The Impossible Trinity

Group 9 Arnab Kumar Saha PGP/16/073 Arvind Topno PGP/16/074 Chandan Kumar PGP/16/079 Krit Narayan Yadav PGP/16/087 Rupa Murudkar PGP/16/092 Dibyalaxmi Devi PGP/16/111

Agenda Trinity : Introduction Extreme examples : USA, China & Hong kong Emerging economies crisis :

East Asia crisis(97-98) Foreign Reserve Accumulation India’s Trinity Conclusion: Indian Perspective

Impossible Trinity

1) free capital flows

2) a fixed exchange rate

3) independent monetary authority

It is not possible for a country to maintain all three of the following:

Why? According to the trilemma , Fixed exchange rate + free capital flows

requires domestic and foreign interest rates to be equal (monetary independence lost) Otherwise, ‘uncovered interest arbitrage’ will force continuous appreciation or depreciation of the currency As such, nations with free capital controls must choose between 1) Fixed exchange rate (by slaving interest rates to foreign rates and consequently losing monetary independence) and 2) Independent monetary authority (adjusting interests slaved to domestic macro conditions but letting the exchange rate fluctuate)

Impossible Trinity (continued) A country can choose any two of the three:

Impossible Trinity (examples)

2) Hong Kong has a fixed exchange rate & allows free flow of capital but does not have independent monetary authority

1) U.S. allows free flow of capital & maintains monetary authority but does not have a fixed exchange rate

3) In the past, China had a fixed and maintained monetary authority but did not allow the free flow of capital

The Trinity & Developing Economies Why are the three vertices important?• Capital Inflows needed for growth and to

finance current account deficits

• Exchange stability – floating rate regime leads to volatility –affects trade and foreign debt

• Independent monetary policy as a tool for increasing output (IS-LM model) and control inflation

The Trinity hurts a developing economy more:• Greater pass-through effect of exchange

rate changes than in the case of developed economies

• More volatility in capital flows – capital flight from the economy & further exchange rate volatility

The “middle-path” approachDirty float OR Capital controls

Trilemma in Major Economies

Country Free Capital Flows

Independent Monetary Policy

Fixed Exchange Rate

USA, AUSTRALIA, NEW ZEALAND, CANADA, INDIA

YES YES NO

CHINA & N KOREA

NO YES YES

HONG KONG& ARGENTINA

YES NO YES

Chinese Currency ControversyFixed Exchange rate Yuan pegged at 8.28 per dollar from 1995-2005 Accumulation of large dollar reserves by Central Bank

Repercussions Cheaper Chinese goods Manufacturing exports dwindling around the world

New Initiatives Fewer controls on capital flows Citizens allowed to invest abroad Floating Exchange rate introduced

Application of Impossible Trinity to European monetary integration In the 1992 crisis of the

European exchange rate mechanism (ERM),

Spain and Portugal temporarily gave up their new financial openness (reinstating controls).

Britain gave up its new link to the other European currencies, dropping out of the ERM.

Austria and the Netherlands continued to cling to the DM.

By the late 90s, however, 11 countries had given up capital controls and (in 1999), their own currencies; as a result, interest rates converged.

EMU-headed countries fully converged starting in 1998

USA and the Trilemma

2008 Financial Crisis forced the Federal reserve into action New Policy initiative-massive appreciation and imported

inflation faced by emerging markets Calls on the US Govt to ease up on monetary reforms Paul Krugman, NY times Columnist-

“ the hard choices emerging markets are facing don’t reflect any kind of spectacular misbehavior on the part of the United States. All that we’re seeing is the classic set of tradeoffs that any currency regime faces — and it’s not the business of the Fed to save other countries from the necessity of making choices.”

Hong Kong & the trinity dilemmaSuggestion from the Asian Crisis To withstand interest rate pain from speculative attack on

their currencies sufficient large reserves healthy financial system

Current Structure Hong Kong dollar anchored to the US dollar using a

currency board monetary base in circulation is backed by US dollar reserves Obliged to import monetary policy from the US.

Exchange Rate Regime in Select Countries (as of 31 July , 2006)Exchange Rate Regime No. Of countries

Fixed Exchange Rate 70

Other conventional fixed peg arrangements 52

Pegged exchange rate within horizontal bands 6

Crawling pegs 5

Currency board arrangements 7

Floating exchange rate 76

Independent floating 25

Managed floating 51

Exchange arrangements with no separate legal tender(Euro) 41

Source : IMF

India

Emerging economies crisis• Late 1980s and early 1990s - emerging

market countries embraced growing financial liberalization and openness

• However, by also trying to maintain some

degree of both exchange rate stability and monetary independence, many of these countries experienced severe financial crises Mexico(1994-5) and East Asia (1997-8)

East Asia crisis (97-98)Over a three-month period between July and October 1997, the highly appreciated currencies • Thailand baht fell nearly 40 per cent• Malaysian ringgit and Philippine peso by about 27 per cent• Indonesian rupiah by about 40 per cent

East Asia crisis (97-98) continued ..• Mexico and Thailand had received large

capital inflows and foreign investment in the 1990s and had been highly regarded by international investors. The peso and baht had also appreciated significantly

• However, both had experienced deterioration in their export growth rates and rise in current account deficits in the years before the crises

East Asia crisis (97-98) continued..• Overvalued exchange rates, speculative attacks and investor panic, all led to currency depreciation

• For countries that had been dubbed “miracle economies” this was a serious blow with wide-ranging economic , social and political ramifications

Post crisis policy changes• More exchange rate flexibility, domestic

monetary independence, and growing financial integration

• But they are still engaging in a great degree of exchange rate management. So, in the face of pressures for their currencies to appreciate, they have been accumulating reserves and sterilizing

Post crisis (continued)• Hoarding of international reserves has

become a key ingredient enhancing the stability of this new pattern

• China displays this policy mix, allowing

financial integration, and in mid-2005 adopting managed exchange rate flexibility, while also accumulating and sterilizing massive amounts of foreign reserve inflows

Massive foreign reserve accumulationresponsible factors 1) Precautionary demand needs - insurance

against sudden stops of foreign capital inflows, thereby offsetting the downside risk of greater financial integration

2) Cushion the effects of trade shocks - on a country’s real exchange rate and its exports, smoothing the adjustment of the current account.

Continued..

3) Avoid relying on the IMF, World Bank, and other international financial organizations, etc. for implicit insurance

4) Lastly, reserve accumulation may occur as a byproduct of managing exchange rates to promote exports by undervaluing domestic currency

Forex Reserve as % of GDP

1997 2007

Emerging Asia 13.1 37.5

China 14.7 45

Hong Kong 51.9 68.3

India 5.9 21.3

Indonesia 6.7 12.5

Korea 3.7 27.5

Malaysia 18.7 56.3

Philippines 8.4 17.6

Singapore 74.7 102.4

Thailand 17 32.8Source:Herve Hannoun(2007),BIS

Capital inflow and sterilization

Capital inflow

Currency appreciation

Rupee in market - inflation

Exchange of dollar with rupee

Central Bank

Sterilization – issue of bonds

Central Bank

Sterilization Response Cost• Central banks may offset the effects of

reserve accumulation on the monetary base in a number of ways, including selling market instruments, such as government bonds or central bank bills

• cost of sterilization: Central bank usually has to sell bonds at a higher interest rate

Indian Experience• Trilemma principle predicts that India’s

experience with increasing financial integration would likely have been accompanied by a loss of monetary independence and/or loss of exchange rate stability

Indian Experience(continued..)• Gradual financial liberalization, first

domestic , then foreign �• More market-determined exchange rate

system and current account convertibility�• Slow and incomplete capital account

liberalization�• Evolution of monetary policy conduct

India : Managed float exchange rate• RBI Exchange Rate Intervention : There is

active intervention by RBI in foreign exchange market with the aim of keeping nominal exchange rate stable

• Capital Flow Controls : India has limits on FDI, FII, External Commercial borrowing, Capital Outflows and restrictions on Commercial banks and Financial markets

Measuring trilemma• Trilemma component indices Monetary Independence (MI) Index : MI Exchange Rate Stability (ES) Index : ES Capital Account Openness (KO) Index : KO

• Trilemma contributions� 2= aMI + bES + cKO + ε

Phase I Q1 1996-97 to Q2 2000-01

Phase II Q3 2000-01 to Q4 2004-05

Phase III Q1 2005-06 to Q2 2009-10

Mon Indep (MI) 0.4335 -0.0752 0.2245

Exchange Rate Stab (ES)

1.2978 1.6548 1.2611

Capital Account Openness (KO)

0.2081 0.4105 0.4598

Total 1.9395 1.99 1.9454

• As capital account openness has increased, we see in phase II monetary indep has been completely lost. exchange rate stability remains a priority

• In phase III, we see some exchange rate stability being sacrificed for restoring monetary independence

• Overall in phase III, we see lower monetary independence and higher capital account openness compared to Phase I

Impact on inflation and volatility• Exchange rate stability appears to dampen

inflation volatility.

• Increased financial integration and Monetary independence does not seem to increase the level of inflation

• It could be that inflation is also dependent on supply side constraints

India: 1991 crisis•Limited FER until 1991($1.2) billion for essential imports (petroleum goods and food grains)

•1991 crisis – Insufficient FER to counter currency overvaluation ; the current account deficit and investor confidence played significant role in the sharp exchange rate depreciation

India: Foreign Reserves•India is now one of the biggest hoarders of �foreign exchange reserves(9th in world)

•Accumulation of reserves FER - US$ 295 billion at end- Oct 2012

India : Reserve Benefits• India has been able to actively manage the

exchange rate and limit exchange rate volatility relative to other emerging market economies, by building up international reserves and intervening actively in the foreign exchange market

• Such reserve management has also helped to some extent in regaining control over monetary policy even in the face of inflows

India : Reserves cost and sterilization• Most increase in reserves during our sample

period was offset by declines in net domestic assets, thereby suggesting that as a consequence of relaxation of capital controls, Indian economy did partially lose monetary independence

• Sterilization more successful 1996Q2 to 2005Q1, less so from 2005Q2 to 2009Q3

India : Forex Reserves

Trilemma and Reserve accumulation

Conclusion : Indian perspective• Capital account openness has cost us reduction in

monetary policy independence or limitations on exchange rate stability

�• Greater financial integration and corresponding

loss of monetary autonomy and exchange rate stability has influenced inflation sometimes

• International reserves accumulation has played a role in managing the Indian trilemma

Lets visualize…… http://www.facebook.com/l.php?u=http%3A%2F

%2Fwww.youtube.com%2Fwatch%3Fv%3DoLbfAfCVG_4&h=gAQEnZvNB

References •ECONOMIC VIEW The Trilemma of International Finance By N. GREGORY MANKIW Published: July 10, 2010•http://www.voxeu.org/article/how-can-impossible-trinity-not-apply-east-asia•http://www.investopedia.com/terms/u/uncovered-interest-arbitrage.asp#axzz2Exu4Zbxp•Sterilization, Monetary Policy, and Global Financial Integration, Joshua Aizenman, Reuven Glick, Review of International Economics, Volume 17, Issue 4, pages 777–801, September 2009•http://mostlyeconomics.wordpress.com/2010/12/22/how-has-india-managed-the-impossible-trinity-over-the-years/•India’s Trilemma: Financial Liberalisation, Exchange Rates and Monetary Policy, Michael Hutchison, Rajeswari Sengupta, Nirvikar Singh, The World Economy Volume 35, Issue 1, pages 3–18, January 2012•http://www.cdedse.org/pdf/work158.pdf•http://www.unescap.org/pdd/publications/adpj_11_2/5_bacha.pdf•http://www.ft.com/cms/s/0/efb6e612-08ca-11dc-b11e-000b5df10621.html#axzz2F0ckxA6l•http://www-siepr.stanford.edu/papers/briefs/policybrief_sep05.pdf