Current account vs capital account in balance of payments

An NRI in Dubai sends fifty thousand rupees to his parents in Kerala every month. The same man opens a fixed deposit with a Mumbai bank for twenty lakh rupees. Both transactions bring foreign currency into India, and both appear in the balance of payments. One belongs to the current account and the other to the capital account.

This is the distinction the paper tests, and it is not about the direction of the money. It is about what the money creates.

The test: does it create a future claim?

Ask one question of any international transaction: does this create an obligation or a claim that extends into the future?

If it does, it belongs in the capital account. An equity stake that can be sold, a loan that must be repaid, a deposit the bank owes back with interest. Something has been acquired or owed, and it will have to be unwound later.

If it does not, the transaction is settled and done. Goods sold, a service delivered, a wage sent home. It belongs in the current account.

That is the whole rule. Everything below is the rule applied.

The current account: transactions that end

The current account has four parts.

Merchandise trade is the export and import of physical goods: refined petroleum going out, crude oil coming in, gold, electronics, textiles.

Services covers IT and software, tourism, transport, insurance and consultancy. An Indian firm billing a German client is a services export. An Indian tourist paying a hotel in Switzerland is a services import.

Investment income is the return on cross-border assets: interest on the RBI's foreign exchange reserves, dividends repatriated by foreign companies, profits from an Indian company's overseas subsidiary. Note that the income is current account even though the asset behind it sits in the capital account.

Transfers are one-way movements with nothing given in return. A worker's remittance to his family, or a foreign government's grant for disaster relief.

What unites them is that the transaction is complete. The good has changed hands, the service has been delivered, the money has moved and will not come back as a claim.

The capital account: transactions that continue

The capital account records the creation or transfer of financial assets and liabilities.

Foreign direct investment is long-term investment with an ownership stake and usually some control: a company building a plant, or acquiring an Indian firm outright.

Foreign portfolio investment is investment in financial assets without control: shares bought on an exchange, government securities bought by a foreign fund. It is easier to reverse than FDI, which is why it is treated as more volatile.

External commercial borrowing is an Indian company taking a loan from a foreign lender, or issuing bonds abroad.

NRI deposits are deposits by non-resident Indians in Indian banks, in NRE, NRO or FCNR accounts.

Every one of these creates a liability that must eventually be serviced or unwound. That is what puts them in the capital account.

Where the trap sits

The remittance and the deposit are the pair to remember, because they involve the same person and the same source of money and land in different accounts.

A remittance is a transfer. Nothing is owed afterwards. Current account.

An NRI deposit is a financial investment. The bank owes principal and interest, and the depositor can withdraw or roll it over. Capital account.

A second pair worth holding: software exports and FDI in a software company. The export is a service delivered and paid for, so it is current account. The investment is an ownership stake, so it is capital account.

Why India runs a deficit, and who pays for it

India typically imports more goods than it exports, led by crude oil, gold and electronics. Software exports and remittances offset a good part of that, but not all of it. The remainder is a current account deficit: the country is spending more foreign currency on current transactions than it earns.

That deficit has to be financed, and it is financed through the capital account. Foreign investors bring dollars as FDI and FPI, NRIs place deposits, Indian firms borrow abroad. The capital account surplus supplies the foreign exchange the current account deficit needs.

The arrangement works while capital keeps arriving. In 2013, when the taper tantrum caused foreign funds to leave quickly, the financing disappeared and the rupee fell sharply. That is what a sudden stop looks like: not a change in trade, but a change in the willingness of foreigners to hold Indian assets.

In 2020-21 the pattern briefly reversed. Oil prices collapsed, travel stopped, and imports fell faster than exports. India recorded a current account surplus for the first time in seventeen years. By the following year, as oil and imports recovered, the deficit returned.

A short drill

The drill is worth doing until the classification is automatic, because the question is usually framed as a list of four items with one odd one out. If you can classify without hesitating, the question takes thirty seconds.

The same logic runs through the external sector questions in the Economy weightage guide. If the vocabulary of deficits is still loose, the fiscal deficit piece covers the domestic counterpart, and the national income chain explains where these flows end up in the aggregates.