Stephen Grenville, 26 November 2011
The impossible trinity doctrine – that it is not possible to have a fixed exchange rate, monetary policy autonomy, and open capital markets – still holds powerful sway over policymakers and academia. But it does not reflect reality in East Asian emerging countries. Assets in different currencies and different countries are not close substitutes. Capital flows to emerging countries present serious challenges, but the trinity is not the best framework for analysing the policy options. Capital flows are rarely discussed without a genuflection in the direction of the impossible trinity, also known as the trilemma. For example, Magud et al (2011) write: “… a trinity is always at work. It is not possible to have a fixed (or highly managed) exchange rate, monetary policy autonomy, and open capital markets.” According to the trilemma, a stable exchange rate without capital controls requires domestic and foreign interest rates to be equal. Otherwise, ‘uncovered interest arbitrage’ will force continuous appreciation or depreciation of the currency. As such, nations without capital controls must choose between stabilising the exchange rate (by slaving interest rates to foreign rates) and stabilising the domestic economy (adjusting interests slaved to domestic macro conditions but letting the exchange rate fluctuate). Mechanically, this is enforced – according to trilemma logic – by substantial capital inflows or outflows and the impact of these on the money supply. Why this doesn’t fit the East Asia experience
Since the 1997–98 Asian crisis, East Asian countries have clearly run their own independent monetary policies.1 They have successfully set interest rates to broadly achieve their inflation objectives. As Figure 1 shows, they are most definitely not all slaving their rates to foreign rates. Figure 1.
Despite this, their exchange rates have been fairly stable. They have managed their primary exchange-rate objective – leaning against the prevailing appreciation pressures in order to maintain international competitiveness (see Figure 2). Remember that according to the classic trilemma, the similarity in exchange-rate movements since the global crisis should have coincided with identical interest rate levels (all equal to, eg, the US interest rate); comparing Figures 1 and 2, we see this isn’t the case. Figure 2.
These attempts to restrain appreciation have involved heavy government intervention, resulting in very large increases in foreign-exchange reserves (Figure 3). This didn’t, however, cause excessive increases in base money (Figure 4), thanks to effective sterilisation by open-market operations and increases in banks’ required reserves. Figure 3. Foreign-exchange reserves as a share of GDP
Figure 4. Growth in foreign-exchange reserves (y-axis) and base money (x-axis), Percent, 2001–07
Why doesn’t the trinity apply?
There are four reasons why the trinity doesn’t work in East Asia. First, if uncovered interest parity held, markets would treat different currencies as close substitutes. An investor would know that the interest differential would be a good guide to where the exchange rate was heading and even small interest differentials would trigger large arbitrage flows. It is now abundantly clear that interest parity offers feeble guidance for the exchange rate–interest rate nexus (see Engel 1996). The parity condition often gets the direction wrong, let alone the quantity (Cavalo 2006), as it does for six of the seven countries illustrated in Figure 5. Figure 5. Annual average interest differential versus change in exchange rate 2001–10
Capital flows responding strongly to interest differentials are the core element in the impossible trinity story. But in practice: * Different currencies are not close substitutes; and
* Capital flows are driven by many other forces besides short-term interest differentials. Second, instead of well-formed...