Exchange rate as a tool to manage economy no longer effective; India facing open trilemma

Received wisdom in international finance is the “Impossible Trilemma”, which essentially states that a country cannot choose to maintain an open capital account, pegged exchange rate and interest rate policy autonomy simultaneously. Something must be compromised. Thus, if a country wants to maintain an open capital account it can decide either to (a) operate a pegged exchange rate but forsake interest rate policy autonomy or (b) give up trying to manage its exchange rate, if it wants complete control over its domestic short-term rates.

The choice of exchange rate regime therefore essentially boils down to what is a more important policy instrument to impact aggregate demand — interest rates or exchange rates?

If domestic demand is a larger share of aggregate demand then controlling the internal price of money is crucial. In such a case, the country needs a much greater degree of interest rate policy autonomy and must therefore choose a more flexible exchange rate regime. If, however, external demand constitutes a larger share of aggregate demand, then it is the external price of money that is paramount. In this instance, the country might prefer to manage the exchange rate and consequently forsake its interest rate policy autonomy.

Asian Exchange Rate Regimes

Taking a quick scan across Asia, it is not surprising to see that many smaller economies have fixed or heavily managed exchange rate regimes — Hong Kong and East Timor to the US dollar (the former via its Linked Exchange Rate System and the latter via complete dollarization), Singapore to a basket of currencies (trade-weighted exchange rate), Brunei to the Singapore dollar, and Nepal and Bhutan to the Indian Rupee.

Given their high dependence on oil, which is priced in US dollars, many countries in West Asia also peg their currencies to the US dollar (so-called petrodollar pegs). Larger Asian economies such as Japan and South Korea have chosen a relatively more flexible exchange rate regime, as has India which has adopted an inflation-targeting regime since mid-2016.

China remains an oddity in the sense of having a large domestic economy but for decades relying on a heavily managed exchange rate regime. This in turn has given rise to periodic accusations in the US and elsewhere of “currency manipulation”.

Some other countries in ASEAN such as Malaysia and Vietnam have chosen to “manage in the middle”, i.e., forsake a degree of monetary policy autonomy and some degree of exchange rate fixity while proactively using capital flow management measures to manage volatility of capital flows.

Global Financial Cycles

This fundamental trilemma in international finance has been forcefully challenged recently by Hélène Rey of the London School of Economics, who proclaimed in 2013 that in the era of financial globalisation, a country with an open capital account would remain highly susceptible to the global financial cycle, independent of the exchange rate regime.

She has highlighted the role of the VIX Index (which is used as a measure of uncertainty and market risk aversion) and the US Fed funds rate in impacting global capital flows, bank leverage and asset prices which have a strong common component (i.e. they are highly correlated across countries).

Rey has argued that the global financial cycle explains how emerging economies in Asia and elsewhere have imported the ultraloose monetary conditions in the US and were faced with a huge run-up in credit and asset prices, regardless of the exchange rate regime. The global financial cycle has, according to her, transformed the trilemma into a “dilemma” in the sense that the only way a peripheral country can hope to maintain independent interest rate policy by compromising its capital account openness. 

There is nonetheless sufficient academic research to date that suggests that a dismissal of the trilemma may be overstated as exchange rate flexibility remains associated with greater monetary policy autonomy, despite financial globalisation.

US Dollar Lending and Global Banks

While the Impossible trilemma itself has not been rendered obsolete by financial globalisation, there are two important caveats to the above analysis.

One, even without foreign exchange intervention by the emerging market central bank, it is possible that domestic currency credit could get squeezed. This is so as a Fed rate hike causes an appreciation of the US dollar and if some liabilities of banks/corporates are held in US dollars while assets and cash flows are predominantly in domestic currency, then that would worsen the balance sheet in domestic currency terms. The deterioration of balance sheets due to currency mismatches reduces the willingness and/or ability of banks to extend credit.

This so-called risk-taking channel of monetary policy is especially of concern in India and many East Asia economies as emerging market debt issued in US dollars (especially to nonbanks) has surged after years of an easy monetary policy in the US which has led to the origination of riskier US dollar loans globally.

Two, if there is de facto dollarization, then it does not matter if domestic currency credit and interest rates change as the bulk of the transactions are done in the US dollars. Thus, a Fed rate hike and consequent US dollar credit squeeze will have direct consequences on emerging markets. There are a few countries in Asia such as Cambodia which are faced with de facto dollarization and are thus susceptible to such a situation.

Similarly, trade in parts and components in Asia as part of regional and global value chains as well as commodities trade are predominantly invoiced in US dollars and could also be faced with a dollar shortage and credit squeeze with concomitant negative macroeconomic implications to Asian economies, regardless of the exchange rate regime.

So, while the trilemma remains a useful description of policy trade-offs and exchange rate flexibility does have some insulating power, financial globalization and US dollar invoicing has reduced the effectiveness of exchange rate as a tool to manage the economy.