Introduction

A core idea in modern macroeconomics is that of the ‘impossible trinity,' the notion that a country can have only two of the following at any given time: an open capital account, a fixed exchange rate, and an autonomous monetary policy. With the exception of the Eurozone countries, most developed countries have an open capital account, a floating exchange rate, and an autonomous monetary policy.¹

In Asia, a few polar examples like Hong Kong, China have a fixed exchange rate, an open capital account, and no monetary policy autonomy. In general, however, Asian economies tend to lack a well-defined monetary policy framework, with most having a combination of some capital controls and exchange rate inflexibility. This raises interesting questions about the current state and possible evolution of monetary policy in Asia, and highlights the need for a consistent monetary policy framework.

In this paper, we focus on 11 major economies in Asia: India; the People's Republic of China (PRC); Hong Kong, China; Taipei,China; Singapore; Malaysia; Thailand; Indonesia; Philippines; Viet Nam; and Republic of Korea (hereafter Korea). This is a highly heterogeneous group, ranging from city-states like Singapore to giants like the PRC, and poor economies like India to rich economies like Taipei,China or Korea. We refer to these economies as the Asia-11.

We examine where the Asia-11 stand with respect to the three corners of the impossible trinity: capital controls, the exchange rate regime, and monetary policy autonomy. We obtain summary statistics for each of the eleven economies, and also focus on numerical values for the three largest economies: India, PRC, and Korea.

Since countries sometimes fail to do as they say, this paper focuses on de facto rather than de jure capital controls, exchange rate regimes, and monetary policy frameworks. More specifically, we focus on de facto conditions for capital account openness and exchange rate flexibility, and their implications for monetary policy as measured by the short-term real interest rate.

We find that while the Asia-11 have undergone some degree of de jure capital account liberalization, in most economies restrictions on capital flows are still in place. However, this has not impeded gradual capital account integration at the de facto level, assisted by a growing sophistication of the financial system.

Alongside this, Asia is characterized by substantial exchange rate inflexibility. Although exchange rate flexibility increased after 2000, this remains low by world standards. Even Korea's highly flexible exchange rate continues to lag the floating exchange rate.

Counter-cyclical monetary policy is one of the strategies by which monetary authorities achieve the objective of stabilizing inflation and output. We focus on this objective in the context of inconsistencies arising from the impossible trinity. Today, most of Asia is characterized by growing de facto capital account integration with substantial de facto exchange rate inflexibility. To the extent that capital flows are procyclical, the currency trading of central banks will convert procyclical capital flows into procyclical monetary policy. The PRC and India are interesting test cases of this phenomenon, given the limited extent of de facto capital account opening in both countries and their relatively weak financial systems. Yet, even in these two countries, we find that monetary policy has been fairly procyclical.

We argue that there are potential difficulties facing economies which have moved towards substantial de facto integration while continuing to have limited exchange rate flexibility. This is particularly a concern for Malaysia and Taipei,China, which combine (i) sophisticated financial systems that erode the effectiveness of capital controls; (ii) substantial de facto openness; and (iii) rigidity in the exchange rate. Since pursuing counter-cyclical monetary policy becomes more difficult when economies with pegged exchange rates experience procyclical capital flows, the paper makes a case for a consistent monetary policy framework.

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