UPSC CSE Prelims
Foreign Exchange Reserves Previous Year Questions (PYQs)

Detailed Explanation:

Answer: Option 1 — 1 Only

Currency devaluation makes domestic goods cheaper for foreign buyers, thereby improving export competitiveness in international markets. However, it decreases (not increases) the foreign value of domestic currency and does not necessarily improve the trade balance as outcomes depend on various other factors like import dependency and global demand elasticity.

✅ Statement 1 – Correct: Devaluation reduces the price of exports in foreign currency terms, making domestic goods more competitive in foreign markets and potentially increasing export demand.

❌ Statement 2 – Incorrect: Devaluation decreases the foreign value of domestic currency, not increases it—this is the fundamental mechanism of devaluation where domestic currency becomes cheaper relative to foreign currencies.

❌ Statement 3 – Incorrect: While devaluation can improve trade balance by boosting exports, it's not guaranteed as it may also increase import costs (especially for import-dependent economies), lead to inflation, and the final impact depends on price elasticity of demand for exports and imports (Marshall-Lerner condition).

📝 Short Notes: Currency Devaluation

• Definition: Deliberate downward adjustment of a currency's value relative to foreign currencies by the government or monetary authority under a fixed/semi-fixed exchange rate regime.
• Immediate Effects: Exports become cheaper in foreign markets; imports become more expensive in domestic terms; foreign currency reserves become more valuable in domestic currency.
• Export Competitiveness: Domestic products gain price advantage in international markets, potentially increasing export volumes if demand is price-elastic.
• Marshall-Lerner Condition: Trade balance improves only if sum of price elasticities of demand for exports and imports is greater than 1; otherwise, trade deficit may worsen.
• J-Curve Effect: Initially trade balance may worsen (due to existing contracts and time lags), then improve over medium to long term as export volumes respond to price changes.
• Risks: Imported inflation (especially for raw materials and energy), potential competitive devaluations by trading partners, reduced purchasing power for foreign goods and services.

Detailed Explanation:

Answer: Option 4 — It is the number of months of imports that could be paid for by a country's international reserves

Import cover is a key indicator of external sector stability that measures how many months of imports a nation can finance using its current foreign exchange reserves. It is calculated by dividing total foreign exchange reserves by average monthly imports. For example, if a country has $300 billion in reserves and monthly imports of $25 billion, its import cover is 12 months. A higher import cover indicates stronger ability to withstand balance of payments crises or sudden capital outflows. The Reserve Bank of India typically aims to maintain adequate import cover (generally 9-12 months) to ensure economic security. Option 1 describes import intensity relative to GDP, Option 2 refers to absolute import value, and Option 3 describes the export-import ratio, none of which capture the reserves-to-imports relationship that defines import cover.

Detailed Explanation:

India's foreign-exchange reserves consist of four components: Foreign Currency Assets (FCAs), Gold holdings by the RBI, Special Drawing Rights (SDRs) from the IMF, and Reserve Tranche Position (RTP) in the IMF.

Loans from foreign countries, World Bank, or other institutions are external debts/liabilities, not part of foreign-exchange reserves which represent assets held by RBI that can be readily deployed.