External Sector - 01
External sector comprises of all economic activities which relates to exchanges outside the territory of the nation. It consists of external trade, foreign currency, foreign accounts of the public and nation, foreign investment, international monetary reserves and international economic groups and integration of national economies.
Foreign Exchange Reserves:
It comprises of foreign currency Assets, gold stock of central bank, special drawing rights and Reserve tranche position in IMF.
Foreign Currency Assets:
Consists of Foreign currency held by central bank, NRI deposits, securities issued by NRI, bonds, stocks with underlying foreign currency assets.
Special Drawing Rights:
Till 1971 — the countries followed Bretton woods exchange — system at which the currencies printed by central banks were backed by physical gold assets. Later it was abandoned due to certain uncertainties in exchange rates.
So IMF as a bank of deposit introduced SDR an artificial currency based on each country’s quota (Depending on size of their economy, openness, etc.)
IMF can give loans to its members during BOP crisis, based on their members deposits in it. Initially, SDR was fixed against gold but later it was fixed based on weightage of a currency in IMF basket (USD, Euro, Chinese yuan, Japanese yen, pound sterling) to its exchange rate.
SDR is called paper gold as it is merely an accounting entity and not backed by gold. As on 2016 : India’s quota 2.7% and it allotted 13 billion SDR. Also 25% of this SDR is kept as reserve tranche position. USA hold (18%) quota, japan (1%) and china (6%) respectively.
India is the 8th largest quota holder in IMF. Voting power in IMF also decided by IMF’s SDR quota. This voting power is exercised by finance minister of India in case of his absence RBI Governor exercise this voting
A reserve tranche is a portion of the required quota of currency each member country must provide to the International Monetary Fund (IMF) that can be utilized for its own purposes—without a service fee or economic reform conditions. The IMF is funded through its members and their quota contributions. The reserve tranche is basically an emergency account that IMF members can access at any time without agreeing to conditions or paying a service fee. In other words, a portion of a member country’s quota can be withdrawn free of charge at its own discretion.
Types of Currency
Soft money is just paper currency backed by government bonds. Here money is printed without keeping adequate reserves like gold in proportion to the newly issued money.
Hard money is money issued with the backing of gold or other very credible assets.
It is a temporary form of hard currency. If the hard currency is existing at fast pace the it is called hot currency.
When a domestic currency is under pressure of depreciation due to hard currency’s high tendency of exiting the economy, it is said that the currency is heated.
Forex Exchange rate
An exchange rate is the value of one nation’s currency versus the currency of another nation or economic zone. An exchange rate is the value of a country’s currency vs. that of another country or economic zone. Most exchange rates are free-floating and will rise or fall based on supply and demand in the market. Some currencies are not free-floating and have restrictions.
Types of Exchange Rates
1. Free Floating
A free-floating exchange rate rises and falls due to changes in the foreign exchange market.
2. Restricted Currencies
Some countries have restricted currencies, limiting their exchange to within the countries’ borders. Also, a restricted currency can have its value set by the government.
3. Currency Peg
Sometimes a country will peg its currency to that of another nation. For instance, the Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85.This means the value of the Hong Kong dollar to the U.S. dollar will remain within this range.
4.Fixed exchange rate regime
It is a method of regulating exchange rate of the world currencies brought by the IMF.
TERMS: (Liberalized exchange rate management system)
This is known as system of double exchange rates adopted on 1992. Under LERMS, the exporters could sell 60% of their foreign exchange earning to the authorized foreign exchange dealers in the open market at open exchange rate while the remaining 40% was to be sold mandatorily to RBI at the exchange rates decided by RBI. Also the government was providing the foreign exchange only for most essential imports. This was introduced to increase foreign exchange reserves and discourage imports.