External Sector and Balance of Payments (BoP)

 

External Sector and Balance of Payments (BoP)

What is the External Sector?

The external sector refers to a country’s economic interactions with the rest of the world, including trade in goods and services, capital flows, remittances, and foreign investments.

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Balance of Payments (BoP)

The Balance of Payments (BoP) is a comprehensive record of a country’s economic transactions with the rest of the world over a specific period, typically a year.

Structure of BoP

1. Current Account

Records transactions related to goods, services, income, and transfers.

• Trade in Goods (Merchandise Trade) – Exports and imports of tangible goods.
• Trade in Services – IT services, tourism, etc.
• Primary Income – Investment income like dividends, interest.
• Secondary Income (Transfers) – Remittances, gifts, grants.

Example:

If India exports software services to the USA, it’s a current account credit.

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2. Capital Account

Records capital transfers (like debt forgiveness) and acquisition or disposal of non-produced, non-financial assets (like patents).

• Generally small for most economies, including India.

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3. Financial Account

Records transactions related to investment flows between India and the rest of the world.

• Foreign Direct Investment (FDI) – Long-term investment.
• Foreign Portfolio Investment (FPI) – Investment in stocks, bonds.
• External Commercial Borrowings (ECBs) – Loans from abroad.
• Reserve Assets – Changes in RBI’s foreign exchange reserves.

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BoP Surplus vs Deficit

• BoP Surplus – Inflows exceed outflows.
• BoP Deficit – Outflows exceed inflows (may lead to depletion of forex reserves).

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Exchange Rate Systems

• Fixed Exchange Rate – Government or central bank pegs currency.
• Floating Exchange Rate – Market demand and supply determine exchange rate.
• Managed Float – Hybrid system, RBI intervenes occasionally.

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India’s BoP Trends

• India typically runs a trade deficit (imports > exports).
• This is partially offset by service exports, remittances, and capital inflows (FDI, FPI).
• Remittances from Indian diaspora are a significant current account credit.

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BoP Crisis 1991

• Severe foreign exchange crisis – reserves fell below two weeks’ worth of imports.
• Led to economic liberalisation and reforms.
• IMF loan came with conditions for structural reforms (LPG reforms).

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Statement-based MCQs

MCQ 1
Consider the following components of the Balance of Payments (BoP):

1. Foreign Direct Investment (FDI)
2. Remittances from abroad
3. Export of software services

Which of the above falls under the Current Account of the BoP?
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3

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MCQ 2
Which of the following events led to India’s 1991 BoP crisis?

1. Decline in exports.
2. Gulf War increasing oil import costs.
3. Large fiscal deficits over successive years.

Select the correct answer using the code below:
a) 1 only
b) 1 and 2 only
c) 2 and 3 only
d) 1, 2 and 3

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MCQ 3
In India’s Balance of Payments, which of the following would be classified as a debit item?

1. Imports of crude oil.
2. Indian companies raising loans from foreign banks.
3. Outward remittances by Indian workers abroad.

Select the correct answer using the code below:
a) 1 only
b) 1 and 3 only
c) 2 only
d) 1, 2 and 3

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MCQ 4
Which of the following measures can help reduce India’s current account deficit (CAD)?

1. Promoting export of services like IT and tourism.
2. Increasing FDI inflows.
3. Reducing import dependence through domestic manufacturing.

Select the correct answer using the code below:
a) 1 and 2 only
b) 1 and 3 only
c) 2 and 3 only
d) 1, 2 and 3

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MCQ 5
India’s largest source of foreign exchange inflow in the Current Account is:
a) FDI inflows
b) Remittances from Indian diaspora
c) Software exports
d) Tourism revenue