RBI AND IMPOSSIBLE TRINITYN Sawaikar

INTRODUCTION

The RBI pursues a policy called a managed float.

The rupee is flexible within limits but the RBI will intervene to prevent “excessive” fluctuations

At the same the RBI seems to keep inflation low

This creates a fundamental conflict in an economy with open capital flows which is often described as the impossible trinity

MANAGED FLOAT An exchange rate which is flexible but where the

central bank intervenes occasionally is called a “managed float”

Reasons for central bank intervention: a) smoothing excessive fluctuations in exchange ratesb) Exchange rates affect trade and aggregate demand Two main methods of influencing exchange rates:a) Direct intervention in the forex marketsb) Indirect intervention through regular monetary policy

which will indirectly influence exchange ratesMany central banks including the RBI pursue a managed

float. One major problem with this policy is that it makes monetary policy less transparent since there are two goals: keeping low inflation and managing the exchange rate.

REAL EFFECTIVE EXCHANGE RATE (REER) The REER is a measure for whether a currency is

undervalued or overvalued. The RBI has used it as guide to exchange rate management.

Effective means that instead of looking at a single exchange rate, a composite is created of the exchange rates of various important trading partners

NEER or nominal effective exchange rate is a composite of different exchange rates of a country’s various trading partners.

Real means that the exchange rate is adjusted for inflation rates in both the home country and the trading partner. After adjusting the NEER for inflation you get the REER.

REER= NEER *(P(d)/P(f))Where P(d) is domestic price level and P(f) is foreign price

level

For example if India has a higher inflation rate than its trading partners but its NEER remains constant then its REER will rise.

RBI AND REER The RBI calculates a 36 country index

which covers around 75% of India’s trade. The base year is1993-94 and the index

uses three-year moving average trade statistics to assign weights to the different currencies.

There are two sets of weights: one based on trade and one based on exports.

In general the RBI has intervened in the market to keep the REER between 95 and 105.

NEER AND REER INDIA FROM 93-94

Source:RBI

IMPOSSIBLE TRINITY The following three are impossible to sustain

simultaneously: 1)A fixed exchange rate 2)Free capital flows3)Independent monetary policy This creates a dilemma for policymakers

since all these three are desirable for different reasons

Policymakers have to choose which of the two are most important for the economy in question

Either they give up completely on one of the three or they partially adjust between the three (relevant to India).

INDEPENDENT TRINITY

fixed exchange rate system

Floating rates

Closed Economy

IndependentMonetary policy

Managed currency

Free capital flows

WHY MANAGE EXCHANGE RATES?

Flexible exchange rates too volatile and prone to overshoot.

Rapidly rising exchange rates can damage export sector. No social safety net for unorganized export sector e.g. textiles.

Rapidly falling exchange rates can spark inflation and damage investor confidence.

WHY OPEN CAPITAL FLOWS?

Capital flows can increase aggregate investment and raise growth rates

FDI investment brings in new technology and raises technological progress and growth

Foreign investment can improve institutional quality of financial markets and increase liquidity.

WHY INDEPENDENT MONETARY POLICY? Monetary policy is the most effective tool for

short-run macroeconomic stabilization Execution lag is much lower than fiscal policy. Effective monetary policy helps keep inflation

low and improve investment climate as well as reduce volatility

Conclusion: All three variables are desirable to an extent. Solution try to find optimal combination of 3 variables.

HYPOTHETICAL EXAMPLE Think of the three legs of the impossible trinity and give them scores

of 1-10: Independent monetary policy: 10 being a fully autonomous

monetary policy Managed currency:10 being a fully fixed exchange rate Capital flows:10 being a fully open capital account. Then the impossible trinity says that a country can have at most a

total score of around 20. One way of achieving this is to give one of the three legs completely

and achieve close to full scores on the other two. Alternatively you can achieve a mix of the three: perhaps around 6

to 7 on each. Policymakers may change the mix according to conditions: e.g.

going from 7 to 6 on capital convertibility in order to move from 7 to 8 on managed currency. Restrictions on PN’s in 2007 may be viewed as an example of this.

IMPOSSIBLE TRINITY IN 2007

In 2007 the RBI seemed to hit the constraints of the impossible trinity

Huge FII inflows, rising rupee RBI intervention to prevent rupee from

appreciating Losing control over inflation because of

overheating economy and high commodity prices

FOREIGN INVESTMENT

1985-86

1986-87

1987-88

1988-89

1989-90

1990-91

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09 0.0

1.0

2.0

3.0

4.0

5.0

6.0

Foreign investment/GDP (%)

Data:RBI

MONETARY GROWTH

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

0.0

5.0

10.0

15.0

20.0

25.0

Monetary Growth % (M0 and M3)

Reserve Money

Broad Money(M3)

Data: RBI

RBI FOREX INTERVENTIONS

purchase,sale of USD by RBI

0

5000

10000

15000

20000

25000

JA

N 2

007

MA

R

MA

Y

JU

L

SE

P

NO

V

JA

N 2

008

MA

R

MA

Y

JU

L

SE

P

NO

V

JA

N 2

009

MA

R

MA

Y

purchase

sale

Data: RBI

INFLATION RISING AND FALLING

Apr-07

May Jun.Jul.

Aug.Se

p.Oct.

Nov.Dec.

Jan-08

Feb.

Mar. Apr.May Jun.

Jul.Aug.

Sep.

Oct.Nov.

Dec.

Jan-09

Feb.

Mar. Apr.May Jun.

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

WPI inflation rate %Source: RBISource: RBI

Data: RBI

IMPOSSIBLE TRINITY IN 2008

At the height of the crisis in late 2008 the RBI faced the impossible trinity in the opposite direction.

Huge capital outflows because of crisis led to downward pressure on the rupee

RBI intervened to prevent rupee depreciation Such intervention was contractionary in

nature which was inappropriate for domestic monetary policy

Once again trade-off between exchange rate management and domestic macroeconomic management

POSSIBLE SOLUTIONS

Sterilization: combine forex intervention with offsetting bond transaction.

Problem offsetting transaction may undercut initial intervention. In general sterilization often ineffective.

Issuing government bonds and interest payments impose significant fiscal cost

Another solution is capital controls: e.g. restrictions on participatory notes proposed in October 2007. However such proposals can be adhoc and increase market volatility

TOBIN TAX? Tobin Tax proposed by economist James

Tobin: a tax on short-term currency transactions in order to reduce exchange rate volatility

In the context of impossible trinity a similar tax would give the government a second tool to control capital inflows while still using monetary policy to focus on low inflation

E.g. Brazil recently imposed a 2% tax on portfolio inflows to restrain capital inflows and prevent appreciation of its currency.

Possible problems: Evasion, reduction of liquidity

However this may be the best of available options.

CONCLUSION

The impossible trinity is a fundamental constraint for monetary policy in an economy like India

Using monetary policy to manage exchange rates and inflation is ineffective

A second policy instrument is required to manage large capital flows.

A quantitative measure like a transactions tax which can be adjusted according to circumstances is perhaps the best solution