This paper contributes to the literature on the policy trilemma by evaluating potential policy combinations for the original BRICS within the framework of the Impossible Trinity. It also introduces a novel modelling approach that defines a boundary for the linear combination of variables associated with the policy trilemma. The findings reveal that the trilemma emerges from the interplay of these three policy dimensions. Given the global influence of the BRICS countries, the results suggest that, if they maintain a fixed exchange rate system, they will likely have to sacrifice either free capital movement or independence from monetary policy. This loss of flexibility could be particularly detrimental, considering their significant international influence and their role as major recipients of capital flows for trade and financial transactions. Consequently, the optimal policy combination for BRICS is free capital flow, monetary independence, and a flexible exchange rate.

BRICS, Impossible Trinity, linear combination, policy trilemma

The Impossible Trinity, also known as the Policy Trilemma or Mundell-Fleming Trilemma, is a concept in international economics that states that a country cannot simultaneously achieve all three of the following policy goals - a fixed foreign exchange rate, free capital movement (absence of capital controls) and an independent monetary policy (Padhan et al., 2021; Aizenman, 2019; Beckmann, 2017; Benazic & Kersan-Skabic, 2016; Ihnatov & Căpraru, 2014; Aizenman & Ito, 2013; Goh, 2009). According to this concept, a country can only pursue two of these three objectives at the same time, in different combinations:

• Fixed exchange rate and free capital movement: the country cannot have an independent monetary policy. The central bank must align its interest rates with the global market to maintain the fixed exchange rate.
• Free capital movement and independent monetary policy: the country cannot maintain a fixed exchange rate. The exchange rate will fluctuate based on market forces, primarily informed by the monetary authority’s constant changes in interest rates and the regime of free capital movement.
• Fixed exchange rate and independent monetary policy: the country must impose capital controls to prevent the free movement of capital, which could destabilise the fixed exchange rate.

Several studies have analysed the phenomenon of the policy trilemma, or the impossible trinity, both at the country level and globally. For instance, Pantelopoulos (2021) demonstrates that Central Bank operational frameworks can be severely tested during periods of financial stress. However, the study also reveals that Central Banks in economies with a balance of payments surplus can navigate the constraints imposed by the trilemma within their operational frameworks.

Basri and Sumartono (2023) explore the policy trilemma in Indonesia during the 2009 quantitative easing (QE) and the 2013 taper tantrum, examining why Indonesian policymakers struggled to apply the trilemma’s principles and the implications of these challenges. They identify three main reasons for Indonesia’s difficulty implementing the trilemma policy: differing monetary policy objectives, volatile floating exchange rates, and balance sheet effects. The authors argue that monetary policy alone cannot effectively manage the Indonesian economy. Instead, they emphasise the importance of complementary measures, such as macroprudential policy, fiscal policy, capital flow management, and institutional quality, in enhancing the effectiveness of policy choices.

Ho and Ho (2018) analyse the shifts in the administration of the Impossible Trinity in Vietnam before and after the 2007-2008 global financial crisis. Using indices representing the trilemma—monetary policy independence (MI), exchange rate stability (ERS), and financial openness (FO)—and regression models based on the ARDL method, the study finds that the Vietnamese government prioritised exchange rate stability during the study period. However, the combination of goals within the trilemma changed across two phases: financial integration was a greater focus before the crisis, while monetary independence became more prominent afterwards.

Aizenman and Ito (2013) show that since 1990, trilemma variables in emerging markets have converged toward intermediate levels, characterised by managed flexibility, sizable international reserves as a buffer, and retention of some degree of monetary autonomy. They also find that the weighted sum of the three trilemma variables remains constant, indicating that a decrease in the weighted sum of the other two must offset an increase in one variable.

Majumder and Nag (2017) examine the policy trilemma in India and conclude that while the trilemma constraint is binding in the long run, there is evidence of short-run deviations. The efficiency of the trilemma depends on factors such as financial stress, financial development, central bank intervention, and liquidity in the economy. The Indian Reserve Bank’s interventions in the foreign exchange market have successfully mitigated the trilemma constraint.

Huh et al.(2016) examined how the trilemma policy variables in Fiji were applied to address policy trade-offs between the three goals. Using the vector autoregressive as an alternative to the SUR model, they found out that the trilemma constraint is binding for Fiji, and policy priority is given to exchange rate stability and independence of monetary policy. They also found no evidence to suggest that exchange rate stability and monetary policy independence made significant contributions to output growth; nevertheless, monetary policy independence contributes significantly to inflation control, and capital account openness would promote output growth.

In their study of the impossible trinity in Asian emerging market economies, Aizenman et al. (2011) examined the trilemma’s influential hypothesis. After using econometrics methods of fixed effects, system GMM and pooled OLS, the result was that the three factors of trilemma structures would converge towards a middle ground among countries with a managed exchange rate flexibility regime, strengthened by substantial international reserve assets and intermediate levels of monetary independence and financial integration.

While most studies on the policy trilemma have focused on individual countries, there has been little research on groups of regionally integrated countries. This paper aims to fill that gap by exploring the possibility of the policy trilemma within the BRICS grouping. Additionally, this study introduces a methodological departure from previous research, which often relies on a constant as the dependent variable in various econometric models. Such an approach may lead to inconsistent estimations due to the lack of variability in the dependent variable. To address this issue, the paper advocates for the use of bounded dependent variables, which can enhance the effectiveness and reliability of the estimators employed in the analysis.

The BRICS countries — Brazil, Russia, India, China and South Africa — hold significant influence on the global stage, primarily due to their economic power and political coordination. Collectively, the BRICS group represents a substantial proportion of the world’s population (approximately 41%), GDP (around 24%), and trade (over 16%) (Duggan et al., 2022). This economic strength enables the BRICS countries to influence global economic trends and policies. The BRICS group provides a platform for these emerging economies to coordinate their strategies and present a united front on various international issues. This helps to balance the influence of traditional Western powers in global governance (Trivedy & Khatun, 2023).

Exploring the policy trilemma is crucial for the BRICS countries, particularly when considering the unification of their economic policies and the advancement of their regional integration efforts towards a more profound economic union. Understanding the dynamics of the trilemma—namely, the trade-offs between monetary independence, exchange rate stability, and financial openness—can guide the BRICS countries in harmonising their policies. This knowledge is essential for addressing the challenges of synchronising monetary policies, stabilising exchange rates, and managing capital flows across diverse economies. Such insights could help BRICS navigate the complexities of regional integration and lay the groundwork for a more cohesive and resilient economic bloc.

The contribution of this paper is threefold. First, it investigates the applicability of the impossible trinity in the context of the BRICS countries. Second, it proposes a new methodology for measuring and evaluating the policy trilemma. Finally, the paper addresses the question of whether an increase in foreign reserves could ease the constraints imposed by the policy trilemma within the BRICS group.

The rest of the paper is structured as follows: Section 2 outlines the data and methodology. Section 3 presents the estimation results and discusses them. Section 4 concludes the paper.

We follow Aizenman and Ito (2013) to construct trilemma measures. The formula used for computing the financial openness index (FOI) index is

FOI = (CAPITAL INFLOW + CAPITAL OUTFLOW) / GDP (1)

Capital inflows and outflows encompass foreign direct investment and portfolio investment as recorded in the balance of payments of the BRICS countries. The exchange rate stability index (ERSI) is constructed using the following expression:

$ERSI=\frac{0.01}{0.01+\mathrm{Sd}\left(Ø\right(\log \left(\mathbf{E}\mathbf{X}\mathbf{C}\mathbf{H}\right))}$ (2)

The monetary policy independence index (MPII) is constructed using the expression:

$MPII=1-\frac{\mathrm{Corr}(i_h,i_f)+1}{2}$, (3)

where Corr(i_h, i_f) represents the linear correlation coefficient between the domestic interest rate (i_h) and the foreign interest rate (i_f), with Sd denoting the standard deviation. The U. S. interest rate has been chosen as the base rate because of its important role in global financial transactions. Quarterly interest rate data were used to calculate the correlation. Data for constructing the indices were sourced from the World Economic Indicators, the World Bank database, and DataStream from Reuters. The sample period spans from 2001 to 2018 and includes the five original BRICS countries. The sample was chosen based on the availability of data.

We follow Huh et al.(2016) and Ito and Kawai (2012), who suggested that the weighted sum of the linear combination of the three policy formulations must be constant, such as

2 = αERSI_t + βFOI_t + γMPII_t + ε_t (4)

The authors suggest that Equation 4 can be estimated using the least squares method.

It is worth noting that, since the policy trilemma is about trade-offs, a linear combination is a natural way to show how an increase in one area (say, greater capital mobility) could be balanced by a decrease in another area (such as monetary independence). This additive structure makes it easier to test and compare the trade-offs in policy trilemma empirically.

In our study, we adopt a similar approach with pooled panel estimation but introduce variability in the dependent variable to define the boundary within the context of policy trilemma and achieve a more efficient estimation of Equation 4. This methodological adjustment is our contribution to the existing literature. Unlike previous studies that did not account for this variability, it is based on the premise that pooled regression estimation without variation in the dependent variable can lead to inefficiencies (Wang & Schmidt, 2002). By allowing for this variability, we enhance the robustness and accuracy of our estimation, providing a more reliable approach to analysing the data.

Thus, the estimated Equation becomes

2 ± 95% CI = αERSI_t + βFOI_t + γMPII_t + ε_t (5)

This equation illustrates the concept of the ‘impossible trinity’ (also known as the ‘trilemma’), which states that it is not possible for a country to simultaneously pursue complete monetary policy independence, fixed exchange rates, and free capital mobility. According to this concept, if a country prioritises one of its policy objectives, it will have to forego one or both of the others, as the combined effect of all three cannot exceed a specific theoretical limit. This trade-off occurs because the linear combination of these policies is restricted within a specific interval, meaning that it is not possible to achieve all three simultaneously.

Before estimating our model, we present the descriptive statistics of the key variables of the model, namely the ERSI, FOI, MPII and RESERVE.

Table 1 presents the mean values for the key variables: ERSI at 0.51, FOI at 0.74, MPII at 0.49, and RESERVES at 4.20. The Jarque-Bera test results indicate that the null hypothesis of normality is rejected for all series. However, given the large number of observations, the central limit theorem is likely to hold, ensuring that the estimators are normally distributed in large samples. This outcome provides confidence in the validity of the linear estimation results obtained through the pooled regression method despite the deviations from normality in the individual series.

The estimation results derived from the econometric model represented by Equation (5) are shown in Table 2. These results provide insights into the relationships and significance of the variables under study, offering a basis for understanding how the model aligns with theoretical expectations and empirical observations. Table 2 highlights key coefficients and statistical significance levels, comprehensively interpreting the model’s performance and reliability.

Table 2 demonstrates that all estimated coefficients are positive, with none exhibiting a negative sign. This finding provides clear evidence in support of the ‘Impossible Trinity’ (or ‘Policy Trilemma’) concept, which states that it is not possible for an economy to pursue fixed exchange rates, an independent monetary policy and free capital mobility simultaneously. The positive coefficients suggest inherent trade-offs betwen these policy stances. Specifically, adopting or intensifying one policy dimension requires compensatory adjustments—typically a reduction—in another dimension to maintain equilibrium or consistency in the dependent variable or the linear policy combination.

However, the p-value of 0.619 for the Monetary Policy Independence Index (MPII) coefficient indicates that the coefficient is statistically insignificant. This result suggests that within the BRICS countries, the primary trade-off exists predominantly between adopting a fixed exchange rate regime and maintaining free capital mobility. Monetary policy independence seems compatible with either of these two policy options individually within the trilemma framework.

The findings reported in Table 2 indicate that the BRICS countries face a strategic choice between two viable policy combinations: (1) monetary policy independence coupled with a fixed exchange rate system or (2) monetary policy independence combined with free capital flow. The second option—monetary policy independence with free capital flow—appears more practical and advantageous, given the economic profile and capital-attracting strength of the BRICS countries.

This approach is justified by the substantial economic influence and financial integration of the BRICS nations within the global economy. These characteristics put them in a strong position to benefit from the flexibility of an independent monetary policy framework, while also encouraging open and liberalised capital markets. As a result, the BRICS can respond more effectively to domestic economic conditions through their monetary policies, while also benefiting from the capital inflows attracted by their significant presence in the international economic and financial landscape. This policy mix aligns with the strategic priorities of the BRICS economies, which are becoming increasingly influential in shaping global economic dynamics and capital flows. These findings may be useful for policymakers in the BRICS nations, particularly in their aspiration to adopt a common currency. The results of this study suggest that policymakers should carefully consider the exchange rate regime that would accompany the proposed common currency. Specifically, operating under a fixed exchange rate system may significantly restrict these nations’ free capital mobility capacity. Consequently, policymakers might opt for alternative exchange rate arrangements—such as a managed float or flexible exchange rate system—to better support their economic integration goals and maintain adequate capital flow flexibility.

Figure 1 compares the actual, predicted, and residual values of the linear combination of the three policies as obtained for the estimation of Equation 5. The results indicate that the linear combination stabilises around a value of 2, which suggests that the model provides a reliable prediction of the interaction between the three policy variables. The closeness of the predicted values to the actual values, coupled with relatively small residuals, underscores the model’s effectiveness in capturing the dynamics of these policies. This alignment reflects a firm fit, demonstrating the model’s accuracy in forecasting the outcomes when these three policy elements are combined.

Figure 1. 

Predicted values of the policy combination

In the subsequent phases of our analysis, we aim to investigate whether the substantial accumulation of foreign reserves in BRICS could alleviate the policy trilemma, potentially enabling their economies to pursue exchange rate stability, monetary policy autonomy, and capital mobility simultaneously. This issue is particularly relevant given that countries such as China have amassed substantial foreign reserves. (see Setser, 2023; Aizenman & Lee, 2014).

Although the policy trilemma suggests that it is difficult for countries to maintain a fixed exchange rate, an independent monetary policy and free capital flows simultaneously, research indicates that having substantial foreign reserves can soften this constraint. For example, selling substantial foreign exchange reserves may enable a central bank to effectively intervene in the foreign exchange market. This can support the stability of a fixed exchange rate regime, even when facing external pressures. This intervention capability offers countries more flexibility in managing the trilemma (Steiner, 2017; Cheng & Rajan, 2020; Aizenman & Ito, 2012).

We test this hypothesis in the case of BRICS with the variable RESERVE added to Equation 5. The results of this hypothesis are reported in Table 3.

The positive coefficients of the variables in Table 3 and the lack of statistical significance for the Monetary Independence Index (MII) indicate that the trilemma remains unresolved, even if BRICS have to accumulate substantial foreign reserves. As shown in Table 2, an increase in foreign reserves leads to a trade-off between a fixed exchange rate system and free capital flow within the BRICS countries. As concluded above, the ideal scenario in this case is a combination of an independent monetary policy and the free flow of capital.

The suggested policy combination implies that adopting a fixed exchange rate system may pose significant challenges for the BRICS countries within the framework of the Impossible Trinity. If BRICS had to choose a fixed exchange rate, they would have to forgo monetary policy independence, meaning they could no longer adjust interest rates in response to domestic economic conditions such as inflation, unemployment, or economic growth. This loss of flexibility is particularly harmful during economic shocks or crises, as it leaves these countries unable to use monetary tools to stabilise their economies. Additionally, the BRICS countries are often vulnerable to external shocks due to their diverse economic structures and exposure to global economic shifts. A fixed exchange rate system makes them more susceptible to these shocks because maintaining the peg may require depleting foreign reserves, which is unsustainable in the long term. Moreover, fixed exchange rate regimes frequently become targets for speculative attacks; if investors believe a currency is overvalued or doubt the central bank’s ability to maintain the fixed rate, they may engage in speculative activities that force the country to abandon the peg, leading to rapid capital flight and potential currency crises. Given these risks, the BRICS countries may find it more advantageous to consider alternative combinations within the Impossible Trinity framework. For instance, they could retain monetary policy independence alongside a floating exchange rate, enabling the currency value to adapt to evolving economic conditions. Alternatively, they could maintain a fixed exchange rate while implementing capital controls to restrict the free movement of capital. Compared to a fixed exchange rate system, these alternatives offer greater flexibility and resilience when it comes to managing economic challenges.

We re-estimated Equation 5 for robustness using fixed and random effects panel data models. The results align closely with those in Table 2, reinforcing the initial findings.

This paper examines the Impossible Trinity, or policy trilemma, in the BRICS countries to explore whether this group can effectively combine monetary policy independence, exchange rate stability, and free capital flow. Departing from the conventional literature, this study introduces a novel approach by proposing that the measure of the Impossible Trinity should be based on a linear combination of these policies that fluctuates within a specific interval rather than being a constant value. This approach enhances the efficiency of estimation using least squares or other econometric methods.

The results of the pooled regression analysis show that adopting a fixed exchange rate system poses significant challenges for the BRICS countries within the Impossible Trinity framework. Specifically, if the BRICS nations opt for a fixed exchange rate, they would likely have to sacrifice monetary policy independence. This would prevent them from adjusting interest rates in response to domestic economic variables such as inflation, unemployment or economic growth.

These findings are particularly significant for BRICS policymakers seeking to achieve varying levels of economic integration, which will necessitate the adoption of informed and strategic policy recommendations. The paper underscores the need for careful consideration of the trade-offs inherent in the Impossible Trinity when formulating economic policies within the BRICS framework.

The findings provide critical guidance for policymakers in the BRICS countries, especially concerning their ambition to implement a common currency. This study highlights the importance of selecting an appropriate exchange rate regime to accompany the new currency. In particular, adopting a fixed exchange rate system may severely limit the potential for unrestricted capital mobility across member states. Therefore, policymakers should consider alternative options, such as managed floating or flexible exchange rate systems, in order to effectively support economic integration objectives while maintaining the necessary flexibility in relation to capital flows.