Balance of Payment Crisis in India, 1991
The Year 1991 was a watershed year in India’s Economic Landscape. The Balance of Payment Crisis and the subsequent Economic Reforms fundamentally altered the trajectory of India’s Economy. The article explores the underlying factors that caused the Balance of Payment Crisis in 1991 and their impact.
Background
Balance of Payments refers to the account of all the transactions between entities in one country with the rest of the world. Broadly, Balance of Payments (BoP) is related to the flow of money into and outside the country. The money flows outward or inward due to the transactions made by the Government, individuals or the firms. The Balance of Payments includes the exchange of goods and services (imports and exports), investments, capital, and transfer payments.
Balance of Payment crisis occurs when a country is unable to pay for its external debts or imports. Balance of Payment crisis can arise due to various reasons.
Genesis of the Crisis: Medium Term
Economic Policies in the 1980s
The Indian Economy grew very slowly in the period of 1950s-70s (a phase disparagingly called as the Hindu Rate of Growth). The GDP of India grew at the rate of 3.5% per annum while the per capita GDP growth rate was only 1.3% per annum during this phase. Most economists attributed this phase of slow growth rate to the socialist policies followed by the successive Indian Governments since the 1950s.
A gradual consensus began to develop in the late 1970s that there is a need to shift from dirigisme towards liberalization in order to increase economic efficiency, provide gainful employment to the vastly growing population, generating resources for social programmes and modernizing the infrastructure. As a policy measure, Economic growth became to be seen as the primary driver for Poverty alleviation.
Expansionary Fiscal Policy
The Government of India started taking several initiatives to stimulate economic growth by driving both aggregate demand and supply in the mid 1980s. Expansionary Fiscal policy financed through domestic and external borrowing was adopted to increase demand. To improve supply, steps were taken to improve infrastructure and increase private participation in production. The latter included: Reduction in constraints on Investment by Private Sector; Reduction in price controls in some industries like cement, aluminium and paper; reduction in licensing restriction on large and foreign companies; promotion packages for industries like electronics and computers, leather, gems and jewellery etc and adoption of partially flexible exchange rate. However these were ‘ad-hoc’ measures and there was a lack of a consistent vision or policy for sustained economic growth e.g. the trade regime was still restrictive with significant tariff controls and other quantitative restrictions (Quotas).
Even then these measures resulted in impressive economic growth in the 1980s compared to 1950s-1970s. Real per capita income grew by nearly 40% in the 1980s compared to 30% growth over the two preceding decades (1960s-1970s). Manufacturing growth also accelerated to 7% per annum in the 1980s. Manufactured exports also increased for a narrow range of products.
Government Control
Although there were some relaxations in the controlled economy, the economic policy in the 1980s could still be characterized by dominant Government control in the labor market, foreign exchange and capital market. At the same time the Government adopted an expansionary fiscal policy. The Gross fiscal deficit of the Union and State Governments increased from 9% of the GDP in 1980 to 12.7% in 1991.
Unfavourable Trade Balance
Concurrently India’s trade balance deteriorated further in the second half of 1980s. This had happened not only due to dependence on imports due to a weak manufacturing base in India but also due to some import liberalization since the mid 1980s especially for Capital Goods, Intermediate Goods, Computers and Electronics etc. Rise in defense imports also contributed to both trade and fiscal deficit.
External Debt Financing
There are multiple ways to fund the deficits e.g. Debt Monetization (Borrowing money from the Central Bank or printing money, Borrowing from domestic and external sources). Each option has its own shortcomings e.g. Debt Monetization can cause rise in inflation, borrowing from domestic sources (like Banks) causes crowding out effect, borrowing from external sources makes the economy vulnerable to external shocks including currency exchange rate. The Government of India had resorted to domestic and external borrowings to fund the twin deficits.
The total domestic public debt increased from 35.6% of GDP in 1980 to 56% of GDP in 1991. The Government relied on risky short term foreign debt instruments (foreign currency bank deposit by NRIs with 2–3 year maturity) as well as through Government securities and treasury bills held by the domestic banks (Controlled by Statutory Liquidity Ratio) to finance this deficit.
The riskiness associated with the short term foreign debt instruments made Indian economy vulnerable to foreign shock as any loss of confidence of foreign creditors on India’s macroeconomic stability could lead to withdrawal of credit.
Genesis of the Crisis: Short Term
Two events lead to immediate precipitation of the crisis. One was the Gulf War which led to oil price shock and the second was domestic political instability.
The Gulf War (August 1990 — February 1991)
Gulf War: As the Gulf war broke out between NATO and Iraq, the oil prices rose suddenly due to supply shock. As India’s domestic oil demand was largely met by the imports from the Gulf, the sudden increase in oil prices led to a large increase in India’s trade deficit.
Domestic Political Instability (1989–1991)
At the same time the political instability contributed to a weak Union Government lacking majority which reduced investor confidence on Indian economy. No political party had secured a complete majority in the 9th Lok Sabha elections held in 1989. The VP Singh Government remained in office from December 1989 to November 1990 and the Chandrashekhar Government had to resign from Office in May 1990. Both the Government lacked adequate support to undertake strong policy measures required to address the looming crisis.
Impact
Economic
The deteriorating condition of the Balance of Payments resulted in a severe economic crisis. The fallout was that India’s credit rating was downgraded to ‘Baa3’ in March 1991 by Moody’s which is the lowest investment grade just one notch above the ‘junk’ or non-investment grade.
The credit rating downgrade made the borrowing from external sources more difficult and India’s access to foreign markets was constrained.
By May 1991 the crisis had become so critical that India’s foreign reserves had depleted to ~USD 2 Billion which was not sufficient to cover 3 months of Imports (This is >34 months in 2020). India was also on the verge of default on its international debt obligation as the Government hadn’t had enough funds to pay the debt.
The Government had to pledge its gold reserves for securing emergency loans from the International Monetary Fund.
Political
The pledging of the gold reserves led to a public outcry and it had a negative impact on the national sentiments. The Government led by the PM Chandrasekhar who had authorized the pleading of the gold lost the 1991 General Elections that were held amidst the crisis (May-June 1991). However it was a bold step as it prevented the ignominy of defaulting on the Sovereign Debt and improved the credibility of India in international markets.
The crisis was essentially a wake call for the policy makers as the new Government undertook drastic reform measures to set the path straight. To address the crisis, the Government of India approached the International Monetary Fund and the World Bank. The new Government formed under the leadership of the Prime Minister Narasimha Rao undertook several initiatives to reform the economy. The reforms were necessitated by the Structural Adjustment Programme as a condition precedent for securing loan from the IMF/WB.
The liberalization measures set the Indian economy on a path of transition from a socialist economy towards a market oriented mixed capitalist economy.
Over the last 3 decades, India’s GDP has risen to be 6th largest economy (as of December 2020). The proportion of the population under the Poverty line has also reduced to 27% in 2015 (54% in 2005). The reforms undertaken via the SAP have been termed as the Reforms of 1991 and are discussed in greater detail in the next part.
Conceptual and Explanatory Notes
Dirigisme
Dirigisme is the economic doctrine where the State plays an active role in directing the control of the economy. This is in contrast with laissez faire approach of the Capitalist Market Economy where there is a minimum Government regulation. The positive Government intervention is directed towards control of market failures. Market failures occur when there is information asymmetry, natural monopoly, public goods, principal agent problems or negative externalities.
The origin of the word Dirigisme is French Word diriger (to direct) which means the state control of the economy. The policy was first adopted in France immediately after World War II wherein the French Government controlled the investments in rebuilding the post war economy, promoting industrialization and protecting against foreign competition. India had also adopted this doctrine indicated by the Centralized Economic Planning (Planning Commission), investment directed by the State (through PSUs), Controlling wages (Minimum Wages Act, 1948) and Supervision of the labor markets (Labor Laws like …..)
Liquidity Crisis
Liquidity Crisis refers to a situation where there is a severe shortage of cash (or other assets which are easily convertible to cash) in the economy (or a firm). A liquidity crisis originates due mismatch in the demand and supply of liquidity. This is generally due to different maturity periods of assets and liabilities or variation in realization of revenues and expenditures.
Consider the following example
The cash reserves are exhausted in period 4. The firm has no cash to fund its expenditure in period 5 and must borrow money. If there had been no revenue recovery in period 6, the mismatch would have prolonged and increased the debt. In case the cash flow mismatch is prolonged, the firm may not even be able to service the debt (i.e. pay the interest and principal debt). In such a case the liquidity crisis would transform into a solvency crisis. A prolonged liquidity crisis can eventually lead to insolvency and bankruptcy.
Supply Shock
A Supply Shock is a sudden unexpected event that suddenly alters the supply of a commodity or a service. A change in the supply of the commodity or service causes a variation in the price. The shock can cause either a positive or negative change in the supply of the good/commodity/service. If the demand remains constant, negative supply shock causes increase in the price and a positive supply shock causes a decrease in the price.
A negative supply shock can occur due to multiple reasons e.g.
- Failure of a crop due to adverse weather conditions
- Disruption in supply chain due to political instability e.g. oil supply shock due to Gulf war in 1991
- Depletion of natural resource e.g. closure of a mine of a mineral ore
- Labor supply shock due to sudden migration e.g. migration due to COVID19
External Shock
External shock is an event that originates outside the domestic economic system but nevertheless has a significant impact on the domestic economy. The shock can be either demand or supply side (of a good/commodity or of the financial system). With the advent of globalization, greater integration of the world economy due to increased trade, and complex interplay of the global financial system, the vulnerability of the economies to external shocks has increased. e.g. the Financial Crisis of 2007–08 that originated in the US eventually had a global impact. Negative external shocks often result in lower economic growth rate, rise in unemployment, higher inflation, fall in the real income etc.
Debt Monetization
Debt Monetization refers to a process where the Government borrows money from the Central Bank to finance its operations. The Central Bank creates new money in the process of buying the debt. Hence this practice is also called printing money. The buying of the
Risk Associated with External Debt
External Debt refers to the money borrowed from foreign creditors e.g. Foreign Banks, Foreign Governments or International Financial Institutions. External Debt is issued in foreign currency and must be paid in the foreign currency.
External debt is preferred in situations:
- The interest rate of foreign loan is lower as it reduces cost of debt servicing
- The payment terms are easier.
- There is shortage of funds in the domestic market, or the domestic fund is to be utilized for other sectors like healthcare
However external debt has certain risks associated with it:
The biggest risk is the currency risk. If there is a depreciation or devaluation of domestic currency, the amount of debt to be repaid increases in terms of domestic currency e.g. India borrows USD 100 million at an exchange rate of INR 40/dollar. This amounts to INR 4000 million (100 million x 40) or INR 4 billion of debt. If after one year the Rupee depreciates to INR 50/dollar, the amount of debt to be repaid amounts to INR 5000 million or INR 5 billion. Thus the amount to be repaid to clear the debt increases by INR 1 billion due to depreciation of Indian Rupee with respect to the US Dollar.
Again, the interest payments on the principal debt amount vary according to change in the exchange rate and debt servicing costs increase with the depreciation of domestic currency.
Secondly increase in debt servicing cost might lead to greater fiscal deficits in future as the interest payments increase which has a negative impact on the Government Budget in the subsequent years. The Government has to borrow more to service old debts thus getting caught in the debt trap.
