Previous Year Question

Devaluation officially reduces the value of the domestic currency in terms of foreign currencies.

It may consequently:

• Make the country’s exports cheaper for foreign buyers.

• Make imports more expensive for domestic consumers.

• Increase demand for exports.

• Reduce the volume of imports.

• Reduce the trade deficit and consequently the current account deficit.

This result is not automatic. Demand for exports and imports must be sufficiently price-elastic. This is expressed through the Marshall-Lerner Condition:

∣Export-demand elasticity∣ + ∣Import-demand elasticity∣ > 1

In the short run, devaluation may initially worsen the trade deficit because the import bill rises before trade volumes adjust. Subsequent improvement produces the J-Curve Effect.

Action 1 can, therefore, help reduce the current account deficit.

Action 2: Reduction in export subsidy—Incorrect

Reducing export subsidies may raise exporters’ costs or weaken their international competitiveness, potentially reducing exports.

Current Account Balance ≈ Exports - Imports + Net Invisibles

Other things remaining equal, a fall in exports may increase rather than reduce the current account deficit. Reducing an export subsidy may separately affect the fiscal deficit or WTO compliance, but it is not a direct measure for reducing the CAD.

Action 3: Attracting more FDI and FII—Correct in the intended UPSC sense

FDI and FII/FPI inflows provide foreign currency and help finance a current account deficit. If FDI creates productive capacity, export production, technology and import substitution, it may also reduce the CAD over the medium or long term.

FDI is generally regarded as a more stable source of financing than FII/FPI because portfolio flows may reverse rapidly when market sentiment changes.

Necessary technical clarification

Under strict Balance of Payments accounting, FDI and FII/FPI are financial-account inflows. They do not automatically reduce the numerical size of the current account deficit; they primarily finance it.

For example:

• CAD = US$50 billion

• Net financial inflows = US$50 billion

The CAD remains US$50 billion; the financial inflows have provided its financing. The CAD itself will decline only if FDI eventually raises exports, reduces import dependence or improves net income and transfer receipts.

Current position (2026)

Modern economic analysis distinguishes between reducing a CAD and financing a CAD:

• Changes in exports, imports, services and remittances alter the size of the CAD.

• FDI, FPI, external borrowing and banking capital are financing sources.

• Stable FDI inflows are generally safer for financing a CAD than volatile portfolio flows.