Opinion | India’s impossible trinity problem

Opinion | India’s impossible trinity problem

News:

1. Analysis of India’s Trinity problem and comparison with past experience in context of currency depreciation
   • Impossible Trinity – It states that country cannot have a Fixed Exchange Rate, An Independent Monetary Policy (Independence of External Factors) and Free Capital flows at the same time. It implies, an open economy can achieve only two of these objective at the cost of third.

Important Analysis:

2. Indian Rupees has been trading at a very low level, the same situation India has dealt with, in 2013.
3. Comparison of Economic situation now and then in 2013
4. Comparison is being made on the account of:

• Depreciation of Rupees
• Foreign Investment Outflow
• Widening Current Account Deficit

5. Differences between the situations.

• India’s Macroeconomic Fundamentals is strong as compared to 2013
• Presently, Inflation is controlled well below double digit.
• High India’s exchange reserves to sustain imports to 10 months.
• Improvement in Portfolio inflows
• Government is committed to fiscal consolidation.

6. Having the quite strong position of economy now, there are some similarities too, which raises the concern such as Trinity Problem.
7. Countries such as U.S, China and EU have chosen different set of combination to deal with Trinity dilemma during financial crisis.

• S has independent monetary policy and no money control, resulting in a flexible exchange rate.
• China has devalued its currency Renminbi in 2015.
• EU has given up Monetary policy independence for a stable exchange rate and financial integration.
• Thailand and Mexico has fixed exchange rate to U.S dollar during forex reserve crisis.

8. India’s reaction during 2013 crisis to tackle Rupees depreciation

• RBI imposed partial capital controls to manage depreciation
• Direct investment by Indian companies abroad were curtailed
• Restrictions were imposed on money outflow on account of remittance.
• Foreign currency non—resident (FCNR) deposits were introduced to attract foreign currency.
• Partial money control with stable exchange rate were adopted

9. Presently, due to foreign portfolio outflows, India is facing similar trilemma as it faced in 2013.
10. Factors affecting Foreign currency inflow are divided into Push and Pull factors.

• Pull Factor – These are country specific factors which pull foreign currency such as:
• Economic Growth of the country
• Interest Rates
• Fiscal stability.

Push Factors – Push capital into emerging market such as:

• Low interest rate in advanced markets or economy (If country A has low interest rate as compared to B, the capital will be pushed from country A to B in lure of extra capital interest gain).

11. Open capital account with a floating exchange rate will always lead to periods of appreciation or depreciation.
12. Though, depreciation of Rupees will make our export cheaper but will increase the cost of import.
13. Thus it is important for emerging markets like India to deal with both volatile inflows and outflows.
14. steps to taken by India

• Either impose capital control or increase interest rates (recently RBI already increased)
• Focus on foreign inflows to finance CAD.
• Promote software export.

15. Market forces should be allowed to determine nominal exchange rate.