October 25, 2012

  • Sth worth noting - 25 Oct

    Why is Singapore ('s exchange rate regime) Different, i.e. Neither Float Nor Fixed?

    (extracts of "Singapore's Exchange Rate Policy)

        Since the Asian crisis, there has been a growing consensus that the only sustainable exchange rate regime for emerging markets is either a currency board or a floating exchange rate regime.  Singapore stands in contrast to this conventional wisdom.  Why does MAS (Monetary Authority of Singapore) choose a managed float?  The short answer is that this provides MAS with flexibility to deal with shocks while at the same time maintaining the purchasing power of the SGD.

         A basic philosophy underlying Singapore's exchange rate policy is to preserve the purchasing power of the SGD, in order to maintain confidence in the currency and preserve the value of workers' savings, especially their CPF balances.  Over the years, the managed float has served Singapore well in this respect.  Inflation and interest rates have been low, and expectations are for the SGD to appreciate over time.

        This includes reducing wages through the variable bonuses, and in extremis by reducing employer contributions to the Central Provident Fund.  This has happened twice: in the mid-1980s recession, and again in the Asian financial crisis.  The Government believes that it is better to confront the issue squarely and persuade workers to accept a direct wage cut.  If it glossed over the problem through a steeper SGD depreciation, workers would find out later that inflation had eroded the purchasing power of their wages.  In fact their loss, would be greater because most workers have accumulated substantial CPF savings denominated in SGD, whose real value would also shrink.  Workers would seek higher wage settlements to compensate, and the wage price spiral would soon erode away the temporary cost advantage.  Worse, Singaporeans would lose confidence in the currency and the Government.

    Why Not Float?

        A floating exchange rate regime would prevent the Government from meeting this fundamental objective.  It would also not be appropriate for a small and open economy like Singapore for two other reasons.

        First, MAS has found the exchange rate to be the most effective instrument to keep inflation low.  Other possible intermediate targets, in particular interest rates, are less effective in influencing real economic activity and domestic inflation outcomes.  The main advantage of a floating regime - the ability to pursue and independent monetary policy - is less relevant to Singapore than to other larger, less open economies with domestic policy imperatives.

        Second, a freely floating SGD may become too volatile in the short-run.  Worse, the currency could become misaligned over a sustained period of time, leading to resource mis-allocation.

    Why Not Fixed?

        First, the Singapore economy has highly diversified trading links, substantial fiscal surpluses, and a long track record of low inflation.  Both inflation and interest rates have been lower in Singapore than in the US.  There is thus little need for a nominal anchor for the SGD to manage inflationary expectations, or for the discipline imposed by the monetary policy of a foreign country - most likely the US - to which the SGD is pegged.

        Second, there would be a cost resulting from the adoption of the anchor country's monetary policy because of the divergence in business cycles.  This is shown by Hong Kong's example.  While Hong Kong's business and economies cycle has become increasingly aligned with that of China, its peg to the USD ties its monetary policy closely of that of the US.  During the early 1990s, the Hong Kong economy was growing rapidly and warranted tighter monetary conditions, but interest rates fell in line with those in the US, which was experiencing an economic slowdown.  This contributed to an asset price bubble.  Then during the Asian crisis, when the regional currencies depreciated sharply, the Hong Kong dollar experienced a sharp involuntary appreciation in trade-weighted terms.  The adjustment was severe, especially in asset price deflation.

        Third, a fixed exchange rate would make it more difficult for Singapore to absorb shocks from abroad, and adjust the value of the SGD exchange rate in line with changes in the country's underlying macroeconomic fundamentals.  This would be so even if the SGD were pegged to a trade-weight basket rather than a single currency.  For example, during the Asian crisis from the late-97 to early-98, when the regional economies depreciated sharply against the USD, the SGD too depreciated against the USD, but by much less.  In trade-weighted terms the SGD actually appreciate moderately, because MAS exercised flexibility to allow the NEER to rise above the policy band.  If the SGD had been required to remain strictly within the policy band, or had been pegged to the NEER, the MAS would have had to force the SGD to depreciate much more against the USD, at a time when market sentiment was weak.  This could have resulted in a loss of confidence in the SGD.  Instead, MAS only brought down the NEER to within the policy band months later, when financial markets had stabilized and conditions had become conducive.

    Source: http://www.mas.gov.sg/