Mundell-Fleming In Action: The Trilemma Facing China And India

In two seminal papers, Nobel Laureate Robert Mundell and Marcus Fleming extended the basic Hicks IS-LM model to incorporate an external sector. The most interesting finding is what’s called the Trilemma – a country cannot simultaneously have exchange rate stability, free capital mobility and an independent monetary policy. You can at best target two of these variables, with the third left to market forces. Trying to achieve all three is effectively impossible, as it sets up inconsistencies in the economy that can and will be exploited by economic agents (read: financial markets).

That’s the real basis for the 1997-98 Asian Financial Crisis a decade ago – you can’t have your cake and eat it too. Most of the crisis victims opted for dropping exchange rate stability; Malaysia famously choose to drop capital mobility, then in 2005 followed the others towards exchange rate flexibility as well.

However, there’s nuances to the stark choices implied by Mundell-Fleming. In this new paper highlighted at VoxEU, the Trilemma choices are evaluated for China and India (excerpt; emphasis added):

The financial trilemma in China and a comparative analysis with India
Joshua Aizenman Rajeswari Sengupta

Emerging markets face what some economists are calling a trilemma. They cannot simultaneously target exchange-rate stability, conduct an independent monetary policy, and have full financial integration. So what to do? This column looks at how Asia’s giants are responding – and in different ways...

…Policymakers face a tradeoff, where increasing one trilemma variable would induce a drop in the weighted average of the other two variables. A lingering challenge is that in practice, most countries rarely face the binary choices articulated by the original trilemma. Instead, countries choose the degree of financial integration, monetary independence, and exchange rate flexibility…

…A continuous hypothesis of the trilemma is that policymakers can choose a combination of the three policy goals subject to a linear constraint, where the weighted average of the chosen capital-account openness, monetary independence and exchange-rate stability adds to a constant…

…China has clearly been placing more priority on minimising exchange-rate fluctuations as a tool for macroeconomic management. The exchange-rate stabilisation objective has been given more policy weight perhaps at the expense of monetary independence and especially capital-account openness.

India is strikingly different. All three indices are consistently and statistically significant in all baseline regressions. Going by the size of estimated coefficients, financial integration is clearly given more importance followed by exchange-rate stability and monetary autonomy…

…One possible interpretation is that the segmentation of domestic capital market in China and capital controls applied there implies that the ‘policy interest rate’ is not reflecting the stance of monetary policy….Another unique feature of China is a combination of more stringent capital controls and massive hoarding of international reserves…Furthermore, the emergence of endogenous capital flows circumventing controls in China (including trade mis-invoicing) may reduce the explanatory power of trilemma variables in China.

In contrast, the trilemma configurations of India and its tradeoffs among policy goals are in line with results of other emerging markets…

…Intriguingly, we find no evidence that hoarding reserves by China and India was associated with higher inflation. Apparently, throughout most of the sample, both countries managed to sterilise effectively, preventing spillover effects from hoarding international reserves to domestic prices…

…However, in China uncertainty is looming large about growing nonperforming loans (NPLs) in its banking system triggered by a massive surge in credit in the aftermath of the Great Recession. China’s loose monetary policy is also feared to have fuelled a real-estate bubble. In addition to these, China faces one major disadvantage in the coming decade or so, with regard to demographics – its population and hence labour force is rapidly ageing and shrinking.

India, on the other hand, has a relatively young population and hence theoretically should benefit from a large demographic dividend. But India is struggling to create more jobs to absorb the rising young labour force. Also, compared with China, India suffers from a major lack of infrastructure investment that is crippling big projects both in public and private sectors. India is also struggling with another set of problems in the aftermath of the Great Recession, the most worrisome being domestic inflation…In the coming decades, the above-mentioned issues will play a crucial role in modifying the context of the trilemma paradigm for these two rising giants in Asia.

I think there’s more research called for here. One of the problems is that I think an equal weight placed on all three policy objectives is non-optimal – a little bit of exchange rate stability, a little bit of capital mobility, and a little bit of monetary independence, all adds up to a precarious balancing act that may only be postponing judgement day.

In this context, I prefer China’s approach of unequivocal dedication to a single policy goal. At most, you’d try for two. Going for the hat-trick, even with some flexibility involved doesn’t strike me as long term sustainable.

But mind the two areas of concern raised by Aizenman and Sengupta – China’s demographics and India’s lack of infrastructure, which will form constraints on future growth. Of the two, India’s hurdle is the easier to overcome, while China’s more resembles a brick wall. Short term, China’s growth is more likely to pull up the rest of the region, but India has the better long term prospects. Just be careful over the next 5-10 years or so – mixing financial sector liberalisation and capital mobility can be incendiary, as East Asia found out in the 1990s.

Technical Notes:

Aizenman, Joshua & Rajeswari Sengupta, “The financial trilemma in China and a comparative analysis with India”, VoxEU, November 2011 (accessed November 16, 2011)

Aizenman, Joshua & Rajeswari Sengupta, “The financial trilemma in China and a comparative analysis with India”, Draft, November 2011 (warning: pdf link)