1. Tight monetary policy of the US Federal Reserve could lead to capital flight.
2. Capital flight may increase the interest cost of firms with existing External Commercial borrowing (ECBs).
3. Devaluation of domestic currency decreases the currency risk associated with ECBs.

Which of the statements given above are correct?
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3
Correct Answer: a) 1 and 2 only

Question from UPSC Prelims 2022 GS Paper

Explanation :

Impact of US Federal Reserve’s Tight Monetary Policy

The US Federal Reserve’s approach to a tight monetary policy can have significant implications for global capital flows. An increase in interest rates can make dollar-denominated assets more attractive, potentially leading to capital flight from other nations as investors seek higher returns in the United States.

Consequences of Capital Flight on External Commercial Borrowings (ECBs)

When capital flight occurs, it can have a direct impact on firms with existing External Commercial Borrowings (ECBs). As capital leaves a country, the domestic currency may depreciate, increasing the cost of servicing foreign-denominated debt. This depreciation means that firms will face higher interest costs for their ECBs, as they require more local currency to meet their debt obligations.

Devaluation of Domestic Currency and Currency Risk

Contrary to reducing risk, the devaluation of a domestic currency actually escalates the currency risk associated with ECBs. A weaker domestic currency means that borrowers will have to exchange more of their currency to acquire the foreign currency needed for debt repayment, thus increasing the financial burden on firms with ECBs.