The rupee’s depreciation to more than 70 to a dollar just ahead of Independence Day led to historical comparisons of the value of the rupee. These can be misleading, as political freedom did not automatically result in India’s monetary independence in 1947. The rupee’s association with Britain was prolonged by factors beyond India’s control.
On a sterling standard 1931 onwards, the rupee, linked to a depreciating currency, depreciated along with the sterling.
Britain (and France) declared war on Germany in 1939. In preparation, India’s economy was geared up by the colonial government towards the war effort through imposition of controls. The first was the exchange control. Completely convertible into any currency until then, the rupee was made inconvertible. Transferring money outside the sterling area required permission under rules that were laid down in London. The maze of controls grew as the war went on.
Dollar securities held by private individuals were compulsorily acquired, and compensation was in rupees at the market price on an arbitrary date, resulting in losses to many. The Bank of England (BoE) sold the securities so acquired, adding the dollars to its coffers. Dollars for the war were also raised by selling silver bullion from India’s reserves to governments outside the sterling area.
Dollars could be spent on imports of essential consumables, not capital goods. What was essential was defined by the war requirements until 1946, when civilian requirements were included. The restrictions on capital goods imports continued because the BoE had blocked what were called India’s sterling balances. By the end of World War II, India had accumulated a sizeable sterling balance of £1,300 million — India’s earnings in foreign currency on its exports for the war, deposited in the BoE in the form of sterling to the credit of the Reserve Bank of India (RBI) account. The balance had grown with import controls limiting forex outflows. The corresponding increase in rupee circulation stoked war inflation in India.
After the war ended, the transfer of the sterling balances was negotiated between India and Britain. (After Partition, Pakistan joined the talks.) India’s key negotiator, B.K. Nehru, has described the protracted settlement in his memoirs.
Winston Churchill had been threatening to write off the sterling balances. In the first round of negotiations, in 1946, by which time Churchill was out of power, the British delegation sought a considerable scaling-down of the sterling balances. India sought word that the sterling — that had become much overvalued — would not be devalued. The visitors refused. The sterling to them was still the premium currency against which other currencies were valued.
The next sterling balances negotiations were held in London in July 1947 against the backdrop of the Government of India having been thrown into chaos by the advancement of the date Independence/Partition to August 15, 1947, from June 30, 1948.
After August 15, India and Pakistan would have had no forex other than the sterling balances to pay for imports. The urgency of reaching an agreement increased. The impossibility of a write-off was accepted. But limits were placed on their use by the two countries — as unrestricted spending would have run the British balance of payments, and consequently its economy, to the ground.
Under this interim agreement, India could spend from the balances in dollars, as Britain had agreed to make the pound convertible under the terms of a loan from the U.S. But Britain soon repudiated the convertibility clause, in turn altering the character of the agreement entered into with India. Pound convertibility was ruled out by the sorry state of British production after the war years. Pent-up demand for consumer goods could only be met with imports from the U.S. Pound convertibility would have exhausted British forex reserves.
A delegation was sent back to London to renegotiate the convertible portion of the sterling balances. It returned empty-handed. The negotiations were concluded in the summer of 1949, after the completion of the bitter separation of Indian and Pakistani finances. (Till July 1, 1948, the RBI continued as the central banker for the Government of Pakistan. India nationalised the RBI on January 1, 1949.)
The Indian side, led by Finance Minister John Mathai, agreed to two types of deductions from the sterling balances. First, towards the pensions of former British members of the ICS. Second, the value of military equipment, regardless of the condition and worth, the British forces had left behind. The subtractions added to £100 million.
Limits were placed on how much could be drawn in a given period from the balances.
At the talks, the British side gave credible warnings of an imminent sterling devaluation. India failed to capitalise on them. The telegram, ‘For (Jawaharlal) Nehru from Attlee’, received on September 21, 1949, announcing a devaluation from $4.03 to the pound to $2.8 to the pound, took India completely by surprise. It effectively wrote off a third of the sterling balances. B.K. Nehru noted that Churchill’s threat was partially achieved by Stafford Cripps, then Chancellor of the Exchequer. India devalued the rupee proportionally: from ?3.309 to a dollar to ?4.762.
The sterling was floated against the major international currencies in the early 1970s, the rupee as late as 1993-1994. The two currencies were delinked in 1975.