ESI Answer Bank Part 2: Rupee, Balance of Payments and External Sector (5 Model Answers)

This is Part 2 of our ESI answer bank. The 2026 oil shock and the rupee’s record low make the external sector a very likely topic for 2027. Revise the basics first in our external sector notes.

Q1. Why did the rupee depreciate sharply in 2026? What can RBI do? (180 words)

Answer: The rupee fell nearly 8% against the dollar in the first half of 2026 and touched a record low of about ₹96.9 in May 2026 (as reported).

Causes:

Oil shock: the West Asia conflict pushed Brent crude towards $110; India imports about 85–90% of its crude, so dollar demand rose.
FPI outflows: foreign investors sold over $20 billion of Indian assets in a few months.
Stronger dollar: expectations of US Fed hikes made dollar assets more attractive.
Hedging and front-loaded imports increased dollar demand further.

RBI’s tools:

Selling dollars from forex reserves to smooth volatility (not to fix a level).
Raising the repo rate (October 2026) to support the rupee and control imported inflation.
Curbing speculation and arbitrage trades in currency markets.
Attracting inflows: higher NRI deposit limits or special deposit schemes, if needed.

Conclusion: RBI targets volatility, not a fixed rate. A gradual fall can even help exports, but a disorderly fall raises inflation, so timely intervention matters.

Teacher’s note: Always mention that RBI follows a managed float. It shows conceptual clarity.

Q2. Is India’s current account deficit a cause for concern? (170 words)

Answer: The current account deficit (CAD) shows how much more India spends abroad (imports, income payments) than it earns. In Q1 FY27 (April–June 2026), the CAD was $4.2 billion, or 0.5% of GDP, slightly higher than a year earlier.

Why it is manageable:

It is well below the 2.5–3% of GDP level that experts consider risky (it was about 4.8% in 2012-13).
A strong services surplus ($51.6 billion in the quarter) and remittances ($42.9 billion) cover much of the large goods deficit.
Forex reserves of over $700 billion give a large buffer.

Risks to watch:

A merchandise trade deficit of $86 billion in one quarter, driven by oil and gold.
Volatile FPI flows that finance the CAD can reverse quickly, as seen in 2026.

Way forward: Boost manufacturing exports through PLI and FTAs, reduce oil dependence with renewables and EVs, and attract stable FDI rather than hot money.

Conclusion: The CAD is not alarming today, but its financing quality needs attention.

Q3. How much forex reserve is enough? Discuss the costs and benefits of large reserves. (175 words)

Answer: India’s forex reserves touched a record of about $729 billion in 2026 and were $717 billion at the end of October 2026, covering about 11 months of imports.

Benefits:

Shock absorber during oil shocks and capital outflows, as in 2026.
Confidence for investors and rating agencies; lowers borrowing costs.
Avoids a 1991-type crisis, when reserves covered barely two weeks of imports.

Costs:

Low returns: reserves are invested in safe foreign bonds that earn little.
Sterilisation costs: when RBI buys dollars, it releases rupees; absorbing that extra money (through OMOs or SDF) has a cost.
Opportunity cost: the money could fund infrastructure, though using reserves for this is risky.

Adequacy measures: import cover (at least 3 months), cover of short-term external debt, and the IMF’s ARA metric. India is comfortable on all of them.

Conclusion: For an emerging market with volatile capital flows and high oil imports, India’s large reserves are a sensible insurance, not a waste.

Q4. What is internationalisation of the rupee? Discuss its benefits and challenges. (170 words)

Answer: Internationalisation means using the rupee freely in cross-border trade, investment and reserves, not just within India.

Steps taken:

Special Rupee Vostro Accounts (SRVA) since July 2022 to settle trade in rupees.
Local-currency settlement agreements with the UAE and others.
Linking UPI with payment systems of Singapore, UAE and others.
Allowing rupee loans to non-residents and rupee bonds abroad (masala bonds).

Benefits:

Lower exchange-rate risk and transaction costs for Indian traders.
Less need for dollar reserves.
Greater economic influence, like the yuan’s rise.

Challenges:

Only partial capital account convertibility.
Trade deficits with most partners mean they collect rupees they cannot fully use.
Need for deeper bond and forex markets and stable inflation.

Way forward: Gradual opening of the capital account, deeper markets and wider use of digital rails like UPI can make the rupee a regional currency first, then a global one.

Q5. “Services exports and remittances are India’s twin cushions.” Explain. (165 words)

Answer: India runs a large goods trade deficit, but two strong inflows cushion its external accounts.

1. Services exports: India is the 7th largest exporter of services, earning about $387 billion in FY25 (Economic Survey 2025-26). IT, business services, consulting and Global Capability Centres drive this. Services have a high domestic value-add and employ skilled youth.

2. Remittances: India is the world’s largest recipient of remittances, about $135 billion in FY25 (about 3.5% of GDP). Remittances support household consumption, especially in Keralam, Uttar Pradesh and Bihar, and are stable even in crises.

Together, they offset a large part of the merchandise deficit, keeping the CAD below about 1% of GDP in recent years.

Risks: AI may automate some IT services; Gulf remittances depend on oil-linked economies.

Way forward: Upskill the workforce in AI and high-end services, sign migration and mobility agreements, and cut remittance costs using UPI links.

Practise next

“Discuss the impact of crude oil prices on India’s economy.” (150 words)
“Should India move to full capital account convertibility? Examine.” (150 words)