EPFO EO/AO 2023 General Ability Test · Question 113 of 120

Correct — A, (a) Both statement I and statement II are correct and statement II is the correct explanation for statement I. This is the only one of the paper's four Statement I and Statement II items on which the explanation limb actually has to be decided, so it is worth working the structure openly. The four options are: (a) both correct and the second explains the first; (b) both correct but the second not the correct explanation of the first, the word not being printed in bold italics because it is the sole difference from (a); (c) the first correct and the second not; (d) the first not correct and the second correct. Test truth first, then, only if both survive, test explanation. Statement I is correct. A very strong US Dollar does squeeze global credit. When the dollar appreciates sharply, dollar funding becomes scarcer and dearer around the world, banks that lend across borders in dollars pull back, and financial conditions tighten well beyond the United States. A strengthening dollar typically accompanies tighter US monetary policy and a flight of capital towards dollar assets, which drains funding from other markets at the same time. Statement II is correct. A great deal of borrowing outside the United States is done in dollars rather than in the borrower's own currency. Governments, banks and companies in many countries, and emerging economies in particular, raise dollar loans and issue dollar bonds, and much international trade is invoiced and settled in dollars as well. Now the explanation limb, and here the second statement genuinely does explain the first. The mechanism runs through balance sheets. A borrower outside America who owes dollars but earns revenue in local currency finds that when the dollar rises, the local-currency cost of servicing and repaying that debt rises with it, even though the debt has not grown by a single dollar. The borrower's net worth falls, the collateral behind its loans is worth less, and the lender's assessment of its creditworthiness deteriorates. Multiply that across a very large stock of dollar debt owed by non-American borrowers and lenders as a class become less willing to extend new dollar credit, cut existing lines, and demand more security. That contraction in the supply of credit is precisely the squeeze statement I describes. The test of a genuine explanation is a counterfactual, and it is decisive here. If borrowers outside America mostly owed money in their own currencies, a stronger dollar would change relative prices and shift trade flows, but it would not directly damage those balance sheets and it would not tighten credit worldwide in the way described. The squeeze happens because the borrowing is in dollars. Statement II is therefore not merely a true fact placed alongside statement I; it is the reason statement I is true, which is what option (a) asserts.

• (b)Both statement I and statement II are correct and statement II is not the correct explanation for statement I — The word not in this option is printed in bold italics, and that emphasis is the entire distinction between this option and the answer: both accept that the two statements are true, and they differ only on whether the second is the reason for the first. Here it is. The squeeze in global credit is not a coincidence occurring alongside widespread dollar borrowing; it is produced by it, through the rise in the local-currency burden of dollar debt when the dollar appreciates. A candidate lands on this option by treating the two statements as separate facts about the dollar, which is the correct instinct on many Assertion-Reason items but the wrong one here. The counterfactual settles it: remove the dollar borrowing and the squeeze does not follow.
• (c)Statement I is correct but statement II is incorrect — This rejects the claim that many countries and companies outside America borrow in dollars, which is not open to doubt. The dollar is the dominant currency of international lending and bond issuance, and borrowers in emerging economies in particular raise a large part of their external finance in it, because dollar markets are the deepest and the cheapest to tap. The option would also leave statement I without a mechanism: if hardly anyone outside America owed dollars, it would be hard to say why a strong dollar should tighten credit globally at all. Rejecting the second statement here amounts to removing the explanation of the first while keeping the first, which is an unstable position.
• (d)Statement I is incorrect but statement II is correct — This accepts the dollar-borrowing fact but denies that a very strong dollar squeezes global credit. The denial does not survive the mechanism. When the dollar rises, dollar-indebted borrowers outside America see their debt burden grow in local-currency terms, their balance sheets weaken, and lenders respond by restricting new dollar credit and tightening terms on existing exposures; at the same time capital tends to move towards dollar assets, draining funding from other markets. A candidate may reach this option by thinking of a strong dollar only through the trade channel, where a costlier dollar makes exports to America dearer and imports from America cheaper. That channel is real, but it is not the only one, and the financial channel is the one the pair of statements is about.

The US dollar is not simply one currency among many; it is the currency in which a large part of the world's cross-border borrowing, bond issuance, trade invoicing and official reserves is denominated. That gives its exchange rate a role no other price has, because it changes the real burden of debt for borrowers who never dealt with an American lender. The channel that matters for credit is the balance-sheet channel. A firm or a government outside the United States that owes dollars while earning local currency has an implicit currency mismatch: if the dollar strengthens, the local-currency value of what it owes rises, its net worth falls, and its capacity to borrow falls with it. Lenders observing that deterioration reduce their exposure, so the supply of credit contracts across many borrowers at once. This is why a strong dollar is often described as a global financial condition rather than a bilateral exchange rate, and why it tends to coincide with capital outflows from emerging markets, wider credit spreads and slower cross-border bank lending. The trade channel runs the other way and is more familiar: a stronger dollar makes American exports dearer and imports into America cheaper, and it lifts the local-currency cost of commodities that are priced in dollars, including crude oil, which for an importing country such as India feeds into the current account deficit and into domestic inflation. Both channels are real, and a complete answer on the subject distinguishes them.

The EO/AO General Ability Test includes a block of current-affairs and economy questions in which the material is drawn from the financial press of the preceding year, and the strength of the dollar was a running story when this paper was set. Questions of this kind do not reward memorised headlines; they reward understanding of a mechanism, because the examiner asks whether one economic fact explains another. The habit rewarded is to be able to state the chain of causation in a sentence, from a rising dollar to a heavier local-currency debt burden to weaker balance sheets to a reduced supply of credit, and to be able to say what would have to be different for the chain to break.

• The dollar is the dominant currency for international borrowing, bond issuance, trade invoicing and official reserves.
• Borrowers outside America who owe dollars but earn local currency carry a currency mismatch on their balance sheets.
• When the dollar appreciates, the local-currency cost of servicing dollar debt rises even though the dollar amount owed has not changed.
• Weaker borrower balance sheets lead lenders to cut new dollar credit and tighten existing exposures, which is the global credit squeeze.
• A strong dollar usually accompanies tighter US monetary policy and a move of capital towards dollar assets, draining funding elsewhere.
• The separate trade channel makes American exports dearer, imports into America cheaper, and dollar-priced commodities costlier for importing countries.
• For India, a stronger dollar raises the rupee cost of imported crude oil, with effects on the current account deficit and on domestic inflation.
• The counterfactual test of an explanation: if borrowing outside America were mostly in local currency, a strong dollar would not tighten global credit in this way.

• Thinking about a strong dollar only through the trade channel and missing the financial channel entirely.
• Treating two true statements as unrelated when one is in fact the mechanism behind the other.
• Assuming a currency mismatch requires the borrower to have dealt with an American lender; the currency of the contract is what matters.
• Confusing the depreciation of one currency with a broad strengthening of the dollar against many currencies at once.
• Skipping the counterfactual test, which is the only reliable way to decide the explanation limb on Assertion-Reason items.

External-sector questions come to EO/AO papers as Statement I and Statement II items testing a causal chain, as two-statement code items on the balance of payments or on reserves, and as single-line questions on the effect of a depreciating rupee. When the item is of the Assertion-Reason kind, the examiner is testing whether the candidate can distinguish an accompanying fact from a cause. Practise stating each mechanism as a chain of three or four links, and then testing it by asking what would happen if the middle link were removed.

No directly related past PYQ was found.

• practice — not a real PYQ

  A sharp appreciation of the US dollar is most likely to affect a company in an emerging economy that has borrowed in dollars by :

  • (a)Reducing the local-currency value of its outstanding debt
  • (b)Raising the local-currency cost of servicing and repaying its debt
  • (c)Leaving its debt burden unchanged, since the dollar amount owed is fixed
  • (d)Converting its dollar debt automatically into local-currency debt

  Answer(b) Raising the local-currency cost of servicing and repaying its debt

• practice — not a real PYQ

  For an oil-importing country such as India, a strengthening of the US dollar against the rupee is most likely to :

  • (a)Lower the rupee cost of imported crude oil
  • (b)Raise the rupee cost of imported crude oil and add to imported inflation
  • (c)Have no effect on the import bill, since oil is priced in rupees
  • (d)Automatically reduce the current account deficit

  Answer(b) Raise the rupee cost of imported crude oil and add to imported inflation