Home / Opinion / Views /  The impossible trinity is better solved than defied

Ever since we opened our economy to global capital, the ‘impossible trinity’ has returned every few years to haunt central bank policy. What we need is more light than heat over this classic trilemma, so let’s be thankful for ‘Monetary Policy Independence under a Flexible Exchange Rate Regime: The Indian Case’ (bit.ly/3LQEuKP), a working paper for the Reserve Bank of India (RBI) by Harpreet Singh Grewal and Pushpa Trivedi. “The trilemma poses a macroeconomic challenge for policymakers where monetary policy independence, exchange rate stability and capital account openness cannot be achieved simultaneously," says its abstract. “While operating with a flexible exchange rate, India intervenes in the foreign exchange market to contain exchange rate volatility arising from surges and ebbs in capital flows. This study employs a range of Vector Autoregressive models to assess the quantum and effectiveness of sterilisation in India and the impact of forex market interventions on monetary policy independence in the post- liberalisation era since 1991. The paper finds evidence of effective sterilisation of the money supply impact arising from forex market interventions and no major constraining influence of [these] on the independence of monetary policy." In brief, as steadying the rupee wasn’t found to weaken RBI’s grip of local interest rates, as pegging it would do, its forex strategy has been a success. Too good to be true?

Let’s take up what an attempt to peg our rupee to the US dollar would do under the trilemma that made most open economies opt for either a currency float to retain monetary control or a peg for other stability aims. In case of an insurge of dollars, RBI would have to buy these up just to hold its peg, injecting the country with liquidity that would weaken its handle on money-market rates and also stoke inflation. The usual way to avert this is to sterilize that injection by selling bonds to mop up the excess cash; yet, as this would cheapen securities and push up their yields, doing it could attract even more inflows, forcing us into a cycle of even tighter money. A fixed exchange rate can thus leave RBI with no policy space to do its main job. The rupee, however, is broadly afloat. RBI does not have an official rupee target against the dollar, even if it engages in bouts of pegging. Nor does India freely allow all inflows and outflows. Although volumes have swelled, our embrace of the world remains partial. With various transfers capped, risks are held in check: bond inflows can’t overwhelm RBI and capital flight is a financial market affair at worst. So the paper’s conclusion that forex-market intervention and its sterilization, while high, have been neither inflationary nor a big policy constraint should not surprise us. Our record does show RBI has pulled off a fine calibration on the trinity, at least for the inflow scenario that prevailed for much of the period under this paper’s review (i.e. from 1991-92 to 2019-20).

What happens in case of outflows? Last year, Turkey tried to prop up its lira and defy the tightening effect of this by easing credit in spite of high inflation—but only to see bank deposits flee even faster. Indian capital clamps mean we bear no such extreme risk. Support for a droopy rupee, however, does slurp up local liquidity. As a covid excess dries up, RBI will find it useful to offload more of its dollar stash (to soften import bills) if and only if the domestic effects of it help quell inflation overall—which is exactly what an autonomous RBI policy must achieve.

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