External Sector — Practice Questions
UPSC Prelims-pattern practice questions on the external sector with explanations — FEMA, forex reserves, the impossible trinity, committees and rupee depreciation.
Questions
These are original UPSC-pattern practice questions. Attempt each one before revealing the answer.
With reference to the Foreign Exchange Management Act (FEMA), 1999, consider the following statements:
- Contraventions under FEMA are treated as civil offences.
- FEMA replaced the Foreign Exchange Regulation Act, 1973.
- The stated objective of FEMA is to conserve foreign exchange by restricting payments abroad.
Which of the statements given above is/are correct?
Solution
Statements 1 and 2 are correct: FEMA replaced FERA and made contraventions civil. Statement 3 is FERA’s philosophy. FEMA’s preamble speaks of facilitating external trade and payments and promoting the orderly development and maintenance of the foreign exchange market.
Answer: A
Consider the following:
- Foreign currency assets
- Gold
- Special Drawing Rights
- Reserve tranche position in the IMF
- Non-resident Indian deposits
How many of the above are components of India’s foreign exchange reserves?
Solution
India’s forex reserves have four components: foreign currency assets, gold, SDRs and the reserve tranche position. NRI deposits are liabilities of Indian banks, recorded under banking capital in the capital account. They add to the supply of foreign exchange but are not part of the RBI’s reserves.
Answer: C
The “impossible trinity” in international economics refers to the inability of a country to simultaneously maintain which of the following?
Solution
The trilemma (from the Mundell–Fleming framework) says a country can choose only two of: a fixed exchange rate, free capital mobility and an independent monetary policy. A country with a fixed rate and open capital account must let interest rates follow the anchor currency. The other options combine macroeconomic goals that have nothing to do with this framework.
Answer: A
Consider the following pairs:
| Committee | Subject | |
|---|---|---|
| 1. | S.S. Tarapore Committee | Capital account convertibility |
| 2. | Arvind Mayaram Committee | Distinction between FDI and FPI |
| 3. | Nachiket Mor Committee | Exchange rate management |
How many of the pairs given above are correctly matched?
Solution
Pair 1 is correct — the Tarapore Committees (1997 and 2006) laid out a road map for capital account convertibility. Pair 2 is correct — the Mayaram Committee (2014) recommended treating 10% or more of equity as FDI. Pair 3 is wrong — the Nachiket Mor Committee (2013) was on comprehensive financial services for small businesses and low-income households, and its work fed into payments banks and small finance banks.
Answer: B
Other things remaining equal, which one of the following is most likely to follow a sharp depreciation of the Indian rupee against the US dollar?
Solution
After depreciation, each dollar buys more rupees — so remittances received are worth more in rupees (D). Crude oil (A) and external debt service (B) become costlier in rupees. Indian exports become cheaper in dollars (C is the reverse).
Answer: D
Mains
“How a current account deficit is financed matters as much as its size.” Discuss with reference to FDI and FPI flows into India.
Solution
Introduction: A current account deficit (CAD) is financed by net capital inflows. The 1991 crisis showed that a deficit financed by short-term debt and volatile deposits can turn into a crisis when those flows reverse.
Body:
- FDI: long-term, tied to plants and firms, hard to withdraw; brings technology, management and export links; does not create repayment obligations like debt.
- FPI: liquid and pro-cyclical; can exit quickly in global risk-off episodes, pressuring the rupee and reserves (“sudden stop”).
- Debt flows (ECBs, short-term credit): create repayment and currency risk.
- Implications: a moderate CAD financed mainly by FDI is sustainable; one financed by hot money needs larger reserve buffers.
- Policy: FDI liberalisation and ease of doing business; prudent ECB norms; adequate reserves; boosting exports to narrow the CAD.
Conclusion: Sustainability depends on both the size of the CAD and the stability of its financing; India’s policy preference for FDI over volatile flows reflects the lessons of 1991.