[TISS/XAT/AO/Interview/Newspaper Reading] - Balance of Payments,Convertibility of Rupee,Exchange Rate and FOREX Reserves

Balance of Payment,FOREX Market and FOREX reserves play a very major role and are taken into serious consideration while formulation of  policies both in Government and Corporate Spheres.

Let's have a look on some very basic questions on Balance of Payments,FOREX Market and how they influence the value of Rupee in the market.

So what is Balance of Payment (भुगतान संतुलन )?

Balance of payment of a country is a systematic record (Format is decided by IMF) of all the economic transactions between residents and non-residents of a country for a specific time period (Usually a year).






What do we track ?

Inflow and Outflow of money in a Country.

It has further two parts :

Current Account and Capital Account

Current Account consists of Import/Export,Income from abroad(Interest,Dividend from FDI,FII etc) and Transfers(IT guys from America remitting money to their Parents in India)

So when we export IT services (Invisible goods) or Mangoes(Visible goods) and earn money we add it to Current Account but when we import things like Oil(Visible good) and pay money we subtract it from Current Account.

Whereas Capital Account consists of Investments(FDI,FII,ADR), Loans(Both to Government(Sovereign) and to Private Companies(External Commercial Borrowings), NRI Accounts in Banks etc.

(Confusion) :  FDI/FII is there in both ? Where is the difference ?

Suppose Bill Gates invests some money as FDI in India => Subtracted from Americas BoP Capital Account and added to India's Capital Account but when he earns some profit  from the same FDI Investment and it is being sent to him in his account in America => Subtracted from India's Capital Account(Because it is profit/Income from FDI that is being sent to America) and added to America's Current Account.

Capital Account usually comes into play when the money involves Investment or Loan for Investment which ultimately results in some Asset Creation,Infrastructure development etc .[Not 100% technically correct but समझने के लिए ]

For India, Capital Account is in surplus(+) while Current Account is in deficit(-ve) [due import > export etc ].

Convertibility :

Rupee is fully convertible when Transaction concerns Current account but partially convertible in Capital Account Transactions.

What does that even mean ?

बकर Time :

Instead of kidnapping a scientist for some stupid Missile(जिसका 'Fuse Conductor' निकलना  बच्चो का खेल है ), Pralayanath Gaindaswami decides to import Iron Man's suit to fight Brigadier Surya Dev Singh. But Tony Stark accepts money only in Dollars and Pralayanath has 'Black Money' only in Rupees.So he needs to convert that money into Dollars and then import that Suit from Tony Stark.

This is a Current Account Transaction as Import is involved hence Rupee is fully convertible into Dollar.

Let's look at another scenario:

Suppose Pralayanath wants to invests some money in Stark Industries to make better Missiles or to take some loan from the 'Joker' and starts his own factory to make superior Missiles.

But

He can do either of these within the prescribed limits by RBI.

Hence in Capital Account Transactions, Rupee is partially convertible.

End of बकर.

MCQ type Fact :

Tarapore Committee in 1997 recommended that India should have Full Capital Account Convertibility.

FOREX Market and Exchange Rate (Rupee vs Dollar):

Before 1993 there was fixed exchange rate system but after that Exchange rate was governed by the demand-supply factors of Currencies.Though there are a plethora of things which decides this demand -supply yet how your country is doing economically is very crucial and the growth prospects there makes your currency 'hot'.There is a world-wide FOREX Market where this currency trading is done and you can convert one currency into other.

Let's understand this through a new बकर :

Suppose Brain-drain stops and with the end of Government's bogus red-tape qtiyapa, Indians gets a new jolt of Innovation in all spheres.Growth pattern is revitalized and many people(including Tony Stark and Bruce Wayne)across the world start investing in India as they know that investing in company of people like Phunshuk Wangdu is safe and they can get hefty returns.

But to invest in India foreigners need Rupees.[Which they can get by exchanging their currency at FOREX Market].

But when so many People are converting their currency into Rupees and investing in India the supply of Rupee in Forex Market is reduced while the demand for Rupees is high.

Thus Value of Rupee is increased i.e. earlier if 1 $ = 63 Rupees now 1 $ = 40 Rupees [Hypothetical].

But why does Rajan(RBI) buys Dollars now ? 

Because Dollar is cheap now and he can sell it when the value of Dollar again becomes high in comparison to Rupee.

But when ?

Suppose there is a surge in Oil Prices across the world and these Oil producing countries don't accept Rupees and demand Dollars.

Now every country needs Dollars and thus in Forex Market the supply of Dollar is reduced and demand is high.

Thus  India might have to pay 1 $ = 70 Rupees instead of 63 Rupees to get Dollar from the FOREX.

Now suppose there is a continuous drastic devaluation of Rupee then Rajan(RBI) will sell Dollars from his FOREX Reserve to increase the supply of Dollars in the market so as to contain this devaluation of Rupee.

That's why it becomes very essential to build a good  FOREX  Reserve.

Just for FYI.

In India FOREX Reserve consists of :

1) Foreign Currency Assests (Dollar,Euro,Yen etc.)
2)Gold
3)Special Drawing Rights from IMF [ Will be discussed separately]
4)RTP in IMF [ Again will be discussed separately]

China has got the highest FOREX Reserves in the world about 3950 Billion Dollars while India has about 316 Billion Dollars.

Food for thought:

Suppose China releases all its FOREX Reserves in the market then the supply of Dollar in the market will be so much that American Economy might even collapse.

I hope this article was useful to you.Happy Learning :)