Indian Economy and Impossible Trinity

• 06 Sep 2023

For Prelims: Impossible Trinity, Reserve Bank of India, Monetary Policy, Foreign exchange reserves

For Mains: Challenges in making impossible trinity possible, India's currency dynamics

Source: BL

Why in News?

The Reserve Bank of India(RBI) and Indian investors are facing a challenge in overcoming the "impossible trinity".

What is the Impossible Trinity?

• About:
  • The impossible trinity, or the trilemma, refers to the idea that an economy cannot pursue independent monetary policy, maintain a fixed exchange rate, and allow the free flow of capital across its borders all at the same time.
    • In a fixed exchange rate regime, the domestic currency is tied to another foreign currency such as the U.S. dollar, Euro, the Pound Sterling or a basket of currencies.
  • An able policymaker can, at best, achieve two of these three objectives at any given time.
  • The idea was proposed independently by Canadian economist Robert Mundell and British economist Marcus Fleming in the early 1960s.
  • The Impossible Trinity is a fundamental concept in international economics and monetary policy.
  • It describes the inherent challenges countries face when trying to simultaneously achieve three specific policy objectives related to their exchange rate and capital flows.
• Challenges Involved:
  • When a country prioritizes free capital flow and a fixed exchange rate, it loses control over its monetary policy, making it susceptible to external economic pressures.
  • If a country chooses to maintain a fixed exchange rate and independent monetary policy, it must impose capital controls to limit the flow of funds across its borders.
  • Opting for independent monetary policy and free capital flow requires accepting exchange rate fluctuations, potentially leading to volatility.
• Examples of the Impossible Trinity in Action:
  • Various countries have faced the challenges of the Impossible Trinity, with some notable examples being the Asian Financial Crisis in 1997 and the European Exchange Rate Mechanism crisis in 1992.
    • These crises were partly attributed to the inability of affected countries to maintain fixed exchange rates, independent monetary policies, and free capital flows simultaneously.

How is India Struggling with the Impossible Trinity?

• Strategies and Actions to Address the Impossible Trinity:
  • Managing Interest Rates:
    • The RBI has been cautious in raising interest rates compared to the US Federal Reserve.
      • The reluctance to raise rates is driven by the fear of causing a recession, especially with the upcoming elections in 2024.
    • A lower interest rate arbitrage signifies a flight of capital back to the US (the world’s reserve currency) and an impending depreciation of the Indian rupee.
  • Composition of Foreign Exchange Reserves:
    • India's foreign exchange reserves primarily consist of 'hot money' (from Foreign Institutional Investors (FIIs) investing in domestic debt or equity markets to cash in on arbitrage opportunities) and corporate borrowing (for example, Adani Green Energy, Vedanta, etc.), not money earned from trade.
      • Relying on reserves not earned through trade poses challenges for maintaining currency stability.
  • Implementing Capital Controls:
    • India has implemented various measures to control capital flows, but their effectiveness remains uncertain.
    • Policy Measures to Control Capital Outflows:
      • Import Bans and Licensing Policies:
        • India imposed import bans, particularly on electronic goods, as a quick response to limit capital outflows.
        • These bans were later transformed into license-based import policies due to domestic manufacturing limitations.
        • However, these measures may inadvertently contribute to supply-pull inflation rather than preventing capital outflows.
      • Tax Changes:
        • India has also increased tax rates on outbound remittances from 5% to 20% as a means to restrict capital outflows.
        • The effectiveness of this tax increase in managing the 'Impossible Trinity' is under scrutiny.
• Influence of China on India's Economic Situation:
  • China's deflation and rate cuts aim to stimulate economic growth. The Chinese consumer price index fell by 0.3% in July year-on-year. Additionally, the INR has appreciated by 4% against the Chinese yuan.
  • A stronger Indian rupee can lead to increased imports from China, affecting India's trade balance and currency dynamics.
  • The depreciating Chinese yuan can make India's exports less competitive in global markets.
• Foreign Institutional Investors (FIIs) and Indian Debt:
  • FIIs are selling holdings of Indian debt securities and seeking more profitable investments abroad, increasing the demand for foreign currency and weakening the Indian rupee in the foreign exchange market.

What are the Implications of the Impossible Trinity for Indian Investors?

• Shielding Against Rupee Depreciation:
  • Investing in sectors like IT and Pharma that primarily earn in dollars can shield against rupee depreciation.
    • As the rupee weakens, these companies may experience increased competitiveness and offer attractive returns.
• Diversifying Investments Abroad:
  • Investors must acknowledge the challenges posed by the 'Impossible Trinity' and adapt accordingly.
    • Investing in international assets becomes crucial for protecting investments in a complex economic environment.

Way Forward

• India should focus on effectively implementing capital control measures. These measures should strike a balance between maintaining a stable currency and encouraging foreign investment.
• The country should actively diversify its foreign exchange reserves and aim to earn money through trade rather than relying heavily on 'hot money' from foreign investors.
  • Additionally, attracting foreign direct investment (FDI) can contribute to currency stability and strengthen the rupee.
• The RBI should adopt a balanced approach to interest rates, considering inflation control and attracting foreign investment. Gradual interest rate adjustments can help achieve this balance.