This isnít 1991
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What the country should do to prevent a balance of payments crisis
India has been downgraded, the GDP growth has fallen sharply, the fiscal deficit and current account deficit have become bigger and inflation has risen. Despite all these difficulties, the country can prevent a balance of payment crisis if it maintains a favourable environment for foreign private capital flows and allows rupee flexibility. In the short term, exchange rate stabilisation will depend on the capital that can come into India. In the medium term, stabilisation of the economy critically relies on exchange rate depreciation.
The GDP growth has fallen sharply from 9.83 per cent in Q2 2009 to 4.25 per cent in Q4 2011 (quarter-on-quarter, seasonally adjusted). This is as bad as what happened during the crisis ó when growth crashed from 11.73 per cent in Q4 2007 to 4.89 per cent in Q1 2008. But that was externally driven, while the growth crash after early 2009 is more rooted in Indian economic policy.
The question on everyone's mind today is: are we headed for another 1991-style BOP crisis and an IMF programme? In the pre-1991 days, India had an administered rate. In addition, there was no access to private capital flows. That resulted in a crisis with no dollars left to import essentials like oil. The only way out was to go to the IMF and ask for money.
Both elements ó the exchange rate and access to private capital flows ó are now on a different footing. India now has a good deal of experience with exchange rate flexibility. The rupee has been allowed to move both ways in the post-1991 years and by now it is apparent that rupee flexibility has not resulted in any big disaster. After the global financial crisis, despite the large reserves, India has allowed rupee depreciation, and not intervened much to hang on to unviable levels of the exchange rate. Moreover, Indian exports have performed well after the rupee weakened, despite the slowdown in world trade.