🧷 Authentic Classroom Explanation by IAS Monk

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📌 The Question:

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

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✅ Correct Answer: (a) 1 and 2 only

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🧠 Classroom Explanation

• Statement 1 is correct
  • When the US Federal Reserve adopts a tight monetary policy (rate hikes), returns on US assets rise.
  • Global investors shift funds from emerging markets to safe-haven US assets like Treasury Bonds.
  • This results in capital flight from countries such as India.
• Statement 2 is correct
  • Capital flight usually leads to depreciation of the domestic currency.
  • Firms with ECBs (foreign currency–denominated loans) must repay in dollars.
  • A weaker rupee means higher repayment cost in rupee terms, raising the effective interest burden.
• Statement 3 is not correct
  • Devaluation/depreciation increases, not decreases, currency risk.
  • Example:
    • Loan taken when $1 = ₹75
    • Repayment when $1 = ₹80
  • Firms must pay more rupees for the same dollar liability, increasing currency risk.

👉 Hence, only Statements 1 and 2 are correct.

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🔍 Curiosity Raiser

Why do decisions taken in Washington
shake balance sheets in Mumbai?

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🧘 IAS Monk Whisper

When the dollar tightens its grip,
emerging markets feel the squeeze first.