BOP Crisis of 1991
The worst financial crisis that India faced was the balance of payment crisis in 1991. This crisis was primarily due to the fiscal imbalances during the 1980's. This blog delves into the basic idea of balance of payments, the events that led to this crisis and the consequences of the same. Further it examines the impact of the steps taken by the government to rectify it. The conclusions are made based on the empirical analysis using secondary data.
In 1991, India ran into an untenable currency crisis, which was caused due to massive amount of deficit in balance of payments. In order to combat the crisis, the government took various fiscal, monetary, finance, industrial and trade policies. This crisis posed as an opportunity to make some fundamental changes in the approach towards economic policies. Therefore, the Indian economy dropped all past policies that prevailed post-independence and the words ‘Liberalization’, ‘Privatization’ and ‘Globalization’ became household terms. Therefore, the new economic policy brought global transition in India.
Introduction to Balance of Payments
When a government spends more than it receives, it runs into a deficit. Conversely, when the government spends lesser than it receives, there is a surplus. Usually, in order to finance the deficit three steps can be taken, printing more money, borrowing from a foreign or domestic source or drawing money from foreign exchange reserves. But these measures can cause further macro-economic issues. Printing more money may lead to inflation, excessive government borrowing from a foreign source can lead to a debt crisis, and drawing large amount of money from foreign exchange reserves can result in high interest rates, which eventually leads to the situation of ‘crowding out’. If government runs into a large deficit in the long run, it will lead to a crisis.
Causes and Consequences of the 1991 BOP crisis
The planning commission was formed in 1950 and since then India was on the path of planned development. In order to achieve economic growth and development, one of the main objectives was strengthening the public sector. The quota-license-inspector-raj was introduced to set up administrative controls over industries. But due to this license raj system, India ran into a continuous trade deficit. To reduce income and inequality through income redistribution there were 11 income brackets. During the 1970s, the government increased the tax rates to higher levels. The marginal rate of taxation reached a 100%. In 1980–81, the central revenue deficit was 1.44% of the GDP, which jumped to 2.44% in 1989–90. Gross fiscal deficit increased during this period from 5.71% to 7.31%.
By 1990–91, Around 29% of the expenditure was on interest payment, 17% on subsidies and 15% on expenditure shares. The burden of subsidies and public interest increased tremendously. This phase between 1980–90 saw an enduring process of inflation induced deficit and deficit induced inflation. This deficit led to an increase in the money supply which further led to an increase in prices. This deficit was continuously increasing because, the rise in price leads to an increase in government expenditure faster than receipts. The quota-license-inspector-raj was primarily responsible for this continuous trade deficit. The foreign sector was affected by these fiscal imbalances, which led to the BOP crisis of 1991. The situation got aggravated because of the increase in price of oil due to the First gulf war.
Steps taken by the Government
The Government took some major policy initiatives to overcome this Balance of payment crisis.
1) As an immediate step, the government took condition-less loans from the IMF and banks of Switzerland and US against the gold reserve.
2) The problem of fiscal deficit is aggravated by providing excess of subsidies, therefore there was a reduction in fertilizer and other subsidies. The licensing and quota system were demolished. The Indian Economy was opened for trade and private markets.
3) There were various tax reforms, such as reduction in taxes brackets from 11 to 3 (Reduction in taxes, therefore an expansionary fiscal policy)
4) Role of Monetary reform: There was a reduction in statutory liquidity ratio (SLR) and cash reserve ratio (CRR). (Contractionary Monetary Policy)
This was done in order to increase competition among the public and private players.
5) The direct control of government over capital markets was removed and replaced with a regulatory framework that was transparent.
6) Devaluation of Rupee was another measure taken by the government in order to combat this situation of balance of payments. It leads to increase in export and thus increase in the inflow of currency. This devaluation of currency was to correct the revamped exchange rates.
If these policy measures were to be analyzed through the IS-LM framework, the expansionary fiscal policy (Due to reduction in taxes) would shift the IS to the right and the contractionary monetary policy (Reduction in CRR and SLR) would shift the LM to the left. This would lead to a small, gradual increase in the Output/GDP and a very large increase in the interest rate.
Therefore, according to our theoretical findings there will be a small increase in the Output, and a large increase in the Interest rate. Let us compare, our theoretical findings with the conclusions from actual data taken from 1991–1995.
Given below are line graphs showing the trend of GDP and Interest Rates of India taken from 1991 to 1995 (Source: World Bank Database). The GDP graph shows a small and gradual increase in GDP in the country, whereas the interest rate graph shows that initially there is a very high increase in interest rates. Therefore, our theoretical findings coincide with the data. Hence, the fiscal and monetary policies adopted by the government were useful in solving the balance of payments crisis.
Graphs for GDP and Interest Rate of India (during the period 1991–1995)
The year 1991 is a landmark in India’s history. The country faced its biggest economic crisis post- independence and used this as an opportunity to bring about a change in its economic reforms. The different policy measures taken by the government helped overcome the balance of payment crisis. In India, global transition was brought about by the economic reforms of 1991. This transition was towards a newer India.
De, S. (2012, January). Fiscal Policy in India: Trends and Trajectory. Retrieved from: https://dea.gov.in/sites/default/files/FPI_trends_Trajectory.pdf.
Kapila, U. (2011). India’s economic development since 1947. New Delhi: Academic Foundation.
Kapila, U. (2012). 1991–2011: Two decades of economic reforms. Place of publication not identified: Ipg-Academic.
Singh, N. T. (2013). Fiscal Reforms in India. IOSR Journal of Humanities and Social Science, 7(2), 52–63. doi:10.9790/0837–0725263
Mathur, R. (2002). India’s economic policy. Jaipur: RBSA.
GDP (constant 2010 US$). (n.d.). Retrieved July 05, 2020, from https://data.worldbank.org/indicator/NY.GDP.MKTP.KD?end=1995
Real interest rate (%). (n.d.). Retrieved July 05, 2020, from https://data.worldbank.org/indicator/FR.INR.RINR?end=1995