External Sector.

The external sector of an economy deals with its economic transactions with the rest of the world. This includes trade in goods and services, capital flows, foreign exchange reserves, and the balance of payments (BOP).

1. India’s Balance of Payments (BOP)

The Balance of Payments (BOP) is a comprehensive record of all economic transactions between residents of a country and the rest of the world during a specific period, usually a year. It consists of two main accounts: the Current Account and the Capital Account.

a) Current Account

The current account records the flow of goods, services, income, and current transfers between a country and the rest of the world.

Goods Account (Merchandise Trade): This records exports and imports of physical goods. The difference between exports and imports of goods is termed the balance of trade.
Services Account: This includes trade in services like software, tourism, financial services, etc.
Income Account: Records income flows such as wages, salaries, dividends, and interest between residents and non-residents.
Current Transfers: Includes unilateral transfers like remittances sent by expatriates to their home country, foreign aid, and gifts.

b) Capital Account

The capital account records the flow of capital between a country and the rest of the world. It includes transactions that affect a country’s foreign assets and liabilities.

Foreign Direct Investment (FDI): Long-term investment by a company or individual from one country in business interests in another country, usually in the form of establishing business operations or acquiring assets.
Foreign Portfolio Investment (FPI): Investment in financial assets such as stocks and bonds in another country, which can be easily liquidated.
External Commercial Borrowings (ECBs): Loans taken by Indian firms from foreign sources, mainly for investment purposes.
Foreign Aid and Grants: Capital inflows in the form of aid or grants provided by foreign governments or international organizations.

c) Goods and Services Account

This account is part of the current account and records all transactions related to the export and import of goods and services. It plays a crucial role in determining a country's trade balance.

2. India’s BOP Performance

a) Balance of Payment versus Balance of Trade

Balance of Payment (BOP): A broader term that includes the current account, capital account, and financial account, reflecting all economic transactions with the rest of the world.
Balance of Trade (BOT): A narrower concept focusing only on the difference between the value of a country's exports and imports of goods. It is a component of the current account.

b) Current Account versus Capital Account

Current Account: Deals with transactions involving goods, services, income, and current transfers. It reflects a country's net income over a period.
Capital Account: Involves transactions that affect national ownership of assets, including FDI, FPI, and ECBs. It reflects changes in a country's foreign assets and liabilities.

3. FDI and FPI in India, External Commercial Borrowings, Foreign Exchange Reserves

a) Foreign Direct Investment (FDI)

FDI involves a long-term interest in and influence over a foreign entity, typically through ownership or controlling stakes. FDI brings not only capital but also technology, expertise, and employment opportunities.

b) Foreign Portfolio Investment (FPI)

FPI involves the purchase of financial assets such as stocks and bonds in another country, without seeking control over the entities. FPI is more volatile and can be quickly withdrawn compared to FDI.

c) External Commercial Borrowings (ECBs)

ECBs are loans obtained by Indian entities from foreign lenders for commercial purposes. These are used for purposes such as expansion, modernization, or new projects. ECBs are typically more attractive due to lower interest rates in international markets.

d) Foreign Exchange Reserves in India

Foreign exchange reserves are assets held by the Reserve Bank of India (RBI) in foreign currencies. These reserves include foreign currencies, gold, SDRs (Special Drawing Rights), and IMF reserve positions. They provide a cushion against economic shocks and help manage the country’s exchange rate.

4. Foreign Exchange Rate Determination in India and Types of Exchange Rate

a) Exchange Rate Determination

The exchange rate in India is determined by the market forces of demand and supply in the foreign exchange market. The RBI may intervene to stabilize the exchange rate, but the primary driver is market dynamics.

Demand for Foreign Exchange: Arises from imports, foreign travel, foreign education, and investment abroad.
Supply of Foreign Exchange: Comes from exports, foreign remittances, FDI, FPI, and external borrowings.

b) Types of Exchange Rate

Fixed Exchange Rate: The value of the currency is pegged to another currency or a basket of currencies. The central bank maintains this fixed rate through intervention.
Floating Exchange Rate: The value of the currency is determined by the market forces of demand and supply without direct government or central bank intervention.
Managed Float: A system where the exchange rate is primarily market-driven, but the central bank intervenes occasionally to stabilize the currency.

5. Capital and Current Account Convertibility in India

a) Capital Account Convertibility

Capital account convertibility refers to the freedom to convert domestic currency into foreign currency and vice versa for capital transactions. Full convertibility allows unrestricted access to international financial markets. India has partial capital account convertibility, with some controls on capital flows to safeguard the economy against volatile capital movements.

b) Current Account Convertibility

Current account convertibility allows for the free exchange of currency for trade in goods and services, income receipts, and current transfers without restrictions. India has achieved full current account convertibility since 1994, allowing for the free flow of goods and services across borders.