Against the backdrop of the most severe financial crisis since the Great Depression, the issue of the trilemma – the hypothesis that a country may only achieve at most two of three goals: monetary independence, exchange rate stability, and financial integration – seems rather distant. We would argue that, on the contrary, the way in which the trilemma has been addressed and how it will constrain future policy choices are questions that need to be answered in order to understand how the world economy has arrived at this juncture. In particular, reserve accumulation on the part of East Asian countries can be viewed as part of how the stage was set for the low interest rates that are blamed by some for the speculative excesses of the last few years.
Reserves and the trilemma
Many have argued that the recent reserve accumulations are closely related to changing patterns of the trilemma among developing countries. There is now good empirical evidence on this. Calvo (1998) suggests that international reserves can reduce both the probability of a sudden stop and the depth of the resulting output collapse. Aizenman and Lee (2007) link the large increase in reserves holding to the deepening financial integration of developing countries and evidence that international reserve hoarding serves as a means of self-insurance against exposure to sudden stops. Cheung and Ito (2007) find that the explanatory power of financial variables as determinants of international reserves holding has been increasing over time while that of trade openness has been declining. Obstfeld et al. (2008) find that the size of domestic financial liabilities that could potentially be converted into foreign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of international reserve stocks.
Shifting positions in the trilemma policy triangle
In a recent paper, (Aizenman, Chinn and Ito, 2008) we study the development of trilemma configurations over the last four decades and find that developing countries, and particularly emerging markets, have moved towards greater exchange rate flexibility and deeper financial integration. More recently, since 2000, developing countries have converged towards managed exchange rate flexibility, monetary autonomy, and financial integration; all enabled by the accumulation of unprecedentedly large international reserves holdings.
So far, the adjustment of emerging economies to the liquidity crisis has proceeded in line with this new trend –the real exchange rate and monetary policy have taken the first brunt of the adjustment. Given the magnitude of the disruption, the absence of deeper adjustment so far is a testament that the observation that the intermediate ground in the trilemma, combined with proper governance and management, allows for a softer landing.
In our paper, we also test and confirm the linearity of the three aspects of the trilemma. In other words, a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two. The textbook trilemma is illustrated in Figure 1.
Figure 1. The trilemma framework
It shows that it is impossible to be simultaneously on all three vertexes of the triangle; a country choosing financial integration, for example, must either forego exchange rate stability to preserve a degree of monetary independence or forego monetary independence to maintain exchange rate stability. Over the last two decades, a growing number of developing countries have opted for hybrid exchange rate regimes – e.g., managed floats buffered by increasing accumulation of international reserves (henceforth “IR”). Despite the increasing pervasiveness of greater exchange rate flexibility, IR/GDP ratios increased dramatically, especially in the wake of the East Asian crisis (see Figure 2). Most of the accumulation has been in Asia.
Figure 2. International Reserves/GDP, 1980-2006
Measuring the trilemma
In our paper, we construct three “trilemma indexes” that measure, on zero to one scales, each country’s monetary independence, exchange rate stability, and financial integration. Figure 3 presents vectors of the three indexes plus the IR/GDP ratio in the “diamond charts” for different income groups over the last four decades.
Figure 3. The recent history of trilemma and international reserves configuration
In each diamond chart, the origin is normalised so as to represent zero monetary independence, pure float, zero international reserves and financial autarky. The figure reveals that developing countries moved over time towards greater exchange rate flexibility and deeper financial integration. Both trends are more pronounced for the emerging market countries than for the non-emerging ones. There has been a decline in monetary independence and sizable increase in international reserves, trends that are again more pronounced for the emerging market countries in the 2000s. In contrast, industrial countries, after giving up some exchange rate stability during the 1980s, increased the stability of their exchange rates during the 1991-2006 period. They moved towards comprehensive financial integration much faster than developing countries. On average, industrial countries ended up with lower monetary independence and lower IR/GDP.
Figure 4 illustrates regional trends in developing countries. The move towards exchange rate flexibility is most evident in developing Asia and Latin America. Emerging Asian economies shared this trend until 2000, at which time exchange rate stability started increasing. The gain in IR/GDP is shared by all these regions, but is much more pronounced in emerging Asia. While the move towards financial integration applies to all these regions, it is more pronounced in Latin America than in developing Asia.
Figure 4. The recent history of trilemma and international reserves configuration regional patterns of developing countries
NOTES: “Emerging Asian Economies” includes China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. “Emerging Latin America” includes Argentina, Brazil, Chile, Colombia, Ecuador, Jamaica, Mexico, Peru, Trinidad and Tobago, and Venezuela.
Trends and tradeoffs
For the industrialised countries, financial opening accelerated after the beginning of the 1990s and exchange rate stability rose after the end of the 1990s, reflecting the introduction of the euro in 1999. The extent of monetary independence has experienced a declining trend, especially since the early 1990s. Until 1990, exchange rate stability was the policy most frequently pursued by developing countries, although it was in decline since the early 1970s. During the 1990s, the level of monetary independence went up, as more countries adopted floating exchange rates and liberalised financial markets. Since 2000, interestingly, all three variables in developing countries have converged towards managed exchange rate flexibility, presumably buffered by holding a sizable amount of international reserves, while retaining monetary autonomy even as financial integration proceeded. These trends are presented in Figures 5 and 6.
Figure 5. Development of the trilemma indexes: Monetary independence, exchange rate stability, and financial openness since 19701
(a) Industrialised Countries
(b) Developing Countries
One question is how the tradeoffs between the three goals are affected. Since the trilemma framework does not impose an exact functional restriction on the variables, we conduct a regression analysis to test a simplest functional form, i.e., whether the three trilemma policy measures are linearly related. Our test results confirm that the weighted sum of the three trilemma policy variables adds up to a constant and explains about 95% of the variation. These results provide evidence that a rise in one trilemma variable results in a drop of a linear weighted sum of the other two (upper panels in Figure 6). The regression results also provide a simple description of the changing ranking among the three trilemma policy goals over time (lower panels in Figure 6), a picture consistent with what is depicted in Figure 5.
Figure 6. Policy orientation for industrial and developing countries
(a) Cumulative Effects:
(b) Individual Effects
In sum, we have provided what we believe is a useful means by which to summarise what policy configurations countries have selected and how specific measures are traded off against each other.
Aizenman, J. and Lee, J. 2007. “International reserves: precautionary versus mercantilist views, theory and evidence,” Open Economies Review, 2007, 18 (2), pp. 191-214.
Aizenman, J., M. D. Chinn and H. Ito 2008. “Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time,” NBER WP 14533.
Calvo, G. 1998. “Capital Flows and Capital-market Crises: The Simple Economics of Sudden Stops.” Journal of Applied Economics 1: 35–54.
Cheung, Y-W and H. Ito. 2007. “Cross-sectional analysis on the determinants of international reserves accumulation,” mimeo, University of California, Santa Cruz.
Chinn, M. D. and H. Ito. 2008 “A New Measure of Financial Openness.” Journal of Comparative Policy Analysis, Volume 10, Issue 3, p. 309 - 322.
Obstfeld, M., J. C. Shambaugh, and A. M. Taylor, 2008. “Financial Stability, The Trilemma, and International Reserves.” NBER WP 14217.
1 Monetary Independence (MI): MI = ; i refers to home countries and j to the base country. Exchange Rate Stability (ERS); ; is the absolute value of the year-on-year depreciation rate, and is the annual standard deviations of the monthly exchange rate between the home country and the base country. Financial Openness/Integration (KAOPEN): Chinn and Ito index of financial openness [see Chinn and Ito (2008)].