The Balance of Payment crisis of 1991 is considered to be the worst financial crisis that India has faced. Balance of Payments encompass all the transactions between a country’s residence and its non-residence and involves goods, services and income. The 1991 crisis was a result of decades of imprudent economic policies prevalent in India. The institutional arrangements in the pre-1991 Indian economy were adequate to sustain the economy but led to a continuous deterioration of the fiscal situation in the country, eventually leading to unsustainable deficit in the balance of payments in 1991.
The planning commission was formed in India for achieving planned development in 1950. The license raj system led India to a continuous trade deficit. The planning process majorly focused on strengthening the public sector in order to achieve economic development and thus administrative controls over industries by introducing quota-license-inspector raj were set up. Private savings were used for catering to the public sector consumption and investment issues and redistribution of wealth through tax and transfers was the major source of tackling inequality and poverty. There were 11 income tax slabs and the marginal rate of taxation along with wealth tax had reached up to 100%. The personal Income tax was as high as 77 % in the 1970’s. The 1991 crisis however did not develop suddenly. It was a result of a decade of imprudence. The 1979 budget can be considered as the turning point with respect to the conservatism of previous fiscal management. The seventh Finance commission led to an increase in the state’s share of the central Government’s tax revenues, while there was no reduction in the Centre’s responsibilities. This caused a small increase in Centre’s fiscal deficit. The fiscal deficit was slowly increasing during the late 1970’s because of higher cost of borrowing, strong growth in the public sector employment and an increase in the wages. The bailout of many loss making firms coupled with a slow growth rate in government revenue led to a decline in the economic situation. In 1970-1971 the interest payment had 19% share in the expenditure, while subsidies had a 3% share. By 1990-1991, the interest payment had the largest share – 29%, even overtaking the expenditure on defence, while the subsidies rose up to 15% of the expenditure. This suggested that the public debt and the subsidies burden was too large at that time.
Some of the major causes that led to the 1991 crisis are :
1) Since the 1960s, India depended on the Soviet Union for the exports as we were unsuccessful in developing good economic relationships with the US and Western Europe. An important part of India’s trade during the 1980’s was the rupee trade with the Soviet Bloc. However, introduction of Mikhail Gorbachev’s policies – ‘Perestroika’ and ‘Glasnost’ along with the breaking up of the eastern European countries led to the termination of several rupee payment agreements. This also had an effect on our exports to the Eastern Europe as these exports had a 22.1 percent share in the total Indian exports but within 10 years during 1991- 1992, the share of these exports was reduced to half – 10.9 %
2) Iraq-Kuwait war which started in the mid 1990’s also contributed towards India’s financial crisis of 1991. The gulf was began with the invasion of Kuwait by Iraq. The gulf war began due to the differences between Iraq and Kuwait. Iraq was at war with Iran. Iran was attacking Iraq and also the oil tankers of Kuwait. Kuwait had provided a debt of 14 billion $ to Iraq for this war. Iraq requested Kuwait to dissolve this debt as they were doing a favour to Kuwait by fighting with Iran. Kuwait disagreed. Also, in order to pay those debts, Iraq asked OPEC countries to reduce their oil production, so that in order to cater to the oil demand the prices of crude oil will increase, thus helping Iraq in increasing their revenues and clearing off their debt to Kuwait. Kuwait however did not agree to this, thus infuriating Iraq. The war between Iraq and Kuwait left India with no option but to buy oil from spot markets on short term contracts that had to be followed up with long term contracts at higher prices. This led to the increase in oil import bill by 60%, eventually causing a rise in the trade deficit.
3) Slow growth in economies which were important trading partners to India led to weaker export markets. The world growth was halved from 4.5% in 1988 to 2.25% in 1991. India’s major export partner USA had a negative growth rate of -1% at that point of time. Thus export earnings for India deteriorated continuously while the imports bill kept increasing. The deteriorating current account deficits led to a low investor confidence. India’s credit ratings also went down as the International Credit rating agency Standard and Poor’s and Moody’s had downgraded India’s long term foreign debt rating to the bottommost investment grade.
4) The investors’ confidence was further affected due to the political uncertainty and instability in the country. In the late 1980s India’s political system was imploding. Prime Minister Rajiv Gandhi was involved in a series of troubles such as the Bofors scandal, The Shah Bano case and the Indian Peace keeping force – IPKF (which led to Rajiv Gandhi’s
assassination at the hands of LTTE in 1991) which led to his downfall in 1989. From November 1989 to May 1991, India had three coalition governments and three prime ministers which led to a delay in dealing with the balance of payment crisis.
5) The trade deficit had increased not just due to the increase in oil prices but the non-oil imports for India had also increased a lot. During the period from 1981 to 1986, the non-oil imports contributed to 68% of the total imports in terms of cost. However during the period 1987-1991 the non-oil imports rose to 81% of the total imports and by 120% as compared to the total non-oil imports during 1981-1986.
6) In the latter half of 1980’s the current account deficit was showing a continuous increasing trend to the point that it was becoming unsustainable. The current account deficit was mainly financed by costly external finance sources like commercial borrowings and NRI deposits. The external debt was showing a very worrying trend in the 1980’s which led to the collapse in 1991. The concessional assistance that India was receiving from the World Bank Group accounted for 89% of the total assistance to India that came from multilateral sources. However, this came down to 35% in 1990. As a result there was an increase in the average interest cost because the funds were being raised from other sources. This is where the commercial borrowings and NRI Deposits came into play as the sources of funding. This costly external debt was used in order to fund Government’s deficit. To provide a perspective, India’s external debt was 194 crores in 1980-1981 and it exponentially increased to 1230 crores in 1990-1991 (almost 6 times)
These were the major reasons which caused a failure in the Balance of Payments situation in 1991 and led to a collapse. The government was on the verge of defaulting and the situation was so critical that India’s foreign exchange reserves were barely enough to cover roughly three weeks of essential imports. Fiscal policy is a critical part of the policy framework in order to achieve economic growth, price stability and equity. In order to achieve these objectives, raising resources through taxation was important and so was restraining the growth of unproductive and non-planned expenditure. However in order to tackle the crisis it was very necessary to raise huge funding. The government did just that. They took a condition-less loan from the International Monetary Fund and even borrowed money from Banks in London and Switzerland. The loan amount was 3.9 billion $. In return 67 tons of gold was kept as reserves at Banks at UK and Switzerland.
Some of the crucial reforms that could have been handled in a more efficient manner to handle such a financial crisis are :
1) In order to make the exports competitive in the foreign market it is very essential to provide quality products. This will lead to an increase in the exports having identified the right kind of markets to export the products. It is not always possible to make products of a particular level of quality without the essential raw material. Also lot of quality material comes to India from abroad. It should be easily available to the Indian industries to access those raw materials. There were a lot of import restrictions. The custom duty was up to 400% on many of the products, thus making the access to those resources costly. Also introduction of foreign investment and companies to the country’s market can provide a major boost to the domestic economy. This will eventually lead to a decrease in the trade deficit which was causing the major issue for the Indian economic system. Keeping all this in mind, various tax incentives were provided to attract the foreign investors. This led to the introduction of foreign companies with better technologies in the India market. Due to this the Indian companies began losing ground in the domestic market to these foreign companies that provided superior products to the Indian buyers. The medium and small companies had to suffer the most as they were not competent enough to suddenly tackle the superior foreign industries. In this case a provision should have been made in order to make the domestic goods competent enough with respect to the price levels of the products. Also, the incentivising the medium and small enterprises with respect to technology would have helped in making the Indian goods competent.
2) India had isolated itself from the world markets till the 1991 crisis in order to protect its fledging economy and achieve self-reliance. However in 1991 to address the Balance of payments crisis, the Indian government decided to remove the restrictions from foreign direct investments (which were around $200 million annually in the pre-globalisation era). Also, The Indian market opened itself to penetration by foreign industries. This resulted in the foreign industries setting up their workstations in India. Thus, due to Globalisation the industrial activity in India increased to a great extent. This in turn caused an increase in the depletion of environmental resources in India. With the increase in the number of construction companies, the harmful emissions released from them have affected the health of the individuals. It has also affected the vegetation cover as well as the wildlife. In India, chlorine, petro chemicals, caustic soda and other such chemical industries also sprang up in large number post the globalisation reforms. To put into perspective the harmful
environmental and social effects of the post globalisation era, a total of 26469 cases with health hazards were recorded in Delhi. While the number grew up to 53829 within 20 years. So the rapid depletion of environment as well as health hazards could have been better controlled by putting a certain limit on the number of industries allowed to enter into the Indian market or by putting a cap on their expansion and at the same time taking measures to conserve environment at the same time.
3) The economic reforms concentrated more on increasing the growth of the country, so much so that Indian economy had to face a period of jobless growth in the post 1990 period. The rigid labour laws in the organised manufacturing sector constricted its growth. The economic reforms accelerated growth but failed to generate adequate employment. The rural unemployment rate for example rose from 5.6% to 7.2% in the early 2000’s. This also degraded the human development index. In fact India’s social development levels were even worse than the eastern and the south eastern Asian countries. So providing employment to the country’s population should have been taken care of in a more efficient manner. Encouraging the people to participate in the agricultural sector and the providing them with employment in the home grown sectors and small scale industries would have helped in reducing the unemployment rate at that point of time. Agricultural sector is considered to be vulnerable to the globalisation process and thus it should have been made more solid and rigid to handle the cons of globalisation. Also, investing in social sectors should have been carried out extensively as it is a precursor to an accelerating growth.
I would like to enlist some of the lessons that I learnt from the course and the assignment :
The course covered the Micro and Macro Economics and the assignment addressed gaining knowledge and analysing any crucial fiscal issue that India has faced, from 1947 till date.
1) With respect to Microeconomics, I understood the importance of law of variable proportion in determining the production capacity for a firm, which also justifies the laws of returns to scale. The fixed factors initially enjoys mechanical freshness and thus the production increases at an increasing rate (increasing returns to scale). After some period of time, the fixed factor starts experiencing mechanical fatigue, due to which production increases at a diminishing rate (decreasing/diminishing returns to scale). And finally the fixed factor experiences exhaustion which causes a decline in the production (negative returns to scale).
2) With respect to Microeconomics, I understood the importance of AC curve in finding least cost point for the short run production of any firm. As average cost is made up of AVC and AFC. It also acquires its shape due to both of them. The AFC curve is rectangular hyperbole as it is defined by the area of rectangle (product of fixed cost and quantity) under it, while the shape of AVC is explained by laws of returns to scale because of the law of variable proportion. These two graphs help us in identifying the shape of AC curve and the LCP.
3) With respect to Microeconomics, I understood the relevance of planning curve in finding the optimum cost for any firm and how it envelopes the Multiple short runs. The short run analysis is ideal in dealing with the cost statistics for production of a firm at a given point of time. However ideally every firm aims for expansion and thus short run analysis is not useful in identifying the production costs over a period of time. Short run analysis can provide the optimal cost of production only at certain point of time but in the long run the planning curve helps in finding the least cost point (least cost of production).
4) With respect to Microeconomics, I understood how revenue is important in determining the type of market or the current market situation. In case of a perfect market the total revenue increases linearly with increase in the supply. Whereas in case of an imperfect market in order to stay in the market it is necessary to competitively price the products so that the demand increases, else the demand might shift to alternative products.
5) With respect to Macroeconomics, I understood the difference between GDP and GNP and why GDP is a real measure of country’s growth. As GDP consists of the total output of all the
sectors of the economy within the country, it purely displays year on year growth in the domestic production. However, GNP consists of Balance of Payments added to the GNP. Thus GNP consists of other factors such as income earned by resident of the country from foreign investments or the income earned by foreign investors with respect to the domestic economy.
6) With respect to Macroeconomics, I understood the importance of business cycles in affecting various aspects of the economy within the country. During the expansion of an economy, the businesses are growing which also causes an increase in the increase in their production and thus the labour cost or income for employees also increases. Thus people have more power to spend and it also increases the credit worthiness of the people. This also gives a rise to inflation. So in order to curb this the Central bank may intervene and increase the interest in order to reduce the number of borrowers and hence the credit in the economy. This might generally represent the peak of the business cycle and thereafter the economy may experience contraction in the growth.
7) With respect to Macroeconomics, I understood the concept of Open Market Operations. OMO methodology is used in order to control the amount of liquidity and credit supply in the market. If the Central bank notices that more credit is available in the market, then it sells the treasury bills to the commercial banks, as a result of which the banks face a reduction in their lending power. If the amount of credit is less then the Central bank buys treasury bills from commercial banks and thus injecting money into the economy.
8) With respect to Macroeconomics, I understood the relevance of crowding out effect. In order to aim for an expansion of the economy, the government carries out an aggressive expansionary fiscal policy to increase its spending. This leads to an increase in interest rates and thus the cost of funds also increases. This leads to lesser investment decisions as the accessibility of funds for debt financing gets affected. Thus, there is a crowding out of the effect in terms of initial investment spending.
9) With respect to the assignment, I understood the importance of world politics in affecting/deteriorating the macroeconomic situation in a particular country. In this case I am referring to the gulf war which caused India to buy oil on the basis of costly long term contracts which in turn affected our economy. Or the downfall USSR which affected our exports income.
10) With respect to the assignment, I understood the impact of oil prices on our economy. In terms of oil consumption India ranks third in the world after USA and China. In order to cater to the high demand for oil, India has been a major importer of oil from the gulf countries. Thus the price fluctuations in the crude oil market affect our country’s trade deficit to a great extent. Any major issues with respect to the OPEC countries causes massive impact on our import bill. Some of the examples are the Gulf war from the mid 1990’s or the recent sanctions being imposed on Iran by the United States.