The Balance of Payments Crisis

A crisis can make or break anyone. Even a nation. Today, on Republic day, we discuss the events that led to the crisis of 1991 and opened India's economy to the rest of the world. ReadOn.

Jan 25, 2021

1991.

A monumental year in the history of India.

It was a year of both gloom and bloom: A year which brought upon India one of the biggest crises since independence. But along with the crisis, came the most radical reforms. Reforms, which changed our country (and economy) forever.

But, how did we find ourselves in the middle of a dire crisis? Did it hit us out of the blue? Or was it a crisis in making, waiting to explode?

ReadOn.

Stepping Stones

India got her freedom from the British Raj in 1947. But the road to real independence was not going to be an easy one.

As former Prime Minister Manmohan Singh puts it: “The brightest jewel in the British Crown was the poorest country in the world in terms of per capita income at the beginning of the 20th century.”

Indians were now tasked to build the nation of their dreams: to transform a poor and drained economy into a flourishing one. And so, with Pt. Jawaharlal Nehru at the helm of affairs, began India’s Tryst with Destiny.

But, the past had cast a shadow on India’s economic policy. The Nehruvian economy wanted to preserve the democracy of India at all costs and reduce dependence on other nations. To make young India self-reliant in the long run, the government gave increased thrust to industrialization with a focus on heavy industries and capital goods (yep, #atmanirbharbharat is not a new thing; it’s an old project, packaged in a new way).

The country went into a cocoon with plans to ‘import only what was required’ and no concrete plans related to export.

Now, to direct the focus on heavy goods industries in entirety, the License Raj System was adopted. The government not only decided which company would produce what but also the price and quantity of production. The strong economic policies turned out to be successful (kinda), as the economy grew at 4.09% between 1952 and 1965.

So far, so good.

Until... the problems started mounting.

The Build-Up

The perils of License Raj have been many (which deserves a piece of its own). For now, let’s focus on the gradual build-up to the climax of 1991.

The focus on heavy goods industries had a spill-over effect. India could not sustain the demand for regular goods. And in turn, it had to increase imports. This led to a situation where the country’s expenses surpassed its revenue (our jargon loving economist friends call it fiscal deficit).

Now, there were three ways to resolve this issue:

Print more money,
Borrow from others (external sources), or
Draw money from foreign exchange reserves.

But resorting to those options isn’t as easy as it seems. They have far-reaching consequences. While piling up of borrowings can lead to a debt crisis, printing money can lead to inflation (more money chasing lesser goods - read this to understand how inflation works).

India’s focus on industrialization weakened its agricultural economy as well. Even with good monsoons in 1964, we required a food aid equal to 1/10th of our Domestic Production.

The very fear that guided us towards industrialization was now staring at us in the form of starvation. India was hit by twin droughts: first in 1965, then in 1966. We did not have sufficient foreign exchange to buy food from the world market. We relied heavily on food aids from the US.

But, as they say, there are no free ‘lunches’ (literally in this case).

India was at war with Pakistan in the same year. The war could lead to an intervention by China, which the US did not want. So, it began to exert subtle pressure on India by reducing its food and military aid (the multiple wars that India got into, also increased military spending).

In return for grains supplied by the US, India was compelled to ‘ceasefire’ (there were other reasons too, but this definitely was one of the contributing factors) and liberalize its policy in the agricultural sector as agreed under the Treaty of Rome. The treaty laid the foundation to India’s Green Revolution. But it also meant - more expenses.

Adding fuel to the fire, many domestic and international events took place which skyrocketed India’s expenditure in the next few years.

The Final Push

In the late 1970s, civil unrest and political turmoil stirred the country. An emergency was imposed by Indira Gandhi’s government. Tired by the autocratic rule of Indira Gandhi, Janta Dal was formed in 1974 and it became the first party to defeat Congress in 1977. Now Janta Dal took some populist measures in the agricultural sector. Agricultural taxes were reduced and fertilizer subsidies were increased by ten folds (from Rs 60 crores to Rs 600 crores).

By the year 1976, import policies were relaxed, allowing the import of some important items subjected to lesser licensing requirements. The non-oil imports in India grew at a steady pace of around 12% throughout the 1980s due to these import liberalization measures. However, the demand for Indian goods in the world market was still to make a mark. The exports of the country could not keep up with the level of imports.

Events not involving India also impacted our economy because of our dependence on other nations (ironical, isn’t it?).

Rupee trade (payment for trade was made in rupees) with the Soviet Bloc was an important element of India’s total trade up to the 1980s. The breakup of the Soviet Union led to the termination of several rupee agreements and the decline of our exports to Eastern Europe from 22.1% in 1981 to 10.9% in 1991-92.

One of the major international events of all times involved the invasion of Kuwait by Iran. The event resulted in the rise of oil prices from US$ 15/barrel to US$ 35/barrel by the end of 1991. Iraq and Kuwait were the major sources of India’s oil imports and the crisis led to an increase of 60% in India’s import bill.

Doomsday

All the above events gradually snowballed into a critical economic situation.

The average rate of inflation in India in 1990-91 was around 10%, whereas the GDP growth rate declined to 5.5%. India’s fiscal deficit grew from 5.71% to 8.4% of GDP in 1990-91.

India’s external debt rose from Rs 194 crore in 1980 to over Rs 1,200 crore by December 1990. Interest payment formed ~30% of India’s total expenditure in the same period. India’s foreign exchange reserves were valued at USD 1.2 Billion in January 1991 and depleted exhaustively by June. The amount left in the reserves was barely enough to cover roughly three weeks of essential imports. India was only a few weeks away from defaulting on its external balance of payment obligation.

And this is what people call the Balance of Payment Crisis of 1991.

India had exhausted all its options.

Printing currency. Check.

Borrowing from external sources. Check.

Even the foreign exchange reserve was fast depleting.

Under such circumstances, India made an emergency borrowing. It took a loan of US$ 2.2Bn by pledging 67 tonnes of Gold as collateral to the International Monetary Fund (IMF).

But the IMF bailout came at a cost. The cost of losing our economic freedom. The cost of opening ourselves to the world. The cost of exposure. The cost of adopting ‘Liberalization, Privatization and Globalization’.

On 24 July 1991, the then Finance Minister, Dr. Manmohan Singh presented the budget that changed India forever.

He ended his speech with the historic lines: “But as Victor Hugo once said, ‘no power on earth can stop an idea whose time has come.’ I suggest… that the emergence of India as a major economic power in the world happens to be one such idea. Let the whole world hear it loud and clear. India is now wide awake. We shall prevail. We shall overcome.”

We shall overcome. Won’t we?