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Q31 (IAS/2022) Economy › External Sector & Trade › External capital flows Official Key

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.

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Q. Consider the following statements: 1. Tight monetary policy of US Federal Reserve could lead to capital flight. 2. Capital flight may in…
At a glance
Origin: Books + Current Affairs Fairness: Moderate fairness Books / CA: 6.7/10 · 3.3/10
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This 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.

How this question is built

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?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Transmission of Repo Rate into Lending Rate > p. 89
Presence: 3/5
“Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate/ money market rate – around the repo rate.] Financial markets play a critical role in effective transmission of monetary policy impulses to the rest of the economy. Monetary policy transmission involves two stages: In the first stage, monetary policy changes are transmitted through the money market to other markets, i.e., the bond market and the bank loan market.”
Why this source?
  • 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.
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
Presence: 4/5
“As free float carries the risk of sudden capital flight and speculative attacks, it can be disastrous for an economy. Thus, a majority of countries combine features of pegged system and free float system in various degrees to follow an intermediate exchange rate regime. India also belongs to this category by following a managed float system. • Depreciation: It occurs when the value of domestic currency falls in the international exchange market. It occurs automatically through the market forces of demand and supply. Devaluation: When the value of domestic currency is deliberately reduced by the government, it is termed 'devaluation'. • Depreciation: For example, if \bar{\zeta}/\frac{4}{3} increases from \bar{\zeta}/5 per $ to ₹80 per $, it signifies depreciation.”
Why this source?
  • 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.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.27 Balance of Payment (BoP) > p. 108
Presence: 3/5
“Actually, there may be some changes in the Forex reserves because of valuation effect i.e., appreciation/depreciation of the US Dollar and the change in price of the gold. This also has an impact on the Forex reserves in addition to Current A/C and Capital A/c transactions. [Recently RBI has brought in new format (as per the guidelines of IMF) for Balance of Payment under which Capital Account has been redefined as 'Capital and financial Account' with a distinction between Capital Account Transactions and Financial Account Transactions. FDI, FPI, Forex Reserves etc. have been made a part of the Financial A/c Transactions.”
Why this source?
  • 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.
Statement analysis

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Statement analysis

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