The ‘Trilemma’ and De-Dollarisation
June 22, 2007
Many emerging markets are now confronting a difficult ‘trilemma’ on whether to (i) stabilise inflation and (ii) target the exchange rate while (iii) keeping a relatively open capital market — three macroeconomic objectives that cannot be satisfied at the same time. As a result, some central banks (e.g., some SE Asian countries, Russia and some LatAm economies) have been forced to allow their exchange rates to appreciate to help alleviate rising inflationary pressures, i.e., the exchange rate is becoming the ‘weakest link’ in the macro stabilisation process in these economies, providing currency investors with interesting opportunities while the G3 markets are so quiet.
In this note, I argue that this trend is likely to continue, but caution that some structural and cyclical factors may, to some extent, help these economies cope with the ‘trilemma’. While we fully agree with the notion that many non-G10 currencies will gradually appreciate against both the dollar and the euro, because of mounting inflationary pressures arising from large balance of payments (BoP) surpluses, we believe it is important to highlight a couple of subtle processes — related to changing money demand — that are at work that may temper the speed with which these economies let their currencies appreciate.