UPSC Prelims 2022 Q61: Indian Economy – External Sector & Balance Of Payments
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 is/are correct?
- (a) 1 and 2 only
- (b) 2 and 3 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Answer: (a) 1 and 2 only
Explanation
Fed tightening, capital flight and ECBs
| Statement | Verdict | Reason |
|---|---|---|
| 1. Tight US Fed policy could cause capital flight | Correct | Higher US rates pull foreign portfolio money out of emerging markets like India |
| 2. Capital flight may raise interest costs on existing ECBs | Correct | Outflows weaken the rupee, so each dollar of interest and principal costs more rupees; floating-rate ECBs also reset higher |
| 3. Devaluation reduces currency risk on ECBs | Incorrect | Devaluation increases the rupee cost of foreign-currency debt, so currency risk rises |
The chain:
| Step | Effect |
|---|---|
| Fed raises rates | US assets pay more |
| Capital flight | Investors sell Indian assets and buy dollars |
| Rupee falls | ECB repayments cost more in rupees |
Answer: (a) 1 and 2 only.
Why each option is right or wrong
- (a) CORRECT. Fed tightening drives capital flight, and the falling rupee raises the cost of existing ECBs.
- (b) Incorrect. Statement 3 is false; devaluation makes foreign-currency debt costlier.
- (c) Incorrect. It drops the true statement 2 and keeps the false claim about devaluation.
- (d) Incorrect. Devaluation raises, not lowers, the currency risk on ECBs.
Key point
Fed hikes → capital flight → weaker rupee → costlier ECB servicing; devaluation increases ECB currency risk.
Remember
Devaluation raises ECB risk; Fed hikes cause capital flight.
Common mistakes
- Thinking devaluation helps foreign borrowers; it helps exporters but hurts those with dollar debt.
- Missing how a weaker rupee raises the rupee cost of interest on dollar loans.
- Not linking US monetary policy to Indian capital flows (the 2013 'taper tantrum' is the classic case).
Exam tip
Weak rupee: good for exporters, bad for dollar borrowers and importers.
Sources
- RBI — Master Direction on External Commercial Borrowings
- Economic Survey 2022-23, Ch 1 (State of the Economy: external sector)