External Sector of India-

Exchange rate-

• The exchange rate refers to the value of one currency in relation to another currency.

Real exchange rate –

• The ratio of foreign to domestic prices, measured in the same currency.

• It is defined as Real exchange rate = e(Pf/ P ).

• where P and Pf are the price levels here and abroad, respectively, and e is the rupee price of foreign exchange (the nominal exchange rate).

• If the real exchange rate is equal to one, currencies are at purchasing power parity.

• This means that goods cost the same in two countries when measured in the same currency.

• If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home.

• The real exchange rate is often taken as a measure of a country’s international competitiveness

Nominal Effective Exchange Rate (NEER)-

• The NEER (Nominal Effective Exchange Rate) of the Indian rupee is calculated based on a weighted average of the exchange rates of currencies used by India's most significant trading partners.

The Real Effective Exchange Rate (REER)-

• The Real Effective Exchange Rate (REER) is calculated as the weighted average of the real exchange rates of all of a country's trade partners.

• The weights used in the calculation are the shares of the respective countries in its foreign trade.

• The NEER (Nominal Effective Exchange Rate) is adjusted by the weight of inflation to get the REER of the rupee.

• In recent months, inflation has been high, which has resulted in the REER of the rupee being more against it than the NEER.

Real exchange rate =

Nominal exchange rate X (Domestic Price Index /Foreign price Index)

Different types of Exchange rates-

1.Flexible Exchange Rates/Floating exchange rate-

• In a system of flexible exchange rates , the exchange rate is determined by the forces of market demand and supply.

• In this case the demand for and supply of currency relative to other currencies determine the exchange rate.

A floating exchange rate has following advantages:

• It provides flexibility to government to follow its own monetary policy.

• There is no need for central banks to have large amount of foreign exchange reserves.

• It leads to automatic adjustments in Balance of payments.

• Threat of Imported inflation is minimized.

Disadvantages of Flexible/floating exchange rates-

• It increase Uncertainty in the financial market.

• Because of uncertainty it hampers the investment in the country.

• It can leads to sudden financial crisis in the country due to financial crisis at international level.

2.Fixed/Pegged exchange rate-

• Wherein the government and central bank attempts to keep the value of the currency is fixed against the value of other currencies, is called fixed exchange rate.

Pegging -

• When a currency is pegged, its value is fixed to that of another currency.

• This means you will always get the same amount of money whenever you exchange the two currencies, because the exchange rate is always the same.

Sometimes, a distinction is made between the fixed and pegged exchange rates.

• It is argued that fixed exchange rates are rigid and unchangeable, whereas pegged exchange rates are maintained by monetary authorities and can be adjusted as needed.

• Specifically, the value at which the exchange rate is pegged, known as the par value, is regarded as a policy variable that can be modified if necessary.

There is a common element between the two systems-

• In a fixed exchange rate system, such as the gold standard, changes to balance of payments surpluses or deficits cannot be made by adjusting the exchange rate.

• In such a system, adjustments must occur either automatically through the workings of the economic system, or by government intervention.

• A pegged exchange rate system can exhibit similar characteristics as long as the exchange rate remains unchanged and is not expected to change.

Advantages of Fixed Exchange Rate-

• A fixed exchange rate system offers advantages such as avoiding currency fluctuations.

• By providing greater stability than a floating rate system, a fixed exchange rate can encourage investment in the country.

• The credibility of the country's monetary policy can also be improved with a fixed exchange rate system.

• Additionally, a fixed exchange rate helps to eliminate exchange rate risks.

Disadvantages of Fixed Exchange Rate-

• It is less flexible in nature.

• Difficulty in keeping the value of the currency.

• It might hinder macroeconomic objectives.

Difference between Fixed and Floating exchange system

Devaluation of currency

• Currency devaluation refers to the decline in the value of a domestic currency under a fixed exchange rate system.

Revaluation

• Revaluation refers to the process of increasing the value of a currency in a fixed exchange rate system.

Depreciation of currency

• It means the decrease in the price of domestic currency under floating exchange rates.

Depreciation of currency

• It means the increasein the price of domestic currency under floating exchange rates

Effects of devaluation or Depreciation-

• Devaluation of a country's currency can make its exports cheaper for foreign buyers.

• Devaluation can also make foreign goods more expensive for domestic consumers, discouraging imports.

• Currency depreciation can lead to inflation, especially in import-dependent countries like India.

• Depreciation may lower investor confidence in the country's economy and hurt its ability to attract foreign investment.

• A country's fiscal health may be impacted by devaluation, with rising export earnings and import payments affecting its current account balance.

• When a country has foreign currency denominated government debts, currency depreciation can lead to an increased interest burden and make it difficult for the government to repay and service foreign debt.

• Remittances from non-resident citizens and businesses abroad can provide a larger amount of domestic currency due to depreciation.

• Depreciation can also result in a higher amount of local currency for a given amount of foreign currency borrowing by the government.

• Currency depreciation may have a positive impact on controlling excessive gold imports, which are often wasteful, and thereby improve the trade balance.

Effects of Appreciation or Revaluation-

It will be opposite of Effects of devaluation or Depreciation like-

• Costlier exports.

• Cheaper import.

• Decrease in Inflation in case of India.

• Enhances investors confidence etc.

3.Managed Floating rate-

• Managed floating rate is a hybrid system of exchange rate management.

• It combines flexible exchange rate system (the float part) and fixed rate system (the managed part).

• Central banks use managed floating to buy and sell foreign currencies to moderate exchange rate movements.

• This system is also known as dirty floating.

• The intervention by central banks is done whenever they feel such actions are necessary.

Advantages of Managed floating system-

• It helps to Reduce the risk of a deflationary recession.

• It increases the impact of Monetary policy of the government.

• It builds confidence in the economy due to certainty.

• It encourages the investment due to certainty in the economy.

Disadvantages of Managed floating system-

• Central bank of the country requires larges reserves to manage it.

• Countries with a managed floating exchange often tend to have weaker financial systems.

• Changing interest rates to influence a currency might conflict against other macroeconomic objective.

Foreign exchange reserves or FOREX Reserves-

• A central bank holds foreign exchange reserves in the form of assets such as foreign currencies, treasury bills, government securities, and bonds.

India’s Forex Reserve include:

A.Foreign Currency Assets/FCA-

• FCA is the largest component of the forex reserve. It is expressed in dollar terms.

• FCAs are assets that are valued based on a currency other than the country's own currency.

B.Special Drawing Rights-

• The Special Drawing Rights (SDR) is an international reserve asset created by the IMF in 1969.

• It was designed to supplement the official reserves of member countries.

• The SDR is not a currency nor a claim on the IMF, but it is a potential claim on the freely usable currencies of IMF members.

• It is possible to exchange SDRs for these currencies.

C.Reserve tranche position with the International Monetary Fund (IMF)-

• A reserve tranche position refers to a share of a member country's required contribution of currency to the International Monetary Fund (IMF), which can be used for the country's own needs.

D.Gold reserves

Regulation of Forex reserves-

The management of foreign exchange reserves is governed by two key acts, namely the RBI Act of 1934 and the Foreign Exchange Management Act of 1999.

Objectives of Holding Forex Reserves-

• To serve as backup funds for the RBI in case of rapid devaluation or insolvency of the rupee.

• To maintain and support confidence in the policies for monetary and exchange rate management.

• To provide the capacity to intervene in support of the national or union currency.

• To limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when borrowing access is curtailed.

• To control the depreciation of the rupee by selling the dollar in the Indian money market.

Exchange rate Management in India-

1.Par Value System (1947-1971)-

• India adopted the par value system of the International Monetary Fund (IMF) soon after achieving independence in 1947. Under this system, the rupee's external par value was set at 4.15 grains of fine gold. This system was in place from 1947 until 1971.

2.Pegged Regime (1971-1992)-

• From 1971 to 1992, India implemented a fixed exchange rate regime known as the "Pegged regime". During this time, the Indian currency was pegged to the US dollar from August 1971 to December 1991 and to the pound sterling from December 1971 to September 1975.

3.The Period Since 1991-

• The time period after 1991 was marked by a significant event where the exchange rate of the Indian rupee was adjusted by 18-19% in two steps, which occurred on July 1 and 3 of that year.

Liberalised Exchange Rate Mechanism System (LERMS)

• The Liberalised Exchange Rate Mechanism System (LERMS) was announced by India in the Union Budget of 1992-93.

• LERMS was operationalised in March 1993 and allowed for the delinking of India's currency from the fixed currency system.

• The move to a floating exchange-rate system was made possible by the implementation of LERMS.

• This marked the first step towards transitioning to a market-determined exchange rate system.

• It allowed exporters to realize 60% of their revenues or earnings at market rates while surrendering the rest at the government rate I.e. 40% .

• The official rate foreign exchange surrendered could be utilized to import crucial commodities such as petroleum, fertilizers, life-saving drugs, and other essential items.

Some of the important terms related to currency-

Hard currency-

• It is the international currency in which the highest faith is shown and is needed by every economy.

Example-

• US Dollar.

Soft currency-

• Soft currency is a term commonly used in the foreign exchange market to refer to a currency that is readily available in the forex market of any given economy.

For example-

• Rupee is a soft currency in the Indian forex market.

Hot currency -

• The term "hot currency" is commonly used in the forex market to refer to any stable and widely accepted currency that is in high demand among traders.

• It is a temporary name given to hard currencies that are considered valuable and easily exchangeable in the global currency exchange market.

Heated currency-

• It is a domestic currency which is under enough pressure (heat) of depreciation due to a hard currency’s high tendency of exiting the economy.

Cheap currency and Dear currency-

• 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 and vice-versa for Dear currency

Foreign Trade of India

Foreign Trade

• All commercial and semi commercial exchange of one country with rest of the world that are giving an opportunity to pay or receive the financial values acceptable in the country with which rest of the world is trading is known as Foreign Trade

Importance of Foreign Trade-

• Greater availability of goods in the country.

• Reduction in costs of production due to cheaper availability of resources from foreign.

• Greater employment opportunities in the country.

• Harmonious relationship between various countries.

• Helps in growth of economy through expansion of industries etc.

Composition of Foreign Trade-

Foreign trade includes Import and Export of goods and services

1.Composition of Exports-

Export from India includes-

Export of goods

Export of services

India's export was largely agro-based during 50's and with time diversification can be seen in it

Export of Goods-

Top Export Items-

• Petroleum products, precious stones, drug formulations & biologicals, gold and other precious metals are the top exported commodities.

• India’s merchandise exports are less than its merchandise imports.

Export of Services-

• The composition of service exports has remained stable over time.

• Software services make up the majority, accounting for 40-45% of exports.

• Business services are the next most significant category.

2.Composition of Imports

It is also divided into 2 parts

Import of goods

Import of services

Import of goods-

Top Import Items-

• Crude petroleum, gold, petroleum products, coal, coke & briquettes constitute top import items.

Import of services

• Business Services, Travel, and Transportation are the three top service imports.

Some of the Facts(till 2022) related to Foreign Trade are as Follows-

India’s top five trading partners continue to be USA, China, UAE, Saudi Arabia and Hong Kong

Most exporting country of India is U.S.A. followed by U.A.E ,China,Hong kong and Singapore etc.

Maximum Import is from China>USA>UAE>Saudi Arabia etc.

Top Export commodities - Petroleum Products >Pearl Precious, Semiprecious Stones >Drug Formulations, Biologicals

Top Import commodities - Petroleum /Crude oil>Gold>Petroleum Products etc.

Challenges in India’s Foreign Trade Promotion-

• High Deficit in Balance of Trade.

• Increase in Volume and Value of trade.

• Change in composition of imports and Exports.

• Lack of Self sufficiency in basic raw material of industries.

• Less focus on secondary and Tertiary sectors  etc.

Regulation of Foreign trade in India-

Previously there was Foreign Exchange Management act 1973 which was replaced by Foreign exchange management act in 1998

Foreign Trade (Development and Regulation) Act, 1992

• It allows central government to make order for the development and regulation of foreign trade. The government may prohibit, restrict or regulate the import and export of goods.

• It allows central government to formulate and announce export and import policy.

• It provides powers for search, seizure penalty and confiscation of goods,documents, etc.

Other Acts includes-

• Export Quality Control and Inspection Act, 1963.

• The Customs act 1962.

Important one liner questions and answers on External sector of India.

What is exchange rate?

It is the value of one currency in relation to another currency.

How is real exchange rate calculated?

It is calculated as the ratio of foreign to domestic prices, measured in the same currency.

What does real exchange rate indicate?

It is often taken as a measure of a country’s international competitiveness.

What is purchasing power parity?

It means that goods cost the same in two countries when measured in the same currency.

How does a rise in real exchange rate affect goods abroad?

It means that goods abroad have become more expensive than goods at home.

What is NEER?

It is the Nominal Effective Exchange Rate of the Indian rupee.

What is REER?

It is the Real Effective Exchange Rate of the Indian rupee.

How is REER calculated?

It is calculated as the weighted average of the real exchange rates of all of a country's trade partners.

 What are flexible exchange rates?

They are determined by the forces of market demand and supply.

What is the advantage of a floating exchange rate?

It provides flexibility to government to follow its own monetary policy.

What is a fixed exchange rate?

It is when the government and central bank attempts to keep the value of the currency fixed against the value of other currencies.

What is pegging?

It means fixing a currency's value to that of another currency.

What is the difference between fixed and pegged exchange rates?

Fixed exchange rates are rigid and unchangeable, whereas pegged exchange rates are maintained by monetary authorities and can be adjusted as needed.

What is the advantage of a fixed exchange rate?

It offers stability and avoids currency fluctuations.

What is the disadvantage of a fixed exchange rate?

It is less flexible in nature.

What is the difference between a fixed and a floating exchange rate system?

A fixed exchange rate is controlled by the government or central bank, whereas a floating exchange rate is controlled by demand and supply forces.

What is devaluation?

It is the decline in the value of a domestic currency under a fixed exchange rate system.

What is revaluation?

It is the process of increasing the value of a currency in a fixed exchange rate system.

What is depreciation?

It means the decrease in the price of domestic currency under floating exchange rates.

How does devaluation affect exports?

It can make exports cheaper for foreign buyers.

How does devaluation affect imports?

It can make foreign goods more expensive for domestic consumers.

What is the risk of devaluation or depreciation?

It may lower investor confidence in the country's economy.

How does depreciation affect inflation?

It may lead to inflation, especially in import-dependent countries like India.