‘Impossible trinity’ conundrum has caused a cash crunch in Asia

SOME of Asia’s biggest central banks are getting a painful refresher in economic theory.

Monetary authorities in China, India and elsewhere have waged a prolonged campaign against the strong US dollar, using a mix of official reserves and opaque derivatives trades to defend their currencies. But their moves have pushed up borrowing costs for local banks just when slowing economies need more liquidity.

China’s overnight and seven-day repo rates surged in February, while bond investors took losses from a sharp rise in yields. Banking liquidity in India suffered its highest deficit in at least 14 years earlier this year and overnight borrowing costs jumped. Liquidity also dried up in Indonesia and Malaysia following central bank currency interventions. 

These moves are explained by what economists call the “impossible trinity”, the idea that countries cannot simultaneously control their currencies, independently set interest rates and allow capital to move freely across borders. Something will break or give way.

“Under the impossible trinity, if a central bank opts to hold the currency stable and one assumes an unchanged capital account regime, rates have to be the adjustment mechanism. That will emerge initially in interbank money market rates,” said Philip McNicholas, an Asia sovereign strategist at Robeco.

Rising interbank rates are a sign of a cash shortage that could hit the wider economy, discouraging banks from lending and potentially crimping economic growth.

The impossible trinity underscores the complicated questions facing investors in emerging markets. Currency depreciation hits the value of the stocks and bonds foreign investors hold in these countries, but if stability comes at a cost to economic growth, the whole investment case can be undermined.

Pushing back

One central bank is starting to push back against the side effects of defending its currency. The Reserve Bank of India (RBI) said on Mar 5 that it would inject US$21.5 billion into the financial system through a mix of bond purchases and swap auctions before the Mar 31 year-end, its latest attempt to offset the cash crunch.

The People’s Bank of China has so far held back from a similar round of big liquidity injections, keeping its focus on the currency. Although there were some hopes that the tide was turning after the government unveiled an economic growth target of around 5 per cent, an ambitious goal that will require looser monetary conditions, bond yields once again spiked on Friday (Mar 7).

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Traders are now braced for a period of uncertainty in a year likely to be defined by US President Donald Trump’s swashbuckling approach to global trade. Central banks may be forced to play whack-a-mole: defending their currencies one day, and easing liquidity strains the next.

“The currency volatility could continue amid ongoing global trade and tariff wars and will imply emerging market central banks, including the RBI, will have to be on their toes on the FX front,” said Madhavi Arora, chief economist at Emkay Global Financial Services in Mumbai. 

The rupee is likely to weaken to 89.50 per US dollar by the end of the year, said Arora, a move of more than 3 per cent from Friday’s levels.

Bank Indonesia has taken a novel approach to defending its currency, launching a new type of rupiah-denominated bill in September 2023 designed to attract capital inflows. But the securities have lured funds away from the banking system, and may have contributed to tightening liquidity, wrote Goldman Sachs strategists including Rina Jio and Danny Suwanapruti in a note on Feb 26.

Bank Negara Malaysia has leaned on currency forwards to support the ringgit, swelling its net short forward book. That has combined with high loan-to-deposit ratios to tighten interbank liquidity, said Robeco’s McNicholas.

There is an irony to the pain being felt by central banks pushing back against a strong US dollar. Stephen Miran, Trump’s pick as chair of the Council of Economic Advisers, has written extensively about the costs to the US of a strong US dollar – and traders have recently obsessed over the potential for a “Mar-a-Lago Accord” that could lead to a prolonged period of US dollar weakness.

That may not sound like such a bad idea to central bankers in Asia, who have increasingly been forced to confront their own costs from US dollar strength.