Express economic history series: The road to a market-determined exchange rate

It was clear to both Manmohan Singh and the RBI that given the severity of the crisis, an immediate, steep devaluation of the rupee was imperative.

Written by Shaji Vikraman | Updated: April 5, 2017 6:09 pm

Soon after the P V Narasimha Rao government took over in June 1991, the Finance Ministry under Manmohan Singh began talking to the RBI on a policy response and strategy to combat the Balance of Payments crisis. Foreign exchange reserves had fallen to about Rs 2,500 crore, enough to meet import payments for just another fortnight. Iraq’s 1990 invasion of Kuwait, the oil shock, a flight of NRI deposits, and restricted access to foreign borrowings led to a major liquidity crisis by mid-1991, and forced the government to approach the International Monetary Fund and World Bank for assistance.

These international financial institutions were at the time criticised for their structural adjustment programmes, which featured standard conditions such as a reduction in the current and fiscal deficit, monetary tightening and devaluation of the currency. Individuals associated with the government then recall that days after becoming PM, Rao mentioned an adjustment of the exchange rate, a euphemism for devaluation. A cheaper local currency would help boost exports earnings and forex reserves.

It was clear to both Manmohan Singh and the RBI that given the severity of the crisis, an immediate, steep devaluation of the rupee was imperative. After approval from Rao, it was decided the devaluation would take place in two stages. The level of devaluation too was agreed upon — although RBI Governor S Venkitaramanan apparently suggested a higher percentage initially.

On July 1, 1991 came the first announcement — of a 10% devaluation, which shocked the market. A second devaluation came in a couple of days — an adjustment of over 20% — which was followed up by major trade policy reforms by the Commerce Ministry, then led by P Chidambaram.

Political resistance after the first announcement prompted Rao to send a ministerial colleague to speak to Singh. The Finance Minister, the story goes, rang C Rangarajan, then Deputy Governor of RBI. Rangarajan replied that he had already “jumped” — meaning the second round of devaluation had already been announced.

By July 12, reserves had sunk to $ 975 million, and policymakers were convinced more needed to be done. In August, Rangarajan, who had moved to the Planning Commission, was told to head a high-level committee on balance of payments, with Y V Reddy, joint secretary in the Finance Ministry in charge of balance of payments and external commercial borrowings, as member secretary.

The committee made several recommendations, including moving towards a market-determined exchange rate with a dual exchange rate mechanism for the interim period, and strict regulation of foreign borrowings and short-term debt. Based on the panel’s interim report, the government introduced the Liberalised Exchange Rate Management System, or LERMS, in March 1992.

The introduction of LERMS was preceded by meetings that Venkitaramanan had with Reddy and Arvind Virmani, then an adviser in the Planning Commission, who made the calculations. To ensure secrecy, they met at the RBI Governor’s bungalow on Carmichael Road in South Mumbai. The new system was announced by Manmohan Singh in the 1992 budget and, in early March, by the RBI. It opened up the way for exporters to realise 60% of their proceeds or earnings at the market rate, while surrendering the rest at the official rate. In other words, India moved from a fixed to a dual exchange rate system. Foreign exchange surrendered at the official rate was made available for importing essential items or products, including petroleum, fertilisers and life-saving drugs.

The high-level committee on BoP had thought of LERMS as a transitory step towards a more market-determined rate, with the expectation that the two rates would converge, paving the way for a change in exchange rate policy. It had reckoned the transition would take a couple of years. But the rupee remained stable between 1992 and 1995, obviating the need to wait long to move ahead. It helped that by late 1992, Rangarajan had moved back to the RBI as Governor, and Montek Singh Ahluwalia, who shared the views of Manmohan Singh and Rangarajan on exchange rate management, had become Finance Secretary. Ahluwalia had discussed the policy with RBI earlier, and had written about it in the so-called “M document” that he had authored while at the PMO in 1990.

By then, exports and inward flows had started to pick up as some liberalisation measures, including trade reforms, showed results. During 1990-92, India’s forex reserves were adequate for just four months’ imports, while over the five years beginning 1992, it was good enough to cover imports for almost seven months. A conscious attempt was made to build foreign exchange reserves. The Rangarajan Committee had suggested targeting a level of reserves that would take into account liabilities that could arise for servicing debt, besides building a cushion for imports for at least three months.

Budget 1993-94 announced, in line with the committee’s recommendations, a move towards a unified exchange rate or a market-determined management system, marking the transition to convertibility on the current account soon afterward.

What is striking about this period of reforms is the leadership and political backing provided by Narasimha Rao — as also the convergence of views among all major stakeholders. It was marked by the involvement of a number of technocrats in policy formulation at the top, led by the Finance Minister himself, and backed by competent bureaucrats grounded in economic policymaking.

Quite in contrast to the scenario now — when the Finance Ministry attempts to disown a draft report perceived as disempowering the RBI, with the seniormost official in the Ministry saying that the report belongs to the “People of India”!


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