Balance of Payments and Exchange Rate
The exam tests the structure of the balance of payments, the current versus capital account split, and how demand and supply in the foreign exchange market set the exchange rate.
Core rules
- BoP records all transactions between residents and the rest of the world in a year. As an accounting statement it always balances because of the reserve entry.
- Current account: merchandise trade, services, primary income (investment income, compensation of employees) and secondary income (remittances and transfers).
- Capital account: FDI, portfolio investment, external borrowings, banking capital, rupee debt service, other capital, and changes in official reserves.
- Autonomous transactions are undertaken for their own sake; accommodating transactions finance the gap. A current account deficit must be financed by a capital account surplus or reserve drawdown.
- Demand for foreign exchange arises from imports, foreign travel, and investment abroad; supply comes from exports, remittances, and foreign investment and loans.
- Fixed, floating and managed-float regimes differ in who sets the rate. Market depreciation and appreciation differ from official devaluation and revaluation.
Worked example
Imports rise, so demand for US dollars shifts right and the dollar price rises from ₹75 to ₹78. The rupee has depreciated by 3/75 = 4%. An exporter of goods worth $100 earlier received ₹7,500 and now receives ₹7,800, improving export competitiveness; importers pay more, so imports may fall and the trade deficit may narrow.
Traps that cost marks
- Treating a BoP deficit as meaning the accounts do not balance.
- Confusing current account deficit with fiscal deficit.
- Saying foreign investment is a current account item; it belongs to the capital account.
- Using devaluation and depreciation interchangeably.