UPSC Prelims 2011 Q10: Indian Economy – External Sector & Balance Of Payments
Consider the following actions which the Government can take:
1. Devaluing the domestic currency.
2. Reduction in the export subsidy.
3. Adopting suitable policies which attract greater FDI and more funds from FIIs.
Which of the above actions can help in reducing the current account deficit?
- (a) 1 and 2
- (b) 2 and 3
- (c) 3 only
- (d) 1 and 3
Answer: (d) 1 and 3
Explanation
Reducing the Current Account Deficit (CAD)
The CAD is the gap when a country's foreign exchange outflow (imports, etc.) exceeds its inflow (exports, remittances).
| Action | Helps reduce CAD? | Reason |
|---|---|---|
| 1. Devaluing the domestic currency | Yes | Makes exports cheaper and imports costlier, improving the trade balance |
| 2. Reduction in export subsidy | No | Cutting subsidy makes exports less competitive, which would widen, not narrow, the CAD |
| 3. Attracting more FDI and FII funds | Helps finance the CAD, but note: | FDI/FII inflows are in the capital account; they help fund the deficit rather than directly shrink the trade gap, but the question groups this as a helpful action |
Why the official key is (d) 1 and 3:
| Action | Effect |
|---|---|
| Devaluation | Directly improves the trade balance |
| Cutting export subsidy | Hurts exports, so it does not help |
| More FDI/FII | Brings in foreign exchange that finances/offsets the deficit |
Answer: (d) 1 and 3.
Why each option is right or wrong
- (a) Incorrect. Cutting the export subsidy would hurt exports, not help the CAD.
- (b) Incorrect. Reducing the export subsidy does not help; it is attracting FDI/FII (3), combined with devaluation (1), that helps.
- (c) Incorrect. Devaluation (1) also helps reduce the CAD; action 3 alone is not the full answer.
- (d) CORRECT. Devaluing the currency and attracting more FDI/FII both help address the current account deficit.
Key point
CAD reduction: devalue the currency (boosts exports) and attract FDI/FII (brings in forex). Cutting export subsidies hurts, not helps, exports.
Remember
CAD fix: devalue currency + attract FDI/FII, not cut export subsidy.
Common mistakes
- Assuming any policy sounding supportive of exports, like cutting a subsidy, automatically helps; a subsidy cut actually weakens exports.
- Forgetting that FDI/FII inflows are capital-account flows that help finance the deficit.
- Missing that devaluation works by making exports cheaper and imports dearer.
Exam tip
A subsidy cut is a withdrawal of support, so it works against the stated export-boosting goal. Treat it as the opposite of helpful.
Sources
- Reserve Bank of India — Macroeconomic and Monetary Developments, Current Account Deficit
- Economic Survey — Chapter on External Sector