Balance of Payments & Foreign Exchange
The balance of payments is the systematic record of all economic transactions between the residents of a country and the rest of the world during a given period, usually one financial year. It is the most complete statement of a country's external economic relations, and for India, which imports large quantities of crude oil, gold and electronic goods, it is a subject of continuous policy attention. The foreign exchange reserves that the country holds act as the buffer that protects the rupee against external shocks. These notes explain the two main accounts of the balance of payments, the meaning of the current account deficit, the components of the foreign exchange reserves, the exchange rate systems, and the legal framework that governs foreign exchange in India.
What is the balance of payments?
The balance of payments, commonly shortened to BoP, records every receipt and payment between residents of the home country and the rest of the world. It is divided into two principal accounts, the current account and the capital account, with a residual item called errors and omissions. The current account deals with the flow of goods, services, income and transfers, while the capital account deals with transactions that change the ownership of assets and liabilities, such as foreign direct investment, foreign portfolio investment, external commercial borrowings, external assistance and banking capital. In accounting terms the BoP always balances, because any excess of payments over receipts must be financed by drawing down reserves or by borrowing, and this financing is itself entered in the accounts.
Current account, balance of trade and invisibles
The balance of trade covers only the merchandise trade, that is, the value of goods exported minus the value of goods imported. The current account is wider: it equals the balance of trade plus the net value of invisibles. Invisibles are so called because they are not visible goods, and they include services such as software, tourism, shipping, insurance and business services, income such as interest and dividend, and transfers such as remittances sent home by non-resident Indians. India normally runs a large trade deficit because oil, gold, coal and electronic goods form the bulk of imports, and this deficit is only partly offset by a surplus in invisibles, chiefly software exports and remittances. A current account deficit, or CAD, means that the country's total current receipts are less than its current payments, and it must be financed by capital inflows. A current account surplus is the opposite situation, where receipts exceed payments.
Foreign exchange reserves and the 1991 crisis
India's foreign exchange reserves have four components: foreign currency assets, which are the largest; gold; special drawing rights held with the International Monetary Fund; and the reserve tranche position in the Fund. The reserves are managed by the Reserve Bank of India, which intervenes in the market to smooth excessive volatility in the exchange rate. The special drawing right is a supplementary reserve asset created by the International Monetary Fund in 1969, and its value is based on a basket of major currencies that includes the United States dollar, the euro, the Chinese yuan, the Japanese yen and the pound sterling. The importance of adequate reserves was demonstrated in 1991, when India faced a severe balance of payments crisis and had to pledge gold to obtain emergency finance, an episode that triggered the economic reforms of that year. Reserves are measured in terms of import cover, that is, how many months of imports they can pay for.
Exchange rate systems
An exchange rate is the price of one currency in terms of another. Under a fixed exchange rate system, the rate is pegged to a reference and held stable by official action, whereas under a floating or flexible system the rate is determined by the forces of demand and supply in the market. India currently follows a managed floating system, in which the market determines the rate but the Reserve Bank intervenes to prevent sharp swings. When the value of a currency is deliberately lowered by the monetary authority under a fixed system, it is called devaluation, while a fall under a market system is called depreciation. Likewise, an official increase is revaluation and a market rise is appreciation. Depreciation makes Indian exports cheaper in foreign markets and imports more expensive at home, which can improve export competitiveness but also raises the import bill and fuels imported inflation, so the effect on the economy is mixed.
Convertibility and the foreign exchange law
The rupee is fully convertible on the current account, which means that foreign exchange for trade in goods, services and normal remittances is available without restriction. This was achieved in 1994 following the recommendations of the Tarapore Committee, and the current account convertibility was formally accepted under the obligations of the International Monetary Fund. The capital account, however, is only partially convertible, and full capital account convertibility has not yet been adopted because of the risks it carries for financial stability. The Foreign Exchange Regulation Act of 1973, known as FERA, was a restrictive law whose violations were criminal offences; it was replaced in 1999 by the Foreign Exchange Management Act, or FEMA, which came into force in 2000 and treats most violations as civil offences. FEMA is administered by the Reserve Bank of India under the overall supervision of the Ministry of Finance.
Other international terms
The London Interbank Offered Rate, better known as LIBOR, was for decades the benchmark interest rate at which major London banks borrowed from one another and was used to price loans and derivatives worldwide; it is now being replaced by new reference rates such as SOFR. A hard currency is a widely accepted and stable currency, such as the United States dollar, that is held as reserves by many countries. External commercial borrowings are loans raised by Indian companies from foreign lenders, and they are recorded in the capital account. The Asian financial crisis of 1997 began with the collapse of the Thai baht and spread to several East Asian economies. The Japanese yen is one of the most widely traded international currencies, and it is an important component of the special drawing right basket.
Key facts at a glance
- The balance of payments records all external economic transactions of residents with the rest of the world.
- Its two main accounts are the current account and the capital account.
- The balance of trade covers merchandise goods only.
- Current account equals the balance of trade plus net invisibles.
- Invisibles include services, income and transfers such as remittances.
- FDI and FPI are capital account transactions, not current account items.
- A current account deficit means current payments exceed current receipts.
- The four components of the reserves are foreign currency assets, gold, special drawing rights and the reserve tranche position.
- India's foreign exchange reserves are managed by the Reserve Bank of India.
- Special drawing rights are issued by the International Monetary Fund.
- India follows a managed floating exchange rate system.
- The current account is fully convertible since 1994; the capital account is only partially convertible.
- FERA was replaced by FEMA, enacted in 1999 and brought into force in 2000.
- 1991 was the year of India's severe balance of payments crisis.
Quick revision points
- The BoP always balances in accounting terms because of the reserve and financing entries.
- Software exports and remittances are the two biggest supports of India's invisibles.
- A weak rupee helps exporters but hurts importers and can raise inflation.
- Devaluation belongs to a fixed system and depreciation to a market system.
- The Tarapore Committee is associated with current account convertibility.
- FEMA applies to the whole of India and to all branches and agencies of Indian residents abroad.
How to prepare this topic
- First learn the difference between the current account and the capital account with one example of each.
- Memorise the four components of the foreign exchange reserves in order.
- Remember the years 1991 for the crisis, 1994 for current account convertibility and 1999 for FEMA.
- Practise distinguishing devaluation from depreciation and revaluation from appreciation.
- Note the institutions and their roles, namely the Reserve Bank and the International Monetary Fund.
- Revise the special drawing right basket and the meaning of import cover.
Common exam traps
- Placing FDI and FPI in the current account by mistake; both belong to the capital account.
- Using devaluation and depreciation as if they are the same thing.
- Confusing the balance of trade with the balance of payments; the former is only about goods.
- Saying that the reserves consist only of dollars and gold; they also include special drawing rights and the reserve tranche position.
- Claiming that India has full capital account convertibility, which is not yet true.
- Mixing up the years of FERA and FEMA.
Frequently Asked Questions
What are the two main components of the balance of payments?
The balance of payments has two main components, the current account and the capital account. The current account records trade in goods and services along with income and transfers, while the capital account records transactions that change the ownership of assets and liabilities, such as foreign direct investment, foreign portfolio investment, external commercial borrowings and banking capital. A residual item called errors and omissions reconciles the two.
Why does India usually run a current account deficit?
India imports large quantities of crude oil, gold, coal and electronic goods, so the merchandise trade deficit is large. Although software exports and remittances create a surplus in invisibles, it is normally not enough to offset the trade deficit, and therefore the current account is usually in deficit. This gap has to be financed through capital inflows such as foreign investment and external borrowings.
What are the four components of India's foreign exchange reserves?
The reserves consist of foreign currency assets, which are the largest component, gold, special drawing rights held with the International Monetary Fund, and the reserve tranche position with the Fund. They are managed by the Reserve Bank of India, which uses them to intervene in the foreign exchange market and to meet the country's external obligations.
What is the difference between devaluation and depreciation?
Devaluation is a deliberate, official reduction in the value of a currency under a fixed exchange rate system, whereas depreciation is a fall in the value of a currency caused by market forces under a floating or managed floating system. Devaluation is a policy decision, while depreciation is a market outcome. The reverse of devaluation is revaluation and the reverse of depreciation is appreciation.
What is FEMA and when did it replace FERA?
FEMA is the Foreign Exchange Management Act, which replaced the restrictive Foreign Exchange Regulation Act, or FERA, of 1973. FEMA was enacted in 1999 and came into force in 2000. It liberalised the management of foreign exchange and treats most contraventions as civil offences rather than criminal offences. It is administered by the Reserve Bank of India under the Ministry of Finance.