India’s Trilemma: Financial Liberalisation, Exchange Rates and Monetary Policy¹

Abstract

A key challenge for macroeconomic policy in open economies is how to simultaneously manage exchange rates, interest rates and capital account openness – the trilemma. This study calculates a trilemma index for India and investigates its evolution over time. We find that financial integration has increased markedly after the mid‐2000s, with corresponding limitations on monetary independence (MI) and exchange rate stability (ES). In addition, we empirically confirm that a rise in one trilemma variable is traded off with a drop in the weighted sum of the other two, i.e. the trilemma configuration is binding in India. Finally, we consider the implications of changes in the trilemma index for macroeconomic outcomes. We find that greater MI systemically contributes to lower inflation, so the twin goals of ES and capital account openness may create policy dilemmas in particular economic environments. ES is associated with less inflation volatility, suggesting that there may be secondary benefits channelled through import and commodity prices. In these relationships, however, changes in international reserves are not statistically significant, suggesting that foreign exchange market intervention has not mitigated the trilemma trade‐off in India.

Is China or India more financially open?

“…Like Gupta Sen (2010), Patnaik and Shah (2012, p 195), rightly criticise Chinn-Ito for "not adequately captur [ing] the gradual easing of capital controls, since it continues to give the same score unless all restrictions [in any dimension] 2 See Bernanke et al (2011); on capital controls, see Ostry et al (2010Ostry et al ( , 2011a and Magud et al (2011). 3 See Glick and Hutchison (2009), Aizenman et al (2010Aizenman et al ( , 2011, Kohli (2011), Hutchison et al (2012) and Patnaik and Shah (2012). 4 See Lane and Schmuckler (2007) and Aizenman and Sengupta (2011). Capital account openness of China and India: de jure and de facto measures Graph 1 Chinn-Ito indices of de jure openness International assets and liabilities (% of GDP)…”

The Impossible Trinity: Where Does India Stand?

“…After the Balance of Payments crisis in 1991, a comprehensive series of liberalization, privatization and deregulation reforms were implemented in the banking sector, trade sector as well as financial markets in India, the net result being, over the next couple of decades the Indian economy witnessed several structural changes (Shah, 2008;Mohan and Kapur, 2009;Hutchison, Sengupta, Singh, 2011). In what follows, I provide a brief account of the Indian economy with respect to the two main tenets of the Trilemma-capital account openness and exchange rate stability.…”

“…Among the few empirical studies that have explored the issue of Trilemma in the Indian context, Hutchison, Sengupta and Singh (2011) were perhaps one of the earliest. In fact, it was also the first paper that took the ACI panel-data approach in measuring the Trilemma and modified it suitably to estimate the Trilemma in a time-series framework for a single country.…”

Central bank transparency and exchange rate volatility effects on inflation-output volatility

“…There are numerous studies that have investigated the negative effect of exchange rate volatility on economic growth (see among others, Aghion et al, 2009;Schnabl, 2009;Arratibel et al 2011) as well as its impact on inflation (Gosh et al 1996;Bleaney, 1999;Bleaney and Francisco, 2005;Hutchison et al 2012). However, less attention has been given to the effects of exchange rate volatility on inflation and output volatility.…”