Consider the following actions which the government can take: 1. Devaluing the domestic currency. 2. Reduction in the export subsidy. 3. Adopting suitable policies which attract greater FDI and more funds from FIIs. Which of the above action/actions can help in reducing the current account deficit?
Contents16
- A1 and 2
- B2 and 3
- C3 only
- D1 and 3
Show answer
Answer: (D) 1 and 3
Actions 1 and 3 help reduce the Current Account Deficit (CAD).
Action 2 would WORSEN it.
Current Account Deficit = Imports > Exports (country spends more foreign currency than it earns).
Action 1 — Devaluing currency (✓ HELPS):
When the rupee weakens:
- Indian exports become CHEAPER for foreigners → exports increase.
- Foreign imports become MORE EXPENSIVE for Indians → imports decrease.
Both effects reduce CAD.
Action 2 — Reducing export subsidy (✗ WORSENS):
Export subsidies make Indian goods cheaper abroad.
REMOVING subsidies makes exports MORE EXPENSIVE → exports decrease → CAD worsens.
This is counterproductive.
Action 3 — Attracting more FDI/FII (✓ HELPS):
More foreign investment brings foreign currency INTO India → improves the capital account → helps finance the CAD → reduces overall external pressure.
Note: FDI/FII technically improve the Capital Account, not Current Account directly, but they help FINANCE the CAD.
Current Account Deficit occurs when a country imports more than it exports, creating pressure on foreign exchange reserves and currency stability.
Devaluation makes exports cheaper and imports costlier, directly improving trade balance, while FDI brings foreign currency inflows to finance the deficit.
The question tests whether students can distinguish between policies that directly affect trade flows versus those that provide financing through capital account improvements.
Current Account Deficit
Indian Economy current account deficit
Current Account Deficit: Components & Policy Impact
Current Account Deficit = Imports > Exports (country spends more foreign currency than it earns)
CAD indicates external sector vulnerability and financing needs
Major components: trade balance, services, income transfers, remittances
India typically runs a CAD due to oil imports and gold demand
What is CAD
Current Account Deficit occurs when a country's total imports exceed its total exports, meaning it spends more foreign currency than it earns. This creates external financing pressure and affects currency stability.
Current Account Components
Component | What it includes | India's typical position |
|---|---|---|
Trade Balance | Goods exports vs imports | Deficit (oil, gold imports) |
Services | IT, software, tourism | Surplus (IT exports) |
Income Transfers | Investment income, wages | Mixed |
Remittances | Money sent by overseas workers | Surplus (large diaspora) |
Trap: FDI/FII improve Capital Account, not Current Account directly - but they help finance the CAD
Trap: Reducing export subsidies worsens CAD by making exports less competitive
Trap: Don't confuse Current Account with Fiscal Deficit (government budget deficit)
Currency Devaluation Effects
Indian Economy devaluing the domestic currency
Currency Devaluation: Trade Balance Impact Mechanism
Devaluation = making domestic currency weaker against foreign currencies
Makes exports cheaper and imports more expensive for trading partners
Generally improves trade balance and reduces CAD
Success depends on price elasticity of demand for exports/imports
Devaluation Impact Chain
%%{init: {"flowchart": {"wrappingWidth": 460}}}%%
flowchart TD
s1["`****Currency Devalues****
Rupee weakens from ₹70/$1 to ₹75/$1`"]
s2["`****Exports Become Cheaper****
Indian goods cost less in foreign currency`"]
s3["`****Export Demand Rises****
Foreign buyers purchase more Indian goods`"]
s4["`****Imports Become Expensive****
Foreign goods cost more in rupees`"]
s5["`****Import Demand Falls****
Indian consumers buy fewer foreign goods`"]
s6["`****CAD Reduces****
Export earnings rise, import spending falls`"]
s1 --> s2
s2 --> s3
s3 --> s4
s4 --> s5
s5 --> s6Real-World Considerations
J-Curve Effect: CAD may worsen initially before improving as contracts adjust
Marshall-Lerner Condition: Devaluation works only if export + import demand elasticity > 1
Inflation Risk: Expensive imports can trigger domestic price rise
India used devaluation in 1991 crisis as part of structural reforms
Export Subsidies & Trade Policy
Indian Economy export subsidy
Export Subsidies: Mechanism & Policy Withdrawal Effects
Export subsidies = government financial support to make exports artificially cheaper
Reducing subsidies makes exports more expensive → exports fall → CAD worsens
WTO restricts export subsidies as trade-distorting measures
India provides export incentives through PLI schemes and SEZ policy
Export Subsidy Types in India
Scheme Type | Mechanism | Beneficiary Sectors | Current Status |
|---|---|---|---|
MEIS (now RoDTEP) | Duty drawback on inputs | All exporters | Operational |
PLI Schemes | Production incentives | Electronics, pharma, textiles | Expanding |
SEZ Benefits | Tax exemptions | SEZ units | Being reviewed |
EPCG Scheme | Duty-free capital goods | Export-oriented units | Operational |
Why Reducing Subsidies Worsens CAD
Export subsidies make Indian goods artificially competitive in global markets. When government reduces these subsidies, Indian exporters face higher costs → their products become more expensive abroad → foreign buyers purchase less → export earnings fall → CAD worsens.
Trap: Reducing export subsidies seems logical for fiscal savings but actually worsens trade balance
Trap: Don't confuse export subsidies with import duties - they work in opposite directions
Common mistake: Thinking all subsidy reductions help the economy - export subsidies are different
FDI & FII Capital Flows
Indian Economy FDI FIIs
FDI & FII: Capital Account Impact on External Balance
FDI = long-term foreign investment in Indian companies/projects
FII = short-term foreign investment in Indian stock/bond markets
Both bring foreign currency inflows → improve Capital Account → help finance CAD
FDI is more stable, FII is more volatile and can reverse quickly
FDI vs FII Comparison
Aspect | FDI (Foreign Direct Investment) | FII (Foreign Institutional Investment) |
|---|---|---|
Nature | Long-term, strategic investment | Short-term, portfolio investment |
Threshold | 10%+ stake in Indian company | <10% stake in listed securities |
Stability | Sticky, hard to withdraw | Volatile, hot money flows |
Examples | Manufacturing plants, acquisitions | Mutual fund investments, hedge funds |
Regulation | FEMA rules, sector caps | SEBI regulations, FPI norms |
How FDI/FII Help with CAD
FDI and FII don't directly reduce Current Account Deficit - they improve the Capital Account instead. However, capital inflows bring foreign currency that helps finance the CAD, reducing pressure on forex reserves and exchange rate.
Policy Tools to Attract Foreign Investment
Liberalizing FDI caps: Raising sectoral limits (e.g. insurance to 74%)
Simplifying approval process: Automatic route vs government approval
Tax incentives: Lower corporate tax rates, treaty benefits
Market access: Opening new sectors like retail, defense manufacturing
Balance of Payments Structure
Indian Economy
Balance of Payments: Current vs Capital Account Dynamics
BoP = systematic record of all economic transactions between India and rest of world
Current Account = trade + services + transfers; Capital Account = investments + loans
BoP Identity: Current Account + Capital Account + Errors & Omissions = 0
Capital Account surplus can offset Current Account deficit
BoP Structure
# Balance of Payments
## **Current Account**
- Merchandise Trade
- Services Trade
- Income Transfers
- Current Transfers
## **Capital Account**
- FDI Flows
- Portfolio Investment
- External Loans
- Banking Capital
## **Reserve Changes**
- RBI Forex Operations
- SDR Allocations
- Gold ReservesIndia's Typical BoP Pattern
Account Component | Usual Sign | Key Drivers | Policy Sensitivity |
|---|---|---|---|
Trade Balance | Deficit (-) | Oil imports, gold demand | High |
Services Balance | Surplus (+) | IT software exports | Medium |
Current Transfers | Surplus (+) | Worker remittances | Low |
FDI | Surplus (+) | Investment climate | Medium |
Portfolio Investment | Volatile | Market sentiment, yields | Very High |
Trap: Capital Account surplus can mask Current Account problems - both matter for sustainability
Trap: Services surplus doesn't automatically offset merchandise deficit - composition matters
Key insight: FDI/FII help finance CAD but don't directly reduce it - this distinction appears in questions