The external sector: balance of payments, exchange rates and reserves

The balance of payments records all economic transactions between residents of a country and the rest of the world. Its current account covers trade in goods and services, income from investments and work, and transfers such as remittances from Indians working abroad. Its capital and financial account covers investment flows, loans and banking capital. A current account deficit means a country is spending more on foreign goods, services and income payments than it earns from them, and the gap must be financed by capital inflows or by drawing on foreign exchange reserves.

India has usually run a current account deficit, financed in part by services exports, especially software and business services, and by remittances, which offset a large merchandise trade deficit from imports such as oil. Foreign direct investment, which brings long-term capital and technology, is generally considered more stable than foreign portfolio investment in shares and bonds, which can reverse quickly when global interest rates or risk sentiment change. Sudden outflows can pressure the rupee, raise import costs and force the central bank or government to respond.

The exchange rate is the price of one currency in terms of another. India follows a managed float: the rupee's value is largely market-determined, but the Reserve Bank of India intervenes in the foreign exchange market to curb excessive volatility, using its foreign exchange reserves. Depreciation makes exports cheaper abroad and imports dearer at home, which can help exporters but worsen inflation, especially through fuel prices. Appreciation has the opposite effects. There is therefore no exchange rate that helps everyone at once.

Foreign exchange reserves, held by the Reserve Bank, act as a buffer against external shocks and as a signal of a country's ability to meet import and debt payments. Reserves rose substantially after the 1991 crisis, when they had fallen to critically low levels, and their adequacy is judged by measures such as months of import cover and short-term external debt. A careful reader distinguishes between a deficit caused by productive investment imports and one caused by consumption or oil shocks, because the policy response should differ.