The Influence of Exchange Rates on Balance of Payments

Every time the rupee slips against the dollar, headlines call it bad news. But is a weaker rupee always bad? Not necessarily. Exchange rates and the balance of payments (BOP) are locked in a two-way relationship: the rate at which your currency trades against others directly shapes how much you earn from exports and how much you pay for imports, and those numbers, in turn, decide whether your BOP shows a surplus or a deficit. Understanding this link is central to any discussion of India’s external sector, especially when the rupee keeps making news for touching new lows.

Quick recap: what the BOP actually records 🔗

The balance of payments is simply a country’s financial diary with the rest of the world. It records every rupee that flows in and every rupee that flows out, whether that is payment for a software export, an oil import bill, remittances from an NRI relative, or a foreign investor buying Indian shares. The BOP has two broad limbs: the current account, which tracks trade in goods and services, income, and transfers, and the capital account, which tracks investment and loan flows. When inflows exceed outflows, the BOP is in surplus; when outflows dominate, it slips into deficit.

The exchange rate is the price that connects these two accounts to the rest of the world. A change in that price changes the competitiveness of exports, the cost of imports, and the attractiveness of Indian assets to foreign investors, which is exactly why the BOP and the exchange rate cannot be studied in isolation.

How the rupee’s value gets decided 🔗

India does not fix its exchange rate, nor does it let it float completely freely. It follows a managed floating exchange rate system, where the rupee’s value is largely set by market demand and supply for foreign currency, but the Reserve Bank of India steps in to prevent excessive volatility rather than to defend any particular level. The RBI buys dollars when the rupee strengthens too fast and sells from its reserves when depreciation turns disorderly. [Image: A simple diagram showing demand and supply of foreign currency determining the exchange rate, with RBI intervention shown as a stabilising force]

Interestingly, the RBI even stopped publishing an official daily reference rate for the rupee against major currencies some years ago, since market-determined rates polled from banks were seen as robust enough on their own. This shift reflects how far India’s foreign exchange regime has moved from the tightly controlled system of the pre-1991 era toward one shaped primarily by market forces, with policy intervention reserved for smoothing out shocks.

A weaker rupee: the textbook story 🔗

When the rupee depreciates, meaning it takes more rupees to buy one dollar, two things happen almost mechanically:

• Exports become cheaper for foreign buyers. An Indian garment priced at ₹2,000 costs a US buyer fewer dollars when the rupee is weak, making Indian goods more price-competitive abroad.
• Imports become costlier for Indian buyers. The same dollar-denominated crude oil shipment now costs more in rupee terms, raising the import bill.

Put together, cheaper exports should sell in larger volumes and costlier imports should be bought in smaller volumes, which improves the trade balance and, by extension, strengthens the current account side of the BOP. This is the reasoning behind why countries sometimes allow, or even encourage, a controlled depreciation when they are trying to boost export earnings.

Why it doesn’t always work out that neatly 🔗

The catch is that this improvement depends entirely on how responsive, or elastic, demand for exports and imports actually is. Economists capture this using the Marshall-Lerner condition, which states that a currency’s depreciation will improve the trade balance only if the combined price elasticity of demand for exports and imports is greater than one. If both are largely insensitive to price, as they often are for essentials like crude oil or life-saving drugs, a weaker rupee can simply mean a larger, not smaller, import bill without a matching jump in export volumes.

There is also a timing problem known as the J-curve effect. Immediately after depreciation, existing trade contracts and buying habits do not change overnight, so the country keeps paying more for the same import quantities while export earnings take time to catch up. The trade balance can actually worsen for a few months before it starts improving, tracing a shape resembling the letter J when plotted on a graph. This is why a depreciating rupee often shows up as a wider current account deficit in the short run, even though the long-run textbook expectation is an improvement.

A stronger rupee: the mirror image 🔗

Appreciation works exactly in reverse. When the rupee strengthens, Indian exports become more expensive for foreign buyers, which can dent overseas demand for goods from IT services to textiles. At the same time, imports become cheaper, encouraging Indians to buy more foreign goods, from crude oil to electronics to gold. If this pattern persists, exports slow, imports rise, and the trade balance, and therefore the current account, comes under pressure.

This is why exporters routinely lobby against a “too strong” rupee, while importers and consumers of imported goods often welcome it. A stronger currency also tends to make imported inflation lower, since the same dollar-denominated goods now cost fewer rupees, which is one reason central banks sometimes tolerate mild appreciation when domestic prices are running hot.

It isn’t only about trade: the capital account link 🔗

Exchange rates influence the BOP through the capital account just as strongly as through trade. Foreign portfolio investors comparing returns across countries care about currency risk. If the rupee is expected to depreciate further, the returns on Indian bonds and equities look less attractive once converted back to dollars, which can trigger outflows and add further downward pressure on the currency, a self-reinforcing loop. Conversely, a stable or appreciating rupee, backed by healthy reserves, tends to draw in foreign direct investment and portfolio flows, cushioning the overall BOP even if the trade account is in deficit.

Interest rates add another layer. When the RBI holds rates higher relative to major economies, rupee-denominated assets offer better returns, pulling in capital inflows that support the currency. This is one reason RBI’s monetary policy stance and its exchange rate objectives are so closely intertwined; the two cannot really be planned separately.

How this plays out in India’s recent numbers 🔗

India’s current account has swung between deficit and brief surplus over the past couple of years, largely tracking global oil prices, IT services exports, and remittance inflows. RBI data showed India’s current account moving into a rare surplus in one quarter of FY24, its first in eleven quarters, underlining just how sensitive the account is to shifts in trade and currency conditions.

More recently, the rupee has weakened past the 90-per-dollar mark, a move linked to a widening current account deficit, softer net foreign direct investment, and a general pattern where the overall balance of payments has been oscillating between modest deficits and small surpluses, with the RBI smoothing the sharper edges through reserve sales and purchases. Despite this pressure, India continues to hold one of the largest foreign exchange reserve stockpiles in the world, which gives the RBI meaningful room to manage volatility without needing to defend a fixed rate. The RBI’s accumulation and deployment of these reserves through market intervention remains one of the central tools for keeping the rupee’s movements orderly rather than disruptive.

Why this matters beyond the exam 🔗

For a student, this topic is not just theory to memorise for an exam. It explains why the news anchors get excited every time the rupee crosses a new low, why the RBI Governor’s policy statements move currency markets, and why a “cheap rupee” is not automatically good news for the economy. It also explains why countries running large trade deficits, like India with its heavy reliance on oil imports, tend to be more exposed to currency swings than countries with diversified, resilient exports.

The relationship is genuinely circular: exchange rates shape the BOP, and the state of the BOP, especially the size of the current account deficit or surplus, feeds back into how the currency is priced by the market. Policymakers spend a great deal of energy trying to manage this loop, because getting it wrong on either side can mean costlier imports, weaker export competitiveness, or unwelcome swings in investor confidence.

What do you think? If you were advising the RBI during a period of rapid rupee depreciation, would you prioritise defending the currency through reserve sales, or let market forces play out and focus on strengthening export competitiveness instead? And do you think India’s heavy dependence on oil imports makes the Marshall-Lerner condition harder to satisfy in the Indian context?

References

1. https://www.dalvoy.com/en/upsc/mains/previous-years/2025/economics-paper-ii/rbi-exchange-rate-management-strategy-india
2. https://ies.gov.in/arthapedia/concept/rbi-reference-exchange-rate
3. https://www.tutor2u.net/economics/reference/the-marshall-lerner-condition
4. https://www.economicshelp.org/blog/143448/economics/j-curve-effect/
5. https://www.drishtiias.com/daily-updates/daily-news-analysis/india-s-balance-of-payments
6. https://www.wrightresearch.in/blog/why-the-rupee-crossed-90-indias-balance-of-payments-story/
7. https://mospi.gov.in/sites/default/files/Statistical_year_book_india_chapters/Chapter%20No.4.pdf