Big picture
India buys oil, electronics and gold from abroad and sells software services, medicines and garments. Indians abroad send money home, and foreign companies invest in India. All these transactions involve foreign exchange, and they are recorded in the balance of payments (BoP).
The price at which one currency is exchanged for another is the foreign exchange rate. When demand for dollars rises faster than their supply, the rupee weakens. This chapter covers how the BoP is structured and how exchange rates are determined.
Learning goals
Explain the meaning and structure of the balance of payments.
Distinguish the current account and the capital account, and identify their items.
Distinguish balance of trade and balance on current account.
Explain autonomous and accommodating transactions, and BoP surplus and deficit.
Explain the foreign exchange rate and the fixed, flexible and managed floating systems.
Explain how the exchange rate is determined by demand and supply under a flexible system.
Distinguish depreciation and appreciation from devaluation and revaluation.
Core ideas
1. Balance of payments
The balance of payments is a systematic record of all economic transactions between the residents of a country and the rest of the world during a given period, usually a year.
It has two main accounts: the current account and the capital account. Receipts from abroad are recorded as credit (+) and payments to abroad as debit (−).
2. Current account
The current account records transactions in goods, services, income and transfers, which do not create claims or liabilities.
Component | Credit (inflow) | Debit (outflow) |
|---|---|---|
Visible trade (goods) | Exports of goods | Imports of goods |
Invisible trade: services | Software, tourism, transport, banking and insurance services sold to foreigners | Such services bought from foreigners |
Invisible trade: income | Interest, profit, dividends and wages earned by residents from abroad | Such incomes paid to non-residents |
Invisible trade: transfers | Gifts and remittances received from abroad | Gifts and remittances sent abroad |
Balance of trade (BoT) = Exports of goods − Imports of goods. It covers only visible items.
Balance on current account = BoT + Net invisibles (services + income + transfers).
Example (₹ thousand crore): exports of goods 400; imports of goods 550; net services +80; net income −10; net transfers +30.
Balance of trade = 400 - 550 = -150 (deficit)
Net invisibles = 80 - 10 + 30 = +100
Current account balance = -150 + 100 = -50 (deficit)India typically runs a trade deficit that is partly offset by a surplus on invisibles, especially software services and remittances.
3. Capital account
The capital account records transactions that create or settle claims and liabilities, or change a country's assets and liabilities abroad.
Item | Credit (inflow) | Debit (outflow) |
|---|---|---|
Foreign direct investment (FDI) | Foreigners set up or buy businesses in India | Indians invest in businesses abroad |
Foreign portfolio investment (FPI) | Foreigners buy Indian shares and bonds | Indians buy foreign shares and bonds |
External borrowings | Loans received from abroad | Loans given abroad and repayments |
Banking capital (including NRI deposits) | Increase in non-resident deposits | Withdrawals |
Note. To decide whether an item is current or capital, ask: does it create a claim or liability? Interest received on a loan is current (income); the loan itself is capital.
4. Autonomous and accommodating transactions; BoP surplus and deficit
Autonomous transactions are made for their own sake, for profit or other economic motives, independent of the BoP position (exports, imports, FDI). They are called above the line items.
Accommodating transactions are made to cover a gap in autonomous transactions (using foreign exchange reserves, borrowing from the IMF). They are below the line items.
BoP deficit: autonomous payments exceed autonomous receipts. It is financed by drawing down foreign exchange reserves or official borrowing.
BoP surplus: autonomous receipts exceed autonomous payments. The surplus adds to foreign exchange reserves.
In an accounting sense, the BoP always balances, because any gap in autonomous transactions is covered by accommodating transactions (official reserve transactions).
5. Foreign exchange rate and exchange rate systems
The foreign exchange rate is the price of one currency in terms of another, for example ₹84 = $1.
System | How the rate is set | Changes are called |
|---|---|---|
Fixed (pegged) exchange rate | The government or central bank fixes the rate and maintains it by buying and selling foreign currency | Devaluation (official reduction in the domestic currency's value) and revaluation (official increase) |
Flexible (floating) exchange rate | Determined by the market forces of demand and supply, without government intervention | Depreciation (market fall in value) and appreciation (market rise) |
Managed floating | Largely market-determined, but the central bank intervenes to prevent excessive fluctuations; India follows this |
Merits and demerits
Fixed rate | Flexible rate | |
|---|---|---|
Merits | Stability encourages trade and investment; prevents speculation | No need for large foreign exchange reserves; BoP adjusts automatically; resources are allocated efficiently |
Demerits | Needs large reserves; can't adjust to market changes; may lead to under- or over-valuation | Uncertainty discourages trade and investment; encourages speculation |
6. Determination of the exchange rate under a flexible system
Demand for foreign exchange (say, US dollars) arises from:
imports of goods and services;
Indians travelling or studying abroad;
Indian investment abroad and purchase of foreign assets;
repayment of foreign loans and sending gifts abroad;
speculation, when people expect the dollar to rise.
The demand curve slopes downward: when the dollar becomes cheaper (the rate falls), imports and travel become cheaper, so more dollars are demanded.
Supply of foreign exchange comes from:
exports of goods and services;
foreign tourists in India;
foreign direct and portfolio investment into India;
remittances from Indians working abroad;
speculation, when people expect the dollar to fall.
The supply curve slopes upward: when the dollar becomes dearer (the rate rises), Indian goods become cheaper for foreigners, exports rise, and more dollars are supplied.
Equilibrium rate: where demand for dollars equals supply of dollars.
Effects of changes
Change | Effect on rate (₹ per $) | Effect on the rupee |
|---|---|---|
Demand for dollars rises (more imports, students going abroad) | Rises | Depreciates |
Supply of dollars rises (more exports, more foreign investment) | Falls | Appreciates |
Example. The rate moves from ₹80 = $1 to ₹84 = $1. More rupees are needed to buy one dollar, so the rupee has depreciated. Indian exports become cheaper for foreigners (a $100 product they buy now earns the exporter ₹8,400 instead of ₹8,000), and imports become dearer for Indians. Depreciation therefore tends to raise exports and reduce imports.
A reliable problem-solving routine
For BoP classification, decide: goods (visible trade), services, income or transfers (current account), or investment and loans (capital account).
Mark each item as a credit (inflow of foreign exchange) or debit (outflow).
Balance of trade covers goods only; current account adds invisibles.
For exchange rate questions, decide whether demand or supply of foreign exchange changes, shift the right curve, and state the effect on the rupee.
Use "depreciation and appreciation" for market-driven changes and "devaluation and revaluation" for official changes under a fixed system.
Connections that matter
National income: exports and imports form net exports in GDP, and net factor income from abroad appears in the current account's income items.
Money and banking: the RBI is the custodian of foreign exchange reserves and intervenes in a managed float.
Indian economic development: the 1991 crisis was a BoP crisis, and globalisation reforms changed India's trade and capital flows.
Common mistakes
Treating balance of trade as the whole current account. BoT excludes invisibles.
Putting FDI or foreign loans in the current account. They are capital account items.
Putting interest received on loans in the capital account. It is income, in the current account.
Calling a market fall in the rupee "devaluation". Devaluation is an official act under a fixed system.
Saying a rise in ₹ per $ means the rupee has appreciated. It has depreciated.
Revision checklist
I can explain the structure of the BoP and the items in each account.
I can calculate balance of trade and current account balance.
I can explain autonomous and accommodating transactions and BoP deficit.
I can compare fixed, flexible and managed floating exchange rates.
I can explain the sources of demand and supply of foreign exchange and the equilibrium rate.
I can explain depreciation, appreciation, devaluation and revaluation and their effects.