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MEBE0029

MEBE0029

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Published by Danish Ahmad

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Published by: Danish Ahmad on Jun 15, 2012
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India’s Forex Reserves
AfteritsindependencefromtheBritishin1947,Indiaformulatedallitseconomicpoliciesontheobjective of attaining self-reliance. The Indian government economic reforms helped India toaccumulateforeignreservestoashighas$100billionbytheendof2003.Toattainproductivityandself-efficiency, the government realised the need to attract foreign capital to India. To encourageforeigninvestment,thegovernmentintroducedmanyreformsandpolicies,startingwiththeIndustrialPolicy Statement of 1948 and the Five Year Plans in 1951. The First Five-Year Plan aimed atindustrialisation of the country, which required importing a lot of machinery. In 1957, increasingimports led to balance of payment crisis, which was financed by using the foreign reserves. In the1960s, the Indian foreign reserves declined after the war between India and Pakistan. In the mid-1960s, the food prices increased due to severe droughts in the country. Further there was increaseinthepricesofoilimportsintheearly1970sandtheforeignreserveswereusedtomaintainstabilityin the economy.TheintroductionofForeignExchangeRegulationActin1973helpedIndiatobuildupitsforeignreserves. In the late 1970s, the prices of oil increased again. In 1980, the deficit in India’s tradeaccount had tobe financed bytakingloanfromthe IMF. In 1990,the Gulf war led toincrease in oilprices, which resulted in a balance of payment crisis in India. India did not have enough foreignreserves to fund this gap and it had to approach IMF for financial aid. In 1991, India devalued itsrupee, followed by changes in its exchange rate regime. The exchange rate regime is the way a
“As per the lease agreement dated 15th May, 1991 entered into between Government of India (GOI)and State Bank of India (SBI), GOl leased to SBl, 20 metric tonnes of gold to raise foreign exchangereserves expected to be of the order of $200 million.”
1
– Mr. Rameshwar Thakur, Minister of State for Finance, India
This case study was written by Bhavika N under the direction of G Srikanth. Revised (in september 2009) by Hepsi Swarna, IBSCDC.It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of amanagement situation. The case was compiled from published sources.© 2004, IBSCDC.No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoeverwithout the permission of the copyright owner.
Ref. No.: MEBE0029
1
Murali D., “When pauper turns prince, there are new worries”, http://www.blonnet.com/2003/01/18/stories/ 2003011800040800.htm, January 18
th
2003
 
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India’s Forex Reserves
2
country manages its currency in respect to foreign currencies and the foreign exchange (Forex)market
2
.Floatingexchangeratesystemisthemostcommonexchangerateregimesintodaysworld.Infloatingexchangeratesystem,acountry’scurrencyissetbytheforeign-exchangemarketthroughsupplyanddemandforthatparticularcurrencyrelativetoothercurrencies.FloatingexchangerateschangefreelyandaredeterminedbytradingintheForexmarket.USdollar,Euro,PoundandYenallfloat. Whereas under fixed or pegged exchange rate regime, the exchange rate is fixed by thecentral government,and thecurrencyis tiedto another currencyor gold,and the currencymoves intandemwiththecurrencytowhichitistied. “TheexchangerateinIndiahadnotbeenfullyfloatinguntilthefinancialyear1992-1993.Evenafterthistheexchangeratemarkethasrequiredinterventionon many occasions by the Reserve Bank of India that sold US dollars in the spot and forwardmarkets...Theexchange rateregimeinIndiacan bestbecharacterisedas intermediate,i.e.betweenfully managed and freely – floating regimes.”
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This holds true for other countries also, as “Mostcommonexchangerateregimeadoptedbycountries,includingindustrialcountries,isnotafreefloat.Most of the countries have adopted intermediate regimes of various types, such as, managed floatswithnopre-announcedpath,andindependentfloatswithforeignexchangeinterventionmoderatingthe rate of change and preventing undue fluctuations. By and large, barring a few, countries have‘managed’ floats and Central Banks intervene periodically. This has also been true of industrialcountries. In the past, the U.S., the EU and the U.K. have also intervened at one time or another.”
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Foreign Exchange Reserves through theYears
ImmediatelyafterIndia’sindependence,theEconomicProgrammesCommitteeoftheCongressParty presented the Industrial Policy Statement of 1948 (IPS 48). The IPS 48 stated that foreigncapitalwasanimportantresourceforIndia,whichwouldhelpbringindustrialisationinthecountry.Later, on April 6th 1949, Jawaharlal Nehru, the first Prime Minister of India, submitted a policystatement on foreign capital to the Indian Parliament. This document stated the role and place of foreigncapital inexplicit terms.The PlanningCommissionwas establishedin 1950,to developthenation’seconomicconditions.ThePlanningCommissionintroducedtheFive-YearPlans.TheFirstFive-year Plan (1951–1956)aimed at raisingdomestic savings andbringingindustrialisation in thecountry.DuringtheFirstPlanthebalanceofpaymentdeterioratedasthecountryimportedmachineryand other producer goods to encourage industrialisation. The gap in the balance of payment wasfinanced by usingthe sterlingbalances.
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In 1957, as India entered the Second Five-Year Plan, it had a shortage of foreign exchange. Thecountry did not have enough foreign exchange balance to fill in the trade deficits. Recognising theneed for foreign exchange, the government entered into an agreement with the IMF in February
2
In the foreign exchange market one currency is traded for another. In Forex market banks, speculators, multinational corporationsand other financial institutions easily buy and sell currencies. The Forex market like any other market is governed by the law of demand and supply. Demand and supply of a currency in the Forex market determines the exchange rates.
3
Agarwal N.R, “Exchange Rate Determination in India Endogenising Foreign Capital Flows and Some Entities of theMonetary Sector”, http://www.iegindia.org/dispap/dis13.pdf, page 2 and page 4
4
Exchange Rate Management: An Emerging Consensus?- Part I", http://www.banknetindia.com/banking/jalan2.htm
5
India had accumulated sterling balances from Britain during the pre-independence period.
 
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3
India’s Forex Reserves1957forfinancialaid,whichwassoonexhaustedbyJune1957.InthesameyeartheIndiangovernmentapproached the US and the World Bank for loans. To receive these loans, the government had totake measures to facilitate foreign investment. In 1958, India received a credit of more than $600million from the US, Germany, Britain, Japan, the World Bank and the IMF.
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Thereafter Indiancollaborationwiththewesterncompaniesincreased.Around150,380and403foreigncollaborationstookplacein1959,1960and1961respectively.Thetotaloutstandingforeigninvestmentwhichwas$1.007billioninDecember1956,increasedto$2.014billionbyMarch1965.
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To promote foreign investment in India, the Indian Investment Centre was set up in 1961. It hadoffices in major investing countries. In the early 1960s, India had accumulated trade deficits. TheGovernment of India also had a budget deficit problem. In 1962, the government subsidised theexports, as a step to reduce the current account deficit. Import tariffs were imposed to increase thegovernmentsrevenue.Thegovernmentalsotriedtoincreasethemoneysupply,byissuingbondstothe Reserve Bank of India (RBI). By taking these measures the government tried to maintain theexchange rate, though the inflation was increasing. In 1964, the World Bank submitted a report onIndianeconomicpolicy.ThereportstatedthatIndiashoulddevaluetherupeeandabolishtheforeigntrade controls. In 1965, a financial aid fromAmerica was suspended, due to the war between Indiaand Pakistan. India also suffered due to two years of drought in 1965 and 1966.Finally in June 1966, India devalued the rupee by 57.5%, from 4.7 rupees to 7.5 rupees perdollar
8
(One British Pound = 2.754 US dollars in 1966). The devaluation was accompanied byliberalising the import policy. The import tariffs were reduced and the export subsidies werelowered.Thedevaluationwasunabletoincreasetheexportsofthecountrybecauseoftheabolitionof subsidies. In five months after the devaluation, India receivedan aidof only$465 millionfromthe World Bank. The aid of the World Bank was made on the condition that India would devaluethe rupee. “If we had waited another six months, we would have had absence of imports inIndia”
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said the then Finance Minister Sachindra Chowdhury, when he was asked as to why thegovernment did not wait for another six months before going for devaluation. But again by1968,theliberalisation policywaschangedand theimportcontrols werere-imposed.Further,in ordertopromoteexportsofnon-traditionalgoodslike,engineeringgoods,chemicals,plastics,papergoods,sports goods and processed foods, many schemes were started. These schemes included the dutydrawbackscheme
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, import replenishmentscheme
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and cash assistance schemes. These schemesdiversified the structure of the exports. The exports of engineering goods increased during themid-1960s. But many of the engineering firms were started with foreign collaborations and their
6
“The Bank and 1957 Forex Crisis”, http://www.ieo.org/world-c2-p2.html
7
Ibid.
8
Panagariya Arvind, “India in the 1980s and 1990s: A Triumph of Reforms”, http://www.imf.org/external/np/apd/seminars/ 2003/newdelhi/pana.pdf, November 6
th
2003, page 14
9
“The Bank and 1966 Forex Crisis”, http://www.ieo.org/world-c2-p3.html
10
A duty drawback scheme is a form of Border Tax Adjustment whereby the duties or taxes levied on imported goods arerefunded, in whole or in part, when the goods are re-exported.
11
Import replenishment scheme enabled registered exporters to obtain raw materials, components and spares against export of specified products.

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