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?

The correct option is 1 and 2 only.

Statement 1 is correct:
A tight monetary policy adopted by the US Federal Reserve involves raising interest rates. When interest rates rise in the United States, the yield on US financial assets becomes more attractive relative to assets in emerging economies. Consequently, foreign portfolio investors tend to pull their capital out of developing economies like India and redirect it back to the US in search of safer, higher-yielding returns. This phenomenon is known as capital flight.

Statement 2 is correct:
Capital flight leads to an increased demand for US dollars, resulting in the depreciation of the domestic currency (e.g., the Indian Rupee) against the US Dollar. External Commercial Borrowings (ECBs) are denominated in foreign currency (typically USD). As the domestic currency depreciates, Indian firms require more rupees to buy the same amount of dollars to service their interest payments and repay the principal. This increases the effective interest cost and overall debt servicing burden for firms with existing ECBs.

Statement 3 is incorrect:
Devaluation or depreciation of the domestic currency increases, rather than decreases, the currency risk associated with ECBs. Since ECBs must be repaid in foreign currency, any fall in the value of the domestic currency means that the borrower has to pay more in domestic currency terms to meet their foreign debt obligations, thereby escalating the exchange rate risk.