The destabilizing effects of a financial crisis are so great that any country will face strong pressure from internal political forces to avoid such a crisis, even if the policies adopted come at a large economic cost. To avert a financial crisis, a nation will typically adopt policies to maintain a stable exchange rate to lessen exchange rate risk and increase international confidence. The restrictions that a country will put in place come in two forms: trade barriers and financial restrictions. Trade barriers are the restrictions on the import of certain goods and financial restrictions are on the flow of money or financial assets across international boundaries. When the flow of goods, services, and financial capital is regulated tightly enough, the government or central bank becomes strong enough, at least in theory, to dictate the exchange rate. However, despite these policies, if the market for a nation’s currency is too weak to justify the given Exchange rate, that nation will be forced to devalue its currency.
The 1966 Devaluation:
As a developing economy, it is to be expected that India would import more than it exports. Despite government attempts to obtain a positive trade balance, India has had consistent balance of payments deficits since the 1950s. The 1966 devaluation was the result of the first major financial crisis the government faced. There is a general agreement among economists that by 1966, inflation had caused Indian prices to become much higher than world prices at the pre-devaluation exchange rate. When the exchange rate is fixed and a country experiences high inflation relative to other countries, that country’s goods become more expensive and foreign goods become cheaper. Therefore, inflation tends to increase imports and decrease exports. Since 1950, India ran continued trade deficits that increased in magnitude in the 1960s.
As India continued to experience deficits in trade and the government budget, the country was aided significantly by the international community. In the period of 1950 through 1966, foreign aid was never greater than the total trade deficit of India except for 1958. Nevertheless, foreign aid was substantial and helped to postpone the rupee’s final reckoning until 1966. In 1966, foreign aid was finally cut off and India was told it had to liberalize its restrictions on trade before foreign aid would again materialize. The response was the politically unpopular step of devaluation accompanied by liberalization. When India still did not receive foreign aid, the government backed off its commitment to liberalization.
Two additional factors played a role in the 1966 devaluation. The first was India’s war with Pakistan in late 1965. The US and other countries friendly towards Pakistan, withdrew foreign aid to India, which further necessitated devaluation. In addition, the large amount of deficit spending required by any war effort also accelerated inflation and led to a further disparity between...