(Bloomberg) -- Some of Asia’s biggest central banks are getting a painful refresher in economic theory.
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Monetary authorities in China, India and elsewhere have waged a prolonged campaign against the strong 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 can’t 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 said on March 5 that it would inject $21.5 billion into the financial system through a mix of bond purchases and swap auctions before the March 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, despite deflationary pressures in China adding to headwinds. Although there were some hopes the tide was turning after the government unveiled an economic growth target of around 5%, an ambitious goal that will require looser monetary conditions, bond yields once again spiked on Friday.