Globalization

In mid-1991, India’s exchange rate was subjected to a severe adjustment. This event began with a slide in the value of the rupee leading up to mid-1991. The authorities at the Reserve Bank of India slowed the decline in value by expending international reserves. With reserves nearly depleted, however, the exchange rate was devalued sharply on July 1 and July 3 against major foreign currencies.

India’s 1991 crisis provides an interesting case study with certain features that are distinct from popular theoretical models. Although some elements were present, the crisis cannot adequately be described as a first generation currency crisis model. It also didn’t follow the second generation models, nor the more recent literature that emphasizes financial sector weakness, overlending cycles, and contagion. In addition, despite progress in liberalizing trade and capital flows, India is still relatively closed and capital inflows have been well below those in other Asian economies. Therefore, India’s 1991 crisis contrasts with the 1997 crisis that hit the very open Asian countries.

First generation models of currency crisis (Krugman, 1979; Flood and Garber, 1984) illustrate the collapse of an exchange rate peg under monetization of government deficits. The collapse can occur quickly, well before reserves have been depleted. The sudden collapse comes about due to the perfect mobility of capital, which moves to maintain uncovered interest parity. In a perfect foresight version of a first generation model, instantaneous capital flows ensure that there are no jumps in the exchange rate that would represent a profit opportunity for speculators. When the shadow value of the exchange rate crosses the fixed rate, there is a sudden loss of reserves and increase in interest rates, and the currency begins to depreciate. In models with uncertainty, interest rates rise before the attack, reflecting the higher probability of devaluation, and the exchange rate can jump.

India’s 1991...