A bit long story but can be informative if interested in India’s economic history. The worst financial crisis, India faced was the Balance of Payment crisis in 1991. Here I have tried to compile the basic idea of balance of payment and how it leads to crisis. Second part of the read will include the details about India’s fiscal situation that led to this economic failure and the steps thus taken by the Government to rectify it. India stepped into an economic revolution, which brought about significant changes in the economy. The following write up is sort of my takeaways from various journals and books that I referred (Bibliography mentioned at the end).
The economic reform of 1991 brought the global transition in India. The transition towards a newer India, and a change in perspective of government towards the role of private players and markets in the economy. The Balance of Payment crisis followed by pledging of Gold reserves, taking loan from IMF and other structural adjustment programme (sponsored by IMF and World Bank) were the initial steps towards the economic reforms that were launched. The BOP crisis was the result of decades of imprudent economic policies that India followed. The institutional arrangements of the economy, pre 1991, were adequate then but were eventually deteriorating the fiscal situation of the country. The role of fiscal policy in India’s history is significant. In 1991, India ran into an unsustainable deficit in balance of payments. The country ran into large deficits for long time and as a result faced the balance of payment crisis.
Though this crisis was a turning point but also an opportunity to make some fundamental changes in approaching the economic policies of the country.
To combat the crisis, the government took various fiscal, monetary, trade, finance and industrial measures. Since mid-1991, the Indian economy took a departure from the past policies prevailed post-independence. Liberalisation, Privatisation and Globalisation are the words that strike the most listening to the reforms that took place post crisis. India’s economy paved itself into a new regime through new economic policy (NEP). It is necessary to know about the economic compulsion that lead to such crisis which lead to these reforms.
What is BOP and how does it lead to crisis?
Government runs into deficit when it spends more than it receives. Alternatively, it runs into surplus when receives more than it spends. To meet the additional expenditure, when in deficit, it can resort to 3 options. Printing money, drawing money from foreign exchange reserves, or borrow from domestic or foreign source. But it is not that easy as it appears. It influences other economic variables while resorting to these measures. Excessive printing of money can lead to inflation. It can lead to debt crisis if the government borrows a lot from foreign source. Excessive borrowing from domestic sources can result in higher interest rates and further the situation of “crowding out”.
If the government draws down on its foreign exchange reserves, that’s when a balance of payments crisis may arise. In all the cases, if a government runs into a large deficit on a long run (which is not prudent for a government), it will lead to the crisis. India faced the worst BOP crisis in 1991 since 1947.
What fiscal situation India had, that caused the crisis is the next bit we will focus upon.
Fiscal Situation before Crisis:
In 1950, planning commission was formed and since then India commenced on the path of planned development. The major portion of planning process was inclined towards strengthening of public sector as a means to achieve economic growth and development. Administrative controls were set up over industries by the introduction of quota-license-inspector raj.
Since 1950, India ran into continuous trade deficit because of license raj system. The private savings were a mode of catering the public sector investment and consumption. The redistribution of income and wealth through tax and transfers was another goal during the time to reduce inequalities and poverty. There were 11 income tax brackets. The Government raised the income tax rates to high levels during the 1970s. The marginal rate of taxation along with the wealth tax reached up to 100% during 70s. In 1974–75 the personal income tax rate was brought down to 77 percent but the wealth tax rate was increased. The central revenue deficit reached to 2.44% of GDP by 1989–90 from 1.4% of GDP in 1980–81. The centre’s gross fiscal deficit increased from 5.71% to 7.31% of GDP. Even after the fall in external liabilities, the overall liabilities were huge.
Around 34% of the expenditure was on defence during 1970–71, interest payment had 19% share while the subsidies were at 3%. Furthermore, by 1990–91, the interest payment had the largest share of 29%, subsidies having 17% and defence had 15% of the expenditure share. The burden of public debt and the subsidy burden was quite great at that time.
The phase of 1980–90 saw the self-perpetuating process of deficit induced inflation and inflation induced deficit. The deficit leads to increase in money supply, which eventually raises the price levels. The rise in price increases the government expenditure faster than the receipts, hence increasing the deficit. Since 1950, India ran into continuous trade deficit because of quota license inspector raj. The fiscal imbalances affected the foreign sector resulting in the BOP crisis of 1991.
This was the worst BOP crisis, India faced since independence. During 1980s, inflow of foreign borrowings increased at burgeoning rates. There was an excessive domestic expenditure on incomes, due to which the fiscal deficit of centre and state reached to 11% in 1991. Total public debt as a ratio of GNP got doubled and foreign currency reserves faced a rapid depletion. In 1990–91, India faced a double digit inflation.
The situation aggravated by the rise in price of oil due to Iraq’s invasion of Kuwait (First Gulf war). First time in Indian history, India’s credit ratings were graded down. Due to which it was denied to access the external commercial credit markets.
Immediate and Subsequent steps taken by Government:
As an immediate action taken against the crisis included taking condition-less loan from IMF and borrowing money from banks of US and Switzerland against the Gold reserves. There is something good that emerged out of this crisis, the overdue economic reforms. Government took some major policy initiatives to address the balance of payment problem. The fiscal deficit during 1990–91 was around 8.4 percent of GDP. The fiscal imbalances were marginally corrected by the budget 1991–92, which envisaged 2% reduction in the fiscal deficit.
Subsidies on fertilizers were reduced along with the abolition of sugar subsidy. Providing excess of subsidies aggravates the fiscal deficit which was brought to balance by reducing these subsidies. The system of quota and licensing was dismantled. The economy was opened for private markets, foreign investment and trade. The road to economic liberalisation was paved by the government to balance the deficit.
Various tax reforms were introduced to make tax structure more stable and transparent. Some of them includes the reduction of tax brackets to 3 with rates of 20%, 30% and 40. The role of monetary reform in balancing the deficit was also significant. The reduction in statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) and guidelines for opening new private sector banks were part of some monetary policies. The rationale behind these reforms was to bring in competition among public sector, private sector and foreign banks.
The government decided to remove direct control of government over capital markets and replacing it with a regulatory framework with transparency. Major industrial and trade policy were reformed. MRTP was repealed and private sector participation was permitted in industrial sector by narrowing down the areas reserved for public sectors.
One of the measures undertaken by the government to improve the balance of payments situation was the devaluation of rupee. Devaluation of currency leads to increase in export and hence increase in inflow of foreign currency. Initially, the rupee was devalued by about 20%. There was a need to bridge the gap between the real and nominal exchange rates, which was emerged due to high inflation. The overhauled exchange rate was corrected by this devaluation.
Year 1991 is marked as a landmark in India’s history. The country faced its biggest economic crisis and used it as an opportunity to bring about significant changes in its economic policies. India saw a rapid transformation in its economy and a different perspective of India knows as New India came into existence since then.
Fiscal Policy in India: Trends and Trajectory. Finance Ministry. [Online] http://www.finmin.nic.in/WorkingPaper/FPI_trends_Trajectory.pdf.
Kapila, Uma. India’s Economic Development since 1947.
Kapila, Uma. Two Decades of Economic Reforms 1991–2011.
Mathur, Reeta. 2002. India’s Economic Policy. 2002.
R.K.Pattnaik, Deepa S.Raj and Jai Chander. EMPIRICAL FISCAL RESEARCH IN INDIA: A SURVEY. RBI. [Online] https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=1990.
Singh, Dr Neha Tomar. 2013. Fiscal Reforms in India. s.l. : IOSR Journal Of Humanities And Social Science (IOSR-JHSS), 2013.
Verma, Sanjiv. The Indian Economy.