Balance of Payments, Exchange Rates and Convertibility

What the balance of payments records

The balance of payments (BoP) is a systematic record of all economic transactions between residents of a country and the rest of the world over a period. It is compiled in India by the RBI, following the IMF's BoP Manual (BPM6).

By double-entry accounting, the BoP always balances. A "deficit" or "surplus" refers to a particular account or to the change in reserves.

Structure of the BoP

1. Current account

• Merchandise trade: exports and imports of goods.
• Invisibles:
• services: IT, travel, transport, financial services;
• primary income: interest, dividends and wages, i.e. investment income;
• secondary income: transfers such as remittances, gifts and grants.

2. Capital account (narrow): capital transfers and non-produced non-financial assets such as patents and spectrum rights. It is small.

3. Financial account:

• FDI;
• portfolio investment (FPI);
• other investment: external commercial borrowings, trade credit, banking capital and NRI deposits;
• reserve assets.

In Indian usage, the "capital account" often refers loosely to the capital and financial accounts together.

4. Errors and omissions: a balancing item for statistical discrepancies.

India's BoP profile

• Large merchandise trade deficit: India imports crude oil, gold, electronics, coal and fertilisers. The goods deficit was about $280–290 billion in 2024–25.
• Large services surplus: software and business services exports have grown into one of the world's largest such surpluses, about $180–190 billion in 2024–25. Global Capability Centres (GCCs) are a major driver.
• Remittances: India is the world's largest recipient, about $135 billion in 2024–25 (RBI). Remittances from advanced economies, especially the US and UK, now exceed those from the Gulf.
• The current account deficit (CAD) is usually modest, about 1–2% of GDP, and is financed by capital inflows. It was only about 0.6% of GDP in 2024–25. India ran a small surplus in 2020–21, when pandemic-era imports collapsed.
• Sustainable CAD: the RBI and economists consider a CAD of about 2.5–3% of GDP sustainable.

The 1991 crisis: a lesson

In 1990–91 the Gulf War oil shock, falling remittances, high fiscal deficits, short-term debt and political instability pushed the CAD to about 3% of GDP. Reserves fell to cover barely two to three weeks of imports.

India pledged gold with the Bank of England and the Bank of Japan, took IMF support, and launched the 1991 reforms:

• rupee devaluation in July 1991;
• trade liberalisation;
• the move to a market-determined exchange rate in 1993.

Exchange rate regimes

• Fixed (pegged): the central bank keeps the rate at a set level. India was in the Bretton Woods system until 1971, then pegged to a basket.
• Floating: determined by the market.
• Managed float: market-determined, with central bank intervention to curb excess volatility. India has followed this since March 1993, after the dual exchange rate (LERMS) of 1992.

The IMF classifies India's de facto regime in recent years as a "stabilised arrangement", reflecting heavy RBI smoothing. The IMF has since revised this label; use the latest Article IV report.

Key terms:

• Depreciation/appreciation: market-driven fall or rise of a currency.
• Devaluation/revaluation: deliberate official changes under a fixed regime.
• Nominal Effective Exchange Rate (NEER): a weighted average against a basket of trading partners. The RBI uses a 40-currency basket.
• Real Effective Exchange Rate (REER): NEER adjusted for relative inflation. A REER above 100 suggests overvaluation, which hurts competitiveness.

Rupee path: about ₹45/$ (2010), ₹68 (2013 "taper tantrum"), ₹83 (2023), and crossing ₹85–88/$ in 2025 amid dollar strength and FPI outflows.

Effects of depreciation:

• Exports become cheaper and imports dearer.
• The trade balance improves with a lag. This is the J-curve, if the Marshall–Lerner condition holds.
• It raises imported inflation (oil) and the burden of foreign-currency debt.

Convertibility

Current account convertibility: the free exchange of currency for current transactions such as trade and travel. India accepted IMF Article VIII obligations in August 1994.

Capital account convertibility (CAC): the freedom to convert currency for capital transactions such as buying foreign assets or borrowing abroad.

• India has partial CAC, with calibrated liberalisation.
• The Tarapore Committee I (1997) and II (2006) set preconditions: fiscal consolidation, low inflation, a sound banking system and adequate reserves.
• The Liberalised Remittance Scheme (LRS) of 2004 allows resident individuals to remit up to $250,000 a year.

The case for caution: the East Asian crisis (1997) showed the dangers of sudden capital reversals. India's caution was vindicated then and in 2008.

Rupee internationalisation

Steps:

• Rupee trade settlement through Special Rupee Vostro Accounts (July 2022);
• local currency settlement agreements with the UAE (2023), Indonesia and Maldives;
• UPI linkages;
• masala bonds: rupee-denominated bonds abroad, first issued in 2014–15.

Benefits: lower exchange risk and less dependence on the dollar.

Constraints: a persistent trade deficit, limited capital account openness, and shallow offshore markets. The RBI's Inter-Departmental Group report (2023) set out a roadmap.

Common prelims traps

• Remittances go in the current account (secondary income), not the capital account.
• FDI and ECBs go in the financial account.
• Devaluation applies to fixed regimes; India's rupee depreciates.
• India has had current account convertibility since 1994, but not full capital account convertibility.
• A REER above 100 means overvaluation, not undervaluation.

Quick self-test

1. *Where do interest payments on external debt appear?* Current account, primary income.
2. *What did the Tarapore committees deal with?* Capital account convertibility.
3. *Why might a depreciation initially worsen the trade balance?* The J-curve: import bills rise before volumes adjust.

Practice: Mains question

*"India's large services surplus and remittances have made its current account deficit manageable despite a persistent merchandise trade deficit." Examine, and discuss the risks. (250 words)*

Analysis: vulnerabilities and buffers

Vulnerabilities:

• Oil: India imports about 85–88% of its crude oil. Every $10 rise in the oil price widens the CAD by roughly 0.3–0.4% of GDP.
• Gold: imports rise when domestic demand rises. The government has tried to divert it through gold monetisation and Sovereign Gold Bonds (2015).
• Electronics imports from China.
• Volatile portfolio flows, which react to US Federal Reserve policy (the 2013 taper tantrum).
• Trade policy shocks, such as higher US tariffs on Indian goods in 2025.

Buffers:

• large forex reserves;
• a low share of short-term external debt;
• resilient services exports and remittances, which are less cyclical than goods.

Policy response to pressure:

• RBI intervention in spot and forward markets;
• measures to attract inflows, such as raising NRI deposit rates or relaxing ECB and FPI debt limits, as in 2013 and 2022;
• curbs on non-essential imports, such as raising gold import duty in 2013.

Long-term solutions:

• raise manufacturing export competitiveness;
• diversify energy sources (renewables reduce oil dependence);
• increase services value-add.

How the exchange rate is determined in practice

Market forces: the rupee–dollar rate is set in the interbank forex market, by demand (importers, FPI outflows, debt repayments) and supply (exporters, remittances, FDI and FPI inflows).

RBI intervention: the RBI enters the market:

• selling dollars when the rupee falls too fast;
• buying dollars (adding to reserves) when inflows surge.

Interest rate differentials: the gap between Indian and US interest rates affects carry trades and hence portfolio flows.

The "impossible trinity" (trilemma): a country cannot simultaneously have a fixed exchange rate, free capital mobility and an independent monetary policy. It can choose only two. India resolves this with a managed float, partial capital controls and an inflation-targeting monetary policy.