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 are correct?

[UPSC Civil Services Exam – 2022 Prelims]

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

Answer: (a)        

Explanation:

Tight monetary policy

• Tight monetary policy is the term used to describe the measures adopted by a central bank to curb inflation and prevent an overheating economy.
• It is also known as contractionary monetary policy.
• The primary objective of tight monetary policy is to control inflation, which can become a concern if excessive consumer and business spending and borrowing occur, leading to a surge in the price level of goods and services.
• Inflation refers to the gradual increase in prices of essential commodities like groceries or clothing over time.
• One of the ways a central bank can curb inflation is by increasing the cost of borrowing for businesses and spending for consumers through a hike in interest rates, which is known as contractionary monetary policy.
• This policy aims to restrict or contract spending.
• Statement 1 is correct: When interest rates rise in the US, foreign investors tend to move their money from emerging markets like India to the US, seeking safer and more secure returns. This phenomenon is known as capital flight.
• Statement 2 is also correct: Foreign institutional investors have sold more than Rs 2 lakh crore worth of Indian equities since October 2021. If this trend continues, it could lead to pressure on the Reserve Bank of India to increase interest rates or result in the depreciation of the rupee against the dollar, which could result in imported inflation for India. Additionally, capital flight could increase the interest costs of firms with existing External Commercial Borrowings (ECBs) as it could lead to a depreciation in the value of the currency and create supply-side constraints for borrowers.
• However, statement 3 is not correct. Devaluation of the domestic currency can increase the currency risk associated with ECBs, leading to higher interest costs for borrowers.