The Hindu Business Line : Full Convertibility: Mundell and impossible trinity

Critics claim that full convertibility or capital mobility and freely floating exchange rates are inimical to India's interests. They refer to Britain's crisis in 1992 and the Asia's in 1997 to buttress their criticism. But G. RAMACHANDRAN says that the critics are wrong on three counts, and calls on Nobel laureate Robert Mundell's theory to back his claim.

Nobel laureate Robert Mundell's contribution to international macroeconomics is extraordinary. The `impossible trinity' is among his best. It is axiomatic. Before we discuss its implications, it is necessary to state its three components. They are capital mobility, fixed exchange rates and interest rate autonomy. The three cannot coexist simultaneously. Any two, but not three .

The trinity was listed incorrectly as capital mobility, freely floating exchange rates and full interest rate autonomy (see Business Line, March 22). Freely floating exchange rates are the antithesis of fixed exchange rates. Capital mobility, freely floating exchange rates and full interest rate autonomy can coexist the way they do in Britain and the United States.

The incorrect listing is the result of an inappropriate use of the `find-replace' function in the word processor. It does not in any manner weaken the case for full convertibility and freely floating exchange rates. Why? After arguing for full interest rate autonomy, its compatibility with floating exchange rates was established. The door was then shut firmly on fixed exchange rates.

Critics at work

The announcement that the Indian rupee is moving towards full convertibility has attracted criticism. The critics have claimed that full convertibility or capital mobility and freely floating exchange rates are inimical to India's interests. The critics have referred to Britain's crisis in 1992 and the Asian crisis in 1997 to buttress their criticism. The critics are wrong on three counts. First, capital mobility and freely floating exchange rates are not joint policy issues. One can exist without the other. Second, the crisis in Britain erupted when policymakers understood the axiomatic inviolability of the impossible trinity. Third, the Asian crisis was craftily brewed by central banks that dodged the impossible trinity.

The Mundell framework

Prof Mundell's globally influential career began 50 years ago. He was awarded the Bank of Sweden Prize in Economic Sciences in memory of Alfred Nobel in 1999 for his holistic enquiry into monetary policy, fiscal policy and exchange rate systems.

Prof Mundell has shown that the effects of monetary and fiscal policy in an open economy depend on capital mobility. In particular, he has highlighted the importance of exchange rate systems. Under floating exchange rates, monetary policy is a powerful tool; fiscal policy is powerless. Under fixed exchange rates, fiscal policy is effective. Prof Mundell led the future of global monetary arrangements through numerous thought experiments. He analysed — in the 1960s — the impact of hypothetical floating exchange rates a decade before the death of fixed exchange rates. He examined the hypothetical effect of capital mobility on exchange rates even though it was restricted by exchange controls. He then showed that autonomous monetary policy in the hands of the central bank would be necessary to support floating exchange rates and unhindered capital mobility.

Wisdom after folly

Europe's exchange rate mechanism (ERM) was born after the death of the Bretton Woods System. It was aimed at fixed exchange rates and stable exchange rates. It required bilateral interventions by central banks. It also required controls on capital mobility to allow member-nations to have different inflation rates aimed at generating employment and economic growth. That is, in order to have fixed exchange rates and autonomous money supply, they controlled capital mobility. No member violated the impossible trinity.

The German unification in 1989 was the first big shock. The second big shock was the single market. The single market required capital mobility and free movement of capital. With fixed exchange rates and no control on capital, member-nations had to implicitly give up their autonomy over monetary policy.

Since Germany was the biggest economy, they aligned themselves to the policies of Germany's Bundesbank. But the reunification called for a very tight monetary policy in Germany and, therefore, in other member-nations. Britain needed something loose and different. The rest is history.

Britain walked out of the ERM because it knew that the impossible trinity could not be violated. Britain regained interest rate autonomy, retained capital mobility and regained floating exchange rates. This explains why Britain is a non-euro country.

Crafty dodgers

The impossible trinity does not apply to pegged exchange rates. Why? Pegged rates are not fixed exchange rates; they are not floating rates either.

Hence, many Asian economies saw pegged rates as the perfect tool to fool the impossible trinity. They could have capital mobility, control over exchange rates, and control monetary policy and interest rates. With autonomous monetary policy, the exchange rate is on autopilot. With fixed exchange rates, the monetary policy is on autopilot. With pegged rates, nothing is on autopilot. This is heady stuff.

By appearing to wield control over both exchange rates and interest rates, Asia's central banks seduced as well as calmed investors.

But they did not disclose that fatal conflicts between monetary policy and exchange rate policy could occur. Monetary base under pegged rates includes the domestic and the foreign components. Therefore, balance of payments crises could occur. This is exactly what happened in 1997.

Asian economies that had a prolonged maintenance of pegged exchange rates could not use their monetary tools in a steady and gradual manner to cool off their overheating economies. They pretended that interest rates would be kept low. Thereby they pretended that their currencies would not be weakened or devalued. The pretensions peeled off. Interest rates went up. Currency values came down. They had to. But many in India incorrectly think high interest rates work towards making the rupee strong.

No tension, no pretension

Unlike Britain under the ERM until 1992, India does not have to shake off any rigid compulsions in tense circumstances.

In a managed float economy, the rupee floats somewhat. The Reserve Bank of India (RBI) has considerable expertise in working with the impact of interest rates and inflation on the value of the rupee.

Unlike some of the Asian economies, India practises no pretensions. The rupee is not pegged.

Moreover, the RBI has useful experience in using the tools of monetary policy. India's progression to full convertibility and floating exchange rates will be smooth.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)