External Sector Vulnerabilities & Balance of Payments (BoP) Crisis

Statement 1 is correct: Foreign currency earnings - The IT sector generates foreign exchange through exports of services. This increases the supply of foreign currency reserves, making it easier to defend the rupee's value in the foreign exchange market during times of stress. Statement 2 is incorrect: While government spending can stimulate economic growth, it can also lead to a higher budget deficit. If the deficit is financed by excessive borrowing, it can put pressure on the currency if investors lose confidence in the government's ability to repay its debts. Statement 3 is correct: Remittances from abroad - When Indians working abroad send money back home, it adds to the inflow of foreign currency. This strengthens the country's foreign exchange reserves and provides a buffer against external shocks. Therefore, the correct code is 1 and 3 only.

India's foreign-exchange reserves include: 1. Foreign currency assets (FCAs): This is the largest component, consisting of deposits and holdings in major currencies like US Dollars, Euros, and Yen. 2. Gold reserves: India holds a significant amount of gold bullion as part of its foreign exchange reserves. 3. Special drawing rights (SDRs): These are international reserve assets created by the International Monetary Fund (IMF) that supplement official foreign reserves. 4. Reserve position in the IMF: This refers to India's quota or shareholding position in the IMF, which can be a source of additional foreign currency if needed.

Statement 1 is Incorrect: Share of agriculture in GDP has actually decreased since 1991, as the service sector has grown significantly. Statement 2 is Correct: Share of India's exports in world trade has increased. India has become a more integrated part of the global economy, with a larger export footprint. Statement 3 is Correct: FDI inflows have increased considerably. The liberalisation measures made India a more attractive destination for foreign investment. Statement 4 is Correct: India's foreign exchange reserves have also increased enormously. This reflects India's improved ability to generate foreign currency and manage its external finances. Therefore, the correct answer is 2, 3, and 4 only. Hence, option B is the correct answer.

Tight monetary policy is an action taken by a central bank, such as the Federal Reserve, to curb overheated economic growth. Central banks employ tight monetary policy when an economy is experiencing rapid acceleration or when inflation, which pertains to overall prices, is escalating too swiftly. Statement 1 is correct. A tight monetary policy by the US Federal Reserve means higher interest rates in the US. This attracts global investors to shift their capital towards US assets for better returns. As a result, there can be capital flight from emerging markets like India to the US. Statement 2 is correct. When capital flows out, the domestic currency tends to depreciate, and global interest rates rise. Firms that have borrowed in foreign currencies through External Commercial Borrowings (ECBs) will now face higher repayment costs in rupee terms. Thus, their cost of servicing these loans increases, raising their overall financial burden. Statement 3 is incorrect. Devaluation of the domestic currency actually increases the currency risk associated with ECBs. Since these loans are denominated in foreign currency (like USD), a weaker rupee means firms have to pay more in rupees to repay the same amount of foreign debt. Therefore, devaluation heightens, not reduces, currency risk. NOTE: The given question was dropped by UPSC from the Official Answer Key.

Not depending on short-term foreign borrowings: This reduces exposure to capital flight. During a crisis, foreign investors may pull their money out of emerging markets like India, leading to rupee depreciation and financial instability. By limiting short-term foreign borrowings, India can lessen the impact of such capital flight. Opening up to more foreign banks: While this might seem beneficial, it can also increase reliance on foreign capital. During a crisis, foreign banks might be more likely to restrict credit, negatively impacting the Indian economy. Maintaining full capital account convertibility: This allows for the free movement of capital in and out of the country. While it can be beneficial in normal times, it can also exacerbate capital flight during a crisis. Therefore, the most prudent strategy is to reduce dependence on short-term foreign borrowings to minimize the vulnerability caused by potential capital flight. Hence, only statement 1 is correct. Hence, option A is the correct answer.