Previous Year Question
Consider the following statements:
Tight monetary policy of the 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
Correct Answer: A
Detailed Solution
Statement 1 is correct.
When the US Federal Reserve raises its policy rate or reduces liquidity to control inflation, returns on US Treasury securities and other dollar-denominated assets may increase. Investors may consequently withdraw funds from relatively risky emerging markets and shift them towards US assets.
This process may:
cause an outflow of Foreign Portfolio Investment from emerging markets such as India;
increase demand for the US dollar;
create depreciation pressure on domestic currencies;
increase domestic bond yields and risk premiums.
The statement uses the expression “could lead”. It therefore describes a possible transmission channel rather than an inevitable outcome.
Statement 2 is correct.
ECBs are commercial debts raised by Indian firms from foreign sources. They are generally denominated in the US dollar, euro or another foreign currency.
Capital flight may increase ECB costs through two channels:
Higher global interest rates and country-risk premiums may increase the cost of floating-rate ECBs and new refinancing.
Rupee depreciation increases the rupee cost of interest payable in foreign currency.
For example, if a company has to pay US$10 million:
At ₹75 per dollar, its liability is ₹75 crore.
At ₹82 per dollar, its liability becomes ₹82 crore.
Thus, even when the dollar liability remains unchanged, its rupee burden increases by ₹7 crore. The effect is more direct if the company has not hedged its foreign-currency exposure.
Statement 3 is incorrect.
Depreciation or devaluation of the domestic currency does not reduce the currency risk associated with ECBs. It normally increases that risk because more units of domestic currency are required to repay foreign-currency principal and interest.
Currency risk can be reduced through forward contracts, options, swaps or a natural hedge, but not merely through currency depreciation.