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

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.