ECBs and Tight monetary policy UPSC pre 2022

This question was asked because inflation in the US was high and due to this the US has to adopt a tight monetary policy which impacted emerging economies [like India].

 

It was a Medium level question because it can be solved based on your knowledge from the standard book but you need to apply elimination method to confirm your answer.

 

 

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 is correct?

(a)        1 and 2 only

(b)        2 and 3 only

(c)        1 and 3 only

(d)        1, 2 and 3

 

Trick - statement 3 is wrong

 

Solution - A

 

Statement -1.Tight monetary policy of US Federal Reserve could lead to capital flight.

 

What is Monetary policy?

 

It is a macroeconomic policy designed by the central bank of a country, to manage money supply & interest rates.

 

It helps shape variables such as inflation, consumption, savings, investment, and capital formation

 

It has an important role in

price stability [inflation control],

economic growth,

job creation and

social justice in any economy.

 

What is Tight monetary policy?

 

The tight monetary policy implies the Central Bank (or authority in charge of Monetary Policy) is seeking to reduce the demand for money and limit the pace of economic expansion.

 

Usually, it is used to control inflation and done by increasing the rate at which banks lend to each other which increases borrowing rates and slows lending.

 

In India the same thing is done using increasing the repo rate.

 

 

It makes borrowing less attractive[all types of borrowing including personal loans] as interest payments increase.

 

It makes investment in US assets more lucrative for investors because they get higher returns and thus leads to capital flight.

 

So, 1 is correct hence option B is eliminated.

 

Statement 2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).

 

What is ECB?

External commercial borrowing (ECBs) are loans in India made by non-resident lenders in foreign currency to Indian borrowers.

 

FDI vs ECBs

FDI	is a channel of direct equity investments in Indian Firms by a non-resident or foreign entities.
ECB	is a form of Debt Financing

 

Capital flight will depreciate the rupee.

 

When the rupee depreciates it would increase the debt-servicing costs (in local currencies) for firms.

 

What is meant by debt servicing?

Debt service is the sum of interest payments and repayment of principal.

 

Hence, 2 is correct.

 

Statement 3. Devaluation of domestic currency decreases the currency risk associated with ECBs.

 

Devaluation of domestic currency increases the currency risk associated with ECBs (as mostly foreign currency denominated).

 

For instance, if at the time of raising a loan through ECBs, 1 dollar was equal to Rs 70 and in future with depreciation/devaluation of domestic

currency, 1 dollar becomes Rs 85.

 

In this case, companies/firms borrowing through ECBs would have to pay back more due to devaluation.

 

Hence, 3 is not correct.

 

Now let's revise the concept using question.