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

Explanation

Convertibility of a currency means that it can be freely exchanged for other currencies and vice versa with-out restrictions. It essentially means that there are no limitations on the flow of the currency in and out of the coun-try. When a currency is convertible, individuals, businesses, and investors can easily convert it to other currencies to make payments abroad, invest in foreign assets, or engage in other inter-national transactions. Similarly, they can convert foreign currencies back into the domestic currency. India has current account convertibility, meaning that there are generally no restrictions on converting rupees for trade-related purposes. There are some regulations on capital account transactions, although these have been progressively liberalized over time.

Explanation

International liquidity refers to the availability of acceptable means of payment for international transactions. It’s essentially about having enough of the currencies that are widely used and accepted in global trade and finance. Historically, gold played this role, but in the modern era, "hard currencies," particularly the US dollar, have become the primary reserve currencies and mediums of exchange for international transactions. The "problem of international liquidity" arises when there is a shortage of these hard currencies. If countries don’t have enough dollars (or other widely accepted currencies) to pay for their imports, service their debts, or invest abroad, it can disrupt international trade and financial flows.

Explanation

Planned expenditures are defined as the expenditure on the programmes that are mentioned in our country’s current five-year plan. For example, electricity, water, communication, transportation, agriculture and other activities, social services, etc. In simple terms, the Expenditure Report shows the expenditures made by Central Aid for state and federal needs and items under the Central Plan. In the context of the Union Budget of India, Non-Plan Expenditure refers to all expenditures of the government that are not part of the Five-Year Plans. This classification was used prior to 2017, after which the distinction between Plan and Non-Plan Expenditure was removed. Non-Plan Expenditure includes both developmental and non-developmental spending and is of-ten obligatory in nature. The major components of Non-Plan Expenditure are:

1. Defence Expenditure: This includes spending on the armed forces, procurement of defense equipment, and other related activities.

2. Interest Payments: These are payments made by the government to service its debt, both domestic and foreign.

3. Salaries and Pensions: This covers the salaries of government employees and pensions for retired personnel.

4. Subsidies: Financial support provided by the government to various sectors, including food, fertilizers, and petroleum, to keep prices low for consumers.

Explanation

The balance of payment(BoP) is a record of all monetary transactions made between the residents of one country and the rest of the world. A balance of payments deficit means the nation imports more than it exports. The current account and capital account are the two components that constitute the balance of payments.

Option (c) is correct: The Current Account of a country’s Balance of Payments (BoP) records the transactions of goods, services, income, and current transfers between residents and non-residents. It comprises the following components:

Balance of Trade (Goods): This is the difference between the value of a country’s exports and imports of tangible goods. Balance of Invisibles:

Services: Transactions involving services such as tourism, banking, and consulting. Income: Earnings from investments abroad (like interest and dividends) minus payments made to foreign investors. Foreign assets are part of the Financial Account, which records investments in financial instruments and assets between countries. SDRs are international reserve assets created by the Inter-national Monetary Fund (IMF) and are recorded in the Financial Account of the BoP.

Explanation

Statement 1, 2 and 4 are correct: The Capital Account in a country’s Balance of Payments (BoP) records the transactions that involve the transfer of capital assets and liabilities between residents and non-residents. It primarily includes:

Foreign Loans are borrowings from foreign entities by the government, private sector, or other institutions. Foreign Direct Investment (FDI) made by foreign entities in the domestic economy, typically involving a significant degree of control or influence over the business operations. Portfolio Investment in financial assets such as stocks and bonds by foreign investors, without the intention of controlling or managing the enterprise.

Statement 3 is incorrect: Private remittances (money sent by individuals working abroad back to their home country) are considered current transfers and are part of the Current Account, not the Capital Account. They represent a flow of in-come, not a capital investment. Current Account Capital Account Meaning Records imports and exports of visible and invisibles Short term implication transactions Covers only earnings and spending. Excludes any borrowings and lending. Shows capital expenditure and income for country Long term implication transactions Only includes borrowings and lending by a country Components Visible trade (Export and Import of goods - Merchandise transactions) Invisible trade (Export and Import of services) Unilateral transactions Direct Investment (FDI) Portfolio Investment (FPI) Loans / External commercial borrowing (ECB) Non-resident investment in Bank, Insurance, Pension schemes. RBI’s foreign exchange reserve

Explanation

India’s foreign exchange reserves are the external assets maintained by the Reserve Bank of India (RBI) to man-age balance of payments, stabilize the currency, and provide a buffer against economic shocks. The components of foreign exchange reserves include:

Foreign Currency Assets (FCAs): These consist of foreign currencies held by the RBI, mainly in US dollars and other major international currencies (Euro, Pound, and Yen). These are invested in highly liquid assets, such as treasury bills of foreign countries. Gold Reserves: The physical gold held by the RBI as a part of India’s reserve assets. Special Drawing Rights (SDRs): SDRs are an international reserve asset created by the International Monetary Fund (IMF) and allocated to its member countries. SDRs can be exchanged for freely usable currencies to meet external financial needs. Reserve Position in the IMF (RTP): It is India’s quota contributions to the IMF, which can be withdrawn if needed.

Option (a), (c) and (d) are incorrect:

Foreign loans are not included in India’s official forex reserves. Loans from the World Bank are not part of foreign exchange reserves.

Explanation

Foreign Direct Investment (FDI) refers to an investment made by an individual or entity from one country into business interests located in another country, with the intent of establishing a lasting interest. This typically involves acquiring a significant degree of influence or control over the foreign company’s operations. In the context of India, FDI includes:

Subsidiaries of Foreign Companies in India are companies incorporated in India that are wholly or majority-owned by foreign parent companies. Majority Foreign Equity Holding in Indian Companies occurs when foreign investors hold more than 50% equity in an Indian company, granting them significant control over its operations. Companies Exclusively Financed by Foreign Companies are entities in India that receive all their capital from foreign investors or parent companies, leading to substantial foreign control. On the other hand, Portfolio Investment refers to investments in a country’s financial assets, such as stocks and bonds, without the intent of controlling or managing the companies. Such investments are typically short-term and speculative in nature. Therefore, Portfolio Investment is not considered a form of FDI.

Explanation

Statement 1 is incorrect: The World Bank does not determine currency exchange rates; these are influenced by market forces and economic indicators. The World Bank is important to the source of financial and technical assistance to developing countries around the world.

Statement 2 is correct: A major factor influencing a currency’s value is the demand for the goods and services that a country offers. If there’s high global demand for a country’s ex-ports, there will be a higher demand for its currency to purchase those exports. This increased demand will generally push the currency’s value up. On the contrary if demand for a country’s goods and services is low, demand for its currency will be low, putting downward pressure on its value.

Statement 3 is correct: Political stability fosters investor confidence, attracting foreign investment and strengthening the currency. Political instability can lead to capital flight and currency depreciation.

Statement 4 is incorrect: While the economic potential of a country (e.g., growth prospects, productivity, and innovation) can influence long-term currency trends, it is not a direct factor in the day-to-day determination of exchange rates.

Explanation

Exports are goods and services that are produced in one country used by another. In economic terms, when foreign nationals visit a country and spend money on goods and services--such as accommodation, food, transportation, and entertainment--it is considered an export for the host country. This is because the country is providing services to non-residents, resulting in an inflow of foreign currency. Therefore, the expenditures by foreign visitors during events like the XIX Commonwealth Games in India are classified as exports.

Explanation

Statement 1 is correct: Devaluation makes a coun-try’s exports cheaper for foreigners and its imports more expensive. This can lead to an increase in export volumes and a decrease in import volumes, which can improve the balance of trade (the difference between exports and imports of goods). An improved trade balance can help reduce the current account deficit.

Statement 2 is incorrect: Reducing export subsidies can make a country’s exports less competitive internationally, potentially decreasing export volumes and worsening the current account deficit.

Statement 3 is correct: While FDI and FII inflows are recorded in the capital account, they can indirectly affect the current account. Increased FDI can boost domestic production capacity, leading to higher exports. FDI and FII inflows can strengthen the domestic currency, making imports cheaper and potentially widening the CAD.