UPSC 2022 Indian Economy Questions with Answers

Explanation

Statement 1 is correct: A tight monetary policy by the US Federal Reserve typically involves increasing interest rates to control inflation. Higher US interest rates can attract investors seeking better returns which can lead to capital outflows from emerging markets as investors move their funds to the US. This phenomenon is known as capital flight.

Statement 2 is correct: Capital flight can lead to the depreciation of the domestic currency as investors sell off local assets. For firms with ECBs(loans in foreign currency) denominated in foreign currencies, a weaker domestic currency means that more local currency is required to service the same amount of foreign debt, effectively increasing the interest cost and principal repayments in domestic currency terms.

Statement 3 is incorrect: Devaluation increases(not decreases) the currency risk associated with ECBs. If a firm has borrowed in a foreign currency and the domestic currency is devalued, the firm will have to pay more in domestic currency terms to repay the loan. This increases the burden of the debt and the currency risk for the borrower.

Explanation

Statements 1 and 2 are correct: Inflation-Indexed Bonds is a debt market securities offered by the government to protect the savings from inflation and offer positive real rates of returns. Since Inflation-Indexed Bonds (IIBs) provide inflation protection to investors, the government can offer these bonds with lower coupon rates compared to traditional bonds. The inflation adjustment compensates for the lower fixed interest.

Statement 3 is incorrect: The existing tax provisions will be applicable on interest payment and capital gains on IIBs. There will be no special tax treatment for these bonds.

Explanation

The real sector refers to the segment of the economy that is involved in the production and consumption of tangible goods and services. It includes industries such as agriculture, manufacturing, construction, mining, and services like health-care, education, and transportation. Statements 1 and 2 are correct:

Farmers harvesting their crops: This is a primary sector activity directly contributing to the production of goods (agricultural produce). Textile mills converting raw cotton into fabrics: This is a manufacturing activity, part of the secondary sector, which also belongs to the real sector. Statements 3 and 4 are incorrect:

A commercial bank lending money to a trading company:

This is a financial sector activity, involving monetary transactions rather than the production of tangible goods or services. A corporate body issuing Rupee Denominated Bonds overseas: This relates to the financial sector and capital markets, as it involves raising funds rather than producing goods or services.

Explanation

Statement 1 is correct: A convertible bond is a fixed-in-come corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. Convertible bonds generally offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature.

Statement 2 is correct: Equity (stock) prices tend to rise with inflation. Companies’ earnings and assets often appreciate during inflationary periods. Therefore, the option to convert a bond into equity provides a hedge against inflation. If inflation rises and the company performs well, its stock price is likely to increase. The bondholder can then convert the bond into equity at a more favorable price, thus benefiting from the rising prices and protecting their investment’s real value (purchasing power). This acts as a form of indexation (linking to a price index) against inflation.