The tyranny of the trinity

The People's Bank of China is doubling the size of the yuan's trading band, another step in its internationalisation.

SCMP, April 15

My pardon if you think you have seen the triangle chart in my column before. You have. I got it from a speech made here by that notable economist Milton Friedman many years ago and I think it neatly sums up China's problem with the yuan.

The rules of the triangle are simple. In any economy you can have any two points of the triangle but you cannot have all three. If you go for all three you set up a pressure cooker without a safety valve. It will blow up in your face sooner or later.

Thus, if you want open borders to trade and capital flows and you want to control your currency's interest rates, you have to keep your hands off your currency's exchange rate and let it be determined by the market. This is the model in the United States and most of the developed world.

Alternatively, you may want those open borders but choose to have control of your currency's exchange rate. You must then keep your hands off domestic interest rates and let the market establish them. This is our model in Hong Kong with the peg.

The third option is to control both your currency's exchange rate and fix your domestic interest rates. In that case you have to shut your borders to all flows of money except, perhaps, those that go to pay for the president's Mercedes. Some things are essential. That's North Korea.