John Marcus Fleming’s and Robert Alexander Mundell’s “impossible trinity”, better known as the “trilemma,” presents a poignant picture for most monetary policymakers.

The concept stipulates that a country cannot have 1. Free capital flow (no capital controls), 2. A fixed/stable exchange rate, and 3. Independent monetary policy, all at the same time.

An able policymaker can, at best, achieve two of these three objectives at any given time.

The Governor of the Reserve Bank of India (RBI) currently faces the problem of trying to overcome the “impossible trinity”.

Over the past year, India has tried to maintain a relatively independent stance from the tightening monetary trend.

The rate hikes in India lag well behind the US Federal Reserve’s push to raise rates. India remains reluctant to increase rates due to the fear of causing a recession (possibly due to the next round of elections in 2024).

A lower interest rate arbitrage signifies a flight of capital back to the US (the world’s reserve currency) and an impending depreciation of the Indian rupee.

The foreign exchange reserves currently held stem from ‘hot money’ (from FIIs investing in domestic debt or equity markets to cash in on arbitrage opportunities) and corporate borrowing (for example, Adani Green Energy, Vedanta, etc.), not money earned from trade.

The “impossible trinity” tells us that if India wishes to maintain stable rates and exercise independence in monetary policy, it would have to restrict capital flows.

Through fiscal and monetary policy measures, India has tried to backstop the slide of the INR against the US dollar through half-hearted capital control efforts.

Hasty move

A hastily implemented import ban on laptops, tablets and other electronic goods, which later turned into a licence-based import policy (due to a lack of domestic manufacturers and thus supply), has been enacted to curb imports and encourage domestic manufacturing. However, these electronic goods play an essential role in the lives of many Indians and are, therefore, a relatively inelastic good.

The policy might end up instigating supply-pull inflation rather than preventing capital from flowing out of the country. Moreover, there has also been an increase in the tax rate on outbound remittances from 5% to 20%, further working to curtail capital outflow. Meanwhile, China, India’s largest trade partner, has been suffering symptoms of deflation, leading to rate cuts and a depreciating yuan.

The Chinese consumer price index fell by 0.3 per cent in July year-on-year. Additionally, the INR has appreciated by 4% against the Chinese yuan. A cheaper yuan compared with an expensive rupee makes China’s exports more competitive in the global markets and threatens to flood India’s domestic market with more affordable Chinese export goods.

The increase in imports in India from China due to a stronger rupee will likely place enormous downward pressure on the rupee. Capital controls (unless draconian) can seldom withstand pressure on the rupee from different macroeconomic factors for too long a period.

The global monetary tightening regime suggests the onset of a “funding winter”. The excess liquidity sloshing around in the US markets seems to be drying up with the fall of SPACs (Special Purpose Acquisition Companies) and other highly leveraged financial instruments. Moreover, with the US interest rates reaching a 22-year high, the attractiveness of equity investments in emerging markets like India wanes. The inevitable repercussion is the cessation of “sticky” equity investments.

Foreign Institutional Investors (FIIs) are offloading Indian debt due to the absence of profitable arbitrage opportunities, further stressing the rupee’s position.

Legendary investor George Soros had famously bet against the British pound, predicting a similar impending depreciation. The rupee’s depreciation seems inevitable, and attempts at resisting it seem futile at best and harmful at worst.

For the astute Indian investor, an impending depreciation in the INR and a complex macroeconomic situation present a dual-pronged opportunity. Firstly, pivoting to domestic companies predominantly earning in dollars (IT and Pharma) would shield the investor from the impending rupee depreciation.

These companies stand to gain as the rupee weakens, offering potentially attractive returns (weaker the currency, stronger the exports). Secondly, diversifying investments abroad becomes paramount, considering the trilemma’s implications and the looming funding winter. Over the next 18 months, hedging against domestic markets by investing in international assets can be protective.

The returns from investing in the US markets are twofold: 1) the general market returns from equities in the US and 2) An INR-USD arbitrage gain, which would materialise as the rupee depreciates against the dollar. India faces an intricate economic jigsaw, challenging policymakers, and investors. Navigating prudently with diversification is the key to enduring this financial storm.

(Anand Srinivasan is a consultant, Sashwath Swaminathan is a research assistant at Aionion Investment Services)

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