Thursday, October 15, 2009

Stronger Exchange Rate ≠ Strong Exchange Rate Policy

Jagdev Singh Sidhu over at The Star thinks we should pursue a strong currency policy because:

"A stronger ringgit will force Malaysians, both employees and employers, to be more efficient and that is something the economy needs to do as I feel it is somewhat in an economic mid-life crisis."

He also makes the statement that:

"The current preference of using interest rates to drive economic growth may be due for a re-think in favour of the currency as the lower-than-normal rates in Malaysia since the Asian financial crisis haven’t really worked."

And third:

"A stronger ringgit is no guarantee that the country will be able to make that transition to a high-income economy but there are a couple of examples nearby which we should look at.

Singapore and Taiwan endured short-term pains when they allowed their currencies to appreciate but they did make the adjustment to incorporate more skills and capital in manufacturing processes. The stronger currency was also a boost for the service sector in those countries."

As you can imagine, I’m going to pick a few holes in this argument.

The first statement assumes that the substitution effect dominates the income effect in the terms of trade (the purchasing power of money we receive from exports, relative to what we can buy of imports). In other words, a stronger exhange rate reduces our competitiveness and we have to become more efficient to continue to sell to external markets.

The general consensus and the empirical evidence in the research literature finds just the opposite. In other words, higher terms of trade (which is what you get with a stronger exchange rate) actually increases export revenues more than the loss coming from reduced demand. So there won’t be much impact in terms of forcing Malaysians to “be more efficient”. In fact, given the relative share of primary resources in exports, there’s probably going to be even less incentive to improve productivity.

A second point is that because of our low value-added industries and with multi-nationals involved in exports, strengthening the exchange rate should in fact have only marginal effects on incomes and trade volume because there’s little local currency pass-through. A higher exchange rate not only reduces the local currency value of exports, but at the same time reduces the local currency value of imported inputs. Assuming the exchange rate elasticities are equivalent, then there will be roughly no change in returns to local content.

Third, given the two effects above, it’s not obvious or automatic that a stronger exchange rate would raise labour incomes in the export sector. Because the income effect dominates, trade volumes will change very little in the manufactured sector, so demand for labour will not change much or at all – which means whatever excess returns are generated from a higher exchange rate will benefit owners of capital, not labour. This also true to a lesser degree for the primary resources sector, where the ratio of imported inputs (e.g. in CPO) is actually quite high. This is not a recipe for raising domestic income levels.

The second statement is really about the conduct of monetary policy in pursuing price stability and economic growth, with the priority on the former as it is also a precondition for the latter. The choices a central bank can make here are setting the monetary base (money supply targeting), setting the price of money (interest rate targeting), and setting the relative price of money (exchange rate targeting). More recently, some central banks have experimented with direct inflation targeting with some success, but our statistical capabilities have to be upgraded for that to happen here.

The first option is a proven failure after experimentation in the early 1980s in the US and UK, and gave rise to Goodhart’s Law. The second has had relative success in maintaining price stability over the past twenty years.

The third is only advisable for relatively small economies with high external exposure or for countries with no external credibility, because in essence it means abdication of any influence over domestic monetary conditions. That’s fairly obvious from the experience of both Singapore and Hong Kong, the two countries in East Asia that use exchange-rate targeting – interest rates and monetary aggregates are subject to far more volatility than countries that use interest rate targeting. It’s also interesting to note that Malaysia’s aggregate economic record in the last decade is marginally better than Singapore’s and much better than Hong Kong’s.

Given this weakness, I don’t see any advantages for Malaysia, with its much more diversified economy, to follow this route. Since the first option is also out, that leaves only interest rate, and potentially, inflation targeting as the basis for monetary policy.

Also, from a currency perspective, it’s not the nominal interest rate that matters but the real interest rate differential. While both nominal and real interest rates have been low across the last decade, that’s consistent with the rest of the world (trade-weighted, real interest rate differential):

In fact, it looks remarkably stable to me since 1990. The implication of course is that with interest rate targeting, both the exchange rate and money supply growth would be inherently more volatile, which has indeed been the case:

Growth in Monetary Aggregates (log annual changes)

Nominal and Real Effective Exchange Rate Indexes (2000=100)

On that basis, since 2005 it’s hard to say that BNM has any currency policy at all, apart from occasional intervention to smoothen volatility as happened this past week.

Now, one might argue that the accumulation of foreign exchange reserves in the past 10 years is a sure sign that the currency is weak, and that the central bank is intervening to prevent currency appreciation. That’s only true if you think the standard open-economy model applies. But that makes it hard to reconcile Singapore’s reserve accumulation with their alleged strong currency policy:

Singapore's International Reserves

My critique is that many who take reserve accumulation as proof of a weak currency policy are ignoring the money supply implication of a trade surplus and capital flows, and the potential for financial fragility inherent with a large accumulation of foreign exchange deposits in the banking system (FX deposits are included in both M2 and M3).

On a more practical basis, it also makes sense for banks to sell their excess forex deposits to BNM since you can’t spend or lend those deposits within Malaysia. Hence inflows of foreign exchange raises demand for local currency, which causes interest rates to rise. Since we have an interest rate targeting regime, that requires the central bank to increase liquidity which damps pressure on interest rates, and incidentally involves selling Ringgit in return for foreign exchange.

Rather than a sign of currency intervention, accumulation of reserves then becomes a form of insurance, in short making sure enough foreign exchange is on hand in case of liquidity emergencies, such as occurred late last year when investor flight to quality caused a USD shortage the world over:

Net Official Reserves

Change in Net Official Reserves

The problem is that open market liquidity operations to manage money supply volatility, conducted in foreign exchange, is functional equivalent to foreign exchange rate intervention and vice-versa. You can’t tell the difference, and it is hardly proof that the central bank is taking any particular stance with respect to the currency, as opposed to domestic liquidity.

On the third statement, you can only accept that Singapore and Taiwan have “strong currency policies” if you believe that Purchasing Power Parity applies (PPP). Otherwise, the latest IMF Article IV consultation with Singapore indicates the SGD to be undervalued and other research (this for instance) indicates that both SGD and NTD are as undervalued as the MYR. The equivalent, opposite statement can actually be made about the USD - its highly overvalued and ought to depreciate relative to everybody else. The truth is probably somewhere in the middle.

And if you followed my writings at all, you’ll know that I believe that the causality between the services sector and the exchange rate runs the opposite from what is stated in the article – a stronger services sector creates an appreciation of the currency, not the other way around.

Bottom line? I don’t believe we have a currency policy at all – the preponderance of evidence suggests that BNM is only concerned with currency volatility, not its level or stability. On that basis, the MYR will continue to trade at or close to its short term, time-varying equilibrium (barring intervention) and gently move towards its medium term, fundamentally consistent equilibrium over the medium term (4-5 years) – which at the present time means an appreciation.

That doesn’t mean there won’t be large currency moves, against the USD for instance which has a lot of structural problems. But interference in the exchange rate won’t solve our structural problems – in fact a strong currency policy is more likely to paper over the problems we have than become a force for change. The MYR will get stronger, but as a consequence of a services-based economic growth strategy. As the fundamentals change, so will the equilibrium exchange rate level.

1 comment:

  1. Wow HishamH,

    That was such a fantastic argument. I'm using your blog as the missing link between theory, conjecture and facts. Great job