External Sector: FDI, FPI & BoP — Set 3

Correct Answer: B. B. It is financed by stable, long-term capital inflows like FDI rather than volatile portfolio flows

A Current Account Deficit is considered sustainable when it is financed by stable, long-term capital inflows — primarily FDI — which create productive assets and do not reverse suddenly. CAD financed by short-term FPI (hot money) or external commercial borrowings is less sustainable as it creates vulnerability to sudden stops and capital flight. The IMF typically considers a CAD of 2-3% of GDP sustainable for a developing economy.

Correct Answer: B. B. The inability of developing countries to borrow internationally in their own currency

Original Sin in international finance, coined by Barry Eichengreen and Ricardo Hausmann, refers to the inability of most developing countries to borrow in international capital markets in their own (domestic) currency. They must borrow in hard currencies (USD, EUR), creating currency mismatch risk — if their currency depreciates, the real debt burden rises sharply. This makes developing economies more vulnerable to external shocks and sudden stops.

Correct Answer: B. B. An international reserve asset created by the IMF to supplement member countries' official reserves

Special Drawing Rights (SDRs) are an international reserve asset created by the IMF in 1969 to supplement member countries' official reserves. SDRs are not a currency but a potential claim on freely usable currencies of IMF members. Their value is based on a basket of five currencies: USD, Euro, CNY (Chinese yuan), JPY, and GBP. India received SDR allocations as part of IMF's general SDR allocation in 2021 ($17.86 billion equivalent).

Correct Answer: B. B. Imports collapsed due to COVID-19 lockdowns, reducing the trade deficit

India had a rare Current Account Surplus (0.9% of GDP) in 2020-21 primarily because COVID-19 lockdowns drastically reduced import demand — particularly for crude oil (as global prices crashed) and gold. The sharp compression of the merchandise trade deficit, combined with resilient service exports and strong remittances, resulted in a current account surplus for the first time in 12 years. This was not due to export strength but import compression.

Correct Answer: B. B. They provide a buffer against external shocks, enable exchange rate management, and enhance credit ratings

Foreign Exchange Reserves serve multiple functions: (1) Buffer against external shocks — sudden stop in capital flows or import payment needs; (2) Exchange rate management tool — RBI can intervene to prevent excessive rupee volatility; (3) Import cover — reserves measured in months of imports (minimum 3 months); (4) Debt servicing — can cover external debt obligations; (5) Confidence signal — adequate reserves improve sovereign credit ratings and investor confidence.

Correct Answer: B. B. Borrowings by Indian companies from foreign lenders in foreign currency

External Commercial Borrowings (ECBs) are commercial loans raised by Indian entities from foreign lenders — foreign banks, international capital markets, multilateral and bilateral institutions, export credit agencies. ECBs can be in the form of bank loans, buyers' credit, suppliers' credit, securitized instruments, and bonds. RBI regulates ECBs through guidelines on minimum maturity, all-in-cost ceilings, and end-use restrictions. ECBs are an important source of foreign capital for Indian corporates.

Correct Answer: B. B. Rupee-denominated bonds issued by Indian entities in overseas markets

Masala Bonds are Rupee-denominated bonds issued by Indian entities (government, corporates, PSUs) in overseas markets. The currency risk is borne by the foreign investor (not the issuer), unlike ECBs where the Indian borrower bears currency risk. 'Masala' is a colloquial reference to India. They were first issued by IFC (World Bank arm) in 2014, and later by Indian companies like HDFC, NTPC, and Indian Railway Finance Corporation to raise capital abroad.

Correct Answer: B. B. NRE (Rupee), NRO (Rupee), and FCNR (Foreign Currency) accounts

NRI deposits in India include: (1) NRE (Non-Resident External) accounts — Rupee-denominated, freely repatriable principal and interest, taxfree; (2) NRO (Non-Resident Ordinary) accounts — Rupee-denominated, used for India income, limited repatriation; (3) FCNR (B) [Foreign Currency Non-Resident Bank] accounts — foreign currency (USD, GBP, EUR, JPY, AUD, CAD) term deposits, fully repatriable and exempt from Indian taxes. NRI deposits are a stable source of foreign capital for India.

Correct Answer: B. B. Short-term speculative capital flows that move quickly across borders chasing higher returns

Hot Money refers to short-term, speculative capital (mainly FPI/portfolio investment) that moves rapidly across international borders seeking higher interest rates, stronger currencies, or better stock market returns. Hot money can cause rapid currency appreciation or asset bubbles when it flows in, and sharp depreciation and market crashes when it suddenly exits. India experienced hot money outflows during the 2013 Taper Tantrum and 2022 US Fed rate hike cycle.

Correct Answer: B. B. Free capital mobility, fixed exchange rate, and independent monetary policy

Mundell's Impossible Trinity (or Trilemma) states that a country can only achieve two of three policy objectives simultaneously: (1) Free capital mobility; (2) Fixed exchange rate; (3) Independent monetary policy. For example, if India allows free capital flows and wants independent monetary policy, it must give up a fixed exchange rate (which is India's choice). The Trilemma was articulated by Robert Mundell and Marcus Fleming and is fundamental to open-economy macroeconomics.