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Deciphering the Economics

Important Questions of Balance of Payments and Foreign Exchange Rate

Balance of Payments and Foreign Exchange Rate Most Important Questions

Balance of Payments and Foreign Exchange Rate

  1. Is the rising reserve of India’s forex reserve a sign of rising production activities?

Ans. No,

In the context of India, the increase in forex reserves does not necessarily indicate a direct rise in production activities. Forex reserves, comprising foreign currencies, gold, and SDRs, serve as a cushion to manage external payment obligations and stabilize the exchange rate.

One of the ways India accumulates forex reserves is through borrowings. When the government or corporations borrow funds from abroad, it leads to an increase in foreign debt and, consequently, the country’s forex reserves.

Additionally, forex reserves can increase due to inflows from non-resident deposits and investments. These inflows, however, may not directly correlate with an increase in production activities but rather reflect the attractiveness of the Indian economy to foreign investors.

Therefore, while rising forex reserves are a positive indicator for the economy, they do not always imply a direct increase in production activities.

2. INR is been depreciating in recent times. What effects it will have on the Current A/c?

Ans. As a result of the depreciation of the rupee, foreign goods become expensive while domestic goods become cheaper. This should lead to a rise in exports and a fall in imports. Accordingly, CAD should improve. But, if we are importing certain essential goods or services like Crude oil, weapons, etc. the imports of which cannot be cut our import bill may increase with the increase in exchange rate. Accordingly, CAD may not improve, even if it may deteriorate further.

3. Will you always appreciate a rise in exchange rate (depreciation of domestic currency) as it increases our exports?

Ans. A rise in the exchange rate can potentially increase exports, but it is not always beneficial for the economy. While a higher exchange rate makes exports cheaper for foreign buyers, stimulating demand for domestic goods and services, there are several factors to consider:

1. Price Elasticity of Demand: The responsiveness of foreign buyers to price changes (elasticity) affects the impact of an exchange rate increase on exports. In some cases, even with a higher exchange rate, demand for exports may not increase significantly if the goods are considered price inelastic.

2. Competitiveness: Exchange rate changes also affect the competitiveness of domestic products relative to foreign alternatives. If other countries’ currencies depreciate more than the domestic currency, their goods become relatively cheaper, potentially offsetting the advantage of a higher exchange rate.

4. Is Improvement in the exchange rate of the country’s currency always beneficial for BOP?

Ans. Improvement in the exchange rate (appreciation of currency) of a country’s currency implies that fewer rupees are to be paid for a dollar than before. It signifies to the relative strength of the Indian rupee in the international market. However, for a developing country like India, it is not always beneficial. Due to the following reasons:

Exports: It would mean that 1 USD can now buy fewer Indian goods for a dollar than before which might cause a cut in US demand for the Indian goods, leading to a fall in exports of the country.

BoP deficit: As exports might fall due to appreciation of domestic currency BoP deficit might also surge.

5. Current A/c Deficit can be managed through import substitution? True or False. Give valid reasons.

Ans. True. Import substitution can be used as a strategy to manage a Current Account deficit. By replacing imported goods and services with domestically produced alternatives, a country can reduce its reliance on imports, which can help improve the trade balance and reduce the Current Account deficit.

For example, if a country is importing a significant amount of electronic goods, it can promote the domestic production of electronics to substitute for these imports. This can lead to a reduction in the trade deficit related to electronic goods and contribute to an overall improvement in the Current Account balance.

However, it is important to note that import substitution alone may not be sufficient to eliminate a Current Account deficit. Other factors such as export promotion, attracting foreign direct investment, and improving overall economic competitiveness are also important in managing a Current Account deficit effectively.

6. Do you think the surplus in Capital A/c in BOP reflects the prosperity of the nation?

Ans. A surplus in the Balance of Payments (BOP) Capital Account does not always indicate a country’s prosperity. It is not a direct indicator of general prosperity, but it can signal investor confidence and draw foreign investment, both of which can support economic growth.
For instance, speculative investments or transient capital inflows may result in a country’s Capital Account Surplus, even though these actions might not promote long-term, sustainable economic growth. Furthermore, borrowings from a surplus in the Capital Account could raise the nation’s external debt and jeopardize its financial stability.
Consequently, to evaluate the overall prosperity of a country, a surplus in the capital account should be weighed alongside other economic indicators, even though it can be a favorable indicator.

7. How is the cancellation of coal block allocation by the Supreme Court of India likely to affect our Current A/c deficit?

Ans. India’s current account deficit is expected to rise as a result of the Supreme Court of India canceling coal block allocation. This is due to the possibility that it may result in increased coal imports while domestic supply could decline. Furthermore, industries that use coal as a raw material could have to pay more, which would hurt their ability to compete on the world market and possibly reduce export revenue. All in all, these elements may have a detrimental effect on India’s current account balance.

8. A country with a trade deficit can have a Current A/c surplus in its balance of payments. Do you agree?

Ans. Yes, a country with a trade deficit can have a Current Account surplus in its balance of payments. The Current Account includes not only the trade balance (exports minus imports) but also services trade, remittances, and investment income.

For example, a country may have a trade deficit due to high import costs for essential goods like oil or machinery. However, it could have a surplus in the services trade, such as earnings from tourism, software exports, or financial services. Additionally, remittances from citizens working abroad can contribute to a surplus in the Current Account.

Therefore, while a trade deficit is typically associated with a Current Account deficit, a country can have a Current Account surplus due to other components of the Current Account.

9. The government takes measures to restrict the autonomous import of gold. How it will affect the foreign exchange rate?

Ans. The foreign exchange rate can be impacted by government restrictions on the autonomous import of gold in several ways.
1. Effect on Demand for Foreign Currency: Foreign currency is frequently used to import gold. Import restrictions on gold have the potential to reduce demand for foreign exchange by lowering the need for foreign money. The foreign currency rate may experience downward pressure as a result.
2. Effect on Current Account Balance: A substantial portion of a nation’s imports consist of gold. Import taxes may go down overall if gold imports are restricted, which would help the current account and trade balances. A current account deficit has the potential to strengthen the home currency and increase the value of the foreign exchange rate.

3. Effect on Inflation: Since gold is frequently viewed as a store of value and can alter the money supply, imports may affect inflation. The government can manage inflation by imposing import restrictions on gold, which may have a knock-on effect on the foreign exchange rate.
All things considered, limiting the independent import of gold may lower the demand for foreign money, enhance the current account balance, and have an effect on inflation—all of which may have an impact on the foreign exchange rate.

10. A deficit in the balance of payments occurs either due to autonomous or accommodating transactions. Defend or refute.

Ans. Refute

Accommodating transactions are less common than autonomous transactions in terms of contributing to a balance of payments (BOP) deficit. Transactions that are motivated by economic activity and market factors, like trade in products and services, investment income, and remittances, are referred to as autonomous transactions.
On the other side, accommodating transactions are steps that the central bank or government takes to correct imbalances in the BOP. These measures consist of taking out loans from overseas lenders, making exchange rate adjustments, or using reserves to make up for shortfalls.
Although accommodating transactions are not the main reason for the deficit, they can help manage one in the BOP. Rather, the primary reason for deficits in the BOP is a difference between the nation’s autonomous transaction revenues and its payments for autonomous.

11. The market price of the US dollar has increased considerably leading to a rise in the rupee value of imports of essential goods. What can the RBI do to correct the situation?

Ans. The Reserve Bank of India (RBI) can take several measures to correct the situation of a considerable increase in the market price of the US dollar leading to a rise in the rupee value of imports of essential goods. It can intervene in the foreign exchange market by selling US dollars and buying Indian rupees to reduce the value of the rupee relative to the US dollar, making imports cheaper. The RBI can also adjust interest rates, conduct open market operations, impose capital controls, and use its foreign exchange reserves to stabilize the rupee and mitigate the impact on the economy.

12. Distinguish between devaluation and depreciation of domestic currency.

Ans. Devaluation and depreciation are both terms used to describe a decrease in the value of a domestic currency relative to other currencies, but they differ in their causes and implications.

Devaluation is a deliberate decision by the government or central bank to reduce the official value of the domestic currency in terms of other currencies. This is typically done through official channels, such as adjusting the exchange rate or fixing a new lower exchange rate. Devaluation is often used as a policy tool to improve the competitiveness of exports and correct trade imbalances. For example, if the Indian government decides to devalue the Indian Rupee from 1 USD = 70 INR to 1 USD = 75 INR, it is a deliberate devaluation.

Depreciation, on the other hand, is a market-driven decrease in the value of the domestic currency relative to other currencies. Depreciation occurs due to various factors such as changes in supply and demand for the currency in the foreign exchange market, economic indicators, and market speculation. Depreciation can be gradual or sudden and is influenced by factors beyond the control of the government or central bank. For example, if the Indian Rupee depreciates from 1 USD = 70 INR to 1 USD = 75 INR due to market forces, it is a depreciation.

In summary, devaluation is a deliberate policy action taken by the government or central bank to reduce the value of the domestic currency, while depreciation is a market-driven decrease in the value of the domestic currency.

13. Comment on the statement that an increase in interest rate in the domestic economy leads to an appreciation of domestic currency.

Ans. The statement is true.

If the domestic interest rate rises and is higher than the interest rate in the rest of the world, the foreigners will be induced to shift their funds to the domestic economy. A greater flow of foreign funds will raise the demand for Indian currency. Implying a rise in demand for the Indian currency, leading to the appreciation of the foreign currency.

14. How does the balance of payments reflect the supply, and demand status of foreign exchange for a country?

Ans.  When there is a surplus in BoP, there are more exports than imports, leading to an increase in the supply of forex while a decrease in demand. As a result, the nation’s foreign exchange reserves may rise as it accumulates more foreign currency than it uses. High levels of foreign investment inflows or robust export performance are frequently linked to a surplus BOP.

A BOP deficit occurs when there is a greater import than exports, leading to a decrease in the supply of forex and an increase in its demand. As a result, the nation may have to sell foreign currency to pay its debts, which might reduce its foreign exchange reserves. The cause of a deficit BOP could be either high import levels or low export competitiveness.

15. Balance of payments always balances. Does it mean a situation of zero net financial obligation for a country?

Ans. Yes, the statement “Balance of payments always balances” means that the sum of all transactions in the balance of payments is zero. However, this does not necessarily mean that a country has zero net financial obligations.

The balance of payments is divided into the Current Account, Capital Account, and Financial Account. While the Current Account records transactions related to trade in goods and services, the Capital Account records transfers of capital assets and the Financial Account records transactions involving financial assets and liabilities.

A country can have a balanced balance of payments (where the sum of all transactions is zero) even if it has net financial obligations. For example, a country may have a surplus in its Current Account (exporting more than importing) but a deficit in its Financial Account (borrowing more than lending). In this case, the surplus in the Current Account would offset the deficit in the Financial Account, resulting in a balanced balance of payments.

Therefore, while a balanced balance of payments implies that a country’s transactions with the rest of the world are in equilibrium, it does not necessarily mean that the country has zero net financial obligations.

16. How are NRI deposits significant for developing countries?

Ans. NRI deposits in developing countries like India are reflected as capital receipts in the BoP accounts. These add to the supply of foreign exchange for the Indian economy. This foreign exchange can be used to offset the current account deficit which usually remains high. In the event of low NRI deposits, these countries have to depend on commercial borrowings from the rest of the world which leads to the high burden of interest payments.

Also, a constant supply of foreign exchange (by way of NRI deposits) keeps the exchange rate under check. This facilitates the import of essential goods like crude oil.

17. What is meant by ‘official reserve transactions? Discuss their importance in the balance of payments.

Ans. Official reserve transactions refer to the buying and selling of foreign exchange by the central bank of a country to influence the exchange rate and manage the balance of payments (BoP). In the case of India, the Reserve Bank of India (RBI) conducts official reserve transactions to maintain stability in the foreign exchange market and manage the country’s external accounts.

The importance of official reserve transactions lies in their role in maintaining external stability and safeguarding the country’s foreign exchange reserves. Here’s how they are used in the context of the BoP:

1. Exchange Rate Management: Official reserve transactions are used to stabilize the exchange rate of the domestic currency. If the value of the rupee is depreciating, the RBI can sell foreign exchange reserves to buy rupees, increasing the demand for rupees and stabilizing its value. Conversely, if the rupee is appreciating, the RBI can buy foreign exchange reserves to increase the supply of rupees and prevent excessive appreciation.

2. BoP Management: Official reserve transactions are also used to manage the overall balance of payments. For example, if India is experiencing a deficit in the Current Account, the RBI can use its foreign exchange reserves to finance the deficit and prevent a rapid depletion of reserves. This helps maintain confidence in the economy and avoids disruptive exchange rate movements.

3. External Debt Servicing: Official reserve transactions are important for servicing external debt obligations. India holds a significant amount of foreign currency-denominated debt, and the RBI uses its foreign exchange reserves to meet these obligations. By managing its reserves effectively, India can ensure timely debt repayments and maintain its creditworthiness in the international market.

Overall, official reserve transactions play a crucial role in managing the exchange rate, ensuring external stability, and meeting external obligations. In the case of India, the RBI’s management of official reserve transactions is essential for maintaining stability in the foreign exchange market and supporting the country’s external sector.

18. What are NRI deposits and NRI remittances? What is the difference between the two?

Ans. NRI deposits are foreign currency deposits made in an Indian bank by a non-resident Indian. These deposits can be repatriated by the NRI on maturity along with the interest earned. There are different kinds of schemes offered to NRIs like FCNR (B) or foreign currency non-resident (banks) and non-resident external (rupee accounts or NRE (RA). The flows from such deposits predominantly come from the Middle-Eastern Asian countries, where working Indians typically use the money return to home.

On the other hand, remittances are foreign currency funds sent by NRIs to their folks in India. These funds are essentially in the name of relatives, mostly immediate family. These are meant for their maintenance and upkeep and hence, cannot be repatriated. Such funds come mainly from North America and Europe, besides the Gulf countries.

Difference

While NRI deposits can be repatriated on maturity or rolled over, they are essentially investments. From the balance of payments -the country’s external sector balance sheet -perspective, NRI deposits are capital flows and hence, vulnerable to outflows. They have been an important source of foreign exchange in times of crisis.

19. “Foreign Institutional Investors (FIIs) remained net sellers in the Indian capital markets over the last few weeks.”

State and discuss the likely effects of the given statement on foreign exchange rates concerning the Indian Economy.

Ans. Selling securities by Foreign Institutional Investors in the Indian market will lead to a fall in the supply of foreign currency in the economy. This situation might lead to excess demand for foreign currency at the prevailing foreign exchange rate.

As a result, a new equilibrium rate of foreign exchange will be determined which will be higher than the prevailing foreign exchange rate, leading to depreciation of domestic currency.

20. Define “Trade Surplus”. How is it different from “Current Account Surplus”?

Ans. Trade surplus refers to an excess value of export of visible (goods) over the value of import of visible (goods) in the balance of payments of a country.

Trade Surplus: Export of goods > Import of goods

The current account includes receipts and payments of foreign exchange on account of all items of exports and imports (visible as well as Invisibles). A current account surplus occurs when the foreign exchange receipts are more than the foreign exchange payments relating to visible as well as invisible items of trade.

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