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Ever since the invasion of Ukraine by Russia, you would regularly read news about exchange rate fluctuations of India. Likewise, you would have read stories about India’s foreign exchange (or forex) reserves go up or down. And more recently, you would have read stories about the rise of India current account deficit increasing.
Try it 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 in the wake of a sharp increase in the trade deficit. “Or that” in April-December 2021, there was an increase of $ 63.5 billion 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 are related to each other.
Therefore, let’s take a detour and understand the one table that explains all of these variables and how they interact. This table is called the Balance of Payments or BoP.
What is the BoP?
Simply put, the Indian BoP (see table 1) is a record of your transactions with the rest of the world. It shows how much money – you can choose to look at it in terms of US dollars or in terms of Indian rupees – has left the country and how much money has entered the country.
How does money get in or out?
Well, every day, Indians (and Indian entities like corporations and governments) and foreigners (and foreign entities) transact. These transactions could be the trade (export or import) of goods (such as cars, gadgets, or commodities) or services (such as an Indian company that sells computer software to someone in the United States or an American company that provides banking services to someone in the United States). some Indians). In addition to trading, 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 India and other countries of the world.
This is not an exhaustive list, but it does give an idea of how money flows in and out of India via various routes.
But why bother counting this cash flow?
In essence, the BoP allows us to calculate 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 deliver a certain number of rupees to first purchase the amount of dollars necessary to complete the purchase.
Let’s take the dollar-rupee exchange rate. Suppose the initial exchange rate is 50, i.e. you have to give 50 Rs to exchange it for US $. If transactions in the next month are such that more Indians are asking for dollars than Americans are asking for rupees, the exchange rate will reflect this change. It can, for example, become 55, thus showing that the US dollar has strengthened against the rupee or that the rupee has weakened against the dollar.
So how does the BoP work?
Here are some of the key features of the BoP:
> All possible transactions are divided into two main accounts. The first is called Current Account and the second Capital Account.
> Individually, one of these accounts may be in surplus or in deficit, but overall the BoP is always in equilibrium. A surplus implies that more money is entering the country than is exiting, while a deficit – which is shown with a negative sign – implies that more money is leaving the country than entering. The fact that, by definition, the BoP is always in balance implies that the deficit on one side must be balanced by a surplus on the other.
> The current account is called “current” because it refers to all transactions that are, so to speak, linked to current consumption.
> The Current Account is further divided into two sub-parts (see table). One is the export and import of physical goods such as iron ore, grain, cars, gadgets etc. This is called the trade balance. If India imports more than it exports, we call it a trade deficit. It is important to note that despite hitting its all-time highest export figure of $ 400 billion in 2021-22, India still has a trade deficit. This is because India would have imported goods worth over $ 400 billion during the past financial year.
> The second sub-part of the Current Account is called the “Invisible” trade. It is called Invisible because it refers to the exchange of services and other transactions that are typically “invisible” – as against, for example, an exchange of cars, chairs or telephones. Such “invisible” transactions include services (e.g. banking, IT insurance, tourism, transportation, etc.), transfers (e.g. Indians working in foreign countries returning money to families at home) and income (such as income earned by some investments).
> As can be seen from the table, between April and December 2021, India had a trade deficit but a surplus in trade in invisibles. However, as the trade deficit was greater than the invisible trade surplus, 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 those operations that are not of current consumption, but 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 can be seen from the table, India recorded a capital account surplus of $ 90 billion from April to December 2021 against a current account deficit of $ 26.6 billion.
How do you balance the BoP?
This is where a third component comes into play. Technically speaking, this third component is part of the capital account, but is shown as a third category to explain its role in balancing the BoP and, in the process, 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 in the BoP accounts – in April and December 2021 The only way to balance the BoP is for some authority to take these excess dollars out of the equation. That authority is the RBI and they take these dollars and keep them with them.
Since the RBI withdraws $ 63.5 billion from the BoP, it is shown with a negative sign before it.
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What’s the RBI doing?
The RBI adds to its foreign exchange reserves. But the RBI is also required to make ends meet. If he has new “assets” in the form of US $ 63.5 billion, then he must also increase his “liabilities” by the same amount. RBI’s liability is the national currency it prints. You may remember how each currency note has the signature of the RBI governor and promise 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 rise 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 does the RBI do this? What would have happened if the RBI hadn’t intervened? How would the BoP balance in that scenario?
Simply put, the RBI steps in to maintain the rupee exchange rate. Imagine a scenario where, starting in April, more and more dollars started entering the Indian economy due to a growing capital account surplus. If the RBI did not intervene, the increase in demand for rupees against the dollar would have meant that the rupee would have appreciated. In other words, the rupee exchange rate, to continue using the previous example, would have gone from Rs 50 to one dollar to Rs 45 to dollar.
But at $ 45 per dollar, India’s exports would become more expensive to the United States or the rest of the world, thereby reducing their demand. At the same time, Indians would find foreign goods at a lower price, so India’s imports would increase. This would have resulted in a widening of the trade or current account deficit to such an extent that the BoP would have balanced itself.
The big difference is that when the RBI stepped in, India’s exchange rate remained stable while India’s forex reserves improved. In a scenario where the RBI does not intervene, the level of forex reserves would have remained the same but the rupee would have appreciated considerably.
That’s it for today on BoP.
At the end of this week, the RBI’s Monetary Policy Committee will meet and reassess the country’s monetary policy stance. The RBI is very likely to find itself with no option but to raise its inflation forecast for next year. Here because.
The RBI, however, may not resort to raising interest rates.
If you want to know more about the threat of inflation in India, you can save it playlist of the show The Express Economist. Specifically, check out this two-part interview with Dr. Aurodeep Nandi of Nomura, In part 1explains why higher prices are here to stay and in part 2, explains how each government benefits from high levels of inflation.