The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during British regime and till late sixties, most of India’s trade transactions were dominated to pound sterling. Under Bretton Woods system, as a member of IMF Indian declared its par value of rupee in terms of gold. The corresponding rupee sterling rate was fixed 1 GBP = RS 18.
When Bretton Woods system bore down in August 1971, the rupee was de-linked from US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank of India, however, remained pound sterling as the currency of intervention. The US $ and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian Agreement in December 1971, the rupee was de-linked from US $ and again linked to pound sterling. This parity was maintained with a band of 2.25%. Due to poor fundamental pound got depreciated by 20%, which cause rupee to depreciate.
To be not dependent on the single currency, pound sterling on September 25, 1975 rupee was de-linked from pound sterling and was linked to basket of currencies, the currencies includes as well as their relative weights were kept secret so that speculators don’t get a wind of the direction of the movement of exchange rate of rupee.
From January 1, 1984 the sterling rate schedule was abolished. The interest element, which was hitherto in built the exchange rate, was also de-linked. The interest was to be recovered from the customers separately. This not only allowed transparency in the exchange rate quotations but also was in tune with international practice in this regard. FEDAI issued guidelines for calculation of merchant rates.
The liquidity crunch in 1990 and 1991 on forex front only hastened the process. On March 1, 1992 Reserve Bank of India announced a new system of exchange rates known as Liberalized Exchange Rate Management System.
LERMS was to make balance of payment sustainable on ongoing basis allowing market force to play a greater role in determining exchange rate of rupee. Under LERMS, the rupee become convertible for all approved external transactions. The exporters of goods and services and those who received remittances from abroad were allowed to sell bulk of their forex receipts. Similarly, those who need foreign exchange to import and travel abroad were to buy foreign exchange from market-determined rate.
From March 1 1993 modified LERMS under which the all forex transactions, under current and capital account, are being put through by Authorized Dealers at market determined exchange rate.