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Historically, the Indian rupee was pegged to the pound sterling until the late 1960s.
As a member of the International Monetary Fund (IMF) under the Bretton Woods system, India declared a par value of the rupee in terms of gold.
The Reserve Bank of India (RBI) maintained this par value within a ±1% band, using the pound sterling as the intervention currency.
In June 1966, the rupee was devalued. The new par value was fixed at 0.118489 grams of gold per Indian rupee, and the rupee-sterling rate was fixed at GBP 1 = Rs. 18.
In August 1971, with the collapse of the Bretton Woods system, major currencies abandoned fixed exchange rates.
The sequence of changes was as follows:
(i) Rupee was pegged to the US dollar at US$1 = Rs. 7.50, though RBI continued using pound sterling as the intervention currency.
(ii) After the Smithsonian Agreement in December 1971, rupee was delinked from the dollar and re-pegged to pound sterling, maintaining a ±2.25% band.
(iii) By 1972, since pound sterling started floating, rupee’s value began fluctuating along with sterling.
(iv) By September 1975, pound sterling was depreciated by 20% due to Britain’s weak economic fundamentals, which led to automatic depreciation of the rupee and contributed to high inflation in India.
(v) On September 25, 1975, rupee was delinked from sterling and pegged to a basket of currencies. The composition and weights of this basket were kept secret to prevent speculation.
The main benefit of the currency basket system was that the rupee was no longer dependent on a single foreign currency, allowing RBI discretion to adjust weights without market interference.
Due to the forex crisis in 1990–91, India recognized the importance of better exchange rate management.
On March 1, 1992, RBI introduced the Liberalised Exchange Rate Management System (LERMS) to enhance the sustainability of balance of payments and allow greater market participation.
Key features of LERMS included:
(i) Rupee convertibility for all approved external transactions.
(ii) Exporters could sell 60% of foreign receipts at market-determined rates.
(iii) The remaining 40% had to be surrendered to RBI at the official exchange rate through authorised dealers.
This dual exchange rate system characterised the 1992 regime, with daily buying and selling rates published by RBI for merchant transactions.
With continued economic liberalisation, the Reserve Bank of India (RBI) made the Indian rupee fully floating on the current account effective March 1, 1993.
This new exchange rate framework was called the Modified Liberalised Exchange Rate Management System (MLERMS).
Under MLERMS, all foreign exchange transactions on the current account of the balance of payments were routed through Authorised Dealers (ADs) at market-determined exchange rates.
Foreign exchange receipts and payments continued to be governed by Exchange Control Regulations.
The MLERMS brought more flexibility to the foreign exchange market by removing trade restrictions and easing exchange controls on current account transactions, thus supporting India's integration into the global economy.
On November 22, 1994, the RBI established the Expert Group on Foreign Exchange Markets in India chaired by Mr. O.P. Sodhani.
The group studied existing forex market structures, explored new derivative products, and assessed the scope for market development.
In June 1995, the committee submitted its report with 33 recommendations, of which 25 called for action by RBI.
Major recommendations included:
(i) Banks should be given more autonomy in forex trading — including freedom to set net overnight positions, gap limits, and take positions in overseas markets.
(ii) They should also be allowed to borrow/invest overseas (up to 15% of Tier 1 capital), set FCNR deposit rates and maturity (within 3 years), and use derivatives for asset-liability management.
(iii) Corporates should be allowed to hedge genuine exposures after declaration. However, due to the Asian Financial Crisis, this was temporarily suspended.
(iv) Corporates with Exchange Earners' Foreign Currency Accounts (EEFCAs) should be allowed margin trading using account balances.
(v) Corporates were given permission to cancel or rebook forward contracts. But after the crisis, only rollovers remained allowed — rebooking/cancellation was suspended.
(vi) Authorised Dealers could be permitted to take cross-currency positions abroad.
(vii) RBI's market intervention should be selective, not frequent.
(viii) More institutions like IDBI, IFCI, etc., should be allowed to participate in the forex market to deepen liquidity.
Some recommendations have not been implemented due to practical constraints such as the risk of excessive speculation.
The gradual liberalisation of the forex market led to the need for capital account convertibility in the early stage of 1997.
On February 28, 1997, the Reserve Bank of India (RBI) set up the Committee on Capital Account Convertibility, popularly known as the Tarapore Committee.
The definition of Capital Account Convertibility was quoted as: “Capital Account Convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market-determined rates of exchange.”
The committee made several broad recommendations related to capital flows and forex policy:
(i) Liberalisation of foreign direct investment (FDI).
(ii) Facilitation of portfolio investment and joint venture investments.
(iii) Support for project exports and opening Indian corporate offices abroad.
(iv) Raising of Exchange Earners' Foreign Currency (EEFC) entitlement to 50%.
(v) Allowing FIIs to use forward contracts to partially hedge exposures in debt and equity markets.
The committee emphasized a credible exchange rate policy to support Capital Account Convertibility (CAC).
It recommended that RBI adopt a monitoring exchange rate band of ±15% around the neutral Real Effective Exchange Rate (REER), with intervention only when the REER moves outside this band.
Transparency in the exchange rate policy was viewed as essential for building market confidence under CAC.
The committee acknowledged the growing integration of the Indian economy, stating that a reasonable current account deficit could be sustained without external vulnerability.
It highlighted that capital flows would play a more prominent role in shaping the balance of payments under CAC.
It recommended benchmarks for foreign exchange reserve adequacy:
(i) Reserves should not be less than six months’ imports.
(ii) Alternatively, reserves should cover three months of imports + 50% of debt service payments + one month of exports.
As part of broader reforms, steps were taken to strengthen risk management in the money market.
Recent RBI guidelines enabled use of Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs) to hedge interest rate risks and support development of fixed income derivative markets.
Measures were also taken to develop the government securities market.
Banks fulfilling eligibility criteria were permitted to import gold for domestic sale.
This step was significant in shifting off-market forex transactions into the formal forex market, enhancing transparency and official tracking of gold imports.
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