The Impossible Trinity

Group 9 Arnab Kumar Saha Arvind Topno Chandan Kumar Krit Narayan Yadav Rupa Murudkar Dibyalaxmi Devi

PGP/16/073 PGP/16/074 PGP/16/079 PGP/16/087 PGP/16/092 PGP/16/111

Agenda
Trinity : Introduction
Extreme examples : USA, China & Hong kong Emerging economies crisis : East Asia crisis(97-98) Foreign Reserve Accumulation

Indias Trinity
Conclusion: Indian Perspective

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

1) free capital flows

2) a fixed exchange rate

3) independent monetary authority

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)

1) U.S. allows free flow of capital & maintains monetary authority but does not have a fixed exchange rate 2) Hong Kong has a fixed exchange rate & allows free flow of capital but does not have independent monetary authority 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 approach Dirty float OR Capital controls

Trilemma in Major Economies

Country USA, AUSTRALIA, NEW ZEALAND, CANADA, INDIA Free Capital Flows
YES Independent Monetary Policy YES Fixed Exchange Rate NO

CHINA & N KOREA NO

HONG KONG & ARGENTINA
YES

YES
NO

YES
YES

Chinese Currency Controversy

Fixed 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 dont reflect any kind of spectacular misbehavior on the part of the United States. All that were seeing is the classic set of tradeoffs that any currency regime faces and its not the business of the Fed to save other countries from the necessity of making choices.

Hong Kong & the trinity dilemma

Suggestion from the Asian Crisis
To withstand interest rate pain from speculative attack on their currencies sufficient large reserves healthy nancial 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 Exchange RateRegime Regime in Select Countries (as of 31 July , 2006) No. Of countries
Fixed Exchange Rate Other conventional fixed peg arrangements Pegged exchange rate within horizontal bands Crawling pegs Currency board arrangements Floating exchange rate Independent floating India Managed floating Exchange arrangements with no separate legal tender(Euro) 70 52 6 5 7 76 25 51 41

Source : IMF

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 accumulation

responsible 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 countrys 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
Emerging Asia China Hong Kong India Indonesia Korea Malaysia Philippines Singapore 13.1 14.7 51.9 5.9 6.7 3.7 18.7 8.4 74.7

2007
37.5 45 68.3 21.3 12.5 27.5 56.3 17.6 102.4 32.8

Thailand 17 Source:Herve Hannoun(2007),BIS

Capital inflow and sterilization

Capital inflow Currency appreciation

Central Bank

Exchange of dollar with rupee

Rupee in market inflation

Central Bank

Sterilization issue of bonds

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 Indias 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 +

Phase I 1996-97 to 2000-01 Mon Indep (MI) 0.4335

Q1 Q2

Phase II Q3 2000-01 to Q4 2004-05 -0.0752

Phase III Q1 2005-06 to Q2 2009-10 0.2245

Exchange Rate Stab (ES) Capital Account Openness (KO) Total

1.2978

1.6548

1.2611

0.2081

0.4105

0.4598

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

 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 : Reserves cost and sterilization

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
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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 777801, September 2009 http://mostlyeconomics.wordpress.com/2010/12/22/how-has-india-managed-the-impossibletrinity-over-the-years/ Indias 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