The policy trilemma of international economics is the inability to simultaneously accomplish three objectives: monetary autonomy, exchange rate stability and unrestricted international capital flows. Choose any two and the third must be given up. Or one can try to achieve all three partially. Monetary autonomy is desirable for controlling inflation. Exchange rate stability may help increase or stabilise foreign trade. Capital flows can finance investment and growth. It is not obvious how policymakers should balance the different objectives.
For a long time, India, like most developing countries, chose a (mostly) fixed exchange rate and monetary autonomy, by having strict capital controls. Monetary policy was autonomous with respect to the rest of the world, not India?s politicians, but that is another matter. Then India began to open up its economy, starting with trade, and then moving on to capital. Since there are still a lot of restrictions on movements of capital in and out of India, some calculations (in particular, the often-used Chinn-Ito index) suggest that capital controls in India are still very severe. Another exercise in turning complex rules into a single number, by Lekshmi Nair, suggests that India has been steadily liberalising international capital flows.
The actual flows tell the same story. If one adds up credits and debits on the capital account (so looking at gross rather than net flows), and calculates the ratio to GDP, this number was almost never above 20% until 2000. Even then, after crossing that mark a few times, it fell back below until 2003, when it began a steady, then accelerated rise. In the second quarter of 2005-06, it jumped to 35%, and went as high as 85% in the last quarter of 2007-08. The ratio has since fallen back, but remains much higher than it was a decade ago. International capital flows are here to stay.
These increased capital flows have meant that RBI has had to struggle to manage the money supply and the exchange rate. The ?managed float? of the exchange rate has become more difficult in recent years, and sometimes RBI?s foreign exchange interventions have impacted its conduct of monetary policy. It seems that the trilemma has been at work in India as well.
Joshua Aizenman has suggested that there is a fourth policy objective?of financial stability. Such stability is easier to achieve in a world of capital controls, but financial integration means that money moves in and out of countries with speed and significant consequences. Financial crises associated with instability of international capital flows can have very high costs in terms of lost output. Aizenman suggests that the need to achieve financial stability with capital account openness explains the increased use of an additional policy instrument.
Asian countries have been building up foreign exchange reserves, even as they have inched towards greater exchange rate flexibility. Reserves provide self-insurance against risks of sudden stops of capital or deleveraging that can accompany financial integration. In fact, Aizenman?s work with Chinn and Ito suggests that building up foreign exchange reserves has allowed some Asian countries to soften the trilemma?maintaining exchange rate stability and monetary autonomy while gradually increasing financial openness.
At the same time, Aizenman also argues that there are limits to what reserves can do?the global financial crisis of 2008-09 threatened to be much greater than what reserves could cover. Countries had to resort to reimposing temporary capital controls during the crisis. Swap lines and pooled reserves offer another line of defence beyond individual country reserves, but so far their scope is limited.
The analysis of Aizenman suggests that as India continues to become more financially integrated with the rest of the world it may need to build its reserves up more, or come up with alternatives. It can continue to manage the exchange rate to some extent but, even with exchange rate flexibility, reserves will have a role to play in dealing with volatility.
Alternatively, India can go back into the arms of the trilemma, with increased capital controls, albeit perhaps more rationally designed than the current patchwork. To some extent, this latter option is part of the discussion on the global financial architecture and global rebalancing. More globally coordinated regulation of capital and the financial sector will throw sand in the wheels of massive international financial flows.
One optimistic scenario would be India growing fast enough, with improved domestic financial intermediation, so that international capital flows are less important and restraining them less costly. It would have to do better than China, which has grown faster, but through massive saving and investment that has not always been very efficient. As with other tradeoffs, growth and efficiency improvements can also soften the tradeoffs inherent in the trilemma.
?The author is a professor of economics at the University of California, Santa Cruz. These are his personal views