International monetary policy involves a tradeoff among the three policy objectives: (a) unrestricted capital movement, (b) a stable exchange rate, and (c) an independent monetary policy. This trilemma still remains a valid constraint on monetary policy making. It suggests that to gain autonomy in monetary policy, a country has to sacrifice on exchange rate stability or impose restrictions on international capital movement. In this paper, we investigate the extent of monetary policy independence in a group of ten Asian countries: China, Malaysia, Japan, India, Indonesia, Philippines, Thailand, Korea, Singapore, and Hong Kong. We then investigate the association between monetary policy independence, the degree of capital controls, and exchange rate flexibility. We address this in two ways: first we intend to find out whether countries still exercise independent monetary policy in the financially integrated world. Second, we intend to find out whether capital controls are still effective. We use monthly data for 1991.1 - 2015.9 in our study. Data on the 3-month interbank interest rates, exchange rates, forward rates, and non-deliverable forward rates are taken from Bloomberg. Data on industrial production, unemployment and inflation are taken from the International Monetary Fund (IMF) –
International Financial Statistics.
While the traditional investigation has considered only the bivariate relationship between the home interest rate and the base rate, we also employ single-equation and vector auto regression (VAR) representations of the trivariate relationship including the desired (or optimal) interest rate in addition to the traditional two variables. We find that in most countries, the relative ranking is consistent across the models and methodologies.
For this trilemma, there are two ways a country can increase its monetary independence (MI): greater flexibility in the exchange rate, and lower degree of capital mobility. The fact that China and Malaysia (the two countries that are known to have imposed the strictest capital controls) consistently rank high in various setups while Hong Kong (which has maintained nearly the freest regime in capital markets) is lowest in MI indicates that perhaps the role of capital controls may be more important than the role of exchange rate flexibility in securing independence in monetary policy making. On the other hand, countries that maintain greater exchange rate stability do not necessarily rank low, unless combined with greater capital mobility as in the case of Hong Kong.
