The Hindu Business Line : The fundamental dilemma

As the impossible trinity implies, given adequate capital controls, an independent monetary policy can be combined with a fixed exchange rate, but only for the short term, says VIVEK MOORTHY.

His most original contribution, in my opinion, was his emphasis on the conflict between stability of prices and stability of exchange.

Milton Friedman, “A Monetarist Reflects”, the Keynes Centenary, London Economist, June 1983.

Right now, rupee policy is stumbling along precariously. Capital account liberalisation since the mid-1990s brought a lot of funds into India and helped finance many new, dynamic firms. But, for the last few years, the enormous magnitude of these inflows has been posing an economic hazard. The gains from lower interest costs, greater availability of credit and more financing for the equity market are increasingly being more than offset by a rising rupee.

The rupee surged in March this year, when the RBI stopped intervening to support the dollar. Had the RBI not continued to intervene since then, the rupee is likely to have risen a lot more, wiping out textile exporters and other industries.

A vigorous, though far from rigorous, debate is raging about what to do. The Finance Ministry, after strenuously courting more capital inflows, is now providing sops to exporters to offset the higher rupee, which has risen due to these inflows. A good description of current export policy is that two hands are pulling in opposite directions.

The current problems stem from a failure of policy. Capital inflows have been greatly liberalised without understanding or thinking through the implications of the impossible trinity (see Diagram).

Impossible Trinity

The impossible trinity implies that under a fixed exchange rate and full convertibility, any slight difference of interest rates will lead to an endless one-way flow of deposits that will destabilise the economy.

This means that under full convertibility, a country must keep its interest rates the same as the foreign rates. With partial controls, a country can juggle some degree of monetary autonomy with some fixity in the exchange rate — as India has managed to do, until recently. A.V. Rajwade and Surjit Bhalla were two members of the Capital Account Convertibility Committees in 2000 and 2006, who dissented to forcefully recommend more inflows. They are now repeatedly stressing that sterilisation of inflows will suffice to keep the rupee weak and exports up. One should not complain about high blood sugar after gorging on cake, and then assert that a few pills will restore the patient to health! But this is precisely what these experts are doing.

In response to their suggestion for more sterilisation, I have argued that “taxes on the banking system and financial repression cannot be a substitute for controls on inflows as if the goal is to maintain an exchange rate peg. Those advocating such policies are overloooking one fundamental fact: India’s underlying inflation rate is about two to three percentage points higher than China’s. Hence India’s interest rates need to be, and are, that much higher.

“Without stringent controls on inflows, under a fixed exchange rate, the flood of external borrowing will swamp the economy. It is ironic that just as China has moved to a more flexible exchange rate since 2005, economists in India might be thinking of emulating its policies. Decisions to withdraw from bank deposits to invest in China’s frenzied stock market have been partly triggered by deposit rates that are too low (Far Eastern Economic Review, June 2007).”

The choices

Given the primacy of autonomous monetary policy, the choice seems to be between (a) full convertibility and a fully flexible exchange rate, with covered interest arbitrage linking domestic and foreign interest rates via the forward-spot exchange rate discount and full hedging option, or (b) more capital controls (assuming these are feasible after so much liberalisation), with some degree of exchange-rate pegging.

The August tightening of External Commercial Borrowing norms, reversing the earlier laxity, was a welcome move. It provided the RBI some respite from having to push the call money rate down, to zero at times to curb the rupee’s rise. Such fire-fighting controls do help and provide some time to carefully consider basic options. Nevertheless, it is necessary to scrutinise the impossible trinity from basic first principles, to arrive at desirable and feasible policies that can be sustained over the long run.

As the impossible trinity implies, provided there are adequate capital controls, an independent monetary policy can be combined with a fixed exchange rate — one can avoid choosing between them. But, even with capital controls, monetary autonomy and a fixed exchange rate can be combined only in the short run. In the long run, an economy tends toward relative purchasing power parity, which is a theoretical arbitrage condition. Hence, a country has to choose between a fixed nominal exchange rate and letting the domestic price level (inflation rate, in practice) adjust to it. Or, it can choose the domestic price level (i.e. its own inflation rate) and let the exchange rate adjust to it.

Capital controls

The irrelevance of capital controls for this long-run choice is a fundamental and yet often neglected point. To comprehend the process by which this happens requires elaboration. Suppose a country has strict capital controls, and the private capital account is zero. Then, with a fixed exchange rate, if it has a current-account surplus, this gets fully absorbed into reserves via central bank purchases, with domestic money supply (and credit) correspondingly going up.

Since there is no deposit arbitrage, the domestic interest rate can be kept different from the foreign interest rate.

But the central bank loses monetary control, since money supply will rise and the domestic interest rate will have to fall due to the current account surplus. As the current account surpluses mount, the economy overheats and pushes up inflation.

If the exchange rate is not re-valued to bring the current account back into equilibrium, then the extra demand stimulus via forex purchases, in turn, sets in corrective forces — imports rise and/or exports fall due to higher inflation, bringing the current account back to zero and the economy to equilibrium. At that point, the external sector does not influence money supply.

The price level (or inflation rate) has adjusted to the exchange rate. Hence, even with capital controls, a country has to face the fundamental dilemma between choosing an exchange rate or monetary autonomy and thus choosing its inflation rate. As Keynes put it, “we cannot keep both our price level and our exchanges stable… And we are compelled to choose.” (A Tract on Monetary Reform, 1923)

China’s predicament

The situation described above is not just an antiquated academic discussion. It corresponds to China’s current predicament. Although the capital account has been liberalised of late, it is still fairly controlled.

The recurring huge current account surpluses were causing money and credit to expand too rapidly, despite massive sterilisation. This has forced the policy-makers to switch gears and adopt a flexible rate since 2005 with many small revaluations — a cumulative 9.3 per cent rise since June 2005.

Unlike the yuan, the pressure for a rupee rise can be eased in the foreseeable future, without giving up monetary autonomy by capital controls since, unlike China, we have a current account deficit. However, in general we cannot avoid making the underlying fundamental choice — either the exchange rate or the price level (inflation rate) has to be the final goal of monetary policy.

(The author, a Professor at IIM Bangalore, can be contacted at vivekmoorthy@iimb.ernet.in)