Impossible trinity’s love affair with RBI…

RBI’s Q1 2013-14 monetary policy was pretty much on expected lines. The rates were kept unchanged and there was hardly any surprise. Much of the policy decisions were taken earlier. Only change was RBI lowering its GDP growth projection from 5.7% to 5.5%.

However, the forward guidance was really interesting:

The monetary policy stance over the last two years has predominantly been shaped by the growth-inflation dynamic even as external sector concerns have had a growing influence on policy calibration over the last one year. The current situation – moderating wholesale price inflation, prospects of softening of food inflation consequent on a robust monsoon and decelerating growth – would have provided a reasonable case for continuing on the easing stance.

However, India is currently caught in a classic ‘impossible trinity’ trilemma whereby we are having to forfeit some monetary policy discretion to address external sector concerns. The recent liquidity tightening measures by the Reserve Bank are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on inflation. 

It should be emphasised that the time available now should be used with alacrity to institute structural measures to bring the CAD down to sustainable levels. The Reserve Bank stands ready to use all available instruments and measures at its command to respond proactively and swiftly to any adverse development.

RBI is fed up of telling the govt to take measures.  First it was to help control inflation (food). then to support growth and now CAD. That is the volume of mess which has been created in the economy.

Anyways, focusing on impossible trinity. It is interesting to note how this trinity thing keeps coming back to haunt India. I was transported back to time. The context is completely different now.

In 2007, very early into my research days I wrote these two pieces on Impossible trinity —

(It is always funny to read your earlier pieces of research. There is so much to re-write. Moreover this crisis has led to sea changes in the way one thought of macro). Capital controls are being prescribed by

During those days, rupee was appreciating (yeah those were the days), capital flows were flowing like the Ganges and inflation started to heat up. So, the issue was if RBI raised the policy rate to manage inflation, it led to higher capital inflows as both growth and interest rate differential were in India’s favor. This further put pressure on the exchange rate and was said to be impacting exports. RBI was trying to manage the trinity by buying forex from markets (which led to surge in reserves) and then sterilizing those flows. Moreover, under Dr Reddy RBI was always skeptical to capital inflows. So the flows could have been higher if FinMin could have its way. PC was the FM then and one does not see any change in the strategy. So in a way, RBI was more comfortable giving up the capital flow pillar of the trinity and using sterilization to absorb excess liquidity.

Coming to 2013, it has all turned around. Strategy has changed from inflation management to exchange rate management.

  • RBI is more comfortable giving up Moneary policy independence!  RBI is lucky as WPI has eased and it focuses on WPI as well. CPI conveys a different trajectory altogether. RBI could easily change the target from WPI to CPI and raise Repo rates. This takes care of all the random measures it has been forced into taking..This would have preserved monetary independence and helped target exchange rates as well.
  • Rupee depreciation has captured the attention just like appreciation did in 2007. So, it has an exchange rate target now somewhere around Rs 60/USD, Though Rupee has crossed Rs 60.80 levels today and will be interesting to see what RBI choses to do..
  • Capital flows continue to be encouraged to finance the CAD. CAD was not an issue in 2007..Unlike previous regime, here no one has a choice. More and more capital flows are needed.

Overall, Rupee movement was a contentious issue in 2007 as it is today. RBI managed the trinity differently as there were choices then. Now it also has a 4th problem of stagnating growth as well. So, if the higher short term rates persist then we could see credit rates going up, leading to further problems for growth rates.

Guv Subbarao in a recent speech said:

Impossible Trinity

18. The best way to understand the challenge of monetary policy formulation in a globalizing world is through the ‘impossible trinity’ trilemma. This trilemma asserts that a country cannot simultaneously maintain all three policy goals of free capital flows, a fixed exchange rate and an independent monetary policy.

19. Given the ‘impossible trinity’ trilemma, countries have made different choices. The most common choice, typical across advanced economies, is to give up on a fixed exchange rate so as to run an open economy with an independent monetary policy. On the other hand, economies that adopt a hard peg give up on the independence of monetary policy. Examples include the currency boards set up by Hong Kong and, for a time, Argentina.

20. In contrast to advanced economies which opt for corner solutions, emerging economies here typically opted for middle solutions, giving up on some flexibility on each of the variables to maximize overall macroeconomic advantage.

India’s Approach to the Impossible Trinity

21. In India too, we have opted for a middle solution on the ‘impossible trinity’ whose contours are the following: (i) We let our exchange rate be largely market determined, but intervene in the market to smooth excess volatility and/or to prevent disruptions to macroeconomic stability; (ii) Our capital account is only partly open; while foreigners enjoy mostly unfettered access to our equity markets, access to debt markets is restricted; there are limits to the quantum of funds resident corporates and individuals can take out for investment abroad, but the limits are quite liberal; and (iii) Because of the liberalization on the exchange rate and capital account fronts, some monetary policy independence is forefeited. What the middle solution also implies is that we have to guard on all the three fronts with the relative emphasis across the three pillars shifting according to our macroeconomic situation.

It will be interesting to read research on which choice works better — giving up mon independence or targeting exchange rates?  Another question is why should capital flows be considered holy? Most policymakers avoid restricting flows on capital. So is it a trinity in that case? When can countries use capital controls? Isn’t the choice usually between exchange rates and price stability. In that case shouldn’t it be a dilemma? There are more qs than answers (as is the case in most things economics).

Meanwhile, Impossible trinity keeps coming back to hit India (and other Asian economies) and resumes its love affair with RBI. IT is an affair which central banks want to avoid but cannot help avoid.   And like all such love stories, the situation keeps changing making it both interesting and nervy for the audience..


2 Responses to “Impossible trinity’s love affair with RBI…”

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    Impossible trinity’s love affair with RBI… | Mostly Economics

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