Modeling International Trinity & Policy Choices for India.

AuthorArora, Nitin


In this globalized world, most of the economies are advancing on the path of higher degree of capital account openness which implies free and unrestricted exchange of domestic currency for foreign currency to perform capital account transactions. Moreover, capital account convertibility is a process through which economies with surplus savings can transfer their excess funds to deficient nations. This transformation process acts as a golden opportunity for the developing economies to admit the additional capital to boost up their development process. Higher degree of capital account openness can affect the domestic macroeconomic performance by increasing the ability of the economy to finance larger current account deficit. However, capital mobility comes with its respective strings attached. On various occasions this has led to severe balance of payment crisis usually accompanied by financial crisis. To overcome the side effects of capital account openness, an economy can resort to unsterilized as well as sterilized solutions. However, unsterilized interventions always carry the risk of increase in inflationary pressures while avoiding appreciation, whereas, sterilization imposes high interest cost on the budget. In addition, the choice of adopting higher degree of capital account openness is never an easy task as it depends upon other policy choices of the economy and at the same time, it consequently alters the effectiveness of other policies. This kind of choice making process of an open economy has been discussed by Markus Flemming (1962) and Robert Mundell (1963) in the form of international trinity hypothesis. This trilemma hypothesis states that an economy can achieve only two policy goals at a time out of the three, i.e. sovereign monetary policy, exchange rate stability and full capital account convertibility.

India has not been facing these tradeoffs of international trinity before 1990 because it has been following the policy of low capital account liberalization. However, with structural transformation of 1991, India has started opening up. As it has earlier been mentioned that increasing capital inflows many a times result in rapid real exchange rate appreciation which further can negatively hit export market. If the central bank tries to prevent this appreciation then it is likely to lead to an increase in money supply resulting in fueling inflationary pressure. Due to these challenges, India is following a calibrated and gradualist approach towards capital mobility. Indian economy is one of those special cases which are not opting the corner solution of international trinity because India is following the intermediate policies, i.e. partial capital mobility, flexible exchange rate only till the fixed level and partial independence of monetary policy. The Reserve Bank of India is increasingly facing the complex challenge of trying to pursue an open capital account, an independent monetary policy, and a managed exchange rate. Given that India has gradually opened up its capital account, the Central Bank is being forced to choose between the other two corners of the impossible trinity i.e., an independent monetary policy and a stable exchange rate. Therefore, the choice of fully convertible capital account is associated with the cost of loosing either the monetary independence or the exchange rate stability. As each one of the policy objectives has some costs along with benefits and policy makers should always be careful while exercising certain combinations of these policies.

Literature Review

Aizenman et al. (2008) have made a major contribution by the construction of three indices for trinity analysis i.e. Monetary Policy Independence Index, Exchange Rate Stability Index and Capital Openness Index. Many other economists like Obstfeld et al. (2004), Hagen and Zhou (2005), etc. have also made empirical attempts to test the validity of trinity hypothesis but they have not considered all the three corners of trinity triangle but only two out of the three.

A little amount of empirical work has been done to test the validity of trinity hypothesis in Indian economy. However, few names can be mentioned for their contribution in this field like Kramer et al (2007), in their empirical work have proved that no strong relationship exists between degree of stability in monetary conditions and the choice of a particular exchange rate or monetary regime. Therefore, international trinity hypothesis is not valid for Indian economy. On the other hand, Gupta and Manjhi (2011) by using data for the period 1980-81 to 2009-10 concluded that international trinity is valid in India and India has adopted middle solutions. However, Joshi (2003) has found that the Indian economy has saved itself from the heat of East-Asian crisis by following the combination of exchange rate targeting with monetary independence. On the other hand, the empirical study by Hutchison et al. (2012) has accepted the existence of trinity in India and this study has also concluded that the monetary independence is helpful in improving the macroeconomic stability in the Indian economy.

Some studies are also available to know the pros and cons as well as necessary conditions of capital account convertibility. In this context, Seth and Verma (2009) have proved empirically that capital account openness affects positively the pace of growth of Indian economy. Therefore, India should go for higher degree of capital account convertibility. Moreover, authors like Patil (1999) and Amodua (2007) have suggested that every economy should adopt all the necessary reforms like development of stabilization policies, trade policies, domestic banking system and domestic capital market, etc. On the other hand, Padmanabhan (2015) has supported capital controls but at the same time said that it is impossible for India to adopt these controls as it has become part of globalized world and it is pertinent for India to open up its capital account.

Database, Methodology & Construction of Trinity Indices

The empirical analysis is based upon the monthly data over the period 1980M1 to 2016M12 retrieved from International Financial Statistics (IFS) database of International Monetary Fund (IMF). The variables extracted are Call Money Rate (CMR), Federal Rate, Exchange Rate of Indian Rupee in Dollars, Net Capital Inflow, and Gross Domestic Product (GDP) at factor...

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