##{"id":59193,"date":"2011-11-22T11:09:55","date_gmt":"2011-11-22T00:09:55","guid":{"rendered":"http:\/\/www.fnarena.com\/index.php\/2011\/11\/22\/the-financial-trilemma-in-china\/"},"modified":"2011-11-22T11:09:55","modified_gmt":"2011-11-22T00:09:55","slug":"the-financial-trilemma-in-china","status":"publish","type":"post","link":"https:\/\/staging.fnarena.com\/index.php\/2011\/11\/22\/the-financial-trilemma-in-china\/","title":{"rendered":"The Financial Trilemma In China"},"content":{"rendered":"

\n\tThe Financial Trilemma<\/span> In China And A Comparative Analysis With India<\/strong><\/p>\n

\n\tBy Joshua Aizenman<\/span>, Professor of Economics, University of California Santa Cruz and Research Associate, the NBER<\/span>; and Rajeswari<\/span> Sengupta<\/span>, Assistant Professor of Economics and Finance, Institute for Financial Management and Research<\/p>\n

\n\tEmerging markets face what some economists are calling a trilemma<\/span>. 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.<\/em><\/p>\n

\n\tPolicymakers dealing with the Great Recession of 2008-09 are confronted with what we call the ‘financial trilemma’<\/span>. This hypothesis, based on pioneering work by Mundell<\/span> and Fleming in the 1960s<\/span>, asserts that a country may not simultaneously target exchange-rate stability, conduct an independent monetary policy, and have full financial integration – it is a potent paradigm of open-economy macroeconomics (see Fleming 1962 and Mundell<\/span> 1963).<\/p>\n

\n\tThe sharp predictions of the trilemma<\/span> and its crisp intuitive interpretation made it the holy grail of the open-economy neo-Keynesian paradigm. A key message of the trilemma<\/span> is scarcity of policy instruments. Policymakers face a tradeoff, where increasing one trilemma<\/span> 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<\/span>. Instead, countries choose the degree of financial integration, monetary independence, and exchange rate flexibility. In Aizenman<\/span> et al (2008), <\/a>Joshua Aizenman<\/span> and colleagues outline the construction of three continuous measures of the trilemma<\/span> variables, and find that, over the last couple of decades amid rapid financial globalisation<\/span>, emerging market economies have mostly opted for managed exchange-rate flexibility buffered by holding sizeable international reserves while increasing financial integration and preserving the degree of monetary independence.<\/p>\n

\n\tThe trilemma<\/span> in China and India: Data analysis<\/strong><\/p>\n

\n\tIn a recent paper (Aizenman<\/span> and Sengupta<\/span> 2011), <\/a>we use the methods outlined above to analyse<\/span> the extent of the tradeoffs faced by policymakers in China and India.<\/p>\n

\n\tUsing quarterly data from 1990Q1<\/span> to 2010Q4<\/span> we measure monetary independence as reciprocal function of the correlation of interest rates in home country (China and India, respectively) and base country (United States). By definition the index lies between 0 and 1, with 1 indicating the greatest degree of monetary independence. We calculate the exchange-rate stability index using quarterly standard deviations of weekly change in log of LCU-US<\/span> Dollar exchange rate (RMB-USD<\/span> exchange rate for China and rupee-USD exchange rate for India). By definition, the exchange-rate stability index ranges from 0 to 1 and the higher the value the greater is the exchange-rate stability. We define the capital-account openness index as the ratio of the sum of inward and outward foreign investment flows to GDP, and we consider three types of capital flows – foreign direct investment (FDI<\/span>), portfolio, and others – as reported by SAFE for China and IFS for India.<\/p>\n

\n\tA continuous hypothesis of the trilemma<\/span> 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. The estimation approach we use here is to regress a constant on all three indices at the same time. The estimated coefficients provide us the weights attached by policymakers to the three policy goals.<\/p>\n

\n\tThe trilemma<\/span> in China and India: Empirical results<\/strong><\/p>\n

\n\tChina has clearly been placing more priority on minimising<\/span> exchange-rate fluctuations as a tool for macroeconomic management. The exchange-rate stabilisation<\/span> objective has been given more policy weight perhaps at the expense of monetary independence and especially capital-account openness.1<\/span><\/p>\n

\n\tIndia 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.<\/p>\n

\n\tPutting our results in broader perspective, China’s trilemma<\/span> configurations are unique compared to other emerging markets both in the predominance of exchange-rate stability, and in the failure of the trilemma<\/span> regression to capture a significant role for financial integration. In contrast, the trilemma<\/span> configurations of India are in line with results from Aizenman<\/span> et al <\/em>(2008, 2011), and consistent with predictions of trilemma<\/span> tradeoffs.<\/p>\n

\n\tOne 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. This would be the case if a large share of borrowing is allocated directly by the state banking system, with preferential treatment of state owned enterprises, and if the supply of credit to the private sector is segmented. Another unique feature of China is a combination of more stringent capital controls and massive hoarding of international reserves. China has been increasing its ratio of reserves to-GDP relentlessly without signs of convergence to a target ratio during the sample period. These policies may relax the trilemma<\/span> constraints in the intermediate run (see Aizenman<\/span> et al <\/em>2011). Furthermore, the emergence of endogenous capital flows circumventing controls in China (including trade mis-invoicing<\/span>) may reduce the explanatory power of trilemma<\/span> variables in China.<\/p>\n

\n\tIn contrast, the trilemma<\/span> configurations of India and its tradeoffs among policy goals are in line with results of other emerging markets. This is reflected both by the significant positive sign of all trilemma<\/span> variables, and by the ‘middle ground’ choices of India (see Hutchinson et al <\/em>(forthcoming) for more discussion).<\/p>\n

\n\tThe trilemma<\/span> in China and India: Impact on inflation<\/strong><\/p>\n