Currency Depreciation Expectations Offset Interest Rate Gains

Steps:

• Central banks raise rates to make domestic assets more attractive for higher yields, drawing capital inflows.
• Capital flows depend on net returns, including interest differentials minus expected currency changes.
• If depreciation is anticipated, investors expect losses on currency conversion, reducing appeal of higher rates.
• Thus, inflows weaken, impairing financial account improvement.

Why A is correct:

• Uncovered interest parity theory states expected depreciation erodes interest rate advantages, deterring capital inflows.

Why the others are wrong:

• B: Stability boosts investor confidence, amplifying rate hikes' pull on capital.
• C: Higher relative rates directly enhance competitiveness for inflows.
• D: Rising reserves signal economic strength, reinforcing policy credibility and effectiveness.

Final answer: A