Foreign Exchange and Exchange Rate: Concepts and Policy

The correct answer is C, 1 and 3 only. Statement 1 is right because the NEER is a trade weighted index of the rupee against a basket of partner currencies, so a rise in the index means the rupee has appreciated in nominal terms. Statement 3 is right because the REER adjusts the NEER for relative prices, so when domestic inflation runs faster than inflation abroad the two indices move apart. Statement 2 is wrong, and this is why options A, B and D fail: a rise in the REER means the rupee has become expensive in real terms, which makes Indian goods dearer abroad and weakens, not improves, trade competitiveness. Option A is wrong because it accepts statement 2 and leaves out the correct statement 3, option B is wrong because it accepts statement 2 and drops the correct statement 1, and option D is wrong because it accepts all three including the faulty second one.

The correct answer is A, 1 and 2 only. Statement 1 is right because when the United States Federal Reserve tightens, returns there become attractive and portfolio money flows out of emerging markets, which is capital flight. Statement 2 is right because such an outflow weakens the rupee and raises risk premiums, so a firm servicing an external commercial borrowing pays more in rupee terms and finds refinancing dearer. Statement 3 is wrong, and this settles the other options: a fall in the value of the domestic currency raises, not lowers, the currency risk on a loan that must be repaid in dollars, because every dollar of repayment now costs more rupees. Option B is wrong because it accepts the faulty third statement and drops the correct first one, option C is wrong for accepting statement 3 while leaving out statement 2, and option D is wrong because it accepts all three.

The correct answer is B, inconsistent regulatory environment. Foreign investors bring in foreign exchange and look for predictable rules, and the difficulty most often listed for India is regulatory uncertainty: changing rules, clearances spread across departments and states, and disputes that take long to settle. Option A is wrong because competition from other foreign firms is a normal feature of any open market and is not a barrier that keeps investment out; investors come precisely to compete. Option C is wrong because India offers a large pool of engineers, managers and low cost workers and is usually described as strong on labour supply even where specific skills are short. Option D is wrong because a very large domestic consumer market is one of the main attractions that draws foreign direct investment to India, not a challenge. Remember that stable and simple rules are counted as the chief attraction for investment inflows.

The correct answer is A, the Foreign Exchange Regulation Act of 1973. FERA treated foreign exchange as a scarce resource, forbade most dealings unless permitted and made breaches criminal offences. It suited a closed economy and became unworkable after 1991, so Parliament passed the Foreign Exchange Management Act in 1999, which came into force in 2000, permits dealings unless restricted and treats breaches as civil matters. Option B is wrong because the Banking Regulation Act of 1949 governs the licensing and supervision of banks. Option C is wrong because the MRTP Act of 1969 dealt with monopolies and restrictive trade practices and was itself replaced by the Competition Act of 2002. Option D is wrong because the SEBI Act of 1992 gave statutory powers to the securities market regulator. Keep the pair FERA 1973 and FEMA 1999 ready, along with the fact that the Reserve Bank administers FEMA.

The correct answer is C, 1994. India accepted the obligations of Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994, which means the rupee can be exchanged freely for trade in goods and services, travel, education, remittances and interest payments. Option A is wrong because 1991 is the year of the balance of payments crisis and of the two step devaluation of the rupee in July, the beginning rather than the completion of the reform. Option B is wrong because March 1993 is when the dual rate of the Liberalised Exchange Rate Management System was unified into a single market determined rate, one step before convertibility. Option D is wrong because 1999 is the year FEMA was enacted. The capital account is still only partly convertible, which is the distinction papers test along with these dates.

The correct answer is D, small savings collected by the government. Small savings such as deposits in post office schemes are domestic rupee liabilities of the government and have nothing to do with the country's external assets. India's foreign exchange reserves, held and managed by the Reserve Bank, have exactly four components. Option A is wrong as an answer because foreign currency assets, mostly securities and deposits held in convertible currencies, are the largest of them. Option B is wrong because gold held by the Reserve Bank is a recognised reserve asset and has been used as one for a long time. Option C is wrong because special drawing rights, the reserve asset created by the International Monetary Fund and valued from a basket of major currencies, form another component. The fourth part, often asked as a fill in the blank, is the reserve tranche position in the IMF.

The correct answer is B, a managed float. Since the unification of the exchange rate in March 1993 the value of the rupee has been determined by demand and supply in the foreign exchange market, while the Reserve Bank intervenes by buying or selling dollars to curb sharp volatility rather than to defend any particular level. Option A is wrong because India abandoned a pegged rate in stages after 1991 and no longer announces a parity with the dollar. Option C is wrong because a currency board issues domestic money only against foreign reserves at a fixed rate, an arrangement India has never used. Option D is wrong because the gold standard, under which currencies were convertible into fixed quantities of gold, ended internationally in the last century. The term dirty float is sometimes used for the same managed arrangement, so treat it as an alternative name.

The correct answer is A. When the rupee depreciates, each dollar buys more rupees, so an Indian good priced in rupees costs a foreign buyer fewer dollars and exports become more competitive, while every imported item costs more rupees than before. Option B is wrong because it reverses this relationship; exports becoming costlier and imports cheaper is the effect of an appreciation. Option C is wrong because repaying a loan fixed in dollars takes more rupees after a depreciation, which is exactly why firms with external commercial borrowings suffer when the rupee weakens. Option D is wrong because crude oil is bought in dollars and forms a large part of India's import bill, so a weaker rupee raises the landed cost of oil, feeds into transport and manufacturing costs and adds to imported inflation. Remittances from workers abroad also fetch more rupees, which is a common additional statement in this question.

The correct answer is B, capital account convertibility. The committee headed by S. S. Tarapore reported in 1997 and again in 2006 and set out a phased road map for making the rupee convertible on the capital account, together with the preconditions to be met first, such as fiscal discipline, low and stable inflation and a strong banking system. Option A is wrong because agricultural credit has been examined by other committees and is not this one's subject. Option C is wrong because the design of the goods and services tax came from an empowered committee of state finance ministers and later the GST Council, a different process altogether. Option D is wrong because the restructuring of public sector banks belongs to the Narasimham Committee reports of 1991 and 1998. Linking each committee with its one subject is the quickest way to answer this recurring question type.

The correct answer is B, the International Monetary Fund. Special drawing rights are an international reserve asset created by the IMF and allotted to member countries in proportion to their quotas; a member can exchange them with other members for usable currencies. Their value is calculated from a basket of major currencies that contains the US dollar, the euro, the Chinese yuan, the Japanese yen and the pound sterling. Option A is wrong because the World Bank lends for development projects and does not issue reserve assets. Option C is wrong because the World Trade Organization frames the rules of international trade and has no monetary role. Option D is wrong because the Bank for International Settlements serves as a bank for central banks and a forum for regulation, but does not create reserve assets. Remember that SDRs and the reserve tranche position are the two IMF related items in India's reserves.