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Indian Rupee Crisis of 2013

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  • 8/10/2019 Indian Rupee Crisis of 2013




    The June 2013 announcement of Quantitative Easing (QE) tapering by the Federal Reserve Bank of

    USA triggered huge capital outflows from emerging markets resulting in turmoil in financial marketsaround the world. Soon India joined the set of fragile economies such as South Africa, Russia, Brazil,Indonesia, Argentina and Turkey facing capital outflows and depreciating currencies.

    On Aug.28, 2013 the Indian Rupee (INR) depreciated to its all-time low of Rs.68.845 per USD. INRhad depreciated by 20% from the beginning of the year and by 13.7% during June Aug.2013 1. Withthis kind of depreciation of INR, market analysts and international investors were left wondering ifIndia growth story was dead. The current crisis was reminiscent of the Balance of Payment crisisthat India had faced in early 1990s. Has India come full circle to the crisis of 1990s after successfuleconomic liberalization programme since the crisis? What went wrong? Where is the INR headed?Has the market over reacted? These are the questions for which market observers, investors and

    policy makers were looking for answers.


    India was a relatively closed economy until 1990-91 when India faced severe Balance of Payment(BoP) crisis. Following this crisis India embarked on a reform programme which liberalized hereconomy both internally and externally. This resulted in increased growth during the post-reform

    period from an average annual growth rate of 5.51% in 1980s to 5.87% during 1992-2003 (see Exhibit1). During 2003-8, India witnessed spectacular growth of around to 9%. India growth story becamea buzz word among investors and Indian policy makers alike. As subprime crisis hit the westernworld, India was not spared either with GDP growth faltering 6.7% during 2008-9 (see Exhibit 2).There was a quick recovery as GDP growth rose to 8.6% and 9.3% during 2009-10 and 2010-11respectively. However growth recovery proved short lived. Inflation surged along with growthrecovery prompting RBI to implement contractionary monetary policy. Towards the end of 2011things had turned gloomy once again for India. Situation turned for the worse in 2012- 2013. Theannouncement of QE tapering accentuated the problem threatening a full blown BoP crisis.

    Post-Independence India

    In the years following her independence in 1947, India followed a policy of inward-looking self-reliant approach to economic growth. Major policy mechanism aiding this approach was Five YearPlans which began with the establishment of Planning Commission in 1950. Indias approach toeconomic development was guided by Indias first Prime Minister Jawaharlal Nehru, who continuedtill 1964. Nehru was Fabian socialist who was impressed by the rise of Russia as an economic powerthrough central planning approach after the Bolshevik Revolution of 1917. Indias economic policieswere characterized by strong role for the public sector. Many of the industries were exclusivelyreserved for the public sector. While India made progress in science and technology, the economicgrowth rate continued to be low with average GDP growth rate of 3.5% from 1950-1980. Economic

    policies prior to 1991 is summarized below.

    Industrial Policy

    Large industries were required to obtain license from the central govt. for expansion, setting up newunits or even for product diversification. Monopolies and Restrictive Trade Practices Act (MRTP)

    1 Ali Syed Ashraf, Sliding Indian rupee: Causes and consequences, Financial Express, Sept 8, 2013.http://www.thefinancialexpress-bd.com/old/index.php?ref=MjBfMDlfMDhfMTNfMV85Ml8xODI1OTc%3D , accessed onMar 16, 2014.

  • 8/10/2019 Indian Rupee Crisis of 2013


    regulated industries with asset bases of more than INR10 million. The objective was to preventconcentration of economic power in the hands of few industrialists. Basic and heavy industries werereserved for investment by Public Sector Enterprises (PSEs). These included Steel, Oil, Minerals,Power, and Telecommunications etc. Foreign Direct Investment (FDI) was restricted to 40% ofequity. There were restrictions on Indian companies entering into collaboration with overseascompanies for technology transfer.

    Trade Policy

    Imports were generally under license except for the ones under Open General License. Peak rate ofcustoms duty was at 300% in 1991. Such restrictions were necessary as INR was kept overvalued tokeep the cost of imported capital goods cheaper. Objective of self-reliance meant that local industrieshad to be protected through tariffs and quotas.

    Financial Sector

    With two rounds of nationalization of banks in 1969 and 1980, the banking sector was controlled by public sector banks. Interest rates were regulated by the central bank. In addition to Cash ReservesRatio to be kept with RBI, commercial banks were required to have 38% of their assets in the form of

    govt. securities under the Statutory Liquidity Ratio (SLR) requirement in 1991. SLR helped fundlarge budget deficits at low interest rates. Restrictions on asset portfolio meant that private sectorwould get loans at high interest rates and the spread between the deposit interest rate and loan interestrates were very high. Indian equity and debt market were not open to foreign investors.

    Fiscal Policy

    Fiscal policy prior to crisis was expansionary with average fiscal deficit during 1985/86 to 1989/90 at10.1% of GDP and primary deficit at 7.5%. Corresponding ratios for 1980/81 to 1984/85 were at 8%and 6.8% respectively 2. Excessive public spending caused high inflation by the end of 1980s .

    1990-91 Economic Crisis

    Annual inflation as measured by CPI during 1990-91 was 13.6% compared to 6.6% in 1989-90 3. Risein oil prices due to Gulf war, falling exports and loss of remittances arising out of Gulf crisis resultedin worsening of BoP situation. India was facing twin deficits of fiscal deficit and BoP current accountdeficit. Foreign exchange reserves stood at approximately USD 4 billion at end of March 1990 4. Indiahad to take loan from IMF from including loan of USD 1786 million in Jan 1991 form Compensatoryand Contingent Financing Facility (CCFF).

    Indias Economic Reform

    Economic reform programme began with devaluation of Rupee to in July 1991 to correct BoP currentaccount deficit. India pledged to cut the fiscal deficit from 8.4% (1990-91) to 6.5% in 1991-92. Thiswas coupled with restrictive monetary policy. These were expenditure reducing and expenditureswitching policies aimed at cutting the BoP current account deficit.

    Simultaneously structural reforms were implemented with a view to liberalize the economy andintegrate the economy with rest of the world. Structural reforms involved de-licensing of industries,removal of reservation of industries for public sector, and disinvestment of Public Sector Enterprises,

    2 Vijay Joshi and I.M.D.Little, India, Macroeconomics and Political Economy 1964-1991, The World Bank, WashingtonD.C., 1994, pg.181.3 Ministry of Finance, Govt. of India, Economic Survey 2012-13.4 Ibid

  • 8/10/2019 Indian Rupee Crisis of 2013


    reduction in barriers to foreign investment, reduction in trade barriers, financial sector deregulationincluding licenses for private sector banks, interest rate deregulation, and reduction in reserve ratios.Structural reforms continued as India adopted a gradualist approach to reforms rather than big bangapproach. For instance, even by 2013 India allowed only 51% foreign ownership in multi-brandretailing that too subject to approval of state governments for such FDI.

    Indias Exchange Rate Reforms

    From the 1970s to March 1, 1992, India was under a fixed exchange rate regime. The exchange ratewas decided by the central bank, RBI. The rate was adjusted in relation to a basket of currencies.Following the BoP crisis, in July 1991 INR was devalued by about 22% vis--vis USD. This wasfollowed in March 1992 with partial floatation of INR and a dual exchange rate system came intoexistence. On March 1, 1993, the dual exchange rate was abolished in favour of one unified marketdetermined exchange rate. Since then all foreign exchange transactions take place at exchange ratesdetermined by the forces of demand and supply. However, RBI intervenes periodically to regulate themarket. Thus, the current system is a managed float. Behaviour of Rupee since the exchange ratereforms is in Exhibit 6.

    Liberalization of Capital Flows

    India debated to move to capital account convertibility in mid 1990s after making it fully convertibleon current account in 1994. However, series of crisis in emerging markets in 1990s made India putthis idea on back burner. India liberalized capital flows gradually over time and made INR partiallyconvertible on capital account. FDI is permitted under automatic route subject to the caps in differentsectors, in some cases 100% FDI is permitted, in other cases this may range from prohibition of FDIinvestment to 24%, 49% or 74% cap on FDI investment (see Exhibit 12). India opened up for

    portfolio investment but only qualified foreign institutional investors (FIIs) are allowed to invest inIndian equity market subject to caps on the extent of equity holding of such investors (see Exhibit 13).Similarly there are restrictions on participation of FIIs in the govt. bond market and corporate bondmarket, overseas borrowings by Indian corporates and banks. These measures have been introducedgradually and the limit expanded over time. Thus India has followed gradualist approach to capitalaccount liberalization. The IMF also backed Indias capital control measure saying that strong capital

    flows pose a key challenge to Indias growth prospects.

    "Directors observed that low yi

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