Slate. All you wanted to know about: The impossible trinity

It is no secret that the Reserve Bank of India has a difficult job in framing a monetary policy that manages growth while keeping inflation in check. Besides these two obvious factors, the central bank also has to keep another factor in mind — currency movement. The direction of the interest rates tends to affect the foreign fund flows in and out of the country and this in turn has a direct impact on rupee movement.

That brings us to the famous trilemma that most central banks face — the impossible trinity.

Imagine a naughty threesome of small children who are so quick and agile that it is possible to keep only two under control at one time. The third will inevitable escape and wreak havoc.

Economists have proved with the help of studies of past data and experiences in various countries that a) a stable exchange rate b) free capital movement and c) an independent monetary policy are the mischievous trio of international economics.

Central banks can hope to achieve only two of these objectives at any point in time. Trying to have all three at the same time invariably results in dire consequences.

This is not just another theory that has to be relegated to text books. It affects the policies of countries and central banks across the globe. China for instance is currently up against the classic trilemma involving the impossible trio.

The country wants to keep the Yuan stable because it aspires to make it an international reserve currency akin to the US dollar. So the currency is allowed to fluctuate only 2 per cent on either side of a peg determined by the Chinese central bank. China is also trying to accelerate the move towards making the Yuan freely convertible as that is one of the pre-requisites for an international currency.

But as we all know the Chinese economy is in need of a stimulus. If the Chinese central bank attempts to cut rates or injects liquidity, the currency will depreciate. Attempting to sustain the current rate of exchange will lead to depletion of forex reserves.

This is impeding China from following the independent monetary policy needed to kick-start growth.

You need to understand this concept as it affects the rupee movement. India has so far not attempted to manage all three factors. The country currently follows an independent monetary policy but it follows a mid-path in controlling the other two.

The currency is partly managed and certain capital flows are freely allowed while others are restricted. This has worked alright until now.

Even if the RBI cuts its policy rates to suit domestic needs, the outflow of funds is limited due to the restraints on capital flows. The currency is also not that greatly affected.

But the RBI has made it clear that it would like to move towards full convertibility over the long-term. If that happens, RBI may not be able to maintain a right rein on interest rates.

An independent monetary policy will be difficult given that rupee is nowhere close to becoming a reserve currency like the dollar.

This is one concept that is impossible to ignore, especially if you are a keen follower of macros.

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