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.
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.
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