What the country should do to prevent a balance of payments crisis India has been downgraded, the GDP growth

has fallen sharply, the fiscal deficit and current account deficit have become bigger and inflation has risen. Despite all these difficulties, the country can prevent a balance of payment crisis if it maintains a favourable environment for foreign private capital flows and allows rupee flexibility. In the short term, exchange rate stabilisation will depend on the capital that can come into India. In the medium term, stabilisation of the economy critically relies on exchange rate depreciation. The GDP growth has fallen sharply from 9.83 per cent in Q2 2009 to 4.25 per cent in Q4 2011 (quarter-on-quarter, seasonally adjusted). This is as bad as what happened during the crisis when growth crashed from 11.73 per cent in Q4 2007 to 4.89 per cent in Q1 2008. But that was externally driven, while the growth crash after early 2009 is more rooted in Indian economic policy. The question on everyones mind today is: are we headed for another 1991-style BOP crisis and an IMF programme? In the pre-1991 days, India had an administered rate. In addition, there was no access to private capital flows. That resulted in a crisis with no dollars left to import essentials like oil. The only way out was to go to the IMF and ask for money. Both elements the exchange rate and access to private capital flows are now on a different footing. India now has a good deal of experience with exchange rate flexibility. The rupee has been allowed to move both ways in the post-1991 years and by now it is apparent that rupee flexibility has not resulted in any big disaster. After the global financial crisis, despite the large reserves, India has allowed rupee depreciation, and not intervened much to hang on to unviable levels of the exchange rate. Moreover, Indian exports have performed well after the rupee weakened, despite the slowdown in world trade. The second big difference with 1991 lies in Indias integration with global financial markets. In 1991, we lived in a FERA world, where cross-border transactions were criminalised. Today, India has made progress in building a deep engagement with global capital markets. In the areas of equity investment, private equity investment and borrowing by large corporations, global financial firms participate in the Indian financial system. Private capital flows into India, bringing in money required to finance the current account deficit. On this front, government policy, budget announcements, tax policies, tax treaties and capital controls have to be mindful that with the sudden, sharp increase in the current account deficit, India needs foreign private capital inflows. If the inflows are small, the rupee will depreciate. In the past five months the RBI has been intervening in the foreign exchange market and selling dollars to prevent a sharp depreciation of the rupee. If the pressure on the rupee to

depreciate was only transitory, the RBI would not have needed to intervene month after month. However, if the pressure is caused by fundamental weaknesses in the economy, a higher inflation rate, a large current account deficit, loss of confidence in the growth story and slowing down of capital inflows, then the RBI intervention can only put off the depreciation and not prevent it altogether. Cutting of interest rates will only weaken the rupee further and propping it up by intervention or by imposing capital controls can only buy some time. But is preventing depreciation an appropriate policy in a slowing economy? Currency depreciation is an automatic stabiliser, were it allowed to happen. The impact of a depreciation is to raise the price of imports, thus pushing more import substitution, and to lower the price of exports, thus pushing exports. Both elements raise domestic production. While policymakers worry about lower growth and try to push growth through cutting interest rates, if, at the same time, the RBI blocks the automatic stabliser role that the currency plays, it hurts growth. Even though the RBI has defended the rupee in recent months, if the crisis deepens, it should be obvious that there is no point in selling reserves in an attempt to defend the rupee. While macroeconomic policy-making at the RBI has many problems, it will hopefully know when it cannot stand in the way of a significant move of the rupee. It is unlikely that the RBI will exhaust its reserves trying to defend the exchange rate. Indeed, even in the global crisis most countries held on to their reserves and allowed their currencies to depreciate. Given how Indian economic policymaking is now under way, it is likely that we will encounter difficulties in coming months. We need to have clarity about our sources of stabilisation and to keep working on strengthening them. First, we need to continue the process of capital account decontrol so as to have strong channels for foreign capital to flow in. Second, we need to move away from the exchange rate policy of recent months, where the RBI has been getting into dangerous ground by selling reserves and defending the exchange rate. The very loss of reserves and the inadequate rupee depreciation that is out of line with the deterioration of fundamentals are triggering off nervousness. In conclusion, economic conditions in India are dire, but we are not going to have a BOP crisis, particularly if two important changes in policy are made (stop defending the rupee and continue to liberalise the capital account). We cannot hope that an IMF programme will reboot Indian economic policy. We will remain stuck in dreary conditions until we find the internal energy to reverse the policy mistakes that have given us a crash in growth from Q2 2009 onwards.

A Balance of payments crises is NOT a Currency crises. A Balance of payments crises can cause a Currency crises. A Balance of payments crises is where the amount of imports exceeds the amount of exports and leads to an inability for the Nation to keep up its Debt payments. This may have more than one underlying reason. A budget crises can be one, this is where the Budget is in deficit. So lets say the National Treasury is borrowing $X billions to meet its Budget and not raising this in taxes. The borrowed money needs to be paid back, this in itself will use up part of the Budget, so next year the Treasury will have to put a larger part of its Budget for Debt payments, this means less money for meeting the demands of the Tax payer (you, me and business). This can be overcome by either raising taxes (which will hit business) or lowering Government spending on its commitment to its voters (in a Democracy). If this happens at the same time that there has been a period of Imports exceeding exports this leads to great problems with the value of the currency. When a Country Imports goods it pays for them with a currency ($, or whatever or Gold), if there are a lot of Imports the Currency of the Nation importing will devalue, this allows the Exporters of that Country to export more goods more easily, thus the balance is restored. The amount of imports should always balance the exports. But you can get round this short term by just borrowing money, But this has to be paid back. This is where the ability of the Nation State to pay its debts comes into play. If the Government can't meet its debt commitments, the currency will keep declining to a point where its exports are so cheap that Country can sell (or export) its way out of the problem. However the Home situation may not allow this, if the Country makes the wrong things or doesn't have the infrastructure or is committed to too much welfare (the last being the biggest) then this can lead to a Balance of payments crises. There is a lot more and other scenarios but it is the reason Greece, and Ireland have had so many problems) Ireland would solve this by going back to the Punt, (its own currency) it has more than enough ability to work its way out of the problem, because the people are pragmatic and understand the needs involved. Greece would solve it the same way, but its population believe there is a Socialist solution (which there ain't) so it will wallow in its own juices for years to come

oP crisis of 1990-91: Overcoming the forex constraint

C Rangarajan While recalling past significant events, it is not uncommon to recall a poets words: Bliss was it in that dawn to be alive, But to be young was very heaven! Unfortunately, this is not quite the feeling, when the events of 1990 and 1991 are recalled. It was a period of stress and strain. At the same time, something significant emergeda new turn and direction to economic policy and management. It was like the birth of a child. It was born in pain. But then, there was the guiding hand of Dr Manmohan Singh with his matchless vision and courage. The new economic policy that emerged in 1991 had many dimensions. The basic philosophy was to improve productivity and efficiency of the system by imparting a greater element of competition. I shall only recall here some developments in relation to the external sector, for, after all, the crisis was triggered by the acute deterioration in the balance of payments. The already worsening situation in the balance of payments with current account deficit averaging 2.2 per cent of GDP (gross domestic product) between 198590 was hit hard by the Iraqi-Kuwait war in August 1990. With the oil bill increasing by $2 billion, overseas markets for exports shrinking and remittances falling, the situation could be met only by drawing down the reserves heavily. 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, making external commercial borrowing and particularly the roll over of short-term credit more difficult. It was at this stage that negotiations were started with IMF for a drawal of $1,025 billion under its Compensatory and Contingency Financing Facility (CCFF) and $789 million under the First Credit tranche of a stand-by arrangement. The drawals were made in January 1991. The IMF understood Indias need. India was a member in good standing. On the previous occasion of recourse to IMF in 1981, we did not draw in full the facility that was granted. CCFF had been amended from the earlier Compensatory Financing facility (CCF) to take care of countries hit by oil price rises. The IMF position on stabilisation programme, however, was clear. It wanted compression of aggregate demand which also suited Indias needs at that time. Despite the drawals from IMF, 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. In fact, some part of the reserves held by the RBI could not be freely used because of contingent claims. During this period, monetary policy had to bear an extraordinary burden. July 1st 1991: The Reserve Bank of India (RBI) devalues the rupee in a two-stage operation codenamed Hop-Skip-and-Jump, to restore external confidence in India and enable the government to seek balance of payments (BoP) support from the International Monetary Fund and the World Bank. The hop was to test waters, both political and economic. Soon hell broke loose. Prime Minister Narasimha Rao came under attack. He called finance minister Manmohan Singh and asked him to call off the jump. Dr Singh, however, was convinced it was a now or never jump. Much better to leave the rupee undervalued than over-valued than over-valued, he thought, and asked the man on the spot to go ahead. July 3rd, 1991: At 9.00 a.m the man on the spot, RBI deputy governor C Rangarajan, announced the jump and called Dr Singh to report: We have done it. A neat exercise executed by two professional economists of the highest integrity and competence, the devaluation of the rupee set the stage for a turnaround strategy for the crisis-ridden Indian economy. For almost a year prior to D-day, Dr Rangarajan was part of the core team, along with chief economic advisor Deepak Nayyar and finance ministry joint secretary handling the Fund-Bank portfolio, Y Venugopal Reddy, which managed the travails of the external sector. The Iraqi occupation of Kuwait and the crisis in the Gulf pushed oil prices up, drained Indias reserves and brought it to the brink of external debt default. The minority Chandrashekhar government, under the leadership of finance minister Yashwant Sinha, tried hard to stave off the crisis by continually negotiating with IMF and the Bank and with bilateral donors. Domestic politics deepened the crisis. A new government took charge in June 1991 and launched far-reaching structural reforms in the economy, with devaluation being the first shot. Dr Rangarajan played a critical role in managing the BoP crisis of 1990-91 and authored the Report of the High Level Committee on Balance of Payments, report that in many ways anticipated the problems faced by the East and Southeast Asian economies in 1997 and set the policy framework for Indias BoP management in the early 1990s, ideas that gained global credibility after the Asian financial crisis hit world markets. Responding to an invitation from The Financial Express to recollect the events and the challenges faced at the time, C Rangarajan, at present Governor, Andhra Pradesh and former Governor, Reserve Bank of India, writes an exclusive essay for our readers on BoP management in 1990-93.

Even as steps were being taken to negotiate with the various international and regional institutions to raise resources, a question that kept coming up was why India could not utilise in some way its gold resources to raise funds. This became a sensitive issue. At the same time, we had to carry conviction with various international institutions that we were quite serious in meeting the situation. Extensive discussions were held with various institutions including BIS (Bank of International Settlement). As a first step, in May 1991, the government leased 20 tonnes of confiscated gold to the State Bank of India which in turn sold it to an international bank with a repurchase option to raise $200 million. Later, RBI moved in four installments 46.9 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. The Reserve Bank of India Act permits the holding of gold outside India up to a certain limit and borrowing from a central bank. Apart from the psychological and other factors associated with sending gold, the very physical act of sending gold of this quantity was not without its drama. Some part of the gold had to be refined to bring it up to international standards. There were several moments of great anxiety. Besides using normal commercial flights, a special plane had to be chartered to send gold. Extraordinary precaution at various points had to be taken while transporting gold from the vault to the airport and all those connected with sending of the gold heaved a sigh of relief when the gold reached London. Subsequently, the loans were repaid during September to November, 1991 and the pledged gold was redeemed. At the end of June 1991, the situation was grim. The foreign currency assets of RBI stood at $1.12 billion. This was hardly equivalent to three weeks of imports. The greatest anxiety was to avoid default of payments to foreign creditors. Any such default would have eroded the countrys credibility. We had to shore up our reserves and we had to ensure a much needed correction to our balance of payments. It was against this background that a 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. In one sense, the announcements on July 1 and 3, were different from earlier announcements on devaluation such as that in 1966. As we had moved to a system of determining the exchange rate in relation to a basket of currencies, with the RBI announcing daily the exchange rate, the downward adjustment in the exchange rate of the rupee had to be effected through changes announced by the RBI. Devaluation at no time was free from controversy. But given the grim situation that the country faced on the external front, a downward adjustment of the exchange rate had become inevitable. Only two questions of extent and modality remained to be answered. The extent of devaluation was determined primarily by the degree of correction that was required in the balance of payments. This was partly a subjective evaluation. We had also to take into account the depreciation already effected by competitor countries. The second question was whether, instead of making a discrete change, we should make small changes in the exchange rate, as we had been doing from 1985 onwards. A sharp discrete change was decided upon to quell expectations. The two-stage discrete adjustment in the exchange rate also intrigued many observers. This was done partly to test the waters and gauge the reaction to the first change before making the next. After the first announcement, to avoid destabilising expectations, the desired change was completed in the second installment. The devaluation of the rupee was accompanied by significant changes in the external trade regime. Perhaps this is what makes the devaluation of 1991, different from others. A process of establishing a more liberalised trade regime was set in motion. A realistic exchange rate provided the basis for a credible reform process. Upper credit tranches under the CCFF and the stand-by arrangement were negotiated with IMF. This required abiding by certain performance indicators. Besides exceptional financing arrangements with the World Bank, Asian Development Bank and a few industrial countries were also negotiated. The India Development Bonds scheme and the Immunity Scheme for repatriation of funds held abroad were introduced. The Immunity Scheme did raise some eyebrows. The net effect of these actions was an increase in the foreign currency assets of the RBI by $3.4 billion by March, 1993. A High Level Committee on Balance of Payments was set up in December 1991 to examine and evolve a medium-term strategy for a sustainable balance of payments. The emphasis was on the capital account. It was composed of members who were already associated with decision- making in various ministries. In fact, many of the decisions taken by the Committee were being implemented simultaneously. This was particularly true of the recommendations relating to the exchange rate. The Interim Report of the Committee had recommended the dual exchange rate system and the Final Report,

the unified market exchange rate system. But these proposals were also being independently processed. The Committee had wide-ranging recommendations on the size of current account deficit, level of foreign exchange reserves and structure of external debt, including short-term debt as well as non-resident Indian deposits. These recommendations provided an anchor to the decision-makers. These recommendations appear particularly significant in the context of the problems several East Asian countries had to face later. Several of these problems had been anticipated by the Committee. Immediately after the devaluation of the rupee, the exim scrip scheme was introduced which provided a link between exports and imports. A natural corollary to this was the introduction of a more generalised dual exchange rate regime in March 1992. Under the new scheme, 40 per cent of the foreign exchange earnings were to be surrendered at the official rate determined by the RBI. The rate on the balance receipts was to be determined by the market. This proportion was determined taking into account the foreign exchange requirements of what were deemed to be essential imports. There was some interesting discussion on what the name of the new system should be. Finally, it was decided to call it Liberalised Exchange Rate Management System (LERMS). The LERMS was an extremely useful period of learning for the market and authorities alike; it allowed players to respond on a limited scale to price signals. The difference between unofficial market rate and official market rate narrowed considerably. In about a years time, the country moved from the dual exchange rate regime to a unified market-based exchange rate regime. Before introducing the unified system, one alternative was considered. That was to change the proportions and reduce the transactions at official rate. However, it was recognised that a dual exchange rate imposed a tax on exports and remittances. The experience of LERMS, which showed that the spread between the official and the market-determined rates never exceeded 17 per cent, emboldened the authorities to move towards unified exchange rate. Several feared at that time that the rupee would depreciate sharply. This was not so. From August 1993 the rupee remained steady in relation to the dollar at Rs 31.37. International confidence in India strengthened considerably and this was reflected in surges in capital flows into India. This prolonged stability of the rupee in nominal terms from August 1993 to August 1995 created another set of problems which had to be tackled in late 1995 and early 1996. Nevertheless, the new regime gained acceptance and strength and has come to stay. This is a fundamental shift in the exchange rate determination. 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. The performance of the external sector since 1991 to this day has been a source of satisfaction. The current account deficit as a percentage of GDP has remained below 1.5 per cent. Because of the improvement in the current account as well as the opening up of the capital account, the reserves remain at a comfortable level. The present level of foreign currency assets at over $40 billion is a far cry from $1 billion in June 1991. While the open economy is always subject to more shocks, it can be safely said that foreign exchange availability is no longer a binding constraint on economic growth.