Proportional Reserve System

The Proportional Reserve System (PRS) is a monetary framework that requires a fixed proportion of a country’s total currency in circulation to be backed by specified reserves, typically in gold and foreign securities. The system was designed to ensure that the value of the currency is supported by tangible assets, thereby maintaining public confidence in its stability. Before the introduction of the Minimum Reserve System in 1956, India followed the Proportional Reserve System for the issue of currency by the Reserve Bank of India (RBI).

Historical Background

The origins of the Proportional Reserve System in India date back to the early years of the Reserve Bank of India, which was established in 1935 under the Reserve Bank of India Act, 1934. The currency issue function was governed by Section 33 of the Act, which laid down rules regarding the maintenance of reserves against the currency issued by the RBI.
Under this system, the central bank was required to maintain a specific proportion of its note issue in the form of gold and sterling securities, ensuring that a substantial part of the currency had backing in valuable, internationally recognised assets.
This arrangement was considered necessary to strengthen confidence in the new currency at a time when India’s financial system was developing and external convertibility was a concern. The system mirrored similar practices in other British Commonwealth countries, reflecting the colonial influence on India’s financial architecture.

Main Features of the Proportional Reserve System

The Proportional Reserve System operated on a fixed rule-based principle of currency issuance. The key features of this system were as follows:

• Fixed Reserve Ratio: At least 40% of the total value of currency issued by the Reserve Bank had to be backed by a combination of gold and foreign (sterling) securities.
• Composition of the Reserve: The reserve assets were divided between gold reserves and foreign securities, with gold forming a minimum portion to ensure intrinsic backing.
• Government Securities Backing: The remaining 60% of the currency issue could be backed by Indian government securities, which represented domestic assets.
• Convertible Nature: The currency issued under this system was considered reliable and stable, as it could theoretically be converted into gold or foreign currency due to its reserve backing.
• Issue Department Separation: The Issue Department of the RBI, which was responsible for currency issuance, was required to maintain these reserves strictly in accordance with the prescribed ratios.

This proportional backing provided a balance between the gold standard tradition and the need for domestic monetary flexibility.

Objectives of the System

The introduction of the Proportional Reserve System was guided by several key objectives:

• To ensure currency stability by linking the value of the rupee with tangible assets such as gold and sterling.
• To maintain public confidence in the newly established Reserve Bank and its currency issue.
• To provide a partial degree of flexibility in expanding the currency supply compared to the older full reserve systems.
• To align India’s monetary system with international standards prevalent during the early 20th century.

Functioning of the System

The Issue Department of the RBI was responsible for issuing currency notes under the Proportional Reserve System. The department had to ensure that the total value of gold and sterling securities always equalled at least 40% of the total currency issued.
For example, if the total currency issued amounted to ₹100 crore, then at least ₹40 crore had to be backed by gold and foreign exchange, while the remaining ₹60 crore could be covered by Indian government securities.
The gold reserves were held partly in India and partly in the Bank of England, while sterling securities were investments in British government bonds or other approved foreign assets.
This system imposed a monetary discipline on the central bank, as the volume of currency that could be issued was limited by the availability of gold and foreign exchange reserves.

Advantages of the Proportional Reserve System

The Proportional Reserve System provided several important benefits, particularly during its early years of operation:

• Stability and Confidence: The partial gold and foreign backing inspired trust in the currency’s value and promoted financial stability.
• International Credibility: By maintaining sterling and gold reserves, the system enhanced India’s credibility in international trade and finance.
• Controlled Money Supply: The requirement of proportional reserves prevented excessive currency creation and limited inflationary tendencies.
• Monetary Discipline: It imposed strict financial discipline on the Reserve Bank, ensuring cautious and prudent currency management.
• Compatibility with the Gold Standard: The system retained the spirit of the gold standard era, ensuring convertibility and external value stability.

Limitations of the Proportional Reserve System

Despite its advantages, the system suffered from several practical and structural limitations, particularly in the context of a developing economy like India.

• Rigid Structure: The fixed proportion of reserves restricted the RBI’s ability to expand the money supply according to domestic needs.
• Dependence on Foreign Exchange: The system tied the stability of India’s currency to fluctuations in the international value of sterling, limiting monetary sovereignty.
• Shortage of Gold and Sterling: Maintaining sufficient gold and foreign exchange reserves was difficult, especially during wartime and economic crises.
• Constraint on Economic Growth: During the Second World War and the post-war reconstruction period, the rigid reserve requirements hampered the government’s ability to meet rising currency demands.
• Inflationary Pressures: The limited money supply could not accommodate the growing economy, leading to liquidity shortages.

These limitations became particularly evident in the 1950s, when India embarked on planned economic development. The growing need for currency and credit expansion could not be met within the rigid proportional reserve framework.

Transition to the Minimum Reserve System

In response to these constraints, the Government of India and the Reserve Bank decided to replace the Proportional Reserve System with the more flexible Minimum Reserve System in 1956. Under the new system, the RBI was required to maintain only a fixed minimum reserve of ₹200 crore (of which ₹115 crore in gold and ₹85 crore in foreign securities), rather than a fixed proportion of total currency issued.
This change allowed the RBI greater freedom to issue currency according to the needs of economic growth, while maintaining a minimal backing to preserve public confidence.

Comparative Summary

Significance and Legacy

The Proportional Reserve System holds an important place in the history of India’s monetary policy. It represented an intermediate stage between the Gold Standard Era and modern fiat money systems. While it successfully maintained currency stability during its early years, it eventually became incompatible with the dynamic needs of a growing economy.