Opinion
Rupee lesson: The impossible trinity is getting the better of us
Summary
- This week served us a sharp reminder: only when Indian markets mature enough to grant us the luxury of full capital account convertibility and a freely floating rupee will we truly gain monetary policy independence.
In Oscar Wilde’s The Importance of Being Earnest, Miss Prism tells her student, Cecily, “You will read your Political Economy in my absence. The chapter on the fall of the Rupee, you may omit. It is somewhat too sensational." This week, serious students of the dismal science, as Economics is known at times, did not have that choice.
Rather, a ‘sensational’ fall of the rupee gave them a rare opportunity to see how an otherwise abstruse economic theory, the ‘Impossible Trinity,’ plays out in real life. It was a classic case of learning the hard way. But first, what does this theory say? According to it, an economy—or a central bank, to be specific—cannot pursue an independent monetary policy, maintain a fixed exchange rate and have free flows of capital at the same time. It must sacrifice one of these three objectives.
We, in India, have long held that we’ve got the better of constraints imposed by the Impossible Trinity in our uniquely Indian way.
So, we claim we are able to pursue an independent monetary policy. Recall the number of times that Reserve Bank of India (RBI) governors have said the central bank’s policy is determined by domestic considerations, not the mighty US Fed—even as we allow some, though not all, capital flows and have a flexible rather than fixed exchange rate for the rupee.
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Do we have the best of all possible worlds? Not quite.
The events of this week expose the fragility of that claim. The sad fact is there are limits to how well any central bank, not just RBI, can work around the inexorable truth of this theory. For one, in a globalized world, no country has complete autonomy over monetary policy (the US merely comes closest).
As for the assertion of rate flexibility, the term is a bit of a misnomer. The rupee’s dollar price does go by market demand and supply, but RBI invariably intervenes. It does this to smooth volatility, it says, but its actions often belie that claim. This happened this week, when the central bank reportedly intervened heavily in the market by selling dollars to nudge up the rupee. On Monday, the currency had slipped to an all-time low of ₹87.95 to the dollar. By Wednesday, it was at ₹86.47.
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What does all this have to do with the Impossible Trinity? Just this. Last Friday, on 7 February, RBI cut its policy repo rate—at which it lends banks short-term funds—from 6.50% to 6.25%. The move followed a series of other liquidity-easing measures in previous weeks. However, in the early part of this week, RBI was compelled to sell dollars to stem rupee depreciation, withdrawing rupees—or liquidity—from the banking system in the process.
Thus, its actions on the forex front had the opposite effect of what it was trying to do with monetary policy. Its freedom to act on the monetary policy front, where it saw a need to ease liquidity, was constrained (and indeed offset) by its actions on the forex front. The net result was that even though it had sought to have more money available with banks to lend, its sale of dollars in defence of the rupee drained liquidity.
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The bottom-line is this: try as we might, the Impossible Trinity will always get the better of us. Sure, while we have had phases of all three goals in a benign balance, the fragility of it frequently gets exposed. Only when our markets mature sufficiently to allow us the luxury of full capital-account convertibility and market-determined exchange rates will we be able to pursue a truly independent monetary policy.
