UPSCNotes
Indian Economy External Sector and Trade GS Paper III

Balance of Payments and Exchange Rates

Balance of payments for UPSC — current and capital accounts, CAD, forex reserves, FDI vs FPI, convertibility, exchange rate regimes, NEER/REER and rupee depreciation.

SyllabusGS III · Effects of liberalisation on the economy — balance of payments, trade, exchange rates and capital flows

By UPSC Notes Editorial Team 13 min read Updated Oct 2026 #economy#external-sector#balance-of-payments

Prerequisites: National Income and Growth · Monetary Policy and Inflation

The Hook: The Summer India Ran Out of Dollars

Connect: In the News → Concept

In mid-1991, India’s foreign exchange reserves had fallen so low that they could pay for only a few weeks of imports. The Gulf War had pushed up oil prices and cut remittances from Gulf workers; foreign lenders and non-resident depositors were pulling money out. To avoid defaulting, the government pledged part of its gold reserves with the Bank of England, devalued the rupee in two steps in July 1991, and borrowed from the IMF. The New Industrial Policy and trade reforms followed within weeks.

The question 1991 raises is the question this topic answers: how does a country “run out” of foreign currency, and what decides what its currency is worth?

The Core Concept

What the balance of payments is

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 (a quarter or a year). It is built on double-entry bookkeeping, so it always balances in an accounting sense. When people say a country has a “BoP problem”, they mean the overall balance is in deficit and has to be financed by running down reserves or borrowing from the IMF.

India’s BoP is compiled and published by the Reserve Bank of India, following the IMF’s Balance of Payments and International Investment Position Manual, sixth edition (BPM6).

The current account

The current account records transactions that do not create a future claim — flows of goods, services and income.

ComponentWhat it containsExample
Merchandise (goods)Exports and imports of physical goodsCrude oil imports, pharmaceutical exports
ServicesTrade in servicesSoftware and IT-enabled services, travel, transport, insurance
Primary incomeReturns on labour and capitalInterest on external loans, dividends paid to foreign investors, compensation of employees
Secondary incomeTransfers with nothing in returnPrivate remittances from Indians abroad, grants

Services, primary income and secondary income together are called invisibles.

  • Trade balance = merchandise exports − merchandise imports. India has run a merchandise trade deficit in almost every year since independence.
  • Current account balance = trade balance + net invisibles. India’s surplus on services (led by software) and remittances usually offsets a large part of the goods deficit, leaving a smaller current account deficit (CAD).
  • The World Bank’s migration and remittances briefs have reported India as the world’s largest recipient of remittances for many consecutive years.

The capital (and financial) account

The capital account records transactions that change the stock of assets and liabilities — they create claims that must be serviced or repaid later.

In India’s standard presentation the broad “capital account” includes:

ComponentWhat it contains
Foreign investmentForeign direct investment (FDI) and foreign portfolio investment (FPI)
LoansExternal assistance (multilateral and bilateral), external commercial borrowings (ECBs), short-term trade credit
Banking capitalIncludes non-resident Indian (NRI) deposits
Rupee debt service and other capitalSmaller items

Under BPM6 terminology, most of these sit in the financial account; the narrow “capital account” holds only capital transfers and non-produced non-financial assets. For UPSC, follow the broad usage unless a question specifies BPM6.

A third line, errors and omissions, captures statistical discrepancies. Whatever remains is the overall balance, which shows up as a change in foreign exchange reserves.

graph TD
    A[Balance of Payments] --> B[Current Account]
    A --> C[Capital and Financial Account]
    A --> D[Errors and Omissions]
    B --> B1[Goods: trade balance]
    B --> B2[Invisibles: services, primary income, secondary income]
    C --> C1[Foreign investment: FDI and FPI]
    C --> C2[Loans: ECB, external assistance, trade credit]
    C --> C3[Banking capital incl. NRI deposits]
    B --> E[Overall balance]
    C --> E
    D --> E
    E --> F[Change in forex reserves]

Foreign exchange reserves

India’s forex reserves have four components: foreign currency assets (the largest), gold, Special Drawing Rights (SDRs) and the reserve tranche position in the IMF. The RBI is the custodian.

FDI vs FPI

BasisFDIFPI
IntentLasting interest and a say in managementFinancial return; no control
Threshold (listed company)10% or more of post-issue paid-up equityLess than 10%
StabilitySticky; hard to withdraw quicklyVolatile (“hot money”)
Typical formNew plant, joint venture, acquisitionShares and bonds bought on exchanges

The 10% dividing line follows the recommendation of the Arvind Mayaram Committee (2014). FDI comes in through two routes: the automatic route (no prior approval) and the government route (approval needed). The Foreign Investment Promotion Board (FIPB) was abolished in 2017; applications now go through the Foreign Investment Facilitation Portal. Since April 2020 (Press Note 3), FDI from an entity of a country that shares a land border with India needs government approval.

Convertibility

Convertibility is the freedom to convert the rupee into foreign currency (and back) at market rates.

  • Current account convertibility: India accepted the obligations of Article VIII of the IMF’s Articles of Agreement in August 1994, making the rupee fully convertible for current transactions (trade, travel, remittances, interest and dividends), subject to reasonable limits.
  • Capital account convertibility: only partial. Two committees chaired by S.S. Tarapore (1997 and 2006) laid out a road map with preconditions such as fiscal consolidation, low inflation and a strong banking system. Liberalisation has been gradual — for example, the Liberalised Remittance Scheme (2004) lets resident individuals remit money abroad up to a ceiling each financial year.

Exchange rate regimes

RegimeHow the rate is setTrade-off
Fixed (pegged)Central bank fixes the rate and defends it with reservesStability, but monetary policy is tied
FloatingDemand and supply in the forex marketMonetary freedom, but volatility
Managed floatMarket-determined, with central bank intervention to curb excess volatilityIndia’s regime

India’s path: a fixed rate after independence, a basket peg from the mid-1970s, a two-step devaluation in July 1991, the Liberalised Exchange Rate Management System (LERMS) with a dual rate in March 1992, and a unified market-determined rate from March 1993. Since then the RBI does not target a level; it intervenes to smooth volatility.

How the RBI intervenes

  • To stop the rupee falling, it sells dollars from reserves (this absorbs rupee liquidity).
  • To stop the rupee rising too fast, it buys dollars (this injects rupees, which it may sterilise through open market operations or the Market Stabilisation Scheme, introduced in 2004).

Devaluation, depreciation and their effects

  • Devaluation / revaluation: a deliberate cut / rise in the value of a currency under a fixed regime, by government decision.
  • Depreciation / appreciation: a fall / rise caused by market forces under a floating regime.

Effects of rupee depreciation

GainsLosses
Exports become cheaper abroadImports (crude oil, electronics, gold) become costlier — imported inflation
Remittances worth more in rupeesExternal debt costs more to service in rupee terms
Imports discouraged; can narrow the trade deficitCan trigger FPI outflows if expected to continue

Whether depreciation actually improves the trade balance depends on elasticities: the Marshall–Lerner condition says it improves if the sum of the price elasticities of export and import demand exceeds one. In the short run the balance often worsens before it improves — the J-curve.

NEER and REER

  • Nominal Effective Exchange Rate (NEER): a weighted average of the rupee’s bilateral nominal exchange rates against a basket of currencies (weights by trade share).
  • Real Effective Exchange Rate (REER): NEER adjusted for inflation differentials between India and its trading partners. It measures trade competitiveness.
  • The RBI publishes 6-currency and 40-currency NEER and REER indices. A rise in the index means the rupee has appreciated — and, for REER, that exports have become less competitive.

The impossible trinity

A country cannot have all three at once: a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose two. India’s managed float with partial capital controls is a middle path that keeps monetary independence.

The Foreign Exchange Management Act (FEMA), 1999 replaced the Foreign Exchange Regulation Act (FERA), 1973. FERA treated violations as criminal offences and aimed at conserving foreign exchange; FEMA makes violations civil and aims at facilitating external trade and payments and the orderly development of the forex market. Money-laundering offences are dealt with separately under the Prevention of Money Laundering Act, 2002.

Memory Anchors

Current account in four words: “Goods, Services, Pay, Gifts” → Goods (merchandise) · Services · Primary income (interest, dividends, wages) · Gifts (secondary income: remittances, grants)

Test for current vs capital: Does it create a claim to be repaid or serviced later? Yes → capital account. No → current account. (Interest on a loan is current; the loan itself is capital.)

Forex reserves: “Four Good Safe Reserves” → Foreign currency assets · Gold · SDRs · Reserve tranche.

Devaluation vs depreciation: Devaluation is a Decision; depreciation is the market’s verdict.

For Prelims

Facts worth a mark
  • Interest and dividends paid abroad are current account (primary income); the underlying loan or investment is capital account.
  • Private remittances are secondary income in the current account, not capital account.
  • FDI vs FPI: 10% of post-issue paid-up equity of a listed company (Mayaram Committee, 2014).
  • Current account convertibility: August 1994 (IMF Article VIII). Capital account: partial (Tarapore Committees, 1997 and 2006).
  • Unified market-determined exchange rate: March 1993, after LERMS (March 1992).
  • Forex reserves = foreign currency assets + gold + SDRs + reserve tranche position.
  • A rise in the REER index = appreciation = loss of export competitiveness.
  • FEMA, 1999 (civil) replaced FERA, 1973 (criminal).

For Mains

  • Dimensions: sustainability of the CAD; quality of financing (FDI vs volatile FPI); exchange rate stability vs competitiveness; reserve adequacy; oil and gold import dependence; services-led exports; trade policy and protectionism.
  • Keywords: twin deficits, sudden stop, hot money, reserve adequacy, imported inflation, managed float, trilemma, sterilisation, export competitiveness, rupee internationalisation.
  • Value-addition: the 1991 crisis as the case study of an unsustainable CAD financed by short-term debt; Tarapore Committees on capital account convertibility; the Marshall–Lerner condition and the J-curve; India’s position as the largest remittance recipient (World Bank).

Common Traps

Trap #1: 'Remittances are capital inflows'
Remittances are unrequited transfers — they create no claim. They sit in the current account under secondary income. NRI deposits, by contrast, are liabilities of Indian banks and sit in the capital account.
Trap #2: 'BoP always balances, so a BoP crisis is impossible'
The accounts balance by construction because the change in reserves is the balancing item. A crisis occurs when the overall deficit cannot be financed — reserves run out and no one will lend. That is what happened in 1991.
Trap #3: Devaluation vs depreciation
In a market-determined regime like India’s since 1993, a falling rupee is depreciation. “Devaluation” applies only to an official change under a fixed or pegged regime — as in July 1991.

In the News

  • July 2022 — the RBI put in place a mechanism for invoicing, payment and settlement of international trade in Indian rupees, using Special Rupee Vostro Accounts — a step towards rupee internationalisation.
  • March 2023 — the government announced the Foreign Trade Policy 2023, effective from 1 April 2023, without a fixed end date (earlier policies ran for five years).

See Current Affairs for the latest BoP and reserves data.

Practice

Prelims

UPSC Practice · Prelims GS I Qbop-1

Consider the following transactions:

  1. Money sent home by Indian workers in the Gulf
  2. Interest paid by an Indian company on its external commercial borrowing
  3. Purchase of shares on an Indian stock exchange by a foreign portfolio investor
  4. Export of software services by an Indian IT firm

How many of the above are recorded in the current account of India’s balance of payments?

  1. A Only one
  2. B Only two
  3. C Only three
  4. D All four
Solution

Remittances (1) are secondary income — current account. Interest on an ECB (2) is primary income — current account. Software exports (4) are services — current account. FPI purchase of shares (3) creates a claim and is recorded in the capital (financial) account. So three items are current account.

Answer: C

UPSC-pattern practice question
UPSC Practice · Prelims GS I Qbop-2

Consider the following statements:

  1. The Nominal Effective Exchange Rate is a weighted average of the rupee’s bilateral nominal exchange rates against a basket of currencies.
  2. The Real Effective Exchange Rate adjusts the nominal effective rate for inflation differentials between India and its trading partners.
  3. A rise in the Real Effective Exchange Rate index indicates a loss of India’s export competitiveness.

Which of the statements given above is/are correct?

  1. A 1 only
  2. B 1 and 2 only
  3. C 2 and 3 only
  4. D 1, 2 and 3
Solution

All three are correct. NEER is a trade-weighted average of nominal rates (1). REER corrects NEER for relative prices (2). A rise in the index means the rupee has appreciated in real terms, which makes Indian goods dearer abroad — a loss of competitiveness (3).

Answer: D

UPSC-pattern practice question
UPSC Practice · Prelims GS I Qbop-3

Since March 1993, the exchange rate of the Indian rupee has been determined primarily by:

  1. A A fixed peg to the US dollar announced by the RBI
  2. B Market forces, with RBI intervention to curb excessive volatility
  3. C A currency basket peg notified by the Ministry of Finance
  4. D Periodic devaluations agreed with the IMF
Solution

India moved to a unified, market-determined exchange rate in March 1993, after the dual-rate LERMS phase of 1992. The RBI does not target a level; it intervenes in the forex market only to curb excessive volatility — a managed float. Option A describes a fixed regime, C a basket peg (India’s pre-1991 practice), and D is not how the rupee is managed.

Answer: B

UPSC-pattern practice question

Mains

UPSC Practice · Mains GS III 15 marks · 250 words Qbop-m1

A depreciating rupee is often reported as bad news. Examine its effects on the Indian economy and discuss the policy options available to manage excessive volatility.

Solution

Introduction: Under India’s managed float (since 1993), the rupee’s value is set by the market, with the RBI smoothing volatility. Depreciation has both costs and benefits; the problem is disorderly movement, not depreciation as such.

Body:

  • Positive effects: exports cheaper and more competitive (if the Marshall–Lerner condition holds); remittances and export earnings worth more in rupees; import substitution encouraged.
  • Negative effects: imported inflation through crude oil, fertiliser, electronics and gold; higher rupee cost of servicing external debt and ECBs; possible FPI outflows feeding further depreciation; strain on the fiscal position through subsidies.
  • Short-run vs long-run: the J-curve — the trade balance may worsen before it improves.
  • Policy options: RBI forex intervention using reserves; measures to attract stable inflows (FDI liberalisation, NRI deposit schemes, easing ECB norms); curbing non-essential imports such as gold; monetary tightening if depreciation feeds inflation; long-term — export diversification, services and manufacturing competitiveness, rupee trade settlement, lower oil dependence.

Conclusion: A gradual depreciation that tracks inflation differentials keeps the REER stable and supports exports. Policy should target volatility and the CAD’s financing quality, not a fixed level of the rupee.

UPSC-pattern practice question

Quick Revision

PointOne-liner
BoPRecord of all transactions between residents and the rest of the world
Current accountGoods + invisibles (services, primary income, secondary income)
Capital accountFDI, FPI, loans (ECB, external assistance), banking capital (NRI deposits)
Overall balanceShows up as change in forex reserves
Forex reservesFCA + gold + SDRs + reserve tranche
FDI vs FPI10% threshold (Mayaram Committee, 2014)
ConvertibilityCurrent account full (Aug 1994); capital account partial
Exchange rateDevaluation July 1991 → LERMS March 1992 → unified March 1993
REERNEER adjusted for inflation; rise = appreciation
FEMA1999 Act; civil; replaced FERA 1973

Key Takeaways

Key Takeaways
  1. Ask “does it create a future claim?” to sort a transaction into the current or capital account.
  2. A CAD is sustainable when it is modest and financed by stable flows (FDI), not by hot money or short-term debt — the lesson of 1991.
  3. India runs a managed float: market-determined rate, RBI intervention only against excessive volatility.
  4. REER, not the rupee–dollar rate, tells you about export competitiveness.
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