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How India's economic interest is better served by letting rupee weaken

The Reserve Bank of India (RBI) had fought hard to hold the value of the US dollar below ₹80 in recent months, using up nearly $45 billion of its foreign exchange reserves since July 1. But it finally yielded to the pressure stemming from the latest interest-rate hike by the US Federal Reserve Board with the dollar attaining the value of ₹81 on September 22.

Many analysts view this rise of the dollar and corresponding fall of the rupee as a sign of weakness in the Indian economy. But such inference is not only wrong but also encourages policymakers to rally behind a strong rupee when the national economic interest might well be served by allowing it to weaken.

To understand how damaging wrong choices on the exchange rate can be, it is instructive to briefly digress to a historical episode going back to the 1950s. During World War 2, strong performance of Indian exports and tight controls on imports had allowed India to accumulate a large volume of foreign exchange in terms of the British pound sterling, which came to be called as the sterling balances.

After the war, as India embarked upon its ambitious Five-Year Plans, it had to resort to money creation to finance part of the expenditure, which resulted in inflation rates exceeding those in its trading partners. With the nominal exchange rates fixed at the time, the higher inflation rates made Indian products uncompetitive relative to foreign ones. Imports became more attractive while, simultaneous, exports suffered.

Evidently, this created a deficit in India's balance of payments (BoP), which had to be financed by drawing on the sterling balances. The availability of these balances proved a big blessing, since they allowed the country to import not just machinery and raw materials required for industrialisation but also consumer goods to soften the blow of inflation. Unfortunately, however, the sterling balances ran out by the end of 1957-58, and India came face-to-face with its first serious BoP crisis.

Meet Licence-Permit Raj

At this point, India had two options: devalue the rupee to make Indian goods more competitive vis-a-vis those of its trading partners, or clamp down on imports by stricter enforcement of import licensing that had been in place since the World War. At the time, devaluation was widely viewed as equivalent to admission that the economy is fundamentally weak. Therefore, there was no political constituency whatsoever for it. So, strict import licensing buttressed by exchange control became the default choice.

Many of the problems associated with the licence-permit raj that followed in the 1960s and beyond had their origins in this fateful policy choice. Even then, the government found itself compelled to devalue the rupee subsequently in June 1966. But it was too little too late by then and, moreover, the policy was ill-timed. Two back-to-back droughts effectively overwhelmed any positive effects that the devaluation could have had.

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