In part 2, I will attempt to explain the monetary arrangements that are being pursued by BNM and how ultimately its hands are tied in relation to what the institution wants to achieve. In the economics field specifically monetary policy, there is a an empirically proven tri-lemma that exists for central banks to follow. The three “perfect” conditions are as follows:
- Independent central bank
- Fixed/Stable exchange rate
- Free capital flows
It follows that a central bank can only hope to have two of the conditions and to forgo the last one whichever it chooses. For example, if the central bank wishes to be independent and have a fixed exchange rate, it needs to close the capital account. If the central bank wishes to be independent and maintain free capital flows, it needs to operate a flexible/floating exchange rate.
At this point, I believe I would need to elaborate what these conditions mean. An independent central bank means that the institution itself is able to pursue its own policies in the economy by using domestic interest rates to increase or decrease economic growth with a trade-off to inflation. For example, during a recession, an independent central bank has the option to decrease interest rates to increase consumption and investment. And if the central bank is in the opinion that inflation is too high, it can increase interest rates to decrease consumption and investment, bringing demand and ultimately prices down.
A fixed/stable exchange rate means that the central bank engages in the foreign exchange market to buy or sell foreign currencies to maintain the exchange rate at a certain rate. For example, in the previous part, I illustrated how the ringgit appreciated when the demand for the ringgit increases. What if as the central bank, I would like to depreciate the currency back to its original price level of p1?
I would in theory, buy USD in the open market to appreciate the USD in relation to the ringgit (ringgit depreciates when USD appreciates). How do I do that? By increasing the supply of ringgit to buy the required USD to depreciate the ringgit back to p1. (shift of SS1 to SS2).
Free capital flows means that investors, corporations are free to move money around into or out of domestic markets without restrictions. Think China if you want a restricted capital flows in that foreign investors have many restrictions to acquire any Chinese assets. (though, they can do so now with a channel from Hong Kong)
So what monetary arrangements does BNM now operates? BNM operates as an independent central bank with “free” capital flows (I am hesitant to state it as completely free since there exists an extensive regulation regarding capital flows still) and lets the ringgit float. What happens lets say if BNM decides to violate this condition to pursue exchange rate stability alongside all these conditions?
Now assuming BNM pursues all three objectives, and the Malaysian economy is in recession, the right thing for an independent central bank to do is to decrease interest rates to spur consumption and investment by printing more ringgit. Because the domestic interest rate has decreased, investors would shift their money overseas with higher interest rates ( free capital mobility so investors are able to shift). They would sell their ringgit in exchange for whatever foreign currency that is required to purchase foreign assets. The demand for foreign currencies will increase causing the ringgit to depreciate in relation to foreign currencies. But BNM still wants to pursue a fixed exchange rate because it wants to provide a stable currency for trade. It has to now used its foreign exchange reserves in its vaults to buy the ringgit in the open market to appreciate it back to its original level.
This isn’t a problem – as long as BNM has infinite foreign currencies but we know this isn’t the case. When foreign currencies run out in the central bank, the central bank is faced with some tough choices:
- Defend the fixed exchange rate, keep capital flows free, but contract its monetary policy (increase interest rates which decrease consumption and investment) in a recession.
- Keep capital flows free, keep interest rates low (fight the recession), but abandon its commitment to defend the exchange rate at a fixed rate
- Keep interest rates low (fight the recession), defend the exchange rate, but restrict capital flows (investors are not able to shift their money out from the country)
I hope its obvious now that BNM as a central bank is not able to “control” the ringgit without forgoing one of the two conditions of free capital mobility and an independent central bank. This is why I have always been opposed to the idea of controlling the exchange rate without first considering the effects of changing the other conditions. Now, I do have my reasons why Malaysia at this juncture is suited more to its existing conditions but that is another topic for another day.
That completes part 2 on why BNM would ultimately face the trilemma condition if it decides to consider controlling the ringgit. In the last part of part 3, I would attempt to explain what the exchange rate means to Malaysia and how it does not fully reflect the Malaysian economy in my opinion.