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Economics for Everyone- Current Account Deficit (CAD)

Prof.M.Guruprasad, AICAR BUSINESS SCHOOL/ Mumbai 11:23 , Jun 26, 2013

This article looks into the basics of CAD, what constitutes the CAD, the causes of CAD and its impact.



 - Reducing CAD is of immediate concern: RBI

 - India’s current account deficit set to worsen again in Q2 2013, says Nomura

 - High current account deficit a matter of concern: Subbarao (Governor, RBI)

 - Current account deficit likely to be at 4% in Q4 FY13: Rajan (Chief Economic Advisor, Government of India)

 - RBI and Government Target Gold to Lower Current Account Deficit -NASDAQ
Now, let us understand the importance and impact of the current account deficit.







Current account deficit (CAD) has been the most discussed issue everywhere nowadays. This article looks into the basics of CAD, what constitutes the CAD, the causes of CAD and its impact. In order to understand CAD we need to understand what do we mean by current account since the issue of current account deficit originates from current account component of the balance of payments of a nation. This further necessitates the need to understanding of the concept of balance of payment (BOP) and open economy. Needless to say the foundation of the above discussions lies in the  emergence of  global trade in this century since with the interdependence of  nations across the globe  any  nation facing BOP and CAD  crisis  faces lot of challenges  in terms of its currency value, hurdles in its foreign investment , global competitiveness and hence overall economic growth.

Keeping in mind this article is structured in the following format. At the outset it discusses the issue of CAD, its importance, causes and its impact. Then it explains the concept current account which is a broader term, here we come to know about the various components of current account and this enables us to understand id detail the issue of CAD. Further, the article in the next stage gives the reader a broader comprehensive view of the concept of balance of payment.  Here we explain the two broad components of the BOP namely the current account (in detail) and the capital account (brief). Further, the article goes on to explain in brief, the current trends in CAD in India, the policy and practice of computing current account in India  and  summary of some of the research inputs by expert economists on this topic.

Current Account Deficit

Current account deficit is when payments exceed receipts from trade of goods & services, transfers and net income.

It indicates a country (say India) is borrowing and is net debtor to rest of the world. A current account deficit is when a country's government, businesses and individuals import more goods, services and capital than it exports. That's because the current account measures trade, as well as international income, direct transfers of capital, and investment income made on assets. When those within the country rely on foreigners for the capital to invest and spend, that creates a current account deficit. Depending on why the country is running the deficit, it could be a positive sign of growth, or it could be a negative sign that the country is a credit risk.

The largest component of a deficit usually a trade deficit. Increasing trade deficit on account of higher imports is the major component leading to increase of current account deficit.

This simply means the country imports more goods and services than it exports. The second largest component is usually a deficit in the net income. This occurs when the country exports dividends on stocks, interest payments made on financial assets, and wages paid to foreigners working in the country. If all payments made to foreigners are greater than the interest, dividends and wages made by foreigners to the country's residents, the deficit will rise.

The last component of the deficit is the smallest, but often the most hotly contested. These are direct transfers, which includes government grants to foreigners. It also includes any money sent back to their home countries by foreigners.

Now, let us understand the Consequences of the Current Account Deficit.

Consequences of the Current Account Deficit

A deficit in the current account leads to depletion of foreign currency assets as these assets are used as a source to fund deficit which forms part of capital account. Depletion of foreign currency assets reduces money supply which in turn results to liquidity issues. High imports results in higher demand for dollar causing rupee to weaken (rupee depreciation) which in turn impacts liquidity.

In the long run, a current account deficit can sap economic vitality. Foreign investors may begin to question whether economic growth can provide an adequate return on their investment. Demand could weaken for the country's assets, including the country's government bonds. As this happens, the national currency will gradually lose value relative to other currencies. This automatically lowers the value of the assets in the foreign investors' currency. This further depresses the demand for the country's assets. This could lead to investors will dumping the assets at any price. The only saving grace is that the country's holdings of foreign assets are denominated in foreign currency. As the value of its currency declines, the value of the foreign assets rise, thus further reducing the current account deficit. In addition, a lower currency value should increase exports, as the goods and services become more competitively priced. Similarly, demand for imports should lessen, as inflation on foreign goods and services sets in. These trends should stabilize any current account deficit. Regardless of whether the current account deficit unwound via a disastrous currency crash or a slow, controlled decline, the consequences of a current account deficit would be the same -- a lower standard of living for the country's residents.

To understand more about the current account deficit, it is important to understand Current account. This will give us understanding of what forms the component of current account deficit and what are the causes for the present crisis.


Current account records transactions of merchandise trade and invisibles (services+ transfers+ net income) of India with rest of the world.

Merchandise Trade refers to trade of goods only. Invisible component is subdivided into services, transfers and net income.

- Services refers to trade in services like transportation, tourism etc.

- Transfers are receipts or payments without any intention of receiving anything in return like workers’ remittances, donations, aids and grants etc.

- Net Income refers to income paid or received on investments like dividends, rents, interest etc.



Over the years, it’s seen the trade deficit has been widening on back of higher imports and slower growth of exports. The key reasons for this trend is Increasing oil and gold imports which are major contributors to the increase of imports. The present crisis is largely due to these factors.

Current account deficit is generally funded by Capital account which records all inflows and outflows of capital of the country.

Both current and capital account are components of balance of payment which records all monetary tractions of a country with rest of the world.

Balance of Payment = Current Account + Capital Account

Positive balance of payment means country is receiving monetary inflows which increase the foreign currency assets.

To understand the details of current and capital account it is important to understand the concept of Balance of Payments


International trade involves international  means of payments. A country engaged in foreign trade receives payments from countries which it receives exports goods and services and requires making payments from where it imports. Accordingly a country  with foreign trade maintains an account of all its receipts and payments from and to the rest of the world. Such an account is called balance of payment. It is defined as “a systematic record of all economic transactions between the residents of the reporting country and residents of foreign residents during a given period of time. Thus it is a system of recording all of a country's economic transactions with the rest of the world over a period (usually one year). The principle tool for the analysis of the monetary aspects of international trade is the balance of Payment.

The following needs some clarification

  • What do we mean by the term residents of the country
  • What does these transaction across include
  • The term resident comprises individual, household, firms and public authorities. Multinationals and their subsidies are treated as residents of the country in which they are located. International institutions like IMF, World Bank, UNO etc. are treated as foreign residents even by the countries in which they are located. Tourists are treated as foreign residents if they stay in the reporting country for less than a year. The term  given period of time refers to a financial year.

The transactions include sales and purchases of all types of goods and services, financial services, financial assets and any other transactions which result in the flow of money in and out of the country. The figures recorded usually in domestic currency of the reporting country. However, as and when necessary, they are also expressed in internationally accepted currency like U.S.A. dollars.

Information regarding the statistics of the inflow and outflow of money is collected from various sources. Such as customs authorities, survey of tourist numbers and expenditure of multinationals etc. each country may devise its own system of collecting statistical information to compile balance of payments records.

The balance of payments is like a balance sheet because for every transaction, whether current or long term, there is credit entry and a debit entry. That is why it is said that  ‘the balance of payments always balances’. The Balance of Payments (BoP) records the transactions in goods, services and assets between residents of a country with the rest of the world. There are two main accounts in the BoP – the current account and the capital account.

A Balance of Payment (B.O.P.) refers to that the systematic double entry record of all economic transition between the resident of a country and the rest of the world carried out in a specific period of time,

Balance of payments and international investment position data are most important, of course, for national and international policy formulation. External aspects (such as payments imbalances and inward and outward foreign investment) play a leading role in economic and other policy decisions in the increasingly interdependent world economy.

“The balance of payments is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. Transactions, for the most part between residents and nonresidents, consist of those involving goods, services, and income; those involving financial claims on, and liabilities to, the rest of the world; and those (such as gifts) classified as transfers, which involve offsetting entries to balance—in an accounting sense—one-sided transactions. A transaction itself is defined as an economic flow that reflects the creation, transformation, exchange, transfer, or extinction of economic value and involves changes in ownership of goods and/or financial assets, the provision of services, or the provision of labor and capital.”- IMF.

The International Monetary Fund (IMF) use a particular set of definitions for the BOP accounts, which is also used by the Organisation for Economic Cooperation and Development (OECD), and the United Nations System of National Accounts (SNA). The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, form a small part of the overall capital account. The IMF separates these transactions out to form an additional top level division of the BOP accounts. The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading subdivisions, which are:

  • The goods and services account (the overall trade balance)
  • The primary income account (factor income such as from loans and investments)
  • The secondary income account (transfer payments)

As discussed earlier the current account records exports and imports in goods and services and transfer payments.  That is the balance of exports and imports of goods is referred to as the trade balance. Adding trade in services and net transfers to the trade balance, we get the current account balance. Transfer payments are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. They consist of remittances, gifts and grants. They could be official or private.

The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc. We note that any transaction resulting in a payment to foreigners is entered as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive sign

The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus). The basic premise is that the monetary authorities of the country are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus). A country is said to be in balance of payments equilibrium when the sum of its current account and its non-reserve capital account equals zero, so that the current account balance is financed entirely by international lending without reserve movements.

Thus, the balance of payments is the record of a country’s transactions with the rest of the world. It consists of three main parts: the current account, the capital account, and official reserves settlement balance. The sum of the three main parts sum to zero. All transactions must be recorded somewhere. If the sum of the three accounts is equal to zero it is hard to speak of a balance of payments deficit. When people speak of a Balance of Payments deficit they are referring to the sum of the current and capital account. If these are in deficit, a surplus is required in official settlements. The difference is made up by the loss of foreign reserves, often gold. This may not be sustainable. So while technically the Balance of Payments is always in balance, when we speak of a Balance of Payments deficit we automatically react to this by thinking of the sum of the current and capital account.

The following table presents a model of balance of payments accounts by incorporating all the transactions under major heads

BALANCE OF PAYMENTS ACCOUNT Understand the Balance of Payments, Its Components and Why It Matters
Receipts (Credits) Payments (Debits)
1)Export of goods 1) Import of goods
Trade Account Balance
2)Exports of services

3) Interest, profits and dividends received
2) Imports of service

3) Interest, profits and dividends paid
4)Unilateral receipts 4) Unilateral payments
Current Account Balance ( 1 to 4)
5) Foreign investments

6)Short term borrowing

7)Medium and long term borrowing
5)Investments abroad

6) Short term lending

7) Medium and long term lending
Capital Account Balance (5 to 7)
8) Statistical discrepancy (Errors and Omissions)
9) Change in reserves (+) 9) Change in reserves (-)
Total Receipts = Total Payments

The above balance of payment shows all the receipts and payments grouped under major accounting heads. The corresponding receipts and payments on both sides are given the same numbers.

We shall now explain the various constituent (Components of Current account) of balance of payments mentioned in the above table

Item no. 1on both sides refer to merchandise exports and imports. They are referred as tangible exports and imports as they include the exports and imports of tangible or visible items. The balance of exports and imports of goods is referred as balance of trade.

Balance of trade of a country shows its export and import of goods or commodities. The balance of trade may be defined as

Export – Import = Balance of Trade

‘Balance of Trade’ may either be positive or negative, that is, there can be either a surplus or deficit in the balance of trade. If a country exports more goods or commodities than it imports, it is said to have a surplus in its balance of trade. If the country imports more goods than its exports, it has a deficit balance of trade.

A trade deficit occurs when the value of a country's imports is greater than the value of its exports. This means that the country's balance of trade is negative.

Obviously, a trade deficit is caused when a country cannot produce all it needs. However, the true causes run a little deeper than that. A country cannot have a trade deficit unless other countries are willing to loan it the funds needed to finance the purchases of imports. Therefore, a country with a trade deficit will most likely have a current account deficit.

A trade deficit can also result if a domestic company manufactures a lot of its products in other countries. If the raw materials are shipped overseas to its plant, that's counted as an export. When the finished good is shipped back home, that's counted as an import -- even though it's made by a domestic company. It's subtracted from the country's Gross Domestic Product, even though the earnings will benefit the company's stock price, and the taxes will benefit the country's revenue stream.

Initially, a trade deficit is not a bad thing. It raises the standard of living of a country's residents, since they now have access to a wider variety of goods and services for a more competitive price. It can reduce the threat of inflation, since the products are priced lower. A trade deficit can also indicate that the country's residents are feeling confident, and wealthy, enough to buy more than the country produces.

Over time, however, a trade deficit can cause jobs outsourcing. That's because, as a country imports certain goods rather than buying domestically, the local companies start to go out of business. The domestic business itself will lose the expertise needed to produce that good competitively. As a result, fewer jobs in that industry are created in the home country. Instead, the foreign companies hire new workers to keep up with the demand for their exports. For this reason, many leaders propose reducing the trade deficit to increase jobs. They often blame trade agreements for causing deficits. A response to trade deficits is often to raise import tariffs, or other forms of trade protectionism.


In addition to exchange of physical goods, a country can exchange (export or import) services with various countries. Most important of these services is usually shipping services. Other services are professional and technical services, banking and insurance services, tourist services, etc. Receipts or payments of interest and dividends on investment (in shares, bonds etc.) in foreign countries are also included in these services. Besides exchange of goods and services which always involves payments there can be ‘transfers’ between two countries which are received free (the country receiving does not have to make any payment for it either at present or in the future). Transfers include gifts, assistance, indemnities, etc. Services and transfer are often classified as ‘invisibles ‘ against physical goods which are ‘visible’.

A detailed split up of various types of services/invisibles is given under item numbers 2, 3, and 4

Item no, 2 on both sides constitute exports and imports of services. The major items included in this are shipping, international airways, insurance, banking and other financial services. Tourism and other services include knowledge related services.

The 3rd item relates to interest, profits and dividends received from and paid to. Investments, direct and portfolio give rise to interest and dividends. The share of this item has been slowly  increasing in recent years under the era of globlisation where movement of capital has become easier. Multinationals from rich countries invest in developing countries. The advanced countries to which these multinationals belong receive huge profits.

Unilateral or unrequited payments and receipts shown in item no.4 refers to those receipts and payments for which there is no corresponding quid pro quo.They include remittances from migrant workers to their families back home, the payment of pensions to foreignresidents,foreign donations, gifts etc. For all these receipts and payments there is no counter obligations. The receipts on these account lead to an increase in income due to receipts from foreigners and are shown as credit. Similarly, the payment to foreign countries or residents results in decrease in income and thus recorded as debit.

Overall trade in services can be divided into factor and non factor incomes. Trade in services, which is denoted as invisible trade (because they are not seen to cross national borders), includes both factor income (payment for inputs minus investment income., or in other words, the interest, profits and dividends on our assets abroad minus the income foreigners earn on assets they own in India) and non-factor income (shipping, banking, insurance, tourism, software services, etc.).

All the receipts and payments on item no 1 to 4 are treated under current account and the balance between them is called balance of current account. The current account in the balance of payments may have a surplus or deficit. The nature of balance (surplus or deficit) on this account is significant. A surplus provides resource enabling that country to pay off past debts, if any, or import capital or consumer goods as per their requirement. A surplus increases a country’s stock of claims on the rest of the world.

A deficit on this account is treated as a problem and calls for remedial measures. Deficit reduces a country’s capacity to import, increases foreign debt burden and may lead to foreign debt trap and other international financial problems.

As we discussed earlier, current account items were traditionally dominated by export and import of goods. Services played a comparatively minor role. However, in the last few decades, trade in services has increased. In case of some countries export of services have exceeded the goods item. The income received from abroad in the form of dividends, interest, and other unilateral receipts have increased.  The developing countries receive more foreign currencies from the remittances of their citizens working abroad. Thus the composition of current account has undergone a substantial change.

Balance of trade, balance of services and balance transfers together constitute the ‘balance of current account’ because all these forms of transactions or transfers take place during a reference period of, say, one year which is considered the current period.


In contrast to the current account, there also exists a capital account between two countries. The capital account shows capital transactions or movements either in the short-term or in the long term. Capital movement includes borrowing or lending, repayment of loan, etc.

‘Balance of current account’ and ‘Balance of capital account’ together constitute the balance of payment of a country.


Autonomous and Accommodating Transactions

International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance remittances which are made by various individuals or institutions guided by the profit motive). These items are called ‘above the line’ items in the BoP.  The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments.

Accommodating transactions (termed ‘below the line’ items), on the other hand, are determined by the net consequences of the autonomous items, that is, whether the BoP is in surplus or deficit. The official reserve transactions are seen as the accommodating item in the BoP (all others being autonomous).

Errors and Omissions constitute the third element in the BoP (apart from the current and capital accounts) which is the ‘balancing item’ reflecting our inability to record all international transactions accurately.

Balance of Payments: Summary



Most modern economies are open. Interaction with other economies of the world widens the choice of an economy in three broad ways

(i) Consumers and firms have the opportunity to choose between domestic and foreign goods. This is the product market linkage which occurs through international trade.

(ii) Investors have the opportunity to choose between domestic and foreign assets. This constitutes the financial market linkage.

(iii) Firms can choose where to locate production and workers can choose where to work. This is the factor market linkage.  Labour market linkages have been relatively less due to various restrictions on the movement of people through immigration laws.

Open economy

An open economy is one that trades with other nations in goods and services and, most often, also in financial assets. Indians, for instance, enjoy using products produced around the world and some of our production is exported to foreign countries. Foreign trade, therefore, influences Indian aggregate demand in two ways.

·  First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing aggregate demand.
·  Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for domestically produced goods.
Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. In the Indian context, the openness has increased over a period of time. However, in comparison to other countries, India is relatively less open. Now, when goods move across national borders, money must move in the opposite direction. At the international level, there is no single currency that is issued by a central authority. Foreign economic agents will accept a national currency only if they are convinced that the currency will maintain a stable purchasing power. Without this confidence, a currency will not be used as an international medium of exchange and unit of account since there is no international authority with the power to force the use of a particular currency in international transactions. Governments have tried to gain confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing authority has no control. This other asset most often has been gold, or other national currencies.

There are two aspects of this commitment that has affected its credibility – the ability to convert freely in unlimited amounts and the price at which such conversion takes place. The international monetary system has been set up to handle these issues and ensure stability in international transactions. A nation’s commitment regarding the above two issues will affect its trade and financial interactions with the rest of the world.

In this context it is important to understand in brief some of the key theories of international or foreign trade

The need for foreign trade - Theories of foreign trade

Various trade theories throw light on the need for foreign trade. Some of the conventional theories are

·  The Absolute advantage theory by Adam smith

·  Comparative Advantage theory by David Ricardo

·  The Factor endowment theory by Heckscher and Ohlin.

Adam Smith said - each nation should specialize in producing things in which it has an "absolute advantage" and sell them in exchange for other things in which it has an “absolute disadvantage” . The theory of "Absolute Advantage" seems to make sense in situations where the circumstances of the geographic and economic environment are relatively simple and straight forward - example: - Switzerland has an advantage in production of watches; Canada has an advantage in making cereal grain.

In most cases, a straight-forward Absolute Advantage does not exist in the real world. Some countries may have an advantage in one commodity, and also a slight advantage in another commodity - however there is still an opportunity for them to trade.

In 1817, David Ricardo looked at Adam Smith's theory and suggested that "there may still be global efficiency gains from trade if a country specializes in those products that it can produce more efficiently than other products - regardless of whether other countries can produce those same products even more efficiently"

The Theory of Factor Endowments suggested you should trade in the products which you can make from the production factors and resources you naturally possess.  For a country like Canada this would mean that it should trade in lumber and minerals and grain since Canada naturally possesses these resources in large quantities. On the other hand it would make sense for Canada to import citrus fruits since its climate does not allow it to grow this fruit without having expensive greenhouses. This theory was espoused by Heckscher and Ohlin.


The nation through its various policy measures try to favourably influence the balance of payment position. The major policy measure by the government of India is its foreign trade policy. Now, let us try to understand I brief about the foreign trade policy.

Foreign Trade Policy

Foreign Trade Policy is framed by the Director General of Foreign Trade (DGFT) functioning under the Ministry of Commerce, Government of India.  The Foreign Trade Policy is announced by means of a Public Notice in the Gazette of India Extra-ordinary. Any changes in Policy and Procedure are notified by means of Public Notices/Notifications/Policy Circulars etc. The Government reserves the right to make amendments / changes in the policy which may become necessary in the public interest from time to time.

Foreign Trade Policy and its objectives

The main objectives of India’s Foreign Trade Policy are:

1)  To double our percentage share of global merchandise trade within the next five years; and
2)  To act as an effective instrument of economic growth by giving a thrust to employment generation.

These objectives are proposed to be achieved by adopting, among others, the following strategies:

i.  Unshackling of controls and creating an atmosphere of trust and transparency to unleash the innate entrepreneurship of our businessmen, industrialists and traders.

ii.  Simplifying procedures and bringing down transaction costs.

iii.  Neutralizing the incidence of all levies and duties on inputs used in export products, based on the fundamental principle that duties and levies should not be exported.

iv.  Facilitating development of India as a global hub for manufacturing, trading and services.

v.  Identifying and nurturing special focus areas which would generate additional employment opportunities, particularly in semi-urban and rural areas, and developing a series of ‘Initiatives’ for each of these.

vi.  Facilitating technological and infrastructural upgradation of all the sectors of the Indian economy, especially through import of capital goods and equipment, thereby increasing value addition and productivity, while attaining internationally accepted standards of quality.

vii.  Avoiding inverted duty structures and ensuring that our domestic sectors are not disadvantaged in the Free Trade Agreements / Regional Trade Agreements / Preferential Trade Agreements that we enter into in order to enhance our exports.

viii.  Upgrading our infrastructural network, both physical and virtual, related to entire Foreign Trade chain, to international standards.

ix.  Revitalizing the Board of Trade by redefining its role, giving it due recognition and inducting experts on Trade Policy.

Foreign investments can be categorized into FDI and FII. Reforms instituted over the last 20 years have opened the economy to significantly more foreign investment by easing the rules and procedures for both public and private investment.  Let us see in brief the recent trade policy reforms.

Foreign Trade Policy Reforms

The Export and Import Policy 1992-1997 was a significant landmark in India’s economic history.  It made, for the first time, a conscious effort to dismantle various protectionist and regulatory policies and accelerate the country’s transition towards a globally oriented economy.  The policy coincided with the Eighth Five Year Plan and yielded impressive growth in exports.  During the Ninth Five Year Plan period the Ministry of Commerce set an ambitious target of achieving 1% share in world trade. Export and Import Policy 1997-2002 was formulated to consolidate the gains of the previous policy and to carry forward the process of liberalization, deregulation, and simplification of procedures and removal of quantitative restrictions in a phased manner. The Export Import Policy 2002-2007 contained provisions, which have made both import and export operationally more simplified.  Thus, the acceleration of the reforms process and providing additional thrust to export growth were the guiding principles of that policy. The Foreign Trade Policy 2004-2009 aimed at doubling the trade in a span of five years.  The main objectives of this policy were economic development and employment generation.  The policy focuses on agriculture, services and other thrust areas like handicraft and handlooms, leather, gem and jewellery etc. For the first time policy went beyond normal trade regulations and considered issues responsible for total development of global trade.

In the Foreign Trade Policy (2004-09), the Government announced to promote the establishment of Common Facility Centres in state and district-level towns for use by home-based service providers, particularly in areas like engineering and architectural design, multi-media operations and software developers. This would help to draw in a vast multitude of home-based professionals into the services export arena. The objective is to accelerate the growth in export of services so as to create a powerful and unique 'Served from India' brand.

Current Account Convertibility

It refers to convertibility of a currency for goods and services and transfer payments.

Current account convertibility refers to freedom in respect of Payments and transfers for current international transactions. In other words, if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current account i.e. in case of transactions such as trade, travel and tourism, education abroad etc.

The government introduced a system of Partial Rupee Convertibility (PCR) (Current Account Convertibility) on February 29, 1992 as part of the Fiscal Budget for 1992-93. PCR is designed to provide a powerful boost to export as well as to achieve as efficient import substitution. It is designed to reduce the scope for bureaucratic controls, which contribute to delays and inefficiency. Government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purpose like travel abroad, studying abroad, engaging the service of foreign consultants etc. What it means that people are allowed to have access to foreign currency for buying a whole range of consumables products and services. Components of Current Account

Covered in the current account are all transactions (other than those in financial items) that involve economic values and occur between resident non-resident entities. Also covered are offsets to current economic values provided or acquired without a quid pro quo. Specifically, the major classifications are goods and services, income, and current transfers. The current account convertibility in 1994 led to liberalization of gold imports and large capital inflows upto 1996.

As part of the reform process, a policy framework was developed to gradually liberalise the external sector, move towards total convertibility on current account, encourage non debt credit inflows while containing all external debt especially short term debt in capital account and make the exchange rate largely market determined. The policy reform in the external sector, accompanied by other changes was guided by the Report of High Level Committee on Balance of Payments, April 1993.  Thus Exchange controls on current account transactions were progressively relaxed culminating in current account convertibility.


India has come a long way from the FERA, 1947 to FERA, 1973 and now to FEMA, 2000. It has seen the days from non-convertibility of money to partial convertibility of money. In 1991 India began to lift restrictions on its currency. A number of reforms remove restrictions on current account transactions (including trade, interest payments and remittances and some capital asset-based transactions). Liberalised Exchange Rate Management System (LERMS) (a dual-exchange-rate system) introduced partial convertibility of the rupee in March 1992.

Currency convertibility refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa. Convertibility in that sense is the obverse of controls or restrictions on currency transactions. While current account convertibility refers to freedom in respect of ‘payments and transfers for current international transactions’, capital account convertibility (CAC) would mean freedom of currency conversion in relation to capital transactions in terms of inflows and outflows. Article VIII of the International Monetary Fund (IMF) puts an obligation on a member to avoid imposing restrictions on the making of payments and transfers for current international transactions. Members may cooperate for the purpose of making the exchange control regulations of members more effective. Article VI (3), however, allows members to exercise such controls as are necessary to regulate international capital movements, but not so as to restrict payments for current transactions or which would unduly delay transfers of funds in settlement of commitments.


The Reserve Bank of India (RBI) is responsible for compiling the balance of payments for India. The RBI obtains data on the balance of payments primarily as a by-product of the administration of the exchange control. In accordance with the Foreign Exchange Management Act (FEMA) of 1999, all foreign exchange transactions must be channeled through the banking system, and the banks that undertake foreign exchange transactions must submit various periodical returns and supporting documents prescribed under the FEMA. In respect of the transactions that are not routed through banking channels, information is obtained directly from the relevant government agencies, other concerned agencies, and other departments within the RBI. The information is also supplemented by data collected through various surveys conducted by the RBI. Data are prepared on a quarterly basis and are published in the Reserve Bank of India Bulletin.

The data are compiled in crores of rupees (one crore is equal to 10 million) and are broadly in conformity with the recommendations of the BPM5. The data are also expressed in millions of U.S. dollars.

Current Account 


The RBI compiles data on merchandise transactions mainly as a by-product of the administration of exchange control. Data on exports are based on export transactions and the collection of export proceeds as reported by the banks. In the case of imports, exchange control records cover only those imports for which payments have been effected through banking channels in India. Information on payments for imports not passing through the banking channels is obtained from other sources, primarily government records and borrowing entities in respect of their external commercial borrowing. Since 1992-93, the value of gold and silver brought to India by returning travelers has been added to the imports data with a contra-entry under current transfers, other sectors. Exports are recorded on an f.o.b. basis, whereas imports are recorded c.i.f. The IMF adjusts imports, for publication, to an f.o.b. basis by assuming freight and insurance to be 10 percent of the c.i.f. value.


Under the exchange control rules, authorized dealers (i.e., banks authorized to deal in foreign exchange) are required to report details in respect of transactions, other than exports, when the individual remittances exceed a stipulated amount. For receipts below this amount, the banks report only aggregate amounts without indicating the purpose of the incoming remittance. The balance of payments classification of these receipts is made on the basis of the Survey of Unclassified Receipts conducted by the RBI. This sample survey is conducted on a biweekly basis.


This category covers all modes of transport and port services; the data are based mainly on the receipts and payments reported by the banks in respect of transportation items. In addition to the exchange control records, the survey of unclassified receipts is also used as a source. These sources are supplemented by information collected from major airline and shipping companies in respect of payments from foreign accounts. A benchmark Survey of Freight and Insurance on Exports is also used to estimate freight receipts on account of exports.


Travel data are obtained from exchange control records, supplemented by information from the surveys of unclassified receipts. The estimates of travel receipts also use the information on foreign tourist arrivals and expenditure, received from the Ministry of Tourism as a cross-check of the exchange control and survey data.

Other services

The insurance category covers all types of insurance (i.e., life, nonlife, and reinsurance transactions). Thus, the entries include all receipts and payments reported by the banks in respect of insurance transactions. In addition to information available from exchange control records, information in the survey of unclassified receipts is also used. The benchmark survey of freight and insurance is used to estimate insurance receipts on account of exports. Other services also cover a variety of service transactions on account of software development, technical know-how, communication services, management fees, professional services, royalties, and financial services. Since 1997-98, the value of software exports for onsite development, expenditure on employees, and office maintenance expenses has been included in other services. Transactions in other services are captured through exchange control records and the survey of unclassified receipts, supplemented by data from other sources. For example, information on issue expenses in connection with the issue of global depository receipts and foreign currency convertible bonds abroad is obtained from the details filed by the concerned companies with the Foreign Exchange Department, RBI.


Investment income

Information on investment income transactions is obtained from exchange control records and foreign investment surveys, supplemented by information available from various departments of the RBI. Interest payments on foreign commercial loans are also reported under the RBI Foreign Currency Loan reporting system. The data on reinvested earnings of foreign direct investment companies are based on the annual Survey of Foreign Liabilities and Assets, conducted by the RBI. Details of investment income receipts on account of official reserves are obtained from the RBI's internal records. Interest accrued during the year and credited to nonresident Indian deposits is also included under this category.

Current transfers

General government

The data are obtained from the Controller of Aid Accounts and Audit, government of India, whereas data on PL-480 grants are obtained from the U.S. Embassy in India.

Other sectors

Transactions relating to workers' remittances are based on the information furnished by authorized dealers regarding remittances received under this category, supplemented by the data collected in the survey of unclassified receipts regularly conducted by the RBI. Redemption, in India, of nonresident dollar account schemes and withdrawals from nonresident rupee account schemes has been included as current transfers, other sectors since 1996-97.


The essence of international payments is that just as an individual who spends more than his income must finance the difference by selling assets or by borrowing, a country that has a deficit in its current account (spending more abroad than it receives from sales to the rest of the world) must finance it by selling assets or by borrowing abroad. Thus, any current account deficit is of necessity financed by a net capital inflow.  A look at the Balance of Payments figures of India for last two to three decades shows that there has been a trade deficit throughout the period and a surplus in invisibles except for 1990-91.  The current account deficit (from 1977-78) had started shrinking and turned into surplus from 2001-02. As mentioned above, during 2002 to 2004, India did have current account surplus but this was not due to trade surplus but increase in trade in services which recorded a growth of almost 100% in 2002.The surplus continued till 2003-04, but turned into a deficit in 2004-05. The large trade deficit could not be bridged by the invisibles surplus. In April-September 2005-06, the current account deficit of US$13 billion was financed by a capital inflow of US$19.5 billion, the extra capital inflow of US$ 6.5 billion being added to our stock of foreign exchange. From 2005 to 2008, higher capital account growth has off set the current account deficit leading to positive balance of payment. However from 2009 due to slower growth in capital account in proportion to higher current account deficit, overall balance of payment has been declining. Current account deficit till H1FY13 is at $38.97bn and Q2FY13 is 5.4% of GDP.

Current account deficit is generally funded by Capital account which records all inflows and outflows of capital of the country. As discussed earlier, foreign currency assets are used to fund the current account deficit and growth in balance of payment increases foreign currency assets.

It’s seen from 2002 when India had current account surplus, foreign currency assets have been increasing. During 2007-2008, although country faced deficits, foreign currency assets increased on account of growth in balance of payment led by growth in capital account. However, 2009 onwards with continuously increasing deficit and declining balance of payment, foreign currency assets have been on a declining trend. Till first half of 2013, exports and imports stand at $146.549bn and $237.221bn respectively resulting in trade deficit of $90.672bn. Increasing oil and gold imports are major contributors to the increase of imports. Till first half of 2013, oil and gold imports stand at $80.28bn and $20.25bn respectively.

A study by AVIRAL KUMAR TIWARI (REASSESSMENT OF SUSTAINABILITY OF CURRENT ACCOUNT DEFICIT IN INDIA, 2012) examined the long-run relationship between oil and non-oil exports and imports, in order to see whether the current account deficit in India is sustainable. The study found that there is a strong evidence of a long-run relationship between non-oil exports and imports and no evidence in the case of oil exports and imports. This implies that a foreign trade deficit is sustainable in the Indian context for non-oil commodities but not for oil commodities.

A study by Dr.DM. NACHANE and P. RANADE (India's Trade Balance In The Eighties - An Econometric Analysis 1996) examined India’s trade balance in the 1980's. The approach attempted is of examining the bilateral trade balances of India with nine trading partners from the non-Communist Bloc. The study found that the nominal and real exchange rates consistently emerge as important influences on the trade balance.

A study on COMPARATIVE ANALYSIS OF BALANCE OF PAYMENTS: INDIAN PERSPECTIVE by Kuldeep Singh Rana, Dr. Dinesh Khurana (2011) revealed the following

Trade balance was in deficit as imports always exceeded the exports. Within the imports the POL items constituting a sizeable position continued to increase throughout. Exports did not achieve the required growth rate. Current account balance includes visible items (trade balance) and invisibles are in a more encouraging position. It declined to $ -2,666 million in 2000-01 from $-9680 million in 1990-91 and recorded a surplus in 2003-04 to the extent of $ 14,083 million. In 2005-06, once again there was a deficit of $ 9,186 million. The main reason for the improvement during 2001-05 was the success of invisible items. The impressive role placed by invisibles in covering trade deficit is due to sharp rise invisible receipts. The main contributing factors to rise in invisible receipts are non factor receipts and private transfers. As far as non factor services receipts are concerned the main development has been the rapid increase in the exports of software services. As far as private transfers are concerned their main constituent is workers remittance from abroad. During this period the private transfer receipts also increased from $ 2,069 million in 1990-91 to $ 24,102 million in 2005-06. The current trend of outsourcing a number of jobs by the developed countries to the developing ones is also helping us to get more jobs and earn additional foreign exchange.

A study on TRENDS IN BALANCE OF PAYMENTS SINCE PLANNING PERIOD by Dr.B.K.SHINDE (2009-2010) finds that India had faced a pressure on balance of payment time to time since planning period, either due to the certain domestic compulsions or due to external factors.

The period for study is subdivided into four periods as follows:-

1)1956-57 to 1975-76 2)1976-77 to 1979-80 3) 1980- 81 to 1990-1994) 1991 onwards

 According to the study during the initial period of planning the position of BOP is adverse because of protection policy followed by govt. regarding to world trade. In 1970’s the position of BOP is satisfactory because of, rapid increase in private remittance, growth in exports etc. In 1980’s the BOP is adversely affected due to, trade deficits, oil shock, unfavourable political conditions etc. since 1990’s the reforms facilitated India to move away from closed economy framework towards a more open and liberal  economy. *Import/ export (BOP) ratio have improved over the period of liberalisation. Foreign exchange reserves position has also improved in the liberalisation period. Remittance from expatriate Indians rose strongly, making India one of the largest recipients of such flows.

A study on Balance-of-Payments Adjustment in India, 1970-71 to 1983-84 by Montek Singh Ahluwalia (1986) found that In common with other oil-importing developing countries, India experienced a severe external shock in 1973 when oil prices quadrupled and again after 1979, when oil prices more than doubled. India was able to adjust to both shocks somewhat more easily than other oil-importing developing countries, but there were important differences between the adjustments in the two cases. The adjustment to the first oil shock was remarkably easy, so much so that the current deficit, which peaked in 1974-75, turned to a substantial surplus within two years. The second external shock was more severe, and although a substantial degree of adjustment has taken place since then, especially in comparison with the severe difficulties faced by many developing countries, the adjustment is not yet complete.

The current account balance also mirrors the saving and investment behavior of the domestic economy. In analyzing changes in the current account position of a country, it is therefore important to understand the manner in which these changes reflect movements in saving and investment.

For example according to some experts India’s trade deficit is not a separate problem from the government’s budget shortfall (fiscal deficit). They are two sides of the same coin. The connection between them becomes evident when one looks at the current account gap not as the excess of imports over exports, but as the difference between the country’s investment and savings. This is basically due to the government announcement of $15 billion farm-debt waiver during the year 2008, as a process of reducing deficits. This policy had a harmful effect on the nation’s savings-investment dynamic. This is because, fiscal profligacy encouraged households to seek cover in imported gold as an inflation hedge. An increasing household investment in “valuables” between the 2008 and 2012 financial years shrank the pool of financial savings available to the domestic corporate sector. That, in turn, made Indian companies increasingly reliant on foreigners’ money to finish projects already underway. The current account deficit shot up to 4.2 percent of GDP in the last financial year. In the last two years, India’s stock of foreign debt has shot up by 32 percent even as the monetary authority’s foreign-currency reserves have fallen.

Unless the current account gap returns to a more sustainable level, a repeat of the 1991 currency crisis cannot be ruled out. In India’s case, a more sustainable current account may mean reducing the deficit to between 2.4 percent and 2.8 percent of GDP, according to a Reserve Bank of India research paper. According to economists, solving the two deficits – fiscal and current account – and bringing both under control will require a three-pronged strategy: a competitive exchange rate, further reductions in subsidies and a frontal assault on inflation. Achieving all three simultaneously will need deft coordination between the government and the monetary authority.

Management of the balance of payments will remain an important problem. Therefore necessary changes should be made in policies in order to strengthen India’s export capability.


 - RBI

 - IMF




 - Balance-of-Payments Adjustment in India, 1970-71 to 1983-84 by Montek Singh Ahluwalia (1986).


 - A study on COMPARATIVE ANALYSIS OF BALANCE OF PAYMENTS: INDIAN PERSPECTIVE by Kuldeep Singh Rana, Dr. Dinesh Khurana (2011).

 - A study by Dr.DM. NACHANE and P. RANADE (India's Trade Balance In The Eighties - An Econometric Analysis 1996).



 - Equitymaster

 - Moneycontrol

 - Various textbooks

 - Author notes

 -- Prof. M. Guruprasad,


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