External Sector of India: UPSC Previous Year Questions (Indian Economy)

Explanation

The International Bank for Reconstruction and Development (IBRD) is a global development cooperative owned by 189 member countries. As the largest development bank in the world, it supports the World Bank Group’s mission by providing loans, guarantees, risk management products, and advisory services to middle-income and creditworthy low-income countries, as well as by coordinating responses to regional and global challenges.

Statement 1 is correct: The International Bank for Reconstruction and Development (IBRD) provides loans, guarantees, and advisory services to middle-income and creditworthy low-income countries.

Statement 2 is incorrect: The International Bank for Reconstruction and Development (IBRD) is part of the World Bank Group and works in coordination with other institutions (like IDA), governments, and partners; IBRD does not work alone. IBRD works closely with all institutions of the World Bank Group and the public and private sectors in developing countries to reduce poverty and build shared prosperity.

Statement 3 is correct: The IBRD was created in 1944 with the initial mission of financing the reconstruction of European nations after World War II.

Explanation

Rapid Financing Instrument (RFI) and Rapid Credit Facility (RCF) are instruments of the International Monetary Fund (IMF) which provides financial assistance to the countries in need. Rapid Financing Instrument (RFI): The Rapid Financing Instrument (RFI) provides rapid financial assistance, which is available to any IMF member countries facing an urgent balance of payment needs. The RFI was created as part of a broader reform to make the IMF’s financial support more flexible to address the diverse needs of member countries. It is one of the facilities under the General Resources Account (GRA) that provide financial support to countries, including in times of crisis. Rapid Credit Facility (RCF): The Rapid Credit Facility (RCF) provides rapid concessional financial assistance to low-income countries (LICs) facing an urgent Balance of Payments (BoP) need with no ex post conditionality where a full-fledged economic program is neither necessary nor feasible. The RCF was created under the Poverty Reduction and Growth Trust (PRGT) as part of a broader reform to make the Fund’s financial support more flexible and better tailored to the diverse needs of LICs, including in times of crisis.

Explanation

Statement 1 is correct: The Nominal Effective Ex-change Rate (NEER) is an unadjusted weighted average rate at which a country’s currency exchanges for a basket of multiple foreign currencies. An increase in NEER signifies that the domestic currency has strengthened or appreciated relative to the selected basket of foreign currencies. An increase in NEER means that, on average, the rupee has become more valuable relative to those other currencies. It takes more of the foreign currencies to buy one unit of the rupee.

Statement 2 is incorrect: Real Effective Exchange Rate (REER) is a measure of a country’s currency value relative to a basket of other currencies adjusted for inflation differentials. An increase in REER implies that the domestic currency has appreciated in real terms, making exports more expensive and im-ports cheaper. Consequently, a higher REER indicates a loss in trade competitiveness, not an improvement.

Statement 3 is correct: If domestic inflation is higher than inflation in other countries, the REER will appreciate (be-come more expensive) even if the NEER remains constant or depreciates. This divergence occurs because the REER calculation accounts for inflation differentials. The higher domestic inflation makes a country’s goods less competitive, even if nominal exchange rates don’t reflect that.

Explanation

Statement 1 is correct: A tight monetary policy by the US Federal Reserve typically involves increasing interest rates to control inflation. Higher US interest rates can attract investors seeking better returns which can lead to capital outflows from emerging markets as investors move their funds to the US. This phenomenon is known as capital flight.

Statement 2 is correct: Capital flight can lead to the depreciation of the domestic currency as investors sell off local assets. For firms with ECBs(loans in foreign currency) denominated in foreign currencies, a weaker domestic currency means that more local currency is required to service the same amount of foreign debt, effectively increasing the interest cost and principal repayments in domestic currency terms.

Statement 3 is incorrect: Devaluation increases(not decreases) the currency risk associated with ECBs. If a firm has borrowed in a foreign currency and the domestic currency is devalued, the firm will have to pay more in domestic currency terms to repay the loan. This increases the burden of the debt and the currency risk for the borrower.

Explanation

Statement 1 is correct: Devaluation is a decrease in the value of a country’s currency relative to other currencies. It means it takes more of the domestic currency to buy one unit of a foreign currency. For example, if the exchange rate changes from 70 to 80 per dollar, the rupee has been devalued. Devaluation makes a country’s exports cheaper for foreign buyers. This can increase demand for exports, leading to higher export volumes and potentially improving the trade balance (ex-ports minus imports).

Statement 2 is incorrect: Devaluation means a decrease(not increase) in the value of the domestic currency relative to foreign currencies. It takes more of the domestic currency to buy one unit of a foreign currency.

Statement 3 is incorrect: Devaluation can potentially improve the trade balance over time by boosting exports and reducing imports, but it is not guaranteed. The trade balance may deteriorate because import costs rise immediately, while export volumes may take time to increase. This phenomenon is called the J-curve effect. If a country devalues its currency, it still has to pay higher prices for imported oil, machinery, and technology. Over time, as foreign buyers demand more of its cheaper exports, the trade balance may improve.

Explanation

Foreign Direct Investment (FDI) refers to an investment made by an entity (typically a company or individual) from one country into a business or asset in another country, with the intent of establishing a lasting interest and exerting a degree of influence over the enterprise’s management and operations. It’s not just about a financial transaction but more about substantial and enduring involvement. Foreign currency convertible bonds (FCCBs) are debt instruments issued by a company in a foreign currency, which can be converted into equity shares at a future date. Because FCCBs can be converted into equity, and thus represent a potential ownership stake so They are considered a component of FDI. Foreign Institutional Investment (FII) are investments made by foreign institutions in the financial markets of another country. In India, if an FII’s investment exceeds 10% of the post-issue paid-up equity capital of a company, it is reclassified as FD Global Depository Receipts (GDRs) are financial instruments used by companies to raise capital from international markets. They represent shares of a foreign company and are traded on international stock exchanges. Investments through GDRs are treated as FDI since they result in foreign equity participation in the issuing company. Non-Resident External (NRE) Deposits are deposits held by non-resident Indians (NRIs) in Indian banks in Indian rupees. They are primarily a means for NRIs to invest their savings in India. While they represent a flow of foreign funds into India, they are not considered FDI. They are more akin to portfolio investments or remittance as they don’t involve a direct stake in a business or substantial management influence.

Explanation

Statement 1 is correct: India has historically faced a trade deficit in merchandise trade, meaning that the value of merchandise imports exceeds the value of merchandise exports. This is primarily due to India’s reliance on imports of crude oil, gold, electronics, and machinery, which are higher in value compared to its exports of textiles, gems, jewelry, and pharmaceuticals.

Statement 2 is incorrect: India’s imports of iron and steel, chemicals, fertilisers, and machinery have not decreased in recent years. These imports have remained significant due to domestic demand and industrial requirements. For example, India imports a large quantity of fertilisers to meet agricultural needs and machinery for industrial and infrastructure development.

Statement 3 is correct: India has a surplus in services trade, meaning that the value of services exports (e.g., IT services, software, business process outsourcing) exceeds the value of services imports. The services sector is a major contributor to India’s economy and helps offset the trade deficit in merchandise trade.

Statement 4 is correct: India typically has a current account deficit, although the size of the deficit can vary from year to year. The current account includes merchandise trade, services trade, and other flows like remittances and investment income. Even though India has a surplus in services trade, the deficit in merchandise trade generally outweighs it resulting in an overall current account deficit. Table: Trade during December 2024 December 2024 (USD Billion) December 2023 (USD Billion) Merchandise Exports 38.01 38.39 Imports 59.95 57.15 Services* Exports 32.66 31.63 Imports 17.50 15.63 Total Trade (Merchandise + Services)* Exports 70.67 70.02 Imports 77.44 72.78 Trade Balance -6.78 -2.76

Explanation

Statement 1 is correct: As of 2023 the Asian Infrastructure Investment Bank (AIIB) had 105 member’s. As of January 2025 the AIIB boasts 110 approved members worldwide which indicates its extensive global reach.

Statement 2 is incorrect: India is the second-largest shareholder in AIIB and holds 7.5% of the voting shares. The largest shareholder is China with 26.5% of the voting shares.

Statement 3 is incorrect: The AIIB’s membership extends beyond Asia and includes countries from Europe, Africa and the Americas. For instance nations like Canada, Egypt, and France are members and reflects the bank’s global appeal.

Explanation

A currency crisis occurs when a country’s currency faces a sudden and sharp depreciation, often due to speculative attacks or a loss of confidence in the economy. Several factors can contribute to reducing the risk of such a crisis:

Statement 1 is correct: India’s Information Technology (IT) sector is a major exporter of services, earning substantial foreign exchange. These earnings increase the supply of foreign currency in the country, strengthening the Indian rupee and mitigating the risk of a currency crisis.

Statement 2 is incorrect: While government spending is crucial for economic growth, excessive expenditure can lead to higher fiscal deficits. This may result in increased borrowing, potential inflationary pressures, and could negatively affect investor confidence, thereby increasing the risk of a currency crisis.

Statement 3 is correct: Remittances are funds sent by Indians working overseas back to India. These inflows add to the coun-try’s foreign exchange reserves, providing a buffer against currency volatility and reducing the risk of a currency crisis.

Explanation

Statement 1 is incorrect: While the government does hold a portion of India’s external debt, the majority of it is owed by non-governmental entities, primarily corporations. As of end-March 2023, India’s total external debt stood at approximately USD 624.7 billion. Of this, the government’s external debt was about USD 130.8 billion, accounting for roughly 20.9% of the total external debt. The remaining 79.1% is owed by non-governmental entities, including private sector corporations and financial institutions.

Statement 2 is incorrect: While a significant portion of In-dia’s external debt is indeed denominated in US dollars, it’s not all in US dollars. Indian entities also borrow in other currencies, such as Euros, Japanese Yen, and British Pounds, among others. Diversification of currency exposure is a com-mon practice in debt management. India’s external debt is de-nominated in various currencies. As of end-March 2023, 53.1% of the debt was in US dollars, 31.1% in Indian rupees, 5.7% in Japanese yen, 3.5% in Special Drawing Rights (SDRs), 2.9% in euros, and the remaining 3.7% in other currencies.