External sector: devaluation, convertibility, trade and investment

Detail

1. Devaluation of July 1991

• Devaluation is when the government or central bank deliberately cuts the official value of its currency. It happens only under a fixed or managed exchange rate, where the authority sets the rate.

• Under a floating rate, the market lowers the value on its own. That is called depreciation, not devaluation.

• What happened: the rupee was devalued in two steps, on 1 and 3 July 1991. The second step came after the government saw that markets reacted well to the first [2].

• Total fall: about 18.7% against the US dollar and 17.38% against the pound sterling [2] (NCERT: "about 18-19% against the dollar").

• At that time the pound sterling was the rupee's intervention currency. This means the RBI officially fixed the rupee's value in pounds, not dollars [2].

• Worked example (numbers are for illustration only):

• Before: $1 = ₹20. After: $1 = ₹24.
• The rupee price of a dollar goes up by (24 − 20) / 20 = 20%.
• The dollar value of one rupee falls from $0.050 to $0.0417, a fall of 16.7%.
• Exam trap: these two percentages are not the same. Always check which one a question asks for.
• Effect on an exporter: a ₹400 shirt used to cost a foreign buyer $20. Now it costs $16.67, so exports become cheaper.

• Effect on an importer: a $100 machine used to cost ₹2,000. Now it costs ₹2,400, so imports become dearer.

• Results (Class 11):

• Exports became cheaper and imports dearer, so the trade gap narrowed.
• It "led to an increase in the inflow of foreign exchange".
• It began freeing the rupee's value from government control.

2. The path to a market-determined exchange rate

Year	Step	What it means in simple words
March 1992	LERMS (Liberalised Exchange Rate Management System) [2][3]	A dual exchange rate: part of foreign exchange was converted at the official rate and part at the market rate. It was brought in along with other reforms in trade, industry and foreign investment [2][3].
1 March 1993	Unified exchange rate [2][3]	The two rates were merged into one market-determined rate. LERMS was only meant to be a short stage on the way to this [2][3].
August 1994	Current-account convertibility	India accepted Article VIII of the IMF's Articles of Agreement [2][3].
1999 (in force 2000)	FEMA 1999 replaced FERA 1973	The law moved from punishing forex offences to managing forex.
1997, 2006	Tarapore Committees on capital-account convertibility	Even today, the capital account is only partly convertible.

• Today: demand and supply in the market decide the rupee's value. The RBI buys or sells dollars only to smooth out sharp swings (volatility). It does not fix a target rate.

3. Convertibility explained

• Convertibility means how freely you can change rupees into foreign currency, and back, at the market rate.
• Current-account convertibility
• Meaning: freedom to change currency for current transactions. These are trade in goods and services, travel, remittances (money sent home by workers abroad), and interest and dividend payments.

• India has had this since August 1994.

• IMF Article VIII

• A member that accepts it promises not to restrict payments for current transactions.
• It also promises not to use multiple (dual) exchange rates or discriminatory currency deals.
• To accept it, India had to remove its existing exchange restrictions. Once it did, the rupee was officially convertible on the current account [4][5].
• By 31 December 1994, 98 IMF members had accepted Article VIII [4][5].

• This is why LERMS (a dual rate) had to end before 1994.

• Capital-account convertibility (CAC)

• Meaning: freedom to change currency for buying or selling assets, such as foreign shares, property, loans and bank deposits abroad.
• India allows this only partly. Limits remain on things like foreign borrowing and how much residents can invest abroad.
• Why go slow: full CAC lets "hot money" (short-term foreign money that moves quickly) leave suddenly. That is how the 1997 East Asian crisis happened.
• The Tarapore Committees of 1997 and 2006 said India should move to CAC step by step, and only after meeting preconditions such as a low fiscal deficit, low inflation and strong banks.

4. FERA 1973 to FEMA 1999

• FERA (Foreign Exchange Regulation Act, 1973) was built for a time when foreign exchange was very scarce.
• Every forex deal was banned unless the government allowed it.

• Breaking the rules was treated as a criminal offence.

• FEMA (Foreign Exchange Management Act, 1999; in force from 2000) takes the opposite approach.

• Every forex deal is allowed unless the law restricts it.
• Breaking the rules is a civil matter, settled with fines.
• The goal is to make external trade and payments easier and to help the forex market grow in an orderly way.

5. Trade barriers: what they are and why India had them (Class 10)

• Tariff
• Meaning: a tax on imports.
• Worked example (illustrative numbers): a Chinese toy costs $10. At ₹80 per $, that is ₹800. A 20% tariff raises the price to ₹960.

• Result: fewer toys are imported, and Indian toy-makers gain.

• Quota

• Meaning: a limit on the quantity of a good that can be imported.

• Quantitative restriction (QR)

• Meaning: any quantity limit on trade, such as a quota, a ban or import licensing.

• Why barriers existed

• To protect infant industries (new domestic industries too young to face world competition) in the 1950s-60s.
• Only essential goods, like machinery, fertilisers and petroleum, could be imported freely.

• All developed countries protected their own producers in their early years of development.

• Why barriers were cut (Class 11)

• QRs and very high tariffs reduced efficiency. Protected firms had no reason to improve.
• This slowed the growth of manufacturing.

6. What the trade reforms did

• Dismantled QRs on imports and exports.
• Cut tariffs sharply:
• The peak tariff was above 300% before 1991.
• It came down to 150% in 1991-92.

• By 2007-08 it was about 10% for non-agricultural goods (NCERT figure, flagged "verify"; not independently confirmed here).

• Abolished import licensing, except for hazardous and environmentally sensitive industries.

• Removed export duties, so Indian goods could compete on price abroad.
• Fully removed QRs on manufactured consumer goods and farm products in April 2001.

7. The WTO case on QRs (US vs India, DS90)

• How it started: on 15 July 1997, the US asked for consultations with India at the WTO. The US said India's QRs broke GATT 1994 Articles XI:1 and XVIII:11, the Agreement on Agriculture (Art. 4.2) and the Import Licensing Agreement [6].
• India's defence
• India had QRs on 2,714 tariff lines (tariff lines are the product categories in a country's customs list). These covered farm, textile and industrial goods [6].
• India said the QRs were allowed because of its balance-of-payments (BoP) problems, under GATT Article XVIII:B [6].

• On 30 June 1997, India offered to remove them over seven years. The US wanted it done faster [6].

• The rulings

• The Panel report (6 April 1999) found India's QRs broke WTO rules [6][7].

• The Appellate Body agreed in its report of 23 August 1999 [8]. It rejected the BoP justification, because India's reserves were no longer at crisis level.

• What India did: on 5 April 2001, India announced it had removed QRs on the remaining 715 items. This met the WTO's ruling [6].

8. Foreign direct investment (FDI) reforms

• FDI means a foreign company invests in an Indian firm to own a lasting stake in it and have a say in how it is run. FPI (foreign portfolio investment) is different: it is buying shares mainly for financial return.
• 1991: foreign investment up to 51% was approved automatically in 34 high-priority industries. This was later widened to most sectors.
• Two routes for FDI:
• Automatic route: no prior government approval is needed. The investor only informs the RBI.
• Government route: prior approval is needed.
• Today most sectors allow 100% FDI under the automatic route. The exceptions are a few strategically important sectors [9].

• More than 90% of FDI inflow comes through the automatic route [9].

• FIPB (Foreign Investment Promotion Board)

• It handled government-route cases from 1991.
• The Union Cabinet approved its abolition on 24 May 2017 [10].
• After that, approvals went to the ministries in charge of each sector. DPIIT (Department for Promotion of Industry and Internal Trade) became the nodal department [10].

• Proposals were first filed on the Foreign Investment Facilitation (FIF) Portal [10]. All proposals needing government approval are now filed on the National Single Window System (NSWS) portal [11].

• FDI inflow trend [10]:

• USD 45.15 billion (2014-15)
• USD 60.22 billion (2016-17)
• USD 83.57 billion (2021-22)

9. Cross-references

• Devaluation vs depreciation, and REER, are covered in the balance-of-payments / exchange-rate note.
• WTO commitments are covered in the international-trade-policy note.

Prelims Hooks

• The July 1991 devaluation took place in two steps (1 and 3 July). It was about 18.7% against the dollar and 17.38% against the pound sterling, which was the intervention currency then [2].
• LERMS (March 1992) was a dual exchange rate system. The unified, market-determined rate started on 1 March 1993 [2][3].
• Current-account convertibility (August 1994) came when India accepted IMF Article VIII, not Article XIV [2][3].
• Trap: India's rupee is fully convertible on the current account but only partly convertible on the capital account.
• Tarapore Committees (1997 and 2006) dealt with capital-account convertibility, not current-account convertibility.
• FEMA 1999 (in force 2000) replaced FERA 1973. Forex violations became civil matters instead of criminal ones.
• WTO dispute DS90 (US vs India) involved QRs on 2,714 tariff lines justified on BoP grounds (GATT Art. XVIII:B). India lost, and the last 715 items were freed on 5 April 2001 [6].
• FIPB was abolished in May 2017. DPIIT is now the nodal department, and proposals go through the NSWS portal [10][11].
• Exam trap: if the rupee goes from ₹20/$ to ₹24/$, the dollar becomes 20% dearer, but the rupee loses only 16.7% of its value.

Mains Points

• Devaluation worked in 1991 only because other reforms came with it.
• Without the trade reforms, cheaper exports could not have raised export volumes.

• The move from a devalued fixed rate (1991), to a dual rate (1992), to a market rate (1993) shows careful sequencing, a lesson for other countries in crisis.

• Slow, step-by-step capital-account convertibility is a trade-off.

• It shielded India from the 1997 East Asian crisis and from sudden outflows of hot money.
• The cost is less access to foreign capital and a less developed market for the rupee.

• The Tarapore conditions (fiscal discipline, low inflation, strong banks) are still the test.

• Trade liberalisation was partly forced from outside.

• India lost the DS90 case once its reserves recovered, which ended the BoP excuse for QRs.
• This shows how the WTO limits policy space (GS-II: international institutions).

• It also raises the question of how to protect farmers and small firms once QRs are gone. Tariffs and trade remedies are the tools left.

• FDI moved from case-by-case control to mostly automatic approval.

• The 51% automatic limit in 1991 grew to 100% automatic in most sectors, over 90% of inflows now use the automatic route, and FIPB was abolished in 2017.
• These changes improved ease of doing business [9][10].
• Debates continue over strategic sectors, keeping a check on the national-security side of investment, and whether FDI actually brings in technology and creates jobs.