Balance of payments and the exchange rate

The first principle

A country, like a household, cannot spend more abroad than it earns abroad unless someone lends to it or invests in it. The balance of payments is the record of all these transactions in a year, and because every purchase must be paid for, it always balances: a deficit on the current account must be financed by a surplus on the capital account or by running down reserves. The exchange rate is the price that does much of the adjusting, which is why the two are studied together.

The core

The accounts

• The current account records flows that do not create a claim to be repaid. It has four parts: trade in goods; trade in services such as software, transport and tourism; primary income, which is interest, dividends and wages paid across borders; and secondary income, which is transfers such as remittances by workers abroad. Services, income and transfers together are called invisibles.
• The capital and financial account records changes in ownership of assets and in debt: foreign direct investment (FDI), foreign portfolio investment (FPI), external commercial borrowing, deposits of non resident Indians and banking flows. Strictly, the international manual keeps the term capital account for capital transfers and sales of non produced assets such as licences, but in India it is used for the whole of this account.
• Reserves and errors. The overall balance is the sum of the two accounts, and it equals the change in the foreign exchange reserves held by the Reserve Bank of India (RBI). Errors and omissions is the statistical gap left when recorded flows do not add up.
• The identity. A current account deficit means the country invests more than it saves, because the current account balance equals national saving minus investment. A deficit is therefore not a sign of trouble in itself; it is a problem when it finances consumption or rests on flighty money.

A worked example: India in 2025-26

• Current account. India ran a merchandise trade deficit of US$337.3 billion and earned net services of US$216.6 billion. Secondary income, mostly remittances, brought in a net US$143.6 billion, while primary income, mostly interest and dividends paid abroad, took out a net US$48.2 billion, so the current account deficit was US$25.2 billion, or 0.6 per cent of gross domestic product (GDP); the parts differ from the total by 0.1 because of rounding (RBI, 8 June 2026, preliminary).
• Financing. Net FDI brought in US$6.9 billion (the RBI Annual Report of May 2026, compiled before this release, gives 7.7) and commercial borrowing US$14.2 billion, but portfolio investors took out US$16.4 billion, so the capital and financial account, including errors, added only about US$1.6 billion.
• The result. The overall balance was −25.2 + 1.6 = −23.6, so reserves on a balance of payments basis fell by US$23.6 billion: the RBI sold dollars from its reserves to meet the excess demand for foreign currency.

The exchange rate

• Regimes. A fixed rate is held by the central bank at a declared level, a free float is set entirely by the market, and India follows a managed float: the rupee is market determined, but the RBI buys and sells dollars to curb excess volatility without targeting a level.
• Depreciation and devaluation. Depreciation is a fall in a market determined rate; devaluation is a deliberate cut in a fixed or managed rate by the authorities, as India did in July 1991.
• Nominal and real effective rates. The nominal effective exchange rate (NEER) is a trade weighted average of the rupee against a basket of currencies, expressed as an index. The real effective exchange rate (REER) adjusts the NEER for relative prices, REER = NEER × (Indian prices ÷ partner prices), so it measures competitiveness. If the NEER falls from 100 to 97 while Indian inflation is 4 per cent and partner inflation 2 per cent, the REER is 97 × 1.04 ÷ 1.02 = 98.9, a real depreciation of only 1.1 per cent. The RBI publishes six and forty currency indices with a base of 2015-16, where a rise means the rupee has appreciated.
• The impossible trinity. A country cannot at once fix its exchange rate, allow free capital movement and run an independent monetary policy; it can choose any two. India keeps an independent inflation targeting policy, allows capital to move within limits, and therefore lets the rupee move.

Dimensions

• Growth. A moderate current account deficit lets a growing economy use foreign saving to invest more, but a deficit above about 2.5 to 3 per cent of GDP has historically preceded stress in India.
• Inflation. A weaker rupee raises the rupee price of imported oil, fertilisers and electronics, so currency stability and inflation control go together.
• Competitiveness. A REER that stays well above its base makes exports dearer and imports cheaper, which hurts labour intensive exporters first.
• Financial stability. Portfolio flows reverse quickly when global interest rates rise, as in the taper tantrum of 2013, so the composition of financing matters as much as its size.
• Strategic. Reserves guard against sanctions, oil shocks and capital flight.

In practice

• Recent position. The current account deficit was 0.6 per cent of GDP in both 2024-25 and 2025-26, and US$4.2 billion, or 0.5 per cent of GDP, in April to June 2026, when portfolio investors again took out money and reserves fell by US$8.1 billion on a balance of payments basis (RBI, 1 September 2026). The pattern is stable: a large goods deficit offset by services exports and by remittances, of which India is the world's largest recipient.
• Reserves. Foreign exchange reserves stood at US$734.6 billion in the week ended 2 October 2026, of which foreign currency assets were US$604.7 billion and gold US$106.4 billion (RBI Weekly Statistical Supplement). By simple arithmetic this covers about 11 months of merchandise imports at the 2025-26 level.
• Capital account convertibility. The Tarapore committees of 1997 and 2006 set preconditions such as a low fiscal deficit, low inflation, healthy banks and adequate reserves. Convertibility remains partial: residents may send up to US$250,000 a year abroad under the Liberalised Remittance Scheme, foreign investment works within sector caps, and commercial borrowing follows a separate framework. Since July 2022 the RBI has also allowed trade to be invoiced and settled in rupees through special vostro accounts.

The 1991 crisis as a case

Through the 1980s large fiscal deficits spilled into a current account deficit that reached about 3 per cent of GDP by 1990-91, financed increasingly by short term debt and deposits of non resident Indians. The Gulf war raised the oil bill and cut remittances, political instability and rating downgrades followed, deposits were withdrawn, and by mid 1991 reserves covered only about two weeks of imports. India pledged gold with the Bank of England and the Bank of Japan, devalued the rupee in two steps in July 1991 and took support from the International Monetary Fund (IMF), and the crisis became the trigger for the reforms of 1991.

A dual exchange rate under the Liberalised Exchange Rate Management System of 1992 gave way to a single market determined rate in March 1993, and in August 1994 India accepted Article VIII of the IMF's articles, making the rupee convertible on the current account. The Foreign Exchange Management Act 1999 replaced the Foreign Exchange Regulation Act 1973, turning exchange control from a criminal matter into a civil one.

Issues and way forward

• A narrow export base for goods. The goods deficit is structural because India imports oil, gold, electronics and coal and exports too few manufactures. Manufacturing competitiveness, energy transition and domestic electronics production reduce the deficit at its source.
• Flighty financing. Portfolio money left in 2025-26 and again in early 2026-27, while net FDI is small because of repatriation and Indian investment abroad. Deeper bond markets, a stable tax regime and a larger share of long term FDI make financing steadier.
• The cost of reserves. Reserves earn low returns, and buying dollars to build them requires the RBI to absorb rupee liquidity. The right size should follow the risks, such as short term debt and portfolio stock, rather than a fixed number of months of imports.
• Rupee management. Defending a level wastes reserves and invites speculation, while letting the rupee overshoot imports inflation. Intervention to smooth volatility, with the level set by the market, is the stated and sound policy.

Common confusions

• Balance of trade and current account. The balance of trade covers goods only (and sometimes services), while the current account adds income and transfers, which is why India's current account deficit is far smaller than its trade deficit.
• Overall balance and balance of payments. The balance of payments always balances in accounting terms; the overall balance is the gap before reserves, and it is met by a change in reserves.
• NEER and REER. The NEER tracks the currency's price; the REER adjusts it for inflation, so a rupee can fall in nominal terms and still gain in real terms.
• Current account and capital account convertibility. The first lets anyone obtain foreign currency for trade, travel and remittances; the second would let anyone move capital in and out freely, which India permits only within limits.

For the exam

• Keyword bank: current account deficit, invisibles, remittances, saving and investment gap, capital account, overall balance, foreign exchange reserves, import cover, managed float, NEER, REER, impossible trinity, current account convertibility, Tarapore committee, Liberalised Remittance Scheme.
• Previous year questions: Practise the previous year questions on this topic →
• Use in an answer:
  • Introduction with data: India's current account deficit was a modest 0.6 per cent of GDP in 2025-26, yet reserves fell by US$23.6 billion because portfolio investors withdrew money (RBI, June 2026).
  • Introduction with a report: The Tarapore committees of 1997 and 2006 tied full capital account convertibility to fiscal discipline, low inflation and sound banks, preconditions India is still building.
  • Conclusion: The lesson of 1991 is that the size of a current account deficit matters less than how it is financed, so India should rely on long term capital and a broader export base.
  • Conclusion: A market determined rupee, smoothed but not defended, together with adequate reserves, gives India both competitiveness and protection against sudden stops.