ECONOMIC CRISIS OF 1991

WITH SPECIAL
RELEVANCE TO FISCAL DEFICIT
AGENDA
ECONOMIC CRISIS OF 1991: FACTORS
ECONOMIC CRISIS OF 1991 : RELEVENCE
OF FISCAL POLICY
Indias BOP crisis
ECONOMIC FACTORS
Series of high fiscal deficits throughout the 1980s
An overvalued exchange rate (aggravated by real
appreciation of the rupee in the first half of the
1980s)
Foreign trade and payments policies biased against
exports
Growing recourse to various forms of external
borrowing to finance a series of large trade and
current account deficits in the latter half of the
eighties.

BoP crisis- Factors and causes

Economic factors
Huge development expenditure owing to which there are
large scale imports
Business cycles in terms of recession, depression,
recovery and boom
High rate of inflation running up to large scale imports of
essential goods
Decline of import substitutes which would necessitate
and increase in imports
Change in cost structure of trading partners
Political factors
Political Instability leading to decline in FDI and FII
Populism policies which may encourage imports
Social factors
Change in tastes and preferences leading to demand
changes
Cross border prejudices which may lead to expensive
sources of imports


FISCAL DEFICIT
High Fiscal Deficit in late 1980s-
1980-85 7.2% of GDP
1985-90 8.9% of GDP
1990-91 9.4% of GDP

CONSOLIDATED DEFICITS OF CENTRAL AND STATE GOVERNMENTS
(AS PER CENT OF GDP AT CURRENT MARKET PRICES)
GOVERNMENT FISCAL DEFICIT
(AS A PERCENTAGE OF GDP)

Fiscal deficit reaching a peak of 9.9 per cent in 1986-87.
Fed into the current account deficits
Reached 2.5 per cent of the GDP and 43.8 per cent of
exports in 1990-91.
The eventual outcome of these developments was the
June 1991 crisis
RELATION BETWEEN FISCAL DEFICIT AND CAD
We know, Y = C+I+G+(X-M) ----------------- (1)
Also, Y-T = C+S -------------------------- (2)
where, Y= Income C= Consumption Expenditure
I = Investments T= Taxes G= Government Expenditure
(X-M) = Net Exports (X=Exports, M=Imports) S= Savings
Combining and arranging (1) and (2), we get
I + (X-M) = S + (T-G)
i.e. Government deficit (T-G) gives a corresponding deficit in
the current account (X-M), given same S and I.
Why fiscal deficit and CAD increased?
Mundle and Rao

Growing revenue deficits, combined with losses of public
enterprises, have constrained the acceleration of public
investment.
The large public draft on private savings has tended to push up
even administered interest rates and crowd out private
investments.
This has limited the growth of productive capacity on the supply
side, while the large deficits have continued to drive the high
growth of aggregate demand.
The widening gap between domestic absorption and domestic
output has led to a growing trade deficit and aggravated the
balance of payments problem arising from indiscriminate external
commercial borrowing.
Why fiscal deficit and CAD increased?
(IMF Staff papers)
During first half of 1980s rapid rise in domestic petroleum
production permitted savings on energy imports.
During second half of 1980s emphasis shifted from import
substitution to export-led growth.
Volume of petroleum imports increased by more than 40
percent from 86/87 to 89/90 with slowing down of domestic
production.
Sharp Increase in Imports of aircraft and defence capital
equipment.
Fiscal position deteriorated due to rising expenditures and
contributed to current account deficits.
Other Effects of High Fiscal deficit?
Pre emption of Domestic Saving
as % of GDP
Plan Private Private Avg Fiscal
Savings Investment Deficit
Eighth Plan 23% 15.3 6.92
(92-93 to 96-97)
Ninth Plan 26.2% 15.9 8.746
(97-98 to 01-02)
% Change 13.91% 3.9% 26.38%
Rising fiscal deficit absorbed part of the increase in private
savings and to this extent crowded out private investment
due to increase in interest rate
Other Effects of High Fiscal deficit?
Higher Interest Rates
Due to high fiscal deficit, Government borrows from open market to
finance its resource gap
Will lead to increase in Interest Rate

Savings and Investment
Plan Aggregate Domestic Fiscal
Investment Deficit
(90-91) 22.5% 9.3
(95-96) 26.8% 6.52
% Change 19.11% -2.98%
Reduction in Fiscal deficit helps in increase in Savings and
Investment
CONCLUSION
Fiscal Deficit one of major reasons for 1991 Economic
Crisiis
Rising fiscal deficit spirals into increase in Current account
deficit due to constraints on supply side and increase in
demand
Can influence the business environment in an economy
through its effects on savings and investment

Overall Balance of payments


Current Account Balance =
Balance of Visible Trade(goods) +
Balance of Invisible Trade(services) +
Balance of Unilateral transfers
Capital Account Balance =
Inflow of foreign exchange
outflow of foreign exchange
Official Reserves:
The holdings of foreign reserves and gold by official
institutions like the central bank
Overall Balance of Payment =
Current Account Balance+ Capital account
balance+
Official Reserve Account







Components of BoP
Current Account
Import and Export of goods
Import and Export of services
Unilateral transfers from one country to another
Capital Account
Foreign Investment
FDI & portfolio Investment
Loans
Commercial Borrowings, External Assistance &
Banking Capital Transactions



Uses of BoP Analysis

Overview of Macroeconomic and Monetary
situations of the economy
Study on prospects of direct investment to the
nation
Implications on the exchange rate of the currency
Provides data for economic analysis
Reveals changes in the composition & magnitude
of foreign trade
Provides indications of future repercussions of
countrys past trade performances
Reveals the weak and strong points of a countrys
foreign trade relations

Pre-CRISIS PERIOD
Economic Indicators-pre Crisis period
GDP growth rate: 5.5 % (3.3% on a per
capita basis)
Industrial Growth : 6.6%
Agriculture: 3.6%
Investments went from nearly 19% of
GDP from to 1970s to 25% by end on
1980s
Composition was predominantly primary
sector which accounted for 32.8% of the
GDP
Economic Policies
Protectionist Policies- defined objective of self reliance
through industrialization and import substitution
Focus was on substituting imports and promoting domestic
industries by heavy intervention while a gross negligence
on exports
External Debt- The development projects caused a large
scale foreign borrowing which created pressure on the
government



Economic policies

Export promotion- Indian exports were
largely dependent on world trade situation
due to predominance of primary goods in
trade mix combined with lower quality
standards.
Exchange rate- Fixed exchange rate was
followed and constant devaluations by the
central bank to promote exports raised the
amount of external debt.
Strong inward looking policy in all











Government Deficit and Current Account- Pre
1991 levels
Real and Nominal Exchange rates
Pre 1991 levels
External Debt and For-ex reserves-
Pre 1991 levels
Trends in Pre BOP crisis period
Capital inflows mainly consisted of aid flows,
commercial deposits and Non resident
Indian deposits
FDI was heavily restricted and foreign
portfolio investments generally channelized
to public sector issued bonds
Gradual loss of for-ex reserves and
deterioration of trade balance due to fixed
nominal exchange rate which was declining
over the 1980s


Trends in For-ex reserves-Figures
Trends contd

Sharp rise in imports due to growth
orientation and ( petroleum imports rose by
40% from 1986-87 to 1989-90 )
Doubling of external debt from 1984-85
($35 bn) to 1990-91 ($69 bn)
Loss of investor confidence led to outflows
being increasingly dependent on short term
external debts. An unstable government and
the gulf crisis further aggravated the
situation

Trends in trade deficit-Figures

Trends.contd

High revenue deficits especially after 1986, for
which the government responded by creating a
surplus capital account to finance them
THE CRISIS
Balance of payments: The Crisis
Also known as the Unfortunate period
of Indian Economy.
Gulf crisis of 1990 increase in oil
import bill
Deterioration of invisible account
Increase in price of oil => overall
current account deficit in 1990-91 : US $
9.7 billion
Important trading partners like US,
Russia turned up to invest in India
Export growth reduced to 4%

World growth declined from 4.5% in
1988 to 2.5% in 1991
Political turmoil VP Singh
government overthrown, Rajiv Gandhi
assassination reduced credibility of
India, investors lost interest and trust
in Indias government.

Balance of payments: The Unbalance
Foreign reserves very low at $1.2
billion
Overshot IMF SDR reserves
Simultaneous outflow of NRI deposits
Serious difficulties in rolling over of
short term loans
Current account deficit of $9.7 billion
almost impossible to finance

Developments in 1991
Current account deficit averaging 2.2% of
the GDP hit hard by the Gulf war
Triggers
oil bill increased by $2 billion
overseas markets for exports shrinked
(West Asia, Soviet Union)
Fall in remittances
The Reserve Position in IMF of $660 million
was drawn in full by September, 1990 to add
to the reserves
The international credit rating agencies
placed India on the watch list in August
1990
Import compression
Curb imports to reduce deficit
Surcharge on oil imports
Cash margin




-20
-10
0
10
20
30
1989-90 1990-91 Apr-Sep 1991
%

c
h
a
n
g
e

Import Trends
Bulk imports
Capital goods
Export related imports
Import compression effects
-50
-40
-30
-20
-10
0
10
20
30
40
%

c
h
a
n
g
e


IIP and Imports
IIP
Non -oil Imports
What actually happened..

Agreement with IMF for a drawing of $1,025
billion under its Compensatory and
Contingency Financing Facility (CCFF)
Drawings of $789 million from the first credit
tranche made in Jan,1991
Despite the drawings, the situation was hardly
under control.
Between March 1991 and June 1991, there
was a sharp withdrawal of non-resident
deposits to the extent of $952 million leading
to further drop in foreign exchange reserves

The Crisis
Despite low trade deficit ,the slide in foreign
reserves continued unabated
Essentially became a crisis of confidence










expected
devaluat
ion
payment
s of
imports
&
exports
withdra
wal by
foreigne
rs
Further
drop in
reserves
Expectat
ion of
default
The Crisis (Contd.)
Foreign exchange reserves fell below $1 b
Barely enough to cover 2 weeks of imports
Likely ramifications




Credit unavailability, trade
disruption
Shortages, industry
dislocation ,unemployment
High inflation , instability
Foreign exchange reserves
The response
As a first step, in May 1991, the
government leased 20 tonnes of
confiscated gold to the State Bank of
India for $200 million
Later, RBI moved in four installments
47 tonnes of the gold held by it to the
vaults of the Bank of England to raise
a temporary loan of $405 million
jointly from the Bank of England and
the Bank of Japan
Loan repaid in Sep-Nov. and the
pledged gold was redeemed
New government assumed charge in
June ,1991



Short term Structural changes
Two-step downward adjustment in the
exchange rate of rupee was effected on July
1 and 3, 1991
This effectively translated into devaluation of
18-19 per cent against major international
currencies
This was coupled with the liberalisation of
the trade regime and lower import tariffs
Besides exceptional financing arrangements
with the World Bank, Asian Development
Bank and a few industrial countries were
also negotiated
Due to the currency devaluation the Rupee
fell from 17.50 per dollar in 1991 to 26 per
dollar in 1992

Long term Structural changes
A High Level Committee on Balance of
Payments was set up in December
1991
Liberalized Exchange Rate
Management System (LERMS) and
move to a single market based
exchange rate system
This obviates the need for the RBI to
determine the rate daily
However, the need to monitor and
watch the movements in the markets
assumes importance, as foreign
exchange markets tend to overshoot
often
Long term Structural changes
(Contd.)
Macroeconomic stabilization on four
fronts to basically improve efficiency
and spur exports
Fiscal correction lowering of
government spending
Trade policy reforms eximscrips
Industrial policy reforms end of
license raj
Public sector reforms autonomy
and efficiency




REFORMS & IMPACTS
Balancing mechanism
Rebalancing by changing the
exchange rate
An upwards shift in the value of
domestic currency relative to others
will make exports less competitive
and make imports cheaper and will
tend to correct a current account
surplus.
Exchange rates can be adjusted by
government in a rules based or
managed currency regime, and when
left to float freely in the market they
also tend to change in the direction
that will restore balance
Balance of Payments: Policies
Government allowed Reserve Bank of
India to ship 47 tonnes of Gold to the
Bank of England in July 1991.
Short-term debt was reduced and
strict controls put in place to prevent
future expansion
Foreign exchange reserves were
consciously accumulated to provide
greater insurance against external
sector stresses and uncertainties


Reforms Undertaken
Fiscal Correction:
Abolishing export subsidies, increasing
fertilizer prices, as well as by keeping
non- plan expenditure in check.
Budget projected a sharp decline in
the budget deficit to Rs.7719 crore in
1991-92.
Fiscal deficit was also projected to
decline from Rs 43,331 crore in 1990-
91 to Rs 37, 772 crore in 1991-92.


Reforms Undertaken
Industrial Policy Reforms:
80 % of the industries were taken out
from the licensing framework.
MRTP Act was amended to eliminate
the need for prior approval by large
companies for capacity expansion or
diversification.
Areas reserved for public sector was
narrowed down and greater
participation was permitted from the
private sector.
Reforms Undertaken
The limit of foreign equity holders was
raised from 40 to 51 % in the wide
range of priority industries.
Technology imports for priority
industries are automatically approved
for royalty payments upto 5 % of
domestic sales and 8 % of export
sales or for lumpsum payments of Rs
1 Crore.
Reforms Undertaken
Results of Industrial Reforms:
The number of investment approvals
rise from 3335 in 1990 to 5538 in
1991.
505 foreign technology import
agreements were also approved.
In 1991, a total of 244 cases of
foreign equity participation with the
proposed equity investment of $ 504
million was approved.
Reforms Undertaken
Public Sector Reforms:
Government undertook a limited
disinvestment of a part of public
sector equity to the public through
financial institutions and mutual funds
in order to raise non- inflationary
finance for development.
Sick Industrial Companies Act: To
Bring public sector undertakings also
in purview.



Reforms Undertaken
Trade Policy Reforms:
Large part of administered licensing of
imports was replaced by import
entitlements linked to export
earnings.
Advance licensing system for exports
was simplified so as to improve
exporters access to imported inputs
at duty- free rates.
Scope of canalization for both exports
and imports was narrowed.
Reforms Undertaken
Anti-export bias in the trade and
payments regime was also reduced
substantially
Effects of these reforms was to reduce
the degree of licensing in import
trade, to broaden, to enhance and
harmonize export initiatives.


Balance of Payments: 1992-93
Foreign exchange reserves had been
build up to respectable level of $5.63
billion from a low of $1.29 billion at
the end of July 2001.
Introduction to LERMS( Liberalized
exchange rate management system)
Mobilization of external assistance
from IMF, World Bank , ADB and
Bilateral donors to support the BOP

LERMS

Introduced, from March 1992, a dual
exchange rate system in the place of
a single official rate.
One official rate for select government
and private transactions and the
market-determined rate for the
others.
Treated current and capital
transactions in different ways.
Decision to permit gold imports was
linked to LERMS
Contd..

Despite the increase in imports to
more normal levels during 1992-93, it
has been possible to manage the BOP
with the stable exchange rate and
comfortable foreign exchange
reserves throughout the year.

Effects of Liberalization
BOP Surplus:
External sector - growth rates moving up
to 11 and 20% in the two years ended
March 2001
India successfully withstood the sharp rise
in international oil prices since the closing
months of 1999.
NRI deposits with the banking system in
India on the rise from 13 billion dollars in
1991-92 to 23.8 billion dollars by March
2001
BOP recorded an overall surplus
consecutively for five years from 1996-97
Indias foreign exchange reserves, 1 billion
in 1990 reached $ 40 billion the average
annual addition being 4.5 billion dollars


Effects of Liberalization
Trade and Investments:
Rise in FDIs and other capital flows
Under the category of Invisibles, a significant
increase in private transfers.
Private transfers grew to a level of 10-12 billion
dollars in the latter half of 1990s.
Increase in exports level and exchange rate
reforms : the major factors that helped
contain the current account deficit in BOP to 1
to 1.5 per cent of GDP between 1991 and
2001
In ten years, 1991- 2001,
Over 37 billion dollars of foreign
investment flowed
18 billion $ was direct investment.


Developments in the next decade
Acceleration of GDP growth to 6.7 per cent
in the period 1992-97 was the highest India
had ever achieved over a five year period.
Sum of external current payments and
receipts as a ratio to gross domestic product
(GDP) doubled from about 19% in 199091
to around 40% by March 2001
Manufacturing achieved average real growth
of 11.3 per cent in the four years 1993-94
to 1996-97
Export growth in dollar terms averaged 20
per cent in the three years 1994 1996 and
the rates of aggregate savings and
investment in the economy peaked in 1995-
96




Developments in the next decade
Private Investments showed an high growth
of 16.34 % per annum during 1992-96.
Real fixed investment rose by nearly 40 %,
led by a more than 50 % increase in
industrial investment

External Commercial Borrowings
-10 0 10 20 30 40 50
1980-81
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
10.9
25.2
48.1
20.1
36.7
31.8
26.8
30.6
-8.4
9.1
13.6
21
10.6
ECB/TC (%)
1980-81 1985-86 1986-87 1987-88 1988-89 1989-90 1990-91
1991-92 1992-93 1993-94 1994-95 1995-96 1996-97
External Commercial Borrowings
Result of a concious government policy to
maintain a strict control over external indebtness
and resulted favourably in improving the credit
rating of India by international agencies.
Some private sector power and petroleum
companies finalizing their financing packages
Large demand for borrowing with projects in
petroleum, oil exploration and
telecommunications.
1993-94:
1994-95:

1995-96:
External Assistance
0
10
20
30
40
50
60
70
1980-81 1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97
60.9
36.2
34.6
46.9
36.7
33.2
26.3
63.9
43.7
18.5
19
29.8
11.7
EXTERNAL ASSISTANCE/TC (%)
1980-81 1985-86 1986-87 1987-88 1988-89 1989-90 1990-91
1991-92 1992-93 1993-94 1994-95 1995-96 1996-97
Developments in the decade
PMU : Project Management Unit was
introduced,as part of the department
of Economic Affairs to monitor
,supervise and strengthen various
projects.
In 1994-95 decided not to approach
IMF for medium term funds.
Advance release of funds to state
governments


Export Growth
9
20.2
20.3
5.6
4.5
-3.9
11.6
20.4
-10
-5
0
5
10
15
20
25
1990-91 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00
A
x
i
s

T
i
t
l
e

EXPORT GROWTH (%)
Decline of Growth in 1997
Decline in world trade since the
second half of 1997
Decline in export prices of some major
items of manufactured goods
Growing infrastructure bottlenecks
Appreciation of the rupee in real
effective exchange rate terms.

Growth of I mports
14.4
10
21.6
12.1
4.6
-7.1
16.5
-10
-5
0
5
10
15
20
25
1990-91 1993-94 1995-96 1996-97 1997-98 1998-99 1999-00
A
x
i
s

T
i
t
l
e

GROWTH OF IMPORTS (%)
References
Balance of payments (BOP)
The balance of payments of a country is a
systematic record of all economic transactions
between the residents of a country and the rest of
the world. It presents a classified record of all
receipts on account of goods exported, services
rendered and capital received by residents and
payments made by them on account of goods
imported and services received and capital
transferred to non-residents or foreigners.


Reserve Bank of India