CHAPTER VI

INFLATION AND BALANCE OF

PAYMENTS (BOPs)

6.1 Introduction

6.2 Indias Merchandise Trade with the rest of the

World

6.3 Indias 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, countrys trade
balances with the rest of the World. Countrys 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.
Countrys 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 Indias 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)

I. I.
I. Trade
Merchandise Variation Merchandise Variation Variation
Year balance
Exports, in % Imports, in % (A-B) in %
f.o.b. ( A) c.i.f. (B)

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, Indias 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 Indias 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, Indias
imports would have grown much faster than the case has been.
Nonetheless, Indias 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
Indias 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)
Merchandise - Merchandise - Trade
WPI
Year Exports, f.o.b. Imports, c.i.f. balance
Inflation
(A) (B) (A-B)
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 1990s.
 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 Indias 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
WPI
Variation Variation
Year Exports Imports Inflation in
in % 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 Indias 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 Variation in Variation Variation in Variation
REER NEER REER NEER
% in % % 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.
 183
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 Variation Variation Variation Variation
REER NEER REER NEER
in % in % in % 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 Indias foreign exchange reserves against that in WPI
inflation since 1950-51.
 185

Table No. 6.6

FOREIGN EXCHANGE RESERVES
Total
End of Financial
Year (Rs Variation (USD Variation WPI
crore) in % Million) in % 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
 186

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
 187

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
Indias trade with the other countries.
Though devaluation is resorted to as a policy to restore balance
in countrys 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
Extent of
WPI Inflation
No. Year Devaluation Date Devaluation
(in %)
(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