Statement (I) : Foreign investment may affect a country's export performance. Statement (II) : Inflow of foreign exchange may cause appreciation of local currency leading to a rise in the price of export commodities.

Correct — A, (a) Both Statement (I) and Statement (II) are individually true and Statement (II) is the correct explanation of Statement (I).

This card describes the ENGLISH column of the booklet, whose Statement (II) reads 'Inflow of foreign exchange'. The Hindi column of the same item prints 'inflow of foreign INVESTMENT' at that point, so the two columns differ by one word in the second statement, while Statement (I) says foreign investment in both. The English wording is the one explained here, and it is the wording that makes the causal chain explicit, because it names the foreign exchange that the investment of Statement (I) brings with it. The difference is the paper's own and is reproduced rather than repaired.

STATEMENT (I) IS TRUE, and note how modestly it is phrased — foreign investment 'MAY AFFECT' export performance. It does not claim that the effect is always present, always large, or always in one direction, and that weak claim is easy to accept because foreign investment influences exports through several channels at once, some raising exports and some lowering them. RAISING exports: a foreign parent brings technology, management practice, quality standards and, most importantly, access to its own global distribution and marketing network, so an affiliate can sell abroad in a way a domestic firm could not. Export-oriented investment, of the kind that special economic zones are designed to attract, exists precisely to produce for foreign markets. LOWERING or diverting exports: market-seeking investment comes to serve the domestic market rather than to export from it, and may displace an existing exporter; profit and royalty repatriation flows the other way in the balance of payments; and the exchange-rate channel described in Statement (II) works against exports directly.

STATEMENT (II) IS TRUE, and it describes one of the most reliable mechanisms in open-economy economics. Follow it one step at a time: foreign investment entering a country arrives as FOREIGN CURRENCY, which must be converted into the local currency before it can be spent domestically; that conversion raises the supply of foreign currency, and the demand for local currency, in the foreign exchange market; with a market-determined rate, the local currency therefore APPRECIATES — it takes fewer units of local currency to buy one unit of foreign currency, so the rupee is 'stronger'; an exporter still needs the same number of rupees to cover costs and margin, but each rupee now costs the foreign buyer more, so the price of the export IN FOREIGN CURRENCY RISES; dearer goods sell in smaller quantities, so export volumes and export competitiveness fall.

AND STATEMENT (II) IS THE EXPLANATION OF STATEMENT (I). Statement (I) asserts that foreign investment may affect exports; Statement (II) sets out a complete, unbroken mechanism by which it does — inflow, appreciation, higher foreign-currency prices, weaker export performance. Every link follows from the one before, and the chain begins with exactly the phenomenon Statement (I) names. That is what code (a) requires: not merely two true statements about the same subject, but a second statement that supplies the reason for the first.

THE NAMED VERSION OF THIS MECHANISM is worth knowing, because it is examined under its own label. When a large inflow — from a natural-resource discovery, a commodity boom, or a surge of capital — appreciates a country's currency and thereby damages its other export industries, the condition is called DUTCH DISEASE. The name comes from the Netherlands, where the exploitation of the Groningen natural gas field discovered in 1959 strengthened the currency and squeezed manufacturing exports.

WHAT A CENTRAL BANK DOES ABOUT IT, which explains a familiar piece of Indian economic news. If the Reserve Bank of India wishes to resist an appreciation driven by capital inflows, it buys the incoming foreign currency and adds it to the foreign exchange reserves, releasing rupees into the system. That is one reason reserves accumulate during periods of heavy inflow. Because the released rupees are themselves inflationary, the operation is often STERILISED by withdrawing an equivalent amount of liquidity through other instruments.

In the printed booklet both statement labels are set in italics with the roman numeral in brackets, each with a space before its colon, and this item's Directions block and its four codes are printed once at the head of the column over question 117.

Why the others are wrong

• (b)Both Statement (I) and Statement (II) are individually true but Statement (II) is not the correct explanation of Statement (I) — Both statements are indeed true, so the first half of this code is satisfied, and the failure is in the second half. Statement (II) is not a companion fact about the same subject; it is a complete causal chain running from the phenomenon Statement (I) names to the effect Statement (I) asserts. Inflows arrive as foreign currency, conversion appreciates the local currency, appreciation raises the foreign-currency price of exports, and dearer exports sell less well. There is no missing link. A candidate might be pulled to this code by noticing that Statement (II) describes only ONE channel, and a negative one, while foreign investment can also raise exports through technology and access to a parent's distribution network. But Statement (I) claims only that foreign investment MAY AFFECT export performance, and a single valid mechanism is sufficient to explain a claim phrased that weakly. The explanatory test asks whether Statement (II) gives a reason for Statement (I), not whether it gives the only reason or the most important one.
• (c)Statement (I) is true but Statement (II) is false — This code requires the exchange-rate mechanism to be false, and it is standard open-economy economics. An inflow of foreign currency increases its supply in the domestic market; where the rate is market-determined, a greater supply of foreign currency relative to demand means the local currency appreciates; and an appreciated local currency makes the country's goods dearer to foreign buyers, because each unit of local currency now costs them more of their own. The chain holds for any inflow, whether from investment, remittances, aid or export earnings themselves. It is the reason that appreciation is generally unwelcome to exporters and welcome to importers, and the reason central banks intervene in currency markets during heavy inflows. The one qualification worth stating is that the effect operates fully only under a floating or managed-floating regime — under a rigidly fixed rate the pressure shows up as reserve accumulation and monetary expansion rather than as an appreciation. That qualification does not make the statement false; India has operated a managed float since 1993.
• (d)Statement (I) is false but Statement (II) is true — This code requires the first statement to be false, and it makes the weakest claim of any statement in this four-item block: that foreign investment MAY affect a country's export performance. To call it false would be to hold that foreign investment can never influence exports in either direction, which is contradicted by the whole design of export-oriented investment policy — special economic zones, export processing zones and the incentives offered to export-oriented units all exist on the premise that inward investment changes export performance. It is contradicted equally by the mechanism the second statement itself describes, which is one route by which investment affects exports. Note the internal incoherence of choosing this code: accepting Statement (II) as true while denying Statement (I) means accepting a mechanism by which inflows affect exports while denying that inflows affect exports. On assertion-reason items, always check that the code chosen is consistent with itself.

THE EXCHANGE RATE IS THE HINGE between foreign capital and export performance, so the vocabulary has to be exact.

APPRECIATION AND DEPRECIATION. Under a market-determined rate, a currency APPRECIATES when it takes fewer units of it to buy a unit of foreign currency — the rupee moving from 70 to the dollar to 65 to the dollar has appreciated. It DEPRECIATES in the opposite case. Where the rate is officially fixed, the deliberate equivalents are called REVALUATION and DEVALUATION. The four terms are frequently examined against one another.

WHAT APPRECIATION DOES. EXPORTS become dearer in foreign currency, because the buyer must part with more of their own money for the same rupee price, so export volumes tend to fall. IMPORTS become cheaper in local currency, so import volumes tend to rise. The trade balance therefore tends to worsen, and domestic producers competing with imports face more pressure. Foreign borrowing becomes cheaper to service in local-currency terms. Depreciation reverses each of these, which is why a weakening currency is often described as helping exporters.

HOW CAPITAL INFLOWS APPRECIATE A CURRENCY. Foreign investment must be converted into local currency to be spent domestically. That conversion is a sale of foreign currency and a purchase of local currency, and in a market-determined system it moves the price accordingly. The same is true of remittances, portfolio inflows and external commercial borrowing, which is why the capital account can drive the exchange rate quite independently of the trade account.

DUTCH DISEASE is the named case in which this becomes a problem. A large inflow — from a natural-resource discovery, a commodity price boom, or a surge of capital or aid — appreciates the real exchange rate and makes the country's other tradable industries, typically manufacturing, uncompetitive. The term comes from the Netherlands after the discovery of the Groningen gas field in 1959.

WHAT A CENTRAL BANK CAN DO. It may buy the incoming foreign currency to hold the rate down, which accumulates FOREIGN EXCHANGE RESERVES and releases domestic currency into the banking system. Because that release is expansionary, the operation is commonly STERILISED by absorbing an equivalent amount of liquidity through open market operations or dedicated instruments. Reserve accumulation during periods of strong inflow is the visible sign of this policy.

FOREIGN INVESTMENT AND EXPORTS, the fuller picture, since the exchange rate is only one channel. POSITIVE CHANNELS — transfer of technology and management practice; quality and standards upgrading; access to the foreign parent's global marketing and distribution network, which is often the single largest gain; scale economies; and integration into global value chains. NEGATIVE OR NEUTRAL CHANNELS — market-seeking investment that produces for the domestic market rather than for export; displacement of existing domestic exporters; repatriation of profits, dividends and royalties, which is a debit on the current account; and the appreciation channel described in this item. The net effect depends on which kind of investment predominates, which is why policy distinguishes export-oriented investment from the rest.

TYPES OF FOREIGN INVESTMENT worth keeping distinct. FOREIGN DIRECT INVESTMENT involves a lasting interest and an element of management control, and is relatively stable. FOREIGN PORTFOLIO INVESTMENT is the purchase of shares and bonds without control, is far more volatile, and is often described as hot money because it can leave as quickly as it arrived. The distinction matters here because portfolio flows can appreciate a currency sharply and then reverse.

Key facts

• In the English column of this item, Statement (II) reads 'inflow of foreign exchange'; the Hindi column prints 'inflow of foreign investment' at the same place, while Statement (I) says foreign investment in both columns.
• A currency appreciates when fewer units of it are needed to buy a unit of foreign currency; it depreciates in the opposite case.
• Appreciation and depreciation are market movements; revaluation and devaluation are the deliberate equivalents under a fixed rate.
• Foreign investment must be converted into local currency, which raises the demand for it and tends to appreciate it under a market-determined rate.
• Appreciation makes a country's exports dearer in foreign currency and its imports cheaper in local currency.
• Dutch disease is the case where a large inflow appreciates the real exchange rate and makes other tradable industries uncompetitive; the term comes from the Netherlands after the Groningen gas discovery of 1959.
• A central bank resisting appreciation buys the incoming foreign currency, which accumulates reserves and releases domestic currency, and it may sterilise the liquidity so released.
• Foreign investment can also raise exports through technology transfer, quality upgrading and access to the parent firm's global distribution network.
• Market-seeking investment produces for the domestic market and need not raise exports; repatriated profits and royalties are debits on the current account.
• Foreign direct investment involves lasting interest and management control and is relatively stable; foreign portfolio investment carries no control and is far more volatile.
• India has operated a managed floating exchange rate since 1993.

Common traps

• Reading appreciation as good news for the whole economy. It is good for importers and for those servicing foreign debt, and bad for exporters.
• Reversing the direction of the exchange rate. A rupee that appreciates buys more foreign currency, so a smaller number of rupees per dollar.
• Rejecting an explanation because it names only one channel. Statement (I) says 'may affect', and one valid mechanism is enough to explain it.
• Choosing a code that contradicts itself, such as accepting the mechanism in Statement (II) while denying the effect asserted in Statement (I).
• Treating foreign direct and foreign portfolio investment as interchangeable. Their stability, their motives and their exchange-rate consequences differ.
• Forgetting that repatriated profits, dividends and royalties are outflows on the current account and offset part of the inflow.

• practice — not a real PYQ

  An appreciation of the rupee against the United States dollar would ordinarily

  • (a)make Indian exports cheaper in dollar terms and imports dearer in rupee terms
  • (b)make Indian exports dearer in dollar terms and imports cheaper in rupee terms
  • (c)leave both exports and imports unaffected
  • (d)raise the rupee cost of servicing dollar-denominated debt

  Answer(b) make Indian exports dearer in dollar terms and imports cheaper in rupee terms — an appreciated rupee means each rupee costs the foreign buyer more dollars, so the dollar price of an Indian export rises, while each dollar of imports costs fewer rupees. Servicing dollar debt becomes cheaper in rupee terms, not dearer, so option (d) has the direction reversed as well.

• practice — not a real PYQ

  The term 'Dutch disease' in economics refers to which one of the following ?

  • (a)A prolonged fall in agricultural productivity caused by soil exhaustion
  • (b)The loss of competitiveness of a country's manufacturing exports following a large inflow that appreciates its currency
  • (c)A banking crisis brought on by excessive lending against property
  • (d)Persistent inflation caused by indexing wages to prices

  Answer(b) The loss of competitiveness of a country's manufacturing exports following a large inflow that appreciates its currency — the term dates from the Netherlands, where the Groningen natural gas field discovered in 1959 strengthened the currency and squeezed manufacturing exports. The condition can be triggered by a resource boom, a commodity price rise, or a surge of capital or aid.