Sunday, August 12, 2012

Journey of the Rupee- 1947-2012

The below article is intended to get an idea of how the rupee has traversed from 1947 until now. This has been written such that a common man can understand without being an expert in economics. However, with this intent the article tries not to cover too many factors or terminologies that can go too deep into economics. Hence, it is a brief explanation of the currency.
Each market sentiment that can control the rupee can be written and explained at lengths running into several pages. I have tried to simplify as much as possible.

Some basics:

Every country has a currency and the currency rate also known as exchange rate is always relative to some other currency or object such as gold. No currency rate stands in isolation. In the early 19th century gold was that object to which currency was evaluated.

1) When the value of any currency increases w.r.t other currencies then the currency is said to be appreciated. An appreciated currency for that country means its imports become cheaper and exports doesn't fetch good money.
2)  When the value of any currency w.r.t other currencies then the currency is said to be depreciated. A depreciated/devalued currency means imports get costlier and exports fetch good money/profits. So, if a country exports more than it imports, then to fetch profits it can devalue its currency. Say if the country feels that its exports are not fetching a good value it can resort to devaluation.

As an example, say Indian rupee v/s Dollar. 1$ = 4 Rs. Now, if India changes to 1$= 10 Rs. then anything India exports to other countries would fetch it a good value, but all that India imports would become expensive.

Note: Excessive devaluation or Excessive appreciation is not good for any country.

Note: Every country has tools and reasons why it would want to appreciate or depreciate its own currency. The explanation of these is beyond this blog article. All countries have done one or both of these many times to suit their economic interests.

If one wants to read more about what affects exchange rate one can read here.

Quickly 3 more terms below:

Current Account = imports value + exports value.
If the sum is +ve then it is SURPLUS and if -ve then it is DEFICIT.

Capital Account = amount of foreign ownership of domestic assets - amount of domestic ownership of domestic assets.

Balance of Payment (BoP)= Current Account + Capital Account.
if  (BoP) is +ve, good for the country.

In case of India - in 1966 and 1991 BoP was too negative to withstand.

A little background on how Dollar became the world's currency:

Post World War II, US had the highest manufacturing capacity in the world, which meant it was the largest exporter in the world at that time. So, almost the entire world depended upon US goods. So, its currency was very critical in world economy. Till 1944 US evaluated its currency to price of gold. The reason being US had the highest gold content. So, the dollar was tied to gold and it was $35 for an ounce of gold. In 1944 US had so much influence on world economy that almost all countries agreed to follow fixed rate system for their currency and their currency was tied to the dollar. The dollar in turn was pegged to gold. In other words this is what happened to India in 1947. 

1) Although India's currency was tied to UK's Sterling, US dollar continued to play a role and almost all country's currencies were pegged at gold (gold price itself was in Dollars). 
2) India made its currency fixed rate regime.
3) Fixed rate regime helped US because it knew it would get a predicted value for the goods it exported to India and no fluctuations means their profit was secured.
4) For India, it meant inflation could be kept low.
5) Unlike today where the dollar-rupee fluctuates daily, the fixed rate made the fluctuation almost once a  year or once in 2 years.

So, with this background let us read some significant events in Indian rupee history post independence.

1947: 1 Rs =1 Sterling.

1948-1966: 1 US$= Rs.4.79
With its economy growing, high industrial growth, high agricultural growth and high foreign currency (Sterling and US dollar) India was somehow able to prevent any financial crisis. However, India being under a fixed rate regime account deficit began to build. Read below to understand both these terms.

1966: 1 US $= Rs. 7.50
India had fought war with Pakistan. Just within 5 years India fought two wars with its neighbors(1962 with China and 1965 with Pakistan) and this had drained a lot of money and had built up huge deficits - meaning it imported more than exported and to pay for its imports it did not have money at all. Due to its war with Pakistan, US cut off all its aid to India. The only condition under which India could get the world aid and more specifically US aid was if India devalued its currency.

India like many other developing economies at that time was under a fixed rate regime. Under a fixed rate regime the government or its central bank always ensures that the currency remains at a constant rate (subject to some small percent of tolerance). The main advantage of fixed rate regime is that it ensures that the country's currency rate is fixed that exhibits stability so that other countries which want to invest in it can do so without thinking of any fluctuations. It also helps to keep inflation low. This system worked for India for some good amount of time mainly because a) there was good amount of foreign aid or money into the country b) most people were poor and fixed rate helped in maintaining a low inflation.

In economics or in politics there is no one mechanism to solve a problem. Economics is far more dynamic than one can think. In 1966 the industrial production and agricultural production was very low. Companies or private sector companies (handful then) showed negative growth. The govt could not borrow from it either. A drought in several parts of the country in addition to the wars had caused huge demand for goods, but less supply situation thereby causing high inflation. Since India was under a fixed rate regime high inflation made its goods more expensive. So, say if US or UK were to buy Indian goods they had to shell out more dollars or pounds respectively.  For more on fixed rate one can read this article here

In a fixed rate regime the country has to have sufficient foreign currency since it should have the capacity to absorb or supply the currency in the market. That is why in a fixed rate regime the country has to stock foreign currency. In India in 1966 this particularly was the opposite. There was no foreign currency left.

[Why adequate foreign currency is required in a fixed rate regime?

Say, for some reason in India there is excess demand (less supply) for dollars. Now, the RBI must not allow the fixed rate to change. So, it starts selling dollars/supplying dollars into the market to meet demand in exchange for Rupees. By doing so, the foreign currency depletes. Beyond a level the depletion can smell doom.

On the other hand if there is excess demand for Rupee, RBI can absorb it by selling/supplying rupees for dollars thereby building up foreign currency.

So, one can see depending upon how demand and supply change RBI must do this to keep the fixed rate as fixed. This is not sustainable since the country cannot always be assured of foreign currency/reserves in its hand.]

Now, look at the precarious situation India was put into in 1966. High inflation, low production, low amount of money to pay for its imports and its exported goods are expensive for US and UK. To make matters worse India asks for US help. Under these circumstances US asked India to devalue its currency so that its goods can become cheaper for US in exchange for its aid. US supplied India wheat which was so much necessary for the very survival of India. So, Rupee was now - 1 $= 7.57 Rs.

Aug 1971: Rupee's link with Sterling broken; tied to US Dollar directly

Dec 1971 : Dollar devalued, Rupee tied to Sterling again.
US devalued its own currency because of its own economic crisis. Subsequently all other currencies were affected. India instead of devaluing its currency broke its ties with Dollar and linked back with Sterling because Sterling was more stable.

1975:  1$ = Rs.8.39 
India links rupee to 3 currencies with a margin of 5% - Dollar, German Mark, Japanese Yen. No longer Sterling was important to India.

1985- 1$ = Rs.12

1991: 1$ = Rs.17.90
Just like in 1966, 1991 was a year where India saw high inflation, low industrial and agricultural output, low foreign reserves. It had become so bad that India had money to pay only 3 weeks worth of imports. India still continued to be a big importer than exporter. India never encouraged exports openly; no incentives were given. Everything that was imported had high tariffs and licenses. All these made imports expensive and with no foreign reserve left .India had to devalue its currency just to ensure foreign currency and goods flood the market (since devaluation would make other countries export more to India in lieu of getting better money/value for their goods).

1993: 1$ = Rs. 31.37
Indian rupee was finally floated. So, fixed rate regime ended and rupee now began to flow with the market sentiment. In a floating rate regime the market forces determine the value of a currency. However, if the rupee floats beyond acceptable limits RBI can step in to control it. The floating rate cannot ensure inflation  be kept under check. However, the market confidence in the economy wholly determines it. Market confidence depends on how the government opens up channels for increaseing competition and capital flow from outside. In the early years the confidence in the economy began to increase. This led to currency remaining in the 30's.

Because of this devaluation imports became costly and exports fetched a higher value. These profits in turn were used to offset the high cost of imports and Indian goods became competitive (watches, motorcycles, cars etc).

Early 2000-2005:- 1$= Rs. 44-45
This period India saw high growth, high industrial production, high growth of software services, huge inflow of dollars. This helped Rupee be stable. Huge capital inflows, high foreign direct investment created foreign reserves enough to balance current account deficit. Basically there was a greater confidence in economy and a lower rupee boosted export profits. With the removal of licenses and tariffs imports became cheaper.

2006-2007: 1$ = Rs.39
High growth of 9% made dollars flood even more. So, to contain the flow of dollars, RBI allowed rupee to appreciate. The excess money was what UPA 1 Government used for Rural Employment, Farm loan waivers etc.

2008-09 1$ = Rs.49-50
This was because dollars began to deplete due to global economic crisis and India was able to register high growth because of domestic savings and consumption.

2010-12 1$ = Rs 50-Rs.56
In the last 2 years the government did not begin to find methods to make foreign investment any easier. High inflation and high interest rates made borrowings expensive. India still continues to be a huge importer. The largest component that India imports is crude oil. Crude oil is dependent on global markets. However, the government continues to subsidize kerosene and other products to poor people causing a huge deficit to build. Unless foreign capital is brought in this would be unstable. It is simple economics that it is wise you spend more only if you can find ways to earn even more. However, with not a single positive step to revive the economy and keeping away from tough decisions has made the economy unstable at this time.

The range of Rs.40-45 is stable for Indian exports and imports. Any further devaluation/appreciation is a big problem.

India will never switch back to fixed rate since it is unsustainable. Floating rate regime is suited since government or RBI intervenes only if necessary. No one can truly understand the floating exchange rate dynamics, however certain indicators as explained above give a pattern of where the rupee is headed to. The most important aspect of policy making must be to attract money so that they build up a reserve and then use the reserve to bring equality in society. Unfortunately, the very man who started the economic liberalization is unable to revive the economy. The readers know who I am referring to - Dr. Manmohan Singh.

The band or range within which rupee fluctuates is very important. A drastic appreciation hurts exports and a drastic depreciation hurts imports.

One must note that the RBI can only act as a facilitator but the real market is run by stockholders and investors and they go by confidence index of the country's economic policy.

References:

Link1
Link2

7 comments:

Unknown said...

gud effort.. nice article.. people like me can understand things better.
I like the way u explain it to me.

Anonymous said...

Nicely explained in simple language.
great work

king said...

good work in a clear description .

Likith said...

I assume Dr. Manmohan is doing intentionally, they understood the dynamics of elections in India totally, where people won't vote for less money (say, 100/- to 500/- ) the bandwidth or Range has become more costlier for politicians to compete against each other with truth,sincerity and respect on our democracy with huge difference roughly say around 2000/- to 5000/- per vote... Now you tell me where the money comes for these politicians where they consider foreign banks as safe havens and power of fluctuating the currency is in their hands. So, they are making sure from last 2 years much of exports does take place and the more money exchange come in , more money to lure voters and thus accomplishing their political needs.... Our currency is very much intentionally controled thus no effective policies from Dr. Manmohan Singh... So, does the bad for india !

Banke Exchangerates said...
This comment has been removed by the author.
Banke Exchangerates said...

Thanks for this great article! Very well done and insightful.

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Arianna said...

My cousin recommended this blog and she was totally right keep up the fantastic work!


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