KW: From Jim Rickards newsletter,

The “impossible trinity” is an economic concept developed by the great economist Robert Mundell in the early 1960s.

Mundell said that a country could not have an open capital account, fixed exchange rate and an independent monetary policy all at the same time without causing a reserve crisis. The idea is that if you have interest rate differentials (due to independent monetary policy) and peg your currency, then capital will flow from the low-yield to the high-yield country.

At some point, these outflows will cause a reserve crisis or cause the pegged exchange rate to break, resulting in a foreign exchange crisis. There are various other outcomes under Mundell’s framework, including precautionary capital flight. The point is that trying the impossible trinity is bound to fail.

China is proving this again today.

They are trying to run an open capital account, maintain independent monetary policy (Chinese rates are significantly higher than U.S. rates) and peg the yuan to the dollar within a range. This policy is failing in multiple ways.

Capital outflows are huge, and downward pressure on the yuan is relentless, all in anticipation of a maxi-devaluation. China may have to slap on capital controls (see story below), but this will upset the IMF, which recently included the yuan in the SDR as one of the big five global reserve currencies.
An open capital account is an invitation to capital flight when you have unrealistic exchange rates or interest rates. That’s exactly what has been happening in China.China is heading for a reserve crisis or a foreign exchange crisis, or both. This will once again prove that the impossible trinity is, indeed, impossible

The reserve position in China has crashed from over $4 trillion to about $3 trillion in the past 18 months. The capital outflows are continuing at a rapid rate. Assuming up to $1 trillion of China’s reserves are not highly liquid (such as shares in Zimbabwe mining companies) and another $1 trillion is needed to bail out China’s banks, then China may be down to just $1 trillion available to defend its currency.

At current rates of capital outflows, China will be broke within one year. The solution is either a maxi-devaluation of the currency or to slap on currency controls. For now, China is putting on capital controls and reducing the ability of Chinese firms and individuals to take money out of the country. But such controls are typically full of holes.

The end result will still be a devaluation of the Chinese yuan against the U.S. dollar. This will incite calls for anti-manipulating measures, including tariffs from the new Trump administration. This is how currency wars turn into trade wars and ultimately damage world growth and make debt crises more likely.

Below, I show you why the U.S. and China are on a collision course that could result in a devastating currency and trade war. And another market crash. Read on.

Regards,

Jim Rickards
for The Daily Reckoning