Chapter 8 · Topic 8.2 · Prelims + Mains2 of 3
External Sector: Reserves, FDI and institutions
Key points
- IMF and World Bank.
Prelims box: facts and traps
| Point | Detail |
|---|---|
| Current account convertibility | Since August 1994 (IMF Article VIII) |
| Capital account | Partially convertible; Tarapore Committees (1997, 2006) |
| Forex reserves (16 October 2026) | US$721.016 billion: foreign currency assets US$591.847 billion; gold US$105.800 billion (RBI WSS) |
| Components | Foreign currency assets, gold, SDRs, reserve tranche position with the IMF |
| 1991 crisis | Reserves covered about two weeks of imports; gold was pledged. |
- In a global crisis, India is better protected by avoiding short-term foreign borrowing than by opening to foreign banks or full capital account convertibility.
- On 9 October 2026 total reserves were about USD 726 billion: foreign currency assets about USD 597.6 billion, gold about USD 105.1 billion, SDRs about USD 18.5 billion and the reserve tranche position about USD 4.8 billion.
- The RBI's half-yearly report shows a valuation gain of about USD 50.2 billion in April-December 2025, which more than offset the BoP-basis drawdown of USD 30.8 billion.
- Trap (UPSC Prelims 2021): “Non-resident external deposits” is incorrect.
- Trap (UPSC Prelims 2020): “Opening up to more foreign banks” is incorrect. “Maintaining full capital account convertibility” is incorrect.
On this page (3 sections)
Convertibility and forex reserves
| Point | Detail |
|---|---|
| Current account convertibility | Since August 1994 (IMF Article VIII) |
| Capital account | Partially convertible; Tarapore Committees (1997, 2006) |
| Forex reserves (16 October 2026) | US$721.016 billion: foreign currency assets US$591.847 billion; gold US$105.800 billion (RBI WSS) |
| Components | Foreign currency assets, gold, SDRs, reserve tranche position with the IMF |
| 1991 crisis | Reserves covered about two weeks of imports; gold was pledged |
Prelims 2015: convertibility of the rupee means freely permitting the conversion of rupee to other currencies and vice versa.
Convertibility of rupee implies
- being able to convert rupee notes into gold
- allowing the value of rupee to be fixed by market forces
- freely permitting the conversion of rupee to other currencies and vice versa
- developing an international market for currencies in India
Show answer
Answer: (c) · UPSC official key
In a global crisis, India is better protected by avoiding short-term foreign borrowing than by opening to foreign banks or full capital account convertibility. The 2020 answer was 1 only.
If another global financial crisis happens in the near future, which of the following actions/policies are most likely to give some immunity to India ? 1. Not depending on short-term foreign borrowings 2. Opening up to more foreign banks 3. Maintaining full capital account convertibility Select the correct answer using the code given below :
- 1 only
- 1 and 2 only
- 3 only
- 1, 2 and 3
Show answer
Answer: (a) · UPSC official key
FDI and FPI
| Point | Detail |
|---|---|
| Routes | Automatic (no prior approval) and Government route; some sectors prohibited (e.g. lottery, atomic energy) |
| Rules | FDI policy by DPIIT; FEMA (Non-Debt Instruments) Rules, 2019 |
| Press Note 3 (2020) | Government approval for FDI from countries sharing a land border |
| FDI equity inflows 2025-26 | US$58.846 billion (₹5,16,936 crore), up 18% (DPIIT fact sheet) |
| FPI | Portfolio stake below 10%; volatile ‘hot money’ |
Prelims 2020: FDI’s major characteristic is that It is a largely non-debt creating capital flow. Prelims 2020
With reference to Foreign Direct Investment in India, which one of the following is considered its major characteristic ?
- It is the investment through capital instruments essentially in a listed company.
- It is a largely non-debt creating capital flow.
- It is the investment which involves debt-servicing.
- It is the investment made by foreign institutional investors in the Government securities.
Show answer
Answer: (b) · UPSC official key
Prelims 2011 said the key difference is that FII helps in increasing capital availability in general, while FDI only targets specific sectors. FCCBs, FII investment meeting set conditions and GDRs can count as FDI; NRE deposits cannot (Prelims 2021 answer: 1, 2 and 3).
Both Foreign Direct Investment (FDI) and Foreign Institutional Investor (FII) are related to investment in a country. Which one of the following statements best represents an important difference between the two ?
- FII helps bring better management skills and technology, while FDI only brings in capital
- FII helps in increasing capital availability in general, while FDI only targets specific sectors
- FDI flows only into the secondary market, while FII targets primary market
- FII is considered to be more stable than FDI
Show answer
Answer: (b) · UPSC official key
Consider the following : 1. Foreign currency convertible bonds 2. Foreign institutional investment with certain conditions 3. Global depository receipts 4. Non-resident external deposits Which of the above can be included in Foreign Direct Investments?
- 1, 2 and 3
- 3 only
- 2 and 4
- 1 and 4
Show answer
Answer: (a) · UPSC official key
Mains 2016: Justify the need for FDI for the development of the Indian economy, and explain the gap between MoUs signed and actual FDI. The causes include land, approvals, contract enforcement and policy uncertainty.
Justify the need for FDI for the development of the Indian economy. Why there is gap between MOUs signed and actual FDIs? Suggest remedial steps to be taken for increasing actual FDIs in India.
IMF, SDR and the World Bank
| Body | Detail |
|---|---|
| Bretton Woods (1944) | Created the IMF and IBRD (World Bank) |
| IMF | Short-term BoP support and surveillance; votes based on quotas; publishes World Economic Outlook |
| SDR | IMF reserve asset; basket of US dollar, euro, Chinese renminbi (added 2016), Japanese yen, pound sterling |
| World Bank Group | IBRD, IDA, IFC, MIGA, ICSID; long-term development lending |
| Reports | World Development Report and Global Economic Prospects (World Bank) |
Prelims 2016 asked which currency was proposed for the IMF’s SDR basket. Answer: Renminbi.
Recently, which one of the following currencies has been proposed to be added to the basket of IMF’s SDR?
- Rouble
- Rand
- Indian Rupee
- Renminbi
Show answer
Answer: (d) · UPSC official key
Mains box: analysis and answer points
- The causes include land, approvals, contract enforcement and policy uncertainty.
- Likely next angle: 1991
- Asked: Mains 2016 (GS Paper III, 12.5 marks): Justify the need for FDI for the development of the Indian economy. Why there is gap between MOUs signed and actual FDIs? Suggest remedial steps to be taken for increasing actual FDIs in India.
Practice
Practice MCQs (8)
As on 9 October 2026, as reported in the RBI's Weekly Statistical Supplement, which one of the following correctly arranges the components of India's foreign exchange reserves in descending order of value?
Answer (c) & explanation
On 9 October 2026 total reserves were about USD 726 billion: foreign currency assets about USD 597.6 billion, gold about USD 105.1 billion, SDRs about USD 18.5 billion and the reserve tranche position about USD 4.8 billion. FCA dominate; gold is a distant but growing second; SDRs exceed the reserve tranche position, mainly because of the 2021 SDR allocation.
With reference to India's foreign exchange reserves as published by the RBI, consider the following statements:
1. Foreign currency assets form the largest component of the reserves.
2. Amounts lent by the RBI to other central banks under the SAARC currency swap arrangement are included in foreign currency assets.
3. India's reserve tranche position in the IMF is a component of the reserves.
Which of the statements given above is/are correct?
Answer (b) & explanation
Statements 1 and 3 are correct. India's reserves have four components: foreign currency assets (FCA), gold, SDRs and the reserve tranche position in the IMF. On 9 October 2026 FCA were about USD 598 billion out of total reserves of about USD 726 billion. Statement 2 is wrong: the RBI's footnote states that FCA exclude amounts lent under the SAARC and ACU currency swap arrangements, investment in IIFC (UK) bonds and RBI's contribution to Nexus Global Payments, because such claims are not readily available.
With reference to the legal and policy framework for deploying India's foreign exchange reserves, consider the following statements:
1. The Reserve Bank of India Act, 1934 provides the overarching legal framework for deployment of the reserves in foreign currency assets and gold.
2. The law permits investment of reserves in sovereign or sovereign-guaranteed debt instruments with a residual maturity not exceeding ten years.
3. The broad strategy for reserve management, including currency composition, is decided by the RBI alone, without consulting the Government of India.
Which of the statements given above is/are correct?
Answer (a) & explanation
Statements 1 and 2 are correct. According to the RBI's half-yearly report, the RBI Act, 1934 (sub-sections of section 17 and section 33(6)) provides the legal framework, permitting deposits with other central banks and the BIS, deposits with overseas commercial banks, sovereign or sovereign-guaranteed debt with residual maturity of up to ten years, other approved instruments, and certain derivatives. Statement 3 is wrong: the broad strategy, including currency composition and investment policy, is decided in consultation with the Government of India.
With reference to the management of India's foreign exchange reserves, consider the following statements:
1. Safety and liquidity are the twin objectives of reserve management, with return optimisation kept in view within this framework.
2. Foreign currency assets are held only in US dollar instruments, since the US dollar is the RBI's intervention currency.
3. Although held in several currencies, the reserves are denominated and expressed in US dollar terms.
Which of the statements given above is/are correct?
Answer (c) & explanation
Statements 1 and 3 are correct. The RBI's half-yearly report (April 2026) states that safety and liquidity are the twin objectives, with return optimisation pursued within that framework. Foreign currency assets are a multi-currency portfolio (US dollar, euro, pound sterling, yen and others), and both the US dollar and the euro are intervention currencies, so statement 2 is wrong. The reserves are nonetheless expressed in US dollar terms, which is why a fall in the euro or yen against the dollar can reduce the reported level without any RBI sale.
According to the RBI's Half Yearly Report on Management of Foreign Exchange Reserves (position as at end-March 2026), consider the following statements:
1. The RBI held about 880 metric tonnes of gold.
2. More than three-fourths of this gold was held within India.
3. The share of gold in the total foreign exchange reserves, in value terms, fell between end- September 2025 and end-March 2026.
Which of the statements given above is/are correct?
Answer (c) & explanation
Statements 1 and 2 are correct. At end-March 2026 the RBI held 880.52 tonnes of gold, of which 680.05 tonnes (about 77 per cent) were held domestically, after about 104 tonnes were moved home during the half-year; 197.67 tonnes were with the Bank of England and the BIS. Statement 3 is wrong: with the rise in gold prices, the share of gold in reserves by value rose from about 13.9 per cent at end-September 2025 to about 16.7 per cent at end- March 2026.
Which one of the following correctly describes the 'reserve tranche position' that is counted as part of India's foreign exchange reserves?
Answer (d) & explanation
A member's reserve tranche is the portion of its IMF quota that the IMF holds in a form readily available to the member: broadly the quota minus the IMF's holdings of the member's own currency. Historically a quarter of the quota was paid in gold, hence the old name 'gold tranche'. A drawing on it is not a use of IMF credit, carries no conditionality and no charges, so it counts as a reserve asset. On 9 October 2026 India's reserve position in the IMF was about USD 4.8 billion. IMF loans are liabilities, not reserves; SDRs are a separate component.
During April-December 2025, India's foreign exchange reserves decreased by about USD 30.8 billion on a balance of payments basis, yet the reported stock of reserves increased by about USD 19.4 billion. Which one of the following best explains this?
Answer (a) & explanation
The change in reserves on a BoP basis excludes valuation effects: it reflects only transactions (current account plus net capital flows). The change in the reported stock includes revaluation of gold and non-dollar assets in US dollar terms. The RBI's half-yearly report shows a valuation gain of about USD 50.2 billion in April-December 2025, which more than offset the BoP-basis drawdown of USD 30.8 billion. There was no new SDR allocation in 2025; errors and omissions and forward settlements are already part of the BoP-basis figure.
With reference to the general allocation of Special Drawing Rights (SDRs) made by the IMF in August 2021, consider the following statements:
1. India received an allocation of about SDR 12.57 billion.
2. The allocation added to India's foreign exchange reserves and also to India's external debt.
3. SDRs were allocated only to member countries facing balance of payments deficits.
Which of the statements given above is/are correct?
Answer (b) & explanation
Statements 1 and 2 are correct. In the IMF's general allocation of about SDR 456 billion, effective 23 August 2021, India received about SDR 12.57 billion (about USD 17.86 billion). The SDRs received are a reserve asset, but an SDR allocation is also recorded as a long-term liability of the Government, so it forms part of external debt; SDR-denominated debt was about 4.3 per cent of India's external debt at end-March 2026. Statement 3 is wrong: general allocations are made to all participating members in proportion to their quotas, not on the basis of need.
0 / 0 correct
Write an answer
In 150 words, explain the significance of External Sector with one recent example.
Flashcards (8)
Current account convertibility since?
August 1994.
Forex reserves 16 October 2026?
US$721.016 bn.
Committees on capital account
convertibility? Tarapore (1997, 2006).
FDI threshold?
10% or more of equity.
FDI equity inflows 2025-26?
US$58.846 bn.
Press Note 3?
Approval for FDI from land-border countries.
Currency added to SDR in 2016?
Renminbi.
World Bank Group members?
IBRD, IDA, IFC, MIGA, ICSID.
Read more: related explainers
In the news
- 24 Oct 2026Net FDI positive for third straight month: $3.3 billion in August 2026, says RBI Bulletin
- 23 Oct 2026Carbon capture: how India can make its ₹20,000 crore CCUS push count, in three phases
- 23 Oct 2026Colour-coded driving licences: draft CMVR amendments for Indian and foreign nationals explained
- 22 Oct 2026Haryana’s first private power distributor: what a parallel licence means for Gurugram and Nuh
Next topic · 8.3 →External Sector: Chapter testSyllabus: GS-III · Effects of liberalization on the economy, changes in industrial policy and their…