External Sector: Balance of Payments, Forex Reserves

The external sector of the economy deals with India's economic relations with the rest of the world: trade in goods and services, the flow of capital, the value of the rupee, foreign exchange reserves and international institutions like the IMF and the WTO. This chapter is very important for the UPSC, because the questions in the Prelims are conceptual (what is included in the current account, what is the SDR) and the Mains asks about the current account deficit, the exchange rate and trade agreements. This note explains the topic in simple language and links it with the news.

Balance of Payments (BoP)

The Balance of Payments is a systematic record of all the economic transactions between the residents of a country and the rest of the world in a given period, normally a year. It has two main accounts: the current account and the capital account. In accounting terms, the BoP always balances, but its components can show a surplus or a deficit.

India usually has a merchandise trade deficit, because imports of oil, gold and electronics are greater than the exports of goods, but a strong surplus in services, led by information technology, and large remittances, as India is one of the largest receivers of remittances in the world. These two items reduce the overall current account deficit (CAD), which is stated as a percentage of the GDP. A high and long-lasting CAD is risky, as it must be financed by foreign capital that can leave suddenly.

Trade Terms You Must Know

• Balance of trade: The difference between the value of exports and imports of goods only.
• Trade deficit: When imports are greater than exports.
• Terms of trade: The ratio of export prices to import prices.
• Tariff and non-tariff barriers: Customs duty, quotas and technical standards that limit imports.
• Protectionism vs free trade: Protecting domestic industry through barriers, or allowing open trade.

Exchange Rate: Basic Ideas

The exchange rate is the price of one currency in terms of another. If the value of the rupee falls against the dollar in a market-determined system, it is called depreciation; if the government lowers the value in a fixed system, it is devaluation. The opposite terms are appreciation and revaluation. A weaker rupee makes exports cheaper and imports costlier, which helps exporters but raises the import bill and inflation. A stronger rupee has the reverse effect. The Real Effective Exchange Rate (REER) is the weighted average of the rupee against a basket of currencies, adjusted for inflation, and it shows the true competitiveness of the economy.

Evolution of India's Exchange Rate System

The rupee is still only partially convertible on the capital account. The Tarapore Committee gave a roadmap for full capital account convertibility, but the government has moved slowly, to protect the economy from sudden capital flows.

Foreign Exchange Reserves

Forex reserves are held by the RBI and have four parts: foreign currency assets (the largest part), gold, Special Drawing Rights (SDRs) and the reserve tranche position with the IMF. The reserves work as a cushion against external shocks, support the confidence of investors, and help the RBI to manage the rupee. India's reserves have been above 600 billion US dollars in recent years, which is among the largest in the world. The SDR is an international reserve asset created by the IMF, and its value is based on a basket of five currencies: the US dollar, the euro, the Chinese yuan, the Japanese yen and the British pound.

Foreign Investment: FDI vs FPI

The law governing foreign exchange is the Foreign Exchange Management Act (FEMA), 1999, which replaced the strict Foreign Exchange Regulation Act (FERA) of 1973 and treats foreign exchange as a matter of management and not of control. The Enforcement Directorate investigates violations of FEMA, and the RBI makes the rules. Other forms of capital inflow are external commercial borrowings (ECB) and the deposits of Non-Resident Indians (FCNR(B), NRE and NRO accounts).

International Institutions and Trade Policy

• IMF: Created after the Bretton Woods conference of 1944; located in Washington DC; gives short-term help to countries with BoP problems.
• World Bank: Gives long-term loans for development projects and poverty reduction.
• WTO: Started in 1995 as the successor of GATT (1948), headquartered at Geneva; it makes the rules of global trade and settles disputes. Its main agreements are on agriculture, TRIPS (intellectual property), TRIMs (investment measures) and GATS (services).
• India's concerns in the WTO: Subsidies and public stockholding for food security, protection of small farmers, and the demand for fair rules from the developed countries.

India's current policy aims at higher exports through the Foreign Trade Policy 2023, Special Economic Zones, schemes like production-linked incentives, and the Free Trade Agreements with countries like the UAE and Australia, which came into force in 2022. India has also allowed trade settlement in rupees through special vostro accounts, to reduce dependence on the dollar. You can connect this with the GDP and national income notes and the inflation notes.

The 1991 Crisis in Brief

In 1991, India faced a severe balance of payments crisis. The foreign exchange reserves fell so low that they could pay for only about two weeks of imports. The main causes were large fiscal deficits, rising oil prices after the Gulf War, a fall in remittances and a loss of confidence of foreign lenders. India took an emergency loan from the IMF, pledged gold to raise foreign currency, devalued the rupee in two steps in July 1991, and began the reforms of liberalisation, privatisation and globalisation. Import licensing was reduced, tariffs were cut, and foreign investment was invited. These reforms opened the economy and increased trade, and they are the base of India's present external sector policy.

Mains Angle: Rupee Depreciation - Causes, Effects and Measures

A frequent Mains question asks why the rupee falls and what can be done. Causes: a widening current account deficit because of costly oil imports, outflow of foreign portfolio investment when interest rates rise in the USA, a strong dollar, global uncertainty and inflation differences. Effects: imports, especially oil, become costlier and push inflation up; companies with foreign debt face a higher burden; exporters gain in competitiveness, though they also import inputs; and students and travellers abroad pay more. Measures: the RBI can sell dollars from its reserves, raise interest rates, attract NRI deposits and ease the rules for external borrowing; the government can promote exports, reduce the import dependence on oil and gold by developing renewable energy, and encourage manufacturing under Make in India. A balanced answer will also mention that a moderate depreciation is not always bad, and the real concern is volatility.

Practice Questions

• Q1. Which item of the current account shows remittances? Answer: Secondary income (transfers).
• Q2. Which Act replaced FERA? Answer: FEMA, 1999.
• Q3. Which component forms the largest part of the forex reserves? Answer: Foreign currency assets.
• Q4. Where is the headquarters of the WTO? Answer: Geneva.

Quick Revision

• BoP = current account + capital account; the CAD is shown as a percentage of the GDP.
• India: goods trade deficit, services surplus, large remittances.
• 1991 crisis, LERMS 1992, market-determined rate 1993, current account convertibility 1994.
• Reserves: foreign currency assets, gold, SDR, reserve tranche.
• FEMA 1999 replaced FERA 1973; WTO started in 1995 at Geneva.

Frequently Asked Questions (FAQ)

What is the Balance of Payments?

It is a record of all the economic transactions between a country's residents and the rest of the world in a year.

What are the two main accounts of the BoP?

The two main accounts are the current account and the capital account.

What is the current account deficit?

It is the excess of payments over receipts in the current account, usually shown as a percentage of GDP.

What is the difference between depreciation and devaluation?

Depreciation is a fall in the value of a currency in a market-determined system, while devaluation is a deliberate lowering by the government in a fixed system.

What is the REER?

The Real Effective Exchange Rate is the inflation-adjusted weighted average of a currency against a basket of currencies.

What are the components of India's forex reserves?

They are foreign currency assets, gold, Special Drawing Rights and the reserve tranche position with the IMF.

What is an SDR?

The Special Drawing Right is an international reserve asset created by the IMF, valued on a basket of five currencies.

What is the difference between FDI and FPI?

FDI is long-term investment with control, while FPI is short-term investment in financial assets without control.

Which Act governs foreign exchange in India?

The Foreign Exchange Management Act, 1999 (FEMA) governs it, and it replaced FERA 1973.

When did India make the rupee convertible on the current account?

The rupee was made convertible on the current account in August 1994.

When was the WTO established?

The WTO was established in 1995 and is headquartered at Geneva.

Why is the 1991 balance of payments crisis important?

It led to the economic reforms of 1991, including devaluation, liberalisation and the move towards a market-determined exchange rate.