1991 Crisis: Devaluation of Rupee

The past few weeks have seen a lot happening in the world economy; Russia-US sanctions, European crisis scare with Italy slumping into recession, Argentina debt default and the Reserve Bank of India Governor Raghuram Rajan cautioning about another global financial crisis. These events lead to a round of discussions with my friends. One such discussion was about the 1991 Economic Crisis of India.

There was a huge current account deficit and the coffers were empty. One major cause of current account deficit was imports being more than the exports. There wasn’t enough foreign exchange left even to import even 3 weeks of supply. So in 1991, former PM and the then Finance Minister Manmohan Singh, in his historic budget, brought liberalization reforms and devalued the rupee twice in 3 days.

While most of my friends had a fair idea about the LPG policy, the continual reforms and their impacts on Indian economy, just a few knew that the Indian currency ‘Rupee’ was devalued and even fewer knew ‘why?’

In this post, I have tried to shed some light on this lesser known event of the 1991 Crisis, the devaluation of rupee.

A prelude:

The primary reason for the crisis was the growing fiscal imbalances over the 1980s. Following the Gulf War, India’s oil import bill swelled, exports slumped, credit dried up, and investors took their money out. Large fiscal deficits eventually lead to huge trade deficits and India was on verge of defaulting on its external payments obligation. By the end of 1990, India was in serious economic trouble. The Indian Rupee was under severe pressure and demands for devaluation were growing. RBI first tried to avoid the devaluation but later, the Indian government permitted a sharp devaluation that took place in two steps within three days (1 July and 3 July 1991) against major currencies.

What is devaluation?

‘Devaluation’ means official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority (The Government) formally sets a new fixed rate with respect to a foreign reference currency. Until 1993, India followed a fixed exchange rate system where Rupee was pegged against 4 world currencies (USD, Pound Sterling, Deutche Mark, and Yen). In 1993, it was changed to floating exchange rate where the market forces decide the value of the currency (Rupee).

When is a currency devalued?

If a nation depletes its foreign currency reserves and finds that its own currency is not accepted abroad, the only option left to the country is to borrow from abroad. However, borrowing in foreign currency is built upon the obligation of the borrowing nation to pay back the loan in the lender’s own currency or in some other “hard” currency.  India borrowed $2.2 billion from the IMF in lieu of 67 tonnes of India’s gold reserves as collateral.

The destabilizing effects of a financial crisis are such that any country feels strong pressure from internal political forces to avoid the risk of such a crisis, even if the policies adopted come at large economic cost. The political instability in India during the late 80s and early 90s was the perfect stage for such imperfect policies which do more harm than good in the long run.  The market for a nation’s currency was too weak to justify the given exchange rate, that is, the price the market was willing to pay for the currency was less than the price dictated by the government.

A weaker rupee makes the imports costlier and we didn’t have enough money to import. So how does it make sense?

India’s current account deficit and drying exports were one of the few prominent reasons that led to the crisis of 1991. Why were the exports down you may ask. Because India’s only major trade partner before 1991 was Soviet Union. With its disintegration in 1991 and the subsequent turmoil in the region, India was left with no one to sell to. Moreover, India’s exchange rate was fixed before 1991 and when the exchange rate is fixed and a country experiences high inflation relative to other countries, that country’s goods become more expensive and foreign goods become cheaper.  Therefore, inflation tends to increase imports and decrease exports.  By devaluing the rupee against the basket of currencies, the government made exports more profitable and the foreign goods expensive, which in turn helped to bring down the current account deficit to some extent. This combined with the loan from IMF, the opening up of the economy and the subsequent reforms over the years helped India get out of the rut of 1991.