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Posted by: Deepa Vasudevan on Thu, Aug 1st, 2013

India's Impossible Trinity

The first quarter review of monetary policy for 2013-14 was presented today. All policy rates were left unchanged: the RBI governor pointed to the "The Impossible Trinity" problem faced by India for his inability to exercise strong monetary action. This phrase, and its relevance, requires some explanation.


The Impossible Trinity is a well-known policy "Trilemma" in international economics which states that it is impossible for an economy to simultaneously achieve


  • A fixed exchange rate
  • Allow free capital inflows and outflows, and
  • Follow an independent monetary policy


A government can target a maximum of two out of three variables at a time; the third will have to be left to market forces.


At the start of 2013-14, the scenario was conducive for reducing interest rates. Strong foreign inflows into capital markets promised a relatively comfortable financing of the current account deficit. Reforms to speed up FDI and improve investment were expected after the budget. Inflation was finally at single digit levels. The Rs/US$ exchange rate was around 54, a level it had more or less maintained for a year. Consequently, RBI opted to ease monetary policy to restore growth and investment.


If capital inflows had remained steady, the easier money policy could have continued. Unfortunately, from mid-June 2013, a general sell-off from emerging markets, combined with India’s vulnerable balance of payments position, resulted in a sharp depreciation of the rupee. By the time the Rs./$ rate dropped to 60, reducing  exchange rate volatility replaced growth as RBI’s immediate priority.


Here is what RBI wanted:


  1. The Rupee should stabilize at a reasonable level
  2. Foreign outflows should stop, and inflows resume
  3. RBI should be able to cut rates when needed to ensure economic growth


To achieve aim I, RBI tightened market liquidity and made short term borrowing more expensive. As funds dried up, speculation reduced and the rupee started recovering some stability (Pic 1). Aim II was simultaneously achieved as the measures boosted confidence and reduced FII sell-offs. SEBI data show that net FIIs outflows on debt and equity was $7.5 billion in June, but only $3.08 billion in July (Upto 30 July).


At this point, RBI faced the Impossible Trinity. The need to stabilize the exchange rate and attract foreign inflows forced it to increase interest rates, even though the economy needs lower rates to generate more growth. By opting to manage external risks, it has given up its ability to conduct an independent monetary policy.


Until the current account situation improves enough to remove the risk of rupee depreciation, sovereign monetary policy will be hostage to our BoP position.


Pic 1: The Rs/$ Exchange Rate 


Pic 1: The Rs/$ Exchange Rate

SURI SEETA RAM on Fri, Aug 2nd, 2013 12:53:06 pm

This analysis is understandable and Convincing. As you pointed, only two out of the three forces at a time can be addressed by the Regulator RBI or Govt. But till the time much water ran down the river, why didn't any agency alert investor and distributor population about this Risk? And even now everyone is left with a feeling that the worst is not yet over. Under the circumstances, how can we help clients protect their Asset Values? How often can we ask them to Churn? Can we really add value?

Prafull Doshi on Thu, Aug 1st, 2013 8:52:12 pm

RBI is stuck with govt.not really have any descipline in raising economy to a higher level and only bent upon the spending programs to the extent of even borrowing for it.This is really pathetic situation for the country and may lead to more debt.Hope they get the wisdom to save the country out of mess.This is happening even an expert economist is at the top.

Munish Kohli on Thu, Aug 1st, 2013 5:23:25 pm

I think US $ will not stop , by this short term measures, what government will do next , if some more good news comes from US and the QE stops

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