[The year] 1990-91 was perhaps one of the worst years that the Indian economy had to face. The deteriorating BOP situation got worse because of certain global developments. The possibility of default in our external payments loomed large. Even though policymakers strived hard to avoid such a situation, a contingency plan was still prepared. Eventually, that calamity was avoided. In fact, the end of the crisis saw a new beginning. The break with the past saw a new dawn.

As mentioned already, the current account deficit of 1989-90 was 2.3 per cent of GDP. The major global shock came with the invasion of Kuwait by Iraq in August 1990. It lasted seven months. Compounding this were the recessionary conditions and slowdown in world trade. On top of these came the break-up of the Soviet Union with which India had a special trade arrangement. The share of Eastern Europe in India’s exports was as high as 22 per cent at that time.

The first impact of the Gulf War was on India’s petroleum, oil and lubricants (POL) import bill. Crude oil prices doubled initially from $15 per barrel to $30 per barrel. Thereafter, towards the end of the year, it declined to $19 per barrel. The POL import bill during 1990-91 was $6 billion as against $3.8 billion for 1989-90.

This amounted to a 58 per cent increase. This was the direct impact and there were many other additional costs. India’s exports to West Asia were severely affected. Remittances from Iraq and Kuwait came down. Added to this was the cost incurred in foreign exchange for the repatriation of the people affected. The total estimated impact amounted to $2.987 billion. The current account deficit as a proportion of GDP rose to 3 per cent of GDP in 1990-91, the highest seen so far.

The capital account of the BOP also came under stress. India faced enormous problems to finance this high level of current account deficit. NRI deposits, which were an important source of support, turned negative by September 1990. There were withdrawals instead of receipts. The net inflow for the year as a whole in 1990–91 was $1.5 billion as against an inflow of $2.4 billion in 1989-90. There was certainly a loss of confidence. The same sentiment was seen with respect to commercial borrowings. This loss of confidence was reflected first in the cost of borrowing and later in the availability itself. Short-term credit by way of banker’s acceptance facility, which financed oil purchases, was available at 0.25 per cent over London Interbank Offered Rate (LIBOR) until November 1990.

Thereafter the premium went up to 0.65 per cent points over LIBOR in March 1991. It rose further to 1.25 per cent points by May 1991. The credit via this route not only became very expensive but there also were occasions when the maturing amounts could not be rolled over.

Borrowing in general became expensive because of the downgrading of India’s credit rating by international rating agencies in March 1991. India’s rating slipped to the bottom of the investment grade. The only way to manage this situation was to draw down the reserves, which had itself dwindled. The reserve drawdown during the year was $1 billion. This was possible only because of the initial accretion to reserves coming from the use of IMF facilities.

The deteriorating fiscal and BOP situation was known to the government and RBI and there were frequent exchanges of notes and consultations. The BOP situation could not be tackled without the government containing its fiscal deficits. The combined fiscal deficit of the Central and state governments, which was around 8 per cent of GDP during the first half of the 1980s, increased to 10 per cent during the second half and touched 12 per cent in 1990-91.

The Central government was aware of this. Attempts were made to raise revenue. At the time of the Gulf crisis, for example, a ‘Gulf evacuation’ surcharge on airfares was imposed. Petroleum prices were raised and a surcharge on corporate income was levied. But the expenditures, especially defence expenditures, were rising. In substance, growth was bought at a high cost. The rising fiscal deficit could not be met through normal channels of borrowing. RBI had to step in to fill the gap. Thus, the extent of monetization rose. This had the effect of pushing up prices.

In the ’70s, the Central government had a revenue surplus but the picture changed in the 1980s with the emergence of large revenue deficits. We had dealt with this in an earlier chapter. Suffice to say, the steep rise in the fiscal deficit was a major contributor to the crisis. There was a continuing exchange of ideas between RBI and the government on the various dimensions of the economy. History refers to the detailed letters sent by RBI on 24 May 1989, 19 February 1990 and 13 August 1990. The August 1990 note was explicit in the need to approach international financial institutions to tide over the crisis. The letter as quoted in the History says:

 ‘The advantage of such extraordinary financing would be that adjustment will take place in a more orderly fashion and will be less disruptive of the growth process. Also, arrangements with the aforesaid multilateral institution/institutions will give the right signals to the financial markets and enhance the willingness of the banking community to lend more money to India. However, recourse to the IMF has political overtones and will involve strong conditionality. Such conditionality will, however, involve more or less similar measures that will have to be taken even if there is no recourse to the IMF. One important difference, however, could be that under a Fund programme tightening imports may be more difficult than would be the case otherwise. Adjustment without extraordinary financing will have to be much stronger implying substantial reduction in the current account deficit in a shorter span of time. Either way, the policy with regard to the exchange range of the rupee may not be different from what is being pursued at present.’  

The letter also talked about revaluing the gold assets held by RBI to international prices. It also reiterated that it might be advisable to keep 15 per cent of the gold reserves outside India as permitted under Section 33 (5) of the Reserve Bank of India Act.

The Act was subsequently amended to revalue gold at the market price. Equally important was the suggestion to keep 15 per cent gold reserves abroad. The suggestion implied earning an income in good times and using it as a pledge in bad times. Had this suggestion been acted upon, much of the travail we went through later could have been avoided.

Excerpted with permission from Forks In The Road: My Days At RBI And Be: My Days at RBI and Beyond’, C Rangarajan, Penguin.