The third chapter

The 1991 and 1997 foreign exchange crises were turning points for India’s reforms. Is history repeating?

/By Mohan Sule

The plunging rupee finally forced the Union government to shake off its policy paralysis. However, the prescription has the potential to do more harm than cure the disease. It took one (Singapore) to four (Thailand) years for the East Asian economies to recover from the depreciation of their currencies, triggered by Thailand’s move to float the bath in July 1997. The Asian Tigers were running large current-account deficits. Some of them had foreign debt in excess of 100% of GDP. Compounding the problem was the recovery in the US. The resultant increase in interest rates by the US Federal Reserve proved to be a magnet for foreign funds. As a counter-attack, most ramped up interest rates to stem the flight of capital. The IMF had to step in with US$ 40-billion infusion to stabilise the region, particularly Indonesia, South Korea and Thailand, in exchange for austerity measures. The collateral damage was the end of the 21-year-old reign of President Suharto of Indonesia as the depreciation of the currency resulted in sharp increase in prices. In India, which was undergoing political uncertainty as minority coalition governments had twice lost the vote of confidence between 1996-08, the rupee dropped 12%. The nuclear test carried out by the two-month-old BJP-led government in May 1998 resulted in international sanctions, end of assistance from the World Bank and Asian Development Bank, and downgrading by credit rating agencies, leading to withdrawal of foreign funds. The Reserve Bank of India had to increase its lending rate by 2% points to 11% and the cash reserve ratio by 50 basis points to 10.5% .The State Bank of India had to issue US$ 4.2-billion sovereign Resurgent India Bonds to stabilize the rupee.

Even then the Indian currency depreciated 16.7% in the 10 months to June 1998. Yet, the impact was not severe. External debt as a proportion of GDP (25%) in 1996–1997 was meager compared with that of Indonesia (61.3%) or Thailand (62%). GDP growth dipped to 4.8% in 1997–1998 but rose again to a healthy 6.5% next year. By the end of 1999, foreign exchange reserves were adequate to cover six months of imports. Even the current account deficit fell to just 1% of GDP. Is history repeating? And will India bounce back again? Take the ingredients. India is grappling with foreign debt as high as 20% of GDP. Foreign funds are exiting on the Fed’s hints of an end to the easy-money policy. There are two options to support the currency. The first is to bring down the fiscal barriers to foreign fund inflows and raise import tariffs to conserve foreign exchange. Telecom has been opened to 100% FDI and insurance to 49%, though the cap in the aviation and defence sectors has been left untouched. The downside is that there is a lag effect before big-ticket investments start coming in. There could be a gap between intention and execution. Despite opening multi-brand retail to 51% FDI, global supermarkets are still waiting and watching as this is a state subject. Also, opening up the economy is meaningless if investors face constant insecurity about pricing, sourcing of raw materials, and tax issues. Foreign investors will have to weigh the cost effectiveness of buying into an Indian company or going it alone. Worryingly the government is toying with more import penalties apart from making overseas gold costly. This could push demand underground and fuel inflation.

The second route is using monetary tools including ramping up interest rates to attract capital. The RBI has indirectly hiked interest rates by 200 basis points and tightened credit outflow. This action had an immediate impact. The rupee appreciated above the 60 level but bond prices plunged, adversely impacting the income of banks and retail investors. Companies will have to borrow at higher rates, too. Besides pressure on the margin, non-performing loans could rise as recovery gets postponed. The equity market might not get the inflows looking for higher yields. Yet there could be a silver lining. The crisis has been a warning that populism is not a substitute for pragmatism. The huge domestic market is no doubt an attraction, but foreign capital cannot be taken for granted. Investors would stay invested as long as returns are appealing. For that to happen the economy has to grow at a steady clip. To facilitate expansion, regulations have to be so tailored that there is transparency, quick and just grievance redressed mechanism, and absence of shocks such as stalling or reversing of policies to meet short-term objectives. Just like the 1991 forex crisis, which sowed the first wave of reforms, and the 1997 currency crisis, 2013 could well be a turning point in the process of unshackling India.