The External Sector is an economic concept that encompasses all transactions between a country's residents and the rest of the world, particularly those involving foreign currency. It includes international trade, investment, capital flows, and external debt. The sector's performance is primarily measured by the Balance of Payments (BoP), which is a financial summary of all economic transactions between residents and non-residents in a given year.
The external sector was heavily regulated in India prior to the economic reforms of mid-1991. The need for liberalisation became critical following the Balance of Payments crisis of 1990-91. This crisis led to the implementation of broad-based reforms in 1991 to integrate the Indian economy with the global economy. The restrictive Foreign Exchange Regulation Act (FERA) of 1973 was replaced by the more liberal Foreign Exchange Management Act (FEMA) of 1999, which made foreign exchange offenses civil instead of criminal.
The BoP mechanism works through two main components: the Current Account and the Capital Account. The Current Account records transactions of goods (visible trade), services (invisible trade), and transfer payments. The Capital Account records capital transactions such as external borrowing, lending, Foreign Direct Investment (FDI), and portfolio investment. The FEMA, 1999, is the governing mechanism, with its main objective being to facilitate external trade and payments. Section 5 of FEMA permits Current Account transactions, subject to reasonable restrictions imposed by the Central Government in consultation with the Reserve Bank of India (RBI). Section 6 of FEMA deals with Capital Account transactions, for which the RBI issues regulations.
The external sector connects to the RBI, which manages the country's Foreign Exchange Reserves. A significant change was the full convertibility of the Current Account on August 19, 1994. India has since been moving towards Capital Account Convertibility based on the recommendations of the S.S. Tarapore Committee (1997).