Consider the following statements :
- Tight monetary policy of US Federal Reserve could lead to capital flight.
- Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).
- Devaluation of domestic currency decreases the currency risk associated with ECBs.
Which of the statements given above are correct ?
1 and 2 only
2 and 3 only
1 and 3 only
1, 2 and 3
Answer is Wrong!
Answer is Right!
This question was previously asked in
UPSC IAS – 2022
Statement 1 is correct: A tight monetary policy by the US Federal Reserve (raising interest rates) makes dollar-denominated assets more attractive, potentially leading to capital flowing out of other countries (capital flight) as investors seek higher returns or safer assets in the US. Statement 2 is correct: Capital flight often leads to depreciation of the domestic currency. Firms with existing External Commercial Borrowings (ECBs) denominated in foreign currency (like USD) will have to pay more local currency to service the same amount of foreign currency interest payments and principal repayments. While the *interest rate* on the ECB might not change, the *cost* of that interest payment in local currency terms increases, effectively increasing the interest cost burden for the firm. Statement 3 is incorrect: Devaluation (or depreciation) of the domestic currency *increases* the currency risk associated with ECBs denominated in a foreign currency. The weaker the domestic currency, the more expensive it becomes to repay the foreign currency debt.
Tightening monetary policy in a major economy like the US can trigger capital movements globally, impacting exchange rates and the cost of foreign debt for entities in other countries.