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
Correct answer
Explanation
The correct answer is A, 1 and 2 only. Statement 1 is right because when the United States Federal Reserve tightens, returns there become attractive and portfolio money flows out of emerging markets, which is capital flight. Statement 2 is right because such an outflow weakens the rupee and raises risk premiums, so a firm servicing an external commercial borrowing pays more in rupee terms and finds refinancing dearer. Statement 3 is wrong, and this settles the other options: a fall in the value of the domestic currency raises, not lowers, the currency risk on a loan that must be repaid in dollars, because every dollar of repayment now costs more rupees. Option B is wrong because it accepts the faulty third statement and drops the correct first one, option C is wrong for accepting statement 3 while leaving out statement 2, and option D is wrong because it accepts all three.
Read the full article: Foreign Exchange and Exchange Rate: Concepts and Policy
Practice Questions
View allWith reference to the Indian economy, consider the following statements: 1. An increase in the Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. 2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness. 3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Which of the above statements 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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Statement 1 is right because the NEER is a trade weighted index of the rupee against a basket of partner currencies, so a rise in the index means the rupee has appreciated in nominal terms.
Read the full explanation →What challenge does foreign investment often face in India?
- A.Excessive foreign competition
- B.Inconsistent regulatory environment
- C.Lack of skilled labour
- D.Lack of consumer base
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Foreign investors bring in foreign exchange and look for predictable rules, and the difficulty most often listed for India is regulatory uncertainty: changing rules, clearances spread across departments and states, and disputes that take long to settle.
Read the full explanation →The Foreign Exchange Management Act, FEMA, replaced which of the following laws?
- A.Foreign Exchange Regulation Act, 1973
- B.Banking Regulation Act, 1949
- C.Monopolies and Restrictive Trade Practices Act, 1969
- D.Securities and Exchange Board of India Act, 1992
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FERA treated foreign exchange as a scarce resource, forbade most dealings unless permitted and made breaches criminal offences.
Read the full explanation →In which year did India accept the obligations of Article VIII of the IMF, making the rupee fully convertible on the current account?
- A.1991
- B.1993
- C.1994
- D.1999
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India accepted the obligations of Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994, which means the rupee can be exchanged freely for trade in goods and services, travel, education, remittances and interest payments.
Read the full explanation →Which of the following is not a component of India's foreign exchange reserves?
- A.Foreign currency assets
- B.Gold
- C.Special drawing rights
- D.Small savings collected by the government
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Small savings such as deposits in post office schemes are domestic rupee liabilities of the government and have nothing to do with the country's external assets.
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