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?

  • 1 and 2 only
  • 2 and 3 only
  • 1 and 3 only
  • 1, 2 and 3

Answer: (a) 1 and 2 only

The Fed’s policy affects the Indian markets through various channels such as:
  • Exchange Rate Channel: The Fed’s rate hikes tend to strengthen the US dollar against other currencies, including the Indian rupee.
    • A weaker rupee also increases the debt servicing costs for Indian borrowers who have taken loans in foreign currency.
  • Capital Flow Channel: The Fed’s rate hikes also reduce the interest rate differential between the US and India, which makes India less attractive for foreign investors who seek higher returns.
    • This could lead to capital outflows from India’s equity and debt markets, which could lower asset prices and increase volatility.
    • Capital outflows could also reduce India’s foreign exchange reserves and create liquidity crunches in domestic markets.
  • Inflation Channel: The Fed’s rate hikes could also affect India’s inflation through two ways.
    • First, a weaker rupee could increase the imported inflation for India, as it raises the cost of imported goods such as oil, gold and electronics.
    • Second, higher global commodity prices due to strong US demand could also push up India’s domestic inflation, as it affects the input costs for various sectors such as agriculture, manufacturing and services.

Tight monetary Policy

  • Tight monetary policy refers to the actions that a central bank takes to limit inflation and an overheating economy. Tight monetary policy is commonly called contractionary monetary policy.
  • Tight monetary policy, or contractionary monetary policy, typically occurs when a central bank wants to keep inflation under control.
  • If there has been too much spending and borrowing by consumers and businesses, the economy can become overheated and that could considerably raise the price level of goods and services.
  • To minimize or slow down inflation, a central bank could make it more expensive for consumers to spend money and businesses to borrow money by raising interest rates. This is a form of contractionary monetary policy—it restricts, or contracts, spending.

Capital Flight

  • In economics, capital flight is a phenomenon characterized by large outflows of assets and/or capital from a country due to some events, resulting in negative economic consequences to that country.
  • In this context, Capital Flight will be induced due to the tight monetary policy of the US federal reserve.
    • Higher interest rates in the US usually lead to foreign investors pulling their money from emerging markets like India back to the US for safer, and more secure returns leading to capital flight.
    • Further capital flight will put pressure on the RBI to hike interest rates or lead to rupee depreciation against the dollar, which again would lead to imported inflation for India.
    • Capital flight may increase the interest cost of firms with existing External Commercial borrowing (ECBs) as the capital flight would lead to depreciation in the value of the currency and create supply-side restraints for borrowers.
    • Devaluation of domestic currency will inadvertently increase the currency risk associated with ECBs and will result in higher interest costs for borrowers.