CDS Economics · Indian Economy

Balance of Payments and Foreign Capital

The current and capital accounts and what goes in each, why India runs a current account deficit, direct against portfolio investment, the foreign exchange reserves, and the IMF and WTO dates CDS asks.

All Indian Economy notes

Why this matters

Eight CDS questions, three of them HARD. The commonest trap is putting an item in the wrong account: invisibles belong to the current account, FDI to the capital account.

Concept 1 of 3: The current account and the capital account

The balance of payments records every rupee that crosses India's border. Money for goods and services, and income and gifts, goes in the current account. Money that buys or sells assets, or is borrowed and lent, goes in the capital account. If India spends more abroad on the current account than it earns, it must cover the gap with capital flowing in.

Definition

The two accounts:

Current account: merchandise trade (goods) plus invisibles. Invisibles are services (IT, travel, transport), income (interest, dividends, wages) and transfers (above all remittances from Indians abroad).
Capital account (also called the financial account): foreign direct investment, portfolio investment, external commercial borrowing, external assistance, NRI deposits, and changes in the reserves.
India's merchandise imports exceed its exports in almost every year. Services exports and remittances narrow the gap but usually do not close it, so India usually runs a current account deficit (CAD).
A CAD is financed by net capital inflows such as FDI. Financing it does not make FDI part of the current account.

Current account balance

\text{Current account balance} = (\text{Exports} - \text{Imports})_{\text{goods}} + \text{Net invisibles}

Worked example

In a year India's goods exports are 450 and goods imports 700 (billion dollars). Net services earn 160, net transfers 100, and net income is −40. Find the current account balance.

Practice this conceptself-check · 4 quick reps

The same idea in a real exam question:

CDS · 2024 · CDS (II) 2024 — General Knowledge · Q95Moderate

Example 1 · Indian Economy · Balance of Payments and Foreign Capital

Which of the following is not included in the Capital Account of the Balance of Payments of a country ?

Invisibles are current account

Services, income and transfers are invisibles, and they sit in the current account. FDI, borrowing and aid sit in the capital account.

Drill 2 more on the current account and the capital account

Concept 2 of 3: FDI, portfolio money and the reserves

A foreign company that builds a factory or a college in India is here to stay: that is direct investment. A fund that buys Indian shares on the stock exchange can sell them tomorrow: that is portfolio investment, and money that can leave that fast is called hot money. The RBI keeps reserves of foreign currency to steady the rupee when such money moves.

Definition

The terms:

Foreign direct investment (FDI): a lasting interest and a say in running the business: setting up a plant, a company or an educational institution, or buying 10 per cent or more of a listed company.
Foreign portfolio investment (FPI): buying shares and bonds through the stock market without control. It can leave quickly, so it is called hot money.
India's foreign exchange reserves: mostly foreign currency assets, plus gold, special drawing rights (SDRs) and the reserve tranche position with the IMF.
Holding reserves has a cost: they earn low returns in safe assets, and the RBI pays to sterilise their effect on money supply.

Item	Fact
Hot money	Foreign portfolio investmentQ
FDI	Lasting interest with control; new plants, firms or institutions
Largest part of India's reserves	Foreign currency assetsQ CDS 2024 (I): holding reserves is not free of cost.
Other parts of the reserves	Gold, SDRs, reserve tranche position with the IMF

Practice this concept3 quick reps

The same idea in a real exam question:

CDS · 2022 · CDS (I) 2022 — General Knowledge · Q59Moderate

Example 2 · Indian Economy · Balance of Payments and Foreign Capital

Which one of the following would be considered as Foreign Direct Investment ?

Buying listed shares is portfolio, not direct

A foreign fund, bank or company buying shares on a stock exchange is portfolio investment, whoever the buyer is. Direct investment means building or controlling a business.

Drill 2 more on fdi, portfolio money and the reserves

Concept 3 of 3: The IMF, the WTO and the dates

When a country runs short of foreign currency it turns to the IMF. Trade rules are set at the WTO, which grew out of the GATT. CDS asks which body gives which help, and when the big trade and payments events happened.

Definition

The bodies and dates:

IMF: lends to countries with balance of payments problems. The Extended Fund Facility gives medium-term help for structural problems, with a reform programme.
Not IMF: IFAD (agriculture loans), IBRD (the World Bank's lending arm), UNDP (development programmes).
GATT 1947; its Uruguay Round ended in 1994; the WTO began on 1 January 1995.
SWIFT (interbank messaging) was founded in 1973 and went live in 1977.
Nasdaq, the first fully electronic stock market, opened in 1971.

Event	Year
GATT signed	1947
Nasdaq opens	1971
SWIFT founded	1973 (live in 1977)Q CDS 2018 (I): SWIFT dated to 1985 was the wrong pair.
Uruguay Round concluded	1994
WTO begins	1995

Practice this concept3 quick reps

The same idea in a real exam question:

CDS · 2022 · CDS (II) 2022 — General Knowledge · Q75Moderate

Example 3 · Indian Economy · Balance of Payments and Foreign Capital

Which one of the following assists a country through 'Extended Fund Facility', often talked about in news ?

SWIFT is older than it looks

SWIFT was founded in 1973 and carried its first live message in 1977, not in the 1980s.

Drill 1 more on the imf, the wto and the dates

Summary — formulas & gotchas at a glance

A revision cheat-sheet for the formulas and gotchas above. Click any concept name to jump back to its full explanation.

Formulas (1)

The current account and the capital account
Current account balance
$\text{Current account balance} = (\text{Exports} - \text{Imports})_{\text{goods}} + \text{Net invisibles}$

Reference tables (2)

FDI, portfolio money and the reserves4 rows

Item	Fact
Hot money	Foreign portfolio investmentQ
FDI	Lasting interest with control; new plants, firms or institutions
Largest part of India's reserves	Foreign currency assetsQ CDS 2024 (I): holding reserves is not free of cost.
Other parts of the reserves	Gold, SDRs, reserve tranche position with the IMF

The IMF, the WTO and the dates5 rows

Event	Year
GATT signed	1947
Nasdaq opens	1971
SWIFT founded	1973 (live in 1977)Q CDS 2018 (I): SWIFT dated to 1985 was the wrong pair.
Uruguay Round concluded	1994
WTO begins	1995

Watch out for (3)

Invisibles are current account
→ The current account and the capital account
Buying listed shares is portfolio, not direct
→ FDI, portfolio money and the reserves
SWIFT is older than it looks
→ The IMF, the WTO and the dates

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