Open Economy Macroeconomics (Balance of Payments & Foreign Exchange) — Practice

Question 1

The exchange rate changes from ₹80/$ to ₹85/$. (i) Has the rupee appreciated or depreciated? (ii) How does this affect Indian software exporters who earn in dollars? (iii) How does this affect Indian families buying an imported iPhone?

Accepted Answer

(i) DEPRECIATION: It now takes MORE rupees (₹85 vs ₹80) to buy $1. The rupee has weakened/depreciated. (ii) BENEFIT for software exporters: An Indian IT company earns, say, $1 million from a US client. At ₹80/$: ₹8 crore. At ₹85/$: ₹8.5 crore. The SAME dollar income converts to MORE rupees. Indian IT firms' rupee revenues and profits RISE when the rupee depreciates — even without winning new contracts. (iii) HARM to importers: An iPhone priced at $1,000 in the US. At ₹80/$: costs ₹80,000 in India. At ₹85/$: costs ₹85,000. The iPhone becomes ₹5,000 more expensive for the Indian buyer. All imported goods — oil, electronics, machinery — cost MORE rupees after depreciation, contributing to inflation.

Question 2

Classify each of the following as current account or capital account transactions in India's Balance of Payments: (a) Tata Motors exports cars to the UK; (b) Reliance borrows from a US bank; (c) An NRI in the UAE sends money to his family in Kerala; (d) Apple Inc. builds a manufacturing plant in India; (e) An Indian student pays tuition fees to a US university.

Accepted Answer

(a) Tata Motors exports cars to the UK → CURRENT ACCOUNT (merchandise/goods exports). A credit entry — India earns foreign exchange. (b) Reliance borrows from a US bank (External Commercial Borrowing) → CAPITAL ACCOUNT. This creates a liability (must be repaid). It is a capital inflow. (c) NRI in UAE sends money to Kerala → CURRENT ACCOUNT (remittances/transfers). Private remittances are a current account credit item (invisible transfers). India is the world's largest remittance recipient. (d) Apple Inc. builds a manufacturing plant in India → CAPITAL ACCOUNT (FDI inflow). This is a long-term foreign direct investment in India's productive capacity. Capital account credit. (e) Indian student pays tuition fees to a US university → CURRENT ACCOUNT (services imports). Educational services are 'invisible imports.' India is paying for services consumed abroad. Debit entry.

Question 3

Explain India's Balance of Payments situation. Why does India typically run a current account deficit, and how is it financed?

Accepted Answer

INDIA'S BALANCE OF PAYMENTS — STRUCTURE: India's BoP consists of two major accounts: the Current Account and the Capital Account. Each records different types of economic transactions with the rest of the world. INDIA'S CURRENT ACCOUNT: MERCHANDISE TRADE (GOODS): India consistently runs a LARGE TRADE DEFICIT. India exports: IT services (not goods), software, pharmaceuticals, gems and jewellery, textiles, engineering goods. India imports: CRUDE OIL (biggest item, ~35-40% of import bill), electronics, gold, machinery, fertilisers. The trade deficit is structurally large because India imports expensive commodities (oil, gold) that it cannot produce domestically in sufficient quantity. INVISIBLES: India has a LARGE INVISIBLE SURPLUS: (1) IT/BPO services: India exports ~$250 billion/year in software and IT-enabled services — a massive surplus. (2) REMITTANCES: ~$125 billion/year sent by NRIs from Gulf countries, US, UK — the world's largest. (3) Tourism: India earns from foreign tourists; Indians also spend abroad. Net: modest positive. Overall: India's invisible surplus partially compensates for the merchandise deficit, but not fully. CURRENT ACCOUNT DEFICIT: India's current account typically shows a DEFICIT of 1-2% of GDP (varies with oil prices). When global oil prices spike (as in 2022-23), the deficit widens. When oil is cheap or exports boom, the deficit narrows. WHY DOES THE CURRENT ACCOUNT DEFICIT PERSIST? (1) Oil dependence: India imports ~85% of its oil — and cannot quickly substitute (though renewables are growing). (2) Electronic goods demand: India imports large quantities of smartphones, semiconductors, and consumer electronics. (3) Gold imports: Indians love gold (~800-1000 tonnes/year imported). These structural factors keep imports structurally higher than exports of goods. FINANCING THE CURRENT ACCOUNT DEFICIT — THE CAPITAL ACCOUNT: India's current account deficit is financed by the CAPITAL ACCOUNT SURPLUS: (1) FDI inflows: India attracts ~$70-80 billion/year in foreign direct investment (manufacturing, services, tech). (2) FII/FPI inflows: Foreign institutional investors buy Indian stocks and bonds (~$30-50 billion/year, volatile). (3) ECB: Indian corporates borrow abroad. (4) NRI deposits (FCNR, NRE accounts). OVERALL BoP: The capital account surplus has generally exceeded the current account deficit → India's FOREIGN EXCHANGE RESERVES have been growing (now ~$670 billion, covering ~11-12 months of imports). THE RBI'S ROLE: The RBI manages the exchange rate under a MANAGED FLOAT system — intervening to smooth excessive volatility without defending a fixed rate. When the current account deficit widens and capital flows fall (e.g., during a global risk-off episode), the RBI SELLS dollars from its reserves to prevent disorderly rupee depreciation. When the capital account surplus is large, it BUYS dollars to prevent excessive appreciation (which would hurt exporters). CONCLUSION: India's BoP structure reflects its development stage — a large, growing economy that is still building its manufacturing base (current account deficit from importing capital goods and commodities) but attracting capital flows (capital account surplus). The challenge is to reduce the structural current account deficit by: (1) increasing domestic oil/renewable energy production, (2) growing manufactured goods exports (PLI schemes), and (3) reducing gold imports.

Practice — Open Economy Macroeconomics (Balance of Payments & Foreign Exchange)

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