Economy

Evolution of India’s Exchange Rate System

Exchange rate refers to the price of a nation’s currency in terms of another nation’s currency. In other words, the domestic currency is expressed in terms of the foreign currency. For example, on 1st July 2018, 1 Dollar was equal to Rs.68.55. This means that a person can buy goods worth Rs. 68.55 using 1 U.S. Dollar (USD) or vice versa.

Exchange rate is an important factor that determines the country’s economic condition. It allows the country to trade with other countries. When the value of the foreign currency increases, imports become expensive and exports become cheaper. Similarly, when the price of the foreign currency reduces, the imports become cheaper and exports become expensive. Therefore, a higher exchange rate can lower the country’s balance of trade and a lower exchange rate can improve it. There are mainly two types of exchange rate systems- Flexible Exchange rate system and Fixed Exchange rate system. In a flexible exchange rate system, the currency’s value is allowed to fluctuate according to the foreign exchange market. There is no intervention by the government or the central bank. It is also known as a floating exchange rate system. But, in a fixed exchange rate system, the value of the currency is fixed against the value of another currency or to gold. This system is also known as a pegged exchange rate system. Currently, India maintains a floating exchange rate system, which is a hybrid of the fixed and floating exchange rate systems.

As we know, exchange rate is important for the growth of the country. This article will attempt to analyse exchange rates in the context of different regimes that India saw after independence. The period from 1947 to the present times has been divided into three main parts.

1947-71

During this time period, India followed a fixed exchange rate system under the Bretton Woods System. This system was formed in 1944, when representatives from 44 countries met to establish an efficient and effective world monetary system. Under this system, the gold exchange standard was introduced. The United States was to maintain the price of gold fixed at 35 dollars per ounce and was supposed to exchange dollars for gold at that price without restrictions or limitations. Other nations were required to fix the price of their currencies directly in terms of dollars and indirectly in terms of gold. The exchange rate could fluctuate within plus or minus 1 percent around the agreed par value.

India was also a part of this system. Therefore, after independence in 1947, India followed the par value system of exchange rate. Therefore, the Indian Rupee’s external par value was fixed in terms of gold with Pound Sterling as the intervention currency. This kind of exchange rate is a relative fixed exchange rate and not a rigid fixed exchange rate.

Under the five-year plan system, from 1950 onwards, the Indian government continuously borrowed money from foreign and private sector savings. The rate of borrowing and loans borne by the government increased to a very high magnitude in 1960. Also, the Indian government was facing a budget deficit and was not in a state to borrow more. This resulted in the devaluation of rupee. This condition was further worsened due to the Indo- China war in 1962, the Indo-Pakistan war in 1965 and the major drought faced by India in 1965-66, which resulted in severe rise in prices and a situation of inflation. Thus, it became mandatory to devalue INR in 1966. The devaluation of Rupee in 1966 in terms of gold, resulted in the reduction of the par value of Rupee. But from 1966 to 1971, the exchange rate of Rupee remained unchanged. This par value system of exchange rate was followed till 1971 till the breakdown of the Bretton Woods system, post which most of the currencies adopted floating systems.

1971-92

With the breaking down of the Bretton Woods system, India moved towards the pegged exchange rate system. The Indian Rupee was linked to U.K. Pound Sterling. This pegging of currency to another country’s currency results in a fixed exchange rate system. It maintains stability among the trading partners. However, although a currency peg can minimize fluctuation, at the same time it increases the imbalances between the countries. Therefore, in 1975, Rupee was pegged to a basket of currencies. This was done to ensure the stability of Rupee and avoid weaknesses associated with a single currency peg.

During 1990 and 1991, India faced a major Balance of Payment (BoP) crisis. The Soviet Union was an important trade partner of India in 1960s. As the Soviet Union started to crack in the 1980s, India’s exports went down significantly. Also, due to the Gulf crisis in 1990, the prices of crude oil (an important import to India) rose significantly. These are the two of many reasons that led India to the BoP crisis in 1991. As our exports to Soviet Union declined rapidly and the prices of imports (crude oil) rose sharply, India faced BoP deficit i.e. exports were much less than imports. This led the country to near bankruptcy. Therefore, India was forced to borrow money from the International Monetary Fund (IMF) against the country’s gold reserves.

The crisis of 1991 did not develop overnight. It is believed that the roots of this crisis in India developed during 1979-81. During that period, India suffered a severe drought as well as the tremors of the global oil shock caused by the Islamic revolution in Iran.

As a result of the BoP crisis, foreign exchange reserves had fallen to low levels that weren’t enough to pay for even a month of imports. The policymakers discussed various ways to deal with the crisis that eventually led to liberalization of the economy. Another way to deal with the situation was devaluation of the rupee.
Devaluation implies to a decrease in exchange rate. This leads to an increase in exports and hence the inflow of foreign currency increases. Therefore, on July 1 1991, as a part of its daily adjustments to the currency, RBI decreased the exchange rate by 9%. Two days later, i.e. on 3rd July 1991, it was pegged down by another 11%. In an article in the Indian Express on 10 November 2015, C. Rangarajan, the then deputy governor of RBI, explained that this move of was planned and well documented and the project was code-named ‘hop, skip, and jump’. With this, the pegged exchange rate system ended and India moved towards a market determined exchange rate system.

1992 – 2018

There was a two-step devaluation of Rupee in 1991 by the RBI which ended the pegged exchange rate system and marked the beginning of the market determined exchange rate system. The Liberalized Exchange Rate Management System (LERMS) was introduced to ease the transition from one system to another. LERMS began from March 1, 1992. Under this system, Rupee was made partially convertible. This partial convertibility of Rupee is known as the dual exchange system. Since India was going through a period of deficit, it was risky to impose full convertibility of the Rupee. LERMS was set up to boost the foreign exchange earnings to improve the BoP. The RBI made foreign exchange available at a low price and hence it was used for essential imports like crude oil. All other imports were financed at the market-based exchange rate.

Since LERMS was only a transitional mechanism, it was removed in 1993 and the market exchange rate system was introduced. That means that the 60:40 ratio was removed and 100% of the foreign exchange receipt was now converted at the market based exchange rate. Also, in 1994, the current account was made fully convertible. Thus when Rupee became a floating currency, the current account of India was made fully convertible, but the capital account was only partially convertible. This was done to protect the domestic market from foreign competition. Since, most of the developed countries have fully convertible capital
accounts, India is also planning to move towards it. There is an ongoing discussion on the pros and cons of moving towards full capital account convertibility to ensure that India benefits from this move.

Picture Courtesy- Hubstaff blog



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