De-jargoned: Impossible trinity

The steps Reserve Bank of India (RBI) took in July to curtail liquidity in order to curb speculation in the currency market has resulted in tightening of yields in the debt market. As a result, some banks have also raised deposit rates for various maturity periods. Thus, RBI’s measures to defend the currency have resulted in a reversal of the direction of interest rates in the economy. In fact, RBI governor D. Subbarao, in his statement on the review of the monetary policy on 30 July, noted that India is currently caught in a classic “impossible trinity”. Put differently, in order to protect the rupee, RBI has lost some independence in how it makes the monetary policy.

What is impossible trinity?

Impossible trinity or trilemma in monetary policy means that a country cannot have a fixed exchange rate, free movement of capital and an independent monetary policy at the same time.

As it happened in India, after lowering interest rates over the last one year, RBI went ahead to protect the rupee by sucking liquidity out of the system, which has resulted in higher cost of money and higher interest rates. From a pure monetary policy standpoint, RBI had no intention of raising interest rates. In fact there was a case to cut policy rates to support growth, but while targeting currency it lost a bit of control on the monetary policy,which resulted in higher interest rates.

Let’s understand this theoretically. Suppose, a country that has a fixed exchange rate raises interest rates to curb in inflation. Higher interest rates will attract foreign capital. Since the country has a fixed exchange rate, the central bank will have to buy foreign exchange to maintain the peg which will lead to injection of domestic currency in the market. The rise in availability of money in the market will bring down its cost (read interest rate) and defeat the central bank’s idea of curbing inflation by raising interest rates. This is why a lot of countries also have capital control in place which allows them to maintain stable currency and have more authority on the monetary policy.

Although the rupee is not pegged to any currency, India does not allow free movement on the capital account. Capital control in developing countries is put in place to preserve financial stability as large inflow and outflows in relatively smaller markets can lead to financial instability. The RBI is not defending the rupee by selling foreign currency in the market, but if it did, the impact on interest rate would have been the same. Selling foreign exchange would reduced the supply of rupee in the market which would have resulted in higher rates.