A dilemma is apparently not complex enough for economists, who are more worried about what they call the trilemma, also described by the profession, in rather ecclesiastical terms, as The Impossible Trinity. The trilemma is a central hypothesis in international finance. It says a country may simultaneously choose any two, but not all, of the following three goals: monetary independence, exchange rate stability and financial integration. Monetary independence here is the result of relatively closed financial markets and implies independence from world financial conditions. China, for example, has a very high level of monetary independence. Aizenman, Chinn and Ito’s paper looks at how Asian economies have chosen policy objectives within the trilemma and how their choices have affected inflation and volatility in output.
Why Asian economies? The authors point to Asia’s V-shaped recovery from the crisis and say that if it is sustained, it will mean two things. One, it will be evidence of a decoupling from the Western economies, particularly because this time, unlike after the Asian crisis, they didn’t have the benefit of the US demand to pull them through. Secondly, it suggests that the Asian economies are better open to cope with crises in a globalized environment. The paper examines the policies adopted by the Asian economies that have helped them reduce output volatility.
Which policies of the trilemma did Asia use? That is the question the paper tries to find answers to. The researchers say different combinations of policies in the trilemma have different repercussions. For example, they say higher levels of monetary independence are associated with lower output volatility. And while economies that focus on exchange rate stability have higher output volatility, that volatility can be mitigated by holding high forex reserves—higher than a threshold level of 20% of the gross domestic product. The study finds that “economies with greater monetary independence tend to experience higher inflation while economies with higher exchange rate stability tend to experience lower inflation. Furthermore, financial openness is associated with lower inflation.” But they also find that economies that have high forex reserves and focus on exchange rate stability may experience higher inflation. That’s a problem central banks in India and China have faced, as their attempts to bolster their currencies leads to their buying dollars and releasing the local currency into the market, which adds to money supply and pushes up inflation unless mopped up by the central bank through what they call sterilization. The authors say there are limits to this sterilization.
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The study says that greater monetary independence also reduces the volatility of investment. And while aiming for exchange rate stability may make investment more volatile, that volatility could be reduced by holding higher forex reserves. Also, financial openness does not play a role in either investment volatility or the real exchange rate.
So which of these policy combinations have Asian economies opted for? The key finding seems to be that as long as countries hold high levels of forex reserves, they can pursue a stable exchange rate and thus reduce volatility in investment. The authors say that “Overall, we find that Asian economies, especially the emerging market economies, are equipped with macroeconomic policy configurations that dampen the volatility of the real exchange rate. These economies’ sizeable amount of IR (international reserves) holding appears to enhance the stabilizing effect of the trilemma policy choices while allowing them to achieve middle-ground policy arrangements. This finding provides a motivation for the recent phenomenal build-up of international reserve holdings in the region.”