Ramesh Singh Summary: External Sector in India- 1 | Indian Economy for UPSC CSE PDF Download

Definition of External Sector

• The external sector encompasses all economic activities conducted in foreign currency, such as exports, imports, foreign investments, external debt, and the balance of payments (BOP).

Forex Reserves

• Forex reserves, or foreign exchange reserves, refer to the total foreign currency assets held by an economy. This includes foreign currencies, gold reserves, Special Drawing Rights (SDRs), and Reserve Tranche Position (RTP) in the International Monetary Fund (IMF).
• These reserves serve as a buffer to stabilize currency exchange rates, manage external shocks, and ensure liquidity during times of crisis.
• As of December 2022, India's forex reserves stood at USD 562.7 billion, sufficient to cover 93 months of imports, highlighting their critical role in ensuring economic stability.

India's Forex Management:

• India accumulated significant forex reserves primarily due to a current account surplus driven by low imports and substantial inflows of foreign direct investment (FDI) and foreign portfolio investment (FPI).
• The Reserve Bank of India (RBI) manages these reserves to prevent excessive appreciation of the rupee, support monetary policies, and manage inflation.
• Despite challenges such as global economic uncertainties and fluctuating oil prices, India's strategy includes maintaining a balanced approach to ensure sustainable economic growth.

External Debt

• External debt refers to the total amount of debt owed by a country to foreign creditors.
• As of September 2022, India's external debt totaled USD 610.5 billion, equivalent to 19.2% of its GDP, showing a prudent management approach post-reforms.
• Key ratios such as concessional debt, short-term debt to forex reserves, and debt service ratio (5.0%) indicate manageable levels and sustainable repayment capacity.
• India's external debt management focuses on maintaining favorable debt-to-GDP ratios and ensuring that debt servicing does not strain the economy's financial health.

External Resilience

• Net International Investment Position (NIIP) measures the difference between a country's external financial assets and liabilities.
• India's NIIP improved, reflecting higher financial assets and lower liabilities to non-residents, indicating enhanced financial resilience.
• Indicators like low short-term debt and comfortable forex reserves bolster India's ability to withstand external shocks and manage financial stability effectively.

Fixed Currency Regime

• IMF-regulated system where exchange rates are fixed against a basket of major currencies (e.g., GBP, USD, JPY, DEM, FRF).
• Exchange rates adjusted periodically by IMF.

Floating Currency Regime

• Exchange rates determined by market forces (supply and demand).
• UK adopted floating regime in 1973 due to flexibility and to avoid payment crises.

Managed Exchange Rates

• Hybrid of fixed and floating systems.
• Government intervenes to stabilize exchange rates through buying/selling currencies or monetary policy adjustments.
• Examples: US and EU (floating with occasional intervention), Canada and Japan (managed with frequent intervention), India (dual exchange rate system since 1992-93).

Foreign Exchange Market

• Market for buying and selling currencies.
• Determines exchange rates under floating or managed exchange rate systems.
• Not applicable in fixed currency or hard fixed regimes.

Exchange Rate in India

• Historically linked to GBP until 1948; then fixed to USD at Rs 3.30 in 1948.
• Delinked from GBP in 1975; RBI started adjusting based on a basket of currencies (USD, GBP, DEM, FRF).
• Moved to dual exchange rate system in 1992-93: official rate and market rate.
• RBI intervenes to stabilize rupee due to high market volatility.

• Volatility of Indian Rupee (INR) 2022-23:

  • Significant volatility due to external factors.
  • RBI intervened to stabilize INR against USD, which depreciated consistently.

Exchange Rate Dynamics

• In recent years, the US dollar has consistently appreciated against several major currencies, impacting global exchange rates.
• During 2022-23, the Indian Rupee (INR) appreciated against some currencies: 0.7% against the UK Pound Sterling, 14.5% against the Japanese Yen, and 6.4% against the Euro.
• The US dollar's strength relative to other currencies indicates its dominant position in international finance despite global economic fluctuations.

Major Terms

• Trade Balance: Difference between exports and imports of an economy over a specified period, reflecting economic health.
• Trade Policy: Framework regulating a country's exports and imports, adapting to economic conditions and international trade dynamics.
• Depreciation: Decline in value of a currency relative to others in foreign exchange markets, affecting competitiveness and trade balance.
• Devaluation: Deliberate reduction in the value of a currency by a government to boost exports or correct trade imbalances.
• Revaluation: Opposite of devaluation, increasing currency value to stabilize or appreciate it against others.
• Appreciation: Increase in currency value against others, impacting imports positively but potentially harming exports.
• NEER & REER: Nominal and real effective exchange rates, used to assess currency competitiveness based on trade-weighted averages.
• EFF (Extended Fund Facility): IMF financial assistance providing temporary liquidity support to member countries, conditional on economic reforms.
• Hard Currency: Stable and globally accepted currency, typically used in international trade and finance.
• Hot Currency: Temporary term for a currency experiencing speculative interest or rapid changes in value.
• Heated Currency: Currency under significant market scrutiny or volatility.
• Cheap Currency: Currency with low exchange rate relative to others, potentially boosting exports but increasing import costs.
• Dear Currency: Currency with high value against others, potentially limiting export competitiveness.

LERMS

LERMS stands for Liberalized Exchange Rate Management System. It was introduced in India as part of economic reforms in 1992, marking a significant shift from the previous fixed exchange rate regime. Here are the key points regarding LERMS:

• LERMS was implemented to liberalize India's exchange rate system and align it more closely with market forces.
• The objective was to move away from a rigid fixed exchange rate system towards a more flexible exchange rate regime that reflected market conditions.
• Under LERMS, India adopted a dual exchange rate system.
• There were two rates: the official rate, which was managed by the Reserve Bank of India (RBI) to control essential imports and stabilize external payments, and the market-determined rate, which fluctuated based on supply and demand in the foreign exchange market.

1. Operational Framework: The system allowed for partial convertibility of the rupee on the current account.

   • It aimed to strike a balance between maintaining stability in essential imports and allowing market forces to determine the exchange rate for other transactions.

2. Transition to Liberalization: LERMS served as an interim step towards full convertibility of the rupee.

   • It paved the way for further economic reforms, including the eventual adoption of a unified exchange rate system and greater integration into global financial markets.

3. Impact and Legacy: LERMS facilitated greater flexibility in managing India's external trade and payments.

   • It contributed to stabilizing the economy during the early stages of liberalization and provided a framework for subsequent reforms in exchange rate management

Indian Dual Exchange Rate System:

• India operates a dual exchange rate system where one rate is official and the other is market-driven.
• The market-driven rate reflects real foreign currency demand and supply dynamics, influencing the official rate.
• The Reserve Bank of India (RBI) may intervene in the forex market to stabilize the rupee's exchange rate.

Current Account

• In banking, a current account refers to a business firm's account for daily transactions, with no interest on deposits and cheque-based withdrawals.
• In the external sector, the current account is maintained by the central bank, showing all current transactions like exports, imports, and remittances.
• India had a current account deficit (CAD) of 4.4% of GDP in 2022-23, managed with adequate forex reserves and intervention strategies.

Capital Account

• Every government maintains a capital account, detailing all capital transactions with other economies, including external loans, FDI, and FPI.
• India's capital account has moved towards partial convertibility, with gradual reforms and restrictions based on economic needs.

Balance of Payments (BOP)

• BOP summarizes an economy's transactions with the rest of the world over a year, combining current and capital accounts.
• A positive BOP adds to forex reserves, while a negative one may require drawing from reserves, potentially leading to a BOP crisis.

Convertibility

• India allows full convertibility on the current account since 1994, facilitating unrestricted foreign exchange transactions for current purposes.
• Capital account convertibility (CAC) in India is partial, governed by regulatory frameworks and gradual liberalization based on economic conditions.
• RBI follows recommendations from the Tarapore Committees to manage and gradually enhance capital account convertibility.