Sunday, January 31, 2010

Managing the Impossible Trinity

I had blogged earlier about the challenges faced in managing the impossible trinity - the impossibility of simultaneously having capital mobility coupled with stable (fixed or an adjustable peg) exchange rates and interest rate autonomy.

The increasingly inter-twined nature of the financial markets and the economy and the rapid global financial market integration over the past two decades poses formidable challenges to Central Banks in managing their monetary policies and the external sector. This challenge is amplified in case of emerging economies where Central Banks do not enjoy the same level of credibility among market participants and the transmission channels for various monetary policy signals remain heavily clogged.

Unlike Central Banks in many developed economies which have, atleast till recently, been more or less focussed on managing price stability and controlling inflation, Central Banks in emerging economies shoulder the additional responsibility of promoting economic growth. But these two objectives occasionally appear to conflict, especially when inflation rears its head as the economy shows signs of overheating, forcing the central bank to step in to tighten policy rates and cool the economy. This often goes against the wishes of their political masters.

The trend of massive foreign capital inflows, with the attendant risk of sudden capital flight, is another risk that has to be carefully managed by these Central Banks. Rapid surges in capital inflows, most often the result of global economic momentum shifts, unsettles the real exchange rate and also the current account balances. On the one hand these capital inflows boost the local equity market, brings in Foreign Direct Investments (FDI) and external commercial capital for businesses, while on the other hand they have the effect of boosting the local currency against the dollar.

The RBI's challenge is to maintain the "Goldilocks" economy, "neither too hot nor too cold", using all the instruments at its disposal. It has to manage high economic growth rates and foreign capital inflows, while containing both inflationary and currency appreciation pressures, and all this with a "light-touch" approach on monetary policy. In India, the RBI is not only the custodian of the monetary policy but also supervises banks and other finciancial institutions and is the primary regulator of the financial markets.

Since the turn of the decade, the Indian economy has been growing at a very rapid pace and attracting foreign capital in large amounts. Though inflation has been kept under control, inflationary pressures remain very real and rears its head recurrently, forcing Central Banks to aggressively intervene. The same problem is confronted when rupee appreaciates with respect to dollar, forcing pressure from exporters to indulge in open market operations to manipulate the currency markets.

As Rakesh Mohan and Muneesh Kapur point out in a working paper, managing the impossible trinity is a delicate balancing act, which requires a careful and calibrated deployment of the full spectrum of policy options, depending on the specific and varying conditions in the real economy and the financial markets. There are no readily available policy prescriptions that can be taken off the shelf and applied to optimally manage both the monetary policy and the exchange rates, even while keeping inflation under control, growth robust and capital inflows welcome.

The RBI has used multiple instruments and a menu of options to manage the external sector and the monetary policy - active management of the capital account, especially debt flows; within debt flows, tighter prudential restrictions on access of financial intermediaries to external borrowings vis-a-vis nonfinancial corporate entities; flexibility in exchange rate movements but with capacity to intervene in times of excessive volatility along with appropriate sterilisation of interventions; associated building up of adequate reserves; continuous development of financial markets in terms of participants and instruments; strengthening of the financial sector through prudential regulation while also enhancing competition; pre-emptive tightening of prudential norms in case of sectors witnessing very high credit growth; and refinements in the institutional framework for monetary policy.

In this context, the authors also favor a carefully sequenced movement (which is also dependent on the developments in both the real economy and financial markets) towards capital account convertibility and controls on debt flows - both private and inflows into risk-free sovereign debt instruments to take advantage of interest differentials (carry trade). They write,

"Capital controls have to be a part of an overall package comprising exchange rate flexibility, the maintenance of adequate reserves, sterilisation and development of the financial sector... During periods of heavy inflows, liquidity is absorbed through increases in the cash reserve ratio and issuances under the market stabilisation scheme. During periods of reversal, liquidity is injected through cuts in cash reserve ratio and unwinding of the market stabilisation scheme. Overall, rather than relying on a single instrument, many instruments have been used in coordination."

Their summary is very appropriate,

"As a result of this approach, growth in monetary and credit aggregates could be contained consistent with the real economy undergoing growth, structural transformation and financial deepening. Inflation was contained even as growth accelerated. Overall, financial stability was maintained even as the global economic environment was characterised by a series of financial crises. The impossible trinity was managed by preferring middle solutions of open but managed capital account and flexible exchange rate but with management of volatility. Rather than relying on a single instrument, many instruments have been used in coordination. This was enabled by the fact that both monetary policy and regulation of banks and other financial institutions and key financial markets are under the jurisdiction of the Reserve Bank, which permitted smooth use of various policy instruments.

Key lessons from the Indian experience are that monetary policy needs to move away from narrow price stability/inflation targeting objective. Central banks need to be concerned not only with monetary policy but also with development and regulation of banks and key financial markets – money, credit, bond and currency markets. Given the volatility and the need to ensure broader stability of the financial system, central banks need multiple instruments. Capital account management has to be countercyclical, just as is the case monetary and fiscal policies. Judgements in capital account management are no more complex than those made in monetary management."

Update 1 (11/7/2010)

Greg Mankiw explains the three different ways in which China, US, and Europe manage the impossible trinity. The first restricts capital inflows, the second permits exchange rate volatility, and the third has given up monetary policy autonomy.

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