Big Mac Index Yet Again

Someone else responded to Mr Gunasegaram's article and thinks a "strong" currency is not a good idea:

"First of all, I believe this is a crazy and short-sighted idea. It likely leads to a recession. When our currency is strong, everything we import seems to be at a discount and this encourages people to spend more on foreign goods and services through imports.

Strong currency also discourages our usual foreign trade partners to buy goods from us, thus export value will drop.

It also causes a country to lose its competitive advantage in attracting foreign investments.

At a time when inflow of money is significantly less than outflow, a serious current account deficit occurs in a broader sense. Malaysia will then be in deep trouble, after a short period of delusive wealth."

...and...

"If the ringgit were to be strengthen to a level of one for one US dollar, I would say good luck to everyone in Malaysia, welcome to the “burgernomics club”.

We will be staring with mouths watering at the Big Mac burger with an attractive price of RM3.54 in Malaysia just to find that our wallet is empty. And conveniently, if you want some money, IMF out there is willingly to lend you plenty.

There is no free lunch. Permanent and sustainable wealth does not come from currency rate delusion."

He's a bit less polite than I was though.

Ye Gods, Not Again: The Big Mac Index And The Ringgit

What is it about The Star and a "weak" Ringgit?

I thought I'd done with the Ringgit for a while, but P Gunasegaram repeats that tired old mantra that Purchasing Power Parity is a valid theory, again quoting The Economist magazine's Big Mac Index. I've covered the weaknesses of the BMI here and here, and I'm not about to go into that again except to note that PPP as a guide to currency value is at best a hypothesis, not a theory. A theory requires that the underlying hypothesis is supported by empirical data, which conspicuously is lacking for PPP.

Mr Gunasegaram also repeats that other tired mantra that an increase in reserves indicates a de facto attempt to devalue the currency. Again, this is not necessarily true as it completely ignores the potential impact of trade and capital flows on the domestic monetary aggregates (and thus inflation), which would necessitate central bank intervention. Since this intervention is functionally equivalent to currency intervention, what looks like an attempt to weaken the currency is actually something quite different.

We're also ignoring recent history here. Here's the log annual change in reserves and the MYRUSD exchange rate (where a negative change indicates appreciation) since 2000:



Two things to note here - first during the fixed rate period, reserve accumulation was volatile. If PPP was in fact operative and the Ringgit is substantially undervalued against the USD then reserve accumulation according to Mr Gunasegaram's hypothesis should have been consistently positive - it was not.

Second during the floating rate period, reserve accumulation had the opposite sign to what his hypothesis suggests. In other words, reserves increased when the Ringgit appreciated, and decreased when the Ringgit depreciated. That's a rather big hole in the "weak" currency meme, but is consistent with BNM's stated policy of ameliorating currency volatility (and not aiming for a target level) when necessary.

If BNM was intervening to create a "weak" Ringgit, then there would be no call to intervene when the Ringgit started weakening last year - which in fact actually happened. And the intervention conducted was more a factor of demand for USD (a response to domestic monetary conditions), rather than to achieve some target rate for the exchange rate.

You can find my extended critique of the "weak" currency meme here and especially here.

On another note, while a "strong" currency policy would indeed have the effect of increasing de facto individual incomes, there's an underlying assumption that nothing else will change. I roughly calculated trade elasticities with respect to the exchange rate in an earlier post - a 1% appreciation in the exchange rate resulted in approximately a 1.55% to 1.57% drop in exports.

Think about that for a minute - if my estimates are correct (and to be fair I'm not all that certain), since the drop in exports exceeds the rise in the exchange rate that implies a drop in export volumes. Since volumes will drop and there is no endogenous change in the supply for labour in the tradables sector, you'll get your higher income at the cost of higher unemployment (and since we're talking about low-cost production, also higher income inequality).

Let's just say I don't think pushing for a "strong", as opposed to a fairly valued exchange rate, is a good policy.

Technical Notes:
1. Data for reserves and MYRUSD exchange rate from BNM's Monthly Statistical Bulletin.

September Trade: I'm Not Worried - Yet

It's an unfortunate fact that most point forecasts are nowhere close to actual realization, a truism that applies to practically any endeavour not just economics (stocks, weather, sports, you name it). Last month's trade numbers are making me look like a genius though - which means I'm probably due for a run of bad luck!

I've already commented on the impact that Ramadhan would have on trade, especially with nearly a full week of production stops due to Eid il Fitri. It's no surprise then that both exports and imports appear to have regressed (log annual and monthly changes):




But the export number was presaged by the drop in imports in August - the point forecasts for my two models were just RM300 million off the actual (the 95% confidence interval was over RM10-13 billion), which is about as close to perfect as you can get. Since both models are driven by imports as predictors of export performance, no surprise that they caught the potential drop in exports.

Seasonally adjusted month-on-month growth moreover was essentially flat (log monthly changes, seasonally adjusted):



I'm taking this development positively, given the underlying cause. What I'm hoping and expecting for now is that my models underperform the next couple of months - we're coming up to the end-of-year shopping season in developed countries, and there should be a bounce in output and exports in October and November.

I'm discounting the fact that imports were flat in September - capital goods imports accounted for most of the poor showing, while there was a marginal increase in intermediate goods imports. October exports should therefore range closer to the upper bounds of the interval forecasts.

Next month's predictions:

Seasonally Adjusted Model


Point forecast:RM43,133m, Range forecast:RM48,479m-RM37,788m

Seasonal Effect Model


Point forecast:RM46,735m, Range forecast:RM53,251m-RM40,219m

Technical Notes
1. September Trade data from Matrade

September 2009 Monetary Policy Update

Banks have begun to raise their lending rates on home loans and other financing – is this justified? From a consumer perspective this is a blow against disposable income, albeit a rather small one (for the moment). But from the banks’ perspective, the rate hike has been probably overdue. The Base Lending Rate (BLR) is supposedly the rate at which banks would lend to their best customers, and essentially provides enough of a margin over their cost of funds (COF) to cover loan defaults, overhead, and reserve requirements. But stiff competition in the banking sector has rendered BLR irrelevant as the benchmark lending rate:




Average lending rates have been consistently below BLR since 2004, and below 3% above overnight money since early 2007:



With prospects of economic recovery now clearer and loan demand sustained, there’s a feeling that interest margins have been overly compressed and banks are mispricing default risks. I have some sympathy for this view – when it comes to loan supply, it’s probably a little better to err on the higher side for pricing. If there is one lesson that we’ve learned from this past crisis, it’s that it’s all too easy to misjudge risk in the financial sector, more so since we have an environment of very low loan defaults and high domestic liquidity. But for those reasons, I don’t expect too much in terms of rate hikes in the next couple of months though – really about 20-30bp, 50bp on the outside.

Speaking of liquidity, there’s been slight movement on the monetary front (log annual changes):



I expect monetary growth to fall back in October-November, but to pick up later in December.

There’s not a whole lot of movement on the interest rate front either. BNM has kept the OPR at 2.00%, and the government only borrowed in September to redeem RM4 billion in MGS that had come due. MGS yields as a result stayed pat:



RM2 bilion in Khazanah bond redemptions also partially offset a year high RM4.5 billion in PDS issuance, so bond supply only marginally expanded.

The only big movement on the monetary front has been the Ringgit, but that's largely a US dollar story and not a Ringgit story, so I'll leave that for another blog post.

What The KLCI Says About Economic Policy

Usually it doesn't.

Teoh Kok Lin makes that point today (emphasis mine):

"BUDGET 2010 was, shall we say, not that warmly received by the man in the street. Some pointed out that the budget gave few goodies to the rakyat or businesses compared with previous years, hence it was not as good and that’s why the stock market was down 0.5% last Monday.

I believe a slight disappointment with the budget played a small role, if any, in the stock market. However, I am perplexed how one can infer from “one-day” stock market movements whether the budget is good or not."

To be more rigorous about it, here are the stats on the log difference in daily closing for the KL Composite Index (sample: January 2000-September 2009):



The two stats of interest are the mean (0.0001) and the standard deviation (0.0096). The observations show that daily changes are approximately normally distributed somewhat more leptokurtic than a normal distribution (from the Jarque-Bera stat "peakier" with a kurtosis stat > 3), with a mean of zero:



Using a 95% confidence interval and the standard deviation of 0.0096, we get:

(1.96 x 0.0096) x 100 = 1.88%

Which means that any movement plus/minus 1.88% is just the normal daily trading range for the KLCI, and doesn't say anything at all about the budget, RPGT, credit card taxes, fuel prices, commodity prices, the US dollar, Tun Mahathir's comments, corruption, politics, or Samy Vellu's hair (or lack thereof).

Edited (changes in blue): The actual distribution of changes has a greater central tendency than a normal distribution. Thanks Hafiz!

Credit Cards: Much Ado About Nothing

Reading through the Sunday Star yesterday, I'm puzzled by the amount of vitriol attracted by the new credit card levy, with a RM50 tax on each principal card, and RM25 on each supplementary card.

The ostensible idea was to encourage "prudent spending", by effectively increasing the costs of access, which had dropped due to the proliferation of "free for life" cards. I'm not sure this is the right policy, or to be more precise, the most effective policy to implement based on the stated goal. On the other hand, a more effective policy might involve heavy handed intervention in the workings of the financial sector that would contravene the spirit of the past ten years of financial liberalization. It’s certainly generated a lot of angst among card-holders, but judging from the public response, the tax appears to be effective in achieving the government’s goal of reducing card “collections”.

But before going into a discussion of right or wrong, it's probably best to proceed from a basis of firm facts - what is the current situation in Malaysia now?

With the explosion of consumer banking that began after the 1997-98 crisis, credit cards and mortgages have been a key battleground for the banking industry. The number of cards have grown exponentially (in millions):




...as have outstanding balances:




This has been coupled with a fairly steady drop in bad debts, although you should note that the default rate is far from typical of other bank business lines (which average under 2%):



On the face of it, this look likes a fairly attractive market for the banks. From the consumer point of view, it doesn't look too bad either. On per card basis, it looks like consumers are acting relatively responsibly:






Balances per card are dropping, as are transactions. The percentage of balances not paid-off at the end of the reporting period is dropping as well even as credit limits are rising, indicating we're in no danger of turning into another Korea just yet.

What complicates matters is that number of cards ≠ number of cardholders. How would recasting the numbers on the basis of population look like? More specifically, based on labour force numbers, we see a very different picture - the ratio of the number of cards to the work force has risen from about 1 in 5 in 1998 to near parity in 2008:






Rollover balances have tripled in the last ten years, indicating card debt is increasing as a percentage of income, and transactions velocity has increased from about once a month to twice a month. The latter is not necessarily bad if balances were stable, but they are in fact increasing which is a little worrying.

So there’s a solid basis for the government’s concerns over easy access to high-cost personal credit. Is a flat tax the optimum effective solution to reduce card usage? Not hardly – ideally there would be some (fairly high) minimum threshold of income to qualify, and perhaps a graduated tax based on credit limits similar to the annual commitment fees banks charge businesses for revolving credit.

I’d also consider putting in a minimum interest rate floor, not just an interest rate ceiling as currently practiced. We are after all talking about unsecured revolving credit where even with bad debts at an historical low is seeing defaults average in the mid-teens (comparable to junk-bond default levels). Some banks are offering under 10% p.a. interest rate charges - I'm not sure if this is not mispricing the financial risk involved.

But such measures are a little harder to enforce on individuals – if income is the barometer, what about the self-employed or those who earn on a commission basis? If access to this segment is curtailed for what is arguably a legitimate portion of the working public, then hard rules based on income are inequitable – and we have enough inequity in this country already, thank you. It’s also more than possible to set limits on the number of cards any one person can have (through CCRIS), though this may involve some loss of privacy. On second thoughts, maybe not such a good idea.

On that basis, a flat tax is a second best solution that despite the fact that it is not yet in place, already appears to be working by all accounts - people are already talking about cutting up their excess, unused cards. I feel the tax measure was really put in place to replace the annual fees typically charged for credit cards, but too often waived by banks in the interests of gaining and retaining customers. Maybe if banks had committed to charging annual fees we might not be having this very public debate.

Technical Notes:
1. Credit card data from BNM's Monthly Statistical Bulletin.
2. Population data from DOS and EPU

DOS gets an upgrade

Read here. Data collection for Census 2010 will apparently be internet-based.