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Quick recap: External sector on one page
Both parts of External sector condensed for quick revision: the balance of payments and its accounts, the current account deficit and its financing, the 1991 crisis and convertibility, exchange rates and regimes, India's exchange rate history, NEER and REER, foreign exchange reserves, FDI, FPI, ECBs and NRI deposits, with a one-table overview and eight mixed questions.
India's dealings with the rest of the world are recorded in the balance of payments. Part 1 of this chapter explained its accounts, how deficits are financed, the 1991 crisis and the step-by-step convertibility of the rupee. Part 2 explained the exchange rate, the foreign exchange reserves and the forms of foreign capital. This recap puts both parts on one page.
The balance of payments records every transaction between residents and non-residents over a period, in double entry, so the whole always balances; residence, not citizenship, decides who is a resident. The RBI compiles it quarterly, broadly on the IMF's BPM6. The current account holds goods trade and the invisibles: services, primary income (interest, dividends, short-term wages) and secondary income (transfers such as remittances). India runs a persistent goods deficit that a services surplus and remittances partly offset. Assets and liabilities go to the capital and financial accounts; in India's standard format the broad 'capital account' covers foreign investment, loans, banking capital and rupee debt service. The current account, the capital account and errors and omissions add up to the overall balance, which raises reserves when in surplus and lowers them when in deficit.
A current account deficit means investment exceeds saving at home and foreign funds fill the gap; its safety depends on whether stable FDI or flighty portfolio money and short-term debt pays for it. Twin deficits and the 2013 taper tantrum, when the deficit had reached about 4.8 per cent of GDP in 2012-13 (RBI data), showed the risk. In 1991, oil prices, lost Gulf remittances, short-term debt and withdrawn NRI deposits left reserves for only a few weeks of imports; gold was pledged, the IMF helped, and the rupee was devalued in two steps in July 1991. The Rangarajan committee (1993) then set the course: a market rate, less short-term debt, more non-debt flows. current account convertibility followed on 20 August 1994 (IMF Article VIII), while the capital account has been opened only in stages, guided by the Tarapore committees of 1997 and 2006; individuals may remit USD 250,000 a year under the Liberalised Remittance Scheme.
The exchange rate is set by the demand for and supply of foreign exchange. More rupees per dollar is a depreciation (of a currency) of the rupee: exports get cheaper abroad, while imports, fuel prices and the cost of foreign-currency debt rise. Devaluation and revaluation are official decisions under a fixed rate, as in 1966 and July 1991. Regimes range from fixed (gold standard, Bretton Woods) through free float to a managed float, which India follows; the impossible trinity says a fixed rate, free capital and independent monetary policy cannot all be had together. India moved from a par value to a basket peg (September 1975), then to the LERMS dual rate (March 1992) and a unified market rate (March 1993). The RBI intervenes only to curb excess volatility, and since July 2022 trade can be invoiced and settled in rupees.
Because India trades with many countries, the NEER averages the rupee's rates against a trade-weighted basket, and the real effective exchange rate adjusts that for relative inflation; the RBI publishes 6- and 40-currency indices, and a REER well above 100 means real appreciation and weaker price competitiveness. The foreign exchange reserves held by the RBI have four parts: foreign currency assets (the largest), gold, Special Drawing Rights and the reserve tranche position in the IMF. They are judged by import cover and by cover for short-term external debt, and when the RBI buys dollars it can sterilise the extra rupees through open market operations or the Market Stabilisation Scheme.
Foreign capital is ranked by stability. foreign direct investment is any foreign investment in an unlisted Indian company, or 10 per cent or more of a listed company's post-issue paid-up equity (Non-debt Instruments Rules, 2019, following the Mayaram committee of 2014); it comes by the automatic route, with only reporting, or the government route, since the FIPB was abolished in 2017. A few sectors such as lottery, gambling and atomic energy are closed, and Press Note 3 (2020) sends investment from countries sharing a land border with India through the government route. foreign portfolio investment is below 10 per cent per investor, registered with SEBI, and quick to leave. external commercial borrowing and NRI deposits (NRE and FCNR(B) repatriable, NRO capped) add to external debt, where the short-term share matters most.
| Item | What it is | Key fact |
|---|---|---|
| Current account | Goods, services, primary and secondary income | Remittances are secondary income |
| Capital / financial account | Flows that create claims or liabilities | FDI, FPI, loans, NRI deposits, reserves |
| Overall balance | Current + capital account + errors and omissions | Surplus adds to reserves |
| 1991 crisis | Reserves for only weeks of imports | Gold pledged; devaluation in July 1991 |
| Convertibility | Current account full; capital account partial | IMF Article VIII, 20 August 1994; Tarapore 1997, 2006 |
| Exchange rate regime | Managed float | LERMS March 1992; unified rate March 1993 |
| REER | NEER adjusted for relative inflation | Above 100 = real appreciation |
| Forex reserves | FCA, gold, SDRs, reserve tranche | Foreign currency assets are the largest part |
| FDI vs FPI | Lasting interest vs portfolio returns | 10% of a listed company's equity is the line |
Exam traps
- The balance of payments as a whole always balances; deficits and surpluses refer to its parts.
- Remittances are current account (secondary income); NRI deposits are capital account.
- Interest and dividends paid abroad are current account (primary income), not capital account.
- A trade deficit can coexist with an overall balance of payments surplus and rising reserves.
- Current account convertibility: 20 August 1994; full capital account convertibility has not been adopted.
- A falling rupee under a managed float is a depreciation, not a devaluation; more rupees per dollar means the rupee has weakened.
- REER above 100 = real appreciation (loss of competitiveness), not undervaluation.
- Any foreign investment in an unlisted company is FDI; the automatic route needs no prior approval; the FIPB was abolished in 2017.
Recap
- Balance of payments: all resident–non-resident transactions, double entry, compiled quarterly by the RBI broadly on BPM6.
- Current account = goods + invisibles (services, primary income, secondary income); India: goods deficit, services and remittance surplus.
- Overall balance = current + capital account + errors and omissions; it moves the reserves.
- A current account deficit is safe or risky depending on its financing; 2013 and 1991 are the warning cases.
- 1991: reserves for weeks of imports, gold pledged, IMF help, devaluation in July; Rangarajan committee 1993.
- Current account convertibility 1994; capital account opened in stages (Tarapore 1997, 2006; LRS USD 250,000).
- Managed float since March 1993 after the 1975 basket peg and LERMS (1992); NEER and REER track the rupee against many currencies.
- Reserves: FCA, gold, SDRs, reserve tranche; FDI (10%+ listed, any unlisted) is preferred to FPI, ECBs and short-term debt.
Practice questions
Q1. In India's balance of payments, money sent home by Indians working abroad is recorded under:
- Primary income in the current account
- Secondary income in the current account
- Other investment in the financial account
- Reserve assets
Show answer
Answer: B. Secondary income in the current account
Remittances are transfers for which nothing is given in return, so they are secondary income in the current account. Primary income is interest, dividends and short-term wages; other investment and reserve assets are financial account items that create claims or liabilities, so the other options are wrong.
Q2. Consider the following statements:
1. A country can have a trade deficit and an overall balance of payments surplus in the same year.
2. Current account convertibility of the rupee was introduced along with LERMS in March 1992.
Which of the statements given above is/are correct?
- 1 only
- 2 only
- Both 1 and 2
- Neither 1 nor 2
Show answer
Answer: A. 1 only
Statement 1 is correct: large capital inflows can more than cover a current account gap. Statement 2 is wrong: LERMS (March 1992) was a dual exchange rate system; full current account convertibility came with acceptance of IMF Article VIII on 20 August 1994. So '2 only', 'Both' and 'Neither' are wrong.
Q3. Consider the following pairs (committee chair : subject):
1. C. Rangarajan : Balance of payments (1993)
2. S.S. Tarapore : Capital account convertibility
3. Arvind Mayaram : Distinguishing FDI from FPI
How many of the pairs given above are correctly matched?
- Only one
- Only two
- All three
- None
Show answer
Answer: C. All three
All three pairs are correct: Rangarajan chaired the High Level Committee on Balance of Payments (1993), Tarapore chaired both committees on capital account convertibility (1997, 2006), and the Mayaram committee (2014) recommended the 10 per cent line between FDI and FPI. So 'only one', 'only two' and 'none' are wrong.
Q4. If the rupee's nominal effective exchange rate stays unchanged while inflation in India is higher than in its trading partners, the real effective exchange rate will:
- fall, showing a gain in competitiveness
- rise, showing a loss of price competitiveness
- stay unchanged, because only nominal rates matter
- become equal to the NEER
Show answer
Answer: B. rise, showing a loss of price competitiveness
The REER adjusts the NEER for relative prices; higher Indian inflation with a steady nominal rate makes Indian goods dearer abroad, so the REER rises, a real appreciation. It does not fall, it is not unaffected (that would ignore inflation, which is exactly what the REER adds), and there is no reason for it to equal the NEER, so the other options are wrong.
Q5. Which one of the following is NOT a part of India's foreign exchange reserves?
- Reserve tranche position in the IMF
- Special Drawing Rights
- Gold held by the RBI
- External commercial borrowings raised by Indian companies
Show answer
Answer: D. External commercial borrowings raised by Indian companies
ECBs are debts of Indian companies to foreign lenders, recorded as capital inflows and external debt, not reserve assets of the RBI. The reserve tranche position, SDRs and gold are three of the four components of the reserves (with foreign currency assets), so those options are wrong answers.
Q6. India's present exchange rate regime is best described as:
- a fixed peg to the US dollar
- a peg to a basket of currencies with the rate announced by the RBI
- a managed float
- a free float with no central bank intervention
Show answer
Answer: C. a managed float
Since March 1993 the rupee's rate has been market-determined, with the RBI intervening only to curb excessive volatility: a managed float. India has no dollar peg; the basket peg was the 1975–1992 arrangement; and the RBI does intervene, so a pure free float is also wrong.
Q7. Consider the following statements:
1. Under Press Note 3 (2020), investment from an entity of a country that shares a land border with India can come only through the government route.
2. Proposals under the government route are still approved by the Foreign Investment Promotion Board.
Which of the statements given above is/are correct?
- 1 only
- 2 only
- Both 1 and 2
- Neither 1 nor 2
Show answer
Answer: A. 1 only
Statement 1 is correct. Statement 2 is wrong: the FIPB was abolished in 2017, and government-route proposals are now approved by the ministry or department concerned. So '2 only', 'Both' and 'Neither' are wrong.
Q8. Which one of the following forms of foreign capital is generally regarded as the most stable source of financing for a current account deficit?
- Portfolio investment in listed shares
- Short-term trade credit
- Foreign direct investment
- Portfolio investment in government bonds
Show answer
Answer: C. Foreign direct investment
FDI reflects a lasting interest in a business, such as a factory, and is hard to withdraw quickly. Portfolio investment in shares or bonds can be sold and taken out at short notice, and short-term trade credit must be repaid or rolled over within a year, so those options are less stable and wrong.
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- Foreign Exchange Management Act, 1999; Foreign Exchange Management (Non-debt Instruments) Rules, 2019 — https://www.indiacode.nic.in
- Reserve Bank of India, balance of payments releases, Handbook of Statistics on Indian Economy (exchange rates, NEER and REER, reserves) — https://www.rbi.org.in
- Reserve Bank of India, Annual Reports; reports of the High Level Committee on Balance of Payments (1993) and the Committees on Capital Account Convertibility (1997, 2006); master directions on the Liberalised Remittance Scheme, ECBs and non-resident deposits — https://www.rbi.org.in
- Press Information Bureau, DPIIT releases on the Consolidated FDI Policy, abolition of the FIPB (2017) and Press Note 3 (2020) — https://pib.gov.in