“Impossible Trinity” refers to the economic hypothesis which states that a country cannot simultaneously have:
In theory, a country must always sacrifice one of the three in order to meet the other two, and the textbook interpretation throws a wrench in pretty much all aspects of central banking which involve foreign currency reserve management. I cited it in my last blog post as the reason we all freak out now that Chinese reserves are shrinking, but really it’s also the reason we all freaked out when Chinese reserves were growing.
The concept of the Impossible Trinity is a simple one: basically at a fixed exchange rate, capital will always flow away from loose/inflationary/low-interest-rate currencies toward tighter/deflationary/higher-interest-rate currencies, if you let it. The concern is that for countries seeking to simultaneously maintain the three prongs of the trinity, foreign currency reserves would either explode to unmanageably high levels or drop rapidly to zero. Supply/demand imbalances for domestic currency almost always exist, and maintaining the trinity reinforces any imbalance rather than mitigating it, theoretically anyway. Let’s use China as the example.
During the reserve accumulation phase, demand for local currency was intense due to the dual current account and capital account surpluses. The currency was undervalued from both trade and investment perspectives – onshore interest rates and potential investment returns were higher than offshore, encouraging the “carry trade*,” and persistent trade surpluses indicated a competitive domestic economy. In order to maintain independent domestic monetary policy, i.e. to prevent the inflationary impact of freshly printed CNY, the reserve inflow was sterilized (see Part II: Mind the Sterilizer). Sterilization puts upward pressure on local interest rates which both highlights unsustainable sterilization costs (interest paid by the central bank exceeds interest received), and actually increases the attractiveness of the “carry trade,” potentially reinforcing the supply/demand imbalance for CNY, rather than mitigating it. In theory, reserves would grow continuously, until one prong of the trinity is abandoned.
Now the pendulum is swinging the other way: as capital flows out of China at the (mostly) fixed exchange rate, foreign reserves are depleted and prior sterilization must be reversed. Reverse-sterilization involves increasing CNY in the system through maturing bills and other central bank open market operations, as well as reserve requirement cuts to stimulate bank lending. These operations put downward pressure on domestic interest rates, which could in theory intensify the capital outflow, rather than mitigate it.
That cycle would not end until one of the following occurs: 1) the foreign exchange rate is allowed to float 2) the borders are closed to capital flow, or 3) the domestic central bank adopts a very tight local monetary policy stance – an enormous interest rate hike, i.e. policy which is not independent. Reserves could, in theory, drop to zero if no abandonment of the trinity occurs first.
If central bank foreign reserve balances balloon to unsustainable levels or drop to zero on the whims of economic agents acting en masse, then at the end of the day, what is the purpose of maintaining any foreign currency reserves at all?
Foreign currency reserves (as distinct from sovereign wealth, which is something else) serve the sole purpose of allowing a supply/demand imbalance to persist at a given foreign exchange rate. Intervention in the foreign exchange market, whether in the open market or in a parallel preferential system as in some EM countries, is all that reserves are good for. We know that in practice, economic agents do not always act en masse, and accumulation or depletion of foreign currency reserves provides a period of time in which the Impossible Trinity may be sustained temporarily.
Foreign Exchange management is a grey area, with few countries attempting to pursue the trinity rigidly. Crawling pegs, one-off revaluations, the spectrum of capital controls, all in addition to reserve management comprise a total package to manage fickle capital flows in and out of an economy. Capital flows are driven in theory by relative monetary policy stance but in practice are driven by human psychology, e.g. the imperfect assessment of a trade-off between carry and risk of devaluation, and plain old greed and fear. Additionally, while reserve managers soak up a supply-demand imbalance for currency, monetary policy stances at home and abroad are evolving naturally, which should affect flows. After all, the Fed has taken a big step in the dovish direction while U.S. data has disappointed in recent weeks. I would not be surprised to see China’s reserve depletion to have slowed markedly over this period. Big reserve stockpiles allow (considerable) time for supply-demand to equilibrate, while impossible-trinity-like conditions are maintained.
*“Carry trade” refers to the practice of foreign investors investing onshore to earn a higher rate of return than they could achieve in their own home currency. Success depends on the foreign exchange rate remaining stable.