Foreign Trade Concepts
Foreign trade, also known as international trade, refers to the exchange of goods and services across national borders. It plays a crucial role in the global economy, enabling countries to access a broader market and benefit from comparative advantages.
Balance of Payments (BoP)
The balance of payments (BoP) is a comprehensive accounting system that records all economic transactions between a country and the rest of the world over a specific period, typically a year or a quarter. It provides a detailed overview of a country’s international financial position and economic relationships with other nations. The balance of payments is divided into three main components:
- Current Account: The current account tracks the flows of goods, services, income, and transfers between a country and the rest of the world. It includes the following sub-components:
- Trade Balance: The trade balance accounts for the exports and imports of goods (merchandise trade). A surplus (exports > imports) or deficit (imports > exports) in this category reflects the trade balance.
- Services: This component includes transactions related to services like tourism, transportation, and financial services. It records income from foreign visitors and expenses paid to foreign service providers.
- Income: The income account tracks income earned by residents from investments and work abroad and income paid to non-residents for their contributions to the domestic economy.
- Transfers: Transfers account for unilateral transfers of money or assets between countries, such as foreign aid, remittances from foreign workers, and gifts.
- Capital Account: The capital account records transactions involving assets, financial investments, and non-produced, non-financial assets. These transactions can include the purchase or sale of assets like real estate, stocks, and bonds, as well as debt forgiveness.
- Financial Account: The financial account tracks international investment and financing activities. It includes:
- Direct Investment: Records investments in foreign companies that provide the investor with significant control or influence over the company.
- Portfolio Investment: Covers transactions related to the purchase or sale of financial securities, like stocks and bonds, in foreign markets.
- Other Investment: This category includes loans, deposits, and other financial transactions not classified as direct or portfolio investments.
- Reserve Assets: This component accounts for changes in a country’s official foreign exchange reserves. Central banks use these reserves to stabilize exchange rates and facilitate international trade
Foreign Capital
Foreign Direct Investment (FDI)
Foreign Direct Investment (FDI) refers to the investment made by individuals, businesses, or governments from one country (the home country) into another country (the host country) with the objective of establishing a lasting interest or significant degree of influence in the foreign business or enterprise
Key Aspects:
- FDI involves the transfer of funds and resources from one country to another. This capital inflow can help stimulate economic growth in the host country by providing funds for investment in infrastructure, technology, and other areas.
- FDI often leads to the creation of jobs in the host country. When foreign companies establish subsidiaries or invest in existing businesses, they typically hire local employees, which can help reduce unemployment and improve living standards
- Foreign investors often bring advanced technologies, processes, and management practices to the host country. This technology transfer can enhance the host country’s productivity, competitiveness, and industrial capabilities
- FDI can provide access to new markets for both the host country and the investing company. Foreign investors can tap into the host country’s consumer base, while the host country gains access to the investing company’s global distribution networks.
- FDI can contribute to overall economic development in the host country by promoting industrialization, improving infrastructure, and fostering innovation and entrepreneurship.
FDI Routes in India
India has several routes through which Foreign Direct Investment (FDI) can enter the country. These routes are regulated by the Reserve Bank of India (RBI) and the Department for Promotion of Industry and Internal Trade (DPIIT), and they define the conditions, limits, and sectors in which FDI is allowed
- Automatic Route: Under the automatic route, FDI is allowed without the need for prior approval from the RBI or the government. Investors only need to notify the RBI within a specified time frame after the investment is made. This route is available for most sectors, except those that are prohibited or require government approval.
- Government Route: In sectors or activities that are not covered under the automatic route, FDI requires government approval. Investors must apply for approval through the Foreign Investment Facilitation Portal (FIFP) or the Foreign Investment Promotion Board (FIPB), depending on the sector.
Examples
- Under the automatic route, FDI of up to 100% is allowed for manufacturing of automobiles and components.
- For the manufacturing of electric vehicles (EVs), 100% FDI is allowed under the automatic route.
- In single-brand retail trading, 100% FDI is allowed, with up to 49% allowed under the automatic route. Beyond 49%, government approval is required.
- Multi-brand retail trading (supermarkets and department stores) with FDI is permitted in some states, subject to certain conditions and restrictions. The FDI limit is typically capped at 51%.
- FDI in the insurance sector is allowed up to 74%, with up to 49% under the automatic route. Beyond 49%, government approval is needed
- In the telecom sector, 100% FDI is allowed, with up to 49% under the automatic route. Beyond 49%, government approval is required
- In the defense sector, FDI up to 74% is allowed under the automatic route, with government approval required for investments beyond 49%
- In most segments of the media and broadcasting sector, including print and digital media, 100% FDI is allowed, with up to 49% under the automatic route
Sectors where FDI Prohibited
- FDI is prohibited in the atomic energy sector, which includes activities related to the production of atomic energy and nuclear power generation.
- FDI is generally prohibited in the gambling and betting industry, which includes casinos and online betting platforms
- FDI is not allowed in the lottery business, except for state-run lotteries
- FDI is prohibited in chit funds, which are traditional Indian savings and credit schemes.
- Nidhi companies are non-banking finance companies (NBFCs) that facilitate mutual benefit funds. FDI is typically not permitted in these entities
- While FDI is allowed in single-brand retail trading, it is generally prohibited in multi-brand retail trading of agricultural products. Some states have allowed it under specific conditions, but this remains a highly regulated area.
- FDI is not allowed in the trading of transferable development rights (TDRs) pertaining to the construction of real estate
Foreign Portfolio Investors (FPIs)
Foreign Portfolio Investors (FPIs) refer to foreign individuals, institutions, or funds that invest in financial assets in a country, such as stocks, bonds, mutual funds, and other securities. FPIs are distinct from Foreign Direct Investors (FDIs), who typically make long-term investments in companies and assets to establish a lasting interest
Key Aspects:
- FPIs invest in a country’s financial markets, primarily by buying and selling securities traded on stock exchanges and fixed-income instruments like bonds and government securities
- FPIs often seek to diversify their investment portfolios by spreading their investments across different asset classes, sectors, and countries. This diversification helps manage risk and enhance returns
- FPIs have the flexibility to buy and sell securities in the secondary market, providing liquidity to the market and contributing to price discovery
- FPIs typically have a shorter investment horizon compared to Foreign Direct Investors (FDIs). They may engage in short-term trading or hold securities for a few months to a few years.
- FPIs are subject to regulatory frameworks and restrictions in the countries where they invest. These regulations are designed to ensure that foreign investments do not pose undue risks to the local financial markets and economy.
Foreign Portfolio vs. Foreign Direct Investment
| FPI (Foreign Portfolio Investment) | FDI (Foreign Direct Investment) |
| FPI involves the purchase of financial assets such as stocks, bonds, mutual funds, and other securities in a foreign country. These investments are typically made with the intention of earning returns on capital and do not result in significant control or ownership of the underlying businesses | FDI entails making an investment in a foreign country with the primary objective of establishing a lasting interest and significant control or influence over a business enterprise or physical assets. FDI often involves the acquisition of a substantial ownership stake (typically at least 10%) in a company or the establishment of new business operations. |
| FPI is generally characterized by a shorter investment horizon. Investors in FPI may engage in trading and portfolio rebalancing activities, and their investments are often more liquid. The focus is on earning capital gains and income from investments. | FDI is characterized by a longer-term commitment. Investors in FDI intend to engage in the day-to-day management or decision-making of the business, contribute to its growth and development, and generate profits over an extended period. |
| FPI investors typically have little to no influence or control over the companies in which they invest. They are passive investors who participate in the financial markets and rely on market dynamics to drive returns. | FDI investors actively participate in the management and decision-making of the businesses they invest in. They often seek to exercise control over company operations and strategy, which may include appointing board members or key executives. |
| FPI investments are often made through financial instruments like stocks, bonds, and securities. Investors may use instruments like mutual funds or exchange-traded funds (ETFs) to gain exposure to foreign markets | FDI investments involve a direct equity stake in a company, either through share acquisition or the establishment of a subsidiary or branch in the host country. FDI can also involve the purchase of real assets such as land, factories, or infrastructure |
| FPI can provide short-term capital inflows, but it may be more susceptible to market volatility and sudden capital outflows. It may not have as direct an impact on job creation and economic development as FDI. | FDI often contributes to long-term economic development by creating jobs, stimulating infrastructure development, transferring technology and expertise, and enhancing the competitiveness of local industries |
| FPI investments are subject to regulations that vary by country and may include foreign ownership limits, reporting requirements, and tax considerations. | FDI is subject to regulations that can be more stringent and may involve government approval, sector-specific conditions, and investment protection measures |
Foreign Institutional Investor (FII)
A Foreign Institutional Investor (FII) is a specific type of investor that primarily deals with investing in the financial markets of a foreign country. FIIs are institutional investors, such as mutual funds, pension funds, insurance companies, and hedge funds, that are based in one country but invest in the securities (like stocks and bonds) of another country. The term “Foreign Institutional Investor” is commonly used in the context of India, where this category of investors plays a significant role in the Indian financial markets. However, the concept of foreign institutional investors is not unique to India and can be applied to other countries as well.
Key points about Foreign Institutional Investors (FIIs) in the Indian context:
- In India, the participation of foreign institutional investors is regulated by the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI). These regulatory bodies set the rules and guidelines for FIIs to invest in Indian financial markets.
- FIIs invest in Indian securities with the aim of earning returns on their investments. They typically look for opportunities in the Indian stock market, bond market, and other financial instruments to diversify their portfolios and achieve financial objectives.
- FIIs are primarily involved in portfolio investment, which means they invest in securities and financial assets without seeking to control or manage the companies in which they invest. They typically hold a diversified portfolio of stocks and bonds.
- There may be limits on the maximum ownership stake an FII can hold in an Indian company. The regulatory authorities monitor these limits to prevent excessive foreign ownership or control in critical sectors.
- FIIs’ investments can have a significant impact on the Indian financial markets. Their buying and selling activities can influence stock prices, bond yields, and market sentiment.
- FIIs can invest in Indian mutual funds, which, in turn, invest in Indian securities. This indirect route allows FIIs to diversify their investments further
- FIIs are required to comply with reporting and compliance requirements set by regulatory authorities. They need to disclose their holdings, transactions, and other relevant information.
- Tax treatment of FIIs in India is subject to applicable tax laws. These investors may have to pay taxes on capital gains and other forms of income earned from their Indian investments.
Foreign Qualified Investors” (FQIs)
“Foreign Qualified Investors” (FQIs) is a term used to describe individuals or entities from foreign countries that meet specific qualifications and criteria to invest in the financial markets of a particular country. These criteria are established by the host country’s regulatory authorities to determine which foreign investors are eligible to participate in the local financial markets. The specific qualifications and requirements may vary from one country to another. Here are some common features associated with Foreign Qualified Investors:
- Eligibility Criteria: Host countries often set certain eligibility criteria that foreign investors must meet to be classified as Foreign Qualified Investors. These criteria may include minimum investment thresholds, net worth requirements, or professional investor status.
- Regulation and Oversight: Foreign Qualified Investors are subject to specific regulations and oversight, and they must adhere to the host country’s rules and regulations for investing in the local financial markets. These regulations are designed to ensure the stability and integrity of the financial system.
- Access to Local Markets: Being classified as a Foreign Qualified Investor typically grants access to local financial markets, allowing them to buy and sell local securities such as stocks, bonds, or other financial instruments.
- Diversification and Investment Opportunities: FQIs may seek opportunities in foreign markets as part of their diversification strategy, aiming to spread their investments across different regions and asset classes.
- Professional Investors: In some cases, Foreign Qualified Investors may include professional investors, such as institutional investors, hedge funds, or investment firms, that meet the regulatory requirements and are allowed to participate in local markets.
- Reporting and Compliance: Foreign Qualified Investors are often required to adhere to specific reporting and compliance obligations, including disclosure of their holdings, transactions, and other relevant information.
- Taxation: Tax treatment for Foreign Qualified Investors can vary based on the tax laws of the host country. Some countries may offer tax incentives or exemptions to attract foreign investment.
- Qualified Institutional Investors (QFIs): In some contexts, you may come across the term “Qualified Institutional Investor” (QFI), which is used to describe certain institutional investors that meet the criteria for investing in the financial markets of a foreign country.
Foreign Exchange
NEER (Nominal Effective Exchange Rate)
The Nominal Effective Exchange Rate (NEER) is a measure that assesses the relative value of a country’s currency concerning a basket of foreign currencies. NEER is called “nominal” because it doesn’t take into account changes in the price level or inflation. Instead, it reflects changes in the foreign exchange rates of a country’s currency against multiple foreign currencies.
Key points about NEER include:
- Currency Basket: NEER is calculated using a weighted average of exchange rates between the domestic currency and a selection of foreign currencies. The composition of this basket is typically based on a country’s trading partners.
- Weighted Average: The currencies in the basket are assigned weights based on the importance of each trading partner to the country’s international trade. Larger trading partners are often given higher weights.
- Trade Balance: Changes in the NEER can indicate whether a country’s currency is appreciating (strengthening) or depreciating (weakening) in the foreign exchange market. A rising NEER suggests that a country’s currency is strengthening in nominal terms.
- Economic Impact: A rising NEER can make a country’s exports more expensive for foreign buyers and imports cheaper for domestic consumers. This can impact a country’s trade balance and economic competitiveness.
- Monetary Policy: Central banks and policymakers often consider NEER when formulating monetary policy, as exchange rates can affect a country’s export competitiveness and inflation.
Real Effective Exchange Rate (REER)
The Real Effective Exchange Rate (REER) is a measure that assesses the relative value of a country’s currency concerning a basket of foreign currencies, taking into account differences in price levels or inflation between the home country and its trading partners. REER is used to determine a country’s currency’s competitiveness in international trade by adjusting the nominal exchange rate for changes in relative prices.
Key points about REER include:
- Currency Basket: Similar to NEER (Nominal Effective Exchange Rate), REER is calculated using a basket of foreign currencies. This basket typically consists of the currencies of a country’s trading partners.
- Weighted Average: Each currency in the basket is assigned a weight based on the importance of that trading partner in the country’s international trade. Larger trading partners often receive higher weights.
- Adjustment for Inflation: The key difference between REER and NEER is that REER adjusts the nominal exchange rate for differences in price levels or inflation rates. It does this by using a price index (e.g., consumer price index or producer price index) to account for changes in relative prices.
- Competitiveness: A rising REER suggests that a country’s currency has become more expensive in real terms. This could make the country’s goods and services less competitive in international markets, potentially leading to a decrease in exports and an increase in imports.
- Economic Impact: Changes in REER can have significant economic implications. An appreciating REER can lead to trade imbalances, as it may make a country’s exports more expensive and its imports cheaper.
- Monetary Policy: Policymakers and central banks often monitor REER to assess the impact of exchange rate changes on trade competitiveness and to make informed decisions regarding monetary policy.
Exchange-traded fund (ETF)
“Exchange-Traded Fund.” It is a type of investment fund and exchange-traded product with shares that are listed and traded on stock exchanges. ETFs are designed to offer investors the opportunity to buy a diversified portfolio of assets, much like a mutual fund, but they are traded like individual stocks.
Key features of ETFs include:
- Diversification: ETFs typically hold a diversified portfolio of assets, which can include stocks, bonds, commodities, or other financial instruments. This diversification helps reduce risk for investors.
- Liquidity: ETF shares are traded on stock exchanges, which means they can be bought and sold throughout the trading day at market prices. This provides liquidity and flexibility for investors.
- Transparency: ETFs disclose their holdings regularly, allowing investors to see exactly what assets are held within the fund. This transparency is useful for investors who want to know the composition of their investments.
- Lower Costs: ETFs often have lower expense ratios compared to traditional mutual funds. They are generally known for their cost-effectiveness.
- Tax Efficiency: ETFs are structured in a way that can be tax-efficient. They typically generate fewer capital gains, which can result in lower tax liabilities for investors.
- Flexibility: ETFs can be used for various investment strategies, such as tracking a specific market index, sector, or asset class, or for implementing more complex strategies like leveraged or inverse investing.
- Trading Options: ETFs offer a variety of trading options, including market orders, limit orders, and stop orders. Investors can also use options and short selling with some ETFs.
- Dividends and Income: Many ETFs pay dividends or interest income to their shareholders, depending on the assets they hold.
- Market Exposure: ETFs provide exposure to a wide range of markets, including domestic and international equities, fixed income, commodities, currencies, and more.
FERA & FEMA
FERA (Foreign Exchange Regulation Act) and FEMA (Foreign Exchange Management Act) are two important Indian laws that regulate foreign exchange transactions and foreign payments in India. Here’s a comparison of FERA and FEMA:
FERA (Foreign Exchange Regulation Act):
- Enactment: FERA was enacted in 1973 and was in effect until 1991.
- Stringency: FERA was known for its strict and stringent regulations regarding foreign exchange transactions and foreign payments.
- Purpose: FERA was primarily enacted to regulate and control foreign exchange transactions and to maintain the stability of the Indian rupee. It aimed to prevent illegal transactions and speculative activities.
- Authorized Dealers: Under FERA, authorized dealers, such as banks and financial institutions, played a central role in handling foreign exchange transactions. They had to adhere to strict regulations set by the Reserve Bank of India (RBI).
- Residential Status: FERA classified individuals as “residents” or “non-residents” based on criteria related to their stay in India. Different regulations applied to these two categories.
- Penalties: FERA imposed severe penalties, including fines and imprisonment, for violations of its regulations.
- Enactment: FEMA was enacted in 1999 and replaced FERA. It is the current law governing foreign exchange transactions in India.
- Liberalization: FEMA introduced a more liberalized and market-oriented approach to foreign exchange regulations. It aimed to simplify and modernize the foreign exchange regime in India.
- Purpose: FEMA focuses on facilitating external trade and payments, promoting orderly development and maintenance of the foreign exchange market, and managing foreign exchange reserves.
- Authorized Persons: Under FEMA, the term “authorized persons” is used to refer to entities permitted by the RBI to deal in foreign exchange. These authorized persons have greater flexibility compared to the authorized dealers under FERA.
- Residential Status: While FEMA maintains the concept of “residents” and “non-residents,” it also introduces the concept of “persons resident in India” and “persons resident outside India.”
- Penalties: FEMA retains the authority to impose penalties for violations, but these are generally less severe compared to those under FERA.
Capital Account Convertibility in India
Capital Account Convertibility (CAC) in India refers to the ability of residents and non-residents to freely and without restrictions, convert domestic financial assets into foreign financial assets and vice versa. It essentially means that there are minimal or no controls on cross-border movements of capital, such as investments, loans, and financial assets. CAC is one of the key components of a country’s exchange rate regime and is often considered alongside Current Account Convertibility (CAC) when assessing a country’s overall currency convertibility.
In India, the approach to capital account convertibility has evolved gradually. Here’s a brief overview of the progress and the current state of capital account convertibility in India:
- Pre-Reform Period (Prior to 1991): Before the economic liberalization in 1991, India had strict capital controls in place. There were stringent restrictions on foreign investments, and the Indian rupee was not freely convertible on the capital account.
- Post-Reform Period (1991 Onwards): With the economic reforms initiated in 1991, India started moving toward a more open and liberalized economy. As part of these reforms, India began relaxing capital controls and gradually moved toward greater capital account convertibility.
- Liberalization of FDI: India has progressively opened up to foreign direct investment (FDI) in various sectors, allowing foreign investors to invest in different industries.
- Foreign Institutional Investors (FIIs): India introduced the concept of Foreign Institutional Investors (FIIs) who could invest in the Indian stock and debt markets, subject to certain limits.
- External Commercial Borrowings (ECBs): India allowed Indian entities to raise funds from international markets through external commercial borrowings, subject to specified terms and conditions.
- Capital Flows: Capital flows, including portfolio investments, have been gradually liberalized, although certain limits and regulations still exist.
- Current State: As of my last knowledge update in September 2021, India had achieved a relatively high level of capital account convertibility, especially in terms of FDI and portfolio investments. However, certain sectors, like the banking and financial sector, still have restrictions on foreign ownership. India’s approach to capital account convertibility remains cautious to maintain financial stability and avoid excessive volatility in financial markets.
For detailed notes on Foreign Trade Concepts for the MPSC Exam Mizoram, visit Chase Academy. Enhance your preparation with expertly curated resources designed for exam success.
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