Bermuda’s impossible monetary trinity
“The point is that you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain — or Canada); or it can choose to leave capital free and stabilise the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today or for that matter most of Europe).”
- Paul Krugman, O Canada — A neglected nation gets its Nobel, Slate — Oct 19, 1999
Life is full of choices. Some come with little ancillary ramifications but some have limitations and constraints. Recently there has been some talk about Bermuda forging ahead with creating its own central bank to garner more control of interest rates and monetary policy.
One of the frameworks used to assess this choice is that of the Impossible Trinity or the trilemma in international economics. This was introduced by Robert Mundell and Marcus Fleming in 1962/63 in their discussions on creating a stable international financial system. Their work was subsequently reviewed and analysed by Maurice Obstfeld, Jay Shambaugh and Alan Taylor from MIT which suggests, upon reviewing 130 years of interest rates, the constraints implied by the trilemma are borne out by history.
The Impossible Trinity states that, when considering options for monetary policy, only two states at once are possible and not all three at the same time. Graphically these options can be depicted as shown in the diagram that accompanies this article.
What this framework suggests is that it is impossible to have a fixed foreign exchange rate, free capital movement (i.e. no capital controls) and an independent monetary policy all at the same time. The options are depicted by the three sides of the triangle. These are as follows:
Option 1: No capital controls and fixed exchange rate (no sovereign monetary policy)
Option 2: No capital controls and sovereign monetary policy (floating exchange rate)
Option 3: Fixed exchange rate and sovereign monetary policy (capital controls)
Let’s walk through each as they apply to Bermuda.
Option 1: current situation
Option 1 is essentially what we have in place today for Bermuda. Bermuda does not have its own central bank and effectively “outsources” this function to the Federal Reserve in the US. We do not set the “Federal Funds Rate” and simply accept US monetary policy. As a result we are able to allow free movement of capital (no capital controls) and maintain a peg to the US dollar. If we attempted to set interest rates different from US rates. We would be subject to option 2 or 3 effects.
Option 2: letting the currency float
Option 2 allows for the free flow of capital (no capital controls) and the sovereign dictation of monetary policy. Thus, depending on policy choices, the Bermuda dollar is likely to appreciate or depreciate. Most countries around the world operate under this system. The outcome of this choice is less clear.
Let’s use a simple example on how this could potentially play out. Assume Bermuda, at some point, decided to stimulate the domestic economy by adopting an expansionary monetary policy and setting interest rates low and increasing the domestic money supply. Let’s say this rate is much lower than the US dollar rate. As a result, local and international arbiters will sell the domestic currency (Bermuda dollars) and buy US dollars in large quantities. The oversupply of Bermuda dollars would lead to a deprecation of the currency — the currency would continue to fall until it equated to the nominal interest rate difference between them. We have written about this previously.
If the BMD$ was to float freely, and taking into account differentials in historic inflation, we would expect it to have a fair value versus the US$ of some 17 per cent lower than its current pegged value based on historical inflation rates. As a result, due to our heavy reliance on imports, domestic inflation would likely soar and the cost of living would only escalate.
Furthermore, since the US is our main trading partner, any significant divergence from their own monetary policy could create a large amount of currency volatility. This would make it increasingly more difficult for local importers to quantify business risk as currency fluctuations would now need to be factored into operations. Furthermore, there would unlikely be any low-cost ways to hedge this exposure given the limited (if not none) tradability of the BMD$.
It is tough to envision any persistent desire to hold Bermuda dollars over an internationally recognised reserve currency such as the US dollar. In fact, the interest rate necessary to entice this demand would actually be much higher than current rates which would be very negative for the domestic economy.
If local interest rates did not rise, the ultimate trend in free-floating Bermuda dollars would likely be down, possibly echoing historic episodes like the peso crisis or/and the Asian currency crisis. A sharp rise in interest rates could lead to much higher taxes as the government has to meet higher interest payments on the country’s debt. One could argue that Bermuda does run a current account surplus so the new central bank could defend the currency to some extent but the surplus is small in terms of the sheer size of foreign currency market that is traded globally.
Option 3: invoking capital controls
Option 3 tries to preserve the peg of the Bermuda dollar while simultaneously having an independent monetary policy. To prevent arbitrage taking place in the foreign exchange market, Bermuda would need to implement capital controls on international transactions. Locals will recall that Bermuda limited currency conversions in the past but has eliminated most of these monetary restrictions.
The government has a “tax” on converting Bermuda dollars and could increase this tax in order to stifle a significant outflow from Bermuda dollars in a crisis. Reimplementing capital controls is also an option in a financial crisis but this is only a short-term remedy. In general, uncertainty and friction for international business would likely undermine confidence in the island and would likely discourage foreign investment.
Bermuda thrives on foreign investment so any policies that threaten the return to capital controls (even just the possibility) would not help encourage investment. Who wants to invest in a slow growing country if there is uncertainty on how you get your investment money returns or capital back?
In summary, and in my opinion, the current system works for Bermuda. The situational uncertainty and likely negative implications of adopting a sovereign monetary policy outweigh any desirable benefit that I can determine. Although it may be politically expedient and palatable to talk about having increasing control of our monetary policy, under this economic framework, I do not envision much benefit or overall positive outcome for Bermuda. As the saying goes, “if it ain’t broke, don’t fix it”.
Sources and links:
• O Canada — A neglected nation gets its Nobel, Oct 19, 1999, Slate Magazine, Paul Krugman. Link: https://tinyurl.com/6qqmc4m
• Impossible trinity: Wikipedia.
• The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility: Maurice Obstfeld, Jay C. Shambaugh, Alan M. Taylor.
Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own.Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index