Devaluation of the Rupee - 1966 and 1991


Since its independence in 1947, India has faced two major financial crises and two consequent devaluations of the rupee. These crises were in 1966 and 1991 and they had similar causes.
Foreign exchange reserves are an extremely critical aspect of any country’s ability to engage in commerce with other countries. A large stock of foreign currency reserves facilitates trade with other nations and lowers transaction costs associated with international commerce. If a nation depletes its foreign currency reserves and finds that its own currency is not accepted abroad, the only option left to the country is to borrow from abroad. However, borrowing in foreign currency is built upon the obligation of the borrowing nation to pay back the loan in the lender’s own currency or in some other “hard” currency. If the debtor nation is not creditworthy enough to borrow from a private bank or from an institution such as the IMF, then the nation has no way of paying for imports and a financial crisis accompanied by devaluation and capital flight results.

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. As in 1991, there was significant downward pressure on the value of the rupee from the international market and India was faced with depleting foreign reserves that necessitated devaluation. 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.

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 liberalise its restrictions on trade before foreign aid would again materialise. The response was the politically unpopular step of devaluation accompanied by liberalisation. When India still did not receive foreign aid, the government backed off its commitment to liberalisation. According to T N Srinivasan, “devaluation was seen as capitulation to external pressure which made liberalisation politically suspect… (Srinivasan, pp 139).”

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. Defence spending in 1965/1966 was 24.06% of total expenditure, the highest it has been in the period from 1965 to 1989 (Foundations, pp 195). 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, but in 1964/1965 there was a record harvest and still, prices rose by 10% (Bhatia, pp 35). The economic effects of the drought should not be understated, but the data show that the drought was a catalyst for, rather than a direct cause of, devaluation.

India’s system of severe restrictions on international trade began in 1957 when the government experienced a balance of payments crisis. This crisis was caused by a current account deficit of over Rs 290 crore which necessitated India lowering its foreign exchange reserves (RBI Bulletin, July 1957, pp 638). The large current account deficit was largely a result of the Second Five-Year Plan which mandated higher imports, especially of capital goods. Exports in the year 1956-1957 stagnated while imports increased by Rs 325 crores from the previous year. Another factor behind the current account deficit was the increase in freight costs due to hostilities in West Asia. Unlike in 1966 and 1991, India did not explicitly devalue the rupee but instead accomplished what Srinivasan refers to as a “de facto” devaluation by imposing quantitative restrictions (QRs) on trade rather than imposing higher tariffs.

The 1991 Devaluation

 1991 is often cited as the year of economic reform in India. Surely, the government’s economic policies changed drastically in that year, but the 1991 liberalisation was an extension of earlier, albeit slower, reform efforts that had begun in the 1970s when India relaxed restrictions on imported capital goods as part of its industrialisation plan. Then the ImportExport Policy of 1985-1988 replaced import quotas with tariffs. This represented a major overhaul of Indian trade policy as previously, India’s trade barriers mostly took the form of quantitative restrictions. After 1991, the Government of India further reduced trade barriers by lowering tariffs on imports. In the post-liberalisation era, quantitative restrictions have not been significant.

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 liberalisation and followed through on that commitment. According to Srinivasan and Bhagwati, “Conditionality played a role, for sure, in strengthening our will to embark on the reforms. But the seriousness and the sweep of the reforms… demonstrated that the driving force behind the reforms was equally… our own conviction that we had lost precious time and that the reforms were finally our only option (IESI, pp 93).”

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. In each case, there was a large adverse shock to the economy that precipitated, but did not directly cause, the financial crisis. 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. 1991 represented a fundamental paradigm shift in Indian economic policy and the government moved toward a freer trade stance.

Thursday, 03rd Nov 2016, 06:29:15 AM

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