[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

REIMAGINING INDIA
Table 2: Cost Of Banks’ Rescue (Rs.Billion)
in terms of a foreign currency
and commits to
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 2001-2002
trade in unlimited
Capital Infusion 57.0 52.9 8.5 15.1 27.0 4.0 18.0
amounts at that rate.
Cumulative Infusion 97.0* 149.9 158.4 173.5 200.5 204.5 222.5 Normally the exchange
*: Includes Rs.40 billion injected prior to 1993
rate is allowed to vary
billion to $5.7 billion which was quite
high compared to 5 percent increase
in non-oil imports. Exports were also
adversely affected due to the impact
of the Gulf war on India’s trading
partners. For example, growth of India’s
single largest trading partner,
the US, fell from 3.9 percent in 1989
to -1 percent in 1991. This led to a
sharp deterioration in the trade account.
The Gulf crisis also resulted
in a decline in non resident workers’
remittances to India.
Apart from these external factors,
political uncertainty in India in 1990
and 1991 led to a fall in investor confidence
further widening current account
imbalances and causing a loss in reserves.
India’s credit rating was downgraded
by credit rating agencies leading
to difficulties in commercial bank financing.
The outflows from the economy
were quick and as the forex reserves
declined, the economy was on the brink
of default by January 1991. One of the
major policy shifts in response to the
financial crisis was a change in exchange
rate management. The next section
briefly outlines exchange rate policy
changes from 1970 to the present.
3.2. Exchange Rate Regime
In India
With the collapse of the Bretton Woods
arrangement in 1973 most developed
economies switched from a fixed exchange
rate to a flexible exchange rate
regime. Under a fixed exchange rate
regime the central bank announces the
buying and selling rates of its currency
within a narrow band.
One major drawback of a fixed exchange
rate regime in economies with
perfect capital mobility is that monetary
stabilization policy becomes ineffective
(Obstfeld, 1995). For example if a government
attempts to increase money
supply by open market purchase of domestic
bonds, households will find
themselves holding more money than
they desire. Since interest rate parity
condition holds, household will sell
their excess money holdings to the central
bank for foreign currency at the
fixed exchange rate and invest abroad
to buy the desired amount of bonds.
Such a mechanism will keep interest
rates unchanged and leave the government
with more bonds on the cost of
forex reserves. One option for government
will then be to refuse to buy the
excess money supply and allow the currency
Table 3: Comparison Of Central Government Holdings By Major
Indian Banks After Public Issue
to depreciate.
In spite of its drawbacks a fixed exchange
rate regime is preferred in some
Bank Name Date of Public Issue Government Percentage
holding after public
developing economies especially those
with limited capital mobility. This is
issue (%) as of 2001
due to the following perceptions: a) A
State Bank of India December 1993 66.34
fixed exchange rate regime removes exchange
rate uncertainty thereby retain-
Sate Bank of Bikaner November 1997 75.00
State Bank of Baroda December 1996 66.88
ing investor confidence and macroeconomic
stability; b) The export import
State Bank of Travancore
January 1998 76.00
industry can be protected from huge
Bank of India February 1997 77.00
swings in exchange rates by keeping it
Corporation Bank October 1997 66.33
stable and c) If the currency is pegged
Oriental Bank October 1994 66.48
to a low inflation currency it helps keep
Dena Bank December 1996 71.00
domestic inflation low. For example, a
120 THE IIPM THINK TANK