Question 7 from UPSC CSE 2022 - Economics

Question

Consider the following statements:
1. Tight monetary policy of the US Federal Reserve could lead to capital flight.
2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).
3. Devaluation of domestic currency decreases the currency risk associated with ECBs.
Which of the statements given above are correct?

Accepted Answer

Correct Option: A. 1 and 2 only

Strategy: The strategy involves identifying statements dependent on monetary policy and currency dynamics. Statement 1 correctly notes that tighter US policy leads to capital flight from emerging markets. Statement 2 is accurate, as capital flight and currency depreciation increase interest costs on foreign-denominated borrowings. Statement 3, however, incorrectly asserts that devaluation decreases currency risk for External Commercial Borrowings (ECBs); devaluation actually increases this risk because borrowers require more domestic currency to service foreign debt. This analysis confirms that only statements consistent with these economic principles are correct, leading to the selection of Option A.

Key Info: Tight monetary policy refers to actions such as raising interest rates by major central banks like the US Federal Reserve to control inflation and moderate economic growth. Such policy increases attractiveness of US assets, strengthening the US dollar and often triggering outflows ('capital flight') from emerging markets as investors shift funds toward safer or higher-yielding options, resulting in selling pressure on local currencies.

Capital flight often leads to depreciation of the domestic currency. For firms with significant External Commercial Borrowings (ECBs)--loans raised by Indian entities from non-resident lenders in foreign currency--a depreciating rupee directly increases their local-currency repayment burden, as more rupees are required to buy every unit of the foreign currency owed.

Interest cost of ECBs rises further if currency depreciation is accompanied by higher global interest rates, directly increasing servicing costs. Most ECBs are variable rate, linked to US benchmarks such as the LIBOR/SOFR, meaning interest obligations can increase alongside Federal Reserve rate hikes.

Currency risk refers to the uncertainty around the future value of one currency relative to another, impacting those with liabilities denominated in foreign currencies. Devaluation (decline in value) of the home currency increases currency risk for ECB borrowers: they face potential increases in repayment costs if the rupee falls further against the currency of borrowing. Risk management for such borrowers often includes hedging through forward contracts or currency swaps.

### Key Institutions/Entities
- **US Federal Reserve** -- Central bank of the United States, setting key policy rates influencing global capital flows and asset prices.
- **External Commercial Borrowings (ECBs)** -- Loans accessed by Indian companies from external sources in foreign currencies; regulated by the Reserve Bank of India (RBI) under Foreign Exchange Management Act (FEMA) provisions.
- **Foreign Portfolio Investors (FPIs)/Foreign Institutional Investors (FIIs)** -- Investors who allocate capital to emerging markets. Their actions influence currency stability, bond yields, and stock market movements.

### Relevant Concepts
- Capital flight, currency depreciation/devaluation, interest rate risk, and currency risk are central to the global transmission of monetary policy effects.

Answer

Option B: 2 and 3 only

Answer

Option C: 1 and 3 only

Answer

Option D: 1, 2, and 3