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Home / IAS Preparation / LERMS (Liberalized Exchange Rate Management System)

LERMS (Liberalized Exchange Rate Management System)| Download UPSC Notes

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The Liberalized Exchange Rate Management System, or LERMS, adopted in the year 1992, was one of the landmark changes brought about in India's foreign exchange policy. This formed an integral part of the various reforms in the economic sector toward liberalizing the Indian economy. Under LERMS, exporters had to convert 60% of their foreign exchange earnings into rupees at market-determined rates, while 40% was required to be surrendered to the Reserve Bank of India at the official exchange rate. This dual exchange rate system facilitated a gradual movement and transition from a controlled exchange rate mechanism to a more market-oriented one, boosting foreign trade and remittances. The different types of Bills involved in foreign exchange transactions were also indirectly influenced by LERMS, improving operational efficiency in trade financing.

The topic falls within the Economics section of the General Studies Paper III of the UPSC examination.

GS Paper

General Studies Paper III

Topics for UPSC Prelims

Introduction and Features of LERMS, Types of Exchange Rates, Evolution of Exchange Rate Systems in India, Role of RBI in Exchange Rate Management.

Topics for UPSC Mains

LERMS and its Impact on Indian Economy, Economic Reforms of 1991, Advantages and Disadvantages of Exchange Rate Systems, Transition to Unified Exchange Rate System.

What is Liberalized Exchange Rate Management System LERMS?

It was part of India's landmark economic liberalization in 1992 that introduced LERMS. The system was created for easing the country's balance of payments position by allowing partial convertibility of the Indian Rupee. LERMS allowed exporters to convert 60% of foreign exchange earnings at market-determined rates, with the remaining 40% being surrendered to the RBI at a fixed rate. It was this novel approach that helped to open the path for a much smoother transition to a flexible exchange rate regime, encouraging foreign investments and promoting external trade.

Evolution of Exchange Rate Management in India

The fixed exchange rate system was the first system adopted in India, whereby the rupee was pegged against a basket of foreign currencies. This provided stability to the exchange rate but reduced the options available to India in responding to global economic changes. The balance of payments crisis of 1991 made economic reforms an imperative need, and certainly, the exchange rate management was one of them. In this backdrop, LERMS was introduced in 1992. It slowly graduated into what is UERS in 1993. Under it, the dual rates were abolished, and the rupee was allowed to be fully determined by the market, which was a giant step toward a liberalized exchange market.

Read the article on the Foreign Exchange Management Act FEMA!

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What is Exchange Rate?

An exchange rate refers to the value of one currency in terms of conversion to another. It is a very important indicator of the health of an economy and plays a major role in foreign trade, overseas investment, and, more importantly, in economic policy formulations. There could be several mechanisms for the determination of exchange rates, which in turn would determine the valuation of different currencies in the global market.

Types of Exchange Rates

Fixed exchange rates peg a country's currency to another major currency or basket of currencies, while floating exchange rates are determined by the forces of supply and demand in the market.

Fixed Exchange Rate

Also known as a pegged rate, this system pegs a country's currency at a fixed value against another key currency, often the USD or a basket of currencies. The government intervenes in the foreign exchange market to maintain this fixed value.

Floating Exchange Rate

In this system, the value of the currency is determined based on market forces of supply and demand relative to other currencies. There is little or no government influence. These rates are influenced by a great deal of market volatility and economic performance.

Managed Float

Also known as a "dirty float," this is a hybrid of fixed and floating rates. Under the system, the currency floats generally according to the market forces; however, the central bank intervenes from time to time to stabilize or increase the value of the currency in order to avoid excessive volatility.

Read the article on the National Stock Exchange of India Limited NSE!

Key Features of LERMS

LERMS introduced dual exchange rates, allowing partial convertibility of foreign exchange earnings, which eased the transition to a market-driven exchange rate mechanism.

  • Dual Exchange Rates: LERMS introduced a system under which 60% of foreign exchange earnings could be converted at market rates and the remaining 40% would be at a fixed, official rate set by RBI. Dual rate system This facilitated gradual shifting to the fully market-driven exchange rate policy.
  • Partial Convertibility: By allowing partial convertibility, LERMS built a bridge between the rigidly controlled exchange rate system and a more liberal, market-driven approach. The smooth management of this transition was critical in not disrupting the economy.
  • Economic Stabilization: LERMS aimed to stabilize India's economy during the crisis of 1991. It helped in stabilizing the forex market by improving the balance of payments situation and fostered an environment more conducive to economic growth.
  • Incentives to Exports and Remittances: The system encouraged exporters and remittance earners to bring in more foreign exchange since they got market-determined rates for a substantial part of their earnings. That was a strong incentive that drew in foreign exchange inflows.
  • Market Orientation: This has introduced market rates for a substantial portion of currency conversions, injecting the market element into India's forex management and brought it closer to international practices and standards.
  • Transitional Mechanism: LERMS worked as a transitional mechanism to ultimately result in the convertibility of the rupee. It assisted in gauging the response of the market and worked out an economy that would go for a uniform exchange rate system.

Read the article on the difference between fera and fema!

Modified Liberalised Exchange Rate Management System

Encouraged by LERMS' performance, further fine-tuning of the system was effected to bring it closer to international norms. The Modified Liberalized Exchange Rate Management System retained the very same principles of LERMS but gave more emphasis to market forces and reduced the level of regulatory intervention. This further facilitated convertibility and more truly reflected the market-determined rates—thereby bringing India closer to a fully liberalized exchange regime.

Advantages of Modified LERMS

Modified LERMS increased market confidence by reducing government intervention and aligning more closely with market dynamics, thus enhancing currency stability and predictability.

  • Greater Confidence in the Markets: The gradual process of liberalization and reduction in the intervention of the government enhanced the confidence of global investors. This increased FDI and portfolio investments to a large extent.
  • Greater Stability in Currency: Being more aligned with the dynamism of the market, the rupee's value has become more stable and predictable, reducing volatility in exchange rates, which makes business financing easier to decide upon.
  • Improved Forex Reserves: The liberal policies result in an inflow of foreign exchange, improving the forex reserves of the country.
  • Economic Integration: Further liberalization made it easier for markets to integrate further with world financial markets and thereby provide the country with easier and stronger participation in global trade and investment.
  • Facilitation of Trade: Simplification of the exchange rate system helped businesses engage in international trade more easily through Modified LERMS, as it reduced the confusions and risks associated with the currency conversion process under the earlier system.
  • Economic Growth: The liberalized framework thus supported broader economic policies aimed at growth, among them industrial policy reforms and infrastructure development—all contributing to positive GDP growth.

Key Takeaways for UPSC Aspirants

  • Economic Reform Catalyst: LERMS was a key driver of the 1991 economic reforms, helping to stabilize the economy and set the stage for future growth.
  • Partial Convertibility: Introduced a balanced approach by allowing for the partial convertibility of the rupee, facilitating a smoother transition to full convertibility.
  • Boost to Exports: The system significantly boosted export earnings by providing more favorable conversion rates for exporters.
  • Foreign Exchange Reserves: Resulted in a marked improvement in India’s foreign exchange reserves, enhancing the country’s financial stability.
  • Transitional Phase: Acted as a critical transitional phase towards a unified, market-determined exchange rate system.
  • Market Confidence: Enhanced global investor confidence through gradual opening up and market-determined policies.
  • Regulatory Framework: Provided a well-structured framework that guided India’s journey from a controlled to a market-oriented exchange rate regime.
  • Global Integration: Played a pivotal role in integrating the Indian economy with global markets, supporting greater participation in international trade and investment.

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LERMS UPSC FAQs

LERMS is the Liberalized Exchange Rate Management System introduced in 1992 to allow partial convertibility of the Indian Rupee.

To stabilize the economy, improve the balance of payments, and facilitate foreign trade.

Dual exchange rates, market orientation, economic stabilization, and boosting exports and remittances.

It led to a significant improvement in India’s foreign exchange reserves.

The Unified Exchange Rate System (UERS) in 1993, which merged the dual rates into a single market-determined rate.

Fixed exchange rates are pegged to another currency, while floating rates are determined by market forces.

It allows a portion of foreign exchange earnings to be converted at market-determined rates and the rest at officially set rates.

By allowing them to convert a significant part of their earnings at market rates, thus realizing better returns.
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