UPSC Prelims 2022 Q61: Fed Tightening, Capital Flight and ECBs Explained

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?

  1. 1 and 2 only
  2. 2 and 3 only
  3. 1 and 3 only
  4. 1, 2 and 3

Answer: (a) 1 and 2 only

Statement-wise explanation

  • 1: correct — When the US Federal Reserve raises rates or shrinks its balance sheet, dollar assets pay more. Foreign investors then sell emerging-market stocks and bonds and move the money back to the US. India saw this in 2013, when the Fed announced in May that it planned to roll back quantitative easing. Foreign institutional money left quickly and the rupee fell sharply. That large, fast outflow is capital flight.
  • 2: correct — Most ECBs are in foreign currency, so interest is paid in dollars. Capital flight weakens the rupee, and the firm then needs more rupees to pay the same dollar interest, so its interest cost rises in rupee terms. Fed tightening also pushes up the US dollar benchmark rates that floating-rate ECBs are priced on, and it makes hedging dearer. The statement says 'may', so it only has to be possible, and it is.
  • 3: incorrect — Devaluing the domestic currency means more rupees are needed to buy each dollar. A borrower with a dollar ECB therefore has to repay more rupees for the same principal and interest. The currency risk does not shrink; it turns into an actual loss. Only ECBs denominated in rupees (such as masala bonds) protect the borrower, because there the foreign lender bears the exchange-rate risk.

How to eliminate

This question needs one piece of reasoning, not three facts. Statement 3 appears in three of the four options. Knock it out and only '1 and 2 only' is left. Statement 3 fails on first principles: if the rupee loses value, a loan taken in dollars costs more rupees to repay, so the risk goes up, not down. You can also check the other two. Statement 1 is the standard 'taper tantrum' story: higher US rates pull money out of emerging markets. Statement 2 says 'may', which is a soft word and easy to satisfy. It follows from statement 1: outflows lead to a weaker rupee, and dollar interest then costs more in rupees. Fact to remember: a foreign-currency loan gets dearer whenever the home currency weakens.

Know more

How US monetary policy reaches an Indian company's balance sheet

When the Fed tightens, effects reach India through a chain:

  1. US yields rise, so dollar assets become more attractive.
  2. Foreign portfolio investors sell Indian equities and debt. A sharp outflow is capital flight. If inflows stop abruptly, it is a sudden stop.
  3. Demand for dollars rises and the rupee weakens.
  4. Borrowers with foreign-currency debt pay more rupees for the same dollar interest and principal.
  5. The RBI may sell reserves or raise rates to defend the rupee, which tightens domestic credit as well.
Who carries the exchange-rate risk? Foreign-currency ECB Rupee-denominated ECB (e.g. masala bond)
Currency of repayment USD/EUR etc. INR
Rupee weakens Borrower pays more Lender earns less in its own currency
Needs hedging by borrower Yes, usually No

Devaluation vs depreciation. India has a market-determined (floating) rupee, so the correct word is depreciation. Devaluation is an official cut in the value of a pegged currency. Either way, more rupees are needed per dollar.

Hedging. Firms buy forwards or swaps to lock in the exchange rate. Hedging costs money, and the cost rises when markets are volatile. A January 2022 RBI working paper estimated the optimal hedge ratio for the ECB portfolio at about 63% during periods of high forex volatility. It also found that rupee depreciation hurts new ECB issuance.

Buffers. Forex reserves are the main defence. The Economic Survey 2021-22 reported reserves of US$633.6 billion on 31 December 2021. India was the fourth-largest holder (end-November 2021), and reserves covered 107.1% of external debt at end-September 2021. The Survey argued that India was better prepared for a 'taper tantrum' than in 2013.

In the news

In early 2022 the US Fed was ending its pandemic stimulus and starting to raise rates to fight high inflation. The Economic Survey 2021-22 (January 2022) noted that this had 'reignited some fears of taper tantrum'. In his March 2022 speech 'Taper 2022', RBI Deputy Governor Michael Patra discussed how this tightening spills over to emerging markets.

NCERT Concepts to Revise

  • Capital flight: Statements 1 and 2 both depend on what capital flight is and what triggers a large, fast outflow.
  • External commercial borrowings: Statements 2 and 3 ask how ECBs are raised and in which currency they are repaid.
  • Sudden stop: A sudden stop is the extreme form of the capital reversal that US tightening can cause in emerging markets.
  • Balance of payments: Capital flight and ECB repayments both appear in the capital account of the balance of payments.

Read more