Policymakers dealing with the Great Recession of 2008–09 are confronted with what we call the ‘financial trilemma’. This hypothesis, based on pioneering work by Mundell and Fleming in the 1960s, asserts that a country may not simultaneously target exchange-rate stability, conduct an independent monetary policy, and have full financial integration – it is a potent paradigm of open-economy macroeconomics (see Fleming 1962 and Mundell 1963).
The sharp predictions of the trilemma and its crisp intuitive interpretation made it the holy grail of the open-economy neo-Keynesian paradigm. A key message of the trilemma is scarcity of policy instruments. Policymakers face a tradeoff, where increasing one trilemma variable would induce a drop in the weighted average of the other two variables. A lingering challenge is that in practice, most countries rarely face the binary choices articulated by the original trilemma. Instead, countries choose the degree of financial integration, monetary independence, and exchange rate flexibility. In Aizenman et al (2008), Joshua Aizenman and colleagues outline the construction of three continuous measures of the trilemma variables, and find that, over the last couple of decades amid rapid financial globalisation, emerging market economies have mostly opted for managed exchange-rate flexibility buffered by holding sizeable international reserves while increasing financial integration and preserving the degree of monetary independence.
The trilemma in China and India: Data analysis
In a recent paper (Aizenman and Sengupta 2011), we use the methods outlined above to analyse the extent of the tradeoffs faced by policymakers in China and India.
Using quarterly data from 1990Q1 to 2010Q4 we measure monetary independence as reciprocal function of the correlation of interest rates in home country (China and India, respectively) and base country (United States). By definition the index lies between 0 and 1, with 1 indicating the greatest degree of monetary independence. We calculate the exchange-rate stability index using quarterly standard deviations of weekly change in log of LCU-US Dollar exchange rate (RMB-USD exchange rate for China and rupee-USD exchange rate for India). By definition, the exchange-rate stability index ranges from 0 to 1 and the higher the value the greater is the exchange-rate stability. We define the capital-account openness index as the ratio of the sum of inward and outward foreign investment flows to GDP, and we consider three types of capital flows – foreign direct investment (FDI), portfolio, and others – as reported by SAFE for China and IFS for India.
A continuous hypothesis of the trilemma is that policymakers can choose a combination of the three policy goals subject to a linear constraint, where the weighted average of the chosen capital-account openness, monetary independence and exchange-rate stability adds to a constant. The estimation approach we use here is to regress a constant on all three indices at the same time. The estimated coefficients provide us the weights attached by policymakers to the three policy goals.
The trilemma in China and India: Empirical results
China has clearly been placing more priority on minimising exchange-rate fluctuations as a tool for macroeconomic management. The exchange-rate stabilisation objective has been given more policy weight perhaps at the expense of monetary independence and especially capital-account openness.1
India is strikingly different. All three indices are consistently and statistically significant in all baseline regressions. Going by the size of estimated coefficients, financial integration is clearly given more importance followed by exchange-rate stability and monetary autonomy.
Putting our results in broader perspective, China’s trilemma configurations are unique compared to other emerging markets both in the predominance of exchange-rate stability, and in the failure of the trilemma regression to capture a significant role for financial integration. In contrast, the trilemma configurations of India are in line with results from Aizenman et al (2008, 2011), and consistent with predictions of trilemma tradeoffs.
One possible interpretation is that the segmentation of domestic capital market in China and capital controls applied there implies that the ‘policy interest rate’ is not reflecting the stance of monetary policy. This would be the case if a large share of borrowing is allocated directly by the state banking system, with preferential treatment of state owned enterprises, and if the supply of credit to the private sector is segmented. Another unique feature of China is a combination of more stringent capital controls and massive hoarding of international reserves. China has been increasing its ratio of reserves-to-GDP relentlessly without signs of convergence to a target ratio during the sample period. These policies may relax the trilemma constraints in the intermediate run (see Aizenman et al 2011). Furthermore, the emergence of endogenous capital flows circumventing controls in China (including trade mis-invoicing) may reduce the explanatory power of trilemma variables in China.
In contrast, the trilemma configurations of India and its tradeoffs among policy goals are in line with results of other emerging markets. This is reflected both by the significant positive sign of all trilemma variables, and by the ‘middle ground’ choices of India (see Hutchinson et al (forthcoming) for more discussion).
The trilemma in China and India: Impact on inflation
We next explore how various choices regarding the three policies along with the surge in international-reserve accumulation have affected domestic inflation. Intriguingly, we find no evidence that hoarding reserves by China and India was associated with higher inflation. Apparently, throughout most of the sample, both countries managed to sterilise effectively, preventing spillover effects from hoarding international reserves to domestic prices.2
The trilemma in China and India: Future issues
While the US and Europe are still reeling under the pressures of the housing market, banking, and sovereign debt crises in the aftermath of the Great Recession, the domestic economies in both China and India have not only recovered but have started booming again. Both economies have benefited in recent times from FDI. While net FDI accounts for more than 2% of GDP in China, for India this percentage is as low as 0.64%. More importantly, both China and India are fast becoming important sources of outward foreign direct investment (OFDI). Total OFDI from India increased from about $25 million in the early 1990s to nearly $14 billion in 2010. China’s annual FDI outflow has grown from $4 billion in 1992 to $68 billion in 2010.
However, in China uncertainty is looming large about growing nonperforming loans (NPLs) in its banking system triggered by a massive surge in credit in the aftermath of the Great Recession. China’s loose monetary policy is also feared to have fuelled a real-estate bubble. In addition to these, China faces one major disadvantage in the coming decade or so, with regard to demographics – its population and hence labour force is rapidly ageing and shrinking.
India, on the other hand, has a relatively young population and hence theoretically should benefit from a large demographic dividend. But India is struggling to create more jobs to absorb the rising young labour force. Also, compared with China, India suffers from a major lack of infrastructure investment that is crippling big projects both in public and private sectors. India is also struggling with another set of problems in the aftermath of the Great Recession, the most worrisome being domestic inflation. In 2010, the annual average wholesale price index (WPI) inflation was as high as 10.2%. The Reserve Bank of India has been raising interest rates consistently since November 2010 to counter inflation, a move that has also been stifling growth. In the coming decades, the above-mentioned issues will play a crucial role in modifying the context of the trilemma paradigm for these two rising giants in Asia.
Figure 1. Evolution of monetary independence in China and India
Figure 2. Evolution of exchange-rate stability in China and India
Figure 3. Evolution of capital-account openness in China and India
Aizenman J and R Sengupta (2011), "The Financial Trilemma in China and a Comparative Analysis with India", Department working paper, November.
Aizenman, J, M Chinn, and H Ito (2011), "Surfing the Waves of Globalization: Asia and Financial Globalization in the Context of the Trilemma", Journal of the Japanese and International Economies, 25(3): 290-320.
Aizenman, J, M Chinn, and H Ito (2008), "Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time", NBER Working Paper Series #14533.
Hutchison, M, R Sengupta, and N Singh (forthcoming), “India’s Trilemma: Financial Liberalization, Exchange Rates and Monetary Policy”, The World Economy.
Fleming, J Marcus (1962), “Domestic financial policies under fixed and floating exchange rates", IMF Staff Papers 9: 369-379.
Mundell, Robert A (1963), "Capital mobility and stabilization policy under fixed and flexible exchange rates". Canadian Journal of Economic and Political Science, 29(4): 475–485.
1 Adjusted R2 for Chinese regressions are found to be well above 95%, with all the policy weights being positive, indicating that policymakers in China do indeed face a tradeoff among the three policy goals. The estimated coefficients of the exchange-rate stability index are highly significant as well as of relatively higher magnitudes than the other two indices.
2 This result may reflect the financial repression stance of both countries, where the authorities occasionally adjusted banks’ reserve/deposit rates at times of abundant liquidity. Yet, this result should be taken with a grain of salt, as it reflects the average patterns observed during the sample period, and thereby is backward-looking. As the international reserves-to-GDP ratio trends upwards in both countries, reaching more than 50% in China, past experience does not guarantee the success of future sterilisation.