The the central bank, the Reserve Bank of India (RBI) faces several dilemmas while running a country as vast as India. One such is the ‘growth vs inflation’ conundrum. The other, relatively lesser known, trouble is the ‘impossible trinity’. It deals with three problem areas – the exchange rates, the inflow of capital and monetary policy independence.
Let’s have a look:
The Rupee Exchange Rate: The RBI is tasked with the responsibility of ensuring the rupee exchange rate does not fluctuate too much. The rupee does not have a fixed exchange rate. So, the RBI cannot intervene too much to ‘fix’ the exchange rate. At best, it can sell or buy dollars to control drastic fluctuations in the currency rate.
The Inflow Of Capital: Since the currency rate is not fixed, any investments by foreigners in India or any payments made by India in foreign currency will affect the rupee. Why? It’s simple—you buy dollars and sell the rupee to pay in foreign currency. This means the rupee’s value will fall. In contrast, a foreign investment leads to a rise in the rupee’s value. So, a free flow of this ‘capital’ will affect the rupee’s exchange rate.
Monetary Policy Independence: Now, if the RBI neither has the freedom to set exchange rates, nor curtail the flow of capital, then it is unlikely to be independent enough to set interest rates. We are talking about independence from external factors. That’s what the economic theory says. So if the RBI wants to be autonomous while setting interest rates, then it has to control either the rupee’s exchange rate or the flow of capital into the country.
The Trilemma: Here’s why this is a classic Mexican standoff. Let’s suppose, the RBI fixes its interest rates independently. This is irrespective of the monetary policy of country X. Now, let’s say the RBI chooses to fix the interest rate at 8% because India’s inflation is higher. Its interest rate is thus higher than country X’s interest rate of 7%. Higher interest rates mean greater returns on deposits. So, investors are likely to prefer borrowing cheaply in country X and investing in India to get higher interest rates on deposits. This means capital inflows are going to be high. In such a case, the rupee is likely to increase in value and appreciate. Now, money is pouring into the system. This means the supply of ‘money’ in the system is high. When supply is higher than demand, price falls, right? And in this case, the price of money is the ‘interest rate’. Now, a fall in interest rate goes against the RBI’s policy of setting higher interest rate—the policy won’t be able to curb inflation. So, the RBI has to control capital inflows. This means, it can either choose to be independent or control flows—there comes your trilemma!
The Current Scenario: India—like any other economy—continues to face this dilemma. It, like many of the western countries, opted for monetary policy independence. Usually, it allows a free exchange rate. Once in a while, it controls capital flows. A classic example is in 2013 when the rupee depreciated drastically. The RBI set up strict controls on capital to stabilise the rupee. Today, however, the rupee is quite stable. However, a report by the State Bank of India indicates that it may be time to relook at capital flows, especially from China. “With India’s trade balance with China increasing from $36.2 billion in FY14 to $51.2 billion in FY17 (47.3% of overall trade deficit), this is indeed a matter of serious concern for policy makers, as evidence of import substitution through Chinese imports is indeed threatening the balance,” the report said.
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