Question

(a) In which sub-account and on which side of balance of payments account will foreign investments in India be recorded? Given reasons.

(b)What will be the effect of foreign investments in India on exchange rate? Explain.

Answer 1

(a) Foreign investment includes foreign direct investment (FDI) and foreign institutional investment (FII) or portfolio investment by the residents of a nation abroad or by the rest of the world in the domestic country. Investments made in the assets of a foreign country is FDI. Here, the assets of the foreign country are owned and controlled by the government or any resident within the domestic territory. On the other hand, FII means investment made in the assets of a foreign country. Here, the assets of the foreign country are not owned and controlled by the government or any resident within the domestic territory. These investments lead to an inward flow of foreign exchange and hence are treated as positive items in the capital account of balance of payments.

(b) Foreign investments will lead to a rise in the supply of foreign currency. Hence, the supply will tend to shift from SS to S′S′ and the new equilibrium point will be reached at Point E′. The exchange rate declines from OR to OR because the demand and supply of foreign currency increases to OQ₁.