• The external sector of the economy refers to the international transactions that both the private and public sector conduct with the rest of the world. Such transactions are systematically recorded in detail within a framework that groups them into accounts, where each account represents a separate economic process or phenomenon of the external sector.
• The external accounts form part of an integrated system of statistics of the economy, and thus all definitions, classifications and accounting rules must be harmonized so that external sector aggregates can be compared and summed with other macroeconomic data, such as those of national accounts, monetary statistics and government statistics. In the goods market, the external sector involves exports and imports. In the financial market it involves capital flows.
• Economic features related to the external sector are as follows:
A. Forex Reserves
• Foreign-exchange reserves or Forex reserves is money or other assets held by a central bank or other monetary authority so that it can pay if need be its liabilities, such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial institutions.
• Reserves are held in mostly the United States dollar and to a lesser extent the EU’s Euro, the British Pound sterling, and the Japanese Yen.
• In a strict sense, foreign-exchange reserves should only include foreign banknotes, foreign bank deposits, foreign treasury bills, and short and long-term foreign government securities. However, the term in popular usage commonly also adds gold reserves, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions.
• Foreign-exchange reserves are called reserve assets in the balance of payments and are located in the capital account.
B. External Debt
• It is that portion of a country’s debt that was borrowed from foreign lenders including commercial banks, governments or international financial institutions such as the International Monetary Fund (IMF) and World Bank.
• According to the IMF, “Gross external debt is the amount, at any given time, of disbursed and outstanding contractual liabilities of residents of a country to nonresidents to repay principal, with or without interest, or to pay interest, with or without principal”.
• Sustainable debt is the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth.
• There are various indicators for determining a sustainable level of external debt. These indicators can be thought of as measures of the country’s solvency. Examples of debt burden indicators include the external debt-to-GDP ratio, external debt-to-total debt ratio etc.
C. Balance of Payment
• Balance of Payment is a systematic record of all the transactions that a nation carries out with outside world. It is the difference between what a nation gets from outside world and what it pays to the outside world. Balance of Payment (BoP) comprises current account, capital account, errors, omissions, changes in foreign exchange reserves.
• Current Account – Under current account of the BoP, transactions are classified into merchandise goods (exports and imports) and invisibles. Invisible transactions are further classified into three categories, namely
a) Services – travel, transportation, insurance, Government not included elsewhere (GNIE) and miscellaneous (such as, communication, construction, financial, software, news agency, royalties, management and business services),
b) Income, and
c) Transfers (grants, gifts, remittances, etc. which do not have any quid pro quo
• Capital Account – Under capital account, capital inflows can be classified by instrument (debt or equity) and maturity (short or long-term). The main components of capital account include foreign investment, loans and banking capital.
• Foreign investment comprising Foreign Direct Investment (FDI) and portfolio investment consisting of Foreign Institutional Investors (FIIs) investment, American Depository Receipts/Global Depository Receipts (ADRs/GDRs) represents non-debt liabilities, while loans (external assistance, external commercial borrowings and trade credit) and banking capital including non-resident Indian (NRI) deposits are debt liabilities.
D. Foreign investment – It comprises of two components:
1) Foreign Direct Investment – FDI is foreign investment with aim of profit motive and provide unique mixture of resources, technology, knowledge, professionalism and management techniques.
• India’s economy has been opening for more FDI. 100% FDI is permitted in sectors like petroleum sector, road building, power, drugs and pharmaceuticals hotels and tourism.
• No FDI is allowed in gambling, betting, lottery, atomic energy etc.
• FDI in India is allowed under Automatic Route i.e. without prior approval of government/RBI whereas other is government route which requires approval of FIPB.
2) Foreign Institutional Investment – FII or Foreign institutional Investment is done in the stock market with the purpose of only trading in shares of companies, in corporate debt and in government securities. Such investments are volatile in nature.
• There is no restriction on FII in the stock market except for the maximum percent shares of a company including in corporate debt instruments and government securities.
• FII also comes in the form of participatory notes (PN) (unregistered FII) and round tipping. Through round tipping, capital goes out of the country only to return from a different route to avoid incidence of tax on profit earned. Much of FII invested in India comes from Mauritius taking advantage of Double Taxation Avoidance Treaty.
• Balance of payment of a country is a separate and independent “record” of all transactions being done in foreign currency in the country. It has great significance for open economies.
E. Exchange Rate – Exchange rate is the value for domestic currency with respect to foreign currency and vice-versa. In India, exchange rates are managed and any capital inflows would be mopped up by RBI to prevent rupee from appreciating thus resulting in build of reserves. They can be either fixed exchange rate or market determined exchange rates.
1) Fixed Exchange Rate System – They are arrived at the intervention of the Central Bank. There are two types of such interventions.
• Currency Board System
– It is done in inflated economies.
– The central bank pegs the home currency to a stronger currency on a 1:1 basis or some different but fixed ratio.
– Home currency will be in circulation equal to inflowing foreign currency.
– Example: Argentina
• Crawling pegged exchange rate
– Fixed rate but Central Bank allows it float between ceiling and floor rates.
– Example: Russia and China
2) Flexible exchange Rate system – They are arrived at the intervention of the market. There are two types of such interventions.
• Full float
– Determined by forces of demand and supply of foreign currency in the home country
– No role of Central Bank.
– Examples are USA, EU.
– Market determined rates are seen as maturity of economics and a test for globally competitive economy.
• Managed exchange rate – Also referred as “dirty floating” as central bank intrude indirectly in influencing exchange rate.
– In managed exchange rate, even though the exchange rate is market determined, there is active indirect intervention by the central bank to bring exchange rate closer to its own perception.
– Example: India
– If exchange rate is market determined and currency make sizeable portion in terms of trade volume, it is known as hard currency. Examples are USA, Japan and UK, etc.
3) Nominal Effective Exchange Rate and Real Effective Exchange Rate
• The nominal effective exchange rate (NEER) and real effective exchange rate (REER) indices are used as indicators of external competitiveness of the country over a period of time.
• NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies, while REER is defined as a weighted average of nominal exchange rates, adjusted for home and foreign country relative price differentials.
• REER captures movements in cross-currency exchange rates as well as inflation differentials between India and its major trading partners and reflects the degree of external competitiveness of Indian products.
• The RBI has been constructing six currency (US Dollar, Euro for Eurozone, Pound Sterling, Japanese Yen, Chinese Renminbi and Hong Kong Dollar) and 36 currency indices of NEER and REER.
F. Convertibility of Rupee
• An economy allows its currency fully or partially convertibility in its current and capital account. The issue of currency convertibility is concerned with foreign currency outflow.
• India took different measures to check the foreign exchange outflow in both current and capital account. But with economic reforms, situation changed drastically.