This post was authored by Adem Tumerkan, Dunham's Content Writer. If you have questions concerning today's topic, please call us at (858) 964 - 0500. Hold us to higher standards.

Have you ever heard of the Impossible Trinity?

Don’t worry if you haven’t - it’s one of those hidden rules in economics that rarely gets talked about. But don’t let that dissuade you, because it shapes the global economy in a big way, especially when it comes to currencies.

In fact, this one rule is a major reason why I believe the Chinese yuan may never replace the U.S. dollar as the world’s top currency - at least not without some big changes on their end.

Curious? Let’s dive in. . .

What Is The Impossible Trinity?

The Impossible Trinity – or known as the policy trilemma1 - is an economic principle that says a country cannot have all three of the following at the same time:

  1. Free Capital Flow – Money can move in and out of the country without any red tape or controls (aka an open capital account).
  2. Fixed Exchange Rate – The country’s currency stays tied to another currency or basket of currencies (aka a currency peg).
  3. Independent Monetary Policy – The central bank acts independently and sets interest rates and monetary policy to control inflation and growth (aka independent central bank policy).

Figure 1: Dunham, 2025

If a country goes for all three, it almost certainly risks chaos in its economy.

So, the deal is simple – a country must pick two and stick with it. Trying to have it all? Well, that’s when things begin to break.

This may seem complex, so let’s look at some real-life examples. . .

Example One: The United States

The U.S. made its pick in the Impossible Trinity game. It decided on two things:

  1. Free Capital Flow – Money can move in and out of the U.S. freely, like water flowing between countries (aka it’s very liquid). Someone can buy or sell dollars as much as they want whenever they want.
  2. Independent Monetary Policy – The U.S. has its own "money boss" called the Federal Reserve (or "the Fed") that can change interest rates to control things like inflation or to help the economy grow as they deem fit.

But here’s the trade-off. . .

  1. The U.S. doesn’t (and can’t) have a Fixed Exchange Rate. This means the value of the U.S. dollar can go up or down, depending on what’s happening around the world. For example, there’s no policymakers pegging the dollar to the euro or yen to manage it’s relative value.

This poses an issue because, as I highlighted in “The U.S. Dollar’s Global Dominance: Perks, Pitfalls, and the Perils of Losing It,” many foreign countries - particularly China, Japan, and the U.K. - park their excess savings in the U.S., artificially pushing the dollar’s value higher.

Critics rightly argue that the U.S.’s large chronic deficits should cause a much weaker dollar. Yet, a glut of foreign money easily parked in the U.S. keeps it strong, making U.S. exports more expensive and less competitive globally. Meanwhile, this dynamic allows these countries to export more to the U.S., fueling America’s trade deficit so that they can boost their own growth.

This is the price the U.S. pays for playing the Impossible Trinity game.

Example Two: Hong Kong

Hong Kong decided to play the Impossible Trinity game differently from the U.S. Here’s what they chose:

  1. Fixed Exchange Rate – Hong Kong keeps its money - the Hong Kong dollar (HKD) - pegged to the U.S. dollar. For instance, since 2005, it always stays between $7.75 and $7.85 to 1 USD. If the HKD gets too strong or too weak, Hong Kong’s central bank steps in to fix it by selling their own dollar reserves or injecting Hong Kong dollars. This helps businesses feel safe because they know the value of the money won’t bounce around.
  2. Free Capital Flow – People and businesses can move money in and out of Hong Kong easily, which makes it a popular place for international trade and investment (aka it’s liquid).

But here’s the catch:

  1. Hong Kong can’t set its own Independent Monetary Policy. Instead, the Hong Kong Monetary Authority (aka the HKMA, the central bank) has to follow whatever the U.S. does with interest rates.

Why? Because if the U.S. raises its interest rates, the U.S. dollar becomes stronger. Hong Kong then has to raise its rates too, to keep the HKD tied to the USD. And vice versa if the Fed cuts interest rates.

But this can cause problems.

For instance, imagine if the U.S. raises rates to slow things down because they’re worried about inflation, but Hong Kong is in a recession. Hong Kong would have to raise rates too, which could make their economy even worse.

This is exactly what’s happened ever since the Fed began tightening interest rates in December 2015. Since then, Hong Kong’s economy has been struggling under the weight of following the Fed into tightening. As the chart below shows, it’s been roughly stagnant for the last 8 years (once the Fed began tightening for the first time since the 2008 financial crisis).

In fact, since 2016, Hong Kong has experienced negative GDP growth in 12 out of 32 quarters - nearly 40% of the time - highlighting frequent periods of economic contraction2. 

Figure 2: St. Louis Federal Reserve, Dunham, January 2025

Or, if Hong Kong is booming and needs to cool down, but the U.S. is lowering rates, Hong Kong might end up overheating and spurring more and more inflation.

That’s the price Hong Kong pays for choosing these two policies.

*Note: Saudi Arabia follows this exact model that Hong Kong does, maintaining a hard peg to the U.S. dollar.

Example Three: China

China, on the other hand, has taken a distinctly different approach.

Here’s what they picked. . .

  1. Fixed Exchange Rate – China keeps the value of its money (the yuan) essentially pegged to the U.S. dollar. Now keep in mind that the People's Bank of China (PBOC) doesn’t explicitly peg it to the U.S. dollar like Hong Kong does, but it is heavily influenced by it, hence the term “shadow peg”. This makes sure that things made in China - like manufacturing goods - can stay cheap, promoting exports. This helps China dump much of its excess capacity to the world, which boost its own growth (I’ve written more about China’s trade ware here).
  2. Independent Monetary Policy – China’s central bank can make their own decisions about interest rates to help its economy. For example, if house prices are going down too fast (which they have been), they can cut rates to try and spark life back into real estate.

But here’s the catch:

  1. No Free Capital Flow – China directly controls how money moves in and out of the country – unlike both the U.S. and Hong Kong. This is known as a “closed capital account” – think of it like having gates around their money to stop people from sending large amounts of it abroad or letting too much foreign money come in.

Why does China do this?

Because if people could move money freely, it would greatly influence the yuan’s value. For example, if China lowers interest rates to help its economy, investors might prefer to send their money to the U.S., where interest rates are higher. That would cause the yuan’s value to drop because too many people are selling yuan to buy U.S. dollars. This could break their “shadow peg.” Thus, by controlling money flows, China can keep its system stable.

*Note: China actually operates with two versions of its currency. You may have heard people talk about the “onshore yuan” (CNY) and the “offshore yuan” (CNH). This dual system is an odd and complex way for China to control its currency domestically while allowing limited use abroad. I’ll dive deeper into this in a future edition of Morning Pour.

What Happens When You Force the Impossible Trinity

The 1997 Asian Financial Crisis shows what happens when a country – Thailand specifically - tries to achieve all three corners of the Impossible Trinity (and failed, miserably)3.

So, what did Thailand Try?

  1. Fixed Exchange Rate – They pegged the baht to the U.S. dollar to attract investment and make the currency stable.
  2. Free Capital Flow – They also allowed money to move freely in and out of the country.
  3. Independent Monetary Policy – Policy makers at the Bank of Thailand wanted to set interest rates (specifically to cut interest rates).

What went wrong?

  • The Crux Of The Demise: Long story short, Thailand had pegged the baht to the U.S. dollar for years. Thus, as the U.S. dollar strengthened in the late 1990s, so did the baht, making Thailand’s exports uncompetitive. Meanwhile, a surging deficit and high short-term foreign-currency debt eroded confidence in its economic stability.

What happened next?

  • Massive Outflows: With these headwinds, domestic and global investors lost confidence in Thailand’s economy and started yanking money out.
  • Currency Blitz: The central bank burned through foreign reserves trying to defend the baht’s peg until they bled themselves out.
  • Breaking Point: Reserves ran out, and Thailand abandoned the fixed exchange rate in July 1997 and leaders were forced to let the baht plunge over 50% after over a decade of stability (see chart below showing the Baht’s collapse relative to the U.S. dollar).

Figure 3: St. Louis Federal Reserve, Dunham, January 2025

What was the fallout?

  • The baht lost over 50% of its value – a massive shock to the once golden goose of Asia’s economic boom.
  • A regional crisis then followed - impacting countries like South Korea and Indonesia.
  • The IMF was forced to intervene with bailout packages to try and stabilize Asia.

The Takeaway:

Thailand’s miserable failure highlights the risks of trying to "have it all" when it comes to the Impossible Trinity. At the end of the day, you’re forced to pick two.

Why This Matters: The Case Against the Yuan Overtaking the Dollar

So why does the Impossible Trinity matter for the U.S. dollar and the talk of de-dollarization?

Because China’s approach shows why the yuan won’t replace the dollar as the world’s reserve currency anytime soon, despite what you hear in the media.

China fixes its exchange rate and runs its own monetary policy. But it does this by shutting off capital flows - a major problem.

A reserve currency must allow money to move freely and quickly, without restrictions. China’s capital controls make the yuan unappealing to central banks and investors who value the U.S. dollar’s liquidity.

Moreover, if China loosened capital controls while maintaining a peg and independent monetary policy - trying to achieve all three sides of the Impossible Trinity - it would risk draining its foreign reserves. History, particularly Thailand’s 1997 collapse, shows this strategy is unsustainable.

In fact, I believe China avoids lifting capital controls because Beijing fears a massive outflow of money. Financially repressed households would likely rush to move their savings abroad into more attractive markets, putting deep pressure on the yuan’s peg.

Of course, China’s $3+ trillion in foreign reserves could sustain this approach for a time4. But eventually, the limits of the Impossible Trinity will catch up. . .

Thus, until Beijing is willing to embrace free capital flows - a move that would require giving up either its peg or its monetary independence - the yuan simply cannot realistically challenge the dollar’s dominance on the global stage.

But as always, this is just some food for thought.

Sources:

  1. What Is a Trilemma and How Is It Used in Economics? With Example
  2. Gross Domestic Product for Hong Kong SAR, China (MKTGDPHKA646NWDB) | FRED | St. Louis Fed
  3. Lessons From Thailand’s 1997 Financial Crisis
  4. Foreign-exchange reserves of China - Wikipedia 

Disclosures

This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.

Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice.

Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA/SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc.

SUBSCRIBE TO
THE DUNHAM BLOG