Haverford College

Economics of Development: China vs. India

Prof. Saleha Jilani

The trilemma as a framework for understanding China and India’s recent

monetary policy choices

By: Hiram Ruiz

Abstract:

The remarkable growth that has characterized China & India in recent years has been the subject

of much literature. China’s trade surplus, one of the largest in the world, has endowed it with extensive

foreign exchange reserves. This has allowed China to become a net lender. The development of the Asian

Infrastructure Investment Bank and moves towards full Yuan convertibility signal that China seems to be

departing from its previous policies of strict capital controls. India, to a lesser extent, has also been

changing its approach towards financial markets. How exactly has this change in policy been unwrapping

in both nations and what are its effects both internally, in the surrounding region and the world? This paper

will seek to answer this question using both a quantitative and historical approach. First, I will discuss

some of the existing literature on the subject. Then I will give a brief historical summary of the financial

market policies followed by each government since the 1990s. Once the reader has a grasp of the structure

and functioning of financial markets, I will introduce the trilemma as a framework which demonstrates the

different policy mixes a government can undertake. Finally, I will demonstrate where the countries started

within the framework, where they are heading, and possible prospects for the future using quantitative data.

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Introduction

The remarkable economic growth recently experienced by China and India, together with the fact

they comprise a large portion of the world’s population has turned them into important players in the world

economy. This has, in turn, motivated a vast amount of literature on a wide array of economic topics

pertinent to both the nations themselves, and the rest of the world. This paper will take advantage of the

abundance of literature on macroeconomic policy and financial markets regarding these countries in an

attempt to frame recent developments as breaks from previous policy stances, within the context of the

impossible trinity of international finance.

One of the most controversial topics within the trilemma is the usefulness of capital controls. IMF

publications such as: (Tseng W. et Al, 2005) and (Ostry, D et Al, 2011) tend to criticize the adaptation of

such policies. They generally cite the distortionary effects on the local economy, international implications

and the lack of credit such measures can induce as the main reasons for opposing the adoption of capital

controls. They do however, make exceptions for temporary controls meant to deal with short periods of

high volatility that arise purely from financial markets and not from fundamentals of the economy, such as

speculative attacks. Others, such as (Lane P. and Schmukler S. 2007) and more especially (Sen P. 2010)

acknowledge the role that capital controls have played in allowing these developing nations to retain

domestic macroeconomic control and exchange rate stability. This paper will examine the role capital

controls have played in China and India’s development strategy.

The exchange rate regime, a much contended topic within macroeconomics, will also be examined

closely in this paper. Currency interventions have enabled China and India to pursue, to lesser degrees of

course, export-led growth. Patnaik I. and Shah A. (2009) describe very insightful methods that attempt to

differentiate the de jure exchange rate regimes from the de facto exchange rate regimes followed by India

and China. They find that both central authorities have de facto pegged their currencies to the USD until

very recently. The choice of exchange rate regime becomes very important when combined with free capital

flows. Essentially, a peg cannot be maintained indefinitely without sacrificing monetary policy sovereignty.

Hence, nations such as China and India have used capital controls in order to maintain both a stable

exchange rate and monetary sovereignty. This basic tradeoff, known as the “trilemma” will be the main

focus of this paper. Before we delve into the mechanisms that create this phenomenon, it is first important

to explore the recent state of financial markets in both countries since they play a central role in the

trilemma.

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Domestic Financial Markets

Chinese financial markets are considered far less developed than their Indian counterparts. Dobson

W. (2006) undertakes the task of comparing the state of both domestic financial systems side by side. She

finds that the most significant problems plaguing them at the time were the prevalence of government

ownership of banks and the underdeveloped state of corporate stock markets. Lane P. and Schmukler S.

(2007) devote part of their chapter in “Dancing with Giants” to this same topic. This section will summarize

their findings more closely and provide an update on the state of both financial systems in order to gauge

the progress China and India have made since the time of writing of these papers nearly a decade ago.

One of the most criticized characteristics that both of these countries’ financial systems share is the

large portion of government ownership of banks. At the start of the 1990’s both nations had very primitive

domestic financial markets by western standards. The period from the 1970’s-1980’s brought a mass wave

of bank nationalization to India in an attempt to increase the savings rate by opening bank branches in

remote rural locations. After this, only 10% of banks in India remained under private or foreign ownership.

(Dobson W. 2006) At the start of the 1990’s however, India faced a balance of payments crisis which forced

it to undertake extensive liberalization as a condition for being bailed out by the IMF. This period saw a

freeing of FDI and most portfolio flows, with the capital account from abroad remaining heavily restricted.

In 1997 the Tarapore Committee issued a detailed framework and timeline for full capital account

convertibility, which it then had to be postponed due to the Asian Financial crisis of the late 90’s.

Nevertheless, liberalization has continued at a steady pace, and Indian financial institutions resemble their

western counterparts in many ways.

Chinese financial markets follow a similar pattern. The People’s Bank of China controlled both

monetary policy and collecting savings until 1984, when four state owned policy banks were given the

latter function. These banks primarily channeled savings into the country’s state owned enterprises (SOE’s).

1995 brought a series of institutional reforms which aimed to establish lending based on creditworthiness

by introducing prudential norms and a change of governing structure. However, these four big banks still

continue to dominate the financial sector to this day, and the other commercial banks are owned by local

governments. The pervasion of government ownership of the banking system is thus much deeper in China

than in India.

Table 1.1 shows government ownership of banks in India and the breakdown of China’s banks,

which are for the most part all government owned. In India one can notice a gradual entry of private

ownership into financial markets, where private institutions have gone from 20% of market share (% of

total assets) in 2005 to 25% in 2013. In China, although banks remain much more strictly controlled by the

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Table 1.1 Banking Sector Breakdown (% Total Assets)

government, some degree of de-centralization can be observed. The big four commercial banks, which are

owned and operated by the central government have been losing market share to smaller institutions which

are mostly owned by local governments. The market share of the big four commercial banks has dropped

an impressive 10% over the span of 9 years. Although the Indian government still owns the vast majority

of banks in India, it has made considerable progress in reducing its share of assets. In China, although some

de-centralization is seen, the government still owns a significant stake in every bank. Both countries have

reformed management structures, incentive schemes for managers and prudential standards. However, the

distortions government ownership creates with misdirected lending to poorly preforming sectors cannot be

completely corrected with oversight reform. (Dobson 2006)

China 2005 2014 Big Four Commercial Banks 52.5 43.23

Joint Stock Banks 15.5 17.9

City Commercial Banks 5.4 9.97

India 2013 Public Sector Banks 75 70.85

Private Banks 19 21.45

Foreign Banks 6 7.68 Sources: China Banking Regulatory Commission & Indian National Reserve

The lack of a strong stock market is another widely cited impediment in the development of Chinese

and Indian financial markets. Figure 1.1 shows stock market capitalization as % of GDP for both India and

China. It also includes Singapore and Korea, since they are liberalized Asian economies which will serve

as comparison. Unsurprisingly, China is at the bottom of the list, with a market capitalization of just under

50% of GDP. It worth noting that a large portion of this is made up of the stock of state owned enterprises,

so the private sector market capitalization will be somewhat lower than shown. India has a larger market

capitalization, around 65%, which is unsurprisingly larger than China’s. Its share of government owned

stock is only 30%. This means that India has both more market capitalization as % and GDP and a higher

portion of it comes from private sector firms. It is clear from the figure however that both countries have

much work to do. Although we can’t expect a country such as China or India to have the same market

cap/GDP ratio as a financial city-state such as Singapore, a percentage closer to Korea’s is likely to result

from further financial liberalization.

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Chinese and Indian financial markets are wildly different from those in more liberalized economies.

The penetration of governments in commercial banking and the undeveloped state of capital markets affects

the allocation of lending. Although India has more banks in private hands and a much more developed stock

market, significant distortions still remain which provide credit to loss making firms at the expense of profit

making ones which go under-funded. Financial markets play a key role in the trilemma, and their

development is required to be able to tap into international capital flows without excessive exposure to risk.

The Trilemma

The Trilemma is a hard choice policymaker’s face in international finance. Figure 1.2 summarizes

the “choose-two-of-three” problem graphically. Completely unrestricted capital flows should lead to the

no-arbitrage uncovered interest rate parity condition. This directly relates exchange rates to interest rates

and hence governments, when faced with currency inflows/outflows, must decide to either let their currency

appreciate/depreciate or to intervene forcedly by adjusting the money supply. This would of course lead to

movements in interest rates which could very well be undesirable. It is not hard to see why countries such

as China and India would be reluctant to give up these two important developmental tools. Until recently,

both countries decided to restrict capital flows in order to retain both exchange rate stability and monetary

sovereignty. In the following sections I will examine each component of the trilemma individually, and

each country’s experience with them. Because both countries utilized very strict capital controls until very

recently, it will be useful to begin with this topic.

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Figure 1.1 Stock Market Capitalization (% of GDP)

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Capital Controls

Capital controls have played a key role in the developmental policies followed by China and India

in recent times. The IMF until very recently preached full capital account convertibility and openly opposed

any type of capital controls. However, international financial developments such as the Asian financial

crisis of the late 90’s and the 2008 sub-prime mortgage crisis in the US have changed the IMF’s stance on

the issue, albeit only minimally. This section will discuss the nature of capital flows and their effects on

developing economies; it will also summarize the experience of China and India with them.

First, some caveats are in order. Capital flows are a very broad term for describing the international

movement of myriads of different types of investment vehicles which vary in inherent risk and maturity.

Distinguishing between them becomes important when talking about financial system stability. Some

authors have undertaken the task of ranking different types of assets by order of riskiness, putting foreign

denominated debt as the most risky and Foreign Direct Investment inflows at the least. (Ostry et al. 2011)

In general, portfolio flows will always be more volatile than direct investment because while the first can

be sold instantly and its value moved out of the country, foreign direct investment cannot usually be

liquidated easily. Thus, FDI inflows are more stable and represent a bigger commitment to the recipient

country than fast moving portfolio flows. Maturity is also related in a similar manner, since short term

inflows can become outflows faster than vehicles with longer maturities. In addition to this, the degree of

controls can vary marginally in the context of different countries. No country has completely open or closed

capital accounts, but some mix of restrictions that can be marginally different from the restrictions of

another country. All of these complexities, in addition to others that will soon be explained, make measuring

Figure 1.2

Free Capital Flows

Monetary

Sovereignty

Exchange Rate

Stability

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the degree of capital controls of a country a difficult affair. However, many have undertaken the task of

measuring the level of capital controls of an economy. Exactly how to do this is a contentious debate within

the literature.

Although a thorough comparison of the different methods for measuring capital controls is beyond

the scope of this paper; due to the complexities detailed above one cannot simply use a single measure as

evidence of capital controls. For this reason, it is important to look at various different measures, keeping

in mind their limitations and what they are actually measuring. Measures can be grouped into two large

types: de jure measures and de facto measures. De jure measures utilize laws and policies officially followed

by the governments in order to create an index of “freeness”, while de facto measures try to gauge to the

extent to which the official laws are actually enforced on the ground. There are also hybrid measures which

include both de facto and de jure measures, but those will not be discussed.

Figure 1.3 shows an index of freedom of investment in India and China from 1995 to 2015. The

index is compiled from a vast number of de jure variables which try to capture the restrictive effects of

capital controls. It ranks countries from 0 to 100 based on such policies, with anything under 50 being

considered a very restricted capital account. As can be observed, both countries have liberalized their capital

accounts over time, albeit gradually, and only during 2000s. Quinn D. et al (2011) find this measure very

imprecise, due to the binary nature of the variables used, the fact that the index only captures de jure

variables and the observation that the US is ranked the same as Albania, Algeria and the Republic of

Mozambique, which are all considered much more closed to capital than the US. A much stronger de jure

measure of capital controls can be found in recent IMF publications.

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Figure 1.3 Hertitage Foundation's Investment Restrictivenes Index

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Fernandez, A. et al (2015) construct a data set that not only measures capital controls across time

and countries broadly, but also includes data on inflow and outflow restrictions separately. Figure 1.4 and

1.5 show the evolution of capital controls on inflows and outflows of China and India from 1995 to 2013.

The index ranks countries from 0 to 1, 0 being the most free and 1 the most restrictive. Note that both India

and China are located at the restrictive extreme of the spectrum, as the previous index also showed. Both

also exhibit rapid liberalization during 1997, the year of the Asian financial crisis. A reversal however, can

be observed in China during the year 1999 and in India during 2001. This reversal seems sustained until

the present day, and interestingly enough, China appears to be somewhat (.10 point) more liberalized in

2013. This is due to the heavy restrictions India keeps on outflows, but can also be attributed to the nature

of the index, which is measures de jure variables of liberalization. In order to completely grasp the

experience with capital controls fully, it is important to take a look at a de facto measure of capital openness.

Lane and Milesi-Ferretti’s (2006, 2007) de facto measure, which has been called the “industry

standard” of de facto measures for capital openness (Quinn D. et al, 2011) takes the sum of total assets and

liabilities in a nation’s financial market and divides it by GDP. Such a measure will reveal how well

integrated a financial market is to the rest of the world, and the division by GDP allows us to grasp the

magnitude relatively fairly by country. Figure 1.6 shows the evolution of this measure for China and India

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Figure 1.4 China Capital Controls (Fernandez et al. IMF)

China Inflows China Outflows China Overall

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Figure 1.5 India Capital Controls (Fernandez et al. IMF)

India Inflows India Outflows India Overall

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from 1990 to 2011. It also includes Singapore and South Korea for contrast. Figure 1.7 drops Singapore

from the figure, as it makes looking at China’s and India’s data difficult due in part to its small GDP. An

overall trend of opening can clearly be observed, as in all countries assets + liabilities have become a larger

fraction of GDP. The late 90’s and the remarkable liberalization of the Asian tigers can clearly be observed.

The sharp increases contrast strongly with the relatively gradual increase of China and India. The

quantitative data seems to align well with our previous two indices, depicting both countries’ capital

accounts as heavily restricted to similar degrees. Both de jure and de facto measures seem to show China

somewhat more open to capital flows than India, which is surprising considering the state of India’s

financial system compared to China’s. This could be attributed to a mix of many reasons, from measurement

inaccuracy to size of the economies. One thing is clear, measuring such a broad term as capital controls will

always be a hard affair. Even after looking at many different indices, there is reason to question what is

being measured. How to measure capital controls is an ongoing debate in economics, but one which pales

in comparison to the bigger debate on the effectiveness of capital controls.

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Figure 1.6 Financial Integration (Lane et al, 2006)

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Figure 1.7 Financial Integration (Lane et al, 2006)

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The effectiveness of capital controls is a much contended topic within economics. The vast majority

of the literature finds that they are ineffective in either assuring financial stability or driving a wedge

between interest rates at home and abroad (their role in the trilemma). However, these findings have been

attributed primarily to the difficulties of measuring capital controls discussed above and the fact that many

countries that impose capital controls do not have the necessary institutional strength to enforce them.

(Quinn D. et al, 2011) Some IMF publications (Ariyoshi A. 2000) find that India and China were successful

in implementing their capital controls due to the fact that they were isolated from the Asian financial crisis

of the late 90’s. Figures 1.6 & 1.7 above clearly show this. Notice how India and China were relatively

unaffected when compared to Singapore and Korea which were much less isolated financially. The paper

attributes this to the institutional strength of both countries which allowed them to enforce the controls and

the fact that they imposed outright restrictions instead of market based restrictions (such as taxation of

flows). Imposing controls creates an incentive to circumvent them as individuals try to make riskless profit

from the interest rate spread between countries and the fixed exchange rate. Essentially, uncovered interest

rate parity does not hold anymore if a financial market is successfully isolated from the world. While the

effectiveness of controls is not the main focus of the paper, it is worth noting that there is a difference

between imposing controls and enforcing them. It is also fair to say India and China have been able to

bridge this difference quite well.

Free capital flows are extremely desirable from an international perspective. They allow

international consumption smoothing; that is, rich countries can invest their excess capital which would

yield low returns domestically into poorer countries and get higher returns, while poorer countries can enjoy

higher investment using capital from abroad. There are however significant risks involved with large,

volatile capital flows. If a recipient country’s financial system does not have the institutional or prudential

strength to adequately absorb the flows and the resulting risk, a financial crisis could easily ensue. This is

due to the fact that large inflows can easily turn into large outflows due to the easiness with which an

underdeveloped financial market can create a bubble. This duality of financial markets is the root of the

debate on whether capital controls should be implemented. While sources such as the IMF have accepted

the role that capital controls can play, they only encourage their adoption as a last resort against impending

financial crises. (Quinn D. et al, 2011) Their fear is the multilateral effects widespread adoptions of them

could have. This fear is not unfounded, a world were capital cannot cross borders would force every country

to finance its own development, and inhibit the international consumption smoothing mentioned above.

Some other economists however, have argued more favorably for their use.

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Two papers, one from the Asian Development Bank and another from the Delhi School of

Economics take a different posture to the IMF’s regarding capital controls. Maria Socorro Gochoco-

Bautista and Changyong Rhee (2013) expand upon the Quinn et al (2011) article quoted throughout this

paper in an attempt to ameliorate what they consider vagueness in the IMF’s protocol for recommending

capital controls. The IMF says that capital controls should be implemented after: “all macroeconomic

options have been exhausted.” They cite this as vague, which is fair, and suggest that capital controls should

be used as long as the country is not using it for “beggar-thy-neighbor” purposes. This means that countries

should not implement them in order to keep their currencies undervalued to gain competitive advantage. In

this sense, their opinions align well with the IMF’s since what they fear are the multilateral effects, they

even cite political tension, of following such policies. Partha Sen’s (2010) paper deals with India’s

experience with capital controls. He argues that India should have kept a tighter lid on capital flows, since

the flows have created a “Dutch Disease” type scenario that has made labor intensive manufacturing

(“India’s ticket out of poverty”) unviable. He cites the large fiscal costs of sterilization the RBI was forced

to undertake and the fact that an isolated financial market and high savings could have financed Indian

growth on more favorable terms than foreign capital as his arguments. Essentially, he argues in favor of

keeping the rupee undervalued in order to pursue export led growth, which is the equivalent of abandoning

free capital flows within the trilemma. This is exactly what the IMF and the Asian Development Bank argue

against, due to its possible multilateral effects. However, as sovereign states, China and India should be

able to use whatever tools they have at their disposal to pursue development. In addition, recent policies

such as quantitative easing followed in the industrialized world have sent with large and volatile capital

flows of cheap credit to developing countries. While the widespread and permanent adoption of capital

controls throughout the world would have devastating financial consequences, the temporary adoption of

them for developmental purposes might yield an optimal result if they speed up development by more than

the temporary multilateral effects they inflict on others. This topic will surely motivate a large amount of

literature in the future as developing countries take note of India’s and China’s recent experiences.

Exchange Rate Regimes

Exchange rate regimes have also played a key role in China and India’s developmental policies.

Both the People’s Bank of China and the Reserve Bank of India have taken different de jure stances on

exchange rate regimes, although there is substantial evidence that points to de facto pegging to the USD by

both nations until recently. (Patnaik I. Shah A. 2009) Figures 1.8 and 1.9 show the nominal exchange rate

to the USD of the Chinese National Yuan and the Indian National Rupee respectively.

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The two periods of pegging of the Yuan to the dollar, the first until 2005, and then from 2008 to

mid-2010 can clearly be observed from the figure above. The People’s Bank of China announced the peg

openly, something which caused significant controversy in the West, because of competitiveness issues.

Since 2011, foreigners can buy Yuan. It is now traded internationally and, the People’s Bank has steadily

increased the volume of Yuan that it trades daily. (Reuters 2014) These measures have caused the Yuan to

appreciate and there is significant evidence that points to the Yuan currently being fairly valued (Cline W.

2014), although due to political and economic reasons in the US, China is still accused of currency

manipulation. The size of China and the liberalization of the Yuan have created a currency bloc in Asia that

uses the Yuan as a reference point. Some predict that the Yuan will become a global reference currency by

mid-2030, although that time could easily be shortened if reforms are expedited. (Subramanian A. Kessler

M. 2013) The Chinese experience with exchange rate regimes is straightforward. The People’s Bank kept

Figure 1.8 CNY nominal exchange rate to USD Source: Google Finance

Figure 1.9 INR nominal exchange rate to USD Source: Google Finance

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a strict peg for some time in order to aggressively pursue export-led growth and speed up development and

more recently, it has allowed market forces to interact with the Yuan in a controlled manner. This has made

the Yuan appreciate and although Chinese firms will now need to deal with some exchange rate movements,

there is a very real possibility of the Yuan becoming a global reserve currency in the near future. The

experience with India is not as clear cut.

The Reserve Bank of India’s de jure exchange rate policy has been to let market forces determine

the exchange rate. However, the RBI intervenes regularly in the market and has de facto pegged the rupee

to the USD until very recently. Patnaik I. and Shah A. (2009) use a linear regression model that takes cross

currency exchange rates to a random freely floating currency (they use the Swiss franc) in order to gauge

how currencies follow the dollar’s path. They then rank countries based on their currency’s rigidity to the

dollar. They find that the Yuan is the 2nd most rigid currency to the dollar and that the Rupee is the 4th. From

January of 2002 to March of 2008 the dollar depreciated around 38%, the Yuan and the Rupee only

depreciated by 14.46% and 17.19% respectively. Patnaik I. and Shah A. conclude that both nations were de

facto pegging their currencies to the USD due to the very low flexibility they exhibited during this period.

Hence, while the RBI was not as explicit as China about its pegging to the USD, it is very clear from the

movements that it in fact was. Although such pegs will give a nation a substantial boost to their exports,

there are reasons for which we wouldn’t expect countries to keep their pegs for a very long time.

Maintaining a peg becomes expensive over time because in order to neutralize the effect of issuing

currency on the domestic monetary base countries have to do substantial sterilization. In doing this, they

are changing their (higher yield) domestic bonds for dollar denominated (lower yield) bonds. This way,

they drive up demand for the foreign currency using theirs and do not change the monetary base back home.

There is a problem tough, changing high yield bonds for low yield ones imposes high fiscal costs on the

government undergoing sterilization. This works fine for some time, but as the pressure to appreciate builds,

governments will have to sterilize ever greater amounts of foreign exchange operations. Eventually,

governments will naturally have an incentive to stop sterilizing their interventions or to simply let their

currency appreciate. This helps explain the recent moves towards flexible exchange rates both countries

have been going and should come as a relief to those who fear the competitive implications of fixed

exchange rates.

Monetary Policy

The last part of the trilemma, sovereign monetary policy, is another somewhat difficult quality to

measure. The first thing to clarify is whether or not the de jure capital controls both countries have in place

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have actually managed to isolate Indian and Chinese financial markets from the worlds’. Patnaik I. and

Shah A. (2009) argue that the controls have not been able to do this and thus China and India have both lost

monetary policy autonomy due to their fixed exchange rates. They attempt to show that the governments’

efforts to keep their currencies pegged have forced them to undertake pro-cyclical monetary policy. Their

argument is that because the capital flow’s appreciative effect on the exchange rate is neutralized by the

government, what would normally be exchange rate movements turn into domestic interest rate movements.

In order to show this in action, they plot GDP growth next to real interest rate movements. Figure 1.10 and

1.11 do this for the period from 1990 to 2013.

First, it is worth noting that this is a very crude measure of monetary policy

control. Opposite movements between GDP growth and Interest Rates could be a sign of pro-cyclical

monetary policy, but they could very well be deliberate. First, let’s look at China’s GDP/Interest Rate

movements. Two large boom periods can be noticed from 1990-1994 and 2005 to 2008. The movement of

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Figure 1.10 GDP Growth (Annual %)

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Figure 1.11 Real Interest Rate (%)

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interest rates during this period seems to move opposite to the GDP growth rates. However, the boom

periods never conclude with a recession or any large drop in growth rate. In fact, during the period from

1991 to 2013, Chinese growth rates have never been lower than 8%, this is hardly the sign of out of control

pro-cyclical monetary policy. Throughout the period growth hovered at around 10%, and although the

interest do move opposite to growth, the growth rate seem quite stable. This does not prove that. Patnaik I.

and Shah A.’s observations are incorrect, but as we have seen there is evidence that China and India were

relatively successful in closing their capital accounts and their macroeconomic track record does not look

out of control.

Now let’s look at India. Indian growth rates move opposite to interest rates until the year 2000.

This seems to align decently with our previous section on capital controls, since this period saw some degree

of capital account liberalization. From then on however, Indian interest rates have remained remarkably

stable at around 7%. Growth rates seem to show a series of bust and boom cycles from 2000 onward, but

since interest rates don’t move a great amount, we can’t precisely attribute this to a loss of monetary control.

The period from 2003 until the 2008 financial crisis shows a period of stable growth around 8%. This points

toward monetary policy control and no evidence of pro-cyclical monetary policy is seen. While India’s

growth rates are much lower and less stable than China’s their interest rate move much less. None of these

observations are conclusive due to the fact that measuring monetary policy control is difficult and looking

at interest rate and growth rate movements does not say much about the underlying causes of them.

However, the fact that both countries were relatively isolated from the Asian financial crisis of the late 90’s

and the lack of uncontrolled boom and bust cycles which conclude in recessions seems to challenge the

notion that both nations had given up monetary policy sovereignty due to the lack of functioning capital

controls.

Conclusion

Looking at the trilemma’s components individually in the context of both China and India allows

us to put together a concise story about the policies followed by both nations. It is clear from our analysis

that both nations are pivoting towards another position within the trilemma for a couple of reasons.

First, developments in the exchange rate regimes of both countries, which have become

increasingly volatile mark a departure from China’s pegging and India’s frequent intervention in the foreign

exchange market. The mounting costs of sterilization are probably the main cause of this. However, it is

also possible that exchange rates are being freed as a first step to capital account liberalization.

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Second, although capital controls still remain in place, this is probably due to the gradualist

approach both countries have taken towards liberalization. The experience of the Asian financial crisis,

were pegs had to be abandoned in a panic due to volatile capital flows have turned policymakers in both

China and India cautious towards capital markets, and rightfully so. In essence, free capital flows will have

to wait until domestic financial markets are more developed and until the currencies achieve full

convertibility.

Third, although some have argued that both China and India have lost monetary policy control due

to the lack of de facto currency controls, our observations of growth in recent times do not seem to point

towards loss of control. China’s policy seems more pro-cyclical than India’s, but its growth record is both

stable and high. India’s growth performance is not as stable, but interest rate movements are. More attention

should be devoted to this issue in a future study using more thorough measurements of monetary policy

control.

These observations seem to point towards a shift in the position within the trilemma for both China

and India. Both nations have done a great deal to free their exchange rates and although capital controls

remain strong in both nations, this is primarily due to financial stability reasons. Hence, both nations are in

the process of changing exchange rate stability for free capital flows within the trilemma. It would not be

surprising to witness full capital account convertibility in the near future.

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World Bank Data