Consider the following statements : 1. Tight monetary policy of 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 ?
- (a) 1 and 2 only ✓ UPSC's answer
- (b) 2 and 3 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Why the answer is (a)
• Statement 1 is correct: when the US Federal Reserve tightens (raises rates), dollar assets become more attractive and investors pull capital out of emerging markets like India — 'capital flight'.
• Statement 2 is correct: capital flight weakens the rupee and pushes up domestic interest rates, raising the rupee cost of servicing dollar-denominated ECBs and of refinancing them.
• Statement 3 is wrong: devaluation of the rupee increases, not decreases, the currency risk on ECBs, since more rupees are needed to repay each dollar of principal and interest.
• Unhedged ECBs are therefore a vulnerability during Fed tightening cycles.
• Hence 1 and 2 only, option (a).
Why the other options are wrong
- (b) 2 and 3 only
- Statement 3 is wrong: devaluation raises currency risk on ECBs.
- (c) 1 and 3 only
- Statement 3 is wrong; statement 2 is correct.
- (d) 1, 2 and 3
- Statement 3 is wrong, so all three cannot be correct.
Asked in the GS Paper I of the UPSC Civil Services Preliminary Examination 2022, held on 5 June 2022. Question and answer key: Union Public Service Commission. Explanation: UPSC Answer Check.