ExplainSpeaking: How does India’s exchange rate relate to its current account deficit, foreign exchange reserves and balance of payments?
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Since the invasion of Ukraine by Russia, you would have regularly read reports on India exchange rate fluctuations. Similarly, you would have read stories about India’s foreign exchange (or forex) reserves rise or fall. And more recently you would have read stories about the rise of India rising current account deficit.
Example of this from the RBI last week: “India recorded a current account deficit of 1.2% of GDP in April-December 2021 compared to a surplus of 1.7% in April-December 2020 due to a sharp increase in the trade deficit.” Or that “in April-December 2021, there was a $63.5 billion increase in foreign exchange reserves.”
Instead of understanding each of these terms separately, it would be better to understand them all at once and, more importantly, to understand how they relate to each other.
As such, let’s take a detour and understand the single chart that explains all of these variables and how they interact. This chart is called the balance of payments or BoP.
What is BoP?
Simply put, the Indian BoP (see table 1) is a record of its transactions with the rest of the world. It shows how much money – you can choose to watch it in US Dollars or Indian Rupees – has gone out of the country and how much money has come into the country.
How does the money come in or go out?
Well, every day, Indians (and Indian entities such as companies and governments) and foreigners (and foreign entities) transact. These transactions can be the trade (export or import) of goods (such as cars, gadgets or raw materials) or services (such as an Indian company selling computer software to someone in the United States or an American company providing banking services to certain Indians). Beyond trade, these transactions also include investments – such as an Indian buying land in the United States or an American company investing in Indian stock exchanges – and the exchange of loans between Indians and other countries of the world.
This list is not exhaustive, but it gives an idea of how money enters and leaves India through various routes.
But why bother to count this flow of money?
Essentially, the BoP allows us to understand the exchange rate of the Rupee against different currencies. Whenever an Indian wants to buy or invest in an American good or service, he will have to hand over a certain number of rupees to first buy the amount of dollars needed to finalize this purchase.
Consider the dollar-rupee exchange rate. Suppose the starting exchange rate is 50, i.e. one has to give 50 rupees to exchange it for US dollars. If the next month the transactions were such that more Indians demanded dollars than Americans demanded rupees, the exchange rate would reflect this change. It can, for example, become 55, showing that the US dollar has strengthened against the rupee or that the rupee has weakened against the dollar.
So how does BoP work?
Here are some of the main characteristics of the BoP:
> All possible transactions are divided into two main accounts. The first is called the current account and the second is called the capital account.
> Individually, either of these accounts can be in surplus or deficit, but overall the BoP always balances out. A surplus implies that more money is entering the country than it is leaving while a deficit – which is displayed with a negative note – implies that more money is leaving the country than it is entering. The fact that, by definition, the BoP always balances implies that the deficit of one account must be compensated by a surplus on the other account.
> The Current Account is called “current” because it refers to all transactions that are, in some way, related to current consumption.
> The current account is further divided into two subparts (see table). One is the export and import of physical goods such as iron ore, wheat, cars, gadgets, etc. This is called the trade balance. If India imports more than it exports, then it is called a trade deficit. It is important to note that despite hitting a record export figure of $400 billion in 2021-22, India would still have a trade deficit. Indeed, India is said to have imported goods worth over $400 billion in the past fiscal year.
> The second sub-part of the Current Account is called the “Invisibles” trade. It’s called Invisibles because it refers to trade in services and other transactions that are usually “not visible” – as opposed to, for example, a trade in cars, chairs, or phones. These “invisible” transactions include services (e.g. banking, insurance, IT, tourism, transport, etc.), transfers (e.g. Indians working in foreign countries returning money to families back home) and income (such as income from certain investments).
> As can be seen from the table, between April and December 2021, India had a trade deficit but a surplus in the trade of the Invisibles. However, since the trade deficit was larger than the trade surplus of the Invisibles, India’s overall current account is also negative or in deficit. This is called the current account deficit (CAD).
The other part of the BoP is the capital account (see table 1). The capital account refers to transactions that are not for current consumption, but rather for investment purposes. The capital account therefore includes net foreign investment – whether through foreign direct investment or foreign portfolio investment – and loans or money that countries borrow from each other.
As the table shows, India had a capital account surplus of $90 billion from April to December 2021 against a current account deficit of $26.6 billion.
How does the BoP balance out?
This is where a third element comes into play. Technically speaking, this third component is part of the capital account but it is presented as a third category to explain its role in balancing the BoP and thereby determining India’s exchange rate as well as the level of foreign exchange reserves.
The net result of a current account deficit (of $26.6 billion) and a capital account surplus (of $90.1 billion) is that a total of US$63.5 billion entered the Indian economy – and BoP accounts – in April and December 2021 The only way to balance the balance of payments is for some authority to remove those excess dollars from the equation. This authority is the RBI and it withdraws these dollars and keeps them with it.
Since the RBI is withdrawing the $63.5 billion from the BoP, it is displayed with a negative sign in front of it.
What is RBI actually?
The RBI is adding to its foreign currency reserves. But the RBI is also required to balance its accounts. If he has new “assets” in the form of US$63.5 billion, he must also increase his “liabilities” by the same amount. RBI’s responsibility is the national currency it prints. You may recall that each bank note bears the signature of the Governor of RBI and promises that he will give the bearer the sum of Rs 100 or Rs 200 etc. This promise is the responsibility of the RBI.
Simply put, the increase in forex also leads to an increase in the money supply in the Indian economy. A higher money supply can also lead to higher inflation.
But why is the RBI doing it? What would have happened if the RBI had not intervened? How would the BoP balance out in this scenario?
In simple terms, the RBI intervenes in order to maintain the exchange rate of the rupee. Imagine a scenario where, starting in April, more and more dollars started flowing into the Indian economy due to a growing capital account surplus. If the RBI did not intervene, the increased demand for rupees against the dollar would have meant that the rupee would have appreciated in value. In other words, the rupee’s exchange rate — to use the previous example — would have gone from Rs 50 to the dollar to Rs 45 to the dollar.
But at 45 to the dollar, Indian exports would have become more expensive for the United States or the rest of the world, thus lowering their demand. At the same time, Indians would have found foreign products cheaper, so Indian imports would have increased. This would have led to a widening of the trade deficit or the current account deficit to such an extent that the BoP would have balanced itself.
The big difference was that when the RBI stepped in, India’s exchange rate remained stable while India’s foreign exchange reserves improved. In a scenario where the RBI did not intervene, the level of foreign exchange reserves would have remained the same but the rupee would have appreciated considerably.
That’s all for today on BoP.
Later this week, the RBI’s Monetary Policy Committee will meet again and reassess the country’s monetary policy stance. Chances are, the RBI will have no choice but to raise the inflation forecast for the coming year. here’s why.
The RBI, however, cannot resort to raising interest rates.
If you want to know more about the threat of inflation in India, you can save this The Express Economist show playlist. In particular, watch this two-part interview with Dr. Aurodeep Nandi from Nomura, In part 1he explains why higher prices are here to stay and in part 2, it explains how each government benefits from high levels of the rate of inflation.