The Mundell-Fleming Trilemma: The Nigerian Experience

Tuesday, July 04, 2017 6:25 PM /FDC 

The Mundell-Fleming trilemma is an economic model first articulated by Robert Mundell and Marcus Fleming in the early 1960s, to argue that an economy cannot simultaneously choose to implement policies of monetary autonomy, free flow of capital and fixed exchange rates.

Also known as the impossible or inconsistent trinity, the model states that a country can only choose two of the options as it is impossible to achieve all three at once. 

A country that wants to maintain a fixed exchange rate regime and have an autonomous interest rate policy cannot allow capital to flow freely across its geographical borders.

Similarly, if the exchange rate is fixed and the country is open to cross-border flow of capital, it cannot have an independent monetary policy that is free from external influence. 

In addition, if a country chooses free movement of capital and wants monetary policy autonomy, it cannot have a fixed exchange rate regime. It has to allow its currency to float. 

Let’s examine why there is a conflict in adopting all three options simultaneously. A country adopts a fixed exchange rate regime (a currency pegged against the USD) and is also open to foreign capital inflows. 

If its central bank sets interest rates (adopting an autonomous monetary policy) above the interest rates set by the Federal Reserve, foreign portfolio investors in search of higher re-turns would flood in, ceteris paribus. 

These foreign capital inflows would increase demand for the local currency, causing the currency to appreciate. If interest rates are below the benchmark rates set by the Federal Reserve, capital would leave the country and the currency would depreciate. 

In a situation where barriers to cross border capital flows are ineffective or futile, the trilemma presents a choice - between a floating exchange rate and control of monetary policy; or, a fixed ex-change rate and monetary policy dependence. 

Developed countries have typically chosen the former. However, countries in the Euro-zone have adopted the latter. This is because capital moves freely in the Eurozone. 

As a result, any country whose interest rate is lower than the rest risks losing foreign capital to countries with higher interest rates. 

Assumptions
The Mundell-Fleming model makes the following basic assumptions. 

·         The country under consideration is a small open economy. That is, the country is so small that it cannot affect global interest rates and it engages in trade with other countries.

·         There are no barriers or controls to the free flow of capital across borders. All financial instruments are perfect substitutes. There are only risk neutral investors in the economy and investment depends on the interest rate.

·         Spot and forward exchange rates are identical, and the existing exchange rates are expected to persist in perpetuity.

·         Wages and inflation are assumed unchanged, the supply of domestic output is elastic and constant returns to scale are assumed.

·         Taxes and savings are directly correlated with income.

·         Trade balance depends solely on income and the prevalent ex-change rate. 

As can be seen from the graph above, there are three options:

A.     Fixed exchange rate and free capital mobility (no monetary policy independence);

B.     Free capital mobility and monetary policy autonomy (no fixed exchange rate system, rather a flexible exchange rate); and

C.     Fixed exchange rate system and monetary policy autonomy (no free flow of capital). 

If free capital mobility is chosen, then the trilemma is reduced to the following choice: either fixed exchange rate with no monetary policy autonomy or flexible exchange rate and monetary policy autonomy. 

The Nigerian Experience
Since the burst of the commodity boom cycle in mid-2014, the naira has depreciated significantly at the parallel market and Nigeria’s foreign exchange policy has been under the searchlight.

The Central Bank of Nigeria (CBN) fixed the exchange rate at N168/$ at the Interbank Foreign Exchange Market (IFEM) in November 2014. The apex bank further devalued the currency to N199/$ in November 2015 and employed capital controls. 

This resulted in a massive exodus of foreign capital from Nigeria. Meanwhile the CBN’s monetary policy was independent and free from external control. Since Nigeria maintained a fixed exchange rate regime and an autonomous monetary policy, it could not control capital inflows, hence the plunge in capital imports. 

In theory, if a central bank wants to fix its exchange rate, the bank must regulate the supply of foreign exchange (forex) in the market with its foreign reserves – buying excess forex in the market and selling where there is a deficit. 

In order to maintain a fixed exchange rate regime, a country requires a robust foreign reserves position. Since the CBN fixed the exchange rate in 2014, it has made use of external reserves to defend the currency. 

However this led to a sharp depletion in the level of external reserves. The plunge in global oil prices coupled with production shut-downs significantly reduced the inflows to the external reserves and con-strained the ability of the CBN to continue to defend the naira. 

The resulting effect of this was an acute scarcity and a sharp depreciation of the naira at the parallel market. The huge gap between the official and the parallel market rate also incentivized unethical practices such as round tripping. 

In July 2016, the CBN announced a new “flexible foreign exchange regime” which saw an increase in capital imports. However, due to scant details about the workings of the new foreign exchange market and heightened uncertainty, the naira depreciated further and capital imports declined. 

In February 2017, the CBN announced an adjustment to the implementation of its forex policy. Although the exchange rate regime was still relatively fixed or a managed float, the CBN in-creased its interventions in the market which crashed the parallel market rate from an all-time high of N520/$ to about N385/$. This was due to a significant accretion in the level of external re-serves. 

In order to achieve exchange rate equilibrium and massive inflows of foreign capital, the Central Bank needs to fully liberalize the foreign exchange market, thus changing its economic policy to an independent monetary policy and free flow of capital. 

This would boost the inflow of foreign exchange and incentivize foreign investors to return to Nigeria. 

The effect of this will be a stronger naira, an increase in economic activity and higher economic growth. After several calls for a liberalized foreign exchange regime by analysts, economists and international organizations, it appears the apex bank is finally succumbing to the pressure. 

The introduction of the investor and exporters window – where the exchange rate is determined by buyers and sellers - suggests that the Central Bank of Nigeria is “testing” a floating exchange rate regime. 

It also increases the likelihood of a fully liberalized exchange rate regime in the near term. A fully liberalized exchange rate system coupled with improved flows of foreign capital will have a significant impact on Nigeria’s economic recovery.   

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