India witnessed Trade deficit throughout in 1980’s and problem became serious because of eroded
forex reserves and loss of rupee trading partners.
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 Direction of Imports ( US $ million)
Country 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95
Germany 1,664.90 1,697.10 1,673.50 1,935.60 1,559.40 1,656.90 1,790.30 2,187.00
Japan 1,639.80 1,816.70 1,692.20 1,808.30 1,369.30 1,427.90 1,522.10 2,039.90
USA 1,543.80 2,236.80 2,561.20 2,923.00 1,994.70 2,147.40 2,736.70 2,905.70
UK 1,410.20 1,655.90 1,782.60 1,612.80 1,201.90 1,417.40 1,536.10 1,559.10
U S S R / Russia 1,240.00 868.6 1,223.40 1,420.10 728.5 254.6 380.4 749.2
Belgium 1,057.10 1,418.90 1,619.80 1,514.60 1,388.00 1,826.80 1,874.80 1,206.70
Malaysia 648.3 549.5 390.7 554.8 394.3 405.9 249.9 490.1
France 615.1 556.4 967 727 614.8 594.7 593.1 615.6
Saudi Arabia 590.4 1,307.30 866.9 1,615.80 1,442.50 1,496.00 1,541.70 1,569.60
UAE 588.4 601.5 857 1,059.10 1,247.50 1,111.70 1,003.10 1,533.10
Iraq 471.5 134.1 277.1 276.2 2.5 0 0 0
Kuwait 363.7 359.8 696.9 202.3 304.7 954.1 1,126.20 1,480.20
Singapore 323.4 428.9 539.9 795.7 694.7 632.1 626.9 899.7
South Korea 257 318.1 342.2 366.1 319.3 355.1 564.5 629.5
Iran 111.1 89.2 233.8 567.1 582 397.7 379.5 536.5
Hong Kong 92.6 121 149.1 165.6 106.2 170.4 188.7 287

Total Trade 17,155.70 19,497.20 21,219.20 24,072.50 19,410.90 21,881.60 23,306.20 28,654.40
Table 2 - Direction of Imports by Countries (RBI, 2017)

Since independence of India, India’s Balance of Payment was always negative with few exceptions. Adverse balance
of payments was most of the time because of adverse Balance of trade. India always imported more commodities than
it exported. Low efficiency, inferior indigenous technology, labour intensive industries, excessive government
regulationsof business, overall bad environment for business led to reduced productivity and economy remained a
deficit economy. For getting commodities people had be in queues. For buying many commodities and service like
scooter, car, telephone etc. there used to be long waiting time of months and years. India is the largest producer of
almost all oil seeds in the world. Still it had to import edible oil. This deficit economy had to rely on imports.
Modernisation attempts by the government in 1980’s resulted in more imports from the western countries. Trade
deficit kept on rising and its cumulative effect was visible as crisis in 1991

India’s Balance of Payments in USD

(US $ million)
Item/ Year 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95
1 2 3 4 5 6 7 8 9
I. Merchandise
A) Exports, f.o.b. 12644 14257 16955 18477 18266 18869 22683 26855
B) Imports, c.i.f. 19812 23618 24411 27914 21064 24316 26739 35904
Trade balance (A-B) -7168 -9361 -7456 -9437 -2798 -5447 -4056 -9049
II. Invisibles, net 2316 1364 615 -242 1620 1921 2897 5680
III. Current account (I+II) -4852 -7997 -6841 -9680 -1178 -3526 -1159 -3369
IV. Capital account (A to F) 5047 8064 6977 7188 3777 2936 9694 9156
A) Foreign Investment 434 357 410 103 133 557 4233 4922
B) External assistance, net 2271 2216 1856 2210 3039 1859 1901 1526
C) Commercial borrowings, net 976 1894 1777 2248 1456 -358 608 1030
D) Rupee debt service - - - -1193 -1240 -878 -1054 -983
E) NRI deposits, net 1419 2510 2403 1536 290 2001 1207 172
F) Other capital -53 1087 531 2284 101 -245 2800 2489
V. Overall balance (III+IV) 195 68 136 -2492 2599 -590 8535 5787
VI. Monetary movements
(VII+VIII+IX) -195 -68 -136 2492 -2599 590 -8535 -5787
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VII. Reserves (increase -/ decrease +) 737 1001 740 1278 -3384 -698 -8723 -4644
VIII. IMF, net -932 -1069 -876 1214 785 1288 188 -1143
IX. SDR allocation - - - - - - - -
Notes : Capital account includes Errors and omissions.

Table 3 - India’s Balance of Payments (RBI, 2017)

1.4 Instability in USSR and Communist countries:

India and USSR entered in treaty of Peace, Friendship and Cooperation in 1971. In 1971, Pakistan attacked India
and in response India invaded East and West Pakistan. On the request of Prime Minister Indira Gandhi, USSR
decided to support India and sent its ships in Indian ocean to deal with the navy fleet which was sent by USA in
Indian ocean. USSR proved India’s true friend in its need. But when USSR invaded Afghanistan, India was did not
want to enter the war to maintain its non-aligned status. However India and USSR relations kept on growing till
resignation of Mikhail Gorbachevfrom the post General Secretary of the Communist Party of the Soviet Union in
December 1991 (Sachdeva).

India had Rupee Trading arrangements with several countries in Eastern Europe and USSR. In 1980 almost 22% of
India’s total exports were made to East Europe which remains high till end of 1991. Imports of capital goods and
defense equipment were financed by long-term trade credits. India’s critical needs like Defense Equipment,
Technology, Petroleum Products, space technology etc. were met by USSR where payment was to be made in
convenient rupee ruble terms. After dissolution of the USSR, many rupee-trading terms were ended in 1990-91.
Rupee trade terms with German Democratic Republic and Poland ended in December 1990 January 1991
respectively. Political uncertainties in USSRkept its leaders worried in 1980’s and in late 1980’s and 1990
onwards. Main objective of USSR was to bring down fiscaldeficit and improve its economy. This resulted in steep
fall in trade between India and USSR. In addition, as USSR broke into 15 countries in 1992, India’s trade with
Eastern Europe and Russia significantly dropped (Virmani, 2001).

As discussed above, CIA believes that major import by India from USSR was Crude Oil and Petroleum Products in
second half of 1980’s (CIA, 1986). India imported 23% of oil needs from USSR in 1984-85, whereas its
composition was 17% in1985-86 and 17% in 1989-90 respectively in India’s total oil imports (Nandy, 2015). Oil
prices crashed after 1985 and Soviet Union suffered due to this. After fall of USSR, sudden drop of trade with
Russia in 1992 can be observed. India could have imported Petroleum Products from Russia, with whom it had
comfortable rupee trading terms, if USSR would have survived or if economic conditions were good in newly
formed Russia. Thus, political and economic disruption in Eastern Europe and USSR gave major blow to India’s
external sector and in turn Indian Economy as a whole (Secretariat,2013). As India had rupee trading terms with
Eastern Europe, it did not bother much about foreign exchange reserves.

India’s liberalization of imports in late 1980’s resulted into heavy rise in imports with slow growth in exports,
which resulted in exchange crisis. If USSR would not have faced economic and political challenges, India would
not have faced balance of Payment crisis in 1991. It is a lesson for India, that excessive dependence on one or two
major trading partners can lead to uncertainties. It’s better to have more number of reliable trade partners with
sound economies. 10
 Composition of India’s Trade with USSR in 1970 and 1985:

Figure 1 - Composition of India’s Imports (CIA, 1986)

1.5 Gulf Crisis:

Political Instability in the gulf was visible since the beginning of 1980. Iraq invaded Iran in September 1980. OPEC
countries were restricting production of Oil in early 1980’s as a result during 1980 and 1981 oil prices were high (Reynolds
& Kolodziej, 2006). Post 1985 oil prices started reducing as OPEC countries started increasing production, but north
European countries and Soviet Union suffered a lot due to reduced oil prices and these reduced oil prices caused economic
disruption in USSR and it broke into pieces without fighting a war (Gaidar, 2007). India should have increased imports of
petroleum and oil products from USSR even at significant premium prices to international oil prices. This was possible
with government intervention as Oil and Gas industry was dominantly controlled by government companies.This could
have been a win-win situation for USSR and India. Iraq invaded Kuwait in 1990due to old enmity and to increase its
territories and access to oil reserves. Gulf war led to slight increase in oil prices and jump in oil imports in 1990 and
1991. Factors like, stopped supply of oil from Iraq and Kuwait, fall of Soviet Union, widened gap of Balance of Payments,
Low Foreign Currency Assets made situation critical and was felt even worst in the country with thedevaluated rupee.
Widely described reason of Balance of Payments Crisis of 1991 is Gulf war and rise in oil prices. But, rise in oil price
was not very high after gulf war broke out. If, India would have worked on economic intelligence / vigilance it could
have predicted changes or could have simulated situations tostudy possible future impact of global political and
economic changes on Indian economy.

1.6 Balance of Payment Crisis of 1991:

Indian companies had taken short-term external loans at lower rates. With fluctuations in interest rates and
devaluation of rupee, higher amount was payable to service debt. In 1991 current account deficit was 3.1 % of
11
GDP, fiscal deficit was high and there was higher inflation in the economy. (Reddy, 2006)
Several Credit rating agencies downgraded India’s credit rating (Taneja & Thakijrta, 1990). S&P downgraded
India’s sovereign rating to junk status in May 1991 (Johnson, 2007). Because of this, generating more loans became
very difficult. When attempts were made to raise foreign exchange from International Monetary Fund, they insisted
on changing economic policies and were not initially ready to provide sufficient assistance without economic
reforms, whereas other international financial institutions and banks were not willing to lend to India because of its
low credit rating. 1991 witnessed lowest foreign investor confidence and foreign investments were lowest in 1991.
Deposits kept byNon Resident Indians suddenly started moving out of country in March 1991 from India. Non
Resident Indians were losing confidence on India because of the media coverages on Falling Forex Reserves,
Rising Fiscal Deficit, high inflation and so these deposits started moving out of country in 1991, contributing to
further reduction of foreign Currency Assets.

As per Dr. Y. V. Reddy economic crisis could have been anticipated much earlier as a result of depleting foreign
exchange reserves from USD 3.1 billion in August 1990 to USD .98 billion in July 1991. Country witnessed
constant fall in foreign exchange reserves for a longer period and problem became serious when foreign exchange
reserves came downbelow 1 billion dollars. Country had only few week’s import cover available in 1991 (Reddy,
2006).

Foreign Exchange Reserves in Selected Countries

(USD billion)
1990 1991 1992 1993 1994 1995 1996
India 1.21 3.58 5.46 9.81 19.39 17.47 197.42
China 28.59 42.66 19.44 21.20 51.62 73.58 98.85
Indonesia 7.35 9.15 10.18 10.99 11.82 13.31 15.06
Malaysia 9.33 10.42 16.78 26.81 24.89 22.95 25.21
South Korea 14.46 13.31 16.64 19.70 25.03 31.93 32.32
Thailand 13.25 17.29 20.01 24.08 28.88 35.46 38.03
Taiwan 35.79 40.28 43.53 44.30 43.38 40.87 40.10
Import Cover in Months
India 0.6 2.1 2.8 5.2 8.7 6.1 6.7
China 6.5 8.2 3.1 2.5 5.4 6.8 9.2
Indonesia 4 4.2 4.5 4.7 4.4 3.9 4.4
Malaysia 3.8 3.4 5.1 7 5 3.5 3.9
South Korea 2.5 2 2.4 2.8 2.9 2.8 2.9
Thailand 4.8 5.5 5.9 6.3 6.4 6 6.5
Taiwan 7.8 7.7 7.2 6.9 6.1 4.7 4.6

Table 4 - Foreign Exchange Reserves (Ministry of Finance, 1997)

As per above table originally prepared by IMF and republished by Ministry of Finance in ‘Economic Survey of India’,
India’s foreign Exchange reserves were only USD 1205 million in 1990 and was USD 3580 million in 1991. These
Foreign Exchange Reserves are only sufficient for making payments of 0.6 months of imports and 2.1months of
importsin 1990 and 1991 respectively. Whereas if we observe foreign exchange reserves of other Asian countries, it
was much higher than that of India and these countries also had higher import cover. If we observe smaller Asian
countries other than china, they had much higher foreign exchange reserves.

4. We can conclude that following were few important reasons for Economic Crisis of 1991:

We observed, fall in imports from USSR from 1987-88 till 1999-89 and thereafter steep fall in import1s2from USSR
post 1991 and newly formed Russia. Thereafter further fall of exports to USSR post 1990-91 and steep decline in
exports to newly formed Russia. As per CIA USSR was one of the important exporter of Oil and defense equipment
to India. Heavy fiscal deficit, economic crisis and Political instability in USSR during 1980’s led to fall of USSR in
1991. Excessive dependence on few trading partners like Germany and USSR for exports and imports of necessary
commodities and thereafter fall of USSR and merger of GDR into Germany distorted rupee trade with these
countries, which resulted in need of hard currency for import of similar commodities. This contributed in fall of
forex reserves.

Balance of Payment adversities was a constant phenomenon in Indian economy. Balance of Payment adversities
were dominated by adverse Balance of Trade and adverse balance of trade was because of inefficiency o the
economy and excessive government regulations for domestic business. Rise in Oil Prices due to Gulf War and
Devaluation of Rupee several times resulted in costlier imports and ultimately high inflation. Political and
Economic Crisis of USSR of late 1980's and its severity at the beginning of 1990's and thereafter fall of USSR can
cancellation of rupee trading agreements, resulting in reduced supply of Oil from USSR. There was a combined
effect to Devaluation of Rupee, Rise inOil Prices and economic and political crisis in USSR on heavy jump in
Import Bill in 1991.

Country failed to maintain sufficient FCA's for facing external jolts. When smaller jolts caused a balance of
Payment Crisis for the nation, what bigger jolts could have done? If we compare today’s economic condition of
India with 1980's, there was nothing seriously wrong with the economy. Economy was growing post 1980's much
above so called ‘Hindu Growth Rate’ (Bhagwati, 1993) (Panagariya, 2004). Economic reforms were started in
1980's, though they were slow. There was import liberalization, which resulted in jump in imports in 1980’s.
Erosion of foreign exchange reserves wasan effect of continuous negative balance of trade.
Government took measures to liberalize trade in 1980's, which resulted into heavy imports and ultimately higher
Balance of Trade deficit. Before liberalizing trading barriers, environment should have made friendlier for private
businesses to grow. If government would have done it in 1970's and 1980's, then at the time 'liberalization of trade
policies' country would have excess quantity of cheap and quality goods for exports which would have worked as
import deterrent / substitution measure. India is a largest producer and exporter of oil seeds in the world. Capacities
should have been built for production of edible oil on mass scale by providing incentives, which could have curbed
imports of edible oil and in place of importing edible oil, India could have exported edible oil on a large scale.
Several cheap and quality manufactured goods could have been exported post domestic economic reforms which
could have helped post trade liberalization to correct the Balance of Trade.

Economy was structurally weak in 1980's to meet foreign economic jolts. LPG model was brought in by Prime
Minister PV Narasimha Rao, which worked as deterrence against Balance of Trade problem. But still structurally
economy is not very strong and still it remains vulnerable for unforeseen jolts. Reforms were undertaken to deal
with the ongoing payment crisis and to improve many aspects of the economy. Nevertheless, still today economy is
not strong enough to deal with major economic disruptions in the world, even with Foreign Currency Assets
touching 400 billion dollars.

Gulf war and in anticipation of problems with Indian economy, NRI deposits had eroded in 1991. Foreign
Investment waslow as country's credit rating was lowered and due to licensing requirements and overall absence of
ease of doing business for the private sector. Due to low ratings it was very difficult to raise funds to finance
payment crisis. These two factors restricted growth in Foreign Currency Assets.

Due to instability, Chandra Shekhar government could not take alternative measures to increase Foreign Currency
13
Assets.Ultimately, Government had to agree on advice of RBI to pledge country's gold to foreign banks so that
 Foreign Exchange can be arranged for facilitating payments.

Foreign Currency Asset depletion was a cumulative effect of rising Balance of Payments in 1980’s. Situation did
not ariseas a result of a short term flaws in the economy. It was a cumulative effect of political instability, economic
reforms of 1980’s, import liberalisation in late 1980’s. There were not only internal weaknesses of economy like
low productivity, inflation, fiscal deficit that were responsible for payment crisis of 1991 but there were substantial
international political and economic factors which gave jolts and are responsible for balance of payment crisis of
1991.

After studying the crisis it gives a feeling that India could not predict or have not taken efforts to predict factors
like, probable fall of communist economies, OPEC Policies, changing commodity prices, economic problems in
USSR, unification of GDR into Germany, Gulf politics and internal economic inefficiency. India failed in its
economic intelligence / vigilance and as a result, it had to pay huge price in terms of exchange rate devaluation and
altering economic and trade policies on the directions of IMF. Reforms were required in Indian economy, but they
should have come from within and not as a step to satisfy conditionality to fight crisis. India could have started with
better reforms much earlier for a balanced growth. We strongly believe that India could have avoided a regretful
situation of pledging of country’s gold and also could have avoided devaluation of rupee in 1991 with economic
vigilance.

References
Ahluwalia, M. (2002). Economic Reforms in india Since 1991: Has Gradualism worked? Journal of Economic
Perspectives, 16(3), 67-88.

Bhagwati, J. (1993). India in Transition: Freeing the Economy. Oxford University Press.
Cerra, V., & Sweta, S. (2002). What Caused the 1991 Currency Crisis in India? IMF Staff Papers 49, no. 3, 395-
425.
CIA. (1986, November). India USSR Strains in Relations. Declassified in Part - Sanitized Copy Approved for
Release 2012/07/16 : CIA-RDP88T00096R000300410001-4. USA: CIA.
Gaidar, Y. (2007). The Soviet Collapse: Grain and Oil. Washington, D.C.: American Enterprise Institute of
Public Policy Research.
Ghosh, A. (2006). Pathways Through Financial Crisis: India. Global Governance, 413-429.
Johnson, J. (2007, January 31). India’s sovereign credit rating upgraded. New Delhi. Retrieved from
https://www.ft.com/content/714d6a02-b0b0-11db-8a62-0000779e2340

Ministry of Finance. (1997). Economic Survey of India 1997: External Sector. New Delhi: Ministry of Finance,
Government of India. Retrieved from http://www.indiabudget.gov.in/es96-97/TAB616.HTM
Nandy, D. (2015). Energy Crisis of India: In Search of New Alternatives. Journal of Business and Financial
Affairs, 1-6.

Panagariya, A. (2004). Growth and Reforms during 1980s and 1990s . Economic and Political Weekly.
RBI. (2017, September 15). Handbook of Statistics on Indian Economy. Table 143 : Key Components of India’s
Balance of Payments - US Dollar, INDIA. Retrieved from
https://rbi.org.in/Scripts/PublicationsView.aspx?id=17918
RBI. (2017, September 15). Handbook of Statistics on the Indian Economy. Table 121 : Direction of Foreign
Trade. India. Retrieved from https://rbi.org.in/Scripts/PublicationsView.aspx?id=17907
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Reddy, Y. V. (2006, December 19). Dynamics of Balance of Payments in India. Hyderabad, Andhra Pradesh,
India. Retrieved from https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/74785.pdf
 Reynolds, D., & Kolodziej, M. (2006). Former Soviet Union oil production and GDP decline: Granger causality
and the multi-cycle Hubbert curve. Energy Economics, 271-289.
Sachdeva, G. (n.d.). India’s relations with Russia. In D. Scott (Ed.), Handbook of India’s International Relations
(pp. 213-222). London and New York: Routledge Taylor and Fransis Group.
Secretariat, G. (2013). Trade Policy Review Mechanism India. General Agreement on Tariffs and Trade Council.

Singh, M. (1991, July 24th). Budget 1991-92, Speech of Shri. Manmohan Singh, Minister of Finance. Retrieved
from http://www.indiabudget.gov.in/bspeech/bs199192.pdf

Taneja, S., & Thakijrta, P. (1990, October 31). International credit rating agencies downgrade India's county
rating. Mumbai, India. Retrieved from https://www.indiatoday.in/magazine/economy/story/19901031-
international-credit-rating-agencies-downgrade-india-country-rating-813183-1990-10-31
Virmani, A. (2001). India's BOP Crisis and Extrernal Reform: Myths and Paradoxes. Indian Council for
Research on International Economic Relations. New Delhi: Indian Council for Research on International
Economic Relations, Lodhi Road, new Delhi.

Causes and consequence:

The crisis was caused by currency overvaluation; [2] the current account deficit, and investor confidence played
significant role in the sharp exchange rate depreciation.[11][12][13]

The economic crisis was primarily due to the large and growing fiscal imbalances over the 1980s. During the mid-
eighties, India started having the balance of payments problems. Precipitated by the Gulf War, India’s oil import bill
swelled, exports slumped, credit dried up, and investors took their money out.[14] Large fiscal deficits, over time, had
a spillover effect on the trade deficit culminating in an external payments crisis. By the end of the 1980s, India was in
serious economic trouble.

The gross fiscal deficit of the government (centre and states) rose from 9.0 percent of Gross Domestic Product (GDP)
in 1980-81 to 10.4 percent in 1985-86 and to 12.7 percent in 1990-91. For the centre alone, the gross fiscal deficit rose
from 6.1 percent of GDP in 1980-81 to 8.3 percent in 1985-86 and to 8.4 percent in 1990-91. Since these deficits had
to be met by borrowings, the internal debt of the government accumulated rapidly, rising from 35 percent of GDP at
the end of 1980 81 to 53 percent of GDP at the end of 1990-91. The foreign exchange reserves had dried up to the
point that India could barely finance three weeks worth of imports.[15]

In mid-1991, India’s exchange rate was subjected to a severe adjustment. This event began with a slide in the value
of the Indian rupee leading up to mid-1991. The authorities at the Reserve Bank of India took partial action, defending
the currency by expanding international reserves and slowing the decline in value. However, in mid-1991, with
foreign reserves nearly depleted, the Indian government permitted a sharp devaluation that took place in two steps
within three days (1 July and 3 July 1991) against major currencies.

RECOVERY:

With India’s foreign exchange reserves at $1.2 billion in January 1991 and depleted by half by June, barely enough to
last for roughly 3 weeks of essential imports,India was only weeks away from defaulting on its external balance of
payment obligations. 15
Government of India’s immediate response was to secure an emergency loan of $2.2 billion from the International
Monetary Fund by pledging 67 tons of India’s gold reserves as collateral security.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 $600
million. The van transporting the gold to the airport broke down en route due to tyre burst and panic followed .The
airlift was done with secrecy as it was done in the midst of the 1991 Indian General elections. National sentiments
were outraged and there was public outcry when it was learned that the government had pledged the country's entire
gold reserves against the loan.A chartered plane ferried the precious cargo to London between 21 May and 31 May
1991, jolting the country out of an economic slumber.The Chandra Shekhar government had collapsed a few months
after having authorised the airlift. The move helped tide over the balance of payment crisis and kick-started P. V.
Narasimha Rao’s economic reform process.

Under Narsimha Rao Government

P. V. Narasimha Rao took over as Prime Minister in June, and appointed Manmohan Singh as Finance Minister.The
Narasimha Rao government ushered in several reforms that are collectively termed as liberalisation in the Indian
media.

The reforms formally began on 1 July 1991 when RBI devalued Indian Rupee by 9% and by a further 11% on 3 July.
It was done in two doses to test the reaction of the market first by making a smaller depreciation of 9%. There was
significant opposition to such reforms, suggesting they were an “interference with India’s autonomy”. Then Prime
Minister Rao’s speech a week after he took office highlighted the necessity for reforms, as New York Times reported,
“Mr. Rao, who was sworn in as Prime Minister last week, has already sent a signal to the nation—as well as the
I.M.F.—that India faced no “soft options” and must open the door to foreign investment, reduce red tape that often
cripples initiative, and streamline industrial policy. Mr. Rao made his comments in a speech to the nation Saturday
night.”The foreign reserves started picking up with the onset of the liberalisation policies and reached an all-time high
US $530.268 billion as on 13 November 2020

The Balance of Payments Crisis of 1991

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.

India achieved significant pick-up in the growth rate averaging 6.0 per cent during the Seventh Five Year Plan
period and a high of 7.6 per cent during the three-year period ending 1990–91. While this was partlyinduced by
highly expansionary fiscal policy, it was aided by the measuresof liberalisation introduced in trade, the industrial
sector and taxation policies at that point.
16
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
thecurrent 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 30.0 per cent 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 BoPposition and the impact of rising fiscal deficit since the late 1989, but timely preventive measures were
stalled by the uncertain political situation.

There was a step-up in external commercial borrowings (ECBs) in 1988–89and 1989–90. The policy stance was that
commercial borrowings were to beresorted to only for financing designated institutions and activities and not for general
BoP support. Commercial borrowings were expected to dropin 1990–91. Reliance on non-resident deposits continued,
with interest rates on these deposits kept slightly above international market levels. These deposits were considered to
be advantageous as a stable source of external financing.

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 termsand therefore by the end of the decade its debt-service ratio became
relatively high by regional standards. Second, the official reserves, whichuntil then had been 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. Despite purchases of US$ 1.8 billion from the International Monetary Fund (IMF) in
January 1991, gross official reserves stood at US$ 5.8 billion (1.3 months of imports) byend-March 1991.

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 plannedfor 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 CAD widened to 3.0 percent of gross domestic product (GDP). Owing
to market concerns about the deteriorating external position and domestic political uncertainty, recourse to 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 ofnon-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 anoutflow of short-term capital as commercial banks failed to renew creditlines. Exports stagnated,
largely because of slack demand in key markets in the industrial nations and the Middle East, as well as growing
disruptionsto 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 asharp 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 recourseto external credit.
A default on payments for the first time in Indian history became a serious possibility in June 1991.

The Reserve Bank in its Annual Report for the year 1991–92 enunciated the underlying causes and events that
resulted in the economic crisis:

The preceding decade had seen acceleration in economic growth,but the relatively high rate of gro1w7th of GDP was
also associatedwith macro-economic imbalance and the persistence of structural rigidities, a certain degree of which
 constrained the sustainabilityof the growth process. Continuing macro-economic imbalance and a delay in taking
corrective action in time accentuated the impact of global economic shock of 1990. Large and growing fiscal deficit
with a sizeable component of monetised deficit inevitably resulted in rapid growth of monetaryliquidity far out of
alignment with the real economic growth, thereby generating severe demand pressures and accelerating the pace of
inflation. These imbalances in turn spilt over onto the external sector in the form of a large and unsustainable current
account deficit. 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 servicingduring the early months of the fiscal year 1991–92. The strain onexternal and internal
resources, the threat to monetary stability and the resultant inflationary process, had begun to hinder investment
plans both in the public and private sectors, giving rise to distortions in production and employment generation. The
situation called for strong stabilisation measures: fiscal correction, monetary tightening, inflation control, and
strengthening of the competitiveness of India’s exports.

In essence, a confluence of economic and political factors was underplay in the build-up to the crisis. The
Government requested a 20-monthstand-by arrangement from the IMF on August 27, 1991, for an amount equivalent
to SDR 1,656 million. This facility was approved by the IMFon October 31, 1991. The arrangement became an
opportunity for both the Government and the Reserve Bank to embark upon a series of home-grown reforms in the real
and financial sectors.

MAJOR CONTRIBUTING FACTORS:PRE-CRISIS DEVELOPMENTS

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 anddirect taxes were
progressively reduced. The result was that fiscal deficitas 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 monetisation of fiscal deficit resulted in higher liquidity growth over and above the overhang of liquidity carried
forward from the earlieryears and the consequent expansionary impact on money supply. To some extent, the Union
Budget for 1989–90 sought to correct the growing imbalances between revenues and expenditures. However, the outcome
turned out to be much worse because the imbalances did not stem fromany let-up in government revenue mobilisation but
due to increases in the government expenditure, which in turn was financed by larger borrowings and the budget deficit. The
Centre’s budgetary deficit in 1989–90 (according to the Reserve Bank’s records) was much higher, by about 30.0per
cent, than the budgeted amount. Likewise, the Reserve Bank credit tothe Central Government in 1989–90 was more than
twice the actual for 1988–89.
The widening of the budgetary deficit on revenue account and the growing recourse to borrowings from domestic and
external sources to finance the deficit had several adverse consequences. First, to the extent that this entailed recourse to
the Reserve Bank, the deficit turned out tobe the principal factor propelling high rates of monetary growth, which, in
turn, fuelled inflationary pressures and expectations. Second, thegreater recourse by the Government to borrowing
from the commercial banking system as well as directly from the households claimed a higherproportion of household
savings for government expenditure, leaving a lower proportion for use in directly productive sectors, such as industry
and agriculture. Third, the mounting stock of public debt led to mountinginterest payments on the Government’s
revenue account, whichexacerbated the problem of continuing revenue account deficits and pre-empted an increasing
fraction of the government expenditure to meet such debt-service obligations. Finally, the high deficit spilled over into
theBoP gap, with the resultant drawdown of foreign exchange reserves.

THE SPILL OVER OF FISCAL DEFICIT INTO

CURRENT ACCOUNT DEFICIT

Imbalances in the external sector reflected the fundamental fact that aggregate absorption in the economy was in excess of
domestically producedgoods and services. In other words, imbalances between aggregate demandand supp1l8y ultimately
spilled over onto the BoP and the gap had to be metby either running down the reserves or increasing debt.
In India, it was the fiscal deficit of the Government that was associated with excess demand and the consequent
deterioration of the current account balance. The fiscal deficit was nurtured principally by a large expansion in net
Reserve Bank credit to the Central Government againstthe issue of ad hoc Treasury Bills, which came to be
popularly known as automatic monetisation of deficit. The Seventh Five Year Plan period alsowitnessed deterioration
in the fiscal imbalances as the ratio of gross fiscaldeficit (GFD) to GDP escalated from 6.3 per cent in the first half of
the 1980s to 8.2 per cent during 1985–1990. The net outcome of this pattern of financing was that the spiral of increased
borrowings and deficit financingpushed up the interest payments, liquidity growth and inflation.

The not-so-apparent and yet the close link between the budget deficit and CAD was aptly stated in the Economic
Survey for the year 1988–89 thus:

Though it has not been appreciated, it must be recognised that high levels of fiscal deficits tend to spill over and
contribute to high current account deficits in the balance of payments. An improvement in the current account of the
balance of paymentsrequires a commensurate reduction in the overall savings- investment gap of the economy. In a
situation such as ours wherethe recent widening of the savings-investment gap is largelyattributable to deterioration
in the budgetary savings, the turn- around in the budgetary performance will contribute substantially towards a sustained
improvement in the balance of payments.

The same relationship was highlighted in the Annual Report of the Reserve Bank for the year 1992–93:
Quite often, monetary policy and exchange rate policy are discussed as separate and distinct segments of overall
financial policy. These two segments are invariably intertwined and as a market-based system develops, it would no
longer be meaningfulto view these as separate segments of policy. If these two segmentsare not made mutually consistent,
one or the other segment of policy could be greatly attenuated.

WIDENING CURRENT ACCOUNT DEFICIT

Before the onset of the 1991 crisis, two instant external shocks contributed to widening of the CAD. First, Iraq’s invasion
of Kuwait in 1990 exposed India to sudden shifts in global oil prices. This also caused the return andrehabilitation of
the Indians working in that region, adversely affecting the inflow of remittances. The petroleum import bill in 1990–91
increased over 50.0 per cent to US$ 6.0 billion. By September 1990, the net inflow of NRI deposits had turned
negative. Access to commercial borrowings became costlier and more difficult, and by December 1990 access to even
short-term credit, particularly the bankers’ acceptance facility (BAF),was constrained. The foreign exchange reserves
fell to US$ 1.2 billion in January 1991.

The second shock was the slow economic growth in India’s exportmarkets. Growth in the US — India’s largest
export destination — fellfrom 4.1 per cent in 1988 to (–)0.2 per cent in 1991. Conditions in anothermajor export market
— the Soviet Union — worsened due to the oil shock.World growth declined from 4.5 per cent in 1988 to 2.2 per cent
in 1991.Consequently, India’s export growth was only 4.0 per cent during 1990–91.Further, India’s export
competitiveness was adversely affected by a steadyappreciation in the rupee’s real effective exchange rate (REER):
20.0 percent between 1979 and 1986. From 1987, the rupee steadily depreciated,but the real exchange rate remained
overvalued until the year of the crisis.

The Reserve Bank in its Annual Report for the year 1989–90 expressed the view that given the small size of the external
sector, the CAD experiencedin the Seventh Plan period was of a large order and was worrisome, and the Bank wanted
the CAD to be reduced to around 1.5 per cent of GDP by according emphasis to higher exports. On the issue of
financing the CAD, which assumed grave proportions soon thereafter and hastened thecrisis (of imminent default in
repayments), the Reserve Bank made the following pertinent observations in the report:

So far the bulk of financing the current account deficit has been provided by external assistance, commercial
borrowings and NRIdeposits. The outlook for concessional aid is not bright. There hasalready been a hardening of the
terms from multilateral institutionsand there are many more claimants to the resources of multilateraland b1il9ateral donors.
As regards commercial borrowings, although we have pursued a prudent policy, the recourse to this sourceof
 borrowing has been rising in the last few years. While India can continue to borrow from the capital market at fine
terms onaccount of its impeccable record of debt service, the recent policystance for still greater caution is appropriate.
The inflow of NRI funds under FCNRA scheme is also becoming a high-cost source of financing given the rise in the
interest rates abroad. The inflowof direct foreign investment capital into India is very small beingaround $200 million a
year as compared with much higher inflows in respect of many other countries in Asia. A larger inflow of direct foreign
investment will help to reduce the pressure on the balance of payments.

CHANGING COMPOSITION OF EXTERNAL DEBT

The changing composition of external debt, which shifted from official tocommercial and towards the short-term,
was one of the factors contributingto the external imbalance. Besides long-term and medium-term debt, there was also
short-term debt in the nature of trade credit and suppliers’ credit, and the BAF relating to imports. Such facilities were
contracted for publicsector undertakings (PSUs), and the outstandings were being financed through rollover of inter-
bank borrowings. This amounted to US$ 3,551.0million as at end-March 1991.

The increasing trend of availability of ECBs during the later part of the 1980s was reversed in 1990. A major
reason was a fall in the overall availability of international credit due to the capital adequacy requirements of the Bank
for International Settlements (BIS). Commercial banks were compelled to restrict credit expansion and were
expected to strengthen their capital base. The gulf crisis created an atmosphere of uncertainty inthe international
capital market, with an adverse impact on developing countries that depended on oil imports, like India. The third factor
was the downgrading of India’s credit rating for long-term funds by internationalrating agencies in March 1991;
India’s rating slipped to the bottom of the investment grade. This prompted international banks to restrict the
renewal of the rollover facility of inter-bank borrowings for Indian banks.The situation led to difficulties in the
retirement of import bills for Indianimporters and PSUs.

The share of external assistance in total debt stock declined to less than 70.0 per cent in 1989–90 as against almost
90.0 per cent during the SixthFive Year Plan. The declining share of external assistance in external capital inflow,
hardening of the terms for such assistance and a rapid rise in therate of interest contributed to bunching of the debt-
service payments inthe late 1980s.

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 2.0 per cent as a result
of widening inflation differentials betweenIndia 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 continuedto widen. All this resulted in eroding India’s international
competitiveness.

DOMESTIC POLITICAL UNCERTAINTY

The country also faced intense political uncertainty during this period. The general elections were held in November
1989, followed by the formation of a coalition Government. Internal political conflicts among the coalition partners on
a variety of issues caused the Government’s fallby November 1990. A group of Members of Parliament (MPs) broke
off from the erstwhile Government and a new Government was formed in November 1990. This support was, however,
withdrawn in February 1991, and the scheduled budget could not be passed. In the midst of campaigning for general
elections, the Prime Minister was assassinated in May 1991. General elections were held in May 1991 and the elected
Government took over only by June 1991. Thus, within a span of two years, during which the country faced a strained
BoP position, there were three unstable governments at the Centre.

20
 BREAK-UP OF THE SOVIET BLOC

Rupee trade with the Soviet bloc was an important element of India’s trade in the 1980s. Exports to Eastern Europe
comprised 22.1 per cent of totalexports in 1980 and 19.3 per cent in 1989. A significant proportion of thetrade,
constituting imports of capital goods and defence equipment, wasfinanced by long-term trade credits. The trade with
these countries was carried out under the rupee payment agreement (RPA), which provided a framework for the size of
turnover and commodity composition with each country. During 1990–91, only three countries, viz., the USSR,
Czechoslovakia and Romania, settled their payments under the RPA. However, the trade was dominated by the USSR,
which accounted for 95.0 per cent of the total trade turnover between India and the three countries under the RPA. Further,
India enjoyed a surplus trade balance with the USSR for almost the entire period of the 1980s. The trade surplus in favour
of India rose from US$ 268.0 million1 (` 212 crore) in 1980–81 to US$ 1,456.5 million (` 2,425 crore) in 1989–90
and further to US$ 1,512.6
million (` 2,714 crore) during 1990–91.

With the introduction of Glasnost and the breaking away of the Eastern European countries, several rupee payment
arrangements were terminated

• Conversions are based on annual average rupee-dollar exchange rate.

in 1990–91. Thus, the RPA with the former German Democratic Republicended in December 1990 with German
reunification, and with Poland theagreement ended in January 1991. As a consequence of these and otherpolitical
developments in Eastern Europe, the flow of new rupee trade credits declined abruptly in 1990–91. The exports share
of the Eastern European countries in India’s external trade also declined to 17.9 per cent during the same period. Such
developments raised concerns about future difficulty in exporting to these markets. The collapse of the USSR in
December 1991 added further woes to rupee trade arrangements withEastern European countries. As a result, the share
of Eastern Europe in India’s exports collapsed to 10.9 per cent in 1991–92. The breakdown oftraditional arrangements
also meant an interruption in new rupee creditsand a consequent increase in the net repayment on the rupee debt account.2

THE GULF WAR

The gulf crisis, which began with the invasion of Kuwait by Iraq on August2, 1990, lasted about seven months until
February 28, 1991. The gulf crisiswas different in terms of its impact from the earlier two oil shocks. First, itdid not have
some of the compensating features of the earlier shocks, viz.,large inflows of remittances, a surge in exports and a tendency
for non-fuelcommodity prices to rise in sympathy with oil prices. Second, it imposedan additional cost of repatriating
NRIs from affected countries in theregion. Third, the crisis adversely impacted international capital markets.

The turmoil in the world oil market emanated from the trade embargo on Iraq and Iraq-occupied Kuwait, which together
contributed about 6.8per cent and around 7.5 per cent of the world oil per day consumption and production,
respectively, during 1991. Given that in the short run theprice elasticity of both supply and demand was rather low, an
increase inoil prices in response to supply decline was inevitable.

The gulf crisis had a serious impact on India’s petroleum, oil and lubricants (POL) import bill. First, alternative
sources for imports of crude oil and petroleum products had to be identified to substitute for imports earlier obtained
from Iraq and Kuwait. Second, since contracts for crude oil and products were market-related, higher prices entailed a
sharp escalation in the import bill of POL. The level and volatility of oil prices increased sharply after the invasion of
Kuwait by Iraq in August

• Virmani, Arvind (2001). “India’s 1990–91 Crisis: Reforms, Myths and Paradoxes”,
Working Paper No. 4/2001-PC. New Delhi: Planning Commission. December.

21
1990. From an average of about US$ 15 per barrel during April–July 1990,the average prices paid by India for crude in
the world market doubled toUS$ 30 per barrel during August–November 1990 and then declined to an average of US$
19 per barrel during the rest of 1990–91. Similarly, theaverage price of petroleum products rose from about US$ 182 per
tonne to US$ 354 per tonne and then declined to US$ 313 per tonne, over the same period. The prices, both of product and
crude, softened from December 1990 to March 1991. However, while crude oil prices fell sharply, productprices
declined relatively slowly. The fall in crude prices was more than
36.0 per cent during December 1990–March 1991 over the preceding four months, while product prices declined by only
about 12.0 per cent over the same period.
The spurt in the prices of crude oil and petroleum products causeda sizeable increase in the POL bill. The POL bill
during 1990–91 was estimated at around `10,820 crore (US$ 6.0 billion) as against ` 6,273 crore (US$ 3.8 billion) for
1989–90. This indicated an increase of about 72.0 percent in rupee terms and 58.0 per cent in dollar terms. Assuming
that theprice of oil and products had remained at the same level (US$ 14.77 per barrel for crude and US$ 181.5 per
metric tonne for products) prevailingduring April–July 1990 for the rest of the year as well, the direct additionalcost of
POL imports would have been around US$ 2.2 billion (` 3,900 crore). After adjusting for exports of petroleum
products, the net POL burden was estimated at US$ 2.0 billion (` 3,625 crore).

The gulf crisis constrained India’s export performance during 1990–91 inmore than one way. In 1989–90, the West
Asian countries accounted for 7.2 per cent of India’s exports, with Kuwait accounting for 0.7 per cent and Iraq about 0.5
per cent. The immediate impact of the gulf crisis arising outof the trade embargo on Iraq and occupied Kuwait, and
dislocation of trade to other countries in West Asia led to a significant loss in exports. The total loss of exports in the gulf
region was estimated at US$ 3,003.0 million, including US$ 1,622.0 million on account of loss of exports to
Kuwaitand Iraq alone. Besides, India could not realise her dues to the extent of US$ 64.0 million under deferred
payment arrangements and about US$ 50.0 million under the projects outside deferred payment arrangementsduring 1990–
91.

The direct overall adverse impact of the gulf crisis lasting for about seven months from August 1990 to February 1991
on the current accountof India’s BoP for the fiscal year 1990–91 was estimated at US$ 2,987.0 million, equivalent to `
5,180 crore (Table 11.1). It must be emphasized that this impact assessment was relative to a normal situation free of
thegulf crisis.

TABLE 11.1
Direct Balance of Payments Impact of the Gulf Crisis during 1990–91

Item ` crore US$ million

Additional POL import bill (net of POL exports) 3,625 2,020

Export loss to West Asia 500 280
(of which: Iraq and Kuwait) (270) (150)
Non-realisation of other export dues from Iraq 205 114
Loss in remittances from Iraq and Kuwait 490 273
Foreign exchange costs of emergency repatriation 360 300
Total 5,180 2,987

Source: Government of India, Economic Survey, 1990–91.

The gulf crisis clearly impacted the balance of trade situation. During1990–91, imports were 22.0 per cent higher than
that in 1989–90, largelyon account of POL imports, while exports rose by 17.5 per cent, as a resultof which the trade
deficit at US$ 9,437.0 million was 38.0 per cent higherthan that in 1989–90. Consequently, there was a rapid drawdown
of foreignexchange reserves during 1990–91. Foreign currency assets (FCA) held bythe Reserve Bank declined by US$
3,460.0 million during the year despitethe BoP support received from the IMF.

REPATRIATION OF INDIAN NATIONALS FROM

IRAQ: IMPACT ON INVISIBLES 22
 The gulf crisis had a significant adverse impact on the flow of remittancesinto India. During the period 1982 to 1986,
Iraq and Kuwait accounted for 12.0 per cent of annual labour outflows from India. In 1987, these two countries
accounted for about 14.0 per cent of the estimated migrant population of about one million in West Asia. In 1988–89,
about 8.5 per cent and 0.2 per cent of total private transfer receipts (remittances) camefrom Iraq and Kuwait,
respectively. As estimated by the Government, theloss in private remittances from Kuwait and Iraq was placed at US$
273.0million (` 490 crore) during 1990–91.

The gulf crisis also had an adverse impact on the capital account. Thefall 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 theimpact of the gulf crisis.

The gulf countries accounted for about 35.0 per cent of foreigncurrency non-resident (account) [FCNR (A)]
flows, with Kuwait contributing 2.0 to 3.0 per cent of these and Iraq only a negligibleamount during the early 1990s.
Net inflows into these accounts fromall sources declined to US$ 142.0 million in 1990–91 from US$ 1,309.0
million in 1989–90. The gulf countries contributed about 65.0 per centof non-resident (external) rupee account
[NR(E)RA] flows, with Kuwait accounting for 18.0 per cent and Iraq an insignificant proportion during the period
1982–86. During the years 1989–90 and 1990–91, there werenet outflows from the NR(E)RA amounting to US$ 2.4
million in 1989–90and US$ 30.0 million in 1990–91. It was estimated that the gulf crisis wasresponsible for a shortfall
of at least US$ 500.0 million in the non-residentaccounts.

In 1990, there was a marked slowdown in borrowings from internationalcapitalmarketbythedevelopingcountriesasagroup.

Allmajor segments of the international financial market experienced a contractionduring the year against the
background of deteriorating global conditionsand uncertainties arising from political and economic consequences of
the gulf war. From the second half of 1990, markets became increasinglyselective and were reluctant to take risks.
Creditworthiness considerations became paramount and capital adequacy requirements constrained the lending activity
of banks. These adverse conditions persisted till the end of 1991. Against this backdrop, India’s commercial
borrowings in terms of commitments dropped sharply to US$ 1,903.0 million in 1990–91 fromUS$ 3,291.0 million in
1989–90. The gulf crisis triggered adverse market perceptions about Indian risk during the year. This affected the
availability of commercial funds to India during 1990–91. The evacuation of about 1,80,000 Indian workers from
Kuwait and Iraq and their repatriation to India was estimated to have cost the country US$ 200.0 million.

LOSS OF CONFIDENCE ABROAD

By November 1990, the Government lost the crucial vote of confidence inParliament. In its place, a minority
Government was formed. The Union Budget due at the end of February 1991 was postponed and instead, a vote on account
was presented on March 4, 1991.

The memorandum to the Central Board of Directors of the Reserve Bank dated November 24, 1990 summed up the
fiscal response of the Government as follows:

The Gulf crisis adversely affected the domestic fiscal scenario. Inorder to deal with the steep rise in the international price
of crude and its concomitant rise in the import bill as also to meet the costof evacuating non-resident Indians from
Kuwait and Iraq, the Government adopted a combination of measures such as rise in petroleum prices, curbs in
consumption of petroleum products and enhanced tax effort. These included a ‘Gulf evacuation’surcharge of 10 per
cent on passengers on Indian Airlines to yieldRs. 40 crore in the current year and Rs. 100 crore in the full year and an
additional surcharge on corporate incomes of 7 per cent to yield Rs. 100 crore in the assessment year 1991–92. Furthermore,
a25 per cent increase was announced on October 14, 1990 in prices of petrol and most other petroleum products, excluding
domestic cooking gas (LPG).

It became clear by the beginning of 1991–92 that the payments crisiswas no longer primarily due to the trade deficit, and
there were expectationsof default and therefore devaluation. This created longer leads in the payments for imports and
lags in the realisation of export proceeds, which attenuated the foreign exchange shortage.

A mention may be made of the conscious attempt by international banks to reduce exposures in order to meet capital
2 3
adequacy norms. Following this, the country’s access to short-term credit, particularly theBAF, becam e restricted.
International rating agencies lowered the creditratings of India/Indian entities, which made it difficult to raise funds in
the commercial markets. Short-term credit by way of bankers’ acceptance lines and six-month credits were available at
0.25 per cent above Londoninterbank offered rate (LIBOR, the standard reference interest rate in international
commercial borrowings) until November 1990. Thereafter,the cost above LIBOR went up to 0.65 percentage points in
March 1991, which rose further to 1.25 percentage points by May that year. By June, the overall cost of credit was even
higher. Under such circumstances, theGovernment had to accord top priority to ensure that external payment
obligations were met and that the foreign exchange reserves were maintained at a reasonable level.

RESERVE BANK ALERTS THE GOVERNMENT

From 1988–89, the Reserve Bank had been continually alerting the Government regarding the adverse consequences of
growing government deficits, their impact on the external payments situation and the worsening BoP position. The
Governor also hinted at the possibility of approaching multilateral institutions to find a remedy.

APPRAISING THE GOVERNMENT OF DETERIORATION

IN BALANCE OF PAYMENTS

In December 1988, the Reserve Bank drew the attention of the Governmentto the severe strains in the BoP of the country. A
review done in May 1990showed that the position had continued to be difficult in the previous year and that the prospects
for improvement in the ensuring year appeared bleak. The foreign exchange reserves (comprising the foreign currency
assets, gold and SDRs) continued to decline during 1988–1989, and the real loss in reserves was much higher if special
transactions were excluded. These special transactions included the funds brought in, receipts from the India Supply
Mission (Washington), the Indian Embassy (Tokyo) and sales of foreign currencies to the Reserve Bank by Industrial
Credit and Investment Corporation of India (ICICI) Ltd, Industrial Development Bank of India (IDBI) and the
Industrial Finance Corporation of India (IFCI). Besides, there was an increasing resort to short-term credit, the
outstandings of which went up by US$ 1,186.3 million (` 1,718 crore) to US$ 2,162.7 million (` 3,132 crore) during
1988–89, i.e., more than twicethe rise of US$ 547.6 million (` 710 crore) during 1987–88. The CAD during 1988–
89 was then estimated to be 2.7 per cent of GDP as against
1.9 per cent in 1987–88, which exceeded the earlier high of 2.3 per cent,reached in 1985–86.

The Reserve Bank in a communication dated May 24, 1989 to the Government focused on wide-ranging key policy
measures needed to correct the situation, i.e., export promotion, exchange rate policy and containment of the fiscal
deficit of the Government. After recountingthe disturbing trends in the foreign exchange reserves, the Reserve Bank
conveyed its concerns over the situation as follows:

From all accounts, it appears that if no strong policy actions are initiated, the trade deficit in 1989–90 will even be higher
than that in 1988–89. Oil prices have already started rising and the increasein commodity prices in general may cause
the import bill to increase faster. Apart from the fact that the rising current account deficit has serious implications for
debt servicing in the future, even in the short run there can be difficulties in financing a deficitof this order. Last year, we
had allowed the reserves to fall to theextent of Rs. 1,500 crore. We cannot allow any further decline inreserves which are
now equivalent only to two-and-a-half months of imports. All these point to the need for decisive action to limitthe trade
and current account deficits.

The Reserve Bank urged the Government to accord more attention tothe export sector by creating adequate surpluses out of
production for the purposes of export, and at least in some sectors it emphasised that exports must become a matter of
primary concern rather than being a residual after meeting domestic demand. This was in addition to the number of
incentives provided to exporters and a highly supportive exchange rate policy. Turning next to the exchange rate policy,
the letter explained thatthe NEER of the rupee against five major currencies had come down from 100.0 in 1979
(average) to 52.1 in 1988 (average). The REER of the rupee in relation to five major currencies, which took into
account the movement of prices in the respective countries, had come down from 100.0 in 1979 to 81.9 in 1988. Thus,
there was a considerable depreciation of the rupee in real terms in relation to the currencies of India’s major trading
partners and competing countries. The communication from theReserve Bank to the Government added, “There is no
doubt that exchange rate adjustments have played an important role in accelerating exports in the recent2p4eriod.” The
letter suggested that having achieved a strongmeasure of real depreciation, exchange rate adjustments in future must be
used primarily to correct price differentials between India and its tradingpartners. The ground rules under which the
exchange rate policy could beeffective and its linkages with other policy areas were described thus:

Exchange rate depreciation works through improving the competitiveness of Indian exports and curbing import
demand. The extent to which external imbalances can be corrected depends upon the elasticity of exports and imports to
price changes. Andmore importantly, a reduction in trade deficit through exchangerate changes can be brought about
only if the overall expenditureare contained in the economy and increase in the domesticprice level is effectively
contained. Otherwise, the advantages ofdevaluation will be wiped out very soon.

The next topic of discussion in the communication was the linkbetween the fiscal deficit and the CAD. The Reserve
Bank stressed thatif the CAD in 1989–90 was not to exceed that in the previous year, the fiscal deficit should be
contained at the level actually achieved in 1988–89and that one way of doing this was for the Government to examine
the expenditures under all heads and bring about overall reduction and alsomake efforts to reduce the import content of
government expenditure, including those on defence. This was considered to be particularly pertinentbecause exchange
rate depreciation might not by itself be adequate to contain import demand and this was all the more so in commodities,
suchas POL products and fertilisers, whose ultimate prices to the consumers had not been suitably altered upwards. In
the case of bulk commodities for which exchange allocation was made directly by the Government, a careful pruning of
imports was needed. Another relevant point made wasthat while trade policy did not encourage the import of finished
consumer products, care had to be taken that this policy was not undermined by liberal imports of their components.

The concluding paragraph of the letter from the Reserve Bank summed up the responsibilities of the Government in
order that the BoPsituation did not get out of control:

The balance of payments position of the country is passing through a very difficult phase. Current account deficits of the
order seen in 1988–89 cannot be sustained. A comprehensive policy packageneeds to be drawn up to limit the deficits to
more reasonable levels.In any such scheme, besides accelerating exports, equal attention must be paid to import planning so
as to limit the growth of imports. A greater control over Government expenditures anda reduction in budget deficit
are equally necessary, if the variouspolicy measures aimed at increasing exports and reducing the volume of imports is
to become effective.

UPSURGE IN INFLATIONARY PRESSURES

The large growth in overall liquidity and the consequent pressure onthe price level was evident until September
1989. The Reserve Bank was,however, constrained from deploying the cash reserve ratio (CRR) as it had reached the
statutory ceiling of 15.0 per cent. This prompted the Governor to bring the situation to the notice of the Principal
Secretary to the PrimeMinister. While the main message in the letter to that effect is covered in the subsequent chapter
on monetary management, it suffices to state here that the thrust of the letter was to supplement the monetary measures by
fiscal measures for an effective anti-inflationary package.

CRITICAL BALANCE OF PAYMENTS SITUATION

The Governor was closely monitoring the developments and was seriously concerned with the alarming scenario in the
country’s BoP situation. TheReserve Bank communicated its concerns in a detailed letter of February19, 1990 to the
Government, giving the factual details of the external position as follows:

Foreign exchange reserves during the current financial year up to February 2, 1990 had declined by Rs. 1,409 crore to
Rs. 5,630 crore, as against a fall of Rs. 1,948 crore in the corresponding period. However, the real loss in reserves
turned out to be muchhigher. But for the special transactions the loss of reserves wouldhave been higher. Reserves in the
current year had benefited from the inflow of funds under the Foreign Currency (Non-Resident) Accounts (FCNRA)
Scheme. The net inflow of funds under this scheme during the current year up to February 2, 1990 amountedto Rs.
2,377 crore, higher by 48.0 per cent than those of Rs. 1,607crore in the corresponding period of 1988–89. The net
inflow of aid, however, had been lower than in the last year. Coming to thecrux of the balance of payments problem, the
grim picture was asfollows. 25
The balance of payments had been under considerable pressuresince the beginning of the Seventh Plan. Foreign
exchange reserves in SDR terms steadily declined from SDR 6,004 million at the endof March 1985 to SDR 2,815
million by the end of December 1989. The current account deficit more than doubled from Rs. 2,852 crore in 1984–85
to Rs. 5,927 crore in 1985–86. Although it camedown somewhat in the following year, it went up to Rs. 6,293 crore in
1987–88 and is estimated to have reached an all-time high of theorder of (Rs. 10,430 crore) in 1988–89 or 2.7 per cent of
GDP. The balance of payments continues to be under pressure duringthe current financial year. Based on the capital
transactions, thecurrent account deficit during April to December 1989 would seem to be running higher than in the
corresponding period of 1988, although in U.S. dollar terms, it would be somewhat smaller than in the last year. The
annual average ratio of current accountdeficit to GDP of 2.2 per cent during the first four years of the Seventh Plan as
against the targeted average of 1.6 per cent for thePlan period underscores the pressure on balance of payments.

The reasons for the large CAD experienced in the Seventh Plan periodwere both large trade deficits and deterioration in
the invisibles account.While India had large trade deficits, the invisibles account — which had given a measure of
support to BoP — had also deteriorated. Net invisiblesreceipts excluding official transfers, which financed as much as
92.0 per cent of the trade deficit in 1978–79 and 65.0 per cent in 1980–81, could offset only 51.0 per cent of the trade
deficit in 1984–85, and were as low as 21.0 per cent in 1988–89. The surplus on the invisibles account was mainly due to
private transfers. If private transfers were excluded, the invisiblesaccount would show a deficit from 1987–88. Net
invisibles excluding private transfers showed a steady deterioration from a surplus of US$ 2,044.3 million ( ` 1,615
crore) in 1980–81 to a modest surplus of US$ 18.0 million (` 23 crore) in 1986–87 and turned into a deficit of US$
792.1million (` 1,027 crore) in 1987–88, a major reason being the persistent rise in interest payments on debt due to
continued higher CAD.

The analysis showed that the large order of CAD in the Seventh Plan period had been financed partly by drawing down
reserves, but mainly by a larger inflow of capital both on concessional terms and commercial termsand by way of NRI
deposits. In addition, short-term debt of acceptance credits was quite substantial. India’s total short, medium and long-
term external debt, as well as NRI deposit liabilities as at end-March 1989, amounted to nearly US$ 60,062.1 million
(` 86,970 crore), which workedout to 22.0 per cent of GDP or about 280.0 per cent of current receipts (exports plus
invisible receipts) during 1988–89. By the end of the Seventh Plan, short, medium and long-term debt and NRI deposit
liabilities were estimated to exceed a staggering US$ 6,009.6 million (` 1,00,000 crore). The Reserve Bank was
categorical that the existing level of reserves of about US$ 3,383.4 million (` 5,630 crore) was ‘very low’ and
workedout to barely 1.6 months of imports. The Reserve Bank emphasised that the country could not afford to lose
any further reserves and must aim at rebuilding them to the equivalent of two to two-and-a-half months’ imports in
the Eighth Plan period. The Bank sounded a note of caution that the country’s credit standing in the international
markets might be adversely affected unless the CAD was quickly reduced in absolute terms.The prognosis
communicated to the Government was:

The large current account deficits can be financed by largerinflows of capital from abroad, by way of higher inflow of
funds under FCNR(A) Scheme and larger utilisation of commercial borrowings. But this will add to debt burden and
debt servicing liabilities. International bankers have already started raising questions in private conversations as to
whether our debt servicing levels are not already excessive. Therefore, though we continue to raise commercial credit on
competitive terms there is a clear andurgent need for caution. At the same time, it is important that wepresent a
balanced view of our external account. Any impressionof panic or serious deterioration would create doubts in the
external financial markets, affect our credit standing and result inhigher interest rates on new loans. The pressures on
balance of payments can be contained only through a reduction in current account deficit in absolute terms as quickly
as possible.

To arrest the deterioration in the invisibles account and thereby reduce the CAD, the Reserve Bank offered a number of
recommendations, some of them having been already suggested to the Government. Theseincluded an improvement
in the domestic fiscal balance by reducingthe budget deficit, augmenting exportable surplus by limiting domestic
consumption of some commodities, a closer examination of the import intensity of exports, containing imports in
defence and bulk items, anda careful pruning of imports for which the Government was making the exchange
allocation. The two new suggestions pertained to restraining domestic consumption of petroleum products and to
further increasing earnings from tourism. However, the most pertinent and rather practicalproposition was to augment
foreign direct investment (FDI) as an alternative or supplement to external borrowings. Conceding that this wasa
‘sensitive’ issue and tended to create apprehensions in some quarters, theReserve Bank espoused the need26to take a
‘rational’ view of the matter inlight of pressures on the country’s external account, the widespread interestthat existed in
 investment in India provided the terms were attractive, the huge surpluses in countries like Japan and Germany, the high
level of self-confidence that Indian industry had developed in partnering with foreigninvestors, and the urgent need for
better technology and higher exports.In this context, the letter also noted the possibility of greater investmentin
Eastern Europe, where rapid political changes were under way to the detriment of Indian interests. The Reserve Bank
emphasised, “There are thus important opportunities which could be gained or lost depending on what decisions we
take on the issue at this crucial time.” To attract substantial investments from abroad, the Governor expressed the
view that some changes in the policies were necessary and in this regard the Government needed to address the
following crucial issues: an increase in foreign holdings in new industries from 40.0 per cent to, say, 51.0 per cent,
simplification and quickening of the procedures for such investment, andthe need and justification for a more liberal
mix of export obligation andsales in the domestic market.

WORSENING OF THE CRISIS TRIGGERED BY THE GULF WAR

Following the discussions between the Reserve Bank and the Government on August 13, 1990, regarding country’s BoP
situation, the Governor senta detailed letter to the Finance Minister, dated August 16, 1990. After going over the main
causes and effects of the rapidly deteriorating state of the BoP and the foreign currency reserves position with special
focus onthe impact of the gulf crisis on the economy, the letter reviewed the patternof financing the looming CAD,
namely, external assistance, commercial borrowings, NRI deposits and foreign exchange reserves.

The main conclusions of the review of the situation were that thoughthe annual commitment of assistance was still quite
high, most of it was tiedto projects, actual utilisation was slow and doubts were expressed aboutwhether donors would be
prepared to provide quick disbursing, essentially BoP assistance. As regards commercial borrowings, international rating
agencies had expressed concerns about India’s rising debt and debt-service ratio and, in fact, Moody’s had placed India on
a watch list as a precursorto a possible downgrade of its credit rating. This meant that internationalbanks would become
more cautious in lending to India and the cost of borrowings would rise; already the margins over LIBOR had started
moving up. NRI deposits, although a somewhat costlier source of externalfinance, had provided strong support to the
country’s BoP and were risingfrom year to year. These deposits were seen to be sensitive to the changing market
perceptions about India and the Reserve Bank’s assessment was that it would be too optimistic to assume a rising curve
of net receipts on this account. The picture was also not bright in the case of acceptancecredits; because of the rollover
beyond 180 days, which had been estimatedat nearly US$ 1.0 billion, the cost had gone up. The State Bank of India
(SBI), which had raised most of this finance, was finding it difficult to substitute this credit with medium-term
facilities. The commercial paper (CP) market was becoming tighter and, with outstanding acceptance credits already on
the higher side, the Reserve Bank felt that there might belimited scope for raising them further. Foreign exchange reserves
havingalready declined to a low level, the Reserve Bank opined that it would be‘inadvisable’ to allow them to fall further.
The Reserve Bank suggested that it would be useful to revalue the gold assets held by the Reserve Bank closerto
international prices by amending the Reserve Bank of India (RBI) Act, 1934. Also, to improve flexibility in the use of
gold reserves, an idea was mooted that 15.0 per cent of the reserves might be kept outside India asalready permitted
under the Act. The extant position was thus summed up as that apart from the inevitable increase in the cost of
commercial borrowings, there might also be some difficulty in obtaining increasing amounts of funds from foreign
commercial banks to finance the CAD notcovered by external assistance and NRI deposits.

The Reserve Bank offered a number of policy options in this letterto arrest the CAD, which was difficult to sustain.
The prime and most important corrective action was seen in fiscal consolidation, viz.:

There is need for a strong adjustment to restore viability of the balance of payments. In fact, such adjustment is
overdue. The elements of the needed adjustments are well known. There has to be substantial fiscal consolidation
through reduction of budgetdeficits, growth of liquidity has to be reined in, exports have to beincreased still further, and a
better balance brought about betweenexports and imports.

As the oil import bill accounted for a major strain on the BoP, the Reserve Bank advocated raising domestic prices to
reflect import costs; this was expected to conserve energy use by restraining, in particular, consumption of oil and, to the
extent feasible, increasing domestic production of oil. 27
On its part, the Reserve Bank suggested taking recourse toextraordinary financing from external sources to tide over the
immediatesituation, a strategy that was in fact eventually adopted. In the same letter, the Government was urged to take
a policy decision to make the requisite adjustments with recourse to extraordinary financing (e.g., fromthe IMF and/or
under the fast-disbursing facilities of the World Bank). The desirability, advantages and disadvantages of such a
method were persuasively expressed:

The advantage of such extraordinary financing would be that adjustment will take place in a more orderly fashion and
will be less disruptive of the growth process. Also, arrangements with the aforesaid multilateral institution/institutions will
give the right signals to the financial markets and enhance the willingness of the banking community to lend more
money to India. However, recourse to the IMF has political overtones and will involve strongconditionality. Such
conditionality will, however, involve more orless similar measures that will have to be taken even if there is norecourse
to the IMF. One important difference, however, could be that under a Fund programme tightening imports may be more
difficult than would be the case otherwise. Adjustment without extraordinary financing will have to be much stronger
implying substantial reduction in the current account deficit in a shorter span of time. Either way, the policy with
regard to the exchange range of the rupee may not be different from what is being pursuedat present.

The advice of the Reserve Bank to choose the option of approachingmultilateral institutions to prevent the occurrence of
the crisis was eventually followed. It was, however, for the Governor, Reserve Bank andthe newly elected Government at
the Centre to carry forward the immediatemeasures to contain the crisis and to undertake reform measures for sustained
long-term growth with stability.

CONCLUDING OBSERVATIONS

The serious external payments crisis that struck in 1991 could be attributed mainly to the highly expansionary fiscal
policy pursued since the mid-1980s that caused some serious distortions in macroeconomic management of both the
domestic and external sectors. Thiswas exacerbatedby certain coincidental geopolitical developments. The early reform
measures introduced from the mid-1980s were implemented without anoverarching framework, resulting in the
emergence of macroeconomic distortions. The fiscal deficit as a percentage of GDP enlarged to 9.4 per cent in 1990–
91 as against the average of 6.3 per cent in the first half of the 1980s. A sizeable component of monetised deficit in the
already large fiscal deficit resulted in rapid growth of monetary liquidity that was far out of alignment with real
economic growth, thereby generating severe demand pressures and accelerating the pace of inflation. These imbalances, in
turn, spilt over on to the external sector in the form of a large and unsustainableCAD. The persistently high level of
fiscal deficit and CAD resulted in asizeable increase in public debt, both domestic and external. There was astep-up
in short-term commercial borrowings in 1988–89 and 1989–90.India was thus faced with large internal and external
financial imbalancesand was consequently vulnerable to adverse external shocks around 1990.

In 1990, two instant external shocks contributed to further wideningof the CAD. The first was Iraq’s invasion of
Kuwait, which resulted in the return and rehabilitation of Indians working in that region. The gulf crisishad a serious
impact on India’s POL import bill, which increased over 50.0per cent. The direct overall adverse impact of the gulf
crisis, lasting for about seven months from August 1990 to February 1991, on the currentaccount of India’s BoP for
the fiscal year 1990–91 was estimated at US$ 2,987.0 million. The gulf crisis had a significant adverse impact on the
flow of remittances into India. By September 1990, the net inflow of NRIdeposits had turned negative. Access to
commercial borrowings becamemore expensive. The fall in capital inflows compounded the problem of financing the
rising levels of the CAD. The second shock was slow economic growth in India’s export markets. Further, India’s export
competitivenesswas adversely affected by steady appreciation in the rupee’s REER by 20.0per cent between 1979 and
1986.

The country also faced intense political uncertainty during this period. Within a span of two years, i.e., November 1989 and
May 1991, there were three unstable governments at the Centre.

Rupee trade with the Soviet bloc was an important element of India’strade in the 1980s. During 1990–91, only three
countries, viz., the USSR, Czechoslovakia and Romania settled their payments under the RPA.Howev2e8r, the trade
was dominated by the USSR, which accounted for95.0 per cent of the total trade with countries under the RPA.
With the introduction of Glasnost and the breaking away of Eastern European countries, several rupee payment
arrangements were terminated in 1990–91.

The changing composition of external debt, which shifted from official to commercial and towards the short-term,
was another factor contributing to external imbalances. Besides long-term and medium-term debt, there was short-term
debt in the nature of suppliers’ credit and BAF. The downgrading of India’s credit rating by international rating agencies
prompted international banks to restrict the rollover facility. The share of external assistance in total debt declined.
The hardening of terms for such assistance and the rise in the rate of interest contributed to bunching of debt-service
payments. In 1990, there was a marked slowdown in borrowings from the international capital market.
Creditworthiness considerations became of paramount importance and capital adequacy requirements constrained the
lending activities of banks. Against this background, India’s commercial borrowings in terms of commitments
dropped sharply.

In November 1990, the Government lost a crucial vote of confidencein Parliament. The Union Budget due at the end
of February 1991 was postponed and a vote on account was presented, which eroded the confidence of the
international community in India’s ability to steerthrough the crisis. By June 1991, the BoP crisis had become a crisis
of confidence in Government’s ability to manage the external sector situation, with a serious possibility of a default in its
external payments.

Ever since 1988–89, the Reserve Bank had been continually alerting the Government regarding the adverse consequences of
increasing governmentdeficit, its impact on the external payments situation and the worseningBoP position. The
Reserve Bank in its communication to the Governmentfocused on policy measures, which were required to correct the
situation,i.e., export promotion, exchange rate policy and containment of the fiscaldeficit of the Government. The
analysis by the Reserve Bank showed that a large order of the CAD in the Seventh Plan period was financed partly by
drawing down the reserves, but mainly by the larger inflow of capital oncommercial terms. In addition, short-term
debt was substantial. India’s total short, medium and long-term external debt as well as NRI deposit liabilities at end-
March 1989 worked out to 22.0 per cent of GDP or about 280.0 per cent of current receipts

The crisis had assumed grave proportions when India was facedwith the possibility of a default in external
payments in June 1991. The Government and the Reserve Bank at official levels, amidst deep politicaluncertainties,
took corrective steps with a resolve not seen any time before in India’s economic history. The country, besides
managing its BoP position, also embarked on a series of enduring macroeconomic andfinancial sector reforms.

Conclusions

This paper is concerned with explaining the 1991 crisis in India and contains three related points of interest. First,
the paper uses error correction models to distin guish between alternative theoretical explanations for the crisis.
The error correc tion models are estimated based on fundamentals that affect the long-run exchange rate and short-
term variables. In terms of fundamentals, the Indian rupee appreci ates in the long run in response to an
improvement in terms of trade, technological progress, and a relaxation of capital controls. The real exchange rate
depreciates when government spending (on tradable goods) increases, the economy opens up and investment
increases. The short-run variable, the current account, is found to be significantly positive and robust to all
specifications. The error correction results suggest that the Mundell-Fleming model provides a better explanation
for exchange rate developments in India in this episode than do first generation models or the Edwards (1989)
explanation of exchange rate misalignments in developing countries. The econometric evidence supports the
position that the current account deficits played a significant role in the crisis. It appears that a confluence of
exogenous shocks led to a loss in investor confidence and to esca lating debt-service burdens that erupted in a
currency crisis.

Second, the theoretically attractive method of Granger and Gonzalo (1995). Which employs joint information from
the error correction model, is used to construct the equilibrium real exchange rate and determine if overvaluation
contributed to the crisis. The estimates do show that the Indian rupee was over valued at the time of crisis in 1991.
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