The Impossible Trinity

Presented by:

Group-8
Introduction
 Post 1990
 Regulated Economy  Growing Degree of
deregulation and liberalization
 Fiscal dominance  monetary – fiscal
coordination
 When the RBI stopped intervening to support the
dollar, the Rupee surged
 Surge in rupees is wiping out textile
exporters and other industries
 The Finance Ministry, is now providing sops
to exporters to offset the higher rupee
 The current problems stem from a failure of
policy. The implication of The Impossible
Trinity was not understood.
Impossible Trinity: What it is ??
 The Impossible Trinity is the Trilemma in
international economics suggesting it is
impossible to have all three of the following
at the same time:
 A fixed exchange rate.
 Free capital movement (absence of capital
controls).
 An independent monetary policy.
 Exchange
Price
Rate
Stability
Stability

Growing Increase Foreign

Country Investments – Investors
Liberalize convert dollars
(India) capital flows into Rs.

Exchange Rate Demand Demand for

fixed -> Bank increases -> domestic
gives/prints Exchange rate currency
desired Rs. should appreciate increases

Exchange
Rate
Supply of Rs. Stability
increases ->
Inflation Price
increases Stability
 Rupee Convertibility
 Convertibility of the rupee or any currency refers to its
convertibility into a foreign currency as desired by its holder.

 The currency is said to be fully convertible if its holder can

convert it into any other currency at rates determined by the
forces of demand and supply and without any interference from
the government.

Thus convertibility of any currency has certain pre-requisites to

it-
1. rate of exchange to be determined by the forces of demand
and supply.
2. no quantitative restrictions on the repatriation of the currency.
 Current account convertibility.
 It refers to currency convertibility required in
the case of transactions relating to exchange of
goods and services, money transfers and all
those transactions that are classified in the
current account.
 Provides full freedom to both residents and
non-residents to trade in goods/services.
 In India, most current account transactions
have been freed from controls over the years.
Path that lead to Current Account Convertibility

After 2000

From 1992
to 2000

Liberalization
began in
1991

Till 1990
 Capital Account Convertibility
 As per FEMA "capital account transaction" means a
transaction which alters the assets or liabilities,
including contingent liabilities, outside India of
persons resident in India or assets or liabilities in
India of persons resident outside India
 The freedom to convert local financial assets into
foreign financial assets and vice versa at market
determined rates of exchange.
 It is associated with changes of ownership in
foreign/domestic financial assets and liabilities.
Capital Account Transaction

Capital Account transactions are classified as :-

1. Portfolio investment involves trade in securities

like stocks, bonds, bank loans, derivatives, etc.
2. Direct investment involves purchase of real
estate, production facilities, or equity investment.
3. Other investment involves holdings in loans,
bank accounts and currencies
Exchange Rate Regime
 Is the way a country manages its currency in
respect to foreign currencies and the foreign
exchange market.
 The market equilibrium exchange rate is the
rate at which supply and demand will be equal.

Types of Exchange Rate Systems

 Flexible Exchange Rate Systems
 Fixed exchange rate systems
 Managed floating rate systems
Flexible Exchange Rate Systems
 The value of the currency is determined by
the market
 So higher demand for a currency =
appreciation of the currency.
 Lower demand = depreciation of the
currency
 Increase in supply of a currency =
depreciation of that currency
 Decrease in supply = appreciation of
currency
 Fixed exchange rate systems
 It is also known as Bretton-Woods System
 Under the absolute fixed exchange rate system, the exchange
rates of the member countries were fixed against the U.S.
dollar, with the dollar in turn worth a fixed amount of gold.
 The basic motivation for keeping exchange rates fixed is the
belief that a stable exchange rate will help facilitate trade and
investment flows between countries
 Under this system the Central Bank stands ready to exchange
local currency and foreign currency at a pre-announced rate
and absorb any excess demand or supply
 This is where it gets tricky as the central bank is required to
hold an adequate stock of foreign currency known as foreign
exchange reserves.
Managed Floating Rate Systems
 Is a hybrid of a fixed exchange rate and a flexible
exchange rate system
 central bank = a key participant
 It intervenes in the foreign exchange market by buying
and selling domestic and foreign currency to keep the
exchange rate close to desired levels.
 Under this regime, the central bank holds stocks of
foreign currency: these holdings are known as foreign
exchange reserves.
Monetary Policy
 Is the process by which the monetary
authority of a country controls the supply of
money to attain a set of objectives oriented
towards the growth and stability of the economy.
 Expansionary Monetary Policy increases the
total supply of money in the economy rapidly by
reducing the interest rates to tackle
unemployment during recession times.
 Contractionary Monetary Policy decreases the
total money supply by increasing the interest
rates to combat
MANAGING CAPITAL MOBILITY
 BENEFITS
 Financing Investment
 Economic growth

 PROBLEMS
 Push up money aggregates
 Inflationary pressures
 Destabilize exchange rate
 Affect domestic financial sector
RISING CAPITAL INFLOW
 Indian economy was growing at 8.5%
plus from 2004 to 2008.

 Interest rate cut by the central Banks in

developed economies.

 Need to build infrastructure capacities in

the country.
 MANAGING CAPITAL
FLOWS
 Restricting capital flows.
 The best way to absorb huge capital inflows is to
strengthen the financial system.
 The RBI has actively withdrawn liquidity from the
system.
 Some restrictions on capital inflows have recently
been introduced, primarily on corporate borrowing.
MANAGING FOREIGN EXCHANGE
RATE
 Predominant objective - Flexible exchange rate

 The exchange rate policy is guided by the need to

 reduce excess volatility
 prevent the emergence of destabilising
speculative activities
 help maintain an adequate level of reserves
 develop an orderly foreign exchange market
 CONCLUSION
 Key elements of RBI’s policy have been
 Active management of the capital account, especially debt
flows
 Flexibility in exchange rate movements but with capacity to
intervene in times of excessive volatility;
 Treating capital flows as largely volatile unless proven
otherwise
 Building up of adequate reserves
 Sterilisation of interventions in the foreign exchange market
through multiple instruments, including cash reserve
requirements
 Monetary policy needs to move away from narrow price
stability/inflation targeting objective.