India’s balance of payment account is actually the reflector of India’s position in the global economy. It shows the level of interaction with the rest of the world (how much is India’s export/ import in relation to its GDP), the degree of integration with the global economy etc. The type of goods we export, import and the dollar value of these all will be obtained from the BoP account.
Technically, balance of payments is a systematic account of all economic transactions (exports, investment) between residents of India and residents of the rest of the world in an accounting period.
It shows the trade in goods, services and capital (foreign investment and Indian investment abroad).
Now, most importantly, the balance of payment account is that it shows the amount of foreign currency India is receiving and paying. The difference between the total dollar receipts (through exports of goods, services and foreign capital obtained) and payments (through imports of goods, services and outflow of capital) shows how much net foreign currency India is getting.
Higher the amount of foreign currency receipts compared to payments, it means foreign currency is in adequate quantity and the price of foreign currency may come down in the market. We call this as appreciation (for example, previously you should pay Rs 65 to get $1 and now you have to pay just Rs 50 to get $1).
On the other hand, if India’s payments are higher than receipts of (foreign currencies) it means that we have to find additional dollars to pay our extra payments. Here, the price of foreign currency will go up in the market as its availability is low (Previously Rs 65 to get $1 and now, Rs 70 to get $1). We call this as depreciation of rupee. Depreciation and appreciation are explained from the angle of domestic currency.
So, there is strong relationship between BoP and the exchange rate or the value of rupee. We can summarize the connection between BoP and the value of rupee (or exchange rate) in the following words.
All economic transactions of the country are registered in the balance of payment account. If all these transactions result in higher dollar earnings, the balance of payments may show a surplus mode and there will be appreciation pressure on rupee. Similarly, if the transactions result in net dollar outflows (higher dollar debit than credit), the BoP will come under deficit mode and there will be depreciation pressure on rupee. In this sense, we can say that value of rupee or exchange rate is a reflection of the balance of payment position of India. At the same time, intervention by the RBI can change these exchange rate situations to an extent.