External Sectors In India

What's External Sector?

All economic activities of an economy which take place in foreign currency

• export, import, foreign investment, external debt, the balance of payment, current account, capital account, etc.

The Balance of Payments (BoP)

It records the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year

• Two main Accounts the current account and the capital account

Current Account

It is the record of trade in goods and services and transfer payments

• It includes all international trade transactions of goods and services

Trade in goods

includes exports and imports of goods

Trade in services

includes factor income and non-factor income transactions

Transfer payments

Receipts that get for free, without providing any goods or services in return.

• They consist of gifts, remittances and grants

Balance on Current Account

Receipts = Payments (Balanced Current Account)

A surplus current account

means that the nation is a lender to other countries

A deficit current account

means that the nation is a borrower from other countries

Balance on Current Account has two components

• Balance of Trade or Trade Balance
• Balance on Invisibles

Balance of Trade (BOT)

The difference between the value of exports and the value of imports of goods of a country in a given period of time

• Export of goods is entered as a credit item
• Import of goods is entered as a debit item

Balance of Trade (BOT) 3 Types

• Balance BOT
• Surplus BOT (Exports>Imports)
• Deficit BOT (Exports<Imports)

Balance on Invisibles

The difference between the value of exports and value of imports of invisibles of a country in a given period of time

• Invisibles include services

Services trade includes

factor and non-factor income

Factor income includes

net international earnings on factors of production

• like land, labour and capital

Non-factor income is

net sale of service products like shipping, banking, tourism, software services, etc.

Capital Account

Direct investment and purchases of interest-bearing financial instruments, non-interest bearing demand deposits and gold

Balance on Capital Account

Capital account is in balance when capital inflows are equal to capital outflows

• Surplus capital account (inflows >outflows)
• Deficit capital account (inflows < outflows)

Balance of Payments Disequilibrium

R - Receipts and P - Payment

• Balanced when R / P = 1
• Favorable when R / P > 1
• Unfavorable when R / P < 1

Definition of FOREX

The system or process of converting one national currency into another

foreign currency assets/reserves

The total foreign currencies an economy possesses at a point of time

The FOREX Reserves

Foreign currency assets added with its gold reserves, SDRs (Special Drawing Rights) and Reserve Tranche Position (RTP) in the IMF

Foreign Exchange Market

The market in which national currencies are traded for one another

Rate of Exchange

The price of one currency in terms of another currency
Two Types

• Fixed (or pegged) exchange rate system
• Flexible (or floating) exchange rate system
• Managed Floating Exchange Rate system also prevails in some countries (Example

Determinants of Exchange Rates

• Differentials in Inflation (Low inflation means high currency value)
• Public Debt (Exchange rate becomes low)
• Current Account Deficits (Excess demand for foreign currency lowers a country’s exchange rate)
• Recession

Appreciation

Increase in the value of a currency against other foreign currency

Depreciation

when domestic currency loses its value in front of a foreign currency

• only take place in flexible (floating) exchange rate system

Devaluation

When exchange rate of a domestic currency is cut down by its government against any foreign currency

• It means official depreciation

Revaluation

The government increasing the exchange rate of its currency against any foreign currency

• It is official appreciation

Soft Currency

A term used in the foreign exchange market

• Currency that is easily available in any economy in its FOREX market
• For example, rupee is a soft currency in the Indian FOREX market

Hard Currency

Safe-haven currency or strong currency is any globally traded currency that serves as a reliable and stable store of value

• The strongest currency of the world is one which has a high level of liquidity
• Dollar , Euro , Yen , Pound

Cheap Currency

The term was first used by the economist J. M. Keynes (1930s)

• If a government starts re-purchasing its bonds before their maturities the money which flows into the economy Is cheap

• Interest rate are low

Hot Currency

Temporary name for any hard currency

• When any hard currency is exiting from any economy at a fast pace, at the time that hard currency is said as hot currency

Heated Currency

Domestic currency under pressure of depreciation due to a hard currency high tendency of exiting the economy

• It is also known as currency under heat or under hammering

Dear Currency

A period of tight monetary policy characterized by high interest rates, which makes borrowing money more expensive and credit less accessible

Foreign Direct Investment (FDI)

When foreign company or individual invest in another country

• primarily characterized as a non-debt creating capital flow
• it's long-term investment from abroad, not just buying stocks

Foreign Portfolio Investment (FPI)

When Foreigners deposit money in national bank of another country or invest in stocks or bonds

• FPI is part of the capital account of BoP

Foreign Institutional Investment (FII)

foreign entity (like a mutual fund, pension fund, or investment bank) that invests in a country's stocks or bonds

• It's a type of FPI