Since Independence in 1947, India has faced many major financial crises; two of them, in 1966 and 1991, have resulted in the deliberate devaluation of the Indian Rupee by the Indian government.
But first, let us see what is Devaluation of a currency?
Consider this, today you could buy 1 USD for about INR 73. Tomorrow if this exchange rate changes to 65, you will be able to buy 1 USD with fewer INRs. INR would be said to be strengthened then. Conversely, if you were to pay more to buy 1 USD (or any currency for that sake) it would weaken the INR.
Devaluation refers to this weakening of any currency.
Devaluation is often a monetary policy tool used by countries that have a fixed exchange rate or semi-fixed exchange rate.
India follows a semi-fixed exchange rate or managed floating exchange rate, a system in which the exchange rate is determined by free-market forces (demand and supply forces), which can be influenced by the intervention of the central bank in the foreign exchange market.
But why devalue your own currency in the first place?
There are three main reasons for devaluing a currency:
1. To boost exports: A weaker currency makes exports cheaper for the buyer. This helps increase foreign trade.
2. To shrink trade deficits: A trade deficit occurs when a country’s imports exceed its exports, it leads to rising debt of the nation, destroying the whole economy.
3. To reduce sovereign debt: A devalued currency helps reduce the regular service burden for Sovereign Debt issued by a country if investments are high from FIIs and interest to be paid are fixed amounts.
The rest of the time, the reasons are purely political — a country in debt, or needing some sort of global political support, is often forced by the lending or a dominant country to devalue its currency to benefit local businesses.
Let us see what happened in India’s case.
Devaluation of 1966
Since the 1950s India has suffered from a negative balance of payment (the difference between all money flowing into the country in a particular period and the outflow of money to the rest of the world).
The main reasons for devaluation were the huge trade deficit, India — Pakistan war, and the drought in 1965.
So to improve the trade deficit, India’s currency was devalued for the first time in June of 1966 by Prime minister Mr. Lal Bahadur Shastri.
Consider the impact — USD was pegged at INR 1 in 1947. In 1967, this fell to above INR 7.
Devaluation of 1991
From 1985–1990, India found itself in serious economic trouble. In 1991 India faced a large government budget deficit and for decreasing this deficit, the government devalued its currency by 18 to 19%.
The main reasons for devaluation were huge gross fiscal deficit, inflation, and rise in oil prices, etc. The effect of this devaluation made the exchange rate 1 USD to 25.92 INR in 1992.
Benefits of devaluation
A devaluation of the currency will make exports more competitive and economical to foreigners.
The current account deficit is the difference between exports and imports. Because of devaluation, imports decrease and exports rise. These situations reduce the current account deficit.
Devaluation benefits agriculture. India is the world’s largest producer of wheat. So fall in the value of the rupee increases the profit of Indian wheat exporters and similarly the export of sugar, rice, cotton, and edible oil, etc. are increased.
Foreign investors bear a loss when the value of a currency is devalued.
After the devaluation of the currency, the inflow of foreign direct investment has increased. After the devaluation of the rupee in 1991, the inflow of FDI increased from 409 crores to 64,193 crores.
Downside of Devaluation
Devaluation causes necessity items like fuel, food, and raw material to become more expensive. It reduces demand for imports and increases the demand for domestic goods.
Devaluation hurts the infrastructure sector. It increases the cost of projects by increasing the cost of raw materials like steel, cement, and the price of construction equipment, wages, etc.
Furthermore, devaluation can also increase uncertainty within the market. The market uncertainty can negatively affect supply and demand due to a lack of consumer confidence, causing a potential recession over time. Moreover, devaluation may also spark trade wars.
All in all, devaluation is a double-edged sword best used with caution.
Originally published at https://blog.prospareto.com.