Mumbai: India’s central bank is managing the “impossible trinity” problem of balancing inflation, capital inflows and currency appreciation well, IDBI Capital Markets said in a research note released on Wednesday.
Economic theory says a country can only attain two of the three objectives of price stability, floating exchange rates and capital mobility. “Impossible trinity” refers to a situation in which it tries to achieve all three aims simultaneously.
Strong growth has raised inflationary pressures prompting the Reserve Bank of India (RBI) to raise interest rates which have attracted huge capital inflows. These flows has caused the rupee to rise sharply forcing the bank to raise reserve requirements.
“The RBI has been managing the trinity as well by adopting a managed floating exchange rate and with some restrictions on capital mobility,” Amol Agrawal, analyst at the Mumbai-based primary dealership, wrote in a note.
But it cannot be done forever as it interfered with natural market forces, he said.
At a policy review on October 30, the central bank raised banks’ reserve requirements by 50 basis points to 7.50% to drain excess cash from the banking system generated by its own intervention.
“If inflation rises in future, it would be testing times for RBI. To counter inflationary pressures, RBI might have to raise policy rates that might bring more capital inflows, further complicating the trinity,” the report said.