India’s exchange rate policy has evolved in line with international and domestic developments.
Post-independence, in view of the prevailing Bretton Woods system, the Indian rupee was pegged to the pound sterling due to its historic links with Britain.
- A major development was the devaluation of the rupee by 36.5 per cent in June, 1966.
- With the breakdown of the Bretton Woods system, and also the declining share of UK in India’s trade, the rupee was de-linked from the pound sterling in September 1975.
During the period between 1975 to 1992, the exchange rate of the rupee was officially determined by the Reserve Bank within a nominal band of plus or minus 5 per cent of the weighted basket of currencies of India’s major trading partners. The Reserve Bank intervened on a day-to-day basis which resulted in wide changes in the size of reserves. The exchange rate regime of this period can be described as an adjustable nominal peg with a band.
The beginning of 1990s saw significant rise in oil prices and suspension of remittances from the Gulf region in the wake of the Gulf crisis. This, and other domestic and international developments, led to severe balance of payments problems in India.
- The drying up of access to commercial banks and short-term credit made financing the current account deficit difficult.
- India’s foreign currency reserves fell rapidly from US $ 3.1 billion in August to US $ 975 million on July 12, 1991 (we may contrast this with the present; as of January 27, 2006, India’s foreign exchange reserves stand at US $ 139.2 billion).
Apart from measures like sending gold abroad, curtailing non-essential imports, approaching the IMF and multilateral and bilateral sources, introducing stabilisation and structural reforms, there was a two-step devaluation of 18 –19 per cent of the rupee on July 1 and 3, 1991.
In march 1992, the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rates was introduced. Under this system –
- 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank and
- 60 per cent was to be converted at the market-determined rates.
The dual rates were converged into one from March 1, 1993; this was an important step towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the IMF. The exchange rate of the rupee thus became market determined, with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases.
Bibliography : NCERT – Introductory Macroeconomics