Author: Yash Prakash Yadav, 1st year student (3 years LL.B.) at Campus Law Centre, Faculty of Law, University of Delhi.
National sovereignty is of great importance for any independent nation and currency is one of the most important and well recognized symbols of the same. This fact is accepted by India.
The official currency of India is the Indian rupee (INR). The word ‘rupee’ is taken from a Sanskrit word ‘rupiya’ meaning ‘silver coin’. Although many South Asian nations use rupee currencies, only the Indian rupee carries the three-letter abbreviation of ‘INR’. The symbol ‘₹’ was adopted in 2010 for the same. In this article we will be tracking the value and management of INR and focus on two devaluation events which in the history of INR which occurred in 1966 and 1991 respectively along with briefly mentioning its history.
Short history of INR
In 6th century BCE, India was one of the first countries along with China to issue coins. Then, Sher Shah Suri introduced a fixed monetary system in the 16th century. At that time, each silver rupee equalled 40 pieces of copper.
Paper rupees was first issued and used in 1770. Rupee remained on the silver standard, that is, measuring the value by the stock of silver backing it. Therefore, the value of silver determined the value of rupee even when most of the world had gold-based currencies. Many of the European colonies discovered silver in the 18th century and increased the supply of the metal henceforth. As stated by the first law of economics, the price of a good falls when supply of a good is increased for lower or unchanged demand. Hence, this discovery led to shrinking this the metal’s price relative to that of gold. This led to high devaluation of the rupee.
The rupee was previously divided into 16 annas starting in 1835, and 100 paise after 1957. The government first pegged the rupee to the British pound (GBP) in 1898, which changed to the US dollar after 1966.
The Reserve Bank of India was founded on 1 April 1935 as a response to handle the economic trouble which came into existence with force after the First World War. RBI was conceptualized as per the guidance and method presented by Dr. B. R. Ambedkar in his book “The Problem of Rupee – Its origin and its solutions”. The preamble of the Reserve Bank of India describes the basic functions of the reserve bank as:
“to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth.”
In other words, the RBI was formed to handle the flow of currency in India and therefore control its price in the international markets to ensure monetary stability.
Although RBI was formed as per the Reserve Bank of India Act of 1934, it was owned privately. It was nationalized in 1949, and is fully owned by the Government of India since then. All pre-independence banknotes were officially demonetized with effect from 28 April 1957. Only the Government of India has the right to mint coins and issue the one rupee note. The coins are issued for circulation only through the RBI. Also, banknotes of all denominations except one rupee are issued by it.
Initially India adopted a very inward looking policy for management of its economic affairs which also included the management of exchange rate for its currency. Exchange rate in simple words is the price of one currency in terms of another currency. India’s policy makers were concerned about vulnerability of India towards external disruptions and their implications which could have compromised the national sovereignty of newly independent India. One of the ways to address this concern was to isolate the nation. The policy makers used different policy tools to achieve the desired results in different sectors. For exchange rate management they placed their bet on the ‘Fixed Exchange Rate System’. As per this system, a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold. But now India follows the system which can be termed as ‘Managed Flexible Exchange Rate System’. Now RBI closely manages the rupee within a very narrow currency band. It allows the exchange rate to move within this band, and intervenes only when it crosses it. Band is fixed by the RBI after discussion with the government, by taking into consideration the desired growth in different sectors in the nation.
We now track down the chronology of India’s exchange rate policies and then consider the reasons behind the devaluation of INR by the government first in 1966, and then in 1991:
Recorded trends in INR with changing exchange rate policies
● In 1947 India joined International Monetary Fund (IMF) as a member. Rupee was tied to Pound.
● In September 1949, Pound was devalued but India maintained fixed exchange rate with it.
● On 6th June 1966, the Rupee was devalued. Rupee fell from 1 US dollar equal to 4.76 INR, to 1 US dollar equal to 7.50 rupee.
● On 18th November 1967 UK devalued Pound but India did not devalue INR.
● In August 1971 INR was pegged to gold/ dollar. The international financial crises also took place during the same period.
● On 18th December, dollar was devalued.
● On 20th December 1971, INR was again tied to pound sterling.
● 1971-1979: during this period INR is overvalued due to India’s policy of import substitution, which is the idea that discouraging imports of manufactured goods from foreign nations can help an economy by increasing the demand for domestically produced goods.
● On 23rd June 1972, UK shifts to floating exchange rate system for Pound. But India maintained its position on Fixed exchange rate with Pound.
● In 1975 India linked INR with basket of currencies of major trading partners. The basket kept changing from time to time, but the link was not changed until the devaluation of INR in1991
● In July 1991 Rupee was devalued by 18-19%.
● In March 1992 the Dual exchange rate, Liberalized Exchange Rate Management System (LERMS), took the spotlight. Rupee was now partially convertible.
● In March of 1993, the unified exchange rate, at 1$= Rs 31.37.
● In 1993 Rupee was made freely (that is 100%) convertible for trading, but not for investment.
India has seen many ups and downs in terms of exchange rate for rupee but it has not changed its policy of floating exchange rate system significantly till date. The main reason for this is India’s experience during its fixed exchange rate system.
We will consider the reasons that India was forced to devalue INR twice during that period. But before that one must understand the working behind the logic of devaluation.
Logic of devaluation
Any country needs to have the required medium of exchange to engage in commerce with other countries. Foreign exchange reserves play a critical role here. If a nation runs out of its foreign currency reserves, and its own currency is not acceptable abroad, then the only option left for the country is to borrow. But this brings the obligation to repay the loan. Repayment is asked in the lender’s own national currency or in some other internationally accepted hard currency. If the nation is not credit worthy to get a loan from private banks and also from institutions such as IMF, then the nation has no way to pay for the imports, and a financial crisis occurs along with devaluation and capital flight.
A country feels strong internal political pressure to avoid the risk of any such crisis. To tackle this risk, a nation usually adopts policies that will maintain a stable exchange rate and lessen exchange rate risk, increase internal confidence, and maintain its foreign currency (or gold) reserves. The restrictions will be of two kinds, trade barriers and financial restrictions.
However, if the market for a nation’s currency is too weak to justify the given exchange rate despite these policies, then the nation will be forced to devalue its currency sooner or later. That is, the price the market is willing to pay for the currency is less than the price dictated by the government.
The 1966 Devaluation
As a developing economy, India had more imports than exports, and therefore ran into a trade deficit. However, India was significantly aided by the international community. But in 1965, when India was at war with Pakistan, many ally nations of Pakistan, like US, withdrew foreign aid to India. When a country following the fixed exchange rate system faces inflation which is higher than other countries, the country’s own goods turn more expensive than foreign goods. Thus, inflation tends to increase imports and decrease exports. During the war in the 1960s, India had budget deficit problems and was not able to get a loan from abroad or from private corporate sector due to negative savings rate in that sector. Lastly, the government issued bonds to RBI which increased the money supply. In a long run, this led to high inflation which was further increased due to large deficit spending to fund the war efforts during the 1965 war with Pakistan. In addition, the drought of 1965-1966 harmed many efforts to tackle economic problems. Ultimately in July 1966, India was forced to devalue and was also asked to liberalize to attract foreign aid. Foreign aid stopped after devaluation, which was politically degrading for the government, and therefore the trust on liberalization was lost.
The 1991 Devaluation
India was still using the fixed exchange rate system. Similar to 1966, India was facing high inflation, increasing budget deficit and tensed balance of payments. there was a problem of less foreign exchange reserves since 1985. The Gulf War increased the oil expenses due to increase in prices. At one point in 1991, India was left with foreign exchange reserves sufficient for only 3 months of import bills. Both, the ruling and the opposition felt that the economy should be globalized, and they devalued as a preliminary step to increase exports to resolve the above problem of scarcity of foreign exchange as this devaluation would lead to higher exports and less imports. But one must also understand that although the policies were needed for liberalization at that point of time, it was still the choice of the government and not a decision which was totally under the threat of the gun called economic recession.
After 1991, India kept introducing policies which led to more and more flexible exchange rate systems, but it is under a framework which allows RBI to influence the exchange rate from time to time whenever required. The above incidents of devolution showed Indian policy makers how policies that lead to inflation can be inefficient in a fixed exchange rate system. It might be right to say that floating exchange rate should have been the first choice of initial policy makers. Surely, one cannot speak of strategies to swim in a flood when in calm waters. It is right to say that if floating exchange rate system would have been followed, then INR would have adjusted on its own and sudden devaluation would not have been needed. But this economic hardship can also be seen as cost for ensuring national sovereignty during that time when people had sacrificed a lot to gain it.
● “Devaluation of Rupee: Tale of Two Years, 1966 and 1991” by Devika Johri and Mark Miller.
● Macroeconomics: Theories and Policies. By Richard T. Froyen, 8th edition