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Liberalised Exchange Rate Management System The story of India's Gulf crisis A.

. Seshan As always, victory finds a hundred fathers, but defeat is an orphan. Count Galeazzo Ciano, The Forex Crisis JULY 12, 1991, was a red-letter day in the history of the Indian economy but not in any happy sense. It marked the nadir in the external sector. The balance-of-payments bottomline was reached. The foreign currency assets of the Reserve Bank of India (RBI) amounted to $975 million. And the limited reserves were not fully in the central bank's custody. An amount of $600 million was kept with the State Bank of India, New York, for reasons given later. Effectively the foreign currency assets available with the RBI were adequate to meet the cost of a week's imports against the desirable norm of three months. From that abysmal position we have reached a level of about $130 billion in foreign currency assets today and suffer from an embarrassment of riches. In recent years, a number of articles have appeared in newspapers and journals on the story of economic reforms in India. Many writers have identified the members of the `A team' which ushered in the reforms leading to the benign situation now. There are others who were silent witnesses to all that was happening, although not a part of the `A Team'. They also have a story to tell. How default was averted In the first place, it was only indirectly because of Saddam Hussein that India woke up to realities. For, the crisis was long in coming. Saddam Hussein's aggression on Kuwait and the events that followed them aggravated India's problems, making it imperative to find solutions. There was also the instability at the Centre and the Chandrasekhar formed a government with the support of the Congress.

The political instability was a blessing in disguise. It was engaged in a game of `life-and-death', and such mundane matters as the forex crisis were left to the central bank. A point was reached when there was a good possibility of the country defaulting on one of its repayment instalments. Borrowing from the market was out of the question, given the junk status accorded to Indian bonds by the rating agencies. The major item of import finance related to oil. Indian Oil Corporation was the canalizing agency and it needed money. The SBI arranged for short-term Acceptance Credit in the inter-bank market in New York, which was just rolled over from day to day. It was then that RBI decided to keep $600 million with SBI in New York, as a contingency reserve for making import payments. Under such circumstances the central bank came up in July 1991 with the bold proposal of pledging its gold stocks to Bank of England and Bank of France and raise a short-term loan of $405 million. It was fully aware of the likely political fallout and the criticism that the country's jewels were being pawned. The whole operation of physically transporting the stocks to London was carried out in secret under the close supervision of a Deputy Governor, who was in constant touch with the officer going in the truck to the airport. The gold was subsequently redeemed through repayments between September and November 1991. But what is not known to the public is the fact that in the process of refining the gold to meet international standards before its pledge there was a value addition which was most welcome at a critical time. The reforms India applied for IMF assistance. It was clear that in its absence the other avenues for raising resources would be closed. The IMF sent its `A team' to India to discuss its conditionalities for lending, the elements of which are well known as the Washington Consensus.

The economic reforms were thus introduced because of the IMF conditionalities and not because of any sudden change of economic philosophy by the Government. Of course, some official economists claimed that it was all the Government's own policy but blessed by the IMF/World Bank. There was a hectic period of the announcement of reforms by the newly-formed Government of P. V. Narasimha Rao, encompassing practically all aspects of economic policy. Depreciation of rupee The RBI's first major announcement was the depreciation of the rupee, in two instalments on July 1 and 3, 1991. It was euphemistically called a "downward adjustment" of the value of the rupee and the first instalment was stated to be to "test the waters". The value of the rupee declined by 18-19 per cent against major currencies to improve the competitiveness of Indian exports. The Index of Real Effective Exchange Rates was used in policy formulation. However, it is no longer the deciding criterion for the central bank, given its limitations. The markets were then taken by surprise, as there had been no inkling of such a large depreciation of the currency. LERMS There was an urgency to overhaul the administered exchange rate system. The RBI Governor formed an internal group with the members being O. P. Sodhani, Controller, Exchange Control Department; P. B. Kulkarni, Chief Officer, Department of External Investments and Operations, and this writer, who was Adviser (International Finance), as Convener. There were inquisitive colleagues who were anxious to know what was going on and would have liked to get into the act. We successfully kept our meetings and discussions confidential, often without any documents but only hand-written notes. The Governor indicated the terms of reference orally. We met on a few occasions and recommended the Liberalized Exchange Rate Management System (LERMS), which was approved by the Governor, and subsequently incorporated in the report of the High Level Committee on Balance of Payments.

LERMS introduced, from March 1992, a dual exchange rate system in the place of a single official rate. It consisted of one official rate for select government and private transactions and the market-determined rate for the others. It treated current and capital transactions in different ways. There were requirements of surrender of foreign exchange by the public to banks with some exceptions. The working of LERMS was smooth from the beginning, contrary to the fears in some quarters that the rupee may undergo a steep depreciation. Some experts expected a market rate of Rs 50 per dollar. When the scheme was introduced, forex dealers felt like prisoners of half a century being suddenly released one morning and not knowing what to do, having lost all moorings in life! However, they adjusted to the new situation quickly. The RBI announced the official rate. The Foreign Exchange Dealers Association of India (FEDAI) intimated the market rate, called the Indicative Rate, to the Authorized Dealers (ADs) for dollar, mark, yen and pound sterling at noon every day. The ADs were free to quote their own rates but, by and large, they were close to the FEDAI rates. The spread, measured as the difference between the official rate and the market rate as a percentage of the former, ranged between 10.2 per cent and 15.8 per cent for ten days between March 3, 1992, when the FEDAI announced the Indicative Rate for the first time, and March 13. The stability of the spread was ensured by several factors. In the first place, there was a marked improvement in NRI remittances through the banking channel, particularly from the Gulf, in view of the facility to convert dollars into rupees at market rate to the extent of 60 per cent. It was also the result of the Government permitting gold imports up to 5 kg by NRIs and other returning Indians, once in six months. More than 90 tonnes were brought into the country before the end of December 1992.

The decision to permit gold imports was linked to LERMS. It was part of the RBI's package of measures for the external sector. The Apex Bank was felt that as long as gold imports were not permitted the hawala market in foreign exchange would prevail. It was well known that the demand for dollars in the unofficial market was linked to the financing of gold smuggled into the country. With a rising supply in the domestic market the margin for the smuggler came down drastically from Rs 1,414 per 10 grams on April 17, 1992, before the reduction in import duty, to Rs 676 per 10 grams on December 24, 1992 marking a fall of 52 per cent. The trend in the decline in the profit continued and it was no longer attractive for the smuggler to engage in illegal activity. The depreciation of the rupee against the dollar vis--vis the official rate ranged between 25 and 30 per cent in February 1992 (before LERMS was introduced) in Hong Kong, New York, Frankfurt, Dubai and other places where the currency was traded unofficially. At the end of 1992 the rate came down to Rs 32 to a dollar a depreciation of 4 per cent over the market rate and 10 per cent over the weighted average rate of official and market rates. It made the hawala transaction no longer attractive to the NRIs, who preferred the banking channel for routing remittances to their families. The RBI's foreign currency assets maintained a rising trend. They reached a level of $5.6 billion on March 31, 1992, rising from $975 million on July 12, 1991. After accounting for assistance received from bilateral and multilateral agencies, receipts under India Development Bond Scheme and Remittances in Foreign Exchange (Immunities) Scheme 1991, about $1 billion remained to be explained. It was essentially the result of reforms in the exchange rate system leading, inter alia, to faster repatriation of export receipts and routing of remittances through banking channels. From April 1, 1991 till March 31, 1992 purchases by the RBI from the ADs amounted to $1.8 billion against the net sales of $5.8 billion the previous year implying a turnaround of $7.6 billion. LERMS had its detractors too. The export community considered the 40:60 rule as a tax on their profession. But it was envisaged as a transitory measure and to help avoid a sudden increase in government expenditure, fiscal deficit and inflation rate. In the next Budget a unified floating rate based on market forces was introduced which continues till today.

What has been written in this article just skims the surface of the whole crisis. The central bank has been undertaking a history project, and two volumes (1935-51 and 1951-67) have been published. After the preparation of the third volume covering 1967 to 1982, which awaits publication, the bank disbanded the History Cell. It looks like the next volume may take time. It is in this context that an ad hoc publication on the Gulf Crisis would be timely. (The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)