Pathways Through Financial Crisis

Topics: 1991, 1907, Monetary policy Pages: 23 (7613 words) Published: April 12, 2013
Global Governance 12 (2006), 413– 429

Pathways Through Financial Crisis: India
Arunabha Ghosh

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

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

The 1991 Crisis In 1991, India experienced a classic external payments crisis: high fiscal and current account deficits, external borrowing to finance the deficits, rising debt service obligations, rising inflation, and inadequate exchange rate adjustment. In 1979, the oil shock, agricultural subsidies, and a consumption-driven growth strategy had pushed up the fiscal deficit. It further increased in the mid-1980s as defense expenditure was substantially increased and direct taxes were progressively reduced.1 The result was that the deficit ballooned from 1985 to reach 9.4 percent by 1990–1991.2 413

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India’s current account position also worsened. Increasing dependence on foreign oil imports, vulnerability to oil price fluctuations, declining remittances from abroad, strong domestic demand (a result of public sector wage increases in the mid-1980s), and rising debt service payments ensured that the current account deficit averaged 2.2 percent of gross domestic product (GDP) during 1985–1990. Also, export competitiveness was adversely affected by the rupee’s steady appreciation: 20 percent between 1979 and 1986.3 In 1987 it steadily depreciated, but the real exchange rate remained overvalued until 1991. To finance the twin deficits, India relied on external funds. Foreign investment at 0.1 percent of GDP during 1985–1990 was negligible.4 During 1980–1985, nearly half of external financing needs were met by external assistance.5 By the mid-1980s, “aid weariness” forced the government to rely more on commercial borrowing.6 Soft loans declined in proportion from 89 percent (1980) to 35 percent (1990).7 Thus, external debt (with a large proportion of short-term debt) started dominating the balance sheet, peaking at 38.7 percent of GDP in 1991–1992, with the debt-export ratio at 563 percent.8 Notwithstanding the weakening fundamentals, one key factor that reduced vulnerability was the absence of private sector external debt. Unlike many other countries, individuals and firms could not raise foreign currency–denominated debt, and the banking sector was not allowed to hold financial assets abroad. One effect of this was that the private sector’s interests were geared more toward internal deregulation than toward external liberalization.9 Two immediate external shocks contributed to the...


Cited: in Nayar, “Political Structure,” p. 340.
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28. Budget speech to the Lok Sabha (lower house), 4 March 1991. 29. Manmohan Singh, budget speech to the Lok Sabha, 24 July 1991. 30. Reserve Bank of India, Annual Report 1990–91, p. 136. 31. I thank Shankar Acharya for this insight. 32. World Bank, “Country Strategy for India” (Washington, DC: World Bank, September 2004), pp. 26–27, available at http://siteresources.worldbank.org/INTINDIA/ Resources/CountryStrategyforIndia_fullversion.pdf (accessed May 2006). 33. Manmohan Singh, budget speech to the Lok Sabha, 29 February 1992. 34. A. Varshney, “Mass Politics or Elite Politics? India’s Economic Reforms in Comparative Perspective,” in J. D. Sachs, A. Varshney, and N. Bajpai, eds., India in the Era of Economic Reforms (New Delhi: Oxford University Press, 1999), p. 247 (emphasis in original). 35. K. C. Dash, “India’s International Monetary Fund Loans: Finessing WinSet Negotiations Within Domestic and International Politics,” Asian Suvey 39, no. 6 (1999): 903. 36. Phone interview with Montek Ahluwalia, 27 April 2004. 37. Calculated from Government of India, “Government Subsidies in India,” Ministry of Finance Discussion Paper, New Delhi, 1997, annexure 4. 38. Interview with Manmohan Singh, in V. N. Balasubramanyam, Conversations with Indian Economists (New Delhi: Macmillan, 2001). p. 94. Also see C. Rangarajan’s interview in the same book. 39. Ahluwalia, “India’s Vulnerability.” 40. Government of India, “Public Sector Commercial Banks and Financial Sector Reform: Rebuilding for a Better Future,” Ministry of Finance Discussion Paper, New Delhi, 1993, p. 13. 41. Until then, the controller of capital issues had been part of the finance ministry. 42. A. Shah and S. Thomas, “The Evolution of the Securities Markets in India in the 1990s,” Indian Council for Research on International Economic Relations Working Paper No. 121.2002, available at www.icrier.res.in/publications.html (accessed May 2004). 43. Phone interview with Arvind Virmani, 8 May 2004. 44. Y. V. Reddy, “Exchange Rate Management: Dilemmas,” Reserve Bank of India Bulletin 51, no. 9 (1997): 701–708. 45. Ahluwalia, “India’s Vulnerability,” p. 210. 46. The Foreign Investment Promotion Board, chaired by the principal secretary to the prime minister, was created to expedite FDI proposals. 47. For a discussion, see Y. V. Reddy, “Managing Capital Flows,” lecture at the Asia-Pacific Research Center, Stanford University, 23 November 1998, reprinted in Y. V. Reddy, Monetary and Financial Sector Reforms in India: A Central Banker’s Perspective (New Delhi: UBSPD, 2000). 48. D. Nayyar, “Capital Controls and the World Financial Authority: What Can We Learn from the Indian Experience?” in J. Eatwell and L. Taylor, eds., International Capital Markets: Systems in Transition (New York: Oxford University Press, 2002), p. 101. 49. For details on the case, see Acharya, “Macroeconomic Management,” pp. 221–222. 50. Reserve Bank of India, Annual Report 1996–97 (Mumbai), p. 122. 51. This explains why V. Joshi, “India and the Impossible Trinity,” World Economy 26, no. 4 (2003): 555–583, labels India as having an “intermediate regime
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with capital controls,” as opposed to what the government called “market-determined” rate or the IMF characterized as “independently floating” rate. 52. They shared information on other countries’ strategies. Phone interview with Arvind Virmani, 8 May 2004. 53. International Monetary Fund, “Press Information Notice: IMF Concludes Article IV Consultation with India” (Washington, DC: IMF, 1997), available at www .imf.org/external/np/sec/pn/1997/pn9711.htm (accessed March 2004). 54. Reserve Bank of India, Annual Report 1996–97, p. 19. 55. Interview with Manmohan Singh, New Delhi, 27 June 2003. 56. Akira Ariyoshi et al., “Capital Controls: Country Experiences with Their Use and Liberalization,” IMF Occasional Paper No. 190 (Washington, DC: International Monetary Fund, 2000), p. 84, available at www.imf.org/external/pubs/ft/op/ op190/index.htm (accessed March 2004). 57. “Indian Test Match,” The Economist, 14 August 1997. 58. Acharya, “Macroeconomic Management,” p. 238. 59. Nayyar, “Capital Controls,” p. 117. 60. Discussion based on Ahluwalia, “India’s Vulnerability,” and Nayyar, “Capital Controls.” 61. N. Jadhav, “Capital Account Liberalisation: The Indian Experience,” paper presented at the conference “A Tale of Two Giants: India’s and China’s Experience with Reform and Growth,” International Monetary Fund and National Council of Applied Economic Research, New Delhi, 16 November 2003, p. 29, available at www .imf.org/external/np/apd/seminars/2003/newdelhi/jadhav.pdf (accessed March 2004); R. Kohli, “Capital Flows and Their Macroeconomic Effects in India,” IMF Working Paper 01/192 (Washington, DC: IMF, 2001), p. 17, available at www.imf.org/ external/pubs/cat/longres.cfm?sk=15471.0 (accessed March 2004). 62. D. Nayyar, Economic Liberalization in India: Analytics, Experience, and Lessons (Calcutta: Centre for Studies in Social Sciences, 1996), p. 33. 63. N. Bajpai, J. D. Sachs, and N. Volavka, “India’s Challenge to Meet the Millennium Development Goals,” Centre on Globalisation and Sustainable Development Working Paper No. 24, April 2005, available at www.earthinstitute.columbia.edu/cgsd/documents/bajpai_indiamdgchallenge.pdf (accessed May 2006). See also A. Deaton and J. Dreze, “Poverty and Inequality in India: A Re-examination,” Economic and Political Weekly, 7 September 2002, pp. 3729–3747. 64. On unequal growth across states, see G. Datt and M. Ravallion, “Is India’s Economic Growth Leaving the Poor Behind?” Journal of Economic Perspectives 16, no. 3 (2002): 89–108. 65. A. Shariff, P. K. Ghosh, and S. K. Mondal, “Indian Public Expenditures on Social Sector and Poverty Alleviation Programmes During the 1990s,” Overseas Development Institute (ODI) Working Paper No. 169 (London: ODI, 2002), available at www.odi.org.uk/Publications/working_papers/wp169.pdf (accessed June 2006). 66. S. M. Dev and J. Mooij, “Social Sector Expenditure in the 1990s: Analysis of Central and State Budgets,” Economic and Political Weekly, 2 March 2002, pp. 853–866. 67. UNDP, Human Development Report 2005, International Cooperation at a Crossroads: Aid, Trade and Security in an Unequal World (New York: Oxford University Press, 2005), pp. 28–29. 68. BBC, “India Launches Rural Health Plan,” 12 April 2005, available at http:// news.bbc.co.uk/1/hi/world/south_asia/4436603.stm (accessed May 2005).
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