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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?

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

Explanation

Let’s analyse the statements:

  1. Tight monetary policy of US Federal Reserve could lead to capital flight.
  • Correct. Tight monetary policy like increasing interest rates can lead to capital flight as it reduces the attractiveness of investing in the US and encourages investors to move their capital abroad.
  1. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).
  • Correct. Capital flight and resulting shortage of capital can drive up domestic interest rates. This increases the interest cost for firms with existing ECBs.
  1. Devaluation of domestic currency decreases the currency risk associated with ECBs.
  • Incorrect. Devaluation of domestic currency increases the currency risk for foreign currency loans like ECBs, as it increases the value of foreign currency debt in domestic currency terms.

Therefore, the correct answer is: 1 and 2 only

Statements 1 and 2 are correct as tight US monetary policy can spur capital flight, which can increase interest costs for firms with ECBs. Statement 3 is incorrect as devaluation increases currency risk of foreign currency debt.

Learn more

  • Tight monetary policy refers to actions taken by a central bank to constrict spending and curb inflation, such as raising interest rates.
  • Capital flight refers to the large-scale outflow of financial assets and capital from a country due to economic or political factors.
  • ECBs or External Commercial Borrowings are loans availed by Indian companies in foreign currencies.
  • Currency risk arises from exchange rate fluctuations which affect the value of foreign currency loans like ECBs.
  • Devaluation refers to deliberate downward adjustment of a currency’s value by the monetary authorities. It increases the currency risk associated with foreign currency loans.

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