The latest Article IV Consultation between the IMF and Malaysia has some rather flattering language (excerpt):
…Executive Directors commended the authorities for their skillful policies, which have underpinned Malaysia’s strong macroeconomic performance despite a weak external environment…Looking ahead, Directors considered that Malaysia’s medium term prospects are favorable, as the authorities continue to focus on safeguarding financial stability, strengthening fiscal sustainability, and securing high and inclusive growth.
Directors endorsed the current settings for monetary policy and the mildly contractionary fiscal stance in the 2013 budget. They nonetheless encouraged the authorities to further develop their medium term [sic] plans to restore a prudent level of federal government debt and rebuild fiscal space…
…Directors noted with satisfaction that the 2012 Financial Sector Assessment Program review found Malaysia’s financial sector to be robust, highly capitalized, and underpinned by a sound supervisory and regulatory framework…
…Directors welcomed the authorities’ intention to implement wide ranging reforms to boost growth and inclusiveness. In this context, they underscored the importance of increasing labor market flexibility, raising female participation, and fostering the skills needed for a high value-added [sic] economy. Directors welcomed the introduction of a minimum wage, and considered that adopting unemployment insurance and pension system reforms would further strengthen social protection.
Directors took note of the staff’s assessment that, despite the significant narrowing of the current account, Malaysia’s external position appears stronger than warranted by fundamentals and desirable policies. However, they agreed with the authorities that this mainly reflects structural factors. A few Directors also pointed to underlying methodological limitations in the assessment of the external position…
I actually found the last paragraph to be the most interesting, but that’s getting ahead of things. Overall, this assessment is fairly balanced – things are going well and policy settings are appropriate, but at the same time noting that there’s still a lot of work to do. GST, subsidy rationalisation, unemployment protection, labour market reform all get a mention. The full report, if you want to read it, is available here.
But returning to that last paragraph though, it’s a very big shift in IMF thinking. I’ve actually been meaning to cover the underlying empirical and theoretical foundations for this, as there have been a couple of papers on this issue after the past couple of months. The IMF is also currently overhauling (warning: pdf link) its existing methodologies.
Basically what the issue amounts to is this: current methodologies for looking at over- or under-valuation of exchange rates rely on the unspoken underlying assumption that international trade is conducted with finished goods. In effect, that assumption means that exports and imports are independent of each other and supply and demand of either are regulated via differences in their domestic against external price i.e. influenced by the exchange rate.
If the exchange rate is overvalued, you would expect to see a trade deficit as imports are relatively cheaper than exports, while if an exchange rate is undervalued, you would expect to see a trade surplus as exports are cheaper than imports. If exchange rates are correctly valued, then there would be balanced trade. In practice, any current account surplus or deficit of at most 2%-3% GDP is typically taken to be “sustainable” and the exchange rate “appropriately” valued.
If however, trade is largely in intermediate goods – unfinished components or raw materials for processing into finished goods or further intermediate goods – then exports and imports are not independent and the impact of the exchange rate would be only on the domestic value-added part of the good. And we’ve seen nothing if we haven’t seen the proliferation of global supply chains and globalisation of trade links in the last two-three decades.
For example, if I export good A in USD terms, with 70% of the components sourced from imports (also priced in USD), movements of the Ringgit would raise and lower my selling price and input price in unison. The impact of the exchange rate on my sales and profits would primarily be on the 30% Ringgit-denominated and locally-sourced portion of my cost of production – in other words, the value-added.
Looking at it from the perspective of the exchange rate and the trade balance, a country with a high portion of imported content in its exports could be expected to have a high trade surplus, irrespective of the valuation or current level of its exchange rate. Conversely, countries with low import content could be expected to have balanced trade if its exchange rate is correctly valued.
In effect, what that means is that countries that have always been viewed as currency manipulators or to have had undervalued currencies, such as Malaysia, or China or Korea, actually have exchange rates that are more appropriately valued than was once thought. There is a “structural” component in their trade surpluses that existing methodologies simply don’t account for.
There’s been a burgeoning literature on global supply chains, but its been mainly in the field of management, or within economics, in terms of the impact on trade itself. The new insights on exchange rate valuation and on the balance of payments however are comparatively new.
The concept will take a long while to catch on though, as the data requirements are massive and intimidating – essentially what’s needed is a global input-output matrix, not a project to be undertaken lightly.
Fortunately the OECD and the WTO have made a start on the problem with the TIVA database which covers 40 countries. But to get a full grasp of the phenomenon we need both a broader range of countries across many more points in time.
Nevertheless the essential point needs to be made that the presence of a trade surplus or trade deficit alone is no longer sufficient in determining whether a currency is incorrectly valued. We have to look at the composition of trade and the composition of each individual good, to make an accurate and reasonable determination.