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Q65 (IAS/2019) Economy › External Sector & Trade › Currency and financial crises Official Key

In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis? 1. The foreign currency earnings of India's IT sector 2. Increasing the government expenditure 3. Remittances from Indians abroad Select the correct answer using the code given below.

Result
Your answer: —  ·  Correct: B
Explanation

The correct answer is option B (1 and 3 only) because foreign currency earnings from India's IT sector and remittances from Indians abroad both contribute to reducing currency crisis risk, while increasing government expenditure does not.

Foreign currency flows into the home country due to exports of goods and services by a country, gifts or transfers from foreigners, and purchase of home country assets by foreigners[1]. India's IT sector exports services and earns foreign exchange, which strengthens the supply of foreign currency and reduces vulnerability to currency crises.

India is the largest recipient of remittances in the world, receiving around $100 billion in 2022, and the balance of invisibles has always been positive because India has always been a net exporter of services[3]. These remittances provide a steady inflow of foreign exchange, cushioning against currency volatility.

However, increasing government expenditure does not reduce currency crisis risk. Infrastructure spending and strengthening of private consumption contribute to raising the current account (CA) deficit[4], which actually increases demand for foreign currency and can worsen the balance of payments position. Therefore, statements 1 and 3 are correct contributors to reducing currency crisis risk, making option B the correct answer.

Sources
  1. [1] Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
  2. [2] Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > 2. Balance of Invisibles > p. 473
  3. [3] Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Another case: > p. 108
  4. [4] https://www.elibrary.imf.org/view/journals/002/2025/054/article-A001-en.xml
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Q. In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis? 1. The…
At a glance
Origin: Mixed / unclear origin Fairness: Moderate fairness Books / CA: 6.7/10 · 0/10

This is a classic 'Macroeconomic Stability' question testing the Twin Deficit link. It moves beyond rote memorization of BoP components to their functional impact on currency stability. If you understood the causes of the 1991 crisis (high fiscal deficit leading to external crisis), this was a sitter.

How this question is built

This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.

Statement 1
Do the foreign currency earnings of India's IT sector contribute to reducing the risk of a currency crisis in India?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
Presence: 5/5
“Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by the foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners. A rise in price of foreign exchange will reduce the foreigner's cost (in terms of USD) while purchasing products from India, other things remaining constant. This increases India's exports and hence supply for foreign exchange may”
Why this source?
  • Explains that exports bring foreign currency into the home country, increasing supply of foreign exchange.
  • By increasing foreign exchange supply, exports (including services like IT) relieve pressure on the currency market.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > LESS DEVELOPED COUNTRIES OFTEN DEVALUE THEIR CURRENCY, IS IT TRUE? > p. 495
Presence: 4/5
“Yes, Less Developed Countries often devalue their currency because: • Devaluation by the government raises the demand of domestically produced goods and services and thereby exports are expected to rise. • Rise of exports helps to raise foreign exchange flow which as a result facilitates imports of essential items. • Devaluation also attracts private foreign investment into the economy which enables a better GDP growth. In July 1991 the Indian government devalued the rupee by between 18 and 19 per cent to overcome the BOP Crisis. Black Wednesday occurred in the United Kingdom in 1992. December Mistake occurred in Mexico in 1994.”
Why this source?
  • States that rising exports raise foreign exchange flow and help overcome a BOP crisis.
  • Links higher export earnings to improved ability to finance imports and attract investment, reducing crisis risk.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > After 1993: > p. 40
Presence: 4/5
“If the opposite happens and investors start leaving India then they will sell their investments in India in Rupee and purchase the foreign currency which will lead to increase in demand of foreign currency and the Rupee will start depreciating. Let us take another example to understand why Rupee depreciated against Dollar continuously after 1993: Suppose the Nominal Exchange Rate is $ 1 = Rs. 40 • Col1: Burger Price; India: Rs. 20; US: $1 In this case US will import the burgers from India as in $1 they will get Rs. 40 and in Rs. 40 they will get 2 burgers in India, so India will export burgers to US.”
Why this source?
  • Illustrates how capital outflows increase demand for foreign currency and cause rupee depreciation.
  • Implies that foreign currency inflows (from exports/services) counteract such depreciation pressures.
Statement 2
Does increasing government expenditure in India contribute to reducing the risk of a currency crisis in India?
Origin: Weak / unclear Fairness: Borderline / guessy
Indirect textbook clues
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > Limitations > p. 499
Strength: 5/5
“• It exposes the economy to global vulnerabilities. \bullet• There remains a fear of sudden capital flight which may also lead to increase in current account deficit.\bullet Risk of speculative attacks.\bullet No ceiling on external debt may be disastrous.\bullet Zontagion effect, i.e., more chances of transmission of the effect of financial crisis occurring in a particular country to the Indian economy. As per the Tarapore Committee, there are some pre-conditions which need to be fulfilled before going for full convertibility of rupee: • 1. Reduce fiscal deficit to 3.5 per cent of GDP. • 2. Reduce public debt by setting up consolidated sinking fund. • 3.”
Why relevant

Links fiscal discipline to external vulnerability by listing 'Reduce fiscal deficit to 3.5% of GDP' as a pre-condition before full convertibility, implying high fiscal deficits increase currency risk.

How to extend

A student could infer that raising government expenditure (which tends to widen fiscal deficit) may increase currency crisis risk unless financed sustainably, and check India's deficit trajectory vs FX stability.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 6: Economic Planning in India > 2. Planning in Post-1991 or Post-Reforms Phase > p. 135
Strength: 5/5
“• Due to the policies followed till 1991, the fiscal deficit and revenue deficit of India \bullet increased. • The dependence on imports and lack of significant exports resulted in Balance of e. Payments crisis. • Apart from these, the country was facing the situation of stagnation along with high \bullet inflation. Simultaneous occurrence of Gulf crisis and reduced foreign exchange reserves resulted in rise in prices. Consequently, our country adopted a different New Economic Policy. Under the New Economic Policy of India: • Private sector was promoted and free play of market was facilitated. • Foreign inflows under FDI and FII were encouraged.”
Why relevant

Describes how high fiscal and revenue deficits contributed to a Balance of Payments crisis pre-1991, connecting fiscal imbalance with external/ currency crises.

How to extend

Use this historical pattern to judge whether increased government spending today (and its effect on deficits) could similarly strain reserves and FX stability.

Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 80
Strength: 4/5
“Deficit Reduction: Government deficit can be reduced by an increase in taxes or reduction in expenditure. In India, the government has been trying to increase tax revenue with greater reliance on direct taxes (indirect taxes are regressive in nature – they impact all income groups equally). There has also been an attempt to raise receipts through the sale of shares in PSUs. However, the major thrust has been towards reduction in government expenditure. This could be achieved through making government activities more efficient through better planning of programmes and better administration. A recent study7 by the Planning Commission has estimated that to transfer Re1 to the poor, government spends Rs 3.65 in the form of food subsidy, showing that cash transfers would lead to increase in welfare.”
Why relevant

Explains that government deficit can be reduced by raising taxes or reducing expenditure, showing government expenditure is a primary driver of fiscal deficit.

How to extend

Combine this with evidence that deficits affect currency risk to evaluate whether increasing spending (without offsetting revenue) would raise currency crisis risk.

Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Indian Govt. securities will very soon join Global Bond Index > p. 48
Strength: 4/5
“Issuing debt in foreign currencies or listing of bonds in international indices, while attracting greater flows, could expose the country to a greater degree of exchange rate risk and potentially lead to volatility in the rupee if external conditions were to turn adverse.• When foreign investors will purchase Govt. of India bonds from the Global bond index then Govt. of India will get funds in dollars/foreign currency and then it will convert in Rupee (for its spending in India) and after maturity of the bonds, Govt. of India will have to first convert rupees (which it will get through tax and other receipts) into dollars/foreign currency to repay to the investors.”
Why relevant

Shows that issuing debt in foreign currencies exposes the country to exchange rate risk and could lead to rupee volatility, linking government financing choices to FX vulnerability.

How to extend

A student can assess whether increased domestic government spending is being financed by foreign-currency borrowing (vs. domestic taxes/rupee debt), which would matter for currency crisis risk.

Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.31 Previous Years Questions > p. 120
Strength: 3/5
“(ii) CAR is decided by each individual bank. Which of the statements given above is/are correct? • (a) (i) only• (b) (ii) only• (c) Both (i) & (ii)• (d) Neither (i) nor (ii)• 34. Which of the following is not included in the assets of a commercial bank in India? [2019] • (a) Advances• (b) Deposits• (c) Investments• (d) Money at call and short notice• 35. In the context of India, which of the following factors is/are contributor/ contributors to reducing the risk of a currency crisis? [2019] • (i) The foreign currency earnings of India's IT sector• (ii) Increasing the government expenditure• (iii) Remittances from Indians abroad• Select the correct answer using the code given below.• (a) (i) only• (b) (i) & (iii) only• (c) (ii) only• (d) (i), (ii) & (iii)• 36.”
Why relevant

Presents an exam-style item listing 'Increasing the government expenditure' as a candidate factor affecting currency crisis risk, indicating it's a debated/considered variable in this context.

How to extend

Treat this as a prompt to investigate empirical/ theoretical arguments for and against spending increases reducing or raising currency crisis risk in India.

Statement 3
Do remittances from Indians abroad contribute to reducing the risk of a currency crisis in India?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > 2. Balance of Invisibles > p. 473
Presence: 5/5
“10. Telecommunication, computer and information services 11. Personal, cultural and recreational services 12. Government goods and services not included elsewhere (GNIE) (for example, receipts and payments for maintenance of foreign embassies, diplomatic missions, defence agencies abroad, etc.) 13. Others, not included elsewhere. In the case of India, though there is net outflow on the account of interest and dividend, balance of invisibles has always been positive because India has always been a net exporter of services and is the largest recipient of remittances in the world. Under the Liberalised Remittance Scheme of RBI, all resident individuals, including minors, are allowed to freely remit up to US$ 2,50,000 per financial year for any permissible current or capital v account transaction or a combination of both.”
Why this source?
  • Identifies that India’s balance of invisibles is positive in part because it is the largest recipient of remittances, tying remittances to net foreign exchange receipts.
  • A positive invisibles account strengthens the overall BOP position, which lowers vulnerability to sudden currency pressure.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Another case: > p. 108
Presence: 4/5
“And this transaction is not for free, as I worked and then the company X paid to me. So, this is called 'Factor Income' under BoP (Current Account). 108 India is the largest recipient of remittances (private transfers) in the world and last year in 2022 it received around $100 billion in remittances. The largest sources of remittances for India comes from Gulf Cooperation Council (GCC) Countries and the US, UK. Kerala is one of the largest recipients of remittances in India. The top five recipient countries are India, Mexico, China, Philippines and Egypt”
Why this source?
  • States the large scale of remittances to India (around $100 billion in 2022), indicating a significant, stable source of foreign currency inflow.
  • Large remittance inflows provide foreign exchange that can help meet external obligations and reduce dependence on volatile capital flows.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Remittances > p. 474
Presence: 3/5
“A remittance refers to money that is sent or transferred to another party. The term is derived from the word 'remit', which means to send back. Remittances can be used for any type of payment including invoices or other obligations. But the term is typically used to refer to money sent to family members back in a person's home country. Remittances are recorded in BOPs. Role of remittances in an economy: • a) Important for economies of small and developing countries. • A way to help raise the standard of living for people abroad and help combat global poverty. • c) In some cases, they make up a significant portion of a country's GDP.”
Why this source?
  • Explains remittances as private transfers recorded in the BOP and notes they can constitute a significant portion of GDP for recipient countries.
  • Framing remittances as important for developing economies implies their role in supporting external balances and economic stability.
Pattern takeaway: UPSC consistently tests the 'Stabilizers vs. Destabilizers' framework in Economy. They will list mixed factors (domestic/external) and ask you to categorize them based on their net impact on the Rupee. The pattern is: Good Inflows (Exports/Remittances) = Stability; Loose Domestic Policy (High Spending/Inflation) = Instability.
How you should have studied
  1. [THE VERDICT]: Conceptual Sitter. Directly solvable using NCERT Class XII Macroeconomics (Open Economy chapter) logic on Supply of Foreign Exchange.
  2. [THE CONCEPTUAL TRIGGER]: Balance of Payments (BoP) mechanics—specifically the distinction between 'Sources of Supply' (Inflows) and 'Sources of Demand' (Outflows) for Forex.
  3. [THE HORIZONTAL EXPANSION]: Memorize the 'Crisis Buffer' toolkit: Import Cover (months of imports reserves can pay), Short-term vs Long-term Debt ratio, NEER vs REER (competitiveness), Masala Bonds (rupee-denominated = low risk) vs ECBs (dollar-denominated = high risk), and the concept of 'Sterilization'.
  4. [THE STRATEGIC METACOGNITION]: Do not study Fiscal Policy and External Sector in silos. The key insight here is the 'Twin Deficit Hypothesis'—how domestic fiscal indiscipline (Statement 2) spills over into external currency vulnerability.
Concept hooks from this question
📌 Adjacent topic to master
S1
👉 Exports and foreign exchange supply
💡 The insight

Exports, including IT services, bring foreign currency into India and increase the supply of foreign exchange.

High-yield for UPSC because it links trade/services receipts to exchange-rate dynamics and reserve adequacy; useful across questions on balance of payments, exchange rate policy, and service-sector contributions. Mastery enables explanation of how service exports stabilise currency and improve external balances.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > LESS DEVELOPED COUNTRIES OFTEN DEVALUE THEIR CURRENCY, IS IT TRUE? > p. 495
🔗 Anchor: "Do the foreign currency earnings of India's IT sector contribute to reducing the..."
📌 Adjacent topic to master
S1
👉 Balance of Payments and currency crisis mechanics
💡 The insight

A weak BOP or sudden capital outflows raises demand for foreign currency, causing rupee depreciation and risk of a currency crisis.

Crucial for answering questions on macroeconomic stability, capital flows and crisis triggers; connects to topics like capital account volatility, reserves, and policy responses (devaluation, capital controls). Knowing this helps analyse vulnerability and mitigation measures.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > After 1993: > p. 40
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > LESS DEVELOPED COUNTRIES OFTEN DEVALUE THEIR CURRENCY, IS IT TRUE? > p. 495
🔗 Anchor: "Do the foreign currency earnings of India's IT sector contribute to reducing the..."
📌 Adjacent topic to master
S1
👉 Forex buffers and swap lines as stabilisers
💡 The insight

Foreign currency reserves and swap agreements provide a buffer to meet dollar demand and stabilise the exchange rate.

Important for policy-focused answers on crisis management and RBI tools; links to reserve adequacy, currency swap mechanisms and their role in reducing exchange-rate volatility. Enables evaluation of policy options to contain currency crises.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Currency Swap Agreement between two countries: > p. 102
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Indian Govt. securities will very soon join Global Bond Index > p. 48
🔗 Anchor: "Do the foreign currency earnings of India's IT sector contribute to reducing the..."
📌 Adjacent topic to master
S2
👉 Fiscal deficit and balance-of-payments / currency stability
💡 The insight

High fiscal deficits from increased government expenditure can worsen balance-of-payments stress and raise vulnerability to currency crises.

This is high-yield for UPSC because questions often link fiscal policy to external sector stability; mastering it helps answer policy-economy questions on convertibility, crisis triggers and fiscal consolidation. It connects to macroeconomic management, public debt policy and external sector reforms, enabling candidates to evaluate trade-offs between fiscal stimulus and currency risk.

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > Limitations > p. 499
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 6: Economic Planning in India > 2. Planning in Post-1991 or Post-Reforms Phase > p. 135
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 80
🔗 Anchor: "Does increasing government expenditure in India contribute to reducing the risk ..."
📌 Adjacent topic to master
S2
👉 Foreign-currency borrowing and exchange-rate risk
💡 The insight

Borrowing or issuing debt in foreign currencies exposes the country to exchange-rate risk and can amplify currency instability.

Understanding this helps answer questions on external vulnerabilities, debt composition and instruments (e.g., Masala bonds versus foreign-currency bonds). It links public debt management to foreign exchange risk and informs policy choices on currency denomination of debt and reserve management.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Indian Govt. securities will very soon join Global Bond Index > p. 48
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > MASALA BOND > p. 266
🔗 Anchor: "Does increasing government expenditure in India contribute to reducing the risk ..."
📌 Adjacent topic to master
S2
👉 Foreign exchange supply and external buffers (exports, remittances, swaps)
💡 The insight

Stable and diverse foreign exchange inflows—exports, transfers and swap lines—support currency stability and reduce crisis risk.

This concept is essential for questions on external sector resilience and crisis prevention strategies; it ties into trade policy, remittance economics and central bank tools (e.g., currency swaps, reserves). Mastery enables discussion of both market and policy instruments that stabilize the exchange rate.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Currency Swap Agreement between two countries: > p. 102
🔗 Anchor: "Does increasing government expenditure in India contribute to reducing the risk ..."
📌 Adjacent topic to master
S3
👉 Remittances as a Balance of Payments item
💡 The insight

Remittances are private transfers recorded in the current account and contribute to a positive invisibles balance, improving external stability.

High-yield for questions on external sector and currency risk because it links household/income flows to macro BOP outcomes; helps answer why some countries face less exchange-rate pressure despite limited export earnings. Connects to topics on current account composition, BOP adjustments, and policy responses.

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Remittances > p. 474
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > 2. Balance of Invisibles > p. 473
🔗 Anchor: "Do remittances from Indians abroad contribute to reducing the risk of a currency..."
🌑 The Hidden Trap

The 'Impossible Trinity' (Mundell-Fleming Trilemma). Since this question tests currency stability, the next logical step is the trade-off policy makers face: A country cannot simultaneously have a fixed exchange rate, free capital movement, and an independent monetary policy.

⚡ Elimination Cheat Code

Apply the 'Inflation Logic' to Statement 2. Increasing government expenditure generally fuels demand and inflation. High inflation erodes domestic currency value (Purchasing Power Parity theory). A losing currency *increases* crisis risk. Thus, Statement 2 is a risk *enhancer*, not a reducer. Eliminate options C and D immediately.

🔗 Mains Connection

Mains GS-3 (Economy): Link 'Remittances' to 'Soft Power' and 'Diaspora Diplomacy' (GS-2). India's resilience to currency shocks is partly due to the 'social capital' of its diaspora, acting as a counter-cyclical buffer during global slowdowns.

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