Foreign Exchange Reforms

The reform of the foreign exchange market was the first important reform undertaken in the external sector. It was closely tied to the immediate crisis that India faced in 1991.

The 1991 devaluation:

In 1991 the country was in the grip of a serious balance of payments crisis — it was running dangerously short of foreign exchange to pay for its imports and meet its external obligations. As an immediate measure to resolve this crisis, the rupee was devalued against foreign currencies. Devaluation means officially lowering the value of the rupee in terms of foreign currencies.

Why devaluation helped:

Lowering the value of the rupee made Indian goods cheaper for foreigners and made holding rupees relatively less expensive to acquire, which encouraged an increase in the inflow of foreign exchange into the country. This eased the immediate shortage of foreign currency.

A lasting change in how the rupee's value is set:

Beyond solving the immediate crisis, the 1991 devaluation set the tone for a deeper, more permanent change. It began the process of freeing the determination of the rupee's value from government control. Earlier, the government largely fixed the exchange rate. After the reforms, the value of the rupee has, more often than not, come to be determined by the market — that is, by the demand for and supply of foreign exchange. When the demand for foreign currency is high relative to its supply, the rupee tends to weaken, and when the supply is ample, the rupee tends to strengthen.

Significance: …