CHAPTER VI

INFLATION AND BALANCE OF

PAYMENTS (BOPs)

6.1 Introduction

6.2 India’s Merchandise Trade with the rest of the

World

6.3 India’s Merchandise Trade and Inflation

6.4 Phase II: 1951-1969

6.5 Phase III: 1969-1991

6.6 Phase IV: 1991-2009

6.7 Impact of inflation on export and import quantity

6.8 Inflation and the exchange rate:

6.9 Inflation and the foreign exchange reserves

6.10 Devaluations of the Rupee and inflation

168

CHAPTER VI

INFLATION AND BALANCE OF PAYMENTS (BOPs)

6.1 Introduction

Inflation not only creates problems within the economy, but also

in the sphere of external trade of a country, that is, country’s trade

balances with the rest of the World. Country’s trade relations with the

other countries involve exports and imports of goods and services and

how much a country will export and import depends, amongst other

thing, on the domestic price level and variation in it, that is, the rate of

inflation.

Country’s transactions with the other countries, which are

recorded in balance of payments (BOPs), get adversely affected if the

domestic price rise is high. High rate of inflation in the domestic

market makes domestic goods unattractive to the foreigners and

therefore, reduces demand for exports. Moreover, because of high

domestic prices, residents prefer to buy foreign goods which implies

increase in imports. The result of falling exports and increasing imports,

on account of high domestic inflation, is the adverse disequilibrium in

the BOPs which, if not kept within limits, can assume serious

proportion and spell a BOPs crisis.

The BOPs crisis, which India experienced in 1991, was of a

similar nature. Policy mistakes in the form of high and unsustainable

fiscal deficit financed through creation of new money led to

unprecedented growth in money supply. The resulting inflation

entailed high growth in imports than exports and finally, led to a very

serious BOPs crisis involving steep decline in foreign exchange

reserves and possibility of default on external payment front.

169

Therefore, it makes perfect sense to study the correlation

between the rate of inflation and some important components of BOPs

like growth in exports and imports, trade balance, exchange rate of the

currency and foreign exchange reserves. This chapter makes an attempt

towards this end.

The relationship between the rate of inflation and different

constituents of BOPs is however more complicated, with both the sides

having impact on each other. In other words, inflation not only affects

the constituents of BOPs, but it can get affected by changes in the latter.

For instance, an upward movement in the price of an imported raw

material will raise the cost of production in those sectors where the raw

material is used and cause prices of finished products to move up.

Similarly, change in the exchange rate of the currency can impact

domestic inflation by changing the import prices. Thus, the relationship

between rate of inflation and different constituents of BOPs is more

complicated than is usually perceived. In this chapter, however, an

attempt is made to ascertain whether any correlation exists between the

two or not instead of studying the cause and effect. The study of

correlation can however indicate the cause and effect relationship that

may exist between the rate of inflation and the different constituents of

BOPs.

6.2 India’s Merchandise Trade with the rest of the World:

For studying the correlation between the rate of inflation and

BOPs, the trade account (balance of trade) of the BOPs is considered.

This is done to make a logical comparison between growth in exports

and imports of goods and changes in trade balance with the WPI

inflation, as the latter does not trace the changes in prices of services.

170

The following table shows the overall payments position of India

on trade account.

Table No. 6.1

KEY COMPONENTS OF INDIA'S BALANCE OF PAYMENTS

(Rupees crore)

Year

I.

Merchandise

Exports,

f.o.b. ( A)

Variation in %

I.

Merchandise

Imports,

c.i.f. (B)

Variation in %

I. Trade

balance

(A-B)

Variation in %

1950-51 647 650 -3

1951-52 730 12.8 964 48.3 -234 7700

1952-53 602 -17.5 633 -34.3 -31 -86.8

1953-54 540 -10.3 592 -6.5 -52 67.7

1954-55 597 10.6 690 16.6 -93 78.8

1955-56 640 7.2 773 12 -133 43

1956-57 635 -0.8 1102 42.6 -467 251.1

1957-58 669 5.4 1233 11.9 -564 20.8

1958-59 576 -13.9 1029 -16.5 -453 -19.7

1959-60 633 9.9 932 -9.4 -299 -34

1960-61 631 -0.3 1106 18.7 -475 58.9

1961-62 668 5.9 1006 -9 -338 -28.8

1962-63 681 1.9 1097 9 -416 23.1

1963-64 802 17.8 1245 13.5 -443 6.5

1964-65 801 -0.1 1421 14.1 -620 40

1965-66 785 -2 1368 -3.7 -583 -6

1966-67 1087 38.5 1991 45.5 -904 55.1

1967-68 1260 15.9 2062 3.6 -802 -11.3

1968-69 1367 8.5 1792 -13.1 -425 -47

1969-70 1405 2.8 1576 -12.1 -171 -59.8

1970-71 1418 0.9 1826 15.9 -408 138.6

1971-72 1581 11.5 2055 12.5 -475 16.4

1972-73 1994 26.1 2161 5.2 -168 -64.6

1973-74 2357 18.2 2867 32.7 -510 203.6

1974-75 3195 35.6 4482 56.3 -1287 152.4

1975-76 4180 30.8 5362 19.6 -1183 -8.1

1976-77 5140 23 5450 1.6 -310 -73.8

1977-78 5440 5.8 6038 10.8 -597 92.6

1978-79 5594 2.8 7806 29.3 -2212 270.5

1979-80 6313 12.9 9753 24.9 -3440 55.5

1980-81 6666 5.6 12877 32 -6211 80.6

1981-82 7766 16.5 14260 10.7 -6494 4.6

171

[

1982-83 9137 17.7 15857 11.2 -6719 3.5

1983-84 10169 11.3 17093 7.8 -6925 3.1

1984-85 11959 17.6 18680 9.3 -6721 -2.9

1985-86 11578 -3.2 21164 13.3 -9586 42.6

1986-87 13315 15 22669 7.1 -9354 -2.4

1987-88 16396 23.1 25693 13.3 -9296 -0.6

1988-89 20647 25.9 34202 33.1 -13556 45.8

1989-90 28229 36.7 40642 18.8 -12413 -8.4

1990-91 33153 17.4 50086 23.2 -16934 36.4

1991-92 44923 35.5 51417 2.7 -6494 -61.7

1992-93 54761 21.9 72000 40 -17239 165.5

1993-94 71147 29.9 83870 16.5 -12723 -26.2

1994-95 84329 18.5 112748 34.4 -28419 123.4

1995-96 108482 28.6 146543 30 -38061 33.9

1996-97 121193 11.7 173754 18.6 -52561 38.1

1997-98 132703 9.5 190508 9.6 -57805 10

1998-99 144436 8.8 199914 4.9 -55478 -4

1999-00 162753 12.7 240112 20.1 -77359 39.4

2000-01 207852 27.7 264589 10.2 -56737 -26.7

2001-02 213345 2.6 268300 1.4 -54955 -3.1

2002-03 260079 21.9 311776 16.2 -51697 -5.9

2003-04 303915 16.9 367301 17.8 -63386 22.6

2004-05 381785 25.6 533550 45.3 -151765 139.4

2005-06 465748 22 695412 30.3 -229664 51.3

2006-07 582871 25.1 862833 24.1 -279962 21.9

2007-08 667757 14.6 1036289 20.1 -368532 31.6

2008-09 798956 19.6 1341069 29.4 -542113 47.1

Note : 1) Data for 2008-09 are preliminary and data for 2007-08 are partially revised.

Source : 1. Handbook of Statistics on Indian Economy, RBI

As can be seen from the table, India’s trade balance was always

negative implying the continuous situation of imports of goods

exceeding exports of goods. The growth in goods imports has most of

the times outpaced the growth in exports with the result that trade

balance has always been in negative. Over a period of 58 years (1951-

2009), the annual average growth in merchandise exports has been

13.7%, while that in merchandise imports 15.4%.

172

6.3 India’s Merchandise Trade and Inflation:

Here an attempt is made to study the impact of high domestic

inflation on merchandise exports and imports of India. In a free

economy, where there are no restrictions on the free movements of

goods, high domestic inflation relative to the inflation in the trade

partners, can have a negative effect on exports and positive effect on

imports. In other words, high domestic inflation will cause imports

growth to exceed the growth in exports and thereby lead to worsening

of trade balance. As can be seen from the data presented in the table

No. 6.1, India always ran a trade deficit, which at first place indicates

that growth in imports outpaced that in exports. However, the relation

between domestic inflation and imports and exports is not that simple.

In a developing country setup, like that of India, where there are

plethora of restrictions on both imports and exports and imports are

strictly regulated in a bid to achieve the objective of self-reliance, the

impact of inflation on imports and exports can not be ascertained very

easily.

In an open economy set up, with no restriction on trade, India’s

imports would have grown much faster than the case has been.

Nonetheless, India’s growth of imports exceeded that of exports under

the impact of development strategy adopted from second five year plan

onwards, which emphasized the development of heavy industries

requiring large quantities of capital goods and technology to be

imported.

So in an Indian setup, the impact of inflation on imports and

exports and trade balance can not be ascertained and it therefore cannot

be said that higher growth in imports than in exports and the negative

trade balance always was the result of high domestic inflation.

173

However, it is to be noted that, though the inflation has been a world

wide phenomenon since the World War II, prices in India have risen

much faster than in most of the other countries.

It is on this background that an attempt has been made to analyze

the relation between the rate of inflation as measured by WPI and

India’s merchandise trade during a period of 58 years covering last

three phases of our study. The following table presents data pertaining

to growth in imports, exports, changes in trade balance and WPI

inflation.

Table No. 6.2

INDIA'S MERCHANDISE TRADE & INFLATION

(Percent variation)

Year

Merchandise -

Exports, f.o.b.

(A)

Merchandise -

Imports, c.i.f.

(B)

Trade

balance

(A-B)

WPI

Inflation

1951-52 12.8 48.3 7700 6.2

1952-53 -17.5 -34.3 -86.8 -12.5

1953-54 -10.3 -6.5 67.7 4.6

1954-55 10.6 16.6 78.8 -6.8

1955-56 7.2 12 43 -5.2

1956-57 -0.8 42.6 251.1 14

1957-58 5.4 11.9 20.8 2.9

1958-59 -13.9 -16.5 -19.7 4.1

1959-60 9.9 -9.4 -34 3.8

1960-61 -0.3 18.7 58.9 6.6

1961-62 5.9 -9 -28.8 0.2

1962-63 1.9 9 23.1 3.8

1963-64 17.8 13.5 6.5 6.2

1964-65 -0.1 14.1 40 11

1965-66 -2 -3.7 -6 7.6

1966-67 38.5 45.5 55.1 13.9

1967-68 15.9 3.6 -11.3 11.6

1968-69 8.5 -13.1 -47 -1.1

1969-70 2.8 -12.1 -59.8 3.7

1970-71 0.9 15.9 138.6 5.5

1971-72 11.5 12.5 16.4 5.6

174

1972-73 26.1 5.2 -64.6 10

1973-74 18.2 32.7 203.6 20.2

1974-75 35.6 56.3 152.4 25.2

1975-76 30.8 19.6 -8.1 -1.1

1976-77 23 1.6 -73.8 2.1

1977-78 5.8 10.8 92.6 5.2

1978-79 2.8 29.3 270.5 0

1979-80 12.9 24.9 55.5 17.1

1980-81 5.6 32 80.6 18.2

1981-82 16.5 10.7 4.6 9.3

1982-83 17.7 11.2 3.5 4.9

1983-84 11.3 7.8 3.1 7.5

1984-85 17.6 9.3 -2.9 6.5

1985-86 -3.2 13.3 42.6 4.4

1986-87 15 7.1 -2.4 5.8

1987-88 23.1 13.3 -0.6 8.1

1988-89 25.9 33.1 45.8 7.5

1989-90 36.7 18.8 -8.4 7.5

1990-91 17.4 23.2 36.4 10.3

1991-92 35.5 2.7 -61.7 13.7

1992-93 21.9 40 165.5 10.1

1993-94 29.9 16.5 -26.2 8.4

1994-95 18.5 34.4 123.4 12.6

1995-96 28.6 30 33.9 8

1996-97 11.7 18.6 38.1 4.6

1997-98 9.5 9.6 10 4.4

1998-99 8.8 4.9 -4 5.9

1999-00 12.7 20.1 39.4 3.3

2000-01 27.7 10.2 -26.7 7.2

2001-02 2.6 1.4 -3.1 3.6

2002-03 21.9 16.2 -5.9 3.4

2003-04 16.9 17.8 22.6 5.5

2004-05 25.6 45.3 139.4 6.5

2005-06 22 30.3 51.3 4.4

2006-07 25.1 24.1 21.9 5.4

2007-08 14.6 20.1 31.6 4.7

2008-09 19.6 29.4 47.1 8.3

Average growth

1951-1969 5 8 450.6 3.9

1969-1991 16.1 17.1 42.1 8.3

1991-2009 19.6 20.6 33.1 6.7

175

1951-2009 13.7 15.4 166.1 6.5

Standard deviation

1951-1969 12.8 22.1 1810.6 7.1

1969-1991 11 14.1 86 6.5

1991-2009 8.5 12.5 58.7 3

1951-2009 12.4 17.1 1009.3 6.1

Correlation with WPI inflation

1951-1969 0.38 0.58 0.1

1969-1991 0.24 0.65 0.33

1991-2009 0.59 0.2 0.15

1951-2009 0.41 0.57 0.02 For trade balance : + indicates worsening & - indicates improvement Source : 1. Handbook of Statistics on Indian Economy, RBI

( based on Table No. 6.1)

6.4 Phase II: 1951-1969

As can be seen from the table, this phase witnessed an annual

average growth of 5% in merchandise exports and 8% in merchandise

imports. The trade balance worsened by an annual average rate of

451% and it largely carried the impact of trade balance worsening that

happened in 1951-52 over 1950-51, which was the low base effect.

Contrary to what should have happened under low inflation

environment, this phase saw imports growth exceeding exports growth

by nearly 3% in annual average terms and worsening of trade balance.

The surge in imports caused by the development strategy tilted towards

industrialization could be attributed to the worsening trade balance

during this phase. The standard deviation figures also indicate that

imports, exports and trade balance fluctuated too much in comparison

with fluctuations in inflation during this phase.

Positive correlations have been observed for imports growth,

exports growth and trade balance with the WPI inflation. The positive

correlations of WPI inflation with imports growth and trade balance are

176

understandable, however that with exports growth is questionable. It

could have happened under the conditions of low relative inflation in

India and elastic demand for Indian exports in foreign markets.

The worsening of trade balance during the years 1966-67 and

1967-68 had little to do with the high inflation. It was largely the result

of increased imports of food grains to mitigate the severity of food

crisis erupted owing to two severe droughts in succession.1

6.5 Phase III: 1969-1991

During this phase, both the imports and exports growth, in

annual average terms turned out to be robust with the former exceeding

latter by a small margin of just 1%. Though the trade balance remained

in deficit, it did not worsen as much as in the previous phase. The

annual average rate of growth in trade deficit was lower at 42%

compared with 451% recorded for the previous phase. The worsening

of trade balance was more pronounced during 1973-75 and 1978-80

under the impact of two oil shocks and the domestic inflation again had

not much to do with it.2

Both the imports and exports as also trade balance and WPI

inflation registered fall in volatility as given by the standard deviation

values. The standard deviation values for imports and exports are

however higher than the one for WPI inflation, which implies the role

of other factors in determining the import and export values.

The correlation values indicate that relatively stronger

association existed between WPI inflation and growth in imports and

between WPI inflation and trade deficit. This does not however mean

that higher average inflation during this phase led to fast growth in

imports and thus fast worsening of trade balance. The impact rather

177

was other way round. The weakening of association between WPI

inflation and export growth as implied in lower correlation quotient is

understandable.

6.6 Phase IV: 1991-2009

This phase witnessed acceleration in both imports and exports

growth by nearly 3.5% each, co-existing with lower annual average

increase in WPI inflation (6.7%) compared with the previous phase.

The acceleration in exports growth can be largely attributed to the

adoption of export-led growth strategy and govt.’s emphasis on exports

as an engine of growth. It can however be agued that lower annual

average inflation during this phase had some positive impact on

exports growth.

The annual average imports growth of more than 20% during this

phase had its link with import liberalization and large pent up demand

of the previous phases, which had strict import regulation policy in

place. The spectacular growth in exports keeping pace with growth in

imports ensured least trade balance worsening.

The fluctuations in all the four parameters declined, with the

fluctuations in WPI inflation falling by nearly half, largely on account

of absence of any external shock, except the Asian Financial Crisis of

1997. The correlation values reflect a distorted picture going exactly

against the logical expectation. This is particularly true about the

correlation between export growth & inflation, with both moving in the

same direction. Growth in exports could be the result of export-led

growth strategy followed since 1991, while the higher average inflation

was on account of the higher inflation during the first half of 1990’s.

178

The correlation between inflation and exports growth should

assume a negative value given the increase in exports growth rate and

fall in inflation rate during this phase. The actual value (0.59) however

indicates a strong positive association. The correlation values of

imports growth and trade deficit with WPI inflation, as is normally the

case, are positive but very low indicating a weakening of association,

with the former two moving up against the decline in the latter.

For the whole period of 58 years from 1951-52 to 2008-09, there

appears to be reasonably good association between the inflation rate

and growth in merchandise imports, with the correlation quotient

assuming a value of 0.57. This implies both move in the same direction.

The correlation quotient between inflation and trade deficit, though

positive, as it should be, is very low and therefore indicates a very

weak association. Contrary to the logical expectation, the correlation

quotient between inflation and merchandise exports growth assumes a

positive value of 0.41, and implies that both have moved in the same

direction. It means merchandise exports are influenced by factors other

than the domestic inflation rate.

6.7 Impact of inflation on export and import quantity:

With a view to draw a logical conclusion regarding the impact of

inflation on India’s exports and imports of merchandise. The quantum

indexes for exports and imports are used and their relation with

inflation is studied using the data presented in the following table.

179

Table No. 6.3

QUANTUM INDEX FOR EXPORTS & IMPORTS &

INFLATION

Year Exports Variation

in % Imports

Variation

in %

WPI

Inflation in

%

1970-71 59.00 67.20

1971-72 59.20 0.34 80.60 19.94 5.6

1972-73 66.50 12.33 76.70 -4.84 10

1973-74 69.50 4.51 87.20 13.69 20.2

1974-75 73.70 6.04 77.20 -11.47 25.2

1975-76 81.70 10.85 76.00 -1.55 -1.1

1976-77 96.80 18.48 76.10 0.13 2.1

1977-78 93.20 -3.72 100.00 31.41 5.2

1978-79 100.00 7.30 100.00 0.00 0

1979-80 106.20 6.20 116.40 16.40 17.1

1980-81 108.10 1.79 137.90 18.47 18.2

1981-82 110.10 1.85 150.60 9.21 9.3

1982-83 116.70 5.99 154.60 2.66 4.9

1983-84 113.00 -3.17 185.40 19.92 7.5

1984-85 120.80 6.90 156.10 -15.80 6.5

1985-86 111.30 -7.86 182.30 16.78 4.4

1986-87 121.30 8.98 212.30 16.46 5.8

1987-88 140.00 15.42 204.80 -3.53 8.1

1988-89 152.10 8.64 224.20 9.47 7.5

1989-90 174.90 14.99 227.80 1.61 7.5

1990-91 194.10 10.98 237.70 4.35 10.3

1991-92 208.60 7.47 228.00 -4.08 13.7

1992-93 222.90 6.86 282.00 23.68 10.1

1993-94 257.50 15.52 329.10 16.70 8.4

1994-95 292.70 13.67 408.30 24.07 12.6

1995-96 384.30 31.29 514.80 26.08 8

1996-97 411.80 7.16 511.80 -0.58 4.6

1997-98 386.00 -6.27 562.10 9.83 4.4

1998-99 399.00 3.37 644.00 14.57 5.9

1999-00 461.00 15.54 705.00 9.47 3.3

2000-01 571.00 23.86 698.00 -0.99 7.2

2001-02 593.00 3.85 733.00 5.01 3.6

2002-03 722.00 21.75 802.00 9.41 3.4

2003-04 765.00 5.96 970.00 20.95 5.5

2004-05 899.00 17.52 1113.00 14.74 6.5

2005-06 1005.00 11.79 1649.00 48.16 4.4

180

2006-07 1164.00 15.82 2047.00 24.14 5.4

2007-08 1227.00 5.41 2603.00 27.16 4.7

Average

growth 9.1 11.4 7.9

Correlation -0.09 -0.09

Source : Compiled on the basis of data taken from 1. Handbook of Statistics on Indian Economy, RBI

Using the value of merchandise exports and imports to study the

correlation between them and domestic inflation may not be the right

way, as the prices of exports and imports are largely determined by the

international forces. So to study the relation between domestic inflation

and merchandise trade, it makes sense to use quantity figures both for

exports and imports, given by their index numbers, as they are largely

determined by the domestic inflation. The above table juxtaposes the

quantum indexes for exports and imports and annual variations in them

against the variations in WPI inflation.

The correlation values given at the bottom of the table can be

used to derive logical conclusion. The correlation quotient between the

change in export quantity and change in WPI inflation, though low, is

negative at -0.09, as the case should be. This implies that increase in

domestic inflation lowers the quantity exported. This is also borne by

the oft-quoted argument that India’s exports are price elastic.

In case of quantum of imports, the negative correlation with

domestic inflation is non-understandable. Rise in domestic inflation

should cause the import quantity to go up. What appears from the

correlation quotient is exactly opposite of that. Though correlation

quotient between change in import quantity and change in domestic

inflation is negative, it is very low. The negative correlation quotient

can be argued to be the result of import substitution that happened in

181

India and strict regulation of imports through high levels of import

duties, import quotas, import licensing and ban over non-essential

imports.

6.8 Inflation and the exchange rate:

Exchange rate of a currency, among other factors, is influenced

by the domestic inflation. Under flexible exchange rate system, though

the exchange rate is determined by the demand and supply of the

currency, what operates from behind the demand and supply are the

factors like inflation. Though India was part of the fixed exchange rate

regime that prevailed in the post-world war II period, it had to devalue

its currency thrice in the post-independence period, largely owing to

the downward pressure exerted on it by the factors like high domestic

inflation.

To understand the impact of domestic inflation on the exchange

rate of rupee, one has to see what happens to the real effective

exchange rate (REER), which is calculated as a weighted average of

nominal exchange rates adjusted for relative price differential between

the domestic and foreign countries.

Real effective exchange rate is constructed as a weighted index

using export based weights or trade based weights for six countries and

thirty six countries. The data on REER for thirty six countries with two

different bases is provided in the following tables.

182

Table No. 6.4

INDICES OF REAL EFFECTIVE EXCHANGE RATE (REER)

AND NOMINAL EFFECTIVE EXCHANGE RATE (NEER) OF

INDIAN RUPEE

(36- Country Bilateral Weights) (Financial Year - Annual Average)

(Base : 1985 = 100)

Export-based Weights Trade-based Weights Year

REER Variation in

% NEER

Variation

in % REER

Variation in

% NEER

Variation

in %

1975-76 107.31 100.28 106.27 97.95

1976-77 102.49 -4.49 101.13 0.85 101.34 -4.64 98.67 0.74

1977-78 101.21 -1.25 102.18 1.04 100.12 -1.20 99.86 1.21

1978-79 93.11 -8.00 99.68 -2.45 91.98 -8.13 97.18 -2.68

1979-80 99.09 6.42 102.79 3.12 97.08 5.54 99.43 2.32

1980-81 106.15 7.12 106.48 3.59 104.48 7.62 103.46 4.05

1981-82 105.74 -0.39 106.20 -0.26 104.48 0.00 103.54 0.08

1982-83 102.09 -3.45 107.09 0.84 101.17 -3.17 104.75 1.17

1983-84 104.51 2.37 106.68 -0.38 104.24 3.03 105.27 0.50

1984-85 100.44 -3.89 101.77 -4.60 100.86 -3.24 101.47 -3.61

1985-86 97.85 -2.58 98.52 -3.19 98.27 -2.57 98.50 -2.93

1986-87 90.12 -7.90 85.77 -12.94 90.24 -8.17 85.85 -12.84

1987-88 85.39 -5.25 81.20 -5.33 85.36 -5.41 81.16 -5.46

1988-89 80.26 -6.01 75.25 -7.33 80.41 -5.80 75.57 -6.89

1989-90 77.34 -3.64 71.60 -4.85 78.44 -2.45 72.16 -4.51

1990-91 73.33 -5.18 66.19 -7.56 75.58 -3.65 67.20 -6.87

1991-92 61.36 -16.32 51.12 -22.77 64.20 -15.06 52.51 -21.86

1992-93 54.42 -11.31 42.30 -17.25 57.08 -11.09 43.46 -17.23

1993-94 59.09 8.58 43.48 2.79 61.59 7.90 44.69 2.83

1994-95 63.29 7.11 42.20 -2.94 66.04 7.23 43.37 -2.95

1995-96 60.94 -3.71 38.74 -8.20 63.62 -3.66 39.73 -8.39

1996-97 61.14 0.33 38.09 -1.68 63.81 0.30 38.97 -1.91

1997-98 63.76 4.29 38.93 2.21 67.02 5.03 40.01 2.67

1998-99 60.13 -5.69 35.32 -9.27 63.44 -5.34 36.34 -9.17

1999-00 59.70 -0.72 34.30 -2.89 63.29 -0.24 35.46 -2.42

2000-01 62.47 4.64 34.24 -0.17 66.53 5.12 35.52 0.17

2001-02 64.36 3.03 34.54 0.88 68.43 2.86 35.75 0.65

2002-03 67.92 5.53 35.41 2.52 72.76 6.33 37.05 3.64

2003-04 69.66 2.56 34.87 -1.52 74.14 1.90 36.25 -2.16

Total -37.81 -97.77 -30.96 -91.90

Average -1.35 -3.49 -1.11 -3.28

Note : 1) Data up to 1991-92 are based on official exchange rates and data from 1992-93 onwards are based on FEDAI (Foreign Exchange Dealers’ Association of India) indicative rates.

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2) REER indices are recalculated from 1994-95 onwards using the new Wholesale Price Index (WPI) series (Base : 1993-94 = 100). 3) REER and NEER indices are estimated using the common price index and the exchange rate for the Euro, thus representing 31 countries and the Euro area w.e.f. 01.03.2002. Source : 1. Handbook of Statistics on Indian Economy, RBI

Table No. 6.5

INDICES OF REAL EFFECTIVE EXCHANGE RATE (REER)

AND NOMINAL EFFECTIVE EXCHANGE RATE (NEER) OF

INDIAN RUPEE

(36- Country Bilateral Weights) (Financial Year - Annual Average) (Base:1993-94 = 100)

Export-based Weights Trade-based Weights Year

REER Variation

in % NEER

Variation

in % REER

Variation

in % NEER

Variation

in %

1993-94 100.00 100.00 100.00 100.00

1994-95 104.88 4.88 98.18 -1.82 104.32 4.32 98.91 -1.09

1995-96 100.10 -4.56 90.94 -7.37 98.19 -5.88 91.54 -7.45

1996-97 98.95 -1.15 89.03 -2.10 96.83 -1.39 89.27 -2.48

1997-98 103.07 4.16 91.97 3.30 100.77 4.07 92.04 3.10

1998-99 94.34 -8.47 90.34 -1.77 93.04 -7.67 89.05 -3.25

1999-00 95.28 1.00 90.42 0.09 95.99 3.17 91.02 2.21

2000-01 98.67 3.56 90.12 -0.33 100.09 4.27 92.12 1.21

2001-02 98.59 -0.08 89.08 -1.15 100.86 0.77 91.58 -0.59

2002-03 95.99 -2.64 87.01 -2.32 98.18 -2.66 89.12 -2.69

2003-04 99.07 3.21 87.89 1.01 99.56 1.41 87.14 -2.22

2004-05 98.30 -0.78 88.41 0.59 100.09 0.53 87.31 0.20

2005-06 100.54 2.28 91.17 3.12 102.35 2.26 89.85 2.91

2006-07 97.42 -3.10 87.46 -4.07 98.48 -3.78 85.89 -4.41

2007-08 104.12 6.88 95.30 8.96 104.81 6.43 93.91 9.34

2008-09 94.01 -9.71 85.96 -9.80 94.44 -9.89 86.15 -8.26

Total -4.52 -13.67 -4.04 -13.47

Average -0.28 -0.85 -0.25 -0.84

Note : 1) Data for 2008-09 are provisional. 2) REER indices are recalculated from 1993-94 onwards using the new Wholesale Price Index (WPI) series (Base : 1993-94 = 100). 3) The 36-Country REER & NEER are revised as 36- Currency REER & NEER respectively and for “note on Methodology” on the indices, please see 2005 Issue of RBI Bulletin. Source : 1. Handbook of Statistics on Indian Economy, RBI

The above tables present data on both REER and NEER with two

different bases. It is the REER that carries the effect of inflation.

184

As can be seen from the table No. 6.4 that REER based on export

based weights has depreciated by a total of nearly 38%, while the

REER based on trade based weights has depreciated somewhat less by

almost 31% during the period from 1975-76 to 2003-04. The average

annual depreciation for the period works out to be 1.35% and 1.11%

respectively.

The table No. 5 also exhibits a similar picture of depreciation in

REER based on both export and trade based weights, over a period

from 1993-94 to 2008-09, the depreciation in REER using export based

weights has been 4.52%, while for REER based on trade based weights,

it is 4.04%. The annual average depreciation turns out to be less than

one at 0.28% and 0.25% respectively. The control over inflation in the

post 1995-96 period can be ascribed to the lower average annual

depreciation in REER.

6.9 Inflation and the foreign exchange reserves:

Foreign exchange reserves get not only impacted by the inflation,

but they also affect it through their effect on domestic money supply.

Foreign exchange reserves flow to that country which exhibits better

macro-economic management, one indicator of which is stable and low

inflation. India had to face the problem of inadequate foreign exchange

reserves several times in the past due to wrong macro-economic

management leading to too much volatility in the domestic inflation.

Though domestic inflation and the quantum of foreign exchange

reserve received are not directly related, here an attempt is made to

find a correlation between them, if any. The following table presents

the variations in India’s foreign exchange reserves against that in WPI

inflation since 1950-51.

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Table No. 6.6

FOREIGN EXCHANGE RESERVES

Total

End of Financial

Year (Rs

crore)

Variation

in %

(USD

Million)

Variation

in %

WPI

INFLATION

1950-51 1029 2161

1951-52 865 -16 1815 -16 6.2

1952-53 881 2 1850 2 -12.5

1953-54 910 3 1911 3 4.6

1954-55 892 -2 1873 -2 -6.8

1955-56 903 1 1895 1 -5.2

1956-57 681 -25 1431 -24 14

1957-58 421 -38 884 -38 2.9

1958-59 379 -10 795 -10 4.1

1959-60 363 -4 762 -4 3.8

1960-61 304 -16 637 -16 6.6

1961-62 298 -2 624 -2 0.2

1962-63 295 -1 619 -1 3.8

1963-64 306 4 642 4 6.2

1964-65 250 -18 524 -18 11

1965-66 298 19 626 19 7.6

1966-67 479 61 638 2 13.9

1967-68 539 13 718 13 11.6

1968-69 577 7 769 7 -1.1

1969-70 821 42 1094 42 3.7

1970-71 733 -11 975 -11 5.5

1971-72 857 17 1194 22 5.6

1972-73 888 4 1219 2 10

1973-74 994 12 1325 9 20.2

1974-75 1022 3 1379 4 25.2

1975-76 1886 85 2172 58 -1.1

1976-77 3243 72 3747 73 2.1

1977-78 4863 50 5824 55 5.2

1978-79 5821 20 7268 25 0

1979-80 5934 2 7361 1 17.1

1980-81 5545 -7 6823 -7 18.2

1981-82 4025 -27 4390 -36 9.3

1982-83 4782 19 4896 12 4.9

1983-84 5972 25 5649 15 7.5

1984-85 7243 21 5952 5 6.5

1985-86 7819 8 6520 10 4.4

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1986-87 8151 4 6574 1 5.8

1987-88 7686 -6 6223 -5 8.1

1988-89 7040 -8 4802 -23 7.5

1989-90 6252 -11 3962 -17 7.5

1990-91 11416 83 5834 47 10.3

1991-92 23850 109 9220 58 13.7

1992-93 30744 29 9832 7 10.1

1993-94 60420 97 19254 96 8.4

1994-95 79781 32 25186 31 12.6

1995-96 74384 -7 21687 -14 8

1996-97 94932 28 26423 22 4.6

1997-98 115905 22 29367 11 4.4

1998-99 138005 19 32490 11 5.9

1999-00 165913 20 38036 17 3.3

2000-01 197204 19 42281 11 7.2

2001-02 264036 34 54106 28 3.6

2002-03 361470 37 76100 41 3.4

2003-04 490129 36 112959 48 5.5

2004-05 619116 26 141514 25 6.5

2005-06 676387 9 151622 7 4.4

2006-07 868222 28 199179 31 5.4

2007-08 1237965 43 309723 55 4.7

2008-09 1283865 4 251985 -19 8.3

Correlation with WPI inflation

1951-1969 0.13 -0.16

1969-1991 -0.39 -0.4

1991-2009 0.43 0.11

1951-2009 0.02 -0.08

Foreign exchange reserves include SDRs, Gold, Foreign Currency Assets*,& Reserve tranche position * :FCA excludes US $ 250.00 million (as also its equivalent value in Indian Rupee) invested in foreign currency denominated bonds issued by IIFC (UK) since March 20, 2009. Source: Handbook of Statistics on Indian Economy, RBI. During the second phase (1950-51 to 1968-69) of the study, the

foreign exchange reserves declined from US $ 2161 million in 1950-51

to US $ 769 million in 1968-69, despite a low annual average WPI

inflation of 3.9%. The correlation quotient between foreign exchange

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reserves in US dollar terms and WPI inflation assumes a negative value,

indicating an inverse relation between the two.

The negative correlation between foreign exchange reserves and

WPI inflation becomes stronger for the third phase (1969-1991). It

works out to be -0.4, nearly 2.5 higher than the one observed for the

previous phase. The mismanagement of the macro economy as

reflected in higher fiscal deficit, high and unsustainable current

account deficit and increase in annual average rate of inflation to 8.3%,

damaged the sentiments of the foreign investors, and led to the fall in

foreign exchange reserves.

The fourth phase (1991-2009) however saw reversal in the

earlier trend in foreign exchange reserves and the better macro

economic management and relatively low level of inflation took them

to a high level of US $ 252 billion in 2008-09 from just US $ 9 billion

in 1991-92. The correlation quotient is found to be positive but very

weak at 0.1

For the entire period covering the last three phase of this study

(1951-2009), the correlation quotient is in the negative, which implies

that high domestic inflation causes fall in foreign exchange reserves

and vice versa.

As mentioned earlier, inflation is also affected by the changes in

foreign exchange reserves. A large increase in foreign exchange

reserves in the post-1991 period following the reforms initiatives have

added significantly to the domestic monetary stock having implication

for inflation. The significant increase in money supply has however

been moped up by the reserve bank of India by resorting to a practice

called sterilization, whereby govt. securities are sold in the open

market.

188

6.10 Devaluations of the Rupee and inflation:

The term devaluation refers to a deliberate reduction in the value

of currency against the foreign currency. It is usually under the

conditions of fixed exchange rate regime that such a step is envisaged

and implemented to correct the disequilibrium in BOPs.

It was thrice that India devalued its currency during its post-

World War II history. These devaluations were effected in 1949, 1966

and in 1991, as part of a broad policy packages that were announced to

restore normalcy in the economic field, particularly in the area of

India’s trade with the other countries.

Though devaluation is resorted to as a policy to restore balance

in country’s payment system with the rest of the world, it has

connections with the inflation, both as a cause and effect. As a cause, it

increases the price of imported goods and thus becomes a source of

imported inflation. As an effect, devaluation is practiced to make the

external value of the currency consistent with the internal value.

The following table presents the data on WPI inflation during the

3 years period preceding and following the three major devaluations in

India.

Table No. 6.7

DEVALUATIONS OF RUPEE AND INFLATION

No. Year Devaluation Date Extent of

Devaluation (in %)

WPI Inflation (in %)

1946-47 12.5

1947-48 11.5

1948-49 22.6

1st 1949-50 Sept 18, 1949 30.5 2.4

1950-51 6.3

189

1951-52 6.2

1952-53 -12.5

1963-64 6.2

1964-65 11.0

1965-66 7.6

2nd 1966-67 June 6, 1966 36.5 13.9

1967-68 11.6

1968-69 -1.1

1969-70 3.7

1988-89 7.5

1989-90 7.5

1990-91 10.3

3rd 1991-92 July 1 & 3, 1991 18-19 13.7

1992-93 10.1

1993-94 8.4

1994-95 8.4

Source: (Compiled) 1) Taneja, S.K.(1968): “The Indian Rupee in Maelstrom”, Sterling Publishers (P.) Ltd., Delhi, 2) Joshi, Vijay and Little, I.M.D. (1999): “India Macroeconomics and Political Economy: 1964-1991”, Oxford University Press, New Delhi.

The points of similarity and differences about the three

devaluations of rupee can be summarized as below.

1. In all the three cases, very high rate of inflation preceded the

devaluation.

2. A low inflation followed the first and second devaluation, while

the third one was followed by a continuation of high inflation of

the preceding period.

190

3. The first devaluation was preceded by the war induced inflation;

the second by two severe droughts induced inflation, while the

third by the Gulf crisis and resulting oil price hike induced

inflation.

4. The second devaluation was also preceded by two wars with

neighboring countries and increase in war expenditure.

5. In case of first devaluation, the external situation was not as

worse as it was during second and third devaluation, and it was

adopted as a defensive strategy following the devaluation of

Pound sterling by U.K.3

6. Before the second and third devaluation, there was a steep fall in

foreign exchange reserves; the first devaluation had comfortable

sterling balances of the war period.

So being a developing country, India imported more than what it

exported. Since 1950, India ran continued trade deficits that increased

in magnitudes towards 1966 and 1991.4 The general agreement among

the economists is that the inflation had caused Indian prices to stay

higher than the world prices,5 leading to perpetuation of trade deficits,

which assumed serious proportions in 1966 and 1991 and thus

warranted correction through devaluation. In all the three instances,

inflation thus turns out to be a cause rather than the effect of

devaluation. The third devaluation was followed by a high inflation but

it was largely on account of the oil price hike and the internal factors

like monetization of the govt.’s deficit.

From the discussion under this chapter, it appears that high

inflation in India, resulting from wrong macro economic management

and supply side shocks, kept the external sector continuously in

imbalance. Worsening of the trade deficit, depreciation of the rupee in

191

real terms, dwindling foreign exchange reserves and devaluation, were

the symptoms of illhealth of the external sector, which was in one way

or another had been caused by the high domestic inflation.

192

References:

1. Joshi, Vijay and Little, I.M.D. (1999): “India Macroeconomics

and Political Economy 1964-1991”, Oxford University Press,

New Delhi, p. 73.

2. Ibid, p. 113.

3. Simha S.L.N. (1970): “History of the Reserve Bank of India,

1935-51,” Volume 1, RBI, Bombay, p. 664.

4. Joshi, Devika and Miller, Mark (2002): “Devaluation of the

Rupee: Tale of Two Years 1966 and 1991”, Centre for Civil

Society, Working Paper No. 0025, p. 84

5. Ibid, p. 84

193