Previous Year Question

Statement 1 is correct. Lower dependence on short-term foreign borrowing reduces an economy’s vulnerability during a global financial crisis.

Short-term external borrowing generally creates the following risks:

• Rollover risk: At maturity, a foreign lender may refuse to renew the loan.

• Sudden-stop risk: Foreign capital inflows may stop abruptly when global uncertainty increases.

• Currency risk: Depreciation of the domestic currency increases the domestic-currency value of foreign-currency debt.

• Liquidity risk: A large amount of foreign currency may have to be arranged within a short period.

If an Indian borrower has borrowed in dollars and the rupee depreciates, more rupees will be required to repay the same dollar principal and interest. Large short-term liabilities can therefore deepen a crisis even when the country maintains substantial foreign-exchange reserves.

Low short-term external debt, a longer maturity profile and adequate foreign-exchange reserves consequently provide greater economic resilience.

Statement 2 is incorrect. The entry of more foreign banks does not automatically protect a country from a global financial crisis. Foreign banks may provide finance, technology and competition, but during a crisis they may:

• transfer liquidity to their parent institutions;

• reduce domestic lending;

• sell risky assets; or

• transmit financial stress from one country to another.

This is known as cross-border transmission or financial contagion. Merely increasing the number of foreign banks is therefore not a policy that provides immunity from a crisis.

Statement 3 is incorrect. Full Capital Account Convertibility permits residents and non-residents to convert domestic currency into foreign currency relatively freely for purchasing, selling or transferring financial assets across borders.

During a crisis, full convertibility may intensify:

• large capital outflows;

• exchange-rate depreciation;

• pressure on foreign-exchange reserves; and

• asset-price volatility.

Without strong banking regulation, deep financial markets and macroeconomic stability, full capital-account convertibility may increase vulnerability instead of providing protection.

India accepted IMF Article VIII obligations and adopted current-account convertibility in 1994, but retained calibrated restrictions on capital-account transactions. Its approach has involved gradual and cautious liberalisation rather than complete capital-account convertibility.

Therefore, among the given measures, only avoiding dependence on short-term foreign borrowing is likely to provide India with some protection from a global financial crisis.