What Caused the 1991 Currency Crisis in India?

Abstract

Which model best explains the 1991 currency crisis in India? Did real overvaluation contribute to the crisis? This paper seeks the answers through error correction models and by constructing the equilibrium real exchange rate using a technique developed by Gonzalo and Granger (1995). The evidence indicates that overvaluation as well as current account deficits and investor confidence played significant roles in the sharp exchange rate depreciation. The ECM model is supported by superior out-of-sample forecast performance versus a random walk model.

Keywords: India, Currency Crisis, Equilibrium exchange rate, error correction model, Gonzalo-Granger decomposition

JEL Classification: F31, F32, F47