UPSC Prelims 2022 · Question 61 of 98
UPSC Prelims 2022 question on Capital Flight Fed Tightening
- ExamUPSC CSE
- Year2022
- PaperGeneral Studies Paper I
- SubjectIndian Economy
- TopicExternal Sector of India
- DifficultyHard
- TypeStatement
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?
Show answer
Answer: A. 1 and 2 only
Verdict
Correct statements: 1 and 2 → Option (a).
Statement by statement
Statement 1 – CORRECT: Tight monetary policy of US Federal Reserve means hiking the federal funds rate. An aggressive monetary tightening would raise US yields and strengthen the US dollar against EM currencies like rupee. As a result, US-based foreign portfolio investors/FIIs investing in countries like India would pull money out and invest in 'safe haven' US assets (Treasury bonds), thus leading significant capital flight from India.
Statement 2 – CORRECT: Capital flight leads to depreciation pressures on emerging market currencies. If the EM currency depreciates against the US dollar, it decreases the value of investments in dollar terms. Companies/firms done borrowing through ECBs would have to pay back more as converting more rupee with their dollar equivalent and in turn increases their interest cost.
Statement 3 – INCORRECT: Devaluation of domestic currency INCREASES the currency risk associated with ECBs (as mostly foreign currency denominated). If at the time of raising loan through ECBs, 1 dollar was equal to Rs 75 and in future with depreciation/devaluation of domestic currency, 1 dollar becomes Rs 80, companies/firms done borrowing through ECBs would have to pay back more — INCREASING, not decreasing, their currency risk.