Exchange Rate Adjustment as an Economic Stabilization Measure in 1991

The Indian rupee is linked to a basket of important currencies of the country’s major trading partners. The major objective of exchange rate policy is to adjust exchange rates in such way as to promote the competitiveness of Indian exports in the world market. Adjustments in the external value of the rupee are therefore made from time to time. The Reserve Bank of India effected an exchange rate adjustment on 1 July, 1991 in which the value of the rupee declined by about 7 to 9 per cent against the major currencies (the Pound Sterling, the US Dollar, the Deutschmark, the French Franc and the Yen). There was another exchange rate adjustment on 3 July, 1991 in which the value of the rupee declined by about 10 to 11 per cent against the major currencies. Between 28 June and 3 July, 1991, the rupee depreciated by about 18 per cent vis-a-vis the basket of 5 currencies while this basket appreciated vis-a-vis the rupee by about 23 per cent. These adjustments had been necessitated by the growing external and internal imbalances in the economy. The balance of payments situation had become very critical and that was reflected in the sharp draw-down on, and low level of, foreign exchange reserves. Since October, 1990 there has been an appreciation in the relatively high rate of inflation in the country and a much slower rate of depreciation in the nominal exchange rate leading to an erosion in the international competitiveness of the economy. It was equally necessary to curb de-stablising market expectations which were generated by perceptions of a growing misalignment of the exchange rate. It is expected that these exchange rate adjustments will stop further deterioration in the country’s balance of payments in the short run and improve it in the medium term by improving the trade balance.

The primary objective of the exchange rate adjustment is one of strengthening the viability of external payments position, i.e., to ensure that exchange rate movements maintain a reasonable incentive for export ­promotion and encourage efficient import substitution activities, and at the same time, to stem the flight of capital from India and discourage how of remittances from abroad through illegal channels. In the immediate short run, exchange rate adjustment is expected to facilitate realization of outstanding export receipts and accelerate, in general, the inflow of remittances by quelling destabilizing market expectations. Downward adjustment in the exchange rate raises the relative price of traded goods (by increasing the domestic price of foreign currency) to non-traded (or home) goods, thereby encouraging production of tradeables while discouraging their consumption. This expenditure-switching effect at a macro level results in correcting the imbalances in the trade and current account.

The Real Effective Exchange Rate (REER) of a currency which is the nominal exchange rate adjusted for the relative change in prices in the respective countries, is a proxy for a country’s degree of competitiveness in world markets. Appreciation in REER reflects deterioration in the country’s international competitiveness, while depreciation in REER reflects the converse.

Many of India’s trade competitors made substantial exchange rate adjustments over the past decades. China and Indonesia, for instance, depreciated their currencies against the US dollar more than India did despite their lower inflation. Over the period end-December 1980 to end-December 1989, China depreciated by 68 per cent and Indonesia by 65 per cent while India depreciated by only 53 per cent against US dollar, whereas the increase in consumer prices in China and Indonesia were lower at 100 per cent and 111 per cent, respectively, against India’s 114 per cent over the same period.

Between October 1990 and March 1991 the REER of the rupee appreciated by about per cent as a result of a much slower rate of depreciation in the nominal exchange rate (2.4 per cent against the major five currencies over the same period) and the widening inflation differen­tials as the country’s domestic inflation accelerated after October 1990. Further, in the five month period between February 1991 and June 1991, the nominal effective exchange rate of rupee decreased only by 2.5 per cent while the inflation differentials continued to widen. All this resulted in an erosion of India’s international competitiveness.

To restore the competitiveness of our exports and to bring about a reduction in trade and current account deficits, a downward adjustment of the rupee had become inevitable. The Reserve Bank of India effected the exchange rate adjustment in two steps in early July 1991. The timing of the exchange rate adjustment was necessitated by the need to nullify adverse expectations and restore international confidence. On the other hand, the magnitude of the adjustment was predicted on the need to restore competitiveness of the country vis-a-vis her competitors in trade. On July 1, 1991 the value of the rupee declined by 8 to 9 per cent against the major currencies (pound sterling, the US dollar, the Deutschmark, the yen and the French franc). On July 3, 1991, the value of the rupee was further lowered by 10 to 11 per cent against the major currencies.

In determining the extent of adjustment, the relevant factors were: differentials in the price levels between India and her major trading partners; the extent of real depreciation of the currencies of competitors; the degree of correction required in our balance of payments; and market expectations. Taking all these factors into account the magnitude of downward adjustment in the external value of the rupee by about 23 per cent was appropriate.

A basic requirement for the success of this exchange rate adjustment policy is that relative price change should bring forth requisite change in production and consumption patterns. Exchange rate depreciation could lead to an improvement of the current account only if export volumes rise and/or import volumes fall sufficiently to outweigh the price effect. Besides, lags in such response to exchange rate changes are also to be reckoned with. There is the well known “J curve” effect of the improvement in balance of trade occurring after an initial deterioration. However, following the stringent monetary restrictions on imports, the expected deterioration of trade deficit did not happen. The trade deficit during the first six months of the financial year 1991-92 contracted significantly.

Credit: Managerial Economics-MGU KTM

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