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Hong Kong and Singapore’s Experience on the Impossible Trinity and its Implications for the Mainland

In the 1960s, Robert A. Mundell and J. Marcus Fleming pointed out in a general equilibrium model that monetary policy is effective in both fixed and floating exchange rate regimes if there is no free flow of capital. However, with free flow of capital, monetary policy will only be effective under a floating exchange rate regime, and ineffective under fixed exchange rate. As such, the Mundell’s Impossible Trinity stated that it is impossible to achieve all of the following three policy options at the same time, i.e. stable foreign exchange rate, free capital movement, and independent monetary policy. The policymakers can only choose two out of the above three policy options.

1.    Why is it impossible?

Based on the mechanism of the Impossible Trinity, if a fixed exchange rate economy opens to foreign capital flows, tries to have an independent monetary policy and sets its interest rates higher (or lower) than the global level, it will receive substantial capital inflows (or capital outflows) which will be present as long as the interest differential persists. The combination of interest rate differential and a fixed exchange rate sets up an arbitrage opportunity which is irresistible. If the policymakers try to hold down the exchange rate (or support exchange rate) through intervention, this will increase (or decrease) the monetary base and hence lower (or higher) interest rates, frustrating the policymakers’ attempt to have an independent monetary policy. Therefore, it is only when the policymakers let their exchange rate floats, an equilibrium is achieved in which they can maintain higher (or lower) interest rates and independent monetary policy, with an appreciating (or depreciating) exchange rate. 

The key of the Impossible Trinity rests on the effective operation of uncovered interest rate parity. Arbitrage opportunity will occur if the difference in interest rates between the two economies is not equal to the expected change in exchange rates between their currencies. With free flow of capital, arbitrage activities will occur until the condition of interest rate parity holds again, i.e. no more discrepancy between interest rates and expected change in exchange rates between the two economies. The arbitrage activities will guarantee equalisation of the returns of similar financial assets denominated in different currencies. As such, the policymakers can only choose one of the following policy options.

i.    Allow free flow of capital and implement fixed exchange rate (give up monetary policy): With free flow of capital and fixed exchange rate, the policymakers could have no control over the monetary base and interest rate level. Capital flows will drive its interest rate towards the world’s average, weakening the effectiveness of its monetary policy. Indeed, Hong Kong chooses this policy option, with no capital control and the implementation of a currency board system. The Hong Kong dollar is now linked to the US dollar at a fixed rate of HK$7.80 to one US dollar, with the interest rate adjustment closely following that of the US.

ii.    Allow free flow of capital and implement independent monetary policy (give up fixed exchange rate): With free flow of capital and independent monetary policy, the interest rate differential will lead to capital movement which in turn will affect the exchange rate level and offset the impact of interest rate differences. As such, the capital movement will not affect its monetary base which ensures the policymakers could effectively implement its monetary policy, but not to maintain the exchange rate level. Most of the advanced economies and the relatively large economies adopt this arrangement.

iii.    Implement independent monetary policy and fixed exchange rate (restrict capital movement): The above two situations showed that the policymakers could only choose to control the interest rate or exchange rate if there is free flow of capital. It is only when the capital movement is restricted, the policymakers could control both the interest rate and exchange rate at the same time, similar to Malaysia after the Asian Financial Crisis.

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Content provided by Bank of China (Hong Kong)
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