Topic 6
🟢 Lite — Quick Review (1h–1d)
Rapid summary for last-minute revision before your exam.
- Balance of Payments (BoP): Systematic record of all economic transactions between residents of India and rest of world; has Current Account and Capital Account
- Current Account Deficit (CAD): When imports > exports + net services/income; India’s CAD ~1-2% of GDP; tolerable if financed by stable capital inflows
- Capital Account: Records capital transfers and investment flows; FDI, FPI, external borrowings
- Foreign Exchange Reserves: ~$600+ billion (2024); RBI intervenes to manage rupee volatility; high reserves provide buffer against crises
- FEMA (Foreign Exchange Management Act): Replaced FERA in 2000; governs foreign exchange transactions; RBI/GOI approval required for current account vs capital account transactions
- ⚡ India’s BoP is managed by RBI within the framework of FEMA and RBI Act; rupee is not fully convertible on capital account (restricted)
🟡 Standard — Regular Study (2d–2mo)
Standard content for students with a few days to months.
International Finance and Organizations
In an increasingly globalised world, understanding international finance is critical for banking professionals. This topic covers India’s balance of payments, foreign exchange management, and key international financial institutions.
Balance of Payments (BoP)
Definition
The Balance of Payments is a systematic record of all economic transactions between residents of India and the rest of the world during a given period.
BoP Identity
Current Account + Capital Account + Errors and Omissions = 0
When a country has a Current Account deficit, it must finance it through Capital Account surplus (net capital inflows) or use reserves.
Structure of BoP
A. Current Account
Records trade in goods, services, income, and transfers.
1. Trade Account (Merchandise)
- Exports: Goods sent out of India
- Imports: Goods brought into India
- Trade Balance = Exports − Imports
- Deficit if Imports > Exports
2. Services Account
- Invisible trade (no physical goods)
- Services exports: Software exports, IT services, business process outsourcing (BPO), tourism, transport
- Services imports: Foreign travel, transport, software licenses
3. Primary Income Account
- Investment income: Dividends, interest payments
- Compensation of employees (workers abroad sending money home)
4. Secondary Income (Current Transfers)
- Private transfers: Remittances from NRIs
- Government transfers: Grants, aid, pension payments
Current Account Balance = Trade Balance + Services Balance + Primary Income + Secondary Income
B. Capital Account
Records capital transfers and acquisition/disposal of financial assets.
1. Foreign Direct Investment (FDI)
- Long-term investment in enterprises
- Inward FDI: Foreign companies investing in India
- Outward FDI: Indian companies investing abroad
- FDI in India (sectors): Manufacturing, IT, services, retail
2. Foreign Portfolio Investment (FPI)
- Short-to-medium term investments in securities
- Equity shares, bonds, government securities
- More volatile than FDI; can reverse quickly in crisis
3. External Commercial Borrowings (ECBs)
- Loans from foreign banks, institutions
- USD/ECU/other currency denominated
- Governed by RBI guidelines
4. Banking Capital
- Foreign currency deposits (NRI deposits)
- Foreign assets held by Indian banks
- Correspondent banking
5. Other Capital
- Rupee debt service (external)
- Non-resident Indian deposits
Components of the BoP Statement
| Account | Components | Sign Convention |
|---|---|---|
| Current Account | Trade (goods) | Negative = deficit |
| Current Account | Services | Net services |
| Current Account | Income | Net income receipts |
| Current Account | Transfers | Net transfers |
| Capital Account | FDI (net) | Inflows positive |
| Capital Account | FPI (net) | Inflows positive |
| Capital Account | ECBs | Net borrowing |
| Capital Account | Banking capital | Net flows |
India’s Current Account Balance
Recent Trends:
- India has run a current account deficit in most years
- 2022-23: CAD was ~2% of GDP (elevated; global commodity price rise post-Ukraine war)
- 2023-24: CAD narrowed to ~1-1.2% of GDP
- Trade deficit is the main driver of CAD
- Services surplus (IT, BPO exports) partially offsets trade deficit
- NRI remittances (~ $100 billion/year) provide support
CAD Financing:
- Foreign Exchange Reserves drawdown
- FDI inflows
- FPI inflows
- ECBs
Foreign Exchange Management
Exchange Rate System
India follows a managed floating exchange rate system since 1993:
- Market-determined exchange rate
- RBI intervenes to prevent excessive volatility
- No fixed peg; no free float
RBI Intervention Tools:
- Spot market intervention (buy/sell dollars)
- Forward market intervention
- Smoothing operations
Foreign Exchange Reserves
Composition:
- Foreign currency assets (dollars, euros, yen, pounds)
- Gold
- SDRs (Special Drawing Rights)
- Reserve position with IMF
SDR: An international reserve asset created by IMF; allocated to member countries based on quota; can be exchanged for hard currency
India’s Forex Reserves (2024):
- ~$640-650 billion
- World’s 4th largest (after Japan, China, Switzerland)
- Provides 11-12 months of import cover
- RBI uses reserves to defend rupee during stress periods
FEMA (Foreign Exchange Management Act, 1999)
Replaced FERA (1973) with the liberalisation of the 1990s.
Key Principles of FEMA:
- Current Account transactions (trade, services) are mostly freely permitted
- Capital Account transactions require RBI/GOI approval (restricted)
- All transactions must be through authorised dealers (banks authorised by RBI)
Capital Account Liberalisation:
- FDI is largely automatic (except in sensitive sectors — defence, railways, media)
- FPI through SEBI-registered FPI route
- External commercial borrowings require RBI approval above limits
- Liberalised Remittance Scheme (LRS): Residents can remit up to $2,50,000 per financial year for specified purposes
Exchange Rate Impact on the Economy
Rupee Depreciation:
- Makes imports expensive → inflation
- Makes exports cheaper → boosts exports
- Increases cost of ECBs (dollar-denominated debt more costly)
- Benefits: Exporters (IT services earn dollars)
- Drawbacks: Import-dependent industries (oil, electronics)
Rupee Appreciation:
- Makes imports cheaper
- Makes exports less competitive
- Reduces import bill, helps inflation
- But can hurt export competitiveness
Key International Financial Institutions
International Monetary Fund (IMF)
Headquarters: Washington D.C. Members: 190 countries Managing Director: Kristalina Georgieva (Bulgarian) Quota System: Each member has a quota based on economic size
India and IMF:
- India joined 1945 (founding member)
- India’s quota: SDR 21.1 billion (~2.7% of total)
- India has used IMF credit lines twice: 1991 crisis, 2013 Taper Tantrum
- India sends officials to IMF as Executive Director
IMF Lending:
- Stand-By Arrangement (SBA): Short-term credit for BoP difficulties
- Extended Fund Facility (EFF): Long-term credit
- Rapid Credit Facility (RCF): For low-income countries
- Flexible Credit Line (FCL): Precautionary for countries with strong policies
World Bank Group
Headquarters: Washington D.C. President: Ajay Banga (Indian-origin; since 2023) Members: 189 countries
World Bank Finance Instruments:
- IBRD Loans: To middle-income countries; market rate
- IDA Grants/Concessional Loans: To poorest countries; very low interest
- IFC Investments: Private sector development
- MIGA Guarantees: Political risk insurance
India-World Bank:
- India has transitioned from borrower to donor (IDA repayments)
- World Bank funds infrastructure, social sector projects in India
- ~$25-30 billion active portfolio
Bank for International Settlements (BIS)
Location: Basel, Switzerland Role: Bank of central banks; hosts Basel Committee on Banking Supervision
- Sets capital adequacy standards (Basel I, II, III)
- Research on monetary policy, banking
Asian Development Bank (ADB)
Location: Manila, Philippines Purpose: Promoting economic development in Asia
- India is a founding member and major borrower
- Finance for infrastructure, energy, urban development
- ~$10 billion active portfolio in India
🔴 Extended — Deep Study (3mo+)
Comprehensive coverage for students on a longer study timeline.
SWIFT (Society for Worldwide Interbank Financial Telecommunication)
- Global messaging network for financial transactions
- Doesn’t transfer money; sends payment instructions
- Based in Belgium; operates in 200+ countries
- Used for: Cross-border transfers, securities transactions, trade finance
- SWIFT and Sanctions: Used by countries to enforce financial sanctions (e.g., SWIFT cut-off of Iranian banks, Russian banks post-Ukraine war)
LIBOR and Its Replacement
LIBOR (London Interbank Offered Rate):
- Benchmark interest rate for short-term loans between banks
- Phased out by end of 2021 due to manipulation scandal
- Replacement: SOFR (Secured Overnight Financing Rate) in US; SONIA in UK; MIBOR/MIBOR in India
India’s Replacement:
- MIBOR (Mumbai Interbank One-day Rate): Current benchmark
- FBIL Overnight Rate: Alternative reference rate
Capital Account Convertibility
Full Convertibility: Ability to freely convert domestic currency to foreign currency for all transactions (current and capital accounts)
Current Account Convertibility: Already largely achieved in India (most current account transactions freely permitted)
Capital Account Convertibility: Restricted in India. India has a partial capital account convertibility:
- FDI: Largely automatic
- FPI: Permitted through FPI route
- ECB: Restricted; requires RBI approval
- Individuals: Limited (LRS allows $2.5 lakh/year)
Tarapore Committee: Recommended full capital account convertibility in stages; not fully implemented yet
India’s External Debt
External Debt (2023-24):
- ~$660-670 billion
- Long-term debt (~80%) vs short-term debt (~20%)
- Multilateral (World Bank, ADB) and bilateral (countries) debt
- Commercial borrowings (ECBs) and NRI deposits
Debt Sustainability:
- External debt to GDP: ~18-19% (manageable)
- Debt service ratio: Interest and principal payments / exports
- Comfortable debt sustainability metrics
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