Consider the following statements:Tight monetary policy of US Federal Reserve could lead to capital

Question

Consider the following statements:Tight monetary policy of US Federal Reserve could lead to capital flight.Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).Devaluation of domestic currency decreases the currency risk associated with ECBs.Which of the statements given above are correct?

Accepted Answer

Tight monetary policy implies the Central Bank (or authority in charge of Monetary Policy) is seeking to reduce the demand for money and limit the pace of economic expansion. Central banks engage in tight monetary policy when an economy is accelerating too quickly or inflation is rising too fast and usually involves increasing interest rates. Tight monetary policy of US Federal Reserve means hiking the federal funds rate–the rate at which banks lend to each other–increases borrowing rates and slows lending. Rate increases make borrowing less attractive as interest payments increase. It affects all types of borrowing including personal loans, mortgages, and interest rates on credit cards.Faster Fed rate could rattle financial markets and tighten financial conditions globally especially in emerging market economies like India. For instance, an aggressive monetary tightening would raise US yields and strengthen the US dollar against EM currencies like rupee. As a result, US-based foreign portfolio investors/Foreign institutional investors investing in countries like India would pull money out from here and invest in safe haven US assets (Treasury bonds) and thus leading significant capital flight from India. Hence statement 1 is correct.The sudden stops and reversal of capital flows will lead to depreciation pressures on emerging market currencies like rupee. When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. If the EM currency depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds. This capital flight may increase interest cost of firms with a large stock of foreign currency debt as rising US dollar would increase the debt-servicing costs (in local currencies) for firms. Hence statement 2 is correct.Devaluation of domestic currency increases the currency risk associated with ECBs (as mostly foreign currency denominated). For instance, if at the time of raising loan through ECBs, 1 dollar was equal to Rs 75 and in future with depreciation/devaluation of domestic currency, 1 dollar becomes Rs 80. In this case, companies/firms done borrowing through ECBs would have to pay back more as converting more rupee with their dollar equivalent and in turn increases their currency risk. Hence statement 3 is not correct.