Indian Economy — External Sector, FEMA, Exchange Rates, Forex

The external sector covers India’s economic interactions with the rest of the world. Kerala PSC tests FEMA provisions, exchange rate systems, forex reserves, and BOP components. Expect 2-3 questions per paper.

Balance of Payments (BOP) — Structure

Component	Sub-components	Nature
Current Account	Trade in goods, Trade in services, Primary income, Secondary income (remittances)	Records regular/recurring transactions
Capital Account	FDI, FPI/FII, External Commercial Borrowings (ECB), NRI deposits, Government loans	Records capital/investment flows
Errors and Omissions	Statistical discrepancy	Balancing item
Overall BOP	Current Account + Capital Account + Errors	Must balance (with forex reserve changes)

Current Account Components

Item	Includes
Trade balance (Merchandise)	Exports minus Imports of goods
Invisibles	Services (IT, tourism, shipping), Primary income (interest, dividends), Secondary income (private transfers including remittances)
Current Account Deficit (CAD)	When total outflows exceed total inflows on current account
Current Account Surplus	Opposite — inflows exceed outflows

Capital Account Components

Item	Details
FDI (Foreign Direct Investment)	Long-term investment; investor takes management control (10%+ equity stake)
FPI (Foreign Portfolio Investment)	Short-term; stocks, bonds; no management control
ECB (External Commercial Borrowings)	Loans from foreign banks/institutions
NRI Deposits	FCNR(B), NRE, NRO accounts
Government borrowings	Bilateral/multilateral loans
Capital Account Convertibility	Freedom to convert domestic currency into foreign currency for capital transactions (India has partial convertibility)

India’s CAD — Key Facts

Metric	Approximate (FY 2024-25)
India’s CAD	About 1.1% of GDP
Largest import item	Crude oil and petroleum products
Largest export item	Petroleum products and IT services
Remittances received	India is the world’s largest recipient (over $125 billion annually)
Kerala’s share of remittances	Significant — Gulf remittances form a major part of Kerala’s economy

Exchange Rate Regimes

System	Description	India’s History
Fixed Exchange Rate	Government fixes currency value against another currency or gold	India followed this from 1947-1975 (pegged to GBP, then USD)
Floating Exchange Rate	Market forces of demand and supply determine the rate	Pure float (no government intervention)
Managed Float (Dirty Float)	Market-determined, but central bank intervenes to prevent excessive volatility	India follows this since 1993
Crawling Peg	Fixed rate adjusted periodically based on indicators	Some developing countries use this

India’s Exchange Rate Evolution

Period	System
1947-1966	Fixed parity with British Pound
1966	Rupee devalued by 36.5% (from Rs 4.76 to Rs 7.50 per USD)
1971	Linked to the dollar after Bretton Woods collapse
1975	Pegged to a basket of currencies
1991	Dual exchange rate (LERMS — Liberalized Exchange Rate Management System) during economic crisis
1993 onwards	Unified market-determined exchange rate (managed float)

FERA vs FEMA

Feature	FERA (1973)	FEMA (1999)
Full form	Foreign Exchange Regulation Act	Foreign Exchange Management Act
Year	1973	1999 (effective June 2000)
Approach	Regulatory (conservation of forex)	Facilitating (management of forex)
Violation	Criminal offence (imprisonment)	Civil offence (penalties/fines)
Philosophy	Restrictive; forex was scarce	Liberal; promote external trade and payments
Replaced	—	Replaced FERA
Administered by	RBI and Enforcement Directorate	RBI (primarily)
Context	License Raj era	Post-liberalization era
Presumption	Guilty until proven innocent	Innocent until proven guilty

Key FEMA Provisions

Provision	Details
Current account transactions	Fully convertible — free for trade, travel, education, medical purposes
Capital account transactions	Partially convertible — regulated by RBI (FDI limits, ECB guidelines)
Enforcement	Enforcement Directorate investigates FEMA violations
Penalties	Civil penalties (up to 3 times the sum involved)
Appellate Tribunal	FEMA Appellate Tribunal handles appeals
Authorized dealers	Banks and entities authorized by RBI to deal in foreign exchange

Foreign Exchange Reserves

Component	Details
Foreign Currency Assets (FCA)	Largest component; includes USD, Euro, GBP, Yen holdings
Gold	Physical gold held by RBI
SDR (Special Drawing Rights)	Allocated by IMF
Reserve Tranche Position	India’s quota position in IMF

India’s Forex Reserve Milestones

Year	Milestone
1991	Forex reserves fell to just $1.2 billion (triggered liberalization)
2004	Crossed $100 billion
2021	Crossed $600 billion (peaked around $642 billion in September 2021)
2024	Rose above $680 billion (4th largest globally after China, Japan, Switzerland)

Country	Forex Reserves (Approx.)
China	Over $3.2 trillion
Japan	Over $1.2 trillion
Switzerland	Over $800 billion
India	Over $680 billion

Convertibility

Type	Status in India	Meaning
Current Account Convertibility	Full (since August 1994)	Freedom to buy/sell forex for trade, travel, remittances
Capital Account Convertibility	Partial	Restrictions on capital flows (FDI limits, ECB rules, overseas investment caps)
Tarapore Committee I (1997)	Recommended full capital account convertibility with preconditions	Preconditions: fiscal deficit below 3.5%, inflation 3-5%, NPA reduction
Tarapore Committee II (2006)	Recommended phased convertibility by 2011	Not fully implemented due to global financial crisis
Fuller Capital Account Convertibility	India moving gradually toward it	RBI liberalizes limits periodically

Important Committees on External Sector

Committee	Year	Subject
Rangarajan Committee	1993	BOP reform; recommended market-determined exchange rate
Tarapore Committee I	1997	Capital account convertibility
Tarapore Committee II	2006	Fuller capital account convertibility
Arvind Mayaram Committee	2014	Definition of FDI and FPI

PSC Quick Recall

Question	Answer
FEMA replaced which act?	FERA (1973)
FEMA came into force	June 2000
FEMA violation is a	Civil offence (not criminal)
India’s exchange rate system	Managed float (since 1993)
Current account convertibility achieved	August 1994
Full capital account convertibility?	No, only partial
Tarapore Committee relates to	Capital account convertibility
India’s forex reserves rank	4th globally
1991 forex crisis — reserves fell to	About $1.2 billion
Largest component of forex reserves	Foreign Currency Assets (FCA)
Largest recipient of remittances globally	India
FDI vs FPI — which is long-term?	FDI