Ramesh Singh : Summary of External Sector in India - Part - 1 - Indian Economy for UPSC CSE

FOREX RESERVES

• The total foreign currencies (of different countries) an economy possesses at a point of time is its 'foreign currency assets/reserves'.
• The Forex Reserves (short for 'foreign exchange reserves') of an economy is its 'foreign currency assets' added with its gold reserves, SDRs (Special Drawing Rights) and Reserve Tranche Position (RTP) in the IMF.
• In a sense, the Forex reserves is the upper limit upto which an economy can manage foreign currency in normal times if need be.

EXTERNAL DEBT
As India started managing its balance of payment in a more prudent way after the reform period, its external debt position has also improved in a big way. As per the standard practice, India's external debt statistics are released with a lag of one quarter. The major details (upto September 2019) released by the RBI on December 31, 2019

• Total external debt was at US$ 557.4 billion (a rise of US$ 47.0 billion). This rise was mainly caused by two reasons—firstly, an increase in commercial borrowings and non-resident Indian (NRI) deposits and secondly, valuation losses resulting from the appreciation of the US dollar against the Indian rupee and major currencies.
• The external debt to GDP ratio stood at 21 per cent (higher than 20.8 per cent of March 2019 (the ratio is based on external debt and GDP valued in rupee terms).
• Debt service ratio at 7.0 per cent (rising from 6.5 per cent). This means that India pays 7.0 per cent of its exports earnings to pay the external debt (inclusive of principal and interest).
• Commercial borrowings (i.e., ECBs) continued to be the largest component of external debt with a share of 39.1 per cent, followed by NRI deposits (24.0 per cent) and short-term trade credit (20.1 per cent).
• US dollar denominated debt continued to be the largest component at 49.5 per cent, followed by the Indian rupee (37.2 per cent), SDR (5.6 per cent), Yen (4.3 per cent) and Euro (3.1 per cent).
• The share of long-term debt in total external debt was 79.6 per cent (falling from 80.7 per cent of March 2019).
• The share of short-term debt (with original maturity of upto one year) in total external debt increased to 20.4 per cent (falling from 19.3 per cent).
• Concessional debt of the total debt was 9 per cent (lower than 9.1 per cent).
• Government debt of the total debt was 21.2 per cent (down from 21.6 per cent).

FIXED CURRENCY REGIME
The fixed currency regime is a method of regulating exchange rates of world currencies brought by the IMF. In this system exchange rate of a particular currency was fixed by the IMF keeping the currency in front of a basket of important world currencies (they were UK£, US$, Japanese ¥ , German Mark DM and the French Franc FFr). Different economies were supposed to maintain that particular exchange rate infuture. Exchange rates of currencies were modified by the IMF from time to time.

FLOATING CURRENCY REGIME

• The floating currency regime is a method of regulating exchange rates of world currencies based on the market mechanism (i.e., demand and supply).
• In the follow up to the fixed currency system of exchange rate determination , it was the UK which blamed the system for its payment crisis of late 1960s.
• Looking at the major loop holes in this system, the UK government decided to switch over to the floating currency regime in 1973 — the same year the IMF allowed an option to its member countries to go for either of the currency systems.
• In the floating exchange rate system, a domestic currency is le t free to float against a number of foreign currencies in its foreign exchange market and determine its own value.

MANAGED EXCHANGE RATES

• A managed-exchange-rate system is a hybrid or mixture of the fixed and flexible exchange rate systems in which the government of the economy attempts to affect the exchange rate directly by buying or selling foreign currencies or indirectly, through monetary policy.
• Today, most of the economies have shifted to this system of exchange rate determination.
• Almost all countries tend to intervene when the markets become disorderly or the fundamentals of economics are challenged by the exchange rate of the time.

FOREIGN EXCHANGE MARKET
The market where different currencies can be bought and sold is called the foreign exchange market. Out of the trades indifferent currencies, the exchange rate of the currency is determined by the economy. This is an institutional framework for the exchange of one national currency for another. This is particularly correct either in the case of a free float exchange (i.e., floating currency) regime or is a managed or hybrid exchange rate system. It is altogether not allowed either in a fixed currency system or a hard fix.

EXCHANGE RATE IN INDIA

• Indian currency, the 'rupee', was historically linked with the British Pound Sterling till 1948 which was fixed as far back as 1928.
• Once the IMF came up, India shifted to the fixed currency system committed to maintain rupee's external value (i.e., exchange rate) in terms of gold or the US ($ D ollar). In 1948, ₹3.30 was fixed equivalent to US $1.
• In September 1975, India delinked rupee from the British Pound and the RBI started determining rupee's exchange rate with respect to the exchange rate movements of the basket of world currencies (£, $, ¥, DM, Fr.). This was an arrangement between the fixed and the floating currency regimes.

TRADE BALANCE
The monetary difference of the total export and import of an economy in one financial year is called trade balance. It might be positive or negative, known to be either favourable or unfavourable, respectively to the economy.

TRADE POLICY
Broadly speaking, the economic policy which regulates the export-import activities of any economy is known as the trade policy. It is also called the foreign trade policy or the Exim Policy. This policy needs regular modifications depending upon the economic policies of the economies of the world or the trading partners.

DEPRECIATION

• This term is used to mean two different things. In foreign exchange market, it is a situation when domestic currency loses its value in front of a foreign currency if it is market-driven.
• It means depreciation in a currency can only take place if the economy follows the floating exchange rate system.
• In domestic economy, depreciation means an asset losing its value due to either its use, wear and tear or due to other economic reasons.

DEVALUATION
In the foreign exchange market when exchange rate of a domestic currency is cut down by its government against any foreign currency, it is called devaluation. It means official depreciation is devaluation.

REVALUATION
A term used in foreign exchange market which means a government increasing the exchange rate of its currency against any foreign currency. It is official appreciation.

APPRECIATION

• In foreign exchange market, if a free floating domestic currency increases its value against the value of a foreign currency, it is appreciation.
• In domestic economy, if a fixed asset has seen increase in its value it is also known as appreciation.
• Appreciation rates for different assets are not fixed by any government as they depend upon many factors which are unseen.

CURRENT ACCOUNT
It has two meanings — one is related to the banking sector and the other to the external sector :

• In the banking industry, a business firms bank account is known as current account. The account is in the name of a firm run by authorised person or persons in which no interest is paid by the bank on the deposits. Every withdrawal from the account takes place by cheques with limitations on the number of deposits and withdrawals in a single day. The overdraft facility or the cash-cum-credit (c / c Account) facility to business firms is offered by the banks on this account only.
• In the external sector, it refers to the account maintained by every government of the world in which every kind of current transactions is shown — basically this account is maintained by the central banking body of the economy on behalf of the government. Current transactions of an economy in foreign currency all over the world are — export, import, interest payments, private remittances and transfers.

CAPITAL ACCOUNT

• Every government of the world maintains a capital account, which shows the capital kind of transactions of the economy with outside economies.
• Every transaction in foreign currency (inflow or outflow) considered as capital is shown in this account— external lending and borrowing, foreign currency deposits of banks, external bonds issued by the Government of India, FDI, PIS and security market investment of the QFIs.

BALANCE OF PAYMENT (BOP)

• The outcome of the total transactions of an economy with the outside world in one year is known as the balance of payment (BoP) of the economy. Basically, it is the net outcome of the current and capital accounts of an economy.
• It might be favourable or unfavourable for the economy. However, negativity of the BoP does not mean it is unfavourable.
• A negative BoP is unfavourable for an economy if only the economy lacks the means to fill the gap of negativity.
• The BoP of an economy is calculated on the principles of accountancy (double-entry book keeping) and looks like the balance sheet of a company— every entry show neither as credit (inflow) or debit (outflow).

CONVERTIBILITY

• Convertibility in India : India's foreign exchange earning capacity was always poor and hence it had all possible provisions to check the foreign exchange outflow, be it for current purposes or capital purposes. But the process of economic reforms has changed the situation to unidentifiable levels.
• Current Account : Current account is today fully convertible (operationalised on 19 August, 1994). It means that the full amount of the foreign exchange required by someone for current purposes will be made available to him at official exchange rate and there could be an unproh ibited outflow of foreign exchange. India was obliged to do so as per Article VIII of the IMF which prohibits any exchange restrictions on current international transactions.
• Capital Account : After the recommendations of the S.S.Tarapore Committee (1997) on Capital Account Convertibility, India has been moving in the direction of allowing full convertibility in this account, but with required precautions. India is still a country of partial convertibility in the capital account, but inside this overall policy, enough reforms have been made and to certain levels of foreign exchange requirements.

LERMS

• India announced the Liberalised Exchange Rate Mechanism System (LERMS) in the Union Budget 1992-93 and in March 1993 it was operationalised.
• India delinked its currency from the fixed currency system and moved into the era of floating exchange-rate system under it.
• Indian form of exchange rate is known as the 'dual exchange rate', one exchange rate of rupee is official and the other is market-driven.
• The market-driven exchange rate shows the actual tendencies of the foreign currency demand and supply in the economy vis-a-vis the domestic currency.

NEER
The Nominal Effective Exchange Rate (NEER) of the rupee is a weighted average of exchange rates before the currencies of India's major trading partners.

REER
When the weight of inflation is adjusted with the NEER, we get the Real Effective Exchange Rate (REER) of the rupee. Since inflation has been on the higher side in recent months, the REER of the rupee has been more against it than the NEER.

EFF
The Extended fund Facility (EFF) is a service provided by the IMF to its member countries which authorises them to raise any amount of foreign exchange from it to fulfil their BoP crisis, but on the conditions of structural reforms in the economy put by the body. It is the first agreement of its kind. India had signed this agreement with the IMF in the financial year 1981-82.

IMF CONDITIONS ON INDIA

• The BoP crisis of the early 1990s made India borrow from the IMF which came on some conditions.
• But by the end of 1999-2000, when India saw the multiple benefits accruing out of the ongoing reforms there was no ideological opposition to the idea.
• It should always be kept in mind that the nature of structural reforms India went through were guided and decided by these pre-conditions of the IMF. This is how the direction of structural reforms of an economy are regulated by the IMF in the process of strengthening the BoP position of the crisis- driven economy.
• The purpose has been served in the Indian case.

HARD CURRENCY
It is the international currency in which the highest faith is shown and is needed by every economy. The strongest currency of the world is one which has a high level of liquidity. Basically, the economy with the highest as well as highly diversified exports that are compulsive imports for other countries (as of high-level technology, defence products, life saving medicines and petroleum products) will also create high demand for its currency in the world and become the hard currency. It is always scarce.

SOFT CURRENCY
A term used in the foreign exchange market which denotes the currency that is easily available in any economy in its forex market. For example, rupee is a soft currency in the Indian forex market. It is basically the opposite term for the hard currency.

HOT CURRENCY
Hot currency is a term of the forex market and is a temporary name for any hard currency. Due to certain reasons, if a hard currency is exiting an economy at a fast pace for the time, the hard currency is known to be hot. As in the case of the SE Asian crisis, the US dollar had become hot.

HEATED CURRENCY
A term used in the forex market to denote the domestic currency which is under enough pressure (heat) of depreciation due to a hard currency's high tendency of exiting the economy (since it has become hot). It is also known as currency under heat or under hammering.

CHEAP CURRENCY
A term first used by the economist J.M. Keynes (1930s). If a government starts re-purchasing its bonds before their maturities (at full-maturity prices) the money which flows into the economy is known as the cheap currency, also called cheap money.

DEAR CURRENCY
This term was popularised by economists in early 1930s to show the opposite of the cheap currency, when a government issues bonds, the money which flows from the public to the government or the money in the economy in general is called dear currency, also called as dear money.

SPECIAL ECONOMIC ZONE

• The special economic zone (SEZ) policy was announced by the government in 2000 which was concretised through the SEZ Act, 2005. It mainly aims to develop 'export hubs' in the country to promote growth and development.
• As an idea it was not new — India had set up Asia's first 'export processing zone' (EPZ) in Kandla in 1965 itself. Later on the idea got another encouragement through the ‘export oriented units' (EOUs). After the SEZ policy was formalised through an Act, the EOUs and EPZs are open to conversion to SEZ.
• By March 2020, the Government had approved 432 proposals for setting up SEZs (in addition to 7 SEZs of the Gol and 11 of States/private sector which were set- up prior to the enactment of the SEZs Act, 2005 ) — out of which 231 SEZs are operational. Today, the SEZs are invested with ₹ 4.80 lakh crore and have created 17.11 lakh employment. They have 21 per cent share in India's total exports.