The Impossible Trinity and Central Banks

Monetary intervention by Central Banks to regulate currencies has suddenly become a hot topic of discussion. The financial turmoil in the global capital markets has increased the exchange rate volatility, forcing Central Banks to intervene actively to stabilize their currencies. Add to this, the threat of the sub-prime mortgage mess dragging the financial markets down and thereby affecting the real economy, has led to calls to adopt a cheap money policy. In this context, it is instructive to go back and look at the Mundell-Fleming model of the Impossible Trinity - capital mobility coupled with stable (fixed or an adjustable peg) exchange rates and interest rate autonomy. Mundell had claimed that no Central Bank can achieve all the three simultaneously. Under any macroeconomic circumstances, only two of these objectives could be simultaneously met.

At first glance the theorem appears simple enough to comprehend. In a system of free capital mobility and fixed exchange rates, unmindful of the domestic macroeconomic conditions, the Central Bank has to swim with the tide and raise or lower rates, so as to maintain the exchange rate. Prof Robert Mundell showed that in a system of floating exchange rates, fiscal policy becomes blunt and monetary policy assumes importance as a tool of macroeconomic management. Under such an arrangement, the Central Banks should have autonomy to regulate interest rates and ensure unrestricted capital mobility. In contrast, a fixed exchange rate regime renders the monetary policy ineffectual and the fiscal policy becomes the instrument of policy. Let me illustrate the context with three examples.

Imagine a scenario where there is turmoil in the global financial markets, generating exodus of capital and thereby volatility in the exchange rates. Assume that this coincides with a period of recession or weak growth in a country. Let us contextualize the aforementioned scenario for different countries with the three parameters in Mundell's theorem.

Imagine a country following free capital mobility and fixed exchange rates. With no restrictions on capital mobility, an exodus of investments, say from the capital markets, would impose strong downward pressures on the local currency. The Central Bank would have no option, but to raise interest rates, to prop up the depreciating currency, which would have serious consequences on economic growth. This eliminates the possibility of any autonomy in the monetary policy. This is no different from what happened in many Latin American countries in the eighties and nineties. This is also the model of the European Union, where countries have given up their individual currencies to usher in the ideal form of fixed exchange rates, by adopting a single currency.

Now imagine another country with capital mobility and interest rate autonomy. The recessionary economy, forces the Central Banks to adopt a more expansionary money supply regime. But the exchange rate volatility puts a downward pressure on the local currency. Since the Government has to prioritize on economic growth, there is no option but to keep rates low, which means abandoning any efforts at maintaining a fixed exchange rate. Most of the developed economies accept this trade-off and maintain floating exchange rates.

Finally, imagine another country committed to fixed exchange rates and interest rate autonomy. As in the previous case, the recessionary economy forces the Central Bank to adopt a more expansionary money supply regime. But the turmoil in the global financial markets generates a downward pressure on the currency. The Government is left with no choice but to clamp down on capital mobility, so as to maintain the fixed exchange rate. This was the world in the 1960s, when Governments pegged their currencies to the US Dollar and imposed stiff restrictions on the free movement of capital. The Chinese Government is a modern day example of this arrangement (though the yuan moves in a band).

The European Union's Exchange Rate Mechanism (ERM) was a classic example of Mundell's Impossible Trinity in action. The ERM Charter mandated the respective Central Banks intervene in the foreign exchange markets to maintain fixed and stable exchange rates. Given the differential domestic macroeconomic requirements of its members, the ERM was also committed to maintaining capital controls, so as to give members the requisite flexibility in pursuing their fiscal policy. Therefore, in keeping with Mundell's theorem, capital controls were imposed so as to have fixed exchange rates and autonomy in monetary policy. It was thought that this was a better trade-off in achieving the economic growth objectives of the ERM members. Any EU member which found its economic objectives demanded a different prescription would have to remain outside the ERM, and accordingly Britain pulled out of ERM to retain its floating exchange rate system.

What are the options available before the Reserve Bank of India (RBI) and what are the possible trade-offs? Obviously macroeconomic stability is a prime requisite for stable economic growth. This objective however demands that the RBI retains autonomy in monetary policy. Further, any fast growing developing economy, being vulnerable to inflationary pressures and other supply-side concerns, monetary policy becomes a critical tool for macroeconomic management. It is no different for India, and thus the importance of interest rate autonomy. Further, while the RBI has traditionally been committed to stable exchange rates, it has not gone overboard to have any rigid target for the rupee exchange rate.

Of the remaining two components of the Trinity, let us examine the consequences of adhering to each of them. If India were to maintain a fixed exchange rate, especially in a period of volatility in the financial markets, the RBI would need to constantly undertake open market operations. In order to contain an appreciating rupee, it would have to purchase large quantities of dollar, and re-invest the proceeds in low yielding securities like the US T Bonds. Further, in order to stem inflationary pressures, it would also have to sterilize the market off the excess rupee liquidity by issuing Government Bonds, for which it would have to pay interest. There is a double whammy of crowding out at work here - the cost of investing in low yielding dollar assets, and the outgo by way of interest payments. And even with all these, we are not sure of achieving our objectives. But tolerance for a more flexible, but stable exchange rate policy, gives the RBI enough room to manouvre without compromising on the other levers of macroeconomic management.

With full capital account convertibility, depending upon the domestic and global macroeconomic picture, there is the possibility of large capital inflows (if the rupee is stronger and rates high) or outflows (if the rupee is weaker and a large current account deficit). Large capital inflows will put upward pressure on the rupee, leading to its appreciation, while large outflows will result in downward pressure on the rupee, leading to its depreciation. The attendant macroeconomic consequences, would force the RBI's hands on interest rates, thereby reducing its freedom in using the monetary policy as an instrument of macroeconomic management.

Therefore, if we were to settle for stable exchange rates, then we would have more flexibility in the available options. Further, a commitment to a stable, but not fixed exchange rate, will ensure that the markets are not allowed to second guess RBI's functional autonomy. The RBI will have the freedom to ease capital controls at its pace, and still retain autonomy over monetary policy. On the balance, given the importance of an autonomous monetary policy and a relatively stable exchange rate, it may therefore be more appropriate to vote for capital controls. It was a policy of capital controls, stable but not fixed exchange rates, and interest rate autonomy that allowed India to weather the East Asian Crisis of late nineties.