W

e live in a time of high uncertainty. The past seven years have been remarkable since the eruption of the global financial crisis in 2008. Vigorous action was needed to avert a repeat of the Great Depression.

Major central banks pursued unconventional monetary policies that have greatly expanded their balance sheets and flooded the financial market with liquidity.

This unprecedented move has put financial stability at risk, as shown recently by high volatility in the financial market.

Meanwhile, the impacts on the real economy remain to be seen and there is renewed concern about global economic growth.

Advanced economies'€™ growth has not fully recovered yet, while emerging markets continue to slow down. Confidence seems remote, despite normalization signals from the US Federal Reserve in December 2015, with its first interest rate hike in almost a decade.

For policymakers, the challenge is therefore how to moderate the impact of global financial and monetary forces for the domestic economy.

The best policy response needs to be formulated with an aim to insulate the economy from the adverse external environment, while keeping the benefits of openness for the economy. These are huge challenges and unfortunately, there are no easy answers.

There are two points to ponder.

First, understanding transmission channels in which external shocks translate to the domestic economy is of utmost importance.

Economists suggest that there are at least three channels: trade, terms of trade and financial channels. One could also add a confidence channel that affects the three channels'€™ work in a more complicated way.

For Indonesia, the first two channels '€” stemming from the collapse of commodity and oil prices '€” have deeply affected our external and fiscal postures.

In the financial channel, the recent turbulence in China'€™s stock market could pose a different risk to the Fed'€™s taper tantrum effect in 2013.

The downside risk to Indonesia'€™s growth from the Fed'€™s policy will probably at best work through financial channels, while the impact of China'€™s turbulence will very likely work through a trade channel.

Understanding the transmission mechanism better will therefore influence how we formulate our response to the shocks.

Second, financial globalization has made countries live with double trilemmas. The first is a monetary trilemma, implying that no country can achieve three macroeconomic targets simultaneously: free capital flows, exchange rate stability and monetary independence.

For example, for a country that adopts a fixed exchange rate regime and at the same time allows free capital flows, its central bank must use its monetary policy to maintain the peg, so it cannot have an independent monetary policy.

If it wants to maintain its monetary independence, say by targeting inflation, while keeping a fixed exchange rate, then it has to give up free capital mobility.

If the choice is to open cross-border capital transactions and keep its monetary independence, then exchange rates must be allowed to move flexibly.

The second is a financial trilemma stating that financial stability, financial integration and national financial or prudential policy cannot be achieved at the same time.

Like the monetary trilemma, the same principle applies: Any two of the three objectives can be combined, but not all three (Schoenmaker, 2011). When the financial market is integrated with the world, the financial trilemma implies that a country must choose between financial stability or, to some extent, some degree of national independent financial policy.

Currently, there are three strands of literature in the international economics. On one side, Michael Woodford (2011) of Columbia University suggested that monetary authority should keep its eye on inflation as the only objective, leaving the exchange rate to adjust freely under a free capital regime.

However, Guillermo Calvo and Carmen Reinhart (2012) observed that many emerging countries de jure adopt floating exchange rate regimes, when in fact, de facto, they mostly do not.

There is a widespread case of '€œfear of floating'€, which is understandable as the impact of the high fluctuation of the exchange rate can be substantial on price, via exchange rate pass-through, and output development.

On the other side, Helene Rey (2013) of the London Business School argued that no country can be immune to the global financial cycle, unless it implements some form of capital restrictions.

The global financial cycle, steered by monetary policy in the central country, in this case the Fed,
constrains the national monetary policy regardless of the exchange rate regime, i.e. whether a fixed or floating rate.

Global spillover from the center to peripheral countries will transmit from capital flows to asset prices and credit growth, which in turn will affect the real sector.

To mute the transmission, Rey also suggested the implementation of macroprudential policy such as limiting excessive credit growth or taking prudential measures on leverage.

Recently, there was a third moderate way proposed by Maurice Obstfeld (2014), chief economist of the International Monetary Fund (IMF). His main argument was that independent monetary policy remains feasible in a financially open economy, but is limited in what it can achieve.

Countries that adopt a flexible exchange rate can still have some form of monetary autonomy at the short-end of the term structure, but he recognized that long-term interest rates are more correlated to external development.

The central bank still retains its capacity to steer the economy, and the changes in short-term rates actually reflect its response to changes in domestic variables (such as inflation and output), and not necessarily to changes in foreign variables (such as the Fed fund rate).

Given persistent external shocks in the near future and effective policy constrained by double trilemmas, the task for policymakers to maintain monetary and financial stability becomes increasingly complex, especially when they are also confronted with multiple macro objectives, such as high growth, low inflation and current account balance.

There will always be difficult tradeoffs. There is always a shortage of policy instruments to attain the many objectives simultaneously.

In the end, policy action has to be made. The principle of openness remains valid as its benefits are still greater than the downsides.

Although it brings risk and uncertainty, openness gives many opportunities for the country to improve its welfare. Many countries have empirically proven so and China with its kaifang (opening up) policy is a good example.

As Deng Xiaoping once said: '€œWhen you open the window, both fresh air and flies come in'€. Thus the challenge for policymakers is to navigate the economy, mitigating the downside risk while at the same time maximizing the benefit, enabling people to seize every opportunity that openness provides.
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The writer is head of Bank Indonesia'€™s Economic Research Group. The views expressed are his own.