Liberalised Exchange Rate Management System — The story of India's Gulf crisis A.Seshan As always, victory finds a hundred fathers, but defeat is an orphan. — Count Galeazzo Ciano, The Forex Crisis JULY 12, 1991, was a red-letter day in the history of the Indian economy but not in any happy sense. It marked the nadir in the external sector. The balance-of-payments bottomline was reached. The foreign currency assets of the Reserve Bank of India (RBI) amounted to $975 million. And the limited reserves were not fully in the central bank's custody. An amount of $600 million was kept with the State Bank of India, New York, for reasons given later. Effectively the foreign currency assets available with the RBI were adequate to meet the cost of a week's imports against the desirable norm of three months. From that abysmal position we have reached a level of about $130 billion in foreign currency assets today and suffer from an embarrassment of riches. In recent years, a number of articles have appeared in newspapers and journals on the story of economic reforms in India. Many writers have identified the members of the `A team' which ushered in the reforms leading to the benign situation now. There are others who were silent witnesses to all that was happening, although not a part of the `A Team'. They also have a story to tell. How default was averted In the first place, it was only indirectly because of Saddam Hussein that India woke up to realities. For, the crisis was long in coming. Saddam Hussein's aggression on Kuwait and the events that followed them aggravated India's problems, making it imperative to find solutions. There was also the instability at the Centre and the Chandrasekhar formed a government with the support of the Congress. It was clear that in its absence the other avenues for raising resources would be closed. The IMF sent its `A team' to India to discuss its conditionalities for lending. It was engaged in a game of `life-and-death'. . The gold was subsequently redeemed through repayments between September and November 1991. The whole operation of physically transporting the stocks to London was carried out in secret under the close supervision of a Deputy Governor. The SBI arranged for short-term Acceptance Credit in the inter-bank market in New York. given the junk status accorded to Indian bonds by the rating agencies. It was fully aware of the likely political fallout and the criticism that the country's jewels were being pawned. The reforms India applied for IMF assistance. as a contingency reserve for making import payments. Under such circumstances the central bank came up in July 1991 with the bold proposal of pledging its gold stocks to Bank of England and Bank of France and raise a short-term loan of $405 million. the elements of which are well known as the Washington Consensus. The major item of import finance related to oil. which was just rolled over from day to day. who was in constant touch with the officer going in the truck to the airport. Borrowing from the market was out of the question. But what is not known to the public is the fact that in the process of refining the gold to meet international standards before its pledge there was a value addition which was most welcome at a critical time.The political instability was a blessing in disguise. Indian Oil Corporation was the canalizing agency and it needed money. and such mundane matters as the forex crisis were left to the central bank. It was then that RBI decided to keep $600 million with SBI in New York. A point was reached when there was a good possibility of the country defaulting on one of its repayment instalments. P. The RBI Governor formed an internal group with the members being O. There were inquisitive colleagues who were anxious to know what was going on and would have liked to get into the act. LERMS There was an urgency to overhaul the administered exchange rate system. The Governor indicated the terms of reference orally. Exchange Control Department. Controller. The markets were then taken by surprise. Kulkarni. and subsequently incorporated in the report of the High Level Committee on Balance of Payments. It was euphemistically called a "downward adjustment" of the value of the rupee and the first instalment was stated to be to "test the waters". some official economists claimed that it was all the Government's own policy but blessed by the IMF/World Bank. Depreciation of rupee The RBI's first major announcement was the depreciation of the rupee. Sodhani. as there had been no inkling of such a large depreciation of the currency. B. There was a hectic period of the announcement of reforms by the newly-formed Government of P. The Index of Real Effective Exchange Rates was used in policy formulation. and this writer. However. often without any documents but only hand-written notes. . P. Of course. which was approved by the Governor. encompassing practically all aspects of economic policy. 1991. Narasimha Rao. as Convener. Chief Officer. who was Adviser (International Finance).The economic reforms were thus introduced because of the IMF conditionalities and not because of any sudden change of economic philosophy by the Government. We successfully kept our meetings and discussions confidential. in two instalments — on July 1 and 3. The value of the rupee declined by 18-19 per cent against major currencies to improve the competitiveness of Indian exports. it is no longer the deciding criterion for the central bank. We met on a few occasions and recommended the Liberalized Exchange Rate Management System (LERMS). Department of External Investments and Operations. V. given its limitations. in view of the facility to convert dollars into rupees at market rate to the extent of 60 per cent.2 per cent and 15. The RBI announced the official rate.LERMS introduced. there was a marked improvement in NRI remittances through the banking channel. yen and pound sterling at noon every day. particularly from the Gulf. a dual exchange rate system in the place of a single official rate. It was also the result of the Government permitting gold imports up to 5 kg by NRIs and other returning Indians. The spread. they were close to the FEDAI rates. from March 1992. contrary to the fears in some quarters that the rupee may undergo a steep depreciation. The Foreign Exchange Dealers Association of India (FEDAI) intimated the market rate. mark. by and large. It treated current and capital transactions in different ways. In the first place. When the scheme was introduced. The ADs were free to quote their own rates but. It consisted of one official rate for select government and private transactions and the market-determined rate for the others. called the Indicative Rate. and March 13. 1992. to the Authorized Dealers (ADs) for dollar. measured as the difference between the official rate and the market rate as a percentage of the former. More than 90 tonnes were brought into the country before the end of December 1992. The working of LERMS was smooth from the beginning. having lost all moorings in life! However. forex dealers felt like prisoners of half a century being suddenly released one morning and not knowing what to do. when the FEDAI announced the Indicative Rate for the first time. they adjusted to the new situation quickly. There were requirements of surrender of foreign exchange by the public to banks with some exceptions. once in six months.8 per cent for ten days between March 3. The stability of the spread was ensured by several factors. ranged between 10. Some experts expected a market rate of Rs 50 per dollar. . It was part of the RBI's package of measures for the external sector. In the next Budget a unified floating rate based on market forces was introduced which continues till today. Frankfurt. before the reduction in import duty. The export community considered the 40:60 rule as a tax on their profession. about $1 billion remained to be explained. inter alia. It was essentially the result of reforms in the exchange rate system leading. receipts under India Development Bond Scheme and Remittances in Foreign Exchange (Immunities) Scheme 1991. After accounting for assistance received from bilateral and multilateral agencies. 1992. 1991 till March 31.8 billion the previous year implying a turnaround of $7.8 billion against the net sales of $5. to faster repatriation of export receipts and routing of remittances through banking channels. With a rising supply in the domestic market the margin for the smuggler came down drastically from Rs 1. But it was envisaged as a transitory measure and to help avoid a sudden increase in government expenditure. They reached a level of $5. . to Rs 676 per 10 grams on December 24. New York. 1992 purchases by the RBI from the ADs amounted to $1. The Apex Bank was felt that as long as gold imports were not permitted the hawala market in foreign exchange would prevail. The depreciation of the rupee against the dollar vis-à-vis the official rate ranged between 25 and 30 per cent in February 1992 (before LERMS was introduced) in Hong Kong. who preferred the banking channel for routing remittances to their families. fiscal deficit and inflation rate. It made the hawala transaction no longer attractive to the NRIs. The RBI's foreign currency assets maintained a rising trend. rising from $975 million on July 12. 1992.The decision to permit gold imports was linked to LERMS. LERMS had its detractors too.414 per 10 grams on April 17. 1992 marking a fall of 52 per cent.6 billion. It was well known that the demand for dollars in the unofficial market was linked to the financing of gold smuggled into the country. Dubai and other places where the currency was traded unofficially. The trend in the decline in the profit continued and it was no longer attractive for the smuggler to engage in illegal activity. 1991.6 billion on March 31. From April 1. At the end of 1992 the rate came down to Rs 32 to a dollar — a depreciation of 4 per cent over the market rate and 10 per cent over the weighted average rate of official and market rates. and two volumes (1935-51 and 1951-67) have been published. It looks like the next volume may take time. RBI.What has been written in this article just skims the surface of the whole crisis. the bank disbanded the History Cell. After the preparation of the third volume covering 1967 to 1982.) . It is in this context that an ad hoc publication on the Gulf Crisis would be timely. which awaits publication. (The author is a former officer-in-charge of the Department of Economic Analysis and Policy. The central bank has been undertaking a history project.