Defending ₹84.2: Reserves, the Rupee and a 2.1% Deficit
A country with GDP of $3,700 billion reports, for the year, merchandise exports of $430 billion and imports of $670 billion; services exports of $340 billion and services imports of $180 billion; primary income of −$55 billion; and secondary income (mainly remittances) of +$57 billion. On the capital side: net FDI +$45 billion, net portfolio flows −$20 billion, external commercial borrowings +$15 billion, NRI deposits +$10 billion, banking capital +$8 billion and other flows +$12 billion. Reserves stood at $600 billion at the start of the year. Monthly goods and services imports average about $65 billion. Over the year the rupee moved from ₹82.5 to ₹84.2 per dollar, and the central bank sold dollars to slow the slide; at one point the quoted rate touched ₹86 before intervention. A exporter lobby wants a weaker rupee; an importer lobby wants it held.
1. Compute the current account deficit and express it as a percentage of GDP. Show how the deficit was financed, classifying each item as current or capital account, and explain why reserves fell by only about $8 billion.
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Current account (US$ billion):
| Item | Amount |
|---|---|
| Merchandise trade balance (430 − 670) | −240 |
| Services balance (340 − 180) | +160 |
| Primary income | −55 |
| Secondary income (remittances) | +57 |
| Current account balance | −78 |
CAD as % of GDP = 78 ÷ 3,700 × 100 = 2.1%. This is a moderate deficit, not a crisis level.
Classification. Current account: merchandise trade, services, primary income (investment income, compensation of employees), secondary income (remittances). Capital account: FDI, portfolio investment, external commercial borrowings, NRI deposits, banking capital and other flows - plus the change in reserves.
Financing. Net capital inflows = 45 − 20 + 15 + 10 + 8 + 12 = +70. The gap is 78 − 70 = $8 billion, met by a drawdown of reserves. Reserves therefore fall by about $8 billion (movements from valuation and gold add noise but do not change the logic).
Why only $8 billion, not $78 billion? Because the deficit is financed mainly by autonomous capital inflows, not by the central bank. Reserves change only by the residual - the 'balance for official financing'. That residual is also the measure of the pressure the central bank faced in the foreign exchange market.
Import cover = 600 ÷ 65 ≈ 9.2 months at the start of the year, falling slightly after the drawdown. That is comfortable, but not unlimited.
2. The central bank sold dollars to slow the depreciation from ₹86 to ₹84.2. Should it defend the rupee? Argue both sides and reach a judgement using the data given.
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Scale of the move. 82.5 → 84.2 is a depreciation of (84.2 − 82.5)/82.5 = 2.06% over the year - small. The central bank intervened when the market overshot towards ₹86, i.e. about 4.2% below the opening rate.
Case for intervening (smoothing):
- Pass-through to inflation. Imported energy and intermediates are priced in dollars; a disorderly slide raises domestic costs quickly and can feed into wages and expectations.
- Balance-sheet stress. Unhedged corporate and bank dollar liabilities become harder to service, which can turn a currency move into a credit event.
- Panic prevention. Thin markets with one-sided expectations can gap; supplying dollars prevents a self-fulfilling spiral unrelated to fundamentals.
- Reserves are there to be used. $600 billion (about nine months of imports) is more than adequate against a 2.1% CAD.
Case against defending (allow adjustment):
- Reserves have an opportunity cost and are finite; defending a level invites speculation that can drain them - the classic fixed-rate trap.
- The deficit is largely financed by stable FDI ($45 billion), not short-term debt, so there is no fundamental misalignment justifying defence.
- Portfolio outflows of $20 billion are the volatile element. Propping up the currency to retain portfolio flows subsidises reversible capital at the expense of the real economy.
- A slightly weaker rupee aids exporters and discourages gold and other import demand, helping the current account over time.
Judgement. The central bank should smooth, not target. Intervention is justified to prevent disorderly overshooting and to slow pass-through, but not to hold ₹84.2 as a promise. This is exactly what managed floating means: exchange-rate stability is an objective, not a fixed parity, and the level should remain market-determined. Defending ₹84.2 while portfolio outflows persist would convert a routine depreciation into a reserve-burning commitment.
3. The exporter lobby claims a weaker rupee will quickly shrink the current account deficit. Evaluate that claim, and distinguish depreciation from devaluation in a managed floating regime.
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The claim relies on elasticity, which is a short-run variable.
Why the deficit may not shrink quickly (the J-curve):
- Import volumes are inelastic in the short run. Crude oil, capital goods and intermediates cannot be cut instantly; contracts are fixed and quantities adjust slowly. A weaker rupee raises the rupee cost of the same barrels before any volume falls, so the import bill can rise at first.
- Export response is lagged. Exporters must find buyers, re-price contracts and expand capacity. Until then, the same quantity is sold, and export revenue in dollars may not rise much, while rupee receipts rise.
- Invoicing. Much trade is invoiced in dollars; a rupee depreciation does not automatically change the dollar price that foreign buyers face unless exporters pass it through, and competitive pressure may mean they do not.
- Inflation feedback. Imported inflation raises domestic costs, eroding the competitiveness gain; the central bank may then tighten, attracting inflows that push the rupee back up.
The trade balance improves durably only if the sum of export and import demand elasticities exceeds one (the Marshall–Lerner condition) - a medium-term, not immediate, proposition.
Depreciation versus devaluation. Depreciation is a fall in a currency's value under a market-determined or managed floating rate - which is what happened here. Devaluation is an administered reduction in the parity under a fixed-rate regime, decided by the authority. The two have identical relative-price effects but different institutional meanings: devaluation is a policy decision that changes a peg, depreciation is a market outcome that policy may smooth.
Verdict on the lobby's claim: a 2% depreciation is far too small to correct a $78 billion deficit quickly, and even a large one would work through the J-curve before improving the balance. Structural export competitiveness - logistics, power costs, scale - matters more than the exchange rate.