A Rupee Sliding from ₹83.20 to ₹86.80: Reading the Balance of Payments
In a financial year a country's external accounts show merchandise exports of $450 billion and merchandise imports of $780 billion; services exports of $340 billion and services imports of $160 billion; net private transfers (remittances) of $125 billion; and net investment income of −$45 billion. Capital inflows are foreign direct investment $25 billion, portfolio investment $30 billion, external commercial borrowing $20 billion and banking capital −$15 billion. Net errors and omissions are −$4 billion. Over the year the rupee moves from ₹83.20 to ₹86.80 per dollar. Crude oil and edible oil make up $150 billion of the import bill, and their world prices have risen 10 per cent. The finance ministry says the current account deficit proves the country is living beyond its means and that a cheaper rupee will correct it by itself. The Reserve Bank has been selling dollars in the market through the year.
1. Compute the current account balance, the capital account balance and the overall balance of payments. What must have happened to reserves, and does that explain the Reserve Bank's dollar sales?
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Current account = (merchandise exports − imports) + (services exports − imports) + net transfers + net investment income = (450 − 780) + (340 − 160) + 125 + (−45) = (−330) + 180 + 125 − 45 = −$70 billion, a current account deficit.
Capital account = 25 + 30 + 20 + (−15) = +$60 billion surplus.
Overall balance = −70 + 60 − 4 (errors and omissions) = −$14 billion, a balance of payments deficit.
A BoP deficit means the country's foreign exchange receipts fell $14 billion short of its payments. Reserves must have fallen by $14 billion, or the deficit was financed by the Reserve Bank supplying dollars from reserves. That is precisely the dollar selling mentioned in the case: under a managed float the RBI releases dollars to absorb excess demand, which slows the rupee's fall from ₹83.20 to ₹86.80 instead of letting it drop further. Note that the rupee depreciated even though the RBI intervened - intervention smooths the adjustment, it does not reverse the underlying shortage of dollars.
2. Evaluate the finance ministry's two claims: that a current account deficit proves the country is living beyond its means, and that a cheaper rupee will correct the deficit by itself.
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"Living beyond its means": partly misleading. A current account deficit means the economy absorbs more goods and services than it produces, and the gap is financed by net capital inflows. Whether that is profligacy depends on what the inflows finance. Here $25 billion is FDI and $20 billion is external commercial borrowing - if these fund factories and infrastructure, the country is borrowing to invest, and future output can service the liability. If inflows are portfolio money and short-term bank capital (banking capital is negative here, a warning sign), the deficit is fragile. The composition, not the size alone, is the issue.
"A cheaper rupee corrects it by itself": only under conditions. Depreciation makes exports cheaper and imports dearer, but the trade balance improves only if export and import elasticities are large enough (the Marshall-Lerner condition) and only after a lag - the J-curve, where the deficit first worsens. Here $150 billion of imports are crude and edible oil, which are price-inelastic: a 10% rise in their world prices alone adds about $15 billion to the import bill, which depreciation does not remove. Depreciation also raises the rupee cost of imported inputs used by exporters and feeds domestic inflation, so it is a partial and slow-acting remedy, not an automatic cure.
3. The Reserve Bank can (i) keep selling reserves, (ii) let the rupee depreciate, or (iii) raise domestic interest rates. Distinguish depreciation from devaluation and judge which mix is appropriate.
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Depreciation is a market-driven fall in the value of the rupee under a floating or managed-float regime, as here (₹83.20 to ₹86.80). Devaluation is an official, administratively announced reduction in the par value of the currency, which belongs to a fixed-rate system. The distinction is about who moves the rate and how, not about the direction of the change.
Option (i), selling reserves: useful for smoothing disorderly moves, but reserves are finite. The overall deficit here is $14 billion; a persistent drain of that size cannot continue indefinitely and invites speculation against the currency.
Option (ii), allowing depreciation: improves price competitiveness and, if the export response comes, narrows the trade deficit. The costs are imported inflation, a heavier rupee burden of dollar debt, and damage to confidence if the slide is disorderly.
Option (iii), raising interest rates: attracts portfolio inflows and supports the currency, but raises borrowing costs for the very firms already postponing investment.
Judgement: a managed float is appropriate - let the rupee adjust in an orderly way while using reserves to prevent a panic, and use the period to reduce import dependence on crude and edible oil and to encourage export sectors with elastic demand. Interest rates should follow inflation, not the exchange rate alone.