There is a hypothesis that economists call “The Impossible Trinity” or the “Trilemma,” which claims that countries cannot control the exchange rate of their currency, allow free capital movement, and maintain an independent monetary policy all at the same time; they must choose two of the three.
The hypothesis was developed in the 1960s by Robert Mundell and Marcus Fleming at a time when capital controls had already failed in many countries and certain governments were battling to peg exchange rates while maintaining an independent monetary policy.
In a nutshell, the hypothesis is as follows: if a country desires a fixed exchange rate (to prop up exports, for example) and also wants free capital flows (to encourage foreign investment), it cannot effectively control price levels because, as it manipulates the supply and demand of money to maintain a fixed exchange rate, price levels will undoubtedly be affected.
If the country wants a fixed exchange rate with the ability to maintain stable prices at home, it must sacrifice free capital movements because these inflows and outflows of cash will cause changes in the exchange rate.
The best way to understand this “trilemma” is to take a look at the problems that Colombia’s Central Bank and government are currently facing.
On Wednesday September 15, 2010, the Central Bank announced that it would purchase at least $20 million dollars per day for at least four months in order to stem the rise in the value of the peso (which has strengthened 13.6% so far this year). This is because Colombian exporters have begun to suffer as their products have become relatively more expensive on world markets.
This policy works because as the bank purchases dollars with pesos, it is effectively taking dollars out of circulation (making them scarcer) and putting more pesos into circulation (making them more abundant) which means that the value of the peso will fall with respect to the value of the dollar.
A weaker peso means that Colombian products are cheaper for foreign consumers, which leads to an increase in Colombian exports. This is exactly what the government wants.
This comparison isn’t perfect because Colombia isn’t seeking to “peg” or fix its exchange rate, but the principals are the same. An exchange rate of $1,800 pesos to the dollar seems to be the threshold level; as the peso strengthens beyond $1,800, Colombian exporters (i.e., the Colombian economy) begin to suffer. In order to avoid a decline in growth, the Central Bank and government must take action.
The predicament for Colombia is that it has become an increasingly attractive place for foreign investment, drawing 20% more foreign direct investment in the first eight months of 2010 than it did over the same period in 2009. So far, Colombia has allowed this capital to freely flow into the country because foreign businesses, like national businesses, create jobs, which generally leads to an improvement in the overall economic situation.
So why is rapid growth in foreign investment a problem for Colombia?
When a company decides to invest in Colombia it needs to purchase pesos to do business. This increases the demand for Colombian pesos which, assuming that the supply of pesos stays the same, increases the value of the peso.
The Central Bank’s latest actions are aimed at increasing the supply of pesos to offset the increased demand, in order to keep the currency from appreciating. At first glance it might seem like they can do this effectively without any problems but that’s where the third element of the “Impossible Trinity” comes into play.
As the Central Bank pumps more pesos into the market and the peso decreases in value, prices in the Colombian market are likely to rise because, as the famous saying goes, you have “too much money chasing too few goods.” We know this as inflation, and it is what keeps many Central Bankers awake at night.
As sellers begin to demand higher prices for their products, consumers see their real incomes decline as the things that they normally buy become more expensive. High rates of inflation are very damaging to an economy and can seriously stifle growth. The delicate job of the Central Bank is a balancing act of maintaining positive growth along with stable prices.
To fight inflation, Colombia’s Central Bank would normally raise interest rates by issuing government-backed bonds (effectively taking pesos out of circulation) which increases the value of the peso, meaning that it takes fewer pesos to buy a given good.
This is a great tool for keeping inflation in check, but it leads us to the same problem of increasing the value of the peso.
This is Colombia’s impossible trinity.
Colombian officials want to encourage foreign investment, they obviously want to maintain price stability, but they don’t want the peso to become too strong because of the negative effects that this has on exporters and the economy as a whole.
These Central Bankers and government officials must decide which position they are going to take if they want to avoid getting caught up in the impossible trinity.
Purchasing dollars can only work to a certain extent and for a certain period of time. Eventually, Central Bankers and government officials must decide whether they will continue to let capital flow into the country and let the peso strengthen while maintaining price stability, or if they are going to limit these capital inflows in order to maintain an export-led growth policy via a cheap peso.
What they will do remains unclear but what is clear is that they must soon make a decision or they risk finding themselves in a dangerous act of juggling three economic hot potatoes, where dropping any one of the three could amount to serious consequences for the Colombian people.
Author Matthew Helm is an American who moved to Colombia where he started the website relocationcolombia.com, specialized in information for potential expats and investors.