India’s socialist-style planning regime’s emphasis on government investment in heavy industry led to a current account deficit of 2.3 percent of GDP during the Second Five-Year Plan (1956–61). By the 1980s, the country’s creditworthiness was ruined by protectionism, industrial control, and excessive government expenditure. Additionally, two oil shocks, in 1972/73 and 1979/80, made long-term concessional financial flows, India’s primary form of external financing, scant. The situation worsened during a third oil shock: in the wake of the 1991 Gulf War. The current account deficit rose to 3.1 percent of GDP, the fiscal deficit increased, and monetary financing of the fiscal deficit led to double-digit inflation. A low credit rating restricted the nation’s access to commercial borrowings and short-term credit. During 1990/91, foreign currency assets dwindled from $3.1 billion to just $975 million. The government had to act fast to deal with this crisis: It took a series of measures to fulfill all its debt obligations, using gold reserves as collateral to borrow from the International Monetary Fund.

In 1992, C. Rangarajan was appointed governor of the Reserve Bank of India, where he had been deputy governor since 1982. He had worked closely with the International Monetary Fund on its loan agreements with India and spearheaded banking reforms. A committee he then chaired played a pivotal role in shaping India’s external-sector reforms in the aftermath of the Gulf crisis. In its report, the committee proposed the following measures: (i) establish a market-based exchange rate for the rupee, (ii) set a ceiling for the current account deficit at 1.6 percent of GDP, (iii) promote non-debt-creating capital flows, and (iv) regulate external commercial borrowings, especially short-term debt. It advocated gradually liberalizing capital outflows and reducing the government’s involvement in external assistance.

A key recommendation was adoption of a market-determined exchange rate, accompanied by relaxation of restrictions on current account transactions. In 1992 these suggestions were taken up through the implementation of the Liberalized Exchange Rate Management System. It introduced a dual exchange rate regime, which eventually transitioned to a single, market-determined exchange rate regime in 1993. Under this system, exporters could sell 60 percent of their forex earnings to authorized dealers at the market exchange rate and had to sell 40 percent to the Reserve Bank of India at predetermined rates. The unification of the exchange rate facilitated current account convertibility, which was officially achieved in August 1994, when the government accepted Article VIII of the International Monetary Fund’s Articles of Agreement, which committed India to ensuring the free convertibility of its currency for current account transactions.

The report tackled India’s balance-of-payments crisis by recommending a market-determined exchange rate, limits on the current account deficit, promotion of non-debt capital inflows, and tighter regulation of external borrowings. These reforms aimed to stabilize the external sector, improve foreign exchange management, and transition toward current account convertibility.

[Report PDF coming soon.]