UPSC CSE Prelims
Balance of Payments Previous Year Questions (PYQs)
Practice solved questions for Balance of Payments with detailed step-by-step solutions, key insights, and trend analysis for UPSC CSE PRELIMS.
Solved Previous Year Questions
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Consider the following statements:
- Tight monetary policy of US Federal Reserve could lead to capital flight.
- Capital flight may increase cost of firms with existing External Commercial Borrowings (ECBs)
- Devaluation of domestic currency decreases the currency risk associated with ECBs
Which of the statements given above are correct?
Detailed Explanation:
Answer: Option 2 — 1 and 2 only
A tight monetary policy by the US Federal Reserve involves raising interest rates, which makes US assets more attractive to global investors, leading to capital flight from emerging markets. This capital outflow causes domestic currency depreciation and increases the cost of servicing External Commercial Borrowings (ECBs) for firms, as they must pay more in domestic currency to repay foreign currency-denominated debt.
✅ Statement 1 – Correct: Tight US monetary policy (higher interest rates) attracts capital to the US, causing capital flight from emerging economies like India as investors seek better returns.
✅ Statement 2 – Correct: Capital flight leads to currency depreciation, increasing the rupee cost of repaying ECBs denominated in foreign currency (like USD), thereby raising the financial burden on firms.
❌ Statement 3 – Incorrect: Devaluation of the domestic currency increases (not decreases) currency risk for ECBs, as firms need more rupees to repay the same amount of foreign currency debt.
📝 Short Notes: External Commercial Borrowings (ECBs)
- Definition: ECBs are commercial loans raised by Indian companies from foreign lenders in foreign currencies, typically for financing imports, infrastructure, or expansion projects.
- Currency Risk: Since ECBs are denominated in foreign currency (usually USD or Euro), any depreciation of the rupee increases the repayment burden in rupee terms.
- Impact of Capital Flight: When capital flows out of India (e.g., due to tight US monetary policy), the rupee depreciates, making ECB repayments more expensive for Indian firms.
- Interest Rate Differential: ECBs are attractive when foreign interest rates are lower than domestic rates, but this advantage is offset if currency depreciation occurs.
- Regulation: The Reserve Bank of India (RBI) regulates ECBs through guidelines on permissible end-uses, borrowing limits, and maturity periods to manage external debt risks.
With reference to the Indian economy, consider the following statements:
- An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.
- An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
- An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements are correct?
Detailed Explanation:
Answer: Option 3 — 1 and 3 only
This question tests the understanding of exchange rate indices and their relationship with inflation and trade competitiveness. Statement 2 is incorrect because an increase in REER indicates overvaluation of the currency, which actually worsens (not improves) trade competitiveness.
✅ Statement 1 – Correct: NEER is a weighted average of a country's currency against a basket of trading partner currencies. An increase in NEER indicates that the domestic currency has appreciated relative to the basket of foreign currencies.
❌ Statement 2 – Incorrect: An increase in REER indicates that the domestic currency is becoming overvalued in real terms (after adjusting for inflation differentials), which reduces export competitiveness and worsens trade competitiveness, not improves it.
✅ Statement 3 – Correct: When domestic inflation is higher than foreign inflation, the real value of the currency depreciates faster than the nominal value. This causes REER to decline or grow slower than NEER, creating a divergence between the two indices.
📝 Short Notes: NEER and REER
- NEER (Nominal Effective Exchange Rate): Weighted average of bilateral nominal exchange rates of home currency against a basket of foreign currencies; measures nominal appreciation/depreciation without considering inflation.
- REER (Real Effective Exchange Rate): NEER adjusted for relative price levels (inflation differentials); measures real appreciation/depreciation and actual competitiveness.
- Formula relationship: REER = NEER × (Domestic Price Index / Foreign Price Index)
- Appreciation vs Competitiveness: If REER increases → currency overvalued → exports become expensive → trade competitiveness worsens; If REER decreases → currency undervalued → exports become cheaper → trade competitiveness improves.
- Inflation Impact: Higher domestic inflation relative to trading partners causes REER to rise faster than NEER (real appreciation), reducing competitiveness.
- Policy Implication: RBI monitors both NEER and REER; a rising REER signals loss of export competitiveness and may require policy intervention.
With reference to the international trade of India at present, which of the following statements is/are correct?
- India’s merchandise exports are less than its merchandise imports.
- India’s imports of iron and steel, chemicals, fertilisers and machinery have decreased in recent years.
- India’s exports of services are more than its imports of services.
- India suffers from an overall trade/current account deficit.
Select the correct answer using the code given below:
Detailed Explanation:
Answer: Option 4 — 1, 3 and 4 only
India consistently runs a merchandise trade deficit (imports exceed exports) and an overall current account deficit, while maintaining a services trade surplus. Statement 2 is incorrect as imports of iron and steel, chemicals, fertilizers, and machinery have actually increased in recent years, not decreased.
✅ Statement 1 – Correct: India's merchandise imports consistently exceed merchandise exports, creating a substantial trade deficit.
❌ Statement 2 – Incorrect: Imports of iron and steel, chemicals, fertilizers, and industrial machinery have registered positive growth rates, not decreased.
✅ Statement 3 – Correct: India maintains a services trade surplus, with service exports significantly exceeding service imports.
✅ Statement 4 – Correct: India suffers from an overall current account deficit (CAD), which was 2.1% of GDP in 2018-19 and 1.5% in H1 of 2019-20.
📝 Short Notes: India's Balance of Payments Structure
- Merchandise Trade: India runs a persistent merchandise trade deficit, with major imports including petroleum, gold, electronics, machinery, and chemicals.
- Services Trade: India enjoys a services trade surplus driven by IT-BPO exports, software services, business services, and remittances.
- Current Account Components: CAD = (Merchandise Trade Balance) + (Services Trade Balance) + (Primary Income) + (Secondary Income/Transfers).
- Major Export Items: Petroleum products, gems & jewelry, pharmaceuticals, engineering goods, textiles, and chemicals.
- Major Import Items: Crude oil & petroleum products, gold, electronic goods, machinery, coal, chemicals, and fertilizers.
- CAD Management: India finances CAD through foreign direct investment (FDI), foreign portfolio investment (FPI), and external commercial borrowings (ECB).
- Historical Trend: The services surplus partially offsets the merchandise deficit, but India typically maintains a moderate CAD of 1-3% of GDP.
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Consider the following statements:
- Most of India’s external debt is owed by governmental entities.
- All of India’s external debt is denominated in US dollars.
Which of the statements given above is/are correct?
Detailed Explanation:
Answer: Option 4 — Neither 1 nor 2
Both statements about India's external debt are incorrect. Most of India's external debt is owed by non-governmental entities (commercial borrowings, NRI deposits, and trade credit account for the majority), while government debt constitutes a smaller portion. Additionally, India's external debt is denominated in multiple currencies, with US dollar being the largest but not the only component.
❌ Statement 1 – Incorrect: Non-governmental debt (US$ 416.7 billion) far exceeds governmental debt (US$ 104.5 billion), making most external debt non-governmental in nature.
❌ Statement 2 – Incorrect: While US dollar-denominated debt is the largest component (45.9%), India's external debt is also denominated in Indian rupee (24.8%), SDR (5.1%), Japanese yen (4.9%), euro (3.1%), and other currencies.
📝 Short Notes: India's External Debt
| Component | Details |
|---|---|
| Definition | Total debt owed by India to foreign creditors (private banks, foreign governments, IMF, World Bank, etc.) |
| By Debtor Type | Non-Government Debt: ~80% (US$ 416.7 billion) Government Debt: ~20% (US$ 104.5 billion) |
| By Components | Commercial Borrowings: 37.4% NRI Deposits: 24.1% Short-term Trade Credit: 19.9% Others: Balance |
| Currency Composition | US Dollar: 45.9% Indian Rupee: 24.8% SDR: 5.1% Japanese Yen: 4.9% Euro: 3.1% Others: Balance |
| Key Debtors | Union Government, State Governments, Corporations, Indian Citizens |
In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis?
- The foreign currency earnings of India’s IT sector
- Increasing the government expenditure
- Remittances from Indians abroad
Select the correct answer using the code given below.
Detailed Explanation:
Answer: Option 2 — 1 and 3 only
A currency crisis occurs when a country faces rapid depletion of foreign exchange reserves, making it unable to meet its international payment obligations. Factors that increase foreign currency inflows help build reserves and reduce such risks.
✅ Statement 1 – Correct: India's IT sector earns substantial foreign exchange through service exports, directly strengthening forex reserves and providing a cushion against currency volatility.
❌ Statement 2 – Incorrect: Increasing government expenditure, especially if financed through borrowing, can widen fiscal deficits and potentially weaken investor confidence, thereby increasing rather than reducing currency crisis risk.
✅ Statement 3 – Correct: Remittances from Indians working abroad constitute a steady inflow of foreign currency, which bolsters forex reserves and acts as a buffer against external shocks.
📝 Short Notes: Factors Reducing Currency Crisis Risk
- Foreign Exchange Reserves: Act as a cushion to meet import bills and external debt obligations during times of stress.
- Current Account Balance: Export earnings (goods and services) and remittances improve the current account, reducing dependency on foreign capital.
- IT & Service Exports: India's IT sector is a major net foreign exchange earner, contributing significantly to invisible receipts.
- Remittances: India is the largest recipient of remittances globally, providing a stable source of foreign currency inflows.
- Fiscal Discipline: Excessive government expenditure leading to high fiscal deficits can trigger capital outflows and currency depreciation if financed unsustainably.
- Capital Controls: Prudent management of capital flows helps prevent sudden stops and reversals that trigger currency crises.
Consider the following statements with reference to ‘IFC Masala Bonds’ -
- The International Finance Corporation, which offers these bonds, is an arm of the World Bank.
- They are the rupee-denominated bonds and are a source of debt financing for the public and private sector.
Select the correct answer using the code given below.
Detailed Explanation:
Answer: Option 3 — Both 1 and 2
✅ Statement 1 – Correct: The International Finance Corporation (IFC) is the private sector arm of the World Bank Group, which comprises five institutions working to reduce poverty and promote sustainable development in developing countries.
✅ Statement 2 – Correct: Masala Bonds are rupee-denominated bonds issued outside India by foreign entities to raise capital in Indian rupees. They serve as a source of debt financing for both public and private sector entities, while the currency risk is borne by the investors rather than the issuer.
Convertibility of rupee implies:
Detailed Explanation:
Convertibility of rupee refers to the freedom to convert Indian rupees into other currencies and vice versa without restrictions, enabling cross-border transactions.
Option 1 refers to the outdated gold standard, Option 2 describes a floating exchange rate system, and Option 4 refers to currency trading infrastructure—none of which defines convertibility itself.
With reference to Balance of Payments, which of the following constitutes/constitute the Current Account?
- Balance of trade
- Foreign assets
- Balance of invisibles
- Special Drawing Right
Select the correct answer using the code given below.
Detailed Explanation:
Current Account of the Balance of Payments (BoP) comprises two main components: Balance of Trade (visible items - exports and imports of goods) and Balance of Invisibles (invisible items - services, income, and current transfers).
Foreign Assets are part of the Capital Account/Financial Account, representing investment flows and changes in ownership of international assets. Special Drawing Rights (SDR) are IMF reserve assets recorded under Reserve Assets in the BoP, not in the Current Account.
Which of the following constitute Capital Account?
- Foreign Loans
- Foreign Direct Investment
- Private Remittances
- Portfolio Investment
Select the correct answer using the codes given below.
Detailed Explanation:
1. Foreign Loans – Capital Account: Borrowings from abroad by government or private sector represent capital inflows and are recorded in the Capital Account.
2. Foreign Direct Investment (FDI) – Capital Account: Long-term investments by foreign entities in domestic companies creating lasting interest are part of the Capital Account.
3. Private Remittances – Current Account: Funds sent by individuals (e.g., migrant workers) to their home country are transfer payments recorded in the Current Account, not Capital Account.
4. Portfolio Investment – Capital Account: Investments in stocks, bonds, and financial securities by foreigners are short-term capital flows part of the Capital Account.
Correct Answer: Option 2 (1, 2 and 4 only) – Private Remittances fall under Current Account.
The balance of payments of a country is a systematic record of
Detailed Explanation:
Balance of Payments (BoP) is a systematic record of all economic transactions between residents of a country and the rest of the world during a specific period (usually a year).
It includes trade in goods (visible trade), trade in services (invisible trade), income flows, current transfers, and capital and financial account transactions—making it comprehensive, not limited to just imports/exports of goods or only government transactions.
The balance of payments of a country is a systematic record of
Detailed Explanation:
✅ Statement 1 – Correct: Balance of Payments (BoP) is a systematic record of all economic transactions between residents of a country and the rest of the world during a given period, typically a year, including goods, services, capital flows, and transfers.
❌ Statement 2 – Incorrect: This describes only the Balance of Trade (visible trade), not the comprehensive BoP which includes services, income, and capital accounts.
❌ Statement 3 – Incorrect: BoP covers transactions by all residents (individuals, firms, banks, government), not just government-to-government transactions.
❌ Statement 4 – Incorrect: Capital movements form only the capital account component of BoP; it also includes the current account (trade, services, income, transfers) and errors & omissions.
Consider the following statements: The price of any currency in the international market is decided by the
- World Bank
- demand for goods/services provided by the country concerned
- stability of the government of the concerned country
- economic potential of the country in question
Which of the statements given above are correct?
Detailed Explanation:
❌ Statement 1 – Incorrect: The World Bank provides loans for development projects; it does not decide or set currency prices in international markets. Currency prices are determined by market forces (demand and supply).
✅ Statement 2 – Correct: High demand for exports (goods/services) requires foreign buyers to purchase the country's currency, increasing its value in foreign exchange markets. This is a Current Account factor.
✅ Statement 3 – Correct: Political stability attracts FDI and FPI (Capital Account flows). Government instability causes capital flight, increasing currency supply and reducing its price.
❌ Statement 4 – Incorrect: While economic potential influences long-term investment sentiment, it is not a direct determinant of daily currency prices compared to immediate trade demand and political stability.
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