Balance of Payments: Exchange Rate Policy
Balance Of Payments: Exchange Rate Policy
Foreign exchange scarcity was a chronic feature of most of India's post-independence history. This was both cause and consequence of India's inward looking (and quasi socialistic) choice of development model, with concomitant negative implications for its economic performance, especially in comparison to emerging economies in East and Southeast Asia.
At independence in 1947, India was left with strong sterling balances arising from its wartime contributions. The prewar exchange rate arrangements continued, with the rupee being pegged (or fixed) to the British pound sterling at the prewar parity. In 1949, when the pound was devalued, the rupee-sterling parity was left unchanged, creating an effective devaluation. During the 1950s low inflation kept the exchange rate competitive. The first major foreign exchange crisis in India came as a consequence of the second Five Year Plan in 1957, which, with its ambitious heavy industry import substitution industrialization strategy, led to a sharp increase in imports. Growing external imbalances resulted in the imposition of severe foreign exchange and import controls, which would persist over the next three and a half decades. A deep distrust of the price mechanism extended to the principal levers of macroeconomic policy, exchange rates and interest rates.
India's Five Year Plans were based on the premise that prices would be constant and that the exchange rate, as one of myriad prices, must remain fixed. Adherence to a fixed exchange rate was necessary (from the narrow perspective of the plan's model) because any change in its level would have upset the careful balance that was part of the plan's design. Indeed, when it did just that (in 1966), the Five Year Plans had to be temporarily suspended. This was the rationale behind the government's aversion to changing the fixed exchange rate, even though conditions had vastly changed. Throughout its history there has been a close link between the health of India's foreign exchange reserves and the stringency of foreign trade and payments controls. The periods of severe tightening (1957–1962, 1968–1974) and moderate relaxation (1966–1968, 1975–1979, 1982–1989) followed this pattern.
Exchange Rate Regime
Table 1 gives the currency regimes prevailing in India during the twentieth century. From being pegged to the pound sterling, the rupee moved to a peg to a basket of currencies in the mid-1970s and a de facto crawling band around the U.S. dollar by the end of the decade. It switched to a floating exchange rate regime in 1993 after a transitional phase of dual exchange rates for two years. The postfloat period is distinguished by remarkable exchange rate stability, which is contrary to commonly observed experience, as countries that switch from fixed to floating exchange rate regimes typically experience a rise in exchange rate volatility. The floating of the rupee has also been accompanied by a rise in the frequency and scale of intervention by the central bank in the foreign exchange market.
The post-independence exchange rate regime, while formally an adjustable peg Bretton Woods–style regime, operated in practice as a fixed nominal exchange rate. (Between 1946 and 1971, under the Bretton Woods system, each country's exchange rates were fixed to the U.S. dollar and could be changed only if the International Monetary Fund (IMF) agreed that the country's balance of payments was in a state of "fundamental disequilibrium." Countries settled their international balances in U.S. dollars, and the U.S. government promised to redeem other central banks' holdings of dollars at a fixed rate of U.S.$35 per ounce.) By the end of the 1950s and in the first half of the 1960s, a fixed nominal rate and mounting inflation led to an appreciation of the real effective exchange rate (REER), and despite severe trade and capital controls and foreign aid, India's balance of payments problems mounted. REER is a measure (index) of the degree of competitiveness of a country relative to its trading partners, where weights are chosen to correspond to the relative importance of each trading partner. In June 1966, under pressure from the United States and the Bretton Woods institutions, India undertook a large nominal devaluation (36.5%), but due to a complex tax regime and high inflation, the REER depreciation was only about 7 percent. The devaluation of 1966 is widely regarded as having been a political disaster that severely shaped India's macroeconomic policies and political economy over the next two decades.
|India's currency regimes|
|SOURCE: Compiled from Reinhart, C. M., and Ken Rogoff, "The Modern History of Exchange Rate Arrangements: A Re-interpretation," NBER Working Paper 8963, Cambridge, Mass.: June 2002.|
|August 1914–March 1927||Peg to pound sterling||Convertibility into sterling was suspended|
|March 1927–September 1931||Peg||Gold standard|
|September 1931–September 1939||Peg to pound sterling||Suspension of gold standard adherence to sterling area|
|September 1939–October 1941||Peg to pound sterling||Introduction of capital controls|
|November 1941–October 1943||Peg to pound sterling; "freely falling"|
|November 1943–October 1965||Peg to pound sterling|
|October 1965–June 1966||De facto band around pound sterling; parallel market||There were multiple exchange rates; band width was +/- 5%|
|June 1966–August 1971||Peg to pound sterling|
|August 1971–December 1971||Peg to U.S. dollar|
|December 1971–September 1975||Peg to pound sterling|
|September 1975–February 1979||De facto crawling band around pound||Band width was +/-2%; officially sterling pegged to a basket of currencies|
|March 1979–July 1979||Managed float|
|August 1979–July 1989||De facto crawling band aroundU.S. dollar||Band width was +/-2%; officially pegged to a basket of currencies|
|August 1989–July 1991||De facto crawling peg to U.S. dollar|
|August 1991–June 1995||De facto peg to U.S. dollar||One devaluation in March 1993; black market premia rose to 27% in February|
|July 1995–December 2001||De facto crawling peg to U.S. dollar||During this period black market premium consistently in single digits|
With the breakdown of the Bretton Woods regime in August 1971, the rupee was briefly pegged to the dollar, but after December 1971 it was pegged to the pound sterling until 1975. This proved to be an astute move, as it led to an automatic depreciation of the rupee (due to the weakness of the sterling) without drawing political attention. In the early 1970s India weathered the first oil shock because the sterling peg led not only to a nominal effective devaluation but to a real devaluation as well (see Figure 1 for India's nominal effective exchange rate [NEER] and REER series, 1970–2003). NEER is an index of the value of a country's currency with respect to a group of countries, usually trading partners (as opposed to only one country). Thus the effective exchange rate depreciated by 20 percent by 1975, although there was no explicit devaluation. In September 1975 the peg was altered from the pound sterling to a basket of currencies. Tight monetary and fiscal policies reduced inflation sharply, resulting in a steady depreciation of the rupee and an export boom.
For reasons that are not entirely clear, India's exchange rate policies faltered in the immediate aftermath of the second oil shock in 1979. There was no nominal depreciation, and mounting inflation led to an appreciation in the REER. However, in 1983 the exchange rate management changed direction (a crawling basket peg). The REER became the explicit indicator for exchange rate policy with a nominal effective exchange rate managed so as to keep the REER at about the 1982 level. By the mid-1980s, the exchange rate policy became much more active, leading to a depreciation in the nominal rate of 47 percent and the REER of 35 percent.
Over the 1980s, while India's economy grew more rapidly, its fiscal performance worsened significantly. The growing fiscal deficit spilled over into the current account, and when India was hit by a succession of external and domestic shocks at the turn of the decade, a full blow balance of payments crisis erupted. The wide-ranging reforms ushered in at the wake of the crisis attacked the plethora of economic controls that had characterized India, both on external sector and domestic policies.
The rupee was devalued by 9 and 11 percent in two stages between 1 and 3 July 1991. A new system of exchange rate management in 1992–1993, the Liberalised Exchange Rate Management System (LERMS) made the rupee partially convertible on the current account. Initially a "dual exchange rate" system was introduced to ease the transition from an onerous trade regime to a market-friendly system encompassing both trade and payments. Under this system, 40 percent of exporter receipts and remittances had to be sold to authorized dealers at the official exchange rate, while the balance were converted at the market rate, which effectively meant that export proceeds were taxed at 0.4 times the difference between the market and the official exchange rate. All capital account transactions (except IMF and multilateral flows against rupee expenditure) were also at the market rate. The success of LERMS in restoring India's external health brought enough confidence to move to a market-based exchange rate system, and the two rates were unified in March 1993.
During the 1980s, India had been losing substantial remittance receipts because of links between gold smuggling and remittances. To address this, tariffs on gold imports were lowered and gold imports gradually liberalized, which led to a shift of a substantial foreign exchange market from the underground (Hawala) to the open market.
The liberalization of the trade and payments system culminated in August 1994, with India finally accepting the IMF Article VIII; thus the rupee officially became convertible on the current account. By the end of the decade (in 2000), India replaced its draconian Foreign Exchange Regulation Act (passed in 1973) with the Foreign Exchange Management Act, moving from a system of administrative controls to a regulatory framework.
Balance of Payments
For the better part of four decades, economic policy making in India was hemmed in by the specter of balance of payments vulnerability. The second Five Year Plan, with its focus on heavy-industry import-substitution industrialization, soon ran into balance of payments problems. The formation of the India Consortium in 1958 and the International Development Association gave India access to considerable concessional foreign aid and foreign exchange. Nonetheless, a series of shocks in the mid-1960s increased India's dependence on foreign donors. As the rupee weakened, India had little choice but to accede to the pressures exercised by the consortium, devaluing the rupee in 1966.
With India's outward orientation from the early 1990s underpinned by continuing trade and payments liberalization, prudent debt management and market-determined exchange rate policies driven by the goal of maintaining competitiveness, the scope for external vulnerability has since declined. By virtually any relevant indicator—foreign debt service ratio, external debt–gross domestic product ratio, and months of current payments—India's situation has improved markedly. When storm clouds threatened, as in the aftermath of the Asian financial crisis in 1997 and India's nuclear tests in 1998, India raised funds from its diaspora: U.S.$4.2 billion from the India Resurgent Bonds issued in 1998 and another U.S.$5.5 billion from the India Millennium Deposit program in 2000.
The reversal of decades of inward-looking policy to one of gradually (but decisively) opening up the economy to external competition and acceptance of a more flexible exchange rate regime helped India to increase its share in world trade of goods from about 0.5 percent at the beginning of the reforms to 0.8 percent a decade later, and of services from 0.6 percent to 1.2 percent in the same period. India's current account receipts were especially boosted by the country's emergence as a proven powerhouse of service exports. The export of relatively unskilled services to the Middle East, coupled with outflows of skilled labor to industrialized countries, has brought growing remittances. Information technology (IT) and IT-enabled services, particularly business process outsourcing, continue to post exceptionally high year-on-year growth, and the prognosis continues to be bright. The years 2001–2002 to 2003–2004 were watershed years: the only time since independence that India has had three successive years of surplus in the current account of its balance of payments.
Capital Account Liberalization
A singular change that epitomized India's post-1991 integration with the global economy, compared to its dirigiste past, was the two-way opening of the capital account that unfolded over a decade. Growing confidence in India's balance of payments situation, as well as a different intellectual and political climate, led the Reserve Bank of India (RBI) in 1997 to constitute a committee for drawing up a road map for full capital account convertibility (CAC). It specified elaborate preconditions—indicators of vulnerability—including, among others, fiscal consolidation, permissible current account imbalances, foreign reserves cover, and a mandated inflation target. The committee recognized that the health of the financial system was particularly important, emphasizing that strengthening the financial system was an important precondition to the move to CAC. Since the release of the CAC report in 1997, all "pure" balance of payments conditions have been attained, indeed exceeded. However, two key conditions remained unmet. The fiscal deficit worsened between 1997 and 2003; and the health of the financial system improved only modestly in the absence of any serious steps toward changing incentives that were blunted by public sector ownership and the concomitant regulatory forbearance that this inevitably entailed. Nonetheless, the RBI gradually went ahead fairly single-mindedly toward CAC, driven by a realization that not moving to a more liberal CAC stance would increase reserves even more and make monetary and exchange rate management more difficult. By 2004 hardly any onerous controls on the capital account remained, other than those pertaining to short-term debt creating flows and borrowing by financial intermediaries. Most recently, Indian residents have been allowed to open bank accounts abroad.
Foreign Exchange Reserves and Its Management: From Drought to Flood
By the late 1990s, India's foreign exchange reserves began climbing rapidly, crossing an unprecedented $130 billion by December 2004, driven mainly by a respectable surplus on the current account, portfolio capital inflows, revaluation of reserves on account of depreciation in the value of the U.S. dollar against other major currencies, and continuing net inflow of nonresident Indian deposits. For decades Indian policy makers had devoted their energies to coping with an endemic droughtlike situation on foreign exchange reserves. In the new millennium they faced a completely new challenge: how to cope with a flood.
The accumulation of reserves was in part a conscious decision. With the RBI committed to liberalizing the capital account on the one hand, and the country's continued inability to address long-standing macroeconomic (especially fiscal) problems on the other, a high level of reserves had become a necessary insurance cover to counter the resulting enhanced risk perceptions of the Indian economy.
Policy circles usually adopt a normative consumption, smoothing-type approach for assessing the "appropriate" level of foreign currency reserves. Consumption smoothing occurs when the temporal profiles of income and desirable consumption do not coincide; then, by using saving and borrowing, purchasing power available in one period is transferred to an earlier (borrow) or later (save) period. Often the demand for reserves is investigated in terms of a buffer stock model, whereby the macroeconomic adjustment costs without reserves are balanced with the cost of holding reserves. Another way of looking at a reserve buildup is analogous to the precautionary motive for savings traditionally put forward. In India's case, the high level of reserves appear to have been affected by three factors: strategic considerations arising from prevailing and likely geopolitical realities; domestic political realities in India that increase its risk and susceptibility to economic shocks; and the high prospective political price that the government of the day will have to pay if the country faces an external payments crisis, that is, if the country runs out of foreign exchange reserves. Thus, India's high accumulation of reserves appears to be driven by its internal economic and political weaknesses and global uncertainties. In other words, its high reserves have been a signal that the country is compensating for its weaknesses in some areas.
Increasing foreign exchange inflows led to new pressures on the RBI. In order to maintain competitiveness, the central bank aggressively bought foreign exchange to stem upward pressure on the rupee. Unlike the past, keeping the exchange rate from appreciating to maintain India's export competitiveness emerged as a key goal of exchange rate management. The real effective exchange rate showed no depreciation on average during the post crisis period, after depreciating by an average of 2 percent per annum during the 1980s. To check the resulting liquidity growth (and contain inflationary pressures) on account of its intervention in the foreign exchange market, the RBI sought to sterilize using its stock of government bonds. However, the increased supply of perceived risk-free assets in turn contributed to crowding out bank lending to the private sector, contributing a much higher (sometimes around 40 percent) share of commercial banks' assets in government securities than was warranted by the mandated Statutory Liquidity Ratio (25 percent). By 2003, mounting foreign exchange inflows meant that even this strategy had run out of course as the RBI exhausted its holding of government bonds. This led it to establish a Market Stabilisation Scheme, comprising a "war chest" of 600 billion rupees of intervention bonds. India's failure to contain large fiscal deficits meant that the burden of coping with the impact of large foreign currency inflows from spilling over into prices and inflation has had to be largely borne on the monetary side.
Political Economy and Analytical Issues
The economic debates on India's exchange rate policies have focused on three questions.
The first concerns the relationship between trade and exchange rates. Indian economic thinking had long been characterized by "export pessimism"; however, it later became apparent that India's exports have been quite responsive to exchange rates, with short-run elasticity of about 0.7 and long-run slightly greater than 1. However, these estimates were valid for goods exports; as India's export basket becomes more services-weighted, this is likely to change. A second debate has centered around the inflationary consequences of devaluation stemming from a belief that India's import basket was relatively inelastic, especially because of India's dependence on oil imports for its energy needs. It was long argued (and not just in India) that since devaluation was inflationary, real devaluation would have little effect. However, by and large the REER has been responsive to nominal exchange rate depreciation in India, although the REER has usually been less than the nominal rate depreciation. The inflationary effects of devaluation have been muted in India by the simple reality that until very recently, India's trade sector was small, relative to the size of the economy.
Exchange rate policies affect different parts of the economy in very different ways. Consequently, they can become a major target of political conflict. Pre-independence Indian industrialists consistently argued for monetary and exchange rate policies that would afford them some degree of protection. The demand for fiscal and monetary policies that would promote their interests was seen not as mere capitalistic interest, but as a general national interest. Indian industrialists joined nationalists, insisting that the rupee was overvalued. As this lifted exports and curbed imports, it was natural for the industrialists to identify with this "nationalist" demand for a devaluation of the currency. Industrialists and nationalists pressed for a gold standard in preference to the gold exchange standard, arguing that the latter facilitated the drain from India through the mechanism of council bills and reverse council bills.
Following the breakdown of Bretton Woods, monetary policy, and especially exchange rate policy, became gradually depoliticized even as fiscal policies became more politicized. In the 1970s India's devaluation was done by stealth (under the cover of the sterling peg); by 1983 the exchange rate policies moved in the direction of a crawling basket peg. Exchange-rate management policies became increasingly overt and active by the end of the decade, when India began operating a discretionary crawling peg regime. An observer trying to understand the political economy of exchange rate management in India is faced with two puzzles: 1) why did India not adopt an undervalued exchange rate as an explicit instrument to promote its hallowed goal of import substitution industrialization? and 2) why, despite the lack of strong interest groups as well as external pressure, India's exchange rate policies in the 1970s and 1980s were reasonably sound (at least as compared to many other developing countries)? The first question is somewhat puzzling in that pre-war, India's industrialists and politicians had opposed a strong exchange rate. It is possible that the anomaly of high foreign exchange reserves at the time of independence (arising from India's contributions to the Allied war effort) led to the par value of the rupee being set too high; but once it was fixed, it was hard to change. Not only would it upset the planning process but new interest groups had formed that had a vested stake in promoting foreign exchange shortages. As regards the second question, it should be emphasized that during this period the small size of the export sector also meant that there were no strong lobbies in favor of maintaining competitive exchange rate regime. However, by the end of the 1990s, the growing importance of trade in the Indian economy and the particular economic and political importance of the IT sector meant that pressures grew from the private sector to maintain a "competitive" exchange rate.
In the new millennium, India's overflowing foreign exchange coffers have mitigated pressures to rectify India's fiscal mismanagement. In the past, when reserves were much more modest, India's policy makers were quite aware that large deficits sustained over a long period would either inevitably spill over into higher levels of inflation (if the deficit was monetized) or a balance of payments crisis (if the country drew increasingly on external savings). Since both outcomes had harsh political repercussions, it forced policy makers to act with due caution (most of the time). Now, with high levels of reserves, policy makers are much less worried about either concern. Liberalization has eased supply-side weaknesses, and monetization has not yet been seriously resorted to, thereby attenuating inflationary pressures. Indeed, the increasing disjuncture between large internal fiscal imbalances on the one hand and improving external balances on the other is analytically relatively unexplored territory in India.
Devesh KapurUrjit R. Patel
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