Will RBI Trade Independent Monetary Policy To Stabilise The Rupee :- Impossible Trilemma Analysis

INR representation 

Introduction -

Recently, the Indian Rupee traded at 90.58 to the US$, which has weakened the Indian rupee significantly in the global forex markets. In fact, in the last 5 years itself, since the pandemic times, the Indian rupee has significantly depriciated against the US$ from 72 INR to 90 INR, which is a massive 20% in the last few years. Optimists, may point it as a trend that the Indian rupee has observed only against the USA, as USA's inflation has been imported into its currency and particularly, that the American economy has struggled since the pandemic, recording growth rates below its expectations. While, the current Trump tariffs on India, high interest rates in the asset markets are credited for such a weak performance of the Indian rupee against the US$, however, there are some macroeconomic fundamentals, which India is getting it wrong, which is reflected in the currency markets.

For starters, the value of a country's currency in forex markets is determined by factors like - inflation rate, interest rate, trade, net capital inflows amongst others, factors which are heavily linked with the monetary policy that the country takes. Here is where the Trilemma theory comes into play in international macroeconomics.

USD to INR

The Impossible Trilemma Theory -

The trilemma theory is central towards the working of macroeconomics in global markets. The trilemma theory basically says, that, at no point of time, a country can maintain - fixed exchange rates, independent monetary policy and free capital flows. In the ideal situation, a country can maintain only 2 of the 3  conditions, for example - during the gold standard era from 1880s to 1920s, countries maintained free capital flows and fixed exchange rates, but the monetary policies were not strong at all. Similarly, the Bretton Woods system, envisaged a system of independent monetary policies and fixed exchange rates, while curbing capital flows. Now these systems have been impacted massively, by host of factors one of them being geopolitical shocks.

This theory has also applied massively to the Indian context, for example, in the pre 1991 era, India exercised a policy of fixed exchange rates and independent monetary policy, while convinently missing out of international capital flows, while in the post 1991 reforms, India prioritized capital flows and independent monetary policies, despite facing massive economic shocks, which has resulted in India, not keeping a committment towards a peg and has virtually adopted a flexible or a floating exchange rates. This pattern can be seen, more pronounced since the 2000s, which has allowed India to gain massive access to global capital markets and keep inflation in check.

Now, economics 101, suggests that, a devalued currency, should lead to rise in trade markets which should be reflected in the currency markets of the country, however, the rising trade gaps, precisely due to higher import bills due to higher depriciation of INR,has resulted in increasing trade gaps, which is actually a worrying sign for the Indian economy.

INR performance with respect to other currencies -

This trend is worrysome, when compared even to the other currencies namely - the Euro, Swiss Franc, Japanese Yen, Russian Rouble, Britian Pound and Chinese Remnenbi, which are traded massively in the forex markets. The attached graph shows how the rupee has traded against these currencies, over the past 5 years.

A comparative graph of 6 non US$ currencies

As it can be seen from the above graph, almost all the currencies, barring the Japanese Yen have appreciated against the Indian rupee, which means that there is more to the eye than what is being predicted by "experts". The growth rates, average interest rate, inflation rates and trade deficits of all the countries has been given in the next table, to understand a better picture of what's happening with the Indian Rupee at the international market. Even the Russian rouble, has appreciated by a small margin in the last 5 years, despite the India - Russia petroleum trade going to an all time high. The same can be said, even with the currency markets of Switzerland, with whom India has signed an EFTA this year or with EU where, India has progressed ahead with the FTA or with the British Pound Sterling where India has concluded the long pending FTA this year. These factors again point to reasons apart from trade, which is resulting in the continued and to an extent the worrying trend of rupee weakening in the forex markets.

RBI's Powerplay -

The table below, shows the average interest rate in India, the average inflation rate in India, trade deficit as percentage of GDP, the net investments as percentage of GDP and average GDP growth sourced from the International Monetary Fund's World Economic Outlook report. The average data is taken from 2020 onwards. The last 5 years has been taken into account, as, the world economy has experienced significant economic shocks like - the cornavirus pandemic, the parallel expansion of BRICS, Russia Ukraine war, tariff  wars, Taliban's takeover of Afghanistan and the Middle East geopolitical crisis. In this context, it becomes important to see what kind of role did the central banks of these countries played, as majority of these countries, saw the political power of the incumbents being reduced massively.

For example:- In India, the highly popular PM Narendra Modi though is serving his third term, but had to depend on allies to form the central government post 2024 election, which has been separately analysed electorally by me, USA saw 2 different election results in 2 presidential elections in this term, Japan - EU - UK have become absolute symbols of how political instability actually looks like where dramatic events like the assasination of Shinzo Abe or the return of labor party happened in the UK after years or the different corruption scandals that hurt EU during this phase, Brazil has also seen the return of Lula da Silva and Switzerland, has had multiple referendums passed during these 5 years. In this background, it can be safely said, that the central banks of these countries have somehow managed to become the key drivers of economic growth in their countries.

Country	Avg Interest Rate (%)	Avg Inflation (%)	Current Account (% of GDP)	Net investment  (% of GDP)	Average GDP growth
India	5.2	5.4	-1.6	4.2	6.2
USA	3.6	4.2	-3.2	7.8	2.2
China	3.1	2.1	+1.4	2.5	4.8
Japan	0.1	1.2	+2.9	3.6	1.1
EU	1.5	3.1	+2.2	4.5	1.4
UK	2.8	3.7	-4.0	9.2	1.3
Brazil	9.3	6.0	-1.3	5.1	2.4
Switzerland	0.4	1.4	+4.6	6.0	1.6

As it can be seen from the above table, the average central bank interest rate in India has been at 5.2% which is almost 1.6% percentage points higher than the Fed. The average inflation rate in India over the past 5 years has been at 5.4%, which means the RBI's policy has transmitted quite successfully to the Indian economy over the past 5 years. From, the first 2 columns, it can be very safely concluded, that the RBI pursued a committment based monetary policy, towards inflation control, which proved to be successful, as reflected in the average GDP growth that the country has recorded which is almost 2% points higher than China and has stabilised inflation well, which was critical during the above mentioned period as the country could have rapidly spiralled into a zone of hyperinflation, which is not good for the Indian economy.

However, too much independent autonomy for the RBI has ended up hurting the net investment, as India trails economies like - USA, UK, Brazil and Switzerland, in attracting capital inflows (both FDI & FII), which is majorly because of the high interest rates. Monetary tightening usually, has an inverse impact on net investments as, investing in the country becomes expensive with low yields which acts as a point of negative perception for the global capital markets. In this regard, from the above table, it can be interpreted that, those countries who have had lower interest rates have ended up benefitting in terms of net capital inflows which is even more critical in today's era of open macroeconomics, where concepts like global supply chains have picked up steam.

The higher growth rates of Indian economy can be explained due to the other factors like - good management of economy during the pandemic, good diplomatic practices, high capital expenditure and an uptick in domestic consumption, which has led to the 6.2% points figure which can be seen in the economy. However, to maintain the consistent economic growth, its extremely critical that, India, exceeds the output gap, which can be possible only through increased capital flows and the widening trade gap with high import bills due to a depriciated rupee(partly due to high interest rates) is not helping the cause of the Indian economy.

Hence, the carefully thought policy of Indian government and more specifically the RBI, to keep independent monetary policy and high capital flows, while not really bothering about the fixed exchange rates is ending hurting up even the high capital flows due to a super powerful central bank which can be seen via the 2 columns of average interest rates and average investment flows.

This can end up creating a mess like, what happened during the collapse of Bretton Woods, where the capital eventually flowed into countries despite a strong affection of countries towards the peg & an independent monteary policy, this resulted in the rapid emergence of emerging economies in the world with a fledgling downfall of the advanced economies, since 1970s which accelerated even more in 2000s. To avoid, losing the current economic edge that India, has, its extremely critical, that the external sector policies are changed. The first change can be perhaps, to give back importance to fiscal policy, so that, the RBI can focus on stabilising the rupee.

Plausible Steps -

Now, Indian policymakers over the years, has avoided taking knee jerk reactions and have instead always looked for a delicate balance between the monetary policy mechanisms and fiscal policy mechanisms. Furthermore, also because the RBI, is answerable to the parliament, the government system in our country, has always stuck a good balance between fiscal and monetary policy. This was primarily seen during the pandemic, where the government adopted a classical economics approach and the RBI also responded with monetary tightening, which is a textbook example of coordination between monetary and fiscal policy interactions.

Additionally, given, how the government system, behaves in India, sacrificing the independent monetary policy may seem to be a very big ask from the RBI. Even during the 1991 LPG reforms or during the response in pandemic, the government improves fiscal policy over the monetary policy, which results in different results. 

The only possible change that can happen, is changing the budgetary outlook, something which is still considered sacred in our country. The government of India, should perhaps consider, again increasing the capital expenditure to around 11 lakh crores (something that helped during the pandemic) and again starting the process of divestment of sick PSUs like Container Corporation of India, restarting the SEZs to boost exports something that I advocated in this blog long back and concluding the trade deals as quickly as possible for which the now out of favour idea of Indian Trade Service must be reintroduced in a massive scale by the UPSC and finally, the government, must allow 75% FDI into sectors like civil aviation, telecom, steel and maybe one or two, manufacturing based industries, which can really increase the job creation capacity of the economy. Moreover, the government should really speed up the 2 proposed projects of the INSTC route and Chennai Vladivostok logistics deal, which should also provide significant impetus to the economy and to the rupee in general.

The government, can take these steps, because of 2 factors - (1) The humungous scale of victories of the BJP in Bihar, Maharashtra, Delhi  & Haryana, which has again increased the political power of Narendra Modi, who is  the most reform oriented prime minister in Indian history and (2) The government has been cutting its fiscal deficits in a big manner since the last 2 budgets, which gives a fantastic legroom for the finance ministry to again increase capital expenditures, which can give massive boost to the economy. 

Finally, the RBI, should really considering steps like, cutting down the interest rates and maybe, selling of forex reserves which are at an all time high right now, to stabilise the rupee in international markets, adopting the dirty float by not allowing the rupee to depriciate below 85, as prolonged weakness of any currency ends up hurting factors like - investors confidence, export competitiveness which cumulatively, dents, the perception of the Indian economy. 

Conclusion -

While a tradeoff for independent monetary policy for the fixed exchange rate, seems very unlikely in India, the least we can do, is to maybe, empower the fiscal policy more and maybe, adopt a dirty float for like 2-3 years, to just stabilise the rupee from taking further geopolitical risk hits, while continuing on the path of reforms.