Q. 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 Prelims 2022)
Answer: 1 and 2 only
Notes: The correct answer is [A] 1 and 2 only. This question tests the relationship between global monetary policy, capital flows, and corporate debt.

• Statement 1 (Correct): A tight monetary policy (increasing interest rates) by the US Federal Reserve makes US dollar assets more attractive to investors. This often triggers capital flight from emerging markets like India as investors pull out funds to seek higher, safer returns in the US.
• Statement 2 (Correct): Capital flight leads to a depreciation of the domestic currency (Rupee) against the Dollar. For firms with External Commercial Borrowings (ECBs), they must pay more in Rupee terms to service the same amount of Dollar debt. This effectively increases the interest cost and the total repayment burden.
• Statement 3 (Incorrect): Devaluation or depreciation of the domestic currency actually increases the currency risk associated with ECBs. If the Rupee weakens, the borrower needs more Rupees to buy the Dollars required for repayment. To reduce this risk, firms usually have to pay for "hedging," which adds to the cost of borrowing.

Historically, the US Fed's "taper tantrums" have shown how sensitive Indian markets and the Rupee are to shifts in American interest rates, directly impacting the balance sheets of Indian corporations relying on foreign debt.