India’s tryst with currency devaluation
25 years ago, on 1 July, the rupee was devalued by 9%, a move RBI terms a turning point which culminated in a more market-driven exchange rate two years later
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1 July 1991, a Monday, was no ordinary start to the week for Indian currency markets. The economy was in the midst of a full-blown balance of payments crisis and foreign exchange reserves had fallen to levels not enough to pay for even a month of imports.
This was a time when the rupee was still pegged, no longer to the pound, but to a basket of currencies. As policymakers discussed various ways to deal with the crisis, which eventually led to the liberalization of the Indian economy, one option that emerged was a one-time devaluation of the rupee.
On the afternoon of 1 July, the Reserve Bank of India (RBI), as part of its daily adjustments to the currency, announced a sharply weaker rate for the rupee—9% lower than the previous day’s levels. Two days later, it was pegged down by another 11%. The devaluation marked the beginning of a complete overhaul not just of the economy but also the currency markets.
RBI documents put down the period as a turning point which, two years later, culminated in a more market-driven exchange rate.
“The initiation of economic reforms saw, among other measures, a two-step downward exchange rate adjustment by 9% and 11% between 1 July and 3 July 1991 to counter a massive drawdown in the foreign exchange reserves, to instil confidence in the investors and to improve domestic competitiveness," says an RBI document, which details the history of the foreign exchange markets in India.
In an article in The Indian Express on 10 November 2015, C. Rangarajan, then deputy governor of RBI, explained how the devaluation played out. The project was code-named “hop, skip and jump", wrote Rangarajan, adding that the idea was always to do a two-stage devaluation. “Why two stages? To test the market with an initial dose and then follow it up. The first announcement would prepare the markets," wrote Rangarajan.
The market, however, got nervous after the first devaluation and started to predict a devaluation steeper than what RBI had in mind. Seeing this, Rangarajan wrote in his article, it was decided to advance the second adjustment. This led to the second devaluation of 11% on 3 July.
What followed in the weeks and months ahead is now well-documented. India moved to start liberalizing its economy and that also meant liberalization of the exchange rate regime.
The Liberalised Exchange Rate Management System was put in place in March 1992. This involved an interim dual exchange rate system being put in place.
Essentially, it meant that India worked with two exchange rates—one used for select government and private transactions and a second rate used by the rest of the market. In March 1993, the dual system was replaced with a unified exchange rate, moving the currency towards a managed float.
“The experience with a market-determined exchange rate system in India since 1993 is generally described as satisfactory as orderliness prevailed in the Indian market during most of the period," notes the RBI document quoted above.
The bout of devaluation in 1991 was not the first time India flirted with currency devaluation. On 6 June 1966, the rupee was devalued dramatically in response to the first significant balance of payments crisis faced by independent India.
It had barely been two decades since India had achieved independence. The economy, still finding its feet, had limited access to foreign exchange. Foreign investments were frowned upon and exports were negligible. The 1950s and the early 1960s were, therefore, years when India ran up high trade deficits. Things got tough in 1965 as India and Pakistan went to war. Military spending skyrocketed, putting further pressure on the Indian government’s finances. At the same time, countries such as the US, which were in those days aligned with Pakistan, withdrew aid to India.
With limited options, the Indira Gandhi-led government that assumed office in 1966 resorted to a steep devaluation of the rupee, a decision that was widely criticized. The rupee in those days was still pegged to the pound which, in turn, was pegged to the dollar. The devaluation meant that the effective value of the rupee went from 4.76 against the dollar to 7.50 per dollar. That worked out to a devaluation of 57%.
“The measure was resorted to with a view to maintain the existing exports by bringing about a better alignment between internal and external prices and, thus, giving exports greater competitive strength. Corresponding new rate of exchange was ₹ 7.50 to 1 US dollar as against the previous rate of ₹ 4.76," says the RBI document quoted above.
The 1966 devaluation, however, was a stand-alone event and failed to do much good for the economy.
In contrast, the second bout of devaluation, in 1991, proved to be far more significant in India’s economic and currency markets history. To be sure, there have been several other milestones in the history of the currency markets since.
Most recently in 2013, a time when global markets were nervous about withdrawal of monetary policy support by the US Federal Reserve and India faced high inflation and wide fiscal and current account deficits, the rupee fell to a record low of 68.85 against the dollar on 28 August.
It took a special concessional swap window from RBI to restore confidence in the currency at the time. This year could also prove to be a critical time for the rupee as foreign currency deposits raised in 2013 mature at a time when the country’s central bank is preparing for a change of guard and the global economy is navigating its way through volatile times.
Sixteen out of 54 forecasters polled by Bloomberg expect the rupee to fall to record lows within the current calendar year. Among them, Barclays expects the rupee to hit 73.50/$ this year.
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