# **Annex 1: Background**

## **India’s 1991 BoP Crisis**

In 1991, India experienced a balance-of-payments (BoP) crisis which pushed it to the verge of default on its external debt.<sup>64</sup> The crisis followed an acceleration in growth to 6 percent in the second half of the 1980s; but fiscal deficits bordering on 10 percent of GDP during this period fed into growing current account deficits. Fiscal deficits were financed in the main by a combination of financial repression and external borrowing, with relatively limited monetization to keep inflation low. As a result of the “twin deficits”, public and external debt grew while reserves fell. External debt almost doubled from $35 billion at the end of 1984/85 to $69 billion at the end of 1990/91, with commercial borrowing and remittances of NRIs becoming increasingly important as the size of current account deficits exceeded available financing on concessional terms. This in turn meant rising dependence on more costly, shorter maturity financing and made India vulnerable to shocks, which came in the form of an oil price hike as a result of the 1990 Gulf War and a related disruption in worker remittances. By September 1990, net inflows from non-resident Indian (NRI) deposits had become negative and access to commercial borrowing was growing costly and difficult. Export growth also weakened with slow growth in trading partners, the US in particular. By the end of January 1991, reserves had fallen to less than a billion dollars and debt service payments were maintained only by an administrative squeeze on imports and emergency financing from the IMF, including a drawdown of $1.8 billion under the Compensatory Financing Facility and First Credit Tranche arrangement. Unstable coalition politics between the end of the Rajiv Gandhi Congress government in late 1989 and the installation of the Narasimha Rao Congress government in June 1991 made matters worse. India suffered a ratings downgrade in early 1991.

The response to the crisis included a large devaluation, an increase in interest rates and a program to implement a large cut in the center’s fiscal deficit. Equally important was an intensification of the process of industrial delicensing and gradual trade liberalization (replacing quantitative restrictions with tariffs) which had begun in the second half of the 1980s. There was a push to drastically accelerate these reforms, with the focus then turning to tax reform, further trade liberalization (including tariff reductions) and financial sector reforms.

From the perspective of the this paper, the following points from the 1991 crisis are of interest: (i) The higher growth achieved in the second half of the 1980s was not destined to last. As RBI (2003a) notes, “...[it] was excessively leveraged through large fiscal deficits and build-up of external debt. In this sense, the growth before the reform was unsustainable.”<sup>65</sup> (ii) The crisis was caused by a combination of deteriorating public finance fundamentals and low international liquidity. Fiscal deficits spilled over into the balance of payments and depleted reserves, making India vulnerable to external shocks which came in the form of the 1990 Gulf War. The crisis thus stemmed from a combination of weak fundamentals and a confidence shock that shut off market borrowing access. Cerra and Saxena (2002) also argue that the rupee was overvalued in an equilibrium sense at the time of the crisis, the persistent depreciation of the real exchange rate over the second half of the 1980s notwithstanding. (iii) The crisis led to fiscal and structural reforms, which had tangibly positive results over the Eighth Plan period. (iv) India crucially managed to avoid a “credit event”, i.e., a default and/or debt restructuring, which would have tarnished its record. While WPI inflation rose to 14 percent in 1991/92, it was quickly brought

> 64 The discussion here draws from Acharya (2001), Cerra and Saxena (2002), Chopra et al. (1995) and Virmani (2001). 65 RBI (2003a) page I-1.

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