Balance of Payments - Components and CAD for UPSC

BoP Structure

The Balance of Payments (BoP) is both an accounting identity and a diagnostic tool. It captures a country's receipts from and payments to non-residents and is organised into distinct accounts so that all credits and debits sum to zero. When a country imports more goods and services than it exports and pays out more in income and transfers than it receives, the current account is in deficit. Such a deficit must be matched by a surplus in the capital and financial account or by drawing down foreign exchange reserves. In practice, the BoP is compiled by the Reserve Bank of India (RBI) using IMF guidelines. The national income identity GDP = C + G + I + ( X - M ) underlies the BoP: if X - M (net exports) is negative, the domestic economy is absorbing more than it produces and must borrow from abroad or use past savings.

The BoP has two overarching accounts:

• Current Account - includes transactions for goods, services, income and current transfers. It measures the transfer of real resources between residents and non-residents. These transactions are further subdivided into merchandise (exports and imports of goods) and invisibles (services, income and current transfers such as remittances). The current account is broader than the trade balance because it covers income from foreign investments and compensation of employees in addition to trade.
• Capital & Financial Account - records changes in financial assets and liabilities. The capital account covers capital transfers and acquisition or disposal of non-produced assets, while the financial account records direct investment, portfolio investment, other investment (loans, trade credits, currency and deposits) and reserve assets. In recent IMF manuals the capital and financial accounts are reported together. Capital inflows finance current account deficits and build reserves.

Because every transaction has a credit and a debit, the BoP always balances: a deficit in the current account implies a surplus in the capital/financial account and vice versa. When the capital inflows are insufficient to cover a large current account deficit, a country must draw down its foreign exchange reserves. Conversely, a current account surplus means the country is accumulating foreign assets. For policymakers, the BoP indicates external vulnerability, the sustainability of consumption and investment, and the impact of global shocks.

Table: Elements of the Balance of Payments

A simple diagram (imagine two boxes labelled "Current Account" and "Capital/Financial Account" with arrows showing flows of goods, services, income and transfers on one side and flows of capital on the other) helps visualise the BoP. The current account box shows exports (credit) and imports (debit), inflows of remittances and outflows of dividends. The capital/financial account box shows inflows of FDI and FPI and outflows like external loan repayments. When the current account records a deficit, the arrows into the capital box must lengthen to finance it; if they do not, reserves shrink.

Current Account

The current account measures the inflow and outflow of goods, services, income and unilateral transfers between residents and non-residents. According to the IMF manual cited in India's Statistical Year Book, the major classifications are goods and services, income and current transfers. Goods and services together form the balance of trade: a country records a surplus when its exports exceed imports and a deficit when imports are larger. Income includes investment income (profits, dividends and interest) and compensation of employees working across borders. Current transfers capture one-way flows such as migrants' remittances, gifts and grants.

In India the merchandise trade balance has traditionally been in deficit because imports of crude oil, machinery and electronics exceed exports. Services trade, however, has been a bright spot thanks to IT and business services. In the June 2025 quarter (Q1 FY 2025-26) the current account logged a deficit of USD 2.4 billion, which was only 0.2 % of GDP and much lower than the USD 8.6 billion deficit (0.9 % of GDP) recorded a year earlier. This improvement occurred despite a wider merchandise trade deficit of USD 68.5 billion because net services receipts rose and remittances remained strong. The RBI noted that net services receipts increased to USD 47.9 billion and personal transfer receipts (mainly remittances) increased to USD 33.2 billion in Q1 FY26 compared with USD 39.7 billion and USD 28.6 billion respectively a year earlier. These invisibles cushioned the trade shortfall. India's balance of payments still showed a surplus of USD 4.5 billion in Q1, reflecting adequate capital inflows.

Seasonal patterns are important. In Q4 FY 2024-25 (January-March 2025) India registered a current account surplus of USD 13.5 billion (1.3 % of GDP) - the first surplus in four quarters - thanks to robust services exports and record remittances. Over the full fiscal year 2024-25, however, the current account still recorded a deficit of USD 23.3 billion (0.6 % of GDP), lower than the USD 26 billion deficit (0.7 % of GDP) in 2023-24 because net invisible receipts increased. Net services receipts surged to USD 53.3 billion in the March 2025 quarter, while remittances reached USD 33.9 billion. These numbers highlight how India's strong service exports and diaspora remittances offset its merchandise trade deficit.

A major difference between the trade balance and the current account is the inclusion of primary income and transfers. Investment income payments - such as dividends paid to foreign investors - can be substantial. In Q4 FY25 the net outgo on the primary income account moderated to USD 11.9 billion from USD 14.8 billion a year earlier. Remittances and other transfers, on the other hand, are inflows that directly support households. India is the world's top recipient of remittances, with inflows crossing USD 100 billion annually and reaching a record USD 123 billion in 2024-25. These flows not only support consumption but also finance part of the current account deficit.

Components of the Current Account

• Goods (Merchandise Trade) - physical commodities exported and imported. India's major exports include petroleum products, pharmaceuticals, engineering goods and software in physical form; major imports are crude oil, gold, electronics and machinery.
• Services - non-factor services such as IT/business services, travel, transportation, insurance and government services. IT services dominate India's export basket and have generated large surpluses.
• Primary Income - compensation of employees and investment income (dividends, interest, profits) on international investments. Outflows occur when multinational firms repatriate profits.
• Secondary Income (Current Transfers) - unilateral transfers without a quid pro quo, notably workers' remittances, gifts and grants. Remittances from Indian migrants are a stable source of foreign exchange.

For UPSC, remember that the current account is broad and includes both visible trade and invisibles (services, income and transfers). A surplus in services or remittances can partially offset a merchandise trade deficit. When the current account is negative, the economy is said to have a Current Account Deficit (CAD).

Capital Account

In the IMF's Balance of Payments manual, the capital account records capital transfers and the acquisition or disposal of non-produced, non-financial assets. Capital transfers include debt forgiveness, migrants' assets, inheritance taxes and uncompensated transfers. Acquisition or disposal of non-produced assets refers to transactions involving natural resource rights, patents or franchises. For most countries, the capital account is small relative to the financial account and often records minimal flows.

In India, capital transfers include grant-assisted projects or donations, while transactions involving intangible assets are rare. Because the capital account is so narrow, analysts usually focus on the financial account when discussing how current account deficits are financed. The combined capital and financial account, sometimes called the capital account in colloquial usage, captures net changes in ownership of financial assets and liabilities. The financial account consists of four major subdivisions:

• Direct Investment (FDI) - long-term investments where the investor has a lasting interest and at least 10 % equity in the enterprise. FDI flows are relatively stable and include cross-border mergers, greenfield projects and reinvested earnings.
• Portfolio Investment - investments in equity and debt securities without controlling interest. Foreign Portfolio Investment (FPI) is more volatile and influenced by global risk appetite and interest rate differentials.
• Other Investment - loans, external commercial borrowings (ECBs), trade credit, bank deposits and Non-Resident Indian (NRI) deposits. These flows can be short- or long-term and may create debt obligations.
• Reserve Assets - foreign currency reserves, gold, Special Drawing Rights (SDRs) and positions with the International Monetary Fund. Changes in reserves reflect the residual financing requirement after current and capital flows.

Recent RBI data show how financial flows helped finance the current account deficit. In Q4 FY25, FDI recorded a net inflow of USD 400 million while FPI saw a net outflow of USD 5.9 billion. For the whole year FY 2024-25 FDI inflows were only USD 1 billion, considerably lower than USD 10.2 billion a year earlier, whereas FPI recorded a net inflow of USD 3.6 billion compared with USD 44.1 billion in 2023-24. Despite weaker investment flows, India's BoP registered a surplus of USD 8.8 billion in the March 2025 quarter due to strong services receipts and remittances. However, the BoP for FY 2024-25 as a whole recorded a deficit of USD 5 billion because the current account deficit and net financial outflows together exceeded the net reserve increase. These figures illustrate the interplay between current and financial accounts and the role of reserves.

Table: Selected Financial Flow Categories and Their Nature

For UPSC, note that healthy FDI and remittances are preferred sources of financing because they are less volatile and do not increase debt, whereas heavy reliance on short-term debt or FPI can make the economy vulnerable to sudden stops.

Current Account Deficit (CAD)

A Current Account Deficit occurs when the value of a country's imports of goods and services plus outflows of income and transfers exceeds the value of its exports and inflows. This means the country is spending more foreign exchange than it earns and must finance the gap. According to India's Statistical Year Book, if the combined effect of trade balance, income and current transfers is negative, "the deficit needs to be financed by external borrowings and/or investments which are constituents of financial accounts". A CAD is not inherently bad; developing economies often run deficits to import capital goods and technology. However, persistent large deficits financed by volatile capital can lead to currency depreciation, depletion of reserves and external vulnerability.

India's CAD has fluctuated over time. It reached a record high of 4.8 % of GDP (USD 87.8 billion) in FY 2012-13; the deficit narrowed to 3.6 % of GDP in the last quarter of 2012-13, down from 6.7 % in the previous quarter, as non-oil and non-gold imports fell with slowing growth. Policymakers responded by raising import duties on gold, encouraging exports and attracting stable capital flows. In subsequent years the CAD moderated, averaging around 1 - 2 % of GDP. During FY 2024-25 the CAD was just 0.6 % of GDP (USD 23.3 billion) thanks to strong services exports and remittances. In Q1 FY 2025-26 it narrowed further to 0.2 % of GDP, showcasing resilience despite a large merchandise trade deficit.

Causes of CAD

• Trade Deficit - High import bill relative to exports. Oil, gold and electronics imports often outpace export growth.
• Low Export Competitiveness - Structural issues such as inadequate infrastructure, supply-chain inefficiencies and regulatory hurdles limit export diversification.
• High Domestic Demand - Consumption and investment booms raise imports of capital goods and intermediate inputs.
• Global Price Shocks - Spikes in crude oil prices or commodity prices widen the trade deficit; a strong domestic currency also makes exports less competitive.
• Income and Transfer Outflows - Profit repatriation by multinational firms and interest payments on external debt widen the deficit, though remittances often counterbalance them.

Consequences and Policy Response

A high CAD can pressure the domestic currency as demand for foreign exchange rises. It may lead to depreciation, imported inflation and loss of investor confidence. In 2013 the rupee fell sharply when the CAD exceeded 4 % of GDP, prompting the RBI to launch special deposit schemes for NRIs and tighten monetary policy. More recently, because India's CAD is modest and financed by stable flows like remittances and FDI, the rupee has remained relatively stable despite global volatility.

Policy measures to contain the CAD include diversifying exports, promoting services, reducing import dependence (e.g., renewable energy to cut oil imports), encouraging FDI, and prudently managing capital flows. Exchange rate flexibility allows the rupee to adjust and limit imbalances. When necessary, the RBI uses reserves to smooth volatility but emphasises that the underlying current account should remain within sustainable limits.

Quick Facts

• India's current account deficit narrowed to USD 2.4 billion (0.2 % of GDP) in Q1 FY 2025-26 from USD 8.6 billion (0.9 % of GDP) a year earlier, despite a larger trade deficit.
• Net services receipts rose to USD 47.9 billion in Q1 FY 2025-26 and personal transfer receipts (remittances) to USD 33.2 billion.
• India posted a current account surplus of USD 13.5 billion (1.3 % of GDP) in Q4 FY 2024-25 and a BoP surplus of USD 8.8 billion in that quarter.
• For FY 2024-25 the current account deficit was USD 23.3 billion (0.6 % of GDP), lower than USD 26 billion (0.7 % of GDP) in FY 2023-24 due to higher net invisible receipts.
• During FY 2012-13 India's CAD peaked at 4.8 % of GDP (USD 87.8 billion) but narrowed sharply after policy measures curbed gold imports and slowed non-essential imports.
• FDI inflows stood at USD 1 billion in FY 2024-25 (down from USD 10.2 billion a year earlier), whereas FPI recorded a net inflow of USD 3.6 billion.
• Foreign exchange reserves are used as a buffer; a drawdown indicates that capital flows were insufficient to finance the current account deficit.

For UPSC Prelims vs Mains

Prelims Pointers

• BoP always balances: current account + capital/financial account + errors and omissions = 0.
• Remember the sub-components of the current account (goods, services, income, transfers) and the distinction between the capital and financial accounts.
• CAD occurs when imports of goods and services and outflows of income exceed exports and inflows.
• India's CAD is modest in recent years (0.6 % of GDP in FY 2024-25; 0.2 % of GDP in Q1 FY 2025-26).
• Important sources of financing include FDI, portfolio investment, external commercial borrowings, NRI deposits and remittances.
• RBI compiles BoP data quarterly; major items like net services receipts, remittances and trade deficits are announced publicly.

Mains Notes

• Analyse the structural reasons for India's trade deficit and evaluate policies to boost export competitiveness (logistics, product diversification, trade agreements).
• Discuss the sustainability of the CAD and the pros and cons of financing it through FDI, FPI and debt-creating flows.
• Examine the role of remittances and services exports in stabilising the BoP. How can India leverage its diaspora and service sector further?
• Critically assess the impact of global shocks (e.g., oil price spikes, US tariffs) on India's external sector and policy responses.
• Evaluate the effectiveness of gold import curbs and external commercial borrowing regulations in managing CAD during high-deficit episodes like 2012-13.
• Use diagrams to illustrate how current account deficits are financed by capital inflows and how reserves act as a buffer.

Financing the Current Account Deficit

When the current account records a deficit, it must be financed by capital inflows or by drawing down official reserves. The Statistical Year Book notes that the deficit "needs to be financed by external borrowings and/or investments which are constituents of financial accounts". Sustainable financing requires attracting stable capital while avoiding excessive external debt.

Sources of Financing

• Foreign Direct Investment (FDI): Long-term investment by foreign firms in domestic enterprises. It is non-debt creating and brings technology, employment and managerial know-how. India liberalised many sectors to attract FDI, though inflows dipped to USD 1 billion in FY 2024-25 amid global uncertainty.
• Foreign Portfolio Investment (FPI): Investments in equities and debt securities. FPI can provide large inflows quickly but is sensitive to global interest rates and risk appetite. India recorded a net inflow of USD 3.6 billion in FY 2024-25, down from USD 44.1 billion in FY 2023-24.
• External Commercial Borrowings (ECBs): Loans raised by companies from international markets. They finance infrastructure and corporate expansion but add to external debt. RBI regulations on maturities and end-use aim to ensure prudent borrowing.
• Non-Resident Indian (NRI) Deposits: Deposits by Indians living abroad. Special schemes like FCNR(B) and NRE deposits have provided large inflows during times of stress, such as the 2013 rupee turmoil.
• Loans and Bilateral Assistance: Multilateral institutions (World Bank, Asian Development Bank) and bilateral partners provide loans and grants. These flows support development projects but require repayment.
• Use of Foreign Exchange Reserves: When capital inflows fall short, the central bank draws down reserves to meet payments. In FY 2024-25 reserves increased by USD 8.8 billion in Q4 but declined over the year, reflecting net outflows.

Policymakers aim to finance the CAD primarily through stable non-debt flows (FDI and remittances) and limit reliance on volatile capital. At the same time, reforms to improve the investment climate, deepen capital markets and diversify exports help reduce the deficit. A low and stable CAD (around 2 % of GDP) is considered sustainable for India, whereas higher deficits may trigger macroeconomic adjustments through currency depreciation or tighter monetary policy.

UPSC Previous Year Questions (Selected)

The following paraphrased questions illustrate how UPSC has tested candidates on the Balance of Payments:

1. 2015 Prelims: Consider the following statements about the Balance of Payments: 1. It always sums to zero. 2. The current account measures only goods and services trade. 3. The capital account records direct and portfolio investment. Which of the above statements are correct? Answer: Statements 1 and 3 are correct; statement 2 is incorrect because the current account also records income and transfers.
2. 2017 Mains (GS III): Discuss the factors responsible for India's persistent current account deficit. What measures have been taken by the government and RBI to finance the deficit and make it sustainable? Answer: Candidates should highlight trade deficits due to oil imports, low export competitiveness, global shocks, and outline measures such as FDI liberalisation, gold import curbs, promotion of services exports, regulation of ECBs, special NRI deposit schemes and exchange rate flexibility.
3. 2021 Prelims: Which of the following items appears under the capital account of India's BoP? (a) Remittances from abroad (b) Foreign portfolio investment (c) Imports of goods (d) Non-resident external deposits. Answer: Options (b) and (d) are correct; remittances and goods trade belong to the current account.
4. 2023 Mains (GS III): Current account deficit must be financed through capital inflows. Examine the risks of financing India's CAD through short-term portfolio flows. Suggest strategies to attract more stable forms of capital. Answer: Candidates should explain that volatile portfolio flows can reverse quickly, causing exchange rate swings. Strategies include improving business climate for FDI, developing long-term domestic bond markets, encouraging remittances and diversifying export earnings.

Practice MCQs

1. The current account of a country's Balance of Payments includes:
   1. Only goods exports and imports
   2. Goods, services, income and current transfers
   3. Capital transfers and FDI
   4. Changes in foreign exchange reserves
2. Which of the following flows is considered a non-debt creating source of financing the current account deficit?
   1. External commercial borrowings
   2. Foreign portfolio investment
   3. Foreign direct investment
   4. NRI deposits
3. India's current account deficit for FY 2024-25 was approximately:
   1. 5 % of GDP
   2. 3 % of GDP
   3. 0.6 % of GDP
   4. -0.2 % of GDP (surplus)
4. A rise in crude oil prices is likely to:
   1. Improve India's current account balance
   2. Widen the trade deficit and CAD
   3. Have no effect on the balance of payments
   4. Reduce import dependence
5. In India, remittances sent by non-resident Indians are recorded in the BoP under:
   1. Capital account
   2. Financial account
   3. Primary income
   4. Secondary income

Answer Key: 1-B, 2-C, 3-C, 4-B, 5-D.

Frequently Asked Questions

Below are concise answers to common queries on the Balance of Payments and current account deficit:

Why does the Balance of Payments always balance?

The BoP is an accounting statement; every transaction has a credit and a matching debit. A current account deficit is by definition financed by capital/financial account surplus and/or reserve changes, so the overall balance is zero.

Is a current account deficit always bad?

No. Developing economies often run a CAD to import capital goods and technology. A moderate deficit financed through stable FDI and remittances is considered manageable. Problems arise when the deficit is large and financed by volatile short-term capital.

How does India finance its current account deficit?

India finances its CAD through foreign direct investment, portfolio investment, external commercial borrowings, NRI deposits and remittances. When these inflows are insufficient, the RBI uses foreign exchange reserves.

What was India's CAD in FY 2024-25 and why did it decline?

India's current account deficit was about USD 23.3 billion (0.6 % of GDP) in FY 2024-25, lower than the previous year because net services receipts and remittances increased, offsetting the merchandise trade deficit.

Which account would record the sale of land to a foreign resident?

The capital account records the acquisition or disposal of non-produced, non-financial assets such as land and natural resource rights.

What is the significance of remittances for India?

Remittances are classified under secondary income in the current account. India is the world's largest recipient; inflows reached around USD 123 billion in 2024-25. They support household consumption and help finance the CAD.

Why did the CAD spike in 2012-13?

In FY 2012-13 India's CAD jumped to 4.8 % of GDP due to a surge in imports of gold and oil and slowing export growth. The government responded with gold import curbs and measures to attract stable capital flows.

How do reserve assets feature in the BoP?

Changes in foreign exchange reserves are recorded under the financial account. An increase in reserves implies a BoP surplus, while a decrease indicates that reserves are being used to finance a deficit or to prevent currency volatility.