Balance of Payments and Exchange Rates

1. The open economy: three linkages, trade as injection and leakage

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Open vs closed

• An open economy trades goods and services with other nations, and usually financial assets too. Most modern economies are open.
• A closed economy has no links with the rest of the world. Earlier chapters used it only to keep the analysis simple.

Three linkages (Class 12, Open Economy Macroeconomics) | Linkage | What it means | |---|---| | Output market | Consumers and producers can choose between domestic and foreign goods and services | | Financial market | Investors can choose between domestic and foreign assets | | Labour market | Firms choose where to produce and workers choose where to work, but immigration laws restrict labour movement |

• Movement of goods has traditionally been seen as a substitute for movement of labour. NCERT studies only the first two linkages.
• The external sector is the fourth sector of the macroeconomy, after households, firms and government. It covers exports, imports and capital flows with other countries.

Trade in the circular flow

• An export is a good or service sold to the rest of the world. It is an injection: foreign spending raises demand for domestic output.
• An import is a good or service bought from abroad. It is a leakage: Indian spending leaves the domestic circular flow and becomes another country's income.

Open-economy income identity

• Y + M = C + I + G + X. Imports add to supply in domestic markets, and exports add to demand.
• Rearranged: Y = C + I + G + X − M = C + I + G + NX.
• Net exports (NX) = exports − imports. NX > 0 means a trade surplus. NX < 0 means a trade deficit.
• Demand for domestic goods = C + I + G + X − M, which is demand for output produced at home. Domestic demand for goods = C + I + G, which includes spending on imports. The two are not the same (NCERT Q9).

Import and export functions

• Import function M = M̄ + mY.
• Autonomous imports (M̄ > 0) are imports that do not depend on domestic income.

• The marginal propensity to import (m, where 0 < m < 1) is the share of an extra rupee of income spent on imports.

• Imports rise with Y and fall with the real exchange rate R.

• Exports depend on foreign income (Yᶠ) and on R. They are treated as exogenous (X = X̄).
• NCERT drill (Q10): if M = 60 + 0.06Y, then m = 0.06. A higher m makes the aggregate demand function flatter, because each round of spending leaks more into imports.

Equilibrium and the open-economy multiplier

• Y = C̄ + c(Y − T) + Ī + Ḡ + X̄ − M̄ − mY. Collect all autonomous items into Ā to get Y* = Ā / (1 − c + m).
• Open-economy multiplier = ΔY/ΔĀ = 1/(1 − c + m). It is smaller than the closed-economy multiplier 1/(1 − c) (Q11).
• Worked example: with c = 0.8 and m = 0.3:
• Closed economy: 1/0.2 = 5.
• Open economy: 1/0.5 = 2.

• A ₹100 rise in autonomous demand raises output by 500 in a closed economy but only 200 in an open one.

• Why it is smaller: part of each round of induced consumption goes on foreign goods. That is an extra leakage in every round.

• Effect of exports: ΔY*/ΔX̄ = 1/(1 − c + m). More exports raise output, just like more government spending.
• Effect of autonomous imports: ΔY*/ΔM̄ = −1/(1 − c + m). An autonomous rise in imports lowers output.
• With proportional taxes T = tY (Q12): multiplier = 1/[1 − c(1 − t) + m].

Extra NCERT drills

• Q13: C = 40 + 0.8Y_D, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y.
• Ā = 140 and the multiplier = 1/0.25 = 4, so Y = 560.
• NX = 90 − 78 = 12.

• If G rises to 50: Y = 600 and NX = 10.

• Q14: if X = 100, then Y = 600 and NX = 20.

• Q18 (t = 0.2, c = 0.75, m = 0.2, Ā = 1,400):
• Y ≈ 2,333.3.
• Budget deficit ≈ 283.3 (G 750 − tax 466.7).

• Trade deficit ≈ 416.7 (M 566.7 − X 150).

• Closed-economy multiplier mechanics are in income-determination-keynes.

2. Balance of payments I: the current account

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Definition and accounting

• The balance of payments (BoP) records transactions in goods, services and assets between residents of a country and the rest of the world over a period, usually a year.
• It uses double entry: every credit has a matching debit. So the BoP always balances in the accounting sense.

Current account

• The current account records trade in goods, trade in services and transfer payments.
• Balance of trade (BoT) = value of goods exports − value of goods imports. Exports are a credit item and imports a debit item.
• A trade deficit arises when goods imports exceed exports. A trade surplus is the reverse.
• Current account balance = BoT + net invisibles (NCERT Q1).

Invisibles

• Invisibles are services, income and transfers. Net invisibles = receipts − payments on these items.
• Non-factor services are traded services that are not payments to factors of production: shipping, banking, insurance, tourism and software.
• The income account records net earnings on factors of production (labour, land, capital): compensation of employees, interest, dividends and profits.
• Transfers are receipts for which nothing is given in return: gifts, grants and remittances (money sent home by citizens working abroad).

Surplus, deficit and saving

• If current receipts exceed payments, the current account is in surplus and the nation is a lender to the world.
• If receipts are less than payments, there is a current account deficit (CAD) and the nation is a borrower. A CAD must be financed by a capital account surplus or by reserves.
• Identity: CA = S − I. A CAD means domestic investment is greater than domestic saving.

NCERT Table 6.1 walk-through (US$ million) | Item | Value | |---|---| | 1. Exports (goods) | 150 | | 2. Imports (goods) | 240 | | 3. Trade balance | −90 | | 4. Net invisibles (a + b + c) | 52 | | a. Non-factor services | 30 | | b. Income | −10 | | c. Transfers | 32 | | 5. Current account balance (3 + 4) | −38 |

• NCERT error: the table labels the trade balance "[2 – 1]". It should be exports − imports, which is row 1 − row 2 = −90.
• NCERT loose: Class 12 counts factor income as part of "trade in services". Under BPM6, factor income is primary income and transfers are secondary income. RBI's current account table reads: goods, services, primary income, secondary income.

India's structural pattern

• India runs a large, persistent merchandise deficit. The main imports behind it are crude oil, gold, electronics and coal.
• Two things offset it:
• A net services surplus from software, business services and global capability centres.

• Remittances. India is the world's largest remittance recipient, at about US$135 bn in FY25 per RBI (verify current).

• CAD figures per RBI:

• FY25: about 0.6% of GDP (US$22.9 bn) (verify current).
• FY26: about 0.6% of GDP (US$25.2 bn) (verify current).
• FY13: a record 4.8% of GDP.

Oil and gold sensitivity

• A rise in crude prices raises the import bill directly, because India imports more than 80% of its crude. Each US$10/barrel rise is commonly estimated to widen the CAD by roughly 0.3-0.4% of GDP (verify current).
• Gold demand for jewellery and savings surges when inflation or uncertainty is high. The FY13 CAD peak came from high oil prices plus a gold-import boom. The response was higher gold import duty.

3. Balance of payments II: the capital (financial) account and BPM6

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What the capital account records

• The capital account records international transactions in assets such as money, stocks, bonds and government debt.
• Buying a foreign asset is a debit, because foreign exchange flows out. Example: an Indian buying a UK car company.
• Selling a domestic asset to foreigners is a credit. Example: shares of an Indian firm sold to a Chinese buyer.
• The account is in surplus when inflows exceed outflows. Inflows include loans received and sales of assets. Outflows include loan repayments and purchases of foreign assets.
• Capital flows are movements of capital into or out of the domestic economy.

Table 6.1 capital account (US$ million) | Item | Value | |---|---| | External assistance (net) | 0.15 | | ECBs (net) | 2 | | Short-term debt | 10 | | Banking capital (net), of which NRI deposits 9 | 15 | | Foreign investment (net): FDI 13 + portfolio 6 | 19 | | Other flows (net) | −5 | | Capital account balance | 41.15 |

The items

• External assistance: aid and concessional loans from abroad.
• External commercial borrowings (ECB): commercial loans such as bank loans, bonds and supplier credit that eligible resident entities raise from non-residents under RBI rules. The rules cover eligible borrowers and lenders, an automatic-route limit (US$750 mn per year for many years), and an all-in-cost ceiling of benchmark + 500 bps. The framework is being revised (verify current).
• Short-term debt: foreign borrowing of short maturity, mostly trade credit.
• Non-resident deposits: deposits of non-residents in Indian banks, under FCNR(B), NRE and NRO accounts. They are part of banking capital.

BPM6

• BPM6 is the IMF's sixth BoP manual (2009). It splits the old capital account into two:
• A narrow capital account: capital transfers and non-produced, non-financial assets.

• A financial account: almost all trade in financial assets (FDI, portfolio, loans, reserves).

• RBI publishes a BPM6 presentation alongside the traditional "major items" table (Class 12 footnote and Box 6.1).

FDI vs FPI

• Foreign direct investment is investment by foreigners in productive enterprises with a lasting interest. In India, a holding of 10% or more of a listed company's equity counts as FDI.
• Foreign portfolio investment is investment in shares and bonds without a controlling stake, below 10% of equity. FIIs are the older name for FPIs.
• An FPI that crosses 10% must sell down or have its holding reclassified as FDI under the RBI/SEBI framework.

Types and routes of FDI

• Greenfield investment builds new facilities from scratch. Brownfield investment buys or expands existing ones. Example of brownfield: Cargill buying Parakh Foods.
• Automatic route: no prior approval is needed. Government route: prior approval from the ministry concerned is needed.
• Press Note 3 (2020) put all FDI from countries sharing a land border with India on the government route.
• The FIPB was abolished in 2017, and its work passed to ministries.

Overseas direct investment

• Overseas direct investment (ODI) is investment by Indian residents in foreign entities.
• It is governed by the FEMA Overseas Investment Rules 2022.
• Examples: Tata-Corus (2007) and Tata-JLR (2008).

Round-tripping

• Round-tripping means sending Indian money abroad, often via Mauritius or Singapore, and bringing it back as "foreign" investment to save tax or gain benefits.
• Fixes:
• DTAA amendments (Mauritius 2016, Singapore 2017), under which capital gains are taxed in India.
• GAAR (from April 2017).
• SEBI beneficial-ownership disclosure rules for concentrated FPIs (2023).

Trends

• Class 11 data: foreign investment (FDI + FII) rose from about US$100 mn in 1990-91 to US$23 bn in 2022-23.
• Recent hook: gross FDI inflows stay high, but net FDI has shrunk sharply. Foreign investors are repatriating profits and exiting through IPOs, and Indian firms are investing more abroad (verify current).

4. BoP equilibrium: the overall balance, reserves and errors

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How a deficit is financed

• A country that spends more than it earns abroad must sell assets or borrow, just like an individual.
• A CAD must be financed in one of two ways:
• a capital account surplus (net capital inflow), or

• drawing down reserves.

• Identity: current account + capital account ≡ 0, once reserve changes are included.

• BoP equilibrium means the CAD is fully financed by international lending, with no reserve movement.

Overall balance and reserves

• Overall balance = CA + KA + errors and omissions.
• A balance of payments surplus is an overall balance above zero, with official reserves rising. A deficit is an overall balance below zero, with reserves falling.
• In a deficit, RBI sells foreign exchange. This is an official reserve sale. The monetary authority is the ultimate financier of any deficit and the recipient of any surplus.

Sign-convention trap (NCERT) | BoP deficit | Balanced BoP | BoP surplus | |---|---|---| | Overall balance < 0 | = 0 | > 0 | | Reserve change > 0 | = 0 | < 0 |

• A fall in reserves is a source of funds, so it is shown as positive. RBI's tables likewise show a reserve increase with a minus sign.

Autonomous vs accommodating | Autonomous transactions | Accommodating transactions | |---|---| | Made for their own reasons, such as profit, independent of the BoP | Made to fill the BoP gap | | "Above the line" | "Below the line" | | Their balance defines a surplus or deficit | Official reserve transactions are the key item |

• Official reserve transactions are the central bank's sales or purchases of reserves to finance a deficit or absorb a surplus (NCERT Q2). They matter more under fixed exchange rates.
• Errors and omissions are the statistical discrepancy, because not every transaction can be recorded accurately.

NCERT error in Table 6.1

• CAB (−38) + KA (41.15) = +3.15.
• For the overall balance to be 0, errors and omissions must be −3.15, not +3.15 as printed.

Stock view

• The international investment position (IIP) is a statement of a country's external financial assets and liabilities at a point in time.
• Net IIP = assets − liabilities. India is a net debtor with a negative net IIP (verify current). The BoP measures flows; the IIP measures the stock they build up.

NCERT Q17: should a CAD be a cause for alarm? Judge it on three tests.

• Quality of financing: stable FDI is safe. Hot money and short-term debt can reverse suddenly.
• Use: a CAD that funds investment builds future export capacity. One that funds consumption does not. Class 11 notes that 1980s foreign borrowing was "spent on meeting consumption needs".
• Size: the Rangarajan HLC (1993) put the sustainable CAD at about 1.6% of GDP. About 2.5-3% of GDP is commonly cited today.

5. The foreign exchange market and short-run exchange-rate determination

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The market

• The foreign exchange market is where national currencies are traded for one another.
• It is world-wide and trading centres are in constant contact.
• Participants: commercial banks, forex brokers, other authorised dealers and monetary authorities.
• Foreign exchange means foreign currencies and claims payable in them. It is earned through exports, remittances and capital inflows, and spent on imports, debt service and investment abroad.
• The foreign exchange rate is the price of one currency in terms of another. ₹50 per $1 is a direct quote.

Demand and supply

• Demand for foreign exchange comes from imports, gifts sent abroad and purchases of foreign assets.

• A higher ₹/$ rate makes imports dearer, so less forex is demanded. The demand curve slopes down.

• Supply of foreign exchange comes from exports, transfers from foreigners and foreign purchases of Indian assets.

• A higher ₹/$ rate makes Indian goods cheaper for foreigners, so supply usually rises. The supply curve slopes up.
• Class 12 caveat: whether supply actually rises depends on the elasticities of export and import demand.

Flexible rate and its movements

• Under a flexible (floating) exchange rate, the rate is set where demand meets supply. There is no central bank intervention.
• Example: more Indians travel abroad. Demand for dollars shifts right and the rate moves from ₹50 to ₹70 per $.
• Currency depreciation is a fall in the rupee's value, meaning more rupees per dollar.
• Currency appreciation is the reverse: fewer rupees per dollar.

Short-run drivers (Class 12)

• Currency speculation: holding a currency in the hope of gaining from its rise. Money is an asset.
• Example: the pound is at ₹80 and investors expect ₹85 by month-end. Buying 1,000 pounds for ₹80,000 and selling at ₹85,000 gives a ₹5,000 profit.

• The extra demand for pounds pushes the pound up today, so the expectation fulfils itself.

• Interest rate differential: the gap between interest rates in two countries.

• Example: bonds pay 8% in country A and 10% in country B, a 2% gap. Funds move to B, so A's currency depreciates and B's appreciates.

• A rise in home interest rates tends to appreciate the home currency. This assumes free capital movement.

• Income: rising income raises imports and so demand for forex. A country whose aggregate demand grows faster than the world's usually sees its currency depreciate, because its imports grow faster than its exports.

Beyond NCERT

• Interest rate parity: the interest gap between two countries equals the expected change in their exchange rate, so no risk-free arbitrage is left.
• Covered IRP: the forward premium ≈ the interest differential.

• Uncovered IRP: expected depreciation ≈ the interest differential.

• Carry trade: borrowing in a low-interest currency such as the yen and investing in higher-yield assets elsewhere.

• In August 2024 the Bank of Japan raised rates and the yen jumped. The yen carry-trade unwind hit global markets, including India.

• Non-deliverable forward (NDF): an offshore forward contract in a non-convertible currency such as the rupee. It is settled in dollars on the rate difference, and no rupees change hands.

• Large offshore NDF markets in Singapore, Dubai and London caused gaps between onshore and offshore rupee prices.
• RBI let Indian banks with IFSC units deal in rupee NDFs from 2020, and later widened access, to narrow this gap (verify current).

6. The long run and real measures: PPP, real exchange rates, terms of trade

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Purchasing power parity

• Purchasing power parity (PPP): if there are no tariffs or quotas, and ignoring transport costs, exchange rates adjust until the same good costs the same everywhere.
• Over the long run, exchange rates therefore reflect relative price levels.

Shirt example (Class 12, Example 6.1)

• A shirt costs $8 in the US and ₹400 in India, so PPP gives ₹50/$.

• At ₹60/$, the US shirt costs ₹480 against ₹400 in India. All buyers go to India.

• Indian prices rise 20% (to ₹480) and US prices rise 50% (to $12). The new rate is 480/12 = ₹40/$. The dollar depreciates.

Q15

• ₹30/$ in 2010. Indian prices double by 2030 and US prices stay flat. PPP gives ₹60/$ in 2030.

Other uses of PPP

• The Big Mac index (The Economist) is an informal PPP check. It compares burger prices across countries to judge over- or undervaluation.
• PPP conversion rates are used to compare GDP across countries. India is the third-largest economy in PPP terms (cross-ref development-and-hdi).

Nominal vs real exchange rate

• The nominal rate e is the rupee price of a dollar.
• The real exchange rate is R = eP*/P, the price of foreign goods in terms of domestic goods.
• A higher R makes foreign goods dearer, so imports fall and exports rise.

• Buying decisions depend on the real rate, because it compares actual goods prices (Q3).

• Q4: 1.25 yen buys ₹1, so ₹0.8 buys 1 yen. R = 0.8 × 3/1.2 = 2.

Effective exchange rates

• Nominal effective exchange rate (NEER): a trade-weighted average of the rupee's bilateral rates against a basket of partner currencies.
• Real effective exchange rate (REER): NEER adjusted for relative inflation. It measures competitiveness.
• RBI publishes 40-currency and 6-currency NEER/REER indices, with base 2015-16 = 100 (verify current).
• A REER above 100 signals overvaluation and lost export competitiveness.

Q16: fixed rate with higher home inflation

• e is fixed and P rises faster than P*, so R falls. That is a real appreciation.
• Exports become dearer and imports cheaper, so the trade balance worsens.

Terms of trade

• Terms of trade: the ratio of export prices to import prices. An improvement means more imports per unit of exports.
• Net barter terms of trade = (Px/Pm) × 100.
• Income terms of trade = net barter ToT × export volume index. This measures the import-buying capacity of exports.
• India imports oil, so a spike in oil prices worsens India's ToT and a fall improves it.
• The Prebisch-Singer thesis says primary-exporters' ToT decline over time (cross-ref international-trade-policy).

Dutch disease

• Dutch disease: a boom in resources, remittances or capital inflows causes real appreciation, which squeezes manufacturing and other tradables.
• Named after the Netherlands' Groningen gas find (1959). The term was coined in 1977.
• The resource curse is covered in growth-theories-business-cycles.

7. Exchange-rate regimes: fixed, floating and managed float

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Fixed rate (Class 12, Fig. 6.3)

• Under a fixed exchange rate, the government sets the rate and the central bank buys or sells forex to hold it.
• Rate set above the market (e₁ = ₹70 against a market rate of ₹50), to cheapen the rupee and promote exports:
• Supply of dollars exceeds demand. The gap is AB in Fig. 6.3.

• RBI buys the extra dollars, so reserves pile up as long as it intervenes.

• Rate set below the market (e₂):

• Demand for dollars exceeds supply, and RBI must meet it from reserves.
• If reserves run out, a black market for foreign exchange appears: an illegal market where dollars sell above the official rate.

Devaluation vs depreciation (NCERT Q7) | Devaluation / revaluation | Depreciation / appreciation | |---|---| | Government decision, fixed regime | Market forces, flexible regime | | Devaluation: the government raises the ₹/$ rate, cheapening the rupee | Depreciation: the market raises the ₹/$ rate | | Revaluation: the government lowers the rate, making the rupee dearer | Appreciation: the market lowers the rate |

Credibility and speculative attacks

• A fixed rate works only if people believe the government can hold it.
• A speculative attack happens when reserves look too small. Speculators sell the currency and buy forex, forcing devaluation.
• Examples:
• Repeated attacks before Bretton Woods collapsed.
• Black Wednesday (16 Sept 1992): the pound left the ERM.
• Thai baht (2 July 1997): the baht was floated, triggering the Asian crisis.

Merits of floating (Class 12)

• The BoP adjusts automatically.
• There is less need for large reserves.
• The country gets independent monetary policy.

Managed floating

• Managed floating ("dirty floating") mixes the two regimes. Central banks buy and sell currencies to moderate movements. Official reserve transactions ≠ 0 (NCERT Q8: yes, the central bank intervenes).
• The world moved to it without any formal agreement.
• Forex intervention: the central bank buys or sells forex to influence the rate or curb volatility.
• RBI's stated policy is to curb excess volatility without targeting a level. It uses spot, forward and buy-sell swap operations.

Regime spectrum, hardest to softest

• Hard pegs:
• Dollarisation.

• Currency board: domestic currency is issued only against full foreign-reserve backing. Hong Kong has run one since 1983, at about HK$7.8/$.

• Conventional pegs.

• Crawling peg: a peg adjusted periodically in small steps, often in line with inflation gaps.
• Managed float, then free float.

India's IMF classification

• The IMF's de facto classification of India moved:
• from "floating",
• to "stabilised arrangement" (Dec 2022-Oct 2023),

• to "crawl-like arrangement".

• India's de jure regime stays floating (verify current).

Impossible trinity (Mundell-Fleming)

• The impossible trinity: a country cannot have a fixed rate, free capital movement and independent monetary policy all at once. It must give up one.
• India's middle path is partial capital openness plus a managed float, with large reserves as the buffer.

Currency wars and manipulation

• Competitive devaluation: countries deliberately weaken their currencies to boost exports at partners' expense, which invites retaliation.

• Examples: 1930s "beggar-thy-neighbour" policies, and the 2010 "currency wars".

• Currency manipulation: deliberately holding a currency down for trade advantage.

• The US Treasury FX report tests three criteria: bilateral trade surplus, current account surplus and persistent one-sided intervention.
• Economies that meet some of them go on a monitoring list. India has featured at times (verify current).

J-curve and Marshall-Lerner

• J-curve effect: after a depreciation, the trade balance first worsens, because import bills rise before volumes change. It then improves as trade volumes adjust.
• Marshall-Lerner condition: depreciation improves the trade balance only if the sum of the export and import demand elasticities is greater than 1. This is Class 12's elasticity caveat.
• Q19 (arrangements for stability): the gold standard, Bretton Woods, currency boards, pegs and managed floats.

8. The international monetary system: gold standard, Bretton Woods and the IMF

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Why a system is needed (Class 12)

• There is no world currency and no world central bank.
• Foreigners accept a national currency only if they trust its purchasing power to stay stable.
• Governments built that trust by promising free convertibility at a fixed price into gold or another currency.
• Credibility rested on two things: unlimited convertibility and the conversion price.
• The international monetary system is the set of arrangements that handles convertibility and conversion prices to keep international transactions stable.

Gold standard (c. 1870-1914)

• Under the gold standard, each currency was convertible into gold at a fixed mint parity, so exchange rates were fixed.
• BoP correction was automatic (NCERT Q5), through the price-specie-flow mechanism:
• A deficit country loses gold, so its money supply falls and prices fall.
• Its exports rise and imports fall, so the deficit closes.

• The surplus country goes through the reverse.

• Breakdown:

• World War I suspended convertibility.
• The interwar gold-exchange standard was fragile.
• The Great Depression ended it. Britain left gold in 1931.

Bretton Woods (July 1944)

• The conference created the IMF and IBRD. India was a founding member.
• The Bretton Woods system was an adjustable peg to the dollar, with the dollar convertible into gold at $35/oz.
• Triffin dilemma: the reserve-currency country must run deficits to supply world liquidity. Those deficits erode confidence in its currency.
• End of the system:
• Nixon shock (15 Aug 1971): the US closed the gold window.
• Smithsonian Agreement (Dec 1971) tried new pegs.
• Generalised float by 1973.
• Jamaica Accords (1976) legalised floating and demonetised gold.

Reserve currencies

• A reserve currency is held in large amounts by central banks and widely used in trade and finance.
• The dollar dominates, followed by the euro, yen, pound and yuan.

IMF quotas

• An IMF quota is a member's subscription. It sets the member's votes, access to IMF financing and SDR allocation.
• 25% of the quota is paid in reserve assets. This forms the reserve tranche position, which the member can draw at any time without conditions or charges.
• India's quota share is about 2.75% and its vote share about 2.63% (verify current).
• The 16th General Review agreed a 50% quota increase without realignment. The 17th review and a new formula are pending (verify current).

Special Drawing Rights

• Special Drawing Rights were created in 1969. The SDR is an international reserve asset: a claim on freely usable currencies, not a currency.
• The basket is USD, EUR, CNY (added 2016), JPY and GBP. Weights were reset in 2022.
• SDRs are allocated in proportion to quotas. The US$650 bn general allocation of August 2021 gave India about US$17.9 bn.

Washington Consensus and structural adjustment

• The Washington Consensus (John Williamson, 1989) listed ten prescriptions:
• fiscal discipline
• reordered public spending
• tax reform
• market interest rates
• a competitive exchange rate
• trade liberalisation
• openness to FDI
• privatisation
• deregulation

• property rights

• A structural adjustment programme is IMF-World Bank lending conditional on such reforms (conditionality).

• Critiques: austerity hurts the poor, reforms are wrongly sequenced (capital opening too early), and one size is made to fit all.
• India's 1991 package followed this template.

9. India's 1991 BoP crisis and the road to a convertible rupee

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Causes (Class 11, Liberalisation, Privatisation and Globalisation: An Appraisal)

• Fiscal overshooting through the 1980s: spending exceeded revenue by margins that borrowing could no longer cover.
• Foreign borrowing was spent on consumption.
• Imports grew fast without matching export growth.
• Prices of essential goods rose sharply.

Triggers (1990-91)

• The Gulf War sent oil prices up.
• Gulf remittances were lost.
• NRI deposits fled.
• Credit ratings were downgraded.
• Political instability added to the loss of confidence.

The low point

• Foreign currency assets fell to about US$1 bn by mid-1991, barely two weeks of imports. Class 11 calls it "not sufficient for even a fortnight".
• Total reserves including gold were about US$6 bn at end-March 1991.
• India could not pay interest to foreign lenders, and no one would lend.

Emergency response

• Gold was sold or pledged:
• About 20 tonnes were sold through SBI.

• About 47 tonnes were pledged with the Bank of England and Bank of Japan.

• India received US$7 bn in loans from the IMF and World Bank (NCERT figure). The loans came with conditionality.

• The New Economic Policy (NEP) had two parts:
• Stabilisation measures: short-term fixes to the BoP and inflation.

• Structural reforms: long-term efficiency and competitiveness.

• The rupee was devalued in two steps in July 1991 (1 and 3 July), by about 18-19%.

Earlier rupee regimes

• The rupee was linked to sterling.
• The 1966 devaluation (57.5%, from ₹4.76 to ₹7.50/$).
• The 1975 basket peg.
• The wider LPG appraisal is in lpg-reforms-1991.

Road to convertibility

• Currency convertibility is the freedom to exchange the rupee for foreign currency at the prevailing rate. It can apply to current transactions only, or to capital transactions too.
• Steps after 1991:
• LERMS (March 1992): a dual rate. 60% of export earnings were converted at the market rate and 40% at the official rate.
• Unified market-determined rate (March 1993). Class 11 says markets "more often than not" now set the rate.
• Rangarajan HLC on BoP reported in 1993.
• Current account convertibility came in August 1994, when India accepted IMF Article VIII. It is the freedom to convert rupees for trade, services and remittances.
• FERA 1973 was replaced by FEMA 1999. FERA was a criminal law; FEMA is civil.

Capital account convertibility

• Capital account convertibility is the freedom to convert domestic assets into foreign assets and back at market rates. India has it only partially.
• The Tarapore Committees (1997, 2006) set preconditions: a low fiscal deficit, low inflation, low bank NPAs and adequate reserves.
• Capital controls are limits, taxes or approvals on cross-border flows. India's calibrated controls include:
• ECB limits
• FPI debt limits

• the Fully Accessible Route (FAR, 2020), which opened specified G-secs fully to non-residents.

• The IMF's "institutional view" (2012) now accepts capital-flow management measures in some conditions.

Liberalised Remittance Scheme

• The Liberalised Remittance Scheme lets resident individuals remit money abroad for permitted current and capital transactions.
• The limit rose from US$25,000 (2004) to US$250,000 per financial year.
• TCS is levied on LRS remittances above a threshold (verify current).

Outcome

• Reserves rose from about US$6 bn (1990-91) to about US$646 bn (2023-24) (NCERT).

10. Forex reserves, RBI intervention and capital-flow volatility

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Composition

• Foreign exchange reserves are the external assets held by RBI. RBI's Weekly Statistical Supplement lists four parts: 1. Foreign currency assets (FCA), the largest part 2. Gold 3. SDRs 4. Reserve tranche position with the IMF

Purposes

• Financing BoP gaps. Class 11 says reserves are kept "to import petroleum and other important items".
• Intervening in the forex market.
• Insurance against sudden stops.
• Building market confidence and supporting credit ratings.

Adequacy metrics

• Import cover: how many months of imports reserves can pay for. It has been about 11 months recently (verify current). The old rule of thumb was 3 months.
• Reserves to short-term debt: the Greenspan-Guidotti rule says it should be at least 100%.
• The IMF's ARA metric, which weighs exports, broad money, short-term debt and other liabilities.

Gold reserves

• Gold reserves hedge against currency and sanctions risk.
• RBI holds about 880 tonnes (verify current).
• About 100 tonnes were brought back from the Bank of England in 2024.
• RBI has bought gold steadily in recent years.

Trajectory

• US$646 bn in 2023-24 (NCERT).
• A peak of about US$705 bn in September 2024.
• Drawdowns followed as RBI sold dollars to defend the rupee (verify current).

Costs of holding reserves

• Sterilisation: RBI buys dollars and so injects rupees. It must then mop up the extra rupees through OMOs or MSS bonds, which costs money.
• Negative carry: reserves earn low returns on US Treasuries, while India pays higher rates on its own borrowing.
• RBI's custodian role is covered in banking-monetary-policy.

Kinds of volatility

• Hot money: short-term speculative capital that moves quickly in search of returns and destabilises markets. FPI debt and equity flows can surge in and rush out.
• Sudden stop: capital inflows halt or reverse abruptly, forcing depreciation and output loss.
• Asia 1997.
• The 2013 taper tantrum: the US Fed hinted at tapering bond purchases. India was among the "Fragile Five" (with Brazil, Indonesia, Turkey and South Africa). The rupee fell to about ₹68.8/$ (Aug 2013).
• India's 2013 response: an FCNR(B) swap window that raised about US$34 bn, and curbs on gold imports.

• March 2020 (Covid).

• Capital flight: large outflows driven by economic or political fear. Example: Sri Lanka in 2022.

Lines of defence

1. Reserves.
2. RBI USD/INR buy-sell swaps, which adjust liquidity and forward cover.

3. Currency swap arrangements: agreements between central banks to exchange currencies for a period, giving liquidity in times of stress. - India-Japan bilateral swap arrangement of US$75 bn. - The SAARC currency swap framework, with India as provider to Sri Lanka, the Maldives and Bhutan. - RBI-UAE arrangements.

4. The IMF as lender of last resort.

11. External debt, sovereign ratings and debt restructuring

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What external debt is

• External debt is money owed to non-residents that requires payment of principal and/or interest.
• It is either sovereign (owed by the government) or non-sovereign (owed by companies and banks).
• Main components:
• Commercial borrowings, the largest part
• NRI deposits
• Short-term trade credit

• Multilateral and bilateral loans

• It is mostly dollar-denominated, so a falling rupee raises the burden.

Size

• About US$736 bn at end-March 2025, about 19% of GDP (verify current).

Vulnerability indicators

• Debt service ratio: principal plus interest payments as a share of current receipts. It was about 35% in 1990-91 and is now in single digits (verify current).
• Short-term debt to reserves.
• Debt to GDP.
• The 1991 near-default is the benchmark (Class 11).

Sovereign credit ratings

• A sovereign credit rating is a rating agency's assessment of a government's ability and willingness to repay. It affects borrowing costs.
• The big three are S&P, Moody's and Fitch. BBB−/Baa3 is the lowest investment grade.
• S&P upgraded India to BBB in August 2025 (verify current).
• Economic Survey 2020-21 argued that India's ratings do not reflect its fundamentals or its willingness to pay.

Default and restructuring

• Sovereign default: a government misses principal or interest payments.
• Sovereign debt restructuring renegotiates the terms in three main ways:
• haircuts, which cut the principal
• lower coupons

• longer maturities

• The Paris Club is a group of creditor governments.

• Comparability of treatment: the debtor must get similar terms from all other creditors, so the burden is shared fairly.

New frameworks

• G20 Common Framework (Nov 2020): used by Zambia, Ghana and Ethiopia. It has been criticised as slow.
• Global Sovereign Debt Roundtable (2023): IMF, World Bank and G20 presidency, bringing debtors and creditors together.

Sri Lanka

• Sri Lanka defaulted in 2022.
• India gave about US$4 bn in bridge support: credit lines, swaps and deferrals.
• An IMF Extended Fund Facility followed in March 2023.
• An Official Creditor Committee was co-chaired by India, Japan and France. An OCC is a group of bilateral government creditors that negotiates a joint restructuring.
• China, a non-Paris-Club creditor, negotiated separately. This feeds the "debt-trap" debate about opaque, collateralised loans.

Innovative finance

• Debt-for-nature swap: creditors forgive part of a debt in return for spending on conservation.
• Belize 2021.
• Ecuador-Galápagos 2023.

• Gabon 2023.

• Blended finance: concessional public or philanthropic money used to reduce risk and draw in private investment. It is part of the G20 agenda for reforming multilateral development banks.

12. Dollar dominance, de-dollarisation and rupee internationalisation

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The dollar's roles

• It makes up about 57-58% of allocated global reserves (IMF COFER, verify current).
• It dominates trade invoicing.
• It dominates cross-border banking and the SWIFT messaging system.
• The US gains an "exorbitant privilege": it borrows cheaply in its own currency.

Dollarisation vs de-dollarisation

• Dollarisation is using the US dollar alongside or instead of the national currency.
• Full: Ecuador (2000), El Salvador (2001), Zimbabwe (multicurrency from 2009).

• Partial: dollar deposits in stressed economies.

• De-dollarisation is reducing reliance on the dollar in trade, reserves and finance. Triggers:

• The freezing of Russia's reserves in 2022 and wider sanctions risk.
• BRICS talk of alternative payment systems.

• Central banks buying gold.

• India's stated line: promote rupee use and reduce risk, not de-dollarise as a policy.

Rupee internationalisation

• Rupee internationalisation means more use of the rupee in cross-border trade, investment and reserves.
• Rupee trade settlement: RBI's July 2022 framework lets trade be invoiced and settled in INR through Special Rupee Vostro Accounts (SRVAs).

Nostro vs vostro | Nostro ("ours") | Vostro ("yours") | |---|---| | An Indian bank's account abroad, in foreign currency | A foreign bank's account with an Indian bank, in rupees |

Local currency settlement

• Local currency settlement (LCS) means settling bilateral trade in the two partners' own currencies instead of the dollar.
• Agreements:
• UAE (2023): the first rupee-dirham crude payment followed.
• Indonesia, the Maldives and Mauritius (verify current).

RBI Inter-Departmental Group roadmap (2023)

• Rupee lending to non-residents.
• INR accounts for non-residents abroad.
• Wider use of the rupee in trade settlement and bond markets.
• INR in the SDR basket as a long-run goal.
• UPI cross-border links are in payment-systems-digital-finance.

Constraints

• Capital account convertibility is only partial.
• Bond and FX markets are shallow.
• India runs a persistent trade deficit, so partners pile up rupees they cannot use. In the Russia case, rupee surpluses stuck in vostro accounts showed this limit.

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Exam angles

Prelims — high-yield facts and traps

• Current account items:
• Remittances, gifts and grants are transfers (secondary income).

• Interest, dividends and wages earned abroad are primary income.

• Capital/financial account items: FDI, FPI, ECB, NRI deposits, external assistance and short-term trade credit.

• Buying a foreign company is a capital account debit.
• Current account balance = BoT + net invisibles. Invisibles = services + income + transfers.
• BPM6 has three accounts: current, capital and financial.
• Autonomous transactions are "above the line"; accommodating ones are "below the line", and official reserve transactions are accommodating.
• NCERT sign convention: in a BoP deficit the overall balance is < 0 and the reserve change is shown > 0.
• "The BoP always balances in the accounting sense" — TRUE (double entry).
• Devaluation/revaluation = government action in a fixed regime. Depreciation/appreciation = market movement in a flexible regime.
• A rise in ₹/$ means the rupee depreciates.
• Managed float means official reserve transactions ≠ 0.
• Direction of effects:
• A higher home interest rate → appreciation.
• Faster home demand growth → depreciation.
• Higher home inflation at a fixed rate → real appreciation → worse trade balance.
• REER above 100 → overvaluation.

• Speculation can be self-fulfilling.

• Reserves = FCA + gold + SDRs + RTP.

• SDR basket: USD, EUR, CNY (added 2016), JPY, GBP. "SDR is a currency" — FALSE.
• The RTP carries no conditionality. The quota sets votes, access to financing and SDR allocation.
• Match concepts to definitions:
• Triffin dilemma: liquidity vs confidence.
• Impossible trinity: fixed rate + free capital + independent monetary policy cannot coexist.
• Dutch disease: a boom → real appreciation → manufacturing squeezed.
• J-curve: the trade balance worsens first, then improves.

• Marshall-Lerner: sum of elasticities > 1.

• Formulas:

• Open-economy multiplier = 1/(1 − c + m); with proportional tax, 1/[1 − c(1 − t) + m].
• m is the coefficient on Y in M = M̄ + mY.
• PPP rate = domestic price ÷ foreign price.
• Real exchange rate R = eP*/P.
• Net barter ToT = (Px/Pm) × 100.

• Income ToT = NBTT × export volume index.

• Global chronology: gold standard (c. 1870-1914) → Bretton Woods (1944) → SDR (1969) → Nixon shock (1971) → float (1973) → Jamaica (1976).

• India chronology: 1966 devaluation → 1975 basket peg → July 1991 devaluation → LERMS (1992) → unified rate (1993) → current account convertibility (Aug 1994) → FEMA (1999) → LRS (2004) → rupee trade settlement (July 2022).
• Traps:
• "India has full capital account convertibility" — FALSE. It has only partial.
• FPI is below 10% of equity.
• "RBI targets a specific exchange rate" — FALSE by its stated policy.
• Class 12 Table 6.1 has two printing errors: the "[2 – 1]" label and the sign of errors and omissions.

Mains — GS-III themes

1. Is a CAD a cause for alarm? Judge it by the sustainable level (Rangarajan 1.6% of GDP; 2.5-3% of GDP cited today), the quality of financing (FDI vs hot money), the saving-investment gap and dependence on oil and gold imports. Services and remittances are India's external strength.

2. Rupee depreciation: - Causes: FPI outflows, a strong dollar, oil prices, tariff shocks. - Effects: imported inflation, gains for exporters, a heavier external-debt burden, risk on unhedged ECBs. - Policy question: should RBI defend a level or only curb volatility? How much reserves are enough, and at what cost (sterilisation, negative carry)?

3. Lessons of 1991, 2013 and 2022 for external vulnerability. 1991 was a BoP-cum-fiscal crisis (twin deficits). IMF conditionality is also a GS-II angle on international institutions.

4. Capital account convertibility: benefits (cheaper capital, integration) vs risks (sudden stops, loss of monetary autonomy). Read it through the impossible trinity and the Tarapore preconditions.
5. Rupee internationalisation and de-dollarisation: prerequisites, benefits, limits (trade deficits, Russia's rupee surplus), and India's position in BRICS payment debates.
6. The global debt architecture: Common Framework delays, Sri Lanka's restructuring and India's neighbourhood role, IMF quota reform and Global South voice, and bias in sovereign rating methods.

Current-affairs hooks

• RBI's quarterly BoP release (CAD/GDP, services, remittances), quarterly external-debt data, weekly reserve figures, and the Economic Survey's external-sector chapter.
• Rupee record lows or rebounds, RBI intervention and USD/INR swaps, US Fed decisions and FPI flows, carry-trade unwinds.
• The IMF Article IV report on India (regime classification), the US Treasury FX report and monitoring list, IMF-World Bank meetings, quota reviews and SDR debates.
• Rating actions on India, bond-index inclusion and FAR inflows, and Budget changes to LRS/TCS and gold import duty.
• New LCS agreements, wider use of SRVAs, UPI cross-border links, and BRICS summits on payment systems.
• IMF programmes and restructurings in Sri Lanka, Pakistan, Bangladesh and the Maldives, India's swap support, and World Bank Migration and Development Briefs on remittances.