Balance of payments and exchange rates

The external sector is the RBI's own territory. It compiles India's balance of payments, manages the foreign exchange reserves, administers FEMA and intervenes in the currency market. India's two sharpest macro crises, in 1991 and the "taper tantrum" of 2013, both began on the external side. So this is one of the ESI topics where the examiner expects precise definitions and judgment about policy.

The balance of payments

India's BoP follows the IMF's sixth manual (BPM6). The RBI's presentation groups it like this:

The rule: current account + capital account + errors and omissions = change in reserves. (In the RBI's tables an increase in reserves is shown with a minus sign, because it is a use of funds.)

Worked example (illustrative, US$ billion):

1. Goods: exports 450, imports 700, so trade balance = −250.
2. Net services +150; net primary income −40; net secondary income +110.
3. Current account balance = −250 + 150 − 40 + 110 = −30 (a deficit).
4. Net capital inflows: FDI 25, portfolio 20, loans 10, banking and other 5, total +60.
5. Errors and omissions −2.
6. Change in reserves = −30 + 60 − 2 = +28 (reserves rise).
7. If GDP is 3,500, the CAD is 30/3,500 ≈ 0.9% of GDP.

This pattern is typical of India: a large goods deficit (oil, gold, electronics, coal) partly offset by a services surplus led by IT and business services and by the world's largest flow of remittances, with the remaining CAD financed by capital inflows.

Why a CAD happens: the saving–investment identity

From national accounts, current account balance = national saving − domestic investment. A CAD means India invests more than it saves and borrows the difference from abroad. Splitting saving into private and government parts gives CA = (private saving − private investment) + (government revenue − government spending). A larger fiscal deficit, other things equal, widens the CAD: the twin deficits idea.

So a CAD is not bad in itself. A developing economy with good investment opportunities should import capital. The questions are its size, its financing and its use.

A CAD of around 2.5% of GDP has often been described by the RBI as sustainable for India, but the right level depends on how it is financed.

Two crises, two lessons

• 1991: a high CAD, rising short-term debt, the Gulf War oil shock and political uncertainty drained reserves to a few weeks of imports. India pledged gold abroad, borrowed from the IMF and launched the 1991 reforms. Lesson: avoid reliance on short-term debt.
• 2013 taper tantrum: when the US Federal Reserve signalled it would slow bond purchases, portfolio money left emerging markets. India, with a CAD near 5% of GDP and high inflation, saw the rupee fall sharply. The RBI tightened liquidity and opened a swap window for FCNR(B) deposits. Lesson: a large CAD financed by portfolio flows is fragile.

Exchange rate regime

India runs a managed float. The rupee's value is set in the market, and the RBI buys or sells dollars to curb excessive volatility, not to defend a particular level. Tools include spot and forward intervention, swaps, changes in rules for capital flows, and communication.

NEER and REER

• NEER (nominal effective exchange rate): a weighted average of the rupee against a basket of trading partners' currencies. The RBI publishes 40-currency and 6-currency indices.
• REER (real effective exchange rate): NEER adjusted for the ratio of domestic to foreign prices. Approximately, % change in REER ≈ % change in NEER + domestic inflation − partner inflation.

A rise in either index means the rupee has appreciated.

Worked example: the rupee's NEER rises 2% in a year; Indian inflation is 5% and trading partners' inflation is 3%. REER change ≈ 2 + 5 − 3 = +4%. The rupee has become about 4% less competitive in real terms, even though the nominal gain was only 2%. If instead the NEER falls 2%, the REER change is −2 + 5 − 3 = 0: the depreciation merely offsets the inflation gap.

Reserves and the impossible trinity

India's reserves have four parts: foreign currency assets (the largest), gold, SDRs and the reserve tranche position in the IMF. They are managed with the priorities of safety, liquidity and then return.

Adequacy is judged by:

• Import cover: months of imports the reserves can pay for.
• Short-term debt cover: the Guidotti–Greenspan rule says reserves should at least equal external debt falling due within a year.
• The IMF's composite reserve adequacy metric, which also counts broad money and portfolio liabilities.

Reserves have a cost: they earn low returns, and buying dollars adds rupee liquidity that the RBI may have to absorb (sterilise), usually through liquidity operations.

The impossible trinity says a country cannot have all three of a fixed exchange rate, free capital movement and an independent monetary policy. India chose independent monetary policy (inflation targeting) and gradually opening capital flows, with a flexible but managed exchange rate. Reserves buy room to smooth volatility within that choice.

Convertibility

• Current account: fully convertible since 1994.
• Capital account: partially convertible. The Tarapore Committees (1997 and 2006) set preconditions: fiscal consolidation, low inflation, a strong banking system and adequate reserves. India has opened in steps, for example through the Liberalised Remittance Scheme (2004) for residents and wider foreign access to government bonds.
• Rupee internationalisation: since 2022, Special Rupee Vostro Accounts allow trade to be invoiced and settled in rupees.

Model answer outline (15 marks)

Question: Is a current account deficit a cause for concern for India? How should it be managed?

1. Opening: define CAD; the identity CA = S − I.
2. Why India runs one: goods deficit (oil, gold, electronics), partly offset by services and remittances.
3. When it is not a worry: financed by FDI; funds productive investment; moderate size.
4. When it is: financed by portfolio or short-term debt; driven by consumption or gold; lessons of 1991 and 2013.
5. Management: export competitiveness (REER), energy transition to cut oil imports, gold monetisation, attracting FDI, adequate reserves, fiscal discipline (twin deficits).
6. Conclusion: size, financing and use together decide sustainability.

Short model answer (10 marks)

Question: Distinguish between NEER and REER. Which is the better guide to export competitiveness?

The NEER is a weighted average of the rupee's exchange rates against the currencies of India's trading partners, with weights based on trade shares. It tells us how the rupee has moved against a basket, not just against the dollar. The RBI publishes 40-currency and 6-currency indices, where a rise means appreciation.

The REER adjusts the NEER for differences in inflation between India and its partners. If Indian prices rise faster than partners' prices, Indian goods become relatively expensive even at an unchanged nominal rate. Roughly, the change in REER equals the change in NEER plus Indian inflation minus partner inflation.

The REER is the better guide to competitiveness, because exporters compete on real prices. For example, if the NEER is unchanged but India's inflation is 3 points higher than its partners', the REER appreciates by about 3%, hurting exports. Policy makers watch the REER to judge whether the rupee is overvalued, while remembering that the choice of base year and weights affects the reading.

Practice questions

1. Remittances from Indians abroad are recorded under which head?
   • Secondary income in the current account.
2. If the CAD is 40, net capital inflows are 55 and errors and omissions are zero, what happens to reserves?
   • They rise by 15.
3. If NEER falls 3%, domestic inflation is 6% and partner inflation is 2%, what is the approximate change in REER?
   • +1% (−3 + 6 − 2), a slight real appreciation.
4. Since when has the rupee been convertible on the current account?
   • 1994.
5. What does the Guidotti–Greenspan rule compare?
   • Reserves with short-term external debt due within a year.
6. Which law replaced FERA?
   • FEMA, 1999.

What to do next

• Take the latest RBI BoP release and rebuild the worked example with real numbers.
• Note the latest REER reading and whether the rupee looks over- or undervalued.
• Read the trade and globalisation guide and the international institutions guide next.