Opinion | India’s impossible trinity problem
An open capital account with a floating exchange rate will always lead to periods of appreciation or depreciation
The Indian rupee has been trading at historically low levels. Comparisons have been made between now and the external sector situation India found itself in 2013. The comparisons begin with the depreciation in the rupee, foreign investment outflows and a widening current account deficit (CAD).
However, India’s macroeconomic fundamentals are far stronger now than they were in 2013. The current government is committed to fiscal consolidation and inflation is well below the double-digit levels witnessed in 2013. Similarly, foreign exchange reserves have risen substantially. India’s exchange reserves now cover approximately 10 months of imports, compared to 6.5 months of imports in June 2013. It should also be pointed out that foreign investment inflows, particularly portfolio inflows, have also turned positive since July this year. While the gains are somewhat modest, the pace of inflows seems to have accelerated between July and August of this year.
Despite key differences, there is one similarity between the 2013 episode of currency depreciation and now. The depreciation episodes of 2013 and 2018 are symptomatic of the impossible trinity, a concept in international economics. Simply put, it states that a country cannot have a fixed exchange rate, an independent monetary policy and free capital flows at the same time.
An independent monetary policy in this context means independence from external factors. The trilemma implies that an open economy can only achieve two of these objectives at the expense of the third.
Countries across the world have chosen different combinations in this trinity. The US, for example, has an independent monetary policy and no capital controls, resulting in a flexible exchange rate. On the other hand, countries in the EU have given up monetary policy independence for a stable exchange rate and financial integration.
Previous examples of the impossible trinity in action include George Soros breaking the Bank of England in September 1992, a day still known as “Black Wednesday”. Mexico had to abandon its peg to the dollar after depleting its forex reserves to preserve the value of the currency. During the Asian financial crisis of 1997-98, Thailand, too, ran down its reserves before abandoning the dollar peg. China in 2015 bowed to this impossible trinity as well when it devalued the renminbi. Therefore, countries across the world have faced, and bowed, to this impossible trinity.
So, what did India do in August 2013? The Reserve Bank of India (RBI) imposed partial capital controls to stem the depreciation of the rupee. Direct investments by Indian companies abroad were curtailed, remittances limits for Indians sending money abroad were reduced and a scheme to encourage foreign currency non-resident (FCNR) deposits was introduced. As the rupee stabilized, these measures were gradually removed. Therefore, opting for a stable exchange rate, partial controls were enacted.
Now in the pressure of foreign portfolio investment outflows this fiscal, India faces a similar trilemma. Should the currency be allowed to depreciate further? If not, the RBI must either impose capital controls or increase interest rates to raise the value of the rupee (losing monetary policy independence).
However, having just raised rates in its last policy review, it is quite unlikely that the RBI will raise rates in reaction to a depreciating rupee. However, a depreciated rupee does have its benefits—primarily through making our exports cheaper. On the other hand, a depreciated rupee will affect the price of our imported products.
Factors affecting foreign currency inflows can be decomposed into “push” or “pull” factors. As the name suggests, pull factors are country-specific factors, such as economic growth, interest rates and fiscal stability that attract or “pull” foreign investment. Push factors, on the other hand, describe situations where low interest rates in advanced markets “push” capital into emerging markets. Therefore, emerging markets must deal with both volatile inflows and outflows in domestic markets. As D. Subbarao, former governor of the RBI said: “The challenge for EMEs (emerging market economies) is to learn to maximize the benefits and minimize the costs of globalization. In particular, EME central banks have to learn to factor in global spillovers into their domestic policies”.
An open capital account with a floating exchange rate will always lead to periods of appreciation or depreciation. With India running a CAD, foreign inflows are necessary to finance this deficit. If portfolio flows turn negative, other sources of funds are needed to fund the CAD. Software exports and remittances have been strong sources of fund inflows for India historically. However, it has been pointed out that both software exports and remittances have been falling as a share of gross domestic product (GDP). On the other hand, in absolute terms, net software exports and remittances have returned to the levels seen in 2015. India, like other countries, cannot escape the impossible trinity.
Market forces should be allowed to determine the nominal exchange rate, but the RBI must monitor the volatility and intervene when necessary.
Ranveer Nagaich is a young professional at NITI Aayog. These are his personal views.
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