Pathways Through Financial Crisis: India

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. ********** India 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) 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 large current account deficit of 3. …