Balance of Payments
Reading our earlier posts regarding deficits and foreign currency reserve will help you understand this one better. In balance of payment, we are trying to account for all the transactions that take place between a country and the rest of the world. According to balance of payment theory, summation of current account and capital account will always be zero.
From our article on deficit, we know that current account deals with the exchange of goods and services between a country and the rest of the world. If the goods exported by a country to the rest of the world is more than goods imported by the same country from the rest of the world, then their is a current account surplus. On the other hand, if imports are more than exports, there will be a current account deficit situation. Let’s hypothetically assume that India’s current account deficit is INR 500 billion. It means that the value of goods imported by India from rest of the world is INR 500 billion more than goods exported out from India. On a net basis, we can say that India is receiving goods and paying money to the rest of the world. Thus, Rupee is flowing out from India in this case.
We defined capital account surplus as a situation where money coming into the country is more than money going out. This can happen with India if investment by rest of the world in India is more than what India is investing in the rest of the world. These investments can come in the form of foreign portfolio investment (FPI) or foreign direct investment (FDI). We will discuss FPI and FII in the next article. Important point to remember is that if you want to invest in India, you can do that only in rupee. Let’s assume that India’s capital account surplus is INR 550 billion. It means, on a net basis rest of the world is investing INR 550 billion in India.
You must be wondering how more money can came into the country, as only INR 500 billion had gone out via payment for imports and when other countries cannot print Rupee notes. Here foreign currency reserves of other countries come into picture. This extra INR 50 billion is coming in from Rupee reserves of other countries, i.e. total Rupee reserves held by foreign countries would have gone down by INR 50 billion. Keep in mind that total money going out will be equal to total money coming in plus change in foreign currency reserves of other countries. So if the money coming in is more than what is going out, the difference is being funded via foreign currency reserves of other countries.
Similarly if money coming in is less than money is going out, the difference amount is being retained as foreign currency reserves by other countries.
Read on to understand two most commonly used financial terms: FII and FDI.