Don’t seek to breach the ‘impossible trinity’

By R.M.B Senanayake

The new government has said last week that they will bring down the rates of interest. Is it prudent to do so? The previous government made the same mistake .They bought foreign exchange (dollars) paying for them with created rupees. They then expected to sterilize them by selling Treasury securities to the market for rupees. But there is a limit to sterilization and with continuous absorption of dollars from the foreign exchange market, sterilization broke down and excess liquidity in the money market emerged causing more downward pressure on the rupee. Then the Central Bank used strong arm tactics and deferred payment for spot transactions to the banks. But these could not be used continuously with any effectiveness. So from about August 2014 sterilization seems to have broken down. The foreigners understood the weakness of the rupee and began their outflow which continued even after the present government was elected in January 2015.

Lower interest rates to stimulate investment

Economic growth can be enhanced by investment in real capital, such as in more or better machinery which requires more capital in money terms as well. A low interest rate implies that firms can borrow more money to invest in their capital stock as they will pay less interest for it. Lowering the interest is therefore considered to encourage economic growth and is often used to alleviate low economic growth. But it is not an option when facing the ‘impossible trinity". In fact the versatile Reserve Bank of India Governor resisted such moves to reduce interest rates in India even recently. This is in the light of the need to pay attention to "impossible trinity" (also known as the trilemma). A "trilemma" is similar to a dilemma where the choice is one of two desirable objectives but in a trilemma it is two out of three objectives in international economics. This states that it is impossible to have all three of the following at the same time:

1 A stable foreign exchange rate

2 Free capital movement (absence of capital controls)

3 An independent monetary policy

According to the impossible trinity theory, a central bank can only pursue two of the above mentioned three policies simultaneously. To see why, consider this example:

* Assume that world interest rate is at 5%. If the home central bank tries to set domestic interest rate at a rate lower than 5%, for example at 2%, there will be undue depreciation pressure on the home currency, because investors would want to sell their low yielding domestic currency and buy higher yielding foreign currency (assuming there are no capital controls). If there are capital controls they can be undermined through deferring the repatriation of export proceeds etc. When the country’s central bank increases interest rates, people will want that currency to earn that higher interest rate which they will deposit in the banks or other financial institutions which pay the higher rate of interest.

* When the demand of the currency is high in foreign exchange markets, people will want that currency to be deposited in the banks to earn higher interest rates.

* If the central bank also wants to have free capital flows, the only way the central bank could prevent depreciation of the home currency is to sell its foreign currency reserves. Since foreign currency reserves of a central bank are limited but a support for the currency, once the reserves are depleted, the domestic currency will depreciate. (Our Central Bank provides such support quite often to maintain the exchange rate without allowing too much movement in it which is detrimental to trade. But there are limits to the exercise of such policy.

* Hence, all three of the policy objectives mentioned above cannot be pursued simultaneously. A central bank has to forgo one of the three objectives. Therefore a central bank has three policy combination options.

* a) A Stable Exchange Rate and Free Capital Flow

* b) An Independent Monetary Policy and Free Capital Flow

* c) a Stable Exchange Rate and Independent Monetary Policy

If free capital movements can take place then arbitrage of a currency will take place where capital will be moved from a place where interest is lower to a place where it is higher. This sort of currency movement will ensure that depreciation or appreciation of a country’s currency vis-à-vis another will be equal to the nominal interest rate differential between them. Suppose a country is growing and in order to grow further would need to increase its investments. So far, its savings have been enough but now it needs to attract foreign savings as well. As a result, the policymakers liberalize capital flows (inwards and outwards) in the country. Faced with this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both. Why?

The explanation is that in the absence of a risk premium, arbitrage of a currency will ensure that capital will move from the place with lower interest to a place where there is higher interest paid. Since under a peg, the exchange rate cannot change, (short of devaluation or abandonment of the peg altogether) this means that the two countries’ nominal interest rates have to be equalized.

This in turn implies that the pegging country has no ability to set its nominal interest rate independently, and hence no independent monetary policy for the other instrument of changes in the money supply also works on the interest rate. The only way then that the country could have both a fixed exchange rate and an independent monetary policy is: if it can prevent arbitrage in the foreign exchange rate market from taking place - institute capital controls on international transactions. But these rarely prove to be effective since exporters can defer bringing their export proceeds to the country.

Suppose a country is growing and in order to grow further would need to increase its investments. So far, its savings have been enough but now it needs foreign savings as well. As a result, the policymakers liberalize capital flows (inwards and outwards) in the country. Given this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both.

Now suppose, the country is Japan whose currency is the yen (this is just an example) and it has both objectives price and exchange rate stability. To achieve the former, it maintains fixed exchange rate and for the latter, it maintains an inflation target (implicit or explicit).

* As capital inflows are allowed, foreign investors take exposure in Japan and bring their dollars, convert it into yen and invest it.

* As a result of the above, the demand for domestic currency goes up. Ideally as demand goes up so should the price meaning exchange rate should appreciate (or go up from Rs 45 per dollar to say Rs. 40)

* But as the currency value is fixed, the central bank needs to maintain the level and instead gives the foreign borrower the desired yen and holds the dollars.

* Now, as the domestic supply of yen increases in the economy due to action above, so does inflation (too much money chasing too few goods). But inflation stability is also an objective of the central bank, the entire thing comes on its head with the central bank unable to manage the situation. Hence the impossibility of making all three objectives work together.

* BUT higher inflation can also be controlled by sterilizing the flows i.e. central banks issue govt. securities and suck the money supply. But that means more expenditure by the government and is not a long-term solution as governments are supposed to direct their expenditure towards enhancing capital base of the country and not for monetary and exchange rate stability.
- Island Sunday 20-09-2015