Let the rupee depreciate: Why Reserve Bank did the right thing in not trying to prop it up artificially
An episode from the 1950s illustrates that a failure to use the exchange rate as an instrument of macroeconomic adjustment can be costly. With the exchange rate fixed at 4.76 rupees per dollar during the 1950s, the rupee was overvalued relative to foreign currencies. This made India’s goods expensive relative to foreign goods and resulted in the import bill consistently exceeding export revenues. The gap had to be covered by running down scarce foreign exchange reserves. By early 1958, the reserve almost ran out.
Rather than devaluing the rupee to properly align the prices of domestic and foreign goods, the then government resorted to what is known as foreign exchange budgeting. Beginning with the second half of 1958, every six months the finance ministry began preparing a detailed budget of how the expected foreign exchange revenues over the following six months would be allocated across different ministries.
That process multiplied the complexity and cost of investment licensing: No licence for investment in a project could now be given unless the finance ministry allocated foreign exchange necessary to buy foreign machinery and inputs. With high inflation making Indian goods progressively more expensive relative to foreign goods, export revenues shrank and import demands expanded leading to progressive tightening of import controls.