Exchange rate stability is an important indicator of a country’s economic strength. Consistent fall or fluctuation in exchange rate adversely affects the balance of payments of the country. India in the past has mostly been a closed economy, following protectionist policies of development. Foreign exchange management and control has been an important tool of lending protection to the domestic economy, checking capital flight, maintaining a comfortable reserve of valuable foreign exchange for developmen needs and import of essential goods and encouraging exports. To attain these objectives India followed a ‘fixed exchange rate’ system till the economic crisis of 1991. It is interesting to study the history of India’s exchange rate as the country waded through the world’s economic scene from being an underdeveloped closed economy beset with poverty and corruption to an rapidly ‘emerging economy’, strong and intelligent enough to sail through world recession with minor bruises!
Exchange Rate Management in India
India was under fixed exchange rate regime till March 1992. The exchange rate of the Rupee was determined and adjusted by the Central Bank (Reserve Bank of India). The Rupee was adjusted to a basket of currencies, comprising of currencies of important trade partners of India like US, Britain, Japa etc. The exchange rate was determined by the government and enforced by pegging operations (intervention in the currency market) and exchange controls by the central bank. Normally the rate was continuously adjusted by small margins to adjust with changing inflation rates, international economic changes and trade requirements. Such a system caused lots of difficulties and complications for international traders.
Two exchange rates prevailed at one point of time – an official exchange rate and a market exchange rate.
The difference between the two often meant losses for the traders. The total control on the rates and movement of foreign exchange by the central bank also discouraged foreign investors and travelers, as all foreign currency had to be surrendered to the RBI which in turn gave back the amount at the fixed exchange rate, which may be higher or lower than the spot market exchange rate. Through the system of fixed/pegged exchange rate and exchange controls, the governments objective was to attain exchange rate stability to encourage traders and discourage speculators. This system of total control, though implemented for the benefit of the domestic economy, it gave birth to lots of corruption and havala trade. It discouraged international traders and investors who often turned to the illegal havala market, causing a drain on the country’s exchange earning through illegal channels.
Liberalized Exchange Rate Management (Post 1991)
In March 1992, following the policies of liberalization and structural adjustment program, the Rupee was made partially convertible on the current account. Under the dual exchange rate system, 40% of the export earnings were to be surrendered at the official exchange and for the rest of the 60%, the exporter received at market exchange rate, which was always higher than the official rate. In 1993, this dual exchange rate system was removed and a single market determined exchange rate prevailed.
The central bank can intervene from time to time to prevent unnecessary volatility of the Rupee. When there was a surge in foreign capital inflow during 1992-93, the RBI had to buy the excess foreign exchange in the market, to prevent appreciation of the Rupee, which would have adversely affected exports. When the Rupee began depreciating sharply at the end of 1995, the RBI intervened by selling the foreign exchange in the market to check further fall of the Rupee.
Major devaluations of Indian Rupee (Causes and effect)
Indian Rupee has faced six major and several minor devaluations since independence, leading to more than a ten fold depreciation in the value of rupee.
When India became independent, a little over Rs. 4 could buy one US dollar, which has today gone down to around Rs. 46 per US dollar.
The first devaluation was made immediately after World War II, consequent to the devaluation of the Sterling in 1948. The second devaluation was done in 1966, when the Dollar-Rupee rate went down from Rs. 4.76 to Rs. 7.5 per US dollar. Third major devaluation was in July 1991, when Rupee was devalued thrice within a span of three days, a panic stricken effort to correct the Balance of Payment crisis. The Rupee was then devalued by about 22%. In 1994-95, the Rupee again tumbled from Rs.31 to Rs. 35 per Dollar. After keeping stable for some time it again slided to Rs.39 in Dec. 1997. By June 1998, it depreciated to more than Rs. 42 per US dollar.
The Rupee was depreciated from time to time to maintain export competitiveness in the world market. But this objective could not be achieved to any great success because India’s major exports in the past were mainly primary products which are price inelastic. Due to supply constraints too exports could not meet whatever little demand increased through depreciation. Post 1991, when the Indian economy was opened up and foreign exchange regulations were significantly relaxed, the exchange rate fluctuated according to market demand and supply caused by international trade and capital flows to and from India and other speculative forces.
The Rupee-dollar exchange rates remained stable at Rs. 31.50 per dollar for about 3 years till September 1995, because of comfortable reserve position and large inflow of portfolio capital. The RBI too artificially maintained the value of rupee, because inflation was high at that time, a strong export thrust was missing and there was the problem of servicing the country’s huge foreign debt. Also in 1995, the State Bank of India, which had to repay a heavy foreign debt in November 1995, started drawing dollars heavily from the market. This pushed the already existing shortage of dollars in the market to worrisome level and led to the sharp depreciation of the Rupee. Also, while Rupee rate was artificially maintained against US dollar, Rupee had declined with respect to other major currencies, particularly the Japanese Yen and the German Deutsche Mark, warranting an adjustment in the Dollar value.
At the same time domestic inflation was eating away the Rupee.
There is the danger of competitive exchange rate depreciation and retaliation by other countries, if many countries are suffering Balance of Payments deficit at the same time. This happened in 1997 when South East Asian countries’ (Thailand, Indonesia, South Korea, Pakistan, and Japan) currencies went into a downward spiral. India’s exports were loosing their competitiveness due to the sharp devaluation of these competing countries, leading to another devaluation, from Rs. 35 to Rs.39 in1998.
Then there are other factors like political changes/upheavals in the country which affect exchange rate through speculation. The Rupee also depreciated against US dollar due to the American sanctions after the nuclear tests, till it reached Rs.42 in June 1998.
With every fall in the rupee, India’s external liabilities relating to debt repayment, repayment of NRI deposits, all go up. A sharp devaluation bankrupts those corporates which have large external debt. It also spread panicky among FIIs, causing outflow of capital.
India went ahead with full convertibility of Rupee on the current account, but rightly adopted a very cautious, phased out approach towards Capital account convertibility. The country was in no way economically strong enough for Capital account convertibility. The volatile Foreign Institutional Investments (FII) would have easily wreaked havoc in the country in the face of any national or international crisis. This cautious approach and RBI intervention has helped India largely, in maintaining a grip on its exchange rate during trying times like the SE Asian crisis and Mexico like situation in 1995. Mexico had artificially maintained an appreciated Peso to check domestic inflation. The high value of Peso lead to a huge current account deficit, leading to a sharp depreciation and heavy capital outflow.
Today, exchange rate is determined not only by demand and supply of currency for trade, but more so by international investments in the country, both FDI and FII. India has come a long way since the 1991 crisis. Capital inflow through FDI and FII have helped build up a large foreign exchange reserve (the 4th largest in the world). The economic growth is also around 7 to 9% and the fiscal and trade deficit are well within sustainable limits. Even in the face of recession the Indian Rupee did not loose its grip much and hovered between Rs.45 and Rs.47. India was able to successfully sail through the recent global recession owing to its strong fundamentals and cautious approach towards capital account convertibility. A strong economy would mean an appreciation of the Rupee. At the same time RBI has raised policy rates to check inflationary pressure. This would encourage more portfolio investment, leading to appreciation of the rupee.
An appreciated Rupee would lead to loss of export competitiveness.
The RBI has thus stepped in to check the rupee from appreciating, following a managed float; allowing the exchange rate to be determined by market forces, while also intervening when required by buying and selling foreign exchange, to protect the economy from the dangers of volatile foreign capital and sudden depletion of reserves.