Question map
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?
Explanation
The correct answer is Option 1 (1 and 2 only). The explanation for the statements is as follows:
- Statement 1 is correct: A tight monetary policy (increasing interest rates) by the US Federal Reserve makes dollar-denominated assets more attractive. This leads to capital flight from emerging markets like India as investors seek higher, safer returns in the US.
- Statement 2 is correct: Capital flight leads to a depreciation of the domestic currency (Rupee). For firms with External Commercial Borrowings (ECBs), a weaker Rupee means they must spend more domestic currency to buy the same amount of dollars to service their debt, effectively increasing their interest and repayment costs.
- Statement 3 is incorrect: Devaluation or depreciation of the domestic currency increases the currency risk associated with ECBs. It makes the repayment of foreign-denominated debt more expensive, potentially leading to a "currency mismatch" on the firm's balance sheet.
Therefore, only statements 1 and 2 represent accurate economic consequences.
PROVENANCE & STUDY PATTERN
Full viewThis is a classic 'Mechanism' question rather than a 'Definition' question. It tests if you can simulate a chain reaction: US Policy → Capital Flows → Exchange Rate → Corporate Balance Sheet. Statements 1 and 2 are standard textbook logic, while Statement 3 is a logic trap that requires understanding that a weaker currency hurts, not helps, foreign borrowers.
This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.
- Statement 1: Can a tight monetary policy by the US Federal Reserve cause capital flight from emerging markets?
- Statement 2: Can capital flight increase the interest costs for firms that have existing External Commercial Borrowings (ECBs)?
- Statement 3: Does a devaluation of the domestic currency decrease the currency risk associated with External Commercial Borrowings (ECBs) denominated in foreign currency?
- Explains that monetary policy changes are transmitted through money markets into bond and bank loan markets.
- States financial markets play a critical role in transmitting monetary policy impulses to the rest of the economy.
- Transmission across markets provides a channel by which an external tightening can affect other economies' financial conditions.
- States that flexible/free float exchange regimes carry the risk of sudden capital flight and speculative attacks.
- Links exchange rate regime vulnerability to rapid cross-border capital movements that can harm an economy.
- Describes that changes in forex reserves and the financial account (FDI, FPI, reserves) reflect capital flow transactions.
- Connects capital/financial account movements and reserve changes as measurable outcomes of cross-border capital flows.
- Gives a concrete example where rupee depreciation raises the rupee cost of dollar-denominated borrowing.
- Demonstrates that currency movements change the cost of servicing foreign-currency debt.
- Defines ECBs as loans raised from non-residents and that they can be denominated in foreign currency.
- Establishes that ECBs expose borrowers to foreign-currency risk which links exchange moves to borrowing costs.
- States ECBs are raised at market rates of interest, implying sensitivity to international market conditions.
- Implies that shifts in global capital flows or market rates can affect the cost of ECBs.
- Directly states that a local currency depreciation raises default probability for firms borrowing in foreign currency, which increases currency risk.
- Compares foreign-currency borrowing to local-currency borrowing, showing depreciation worsens outcomes for foreign-currency debt.
- Specifies that for dollar borrowers a depreciation increases their debt burden and financing cost in domestic currency, implying higher currency risk.
- Directly links exchange rate depreciation to worsening the domestic-currency value of foreign-currency debts.
- Reports estimation results showing a depreciation of the local currency worsens firms' ability to repay foreign-currency debt, indicating higher currency risk.
- Provides empirical evidence from loans to foreign firms that depreciation increases strain on foreign-currency borrowers.
Defines ECBs and notes they can be foreign-currency denominated, and contrasts Masala bonds (rupee‑denominated) where investors, not the borrower, bear currency risk.
A student can use this to infer that denomination determines who bears exchange‑rate exposure, so a change in domestic currency value will alter the borrower's foreign‑currency repayment burden.
Gives an example showing how external debt denominated in one currency is converted into another (dollar) and how exchange‑rate movements change the measured external debt.
Defines devaluation (official reduction of domestic currency value under a pegged system) and explains it makes the domestic currency cheaper and tends to raise exports.
Combine this definition with the ECB denomination rule to reason how an official fall in domestic value changes domestic‑currency cost of foreign‑currency debt service.
Contrasts depreciation and devaluation and emphasizes that devaluation is a deliberate reduction in domestic currency value—relevant to understanding the shock whose impact is being questioned.
Use this to distinguish scenarios (official devaluation vs market depreciation) when assessing whether currency‑risk exposure for ECBs changes and by how much.
Contains the exact claim as a prior exam question, indicating this is a contested conceptual point in study material.
A student can treat this as a prompt to test both directions: compute borrower exposure before and after devaluation using exchange‑rate examples to verify the claim.
- [THE VERDICT]: Conceptual Sitter. Solvable purely with logic derived from standard texts like Vivek Singh (Ch. 2 & 17) or Nitin Singhania (Ch. 9 & 16).
- [THE CONCEPTUAL TRIGGER]: External Sector Vulnerability & Balance of Payments. Specifically, the 'Transmission Mechanism' of global monetary shocks to domestic markets.
- [THE HORIZONTAL EXPANSION]: Memorize these siblings: Masala Bonds (Rupee-denominated = Investor bears risk) vs. Standard ECBs (Dollar-denominated = Borrower bears risk); The concept of 'Hedging' (insurance against currency risk); Difference between Depreciation (Market-led) vs. Devaluation (Govt-led); NEER vs. REER.
- [THE STRATEGIC METACOGNITION]: Don't just memorize what an ECB is. Always ask the 'Crisis Question': 'If the Rupee crashes by 10%, what happens to this instrument?' If you had applied this 'Stress Test' mindset, Statement 3 would be immediately identified as false.
Monetary policy actions transmit through money markets into bond and loan markets and then to the real economy.
High-yield: explains how external policy shocks (e.g., US Fed tightening) propagate to emerging markets, affecting interest rates, asset prices and capital flows. Connects macro policy, financial markets and balance of payments questions; useful for essays and mains questions on transmission and policy spillovers.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Transmission of Repo Rate into Lending Rate > p. 89
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Transmission of Repo Rate into Lending Rate > p. 90
Flexible exchange rate regimes can be vulnerable to sudden capital flight and speculative attacks.
High-yield: helps answer questions on exchange rate choice, vulnerability to external shocks, and the need for reserves or managed float. Links to BoP stability, macroprudential policy and exchange-rate management strategies tested in GS papers and essays.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > WHICH EXCHANGE RATE SYSTEM SUITS AN ECONOMY BEST? > p. 494
FDI, FPI and forex reserve movements comprise the financial account and determine cross-border capital flows.
High-yield: mastering this clarifies how capital flight shows up in official statistics (financial account and reserves) and informs policy responses (capital controls, reserve management). It ties BoP concepts to policy instruments and exam questions on external sector management.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.27 Balance of Payment (BoP) > p. 108
ECBs can be denominated in foreign currencies, creating exposure of Indian borrowers to currency-related cost changes.
High-yield for UPSC: explains why external borrowings carry exchange-rate risk and links to balance of payments and currency policy questions. It connects debt instruments to forex management and informs questions on corporate external vulnerability.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Debt Instruments > p. 100
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Types of Loans > p. 479
Depreciation of the rupee raises the rupee amount required to service foreign-currency loans, increasing firms' borrowing costs.
Crucial for answering questions on currency fluctuations, corporate balance sheets, and macroeconomic stability. Enables analysis of how capital outflows or forex shocks affect corporate finance and external debt servicing.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > MASALA BOND > p. 266
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Debt Instruments > p. 100
ECBs are obtained at market interest rates, so changes in international capital markets or capital flows can alter the cost of these loans.
Useful for questions on capital flows, interest-rate transmission, and policy responses; links international monetary conditions to domestic corporate borrowing costs and debt sustainability analysis.
- Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Types of Loans > p. 479
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Debt Instruments > p. 100
An ECB denominated in foreign currency places exchange‑rate exposure on the borrower, while rupee‑denominated Masala bonds transfer that exposure to investors.
High-yield for questions on external debt and risk allocation: it explains who is vulnerable when exchange rates move, links to debt servicing and sovereign/corporate vulnerability, and appears in policy and balance‑of‑payments questions. Mastering this helps answer questions about debt instruments, investor incentives, and risk management.
- Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Debt Instruments > p. 100
Hedging Costs. Since this question tested unhedged currency risk, the next logical question is on 'Hedging': The cost of buying forward contracts to protect against depreciation. Also, look out for 'Original Sin' in economics—the inability of emerging markets to borrow abroad in their own currency.
The 'Pain Test' Logic. Look at Statement 3: 'Devaluation decreases currency risk.' Apply common sense: If your home currency loses value (devaluation), buying Dollars to repay a loan becomes *more expensive*. This increases your financial pain (risk). Therefore, the claim that risk 'decreases' is logically inverted. Eliminate Statement 3 to arrive at Option A immediately.
Mains GS-3 (Economy) & GS-2 (IR): Link this to the 'Impossible Trinity' (Mundell-Fleming model). It explains why India cannot simultaneously have a fixed exchange rate, free capital movement, and independent monetary policy. This limits India's strategic autonomy when the US Fed acts.