Impossible Trinity - A Macro-economic Policy Conflict!

Introduction

This article discusses the theorem of Impossible Trinity, choices in front of any Central Bank and consequences of its actions. An attempt has been made to highlight an important macroeconomic policy challenge faced by the Central Banks and Reserve Bank of India’s (RBI) steps towards handling this challenge.

The Theorem

The theory of impossible trinity states that it is impossible simultaneously to have full capital mobility, fixed exchange rate and an independent monetary policy.

Here, capital mobility refers to freedom given by a country with respect to inbound and outbound capital flows i.e. no quantitative or qualitative restrictions. All the entities and individuals within the country are allowed to invest/remit money abroad and foreign residents can do so in the host country. Fixity in exchange rate results whenever RBI intervenes in the foreign exchange market in order to control unnecessary deviation in the market exchange rate from the standard, desirable from the economy’s fundamentals point of view. A monetary policy can be said to be independent only, when it is used to regulate growth of the economy. This means, reducing/increasing the interest rates with the sole purpose of accelerating/decelerating the economy growth rate. For example, a decrease in interest rate is warranted in order to push industrial growth after the recent recession.

Application

Now, I would like to discuss the importance of this theorem taking 3 cases, considering a situation where the Indian economy is having in the midst of strong economic growth phase:

· If RBI goes with free capital mobility and fixed exchange rate

This means that there are no restrictions on the incoming and outgoing movement of funds. Also, RBI commits to keep Rupee exchange rate fixed with reference to a foreign currency, say US Dollar (USD).

Now, suppose strong economic growth results in huge capital inflows into the country. These inflows will increase the supply of USD and demand for Rupee which will cause the Rs/$ exchange rate to appreciate. In such a case, if RBI wants to keep exchange rate fixed, it will have to intervene in the foreign exchange market and start buying USD (thereby selling Rupee), so as to depreciate Rupee. This process will increase money supply. If this money supply is normal, there is no worry, but if it is excess, will result in inflation. Such consequent inflation will prevent RBI from intervening in the foreign exchange market, as it hurts Indian economy growth. RBI had faced such a situation in 2008 when it had decided not to intervene in the market due to concerns of inflation.

So, rather than intervening through foreign exchange market, another option available before it is to cut interest rates, so that foreign capital inflows decrease and exchange rate is restored to its earlier value. But in this process, RBI looses its monetary independence and interest rate autonomy, as reduction in interest rate has come to regulate exchange rate, which was unwarranted as the country is already in strong growth phase. Such, reductions may lead to ‘overheating’ in the economy.

· If RBI goes with free capital mobility and desires monetary independence

As explained earlier, increase in capital inflows results in appreciation of the Rs/$ exchange rate. Since, RBI desires monetary independence; it cannot reduce interest rate to discourage capital inflows. So, only tool available is intervention in the foreign exchange market, but this will result in inflation. To avoid inflation, RBI has to let exchange rate determination to market forces.

· If RBI wants monetary independence with a fixed exchange rate regime

Continuing with the previous example, now interest rate reduction is rule out. Intervention in foreign exchange market is also not possible due to fear of inflation. So, to regulate exchange rate, the only option before RBI to is curb capital inflows/mobility as this itself was the cause of initial Rs/$ exchange rate appreciation.

These scenarios can also be looked into from the point of view of a country with weak economic growth.

India’s Case

In India, RBI’s efforts have always been towards inflation-controlled economic growth. Such an approach requires interest rate autonomy. Thus, what RBI has to choose is either fixed exchange rate regime or free capital mobility.

A temporary depreciation in the Rs/$ exchange rate has generally been taken favorable in India because of economic significance and lobbying by exporters. But it has also resulted in increase in the Balance of Trade deficit due to India’s excessive reliance on oil imports, causing further depreciation.

In case of rate appreciation, RBI has generally adopted a managed exchange rate regime with selective intervention to support exports. Such an approach has always resulted in an excessive money supply and resulting inflation. This brings Government into picture, which issues bonds under Market Stabilization Scheme (MSS) to absorb the excess liquidity, so as to curtail inflation. But problem doesn’t end here. These bonds do carry interest payments, which in turn increase revenue and fiscal deficit, cause Government finances in bad shape and downgrading in country’s credit rating. Corporate world feels pinch as their interest rates on foreign financing increases. We are not left untouched as Government has to reduce its spending on social initiatives and if it desires to maintain or increase such spending, it increases tax rates.

Also, any RBI intervention of buying USD leaves it with increased reserves of it. These reserves have to be invested in financial securities abroad (mainly US bonds), which offer meager return. So, total cost of these interventions should be seen as a sum of several above mentioned factors.

What happens when RBI opts for free capital mobility? This issue has been widely debated at all the forums – conferences, print and electronic media, but in the name – full Capital Account Convertibility (CAC). Tarapore committee has given recommendations on implementation of full CAC in India and the issue is still under consideration. But an adoption of such a regime has to result in the free float of exchange rate. But for India, macroeconomic consequences of such an act can be huge as if the volatility is excess, export oriented companies will be unsure about their future revenues and will also result in wide fluctuations in Balance of Trade. Ultimately, RBI will be forced to play with the interest rate and thereby loose monetary independence.

Conclusion

India’s action to tackle impossible trinity has been of adopting a mixture of partial interest rate autonomy, managed exchange rate regime and limited capital mobility. Though in first two aspects, RBI and Government have considerable freedom, there is an increasing world pressure on India, to relax capital controls in this financially integrated world.

It is indeed a macroeconomic policy conflict, which needs to be tackled by RBI and the Union Government.

References:

·Joshi, Vijay, “India and the Impossible Trinity,” World Economy, Vol. 26,

pp. 555-583, April 2003

·Gulzar Natarajan’s blog

(http://gulzar05.blogspot.com/2007/11/impossible-trinity-and-central-banks.html)

·Several recent articles from The Hindu Business Line website

(http://www.thehindubusinessline.com/cgi-bin/bl.pl?subclass=518)

(http://www.thehindubusinessline.com/cgi-bin/bl.pl?subclass=033)

(This article was originally published on www.iimconnect.com - a networking website for IIM students,

alumni and faculty)