Balance of Payments, Exchange Rates, Types of Currencies, and Management

This study material is designed for aspirants preparing for competitive exams like UPSC, banking, or economics-related tests on cracktarget.com. It covers the key topics in a structured, easy-to-understand format with definitions, explanations, examples, tables, and visuals. Focus on understanding concepts, historical context (especially the 1991 reforms), and their interconnections.

Introduction: The 1991 Economic Reforms and BoP Crisis

The “opening up” of the Indian economy refers to the Liberalization, Privatization, and Globalization (LPG) reforms initiated in 1991. These were triggered by a severe Balance of Payments (BoP) crisis, where India faced acute foreign exchange shortages.

Causes of the 1991 BoP Crisis

• High Fiscal Deficits: Government spending exceeded revenue, leading to internal debt and inflation.
• Current Account Deficit: Imports (especially oil) surged due to the Gulf War (1990-91), which increased crude oil prices, while exports stagnated.
• Depleting Forex Reserves: Reserves fell to about $1 billion, barely enough for two weeks of imports. India had to pledge gold to secure loans from the IMF and World Bank.
• External Factors: Collapse of the Soviet Union (a major trade partner) and global recession reduced remittances and exports.
• Internal Issues: Over-regulated economy with license raj, high tariffs, and fixed exchange rates hindered competitiveness.

Key Reforms and Impact

• Devaluation of Rupee: The rupee was devalued by about 18-19% in July 1991 to boost exports.
• Liberalization: Reduced import tariffs, abolished industrial licensing, and opened sectors to FDI.
• Privatization: Disinvestment in public sector units.
• Globalization: Encouraged foreign trade and investment.
• Outcome: Forex reserves recovered, GDP growth accelerated from 1.1% in 1991 to over 6% in subsequent years, and India integrated into the global economy. However, it increased vulnerability to external shocks.

The crisis highlighted the need for effective BoP management, flexible exchange rates, and currency policies.

Section 1: Balance of Payments (BoP)

Definition

BoP is a systematic record of all economic transactions between residents of a country (India) and the rest of the world over a period (usually a year). It includes trade in goods, services, income, transfers, and capital flows. BoP always balances in an accounting sense (credits = debits), but imbalances in sub-accounts can signal economic issues.

Components of BoP

BoP has three main accounts:

1. Current Account: Records trade in goods and services, income, and unilateral transfers.

• Trade Balance (Merchandise): Exports minus imports of goods (visible items). India often has a deficit due to oil imports.
• Invisibles: Services (e.g., IT exports, tourism), income (e.g., remittances, dividends), and transfers (e.g., gifts).
• India’s current account deficit was -1.2% of GDP in 2023-24, cushioned by strong service exports and remittances.

1. Capital Account: Records capital inflows/outflows, including FDI, FII (portfolio investment), loans (ECBs), and NRI deposits.

• FDI: Long-term investments (e.g., in manufacturing). India attracted $70.9 billion in FDI in 2023-24.
• FII: Short-term (volatile) investments in stocks/bonds.
• Capital account surplus often offsets current account deficits.

1. Reserve Account: Changes in forex reserves held by RBI (e.g., gold, SDRs, foreign currency assets). Used to balance overall BoP.

Component	Sub-Components	Examples in India	Impact on BoP
Current Account	Merchandise Trade	Oil imports (deficit)	Negative if imports > exports
	Services	IT/BPO exports (surplus)	Positive
	Income	Remittances from NRIs	Positive
Capital Account	FDI/FPI	Tech sector investments	Positive inflows
	Loans/ECBs	External borrowings	Positive but increases debt
Reserve Account	Forex Reserves	RBI holdings ($650+ billion in 2024)	Balances deficits

BoP Disequilibrium and Corrective Measures

• Deficit: When outflows > inflows (e.g., 1991 crisis). Causes: High imports, low exports, inflation.
• Surplus: Inflows > outflows (rare for India).
• Corrective Measures: Export promotion (subsidies, SEZs), import substitution, devaluation, monetary tightening, or IMF loans.

In India, RBI manages BoP through forex interventions and policies.

Section 2: Exchange Rates

Definition

Exchange rate is the price of one currency in terms of another (e.g., INR/USD = ₹83). It determines the cost of international trade and investment.

Types of Exchange Rates

• Nominal Exchange Rate: Actual market rate (e.g., spot rate).
• Real Exchange Rate: Adjusted for inflation (REER/NEER in India, calculated by RBI using 36-currency basket).
• Fixed Exchange Rate: Pegged to another currency (e.g., pre-1991 rupee pegged to a basket).
• Floating Exchange Rate: Determined by market forces (supply/demand).
• Managed Float: Market-driven with RBI interventions (India’s current regime since 1993).

Determination of Exchange Rates

• Demand and Supply: Demand for foreign currency rises with imports/investments abroad; supply from exports/inflows.
• Factors Affecting: Inflation (high inflation depreciates currency), interest rates (higher rates attract inflows, appreciate currency), trade balance, political stability.
• Purchasing Power Parity (PPP): Currencies adjust so goods cost the same globally (e.g., Big Mac Index).
• In India: Rupee depreciated from ₹45/USD in 2011 to ₹83/USD in 2024 due to trade deficits and global factors.

Exchange Rate Regimes in India

• Pre-1991: Fixed regime with periodic devaluations (1949, 1966, 1991).
• 1992-93: Liberalized Exchange Rate Management System (LERMS) – dual rates.
• Post-1993: Market-determined with RBI managing volatility.

Section 3: Types of Currencies

In international finance, currencies are classified based on convertibility, stability, and usage.

Key Types

1. Hard Currency: Stable, widely accepted (e.g., USD, EUR). Low inflation, backed by strong economies.
2. Soft Currency: Volatile, restricted (e.g., some emerging market currencies like INR pre-reforms).
3. Reserve Currency: Held by central banks for international transactions (e.g., USD – 58% of global reserves; EUR, JPY).
4. Fiat Currency: Government-issued, not backed by commodities (most modern currencies, including INR).
5. Commodity Currency: Influenced by commodity exports (e.g., AUD tied to mining).
6. Digital/Cryptocurrency: Emerging (e.g., Bitcoin), but not legal tender in India (RBI’s CBDC – e-Rupee is being piloted).
7. Convertible vs. Non-Convertible:

• Fully Convertible: Freely traded (e.g., USD).
• Partially Convertible: Restrictions on capital account (India’s INR is fully convertible on current account since 1994, partial on capital).
• Non-Convertible: Not traded internationally.

Type	Examples	Characteristics
Hard	USD, EUR	Stable, global acceptance
Soft	Zimbabwe Dollar	High inflation, limited use
Reserve	USD (dominant), CNY (rising)	Used in forex reserves
Fiat	INR, GBP	Backed by government faith

In Indian context: INR is partially convertible; RBI promotes internationalization through rupee trade settlements (e.g., with UAE, Russia).

Section 4: Management of BoP, Exchange Rates, and Currencies

Role of RBI in Management

RBI manages forex under the Foreign Exchange Management Act (FEMA), 1999, replacing FERA, 1973. Goals: Maintain orderly markets, build reserves, and ensure stability.

Key Management Tools

• Forex Interventions: RBI buys/sells USD to stabilize INR (e.g., sold $70 billion in 2022 to curb depreciation).
• Monetary Policy: Adjust repo rate, CRR to influence inflows (higher rates appreciate INR).
• Capital Controls: Limits on ECBs, FDI caps in sensitive sectors.
• Reserve Management: India’s reserves > $650 billion (2024), covering 11 months of imports.
• Currency Convertibility: Full on current account; gradual on capital (Tarapore Committee recommendations for fuller CAC).
• Devaluation/Depreciation: Used in crises (1991 devaluation boosted exports by 20%).

Historical Evolution

• 1947-1971: Par value system under IMF.
• 1975-1992: Pegged to currency basket.
• Post-1993: Managed float.
• Recent: Focus on volatility management amid global uncertainties (e.g., COVID-19, Ukraine war).

Key Takeaways and Exam Tips

• Interconnections: BoP deficits lead to currency depreciation; reforms opened India but require vigilant management.
• Recent Data: Monitor RBI reports for current BoP figures.
• For Exams: Focus on 1991 crisis, BoP components, exchange rate types, RBI tools. Use mnemonics (e.g., Current Account: Goods, Services, Income, Transfers – GSIT).
• Practice Questions:

1. Explain the causes and consequences of the 1991 BoP crisis. (Essay)
2. Differentiate between fixed and floating exchange rates with Indian examples. (Short Answer)
3. MCQ: Which is not a component of Current Account? (a) FDI (b) Remittances (c) Services (d) Goods. (Answer: a)

Study sources like RBI Annual Reports and Economic Survey for updates.