Asian financial crisis and lessons for India

August 31, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

Several economists have gone to great lengths to say that India in 2013 is not facing a repeat of the 1991 balance-of-payments crisis or the Asian financial crisis in 1997. Clearly, the crisis India faces now is unique – as most economic crises usually are.

That does not mean there is nothing to be learnt from past crises. We believe there are several similarities between the Asian one and India’s situation today.

There are many reasons and theories attributed to the cause of the Asian crisis. Some of the common factors in the affected countries, in varying degrees, were – high current account deficits, semi-fixed exchange rates, extremely high dependence on foreign capital inflows & borrowings, inefficient asset creation, crony capitalism and undercapitalized banks.

When panic struck, the central banks in the region tried desperately to defend their currencies from depreciating in the face of capital flight. The defence was ultimately unsuccessful and the currencies depreciated between 50 and 80 percent in a few months, busting many large corporates and banks that had direct or indirect foreign exchange liabilities.

While India’s situation is not as severe as the one facing the Asian tigers in the summer of 1997, the parallels are unmistakable:

– India has been running persistently high current account deficits for many years, reaching a high of 5 percent in recent times.

– It has been increasingly relying on external capital flows – debt and equity – to finance this deficit.

– Its reliance on short-term debt and fickle equity flows has been rising for several years.

Its crony capitalists have invested significant sums in infrastructure assets and capacities that run the risk of turning bad due to policy paralysis and poor decisions.

– Its banking system is undercapitalized and riddled with bad debts.

– Many corporates carry fair amounts of unhedged foreign exchange liabilities.

– With capital flight arising from the U.S. Fed’s taper, its central banks are also making the mistake of entering into a battle with the market in defending the fundamentally weak currency.

If there was one lesson to be learned from the Asian crisis, it was that relying on short-term capital flows to bridge an unsustainable current account gap is a sure path to disaster.

Short-term fixes and interventions in the exchange market are expensive and ultimately futile. The only sustainable remedy for a stable currency is a growing economy and low inflation, which automatically keeps the trade and current account balance in check.

For this, the government needs to urgently undertake structural reforms to increase productivity and make the domestic economy much more competitive than it is now.

Reduce subsidies, drastically reduce red tape, overhaul labour laws, aggressively privatize and significantly reduce the role of government in business. While these measures may appear to be long term in nature, the very act of moving ahead with them will restore confidence in economic agents and also have a stabilizing effect on the rupee.

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