Devaluation of the Rupee: Tale of two years – 1966 and 1991 Since its Independence in 1947, India has faced two major financial crises and two consequent devaluations of the rupee. They were in 1966 and 1991. Foreign exchange reserves are very important for any country to engage in International commerce. Having huge sums of reserves helps trade with other nations and also reduces the transaction costs associated with international commerce. When a nation runs out of foreign currency and finds that other nations are not willing to accept the nation’s currency, the only option left is to borrow abroad.
But, borrowing in foreign currency means we need to pay back in the same currency or in some other hard currency. If the borrowing nation is not credit worthy to borrow from a private bank or from institutions as the IMF, then the nation has no way of paying for its imports and a financial crisis accompanied with devaluation and capital flight occurs. The destabilizing effects of a financial crisis are so great that any country will face strong pressure from internal political forces to avoid such a crisis, even if the policies adopted come at a large economic cost.
To avert a financial crisis, a nation will typically adopt policies to maintain a stable exchange rate to lessen exchange rate risk and increase international confidence. The restrictions that a country will put in place come in two forms: trade barriers and financial restrictions. Trade barriers are the restrictions on the import of certain goods and financial restrictions are on the flow of money or financial assets across international boundaries. When the flow of goods, services, and financial capital is regulated tightly enough, the government or central bank becomes strong enough, at least in theory, to dictate the exchange rate.
However, despite these policies, if the market for a nation’s currency is too weak to justify the given Exchange rate, that nation will be forced to devalue its currency. The 1966 Devaluation: As a developing economy, it is to be expected that India would import more than it exports. Despite government attempts to obtain a positive trade balance, India has had consistent balance of payments deficits since the 1950s. The 1966 devaluation was the result of the first major financial crisis the government faced.
There is a general agreement among economists that by 1966, inflation had caused Indian prices to become much higher than world prices at the pre-devaluation exchange rate. When the exchange rate is fixed and a country experiences high inflation relative to other countries, that country’s goods become more expensive and foreign goods become cheaper. Therefore, inflation tends to increase imports and decrease exports. Since 1950, India ran continued trade deficits that increased in magnitude in the 1960s.
As India continued to experience deficits in trade and the government budget, the country was aided significantly by the international community. In the period of 1950 through 1966, foreign aid was never greater than the total trade deficit of India except for 1958. Nevertheless, foreign aid was substantial and helped to postpone the rupee’s final reckoning until 1966. In 1966, foreign aid was finally cut off and India was told it had to liberalize its restrictions on trade before foreign aid would again materialize. The response was the politically unpopular step of devaluation accompanied by liberalization.
When India still did not receive foreign aid, the government backed off its commitment to liberalization. Two additional factors played a role in the 1966 devaluation. The first was India’s war with Pakistan in late 1965. The US and other countries friendly towards Pakistan, withdrew foreign aid to India, which further necessitated devaluation. In addition, the large amount of deficit spending required by any war effort also accelerated inflation and led to a further disparity between Indian and international prices. Defense spending in 1965/1966 was 24. 06% of total expenditure, the highest it has been in the period from 1965 to 1989.
The second factor is the drought of 1965/1966. The sharp rise in prices in this period, which led to devaluation, is often blamed on the drought. Unlike in 1966 and 1991, India did not explicitly devalue the rupee but instead accomplished a “de facto” devaluation by imposing quantitative restrictions (QRs) on trade rather than imposing higher tariffs. The government used the method of QRs with varying levels of severity until the Import-Export Policy of 1985-1988. In July 1966 India was forced by economic necessity to devalue the rupee and attempt to liberalize the economy to attract foreign aid.
The drought of 1965/1966 harmed reform efforts as feeding those in drought-affected areas took political precedence over liberalizing the economy. The 1991 Devaluation: 1991 is often cited as the year of economic reform in India. While the devaluation of 1991 was economically necessary to avert a financial crisis, the radical changes in India’s economic policies were, to some extent, undertaken voluntarily by the government of P V Narasimha Rao. As in 1966, there was foreign pressure on India to reform its economy, but in 1991, the government committed itself to liberalization and followed through on that commitment.
In 1991, India still had a fixed exchange rate system, where the rupee was pegged to the value of a basket of currencies of major trading partners. At the end of 1990, the Government of India found itself in serious economic trouble. The government was close to default and its foreign exchange reserves had dried up to the point that India could barely finance three weeks’ worth of imports. As in 1966, India faced high inflation, large government budget deficits, and a poor balance of payments position. In the case of the 1991 devaluation, the Gulf War led to much higher imports due to the rise in oil prices.
Also, foreign currency assets fell to US $1. 2 billion. Since the Gulf War had international economic effects, there was no reason for India to be harmed more than other countries. Instead, it simply further destabilized an already unstable economic situation brought on by inflation and debt. In July of 1991 the Indian government devalued the rupee by between 18 and 19 percent. In March 1993 the government unified the exchange rate and allowed, for the first time, the rupee to float. From 1993 onward, India has followed a managed floating exchange rate system.
Under the current managed floating system, the exchange rate is determined ostensibly by market forces, but the Reserve Bank of India plays a significant role in determining the exchange rate by selecting a target rate and buying and selling foreign currency in order to meet the target. Initially, the rupee was valued at 31. 37 to one US dollar but the RBI has since allowed the rupee to depreciate against the dollar. What Went Wrong? Clearly, there are many similarities between the devaluation of 1966 and 1991. Both were preceded by large fiscal and current account deficits and by dwindling international confidence in India’s economy.
Inflation caused by expansionary monetary and fiscal policy depressed exports and led to consistent trade deficits. Additionally, from Independence until 1991, the policy of the Indian government was to follow the Soviet model of foreign trade by viewing exports as a necessary evil whose sole purpose was to earn foreign currency with which to purchase goods from abroad that could not be produced at home. As a result, there were inadequate incentives to export and the Indian economy missed out on the gains from comparative advantage.
It is easy in retrospect to fault the government’s policies for leading to these two major financial crises, but it is more difficult to convincingly state what the government should have done differently that would have averted the crises. By borrowing from the Reserve Bank of India and, therefore, essentially printing money, the government could finance its extravagant spending through an inflation tax. Additionally, the large amounts of foreign aid that flowed into India clearly did not encourage fiscal or economic responsibility on the part of the government.
In 1966, the lack of foreign aid to India from developed countries could not persuade India to liberalize and in fact further encouraged economic isolation. In 1991, on the other hand, there was a political will on the part of the government to pursue economic liberalization independent of the threats of aid reduction. These two financial episodes in India’s modern history show that engaging in inflationary economic policies in conjunction with a fixed exchange rate regime is a destructive policy.
If India had followed a floating exchange rate system instead, the rupee would have been automatically devalued by the market and India would not have faced such financial crises. A fixed exchange rate system can only be viable in the long run when there is no significant long-run inflation. Chronology of India’s exchange rate policies: • 1947 (When India became member of IMF): Rupee tied to pound, Re 1 = 1 s, 6 d, rate of 28 October, 1945 • 18 September, 1949: Pound devalued; India maintained par with pound • 6 June, 1966: Rupee is devalued, Rs 4. 6 = $1, after devaluation, Rs 7. 50 = $1 (57. 5%) • 18 November, 1967: UK devalued pound, India did not devalue • August 1971: Rupee pegged to gold/dollar, international financial crisis • 18 December, 1971: Dollar is devalued • 20 December, 1971: Rupee is pegged to pound sterling again • 1971-1979: The Rupee is overvalued due to India’s policy of import substitution • 23 June, 1972: UK floats pound, India maintains fixed exchange rate with pound • 1975: India links rupee with basket of currencies of major trading partners.
Although the basket is periodically altered, the link is maintained until the 1991 devaluation. • July 1991: Rupee devalued by 18-19 % • March 1992: Dual exchange rate, LERMS, Liberalized Exchange Rate Management System • March 1993: Unified exchange rate: $1 = Rs 31. 37 • 1993/1994: Rupee is made freely convertible for trading, but not for investment purposes.
