All economic activities of an economy which take place in foreign currency fall in the external sector such as balanced of payment, export, import, foreign investment, external debt, current account, capital account, exchange rates etc.



Foreign exchange reserves are assets denominated in a foreign currency that are held on reserve by a central bank. These may include foreign currencies, bonds, treasury bills and other government securities.

India is fifth largest in the world in foreign exchange reserves as per IMF.


Forex Reserves Consist of:


• Bank deposits

• Gold

• Special drawing rights (SDRS)

• Reserve tranche position (RTP)

• Foreign currency assets (FCA)

• Government securities

Foreign Exchange Reserves as of 20 NOV 2020 (by RBI)

• FCA= $533.103 Billion

• Gold= $36 Billion

• RTP= $4.68 Billion

• SDRs= $1.4 Billion

• Gold= $36 Billion





• SDR is an international reserve asset, created by the IMF in 1969.

• Value of the SDR is based on a basket of five currencies- Dollar, Euro, Renminbi, Yen, and Pound Sterling.

• It is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.


  • Exchange rate is Price at which one currency is converted into or exchanged for another currency.
  • Various Exchange rates mechanism:


Complete intervention of Authority (government or central bank) in determination of the currency exchange rate. Market forces(demand and supply) determine the value of currency

No role of authority

Exchange rate is largely determined by market forces.

In crisis, central banks may intervene to stabilize the exchange rate




Nominal Effective Exchange Rate (NEER) Real Effective Exchange Rate (REER)
Weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies Weighted average of nominal exchange rates, adjusted for inflation.
It is the exchange rate of one currency against a basket of currencies, weighted according to trade with each country (not adjusted for inflation). Is calculated on the basis of NEER.

Captures inflation differentials between country and its major trading partners and reflects the degree of external competitiveness



Currency convertibility is the ease with which the currency of a country can be freely converted into any other foreign currency or gold at market determined exchange rate.




Partial Convertibility:

Portion allowed by the government which can be converted into foreign currency with least restrictions.

Union Budget for 1992-93, introduced it on current account under Liberalized Exchange Rate Management System (LERMS)

Also known as Dual exchange system.

Presently partial convertibility still operational on capital account.



Full Convertibility:

Freedom to convert domestic currency into any foreign currency and vice versa without any regulatory intervention.

• Dual exchange rate system got automatically abolished and LERMS was now based upon the open market exchange.

• In 1994, the Government of India declared full convertibility of Rupee on Current account.

Tarapore Committee I (1997) and II (2006): • Constituted by the RBI for suggesting a roadmap on full convertibility of Rupee on Capital Account.



Advantages of capital account convertibility:

  • Availability of large funds
  • Reduction in cost of capital.
  • Greater financial competitiveness.
  • Increase in FII/FPI flow.


  • Marketplace where the international foreign currencies are sold and purchased simultaneously is known as the foreign exchange market or forex market.
  • Exchange rate management in India:


Par value system till 1971: Government fixes external value Pegged regime (1971-1992): Rupee was pegged to US dollar Partial convertibility (1991-93): Under the Liberalised Exchange Rate Management System (LERMS) Market based exchange rate Regime since 1993


LERMS (Liberalized exchanged rate mechanism system): • Operationalized in 1993.

• India delinked its currency from fixed currency system and moved into the era of floating exchange-rate system under it.


  • A systematic record of all economic transactions between the residents of one country with the residents of the other country in a financial year.
  • It consists of balance of trade, balance of current account and capital account.


Balance of trade: Difference between the monetary value of a nation’s exports and imports over a certain time period.


  • Balance of payments divides transactions in two accounts:
  1. Current account
  2. Capital account


Current Account

  • Invisible
  • Visible
  • Goods(+)
  • Services [+)
  • Income
  • 1. Dividend
  • 2. Interest
  • 3. Profit
  • Transfer [+]
  • 1. Gift
  • 2. Donation
  • 3. Remittance
Capital account [+]

  • Investment [+]
  • 1.Sovereign 2.Commercial
  • NRI account [+]
  • 1. Gift
  • 2.Donation 3.Remittance
  • Loan (+)
  • 1 FDI 2. FII/FPI




• Records imports and exports of visible and invisibles

• Short term implication transactions

• Covers only earnings and spending.

• Excludes any borrowings and lending.

• Shows capital expenditure and income for country

• Long term implication transactions

• Only includes borrowings and lending by a country





• Visible trade(Export and Import of goods-Merchandise transactions )

• Invisible trade(Export and Import of services)

• Unilateral transactions

• Direct Investment (FDI)

• Portfolio Investment (FPI)

• Loans / External commercial borrowing (ECB)

• Non-resident’s investment in Bank, Insurance, Pension schemes.

• RBI’s foreign exchange reserve




Deficit (CAD)

• If the value of the goods and services imported exceeds the value of those exported.

• Current Account deficit = Trade gap(export – import) + Net current transfers (foreign aid) + Net factor income (Interest, Dividend)

• When more money is flowing out of a country to acquire assets and rights abroad


• If the value of the goods and services exported exceeds the value of those imported. • Money is flowing into the country, but these inflows reflect changes in the ownership of national assets by way of sale or borrowing.


• Current account convertibility relates to the removal of restrictions on payments relating to the international exchange of goals, services and factor incomes. • Capital account convertibility refers to a liberalization of a country’s capital transactions such as loans and investment.
Current status • Allowed Full convertibility • Only Partial convertibility



Monetary difference of the total export and import of an economy in one financial year is called trade balance.

Top export destinations of India Top Import sources of India Top Export products Top Import products



Hong Kong


• China



• Saudi Arabia

• Petroleum products

• Pearls, precious and semi-Precious stones

• Drug formulations, biologicals

• Gold and other precious metal jewellery

• Iron and steel

• Petroleum products

• Mineral fuels including oil

• Gems, precious metals

• Machinery including computers, Organic, Electrical machinery

• Pharmaceuticals products.



  • Part of a country s debt which has been borrowed from foreign creditors which includes private commercial banks, international financial institutions such as the World Bank, International Monetary Fund (IMF), and sovereign governments.
  • Types of external debts:
  1. Short term debt: Maturity period 1 year or less
  2. Long term debt: Maturity period more than 1 year
  3. Sovereign debt : Bonds issued by the national government in any foreign currency to generate funds to meet its financial expenses
  • At end-March 2020, RBI put India’s external debt at US$ 558.5 billion.




Revaluation Devaluation Appreciation Depreciation
Government or the central bank

Value of its currency increases

• Government or the central bank

• Value of its currency decreases.

• Value of its currency is determined by the market forces of demand and supply.
• Happens when

• Supply of currency = Decreases

• Happens when

• Supply of currency = Increases

Associated with fixed exchange rate regime • Associated with floating exchange regime



Exports become expensive.

Imports become cheaper.

Value of the remittances decreases

Overall Inflation decreases

• Exports become cheaper

• Imports become expensive

• Increase in aggregate demand

• Increase in inflation


Other Related Terms


Hard currency:

International currency which has highest faith, strongest currency of the world and highest level of liquidity.

Ex: US Dollar, The Euro

Soft currency:

• It is just the opposite of Hard currency.

• Ex: Indian Rupee is the Soft currency in the Indian Forex market.

Hot currency:

• It is the term for the Forex market and is the temporary name for any Hard currency.

• If any Hard currency is exiting any economy at a fast pace for the time, the Hard currency is said to be hot currency.


Heated currency:

• Domestic currency which is under pressure (heat) of depreciation due to any hard currency’s high tendency of exiting the economy.

• Also known as currency under Heat or under Hammering.

• In the case of SE Asian crisis (1997), the US Dollar becomes hot.

Cheap currency:

• When a government starts re-purchasing its bonds before their maturities and at full maturity prices, there is increase in supply of money which is called cheap money.
Dear currency

• It is just opposite of cheap money.

• Government issues bonds, the flow of money increases from public to the government hence supply of money in the market decreases, which is dear currency.


Schemes By IMF


Stand-By Arrangement (SBA):

• Helps countries in economic crisis to overcome the Balance of Payment (BoP) problems.

Flexible Credit Line (FCL):

• For countries with very strong track records of policy implementation.

• No ongoing conditions and no caps on the size of the credit line.

Precautionary and Liquidity Line (PLL):

• PLL provides financing to meet actual or potential balance of payments needs of countries with sound policies

• Serve as insurance and help resolve crises.





Extended Fund Facility:

• It is service provided by the IMF to its member countries which authorizes them to raise any amount of foreign exchange from it to fulfill their BoP crisis, but on the conditions of structural reforms in the economy.

Established to provide assistance to countries:

Ø Experiencing serious payments imbalances because of structural impediments.

Ø Characterized by slow growth and an inherently weak balance of payments position.


Trade Integration Mechanism

• Allows IMF to provide loans under one of its facilities to a developing country whose balance of payments is suffering because of multilateral trade liberalization.


India and the IMF:
  • India joined the IMF in 1945, as one of the original founding members
  • IMF credit helped India in response to emerging BOP problems on 2 occasions
  1. In 1981-82, India borrowed SDR 3.9 billion
  2. In 1991-93, India borrowed a total 2.2 billion under 2 stand by arrangements, and in 1991 it borrowed SDR 1.4 billion under Compensatory Financing Facility.





Most Favoured Nation (MFN)

As per the WTO agreements, member countries cannot normally discriminate between their trading partners. If any country grants one country a special favour such as a lower customs duty rate for one of their products the same would need to be extended to all other WTO members. This principle is known as Most Favoured Nation.

Countervailing Duties


Countervailing Duties (CVDs) are tariffs levied on imported goods to offset subsidies made to producers of these goods in the exporting country. CVDs are meant to level the playing field between domestic producers of a product and foreign producers of the same product who can afford to sell it at a lower price because of the subsidy they receive from their government.


Anti-Dumping Duty

Anti-dumping duty is a tariff imposed on imports manufactured in overseas countries and that are priced below the fair market value of similar goods in the domestic market. The government imposes anti-dumping duty on foreign imports when it believes that the goods are being dumped in the domestic market. Anti-dumping duty is imposed to protect local businesses and markets from unfair competition by foreign imports.


Peace clause’

The term ‘peace clause’ has been a cause of disquiet ever since India dug in its heels on the issue of domestic food security in the recent World Trade Organisation (WTO) negotiations, leading to a deadlock. Should the WTO have a say in India’s policy of buying foodgrains at a fixed price from farmers and supplying it below cost to the poor? India thinks not, but developed nations disagree.
Debt Service Ratio

In economics and government finance, a country’s debt service ratio is the ratio of its debt service payments (principal + interest) to its export earnings. A country’s international finances are healthier when this ratio is low. For most countries the ratio is between 0 and 20%.


GAAR, POEM and related terms



Tax Avoidance

Tax avoidance is the legal use of the country’s tax regime in order to reduce tax liability by legal means.

This includes investing funds in any investment/insurance so that the net amount earned is less and the taxpayer has to pay only a reduced amount as tax. Tax avoidance is completely legal.


Tax Evasion

• Tax evasion is the willful and illegal evasion of taxes by individuals, trusts and corporations. In this case, taxpayers misrepresent their financial state of affairs deliberately to the tax authorities.

• This includes fraudulent practices such as dishonest tax reporting, declaration of less income or profits than the amount actually earned, and also overstating their deductions.


Tax Haven

• Tax heavens are the countries that have lower tax rates, provides secrecy and anonymity to the account holders and do not share tax information with other countries.


GAAR (General Anti-Avoidance Rules)

• Originally proposed in the Direct Taxes Code 2010

Objective = To codify the doctrine of ‘substance over form’ where the real intention of the parties and purpose of an arrangement is taken into account for determining the tax consequences, irrespective of the legal structure of the concerned transaction or arrangement.

• Targeted at aggressive tax planning arrangements or transactions made specifically to avoid taxes

• Introduced in India because of VODAFONE case ruling by the Supreme Court.


Place of Effective Management (PoEM) Rules

• PoEM is aimed at ensuring sufficient economic activity takes place in a particular country and determining a foreign company’s residential status.

• Helps to assess if companies are setting up shell subsidiaries abroad to evade taxes.

• It means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made.



• Multilateral Convention/MLI is an outcome of the OECD / G20 Project to tackle Base Erosion and Profit Shifting (the “BEPS Project”)

• Tackles tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations.

• India has recently ratified the Multilateral Convention to implement tax treaty related measures.


  • Foreign investment refers to the investment in domestic companies and assets of another country by a foreign investor.
  • Types of foreign investments:




Foreign direct Investment (FDI)

Long term investment

Investment in physical asset

Aim to increase enterprise capacity or productivity or change management control

Leads to technology transfer, access to markets and management inputs

FDI flows into primary market

Entry and exit is relatively difficult

Eligible for profits of company

Does not tends to be speculative

Foreign Institutional Investment (FII)/ Foreign Institutional Investment (FII) • Generally short-term investment

• Investment in financial asset

• Aim to increase capital availability

• FPI results in only capital inflows

• FPI flows into secondary market

• Entry and exit is relatively easy

• Eligible for capital gains

• Tends to be speculative

Qualified foreign Investment (QFI) QFI is Individual, group or association, resident in a foreign country that is compliant with Financial Action Task Force (FATF) standard.




Financial Action Task Force (FATF)

• Inter-governmental body established in 1989 during G7 summit.

Objectives: To set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system.

• Secretariat: OECD headquarters in Paris.

FATF has two list:

Ø Grey List: Countries that are considered safe haven for supporting terror funding and money laundering are put in the FATF grey list. EX: Pakistan

Ø Black List: Countries known as Non-Cooperative Countries or Territories (NCCTs) are put in the blacklist. These countries support terror funding and money laundering activities. The FATF revises the blacklist regularly, adding or deleting entries. EX: Iran, North Korea.

Bilateral Investment Treaty (BIT)

• Treaties between two countries aimed at protecting investments made by investors of both countries.

• Treaties impose conditions on the regulatory behavior of the host state and limit interference with the rights of the foreign investor.



  • According to the FDI policy guideline, “Marketplace model of e-commerce means providing of an information technology platform by an e-commerce entity on a digital and electronic network to act as a facilitator between buyer and seller.”
  • Marketplaces are platforms that enable a large, fragmented base of buyers and sellers to discover price and transact with one another in an environment that is efficient, transparent and trusted.
  • Amazon and Flipkart in india have market place model.
  • According to the FDI policy, “Inventory model of ecommerce means an ecommerce activity where inventory of goods and services is owned by e-commerce entity and is sold to the consumers directly.”
  • The main feature of inventory model is that the customer buys the product from the ecommerce firm. He manages an inventory (stock of products), interfaces with customers, runs logistics and involves in every aspects of the business.
  • Alibaba of China is following the inventory model.


Foreign Currency Borrowings And Associated Risk

  • External Commercial Borrowings (ECB) is a loan availed by an Indian entity from a non-resident lender with a minimum average maturity.
  • Recently, RBI issued a guideline stating that all eligible borrowers can raise ECB up to USD 750 million or equivalent per financial year under the automatic route.
  • Department of Economic Affairs, Ministry of Finance, along with RBI, monitors and regulates ECB guidelines and policies. U.S. dollar-denominated debt remains largest component of the external debt.
  • S. dollar-denominated debt remains largest component of the external debt.
  • Sahoo Committee (2013) was set up to develop a framework for access to domestic and overseas capital markets.
  • Change in ECB Norms: ECB up to USD 50 million or its equivalent can be raised by eligible borrowers with minimum average maturity period of 3 years.


Risks associated with ECB:

• Could results in higher debt on the balance sheet

• Possible downgrade by rating agencies which eventually might increase the cost of debt.

• Exposes the company to interest and currency fluctuations.

Advantage of ECBs:

• Lower interest rates

• Longer maturity

• Capital gains


Government steps to promote trade:


Nirvik (Niryat Rin Vikas Yojana) scheme:

Introduced by Credit Guarantee Corporation of India

It is Export Credit Insurance Scheme (ECIS)

To enhance loan availability and ease the lending process.


Remission of duties or taxes on export products:

• Replaced Merchandise Exports from India Scheme (MEIS) for improving export of goods.

• WTO compliant scheme will reimburse all taxes and duties paid on inputs consumed in exports.

• End to end digitised

Services Exports from India Scheme (SEIS) • To promote exports in services

• Rewards (duty credit scrips) to exports of services.

• Scrips are transferable and can be used to pay certain central duties & taxes.








Special Economic Zone:

By SEZ act 2005

Aim: develop expert hubs to promote growth and development

• Can be set up by either central or state government or even by private sector

• India had set up Asia’s first ‘export processing zone’ (EPZ) in Kandla in 1965 itself.

• Recent steps (till March 2020) taken by the Government to strengthen SEZs in the country are:

Ø Minimum Land Area requirement = reduced to 50 per cent for multi-product and sector-specific SEZs.

Ø A new sector ‘agro-based food processing’ sector has been introduced

Ø Dual use of facilities like Social and Commercial infrastructure by SEZs and non-SEZs entities has been allowed in order to make SEZ operations more viable.

Ø Sectoral broad-banding has been introduced to encompass similar and related areas under the same sector.

Ø ‘SEZ India’ mobile app launched to help the SEZs to track their transactions.


Trade Infrastructure for Export Scheme:

Objective: To address the export infrastructure gaps in the country.

• Provides financial assistance in the form of grant-in-aid to Central/State Government owned agencies for setting up or for up-gradation of export infrastructure.



Agriculture Export Policy 2018:



• To double agricultural exports from present US$ 30 Billion to US$ 60 Billion by 2022

• To strive double India’s share in world agri exports.

• Scheme focus is on agriculture export oriented production, export promotion, better farmer realization


Export Credit Guarantee Corporation of India (1957)

  • Objective: To promote exports from the country by providing credit risk insurance and related services for exports.
  • Wholly owned by the Ministry of Commerce and Industry

Government Recent Initiatives For Trade Promotion

  • E-Filing & E-payment
  • 24×7 customs clearance
  • Paperless environment
  • Single window for customs
  • Angel tax reforms
  • Training: Through Niryat bandhu scheme and many others


Niryant Bandhu: Reach out to the new and potential exporters and mentoring them.


Trade Agreements And Their Types

Treaty between two or more governments that define the rules of trade for all signatories.




Preferential trade agreement (PTA):

It is a trading bloc that gives preferential access to certain products from the participating countries.

Done by reducing tariffs but not by abolishing them completely.

It requires the lowest level of commitment to reducing trade barriers

Ex: Mercosur preferential trade agreement, Asia pacific trade agreement

Generalized System of Preferences (GSP)

• GSP is a preferential schemes granted by industrialized nations to developing countries.

• It involves reduced Most Favored Nations (MFN) Tariffs or duty-free entry of eligible products exported by beneficiary countries to the markets of donor countries.

• Recently the US government has withdrawn its GSP benefits to India.


Free Trade Agreement (FTA)

• It is trade bloc which eliminates tariffs, import quotas, and preferences on most (if not all) goods and services traded between member countries.

• EX: SAFTA (South Asian PTA to FTA), ASEAN FTA

CECA (Comprehensive Economic Cooperation Agreement) / CEPA (Comprehensive Economic partnership Agreement): • When the countries go beyond FTA and agree for a greater degree of economic integration which extends to capital and human resources, and to expand trade and investment, it would result in CECA or CEPA.

• CEPA has a bit wider scope than CECA. While CECA come first with elimination of tariffs, CEPA comes later including trade in services and investments.

EX: India: CEPA with Japan and CECA with Singapore .


Customs Union

• An agreement between member countries of a custom union remove trade barriers among themselves and adopt common external trade barriers.

• EX: Gulf Cooperation Council (GCC), East African Community (EAC).

Common Market

• Type of a custom union in which members remove internal trade barriers, adopt common policies, allow members to move resources among themselves freely.

Economic Union

• It is a type of a trade block which is a composed of common market with a customs union.

• Members eliminate trade barriers among themselves, adopt common external barriers, allow free import and export of resources, adopt a set of economic policies, and use one currency.

• EX: European union


Agreements in news


Trade Purpose/Feature Countries


Regional Comprehensive Economic Partnership (RCEP)

To create an “integrated market” spanning all 16 countries.

To make it easier for products and services of each of these countries to be available across this region. Largest economic bloc. Recently India opted to stay out of RCEP.

10 ASEAN countries (Cambodia, Indonesia, Brunei, Laos, Malaysia, Vietnam, the Philippines, Myanmar, Singapore, Thailand) + China, South Korea, Australia, Japan, India, and New Zealand.
Transatlantic Trade And Investment Partnership (TTIP) Promoting trade and multilateral economic growth European union and United States
Comprehensive and Progressive Agreement for Transpacific Partnership (CPTPP) Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam. Third largest free-trade area in the world by GDP.

Evolved from the Trans-Pacific Partnership (TPP), which never entered into force due to the withdrawal of the United States.



The new five year Foreign Trade Policy, 2015–20 provides a framework for increasing exports of goods and services as well as generation of employment and increasing value addition in the country, in keeping with the Make in India.






• Exim policy or Foreign Trade Policy for the years 2015-20, aims at doubling the overseas sales to $900 billion by 2019-20 and making India global, while integrating the foreign trade with “Make in India” and “Digital India Programme”.

• To support both the manufacturing and services sectors, with a special emphasis on improving the ‘ease of doing business’.






  • Incentives are to be provided in the form of duty scrips as % of FOB (free on board) value of exports.
  • Service Exports from India Scheme (SEIS) will be only for India based service providers and will be based on net foreign exchange earned.
  • Both SEIS and MEIS schemes are applicable to SEZ units.
  • Paperless Trade and Online filling of forms
  • Provision for Export oriented units, Export hardware technology park and software technology park.
  • The Duty free scrips (form of credit) are provided to the exporters under various export promotion schemes of the government.
  • Government has extended foreign trade policy for one year till March 2021 amid the outbreak of the corona virus pandemic outbreak.
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