Spare The Float, Ruin The Economy

I respect TDM a great deal for many of things he’s done. His macro policy recommendations need a lot of work though (excerpt):

Peg ringgit to create environment of certainty in market -- Dr M

KUALA LUMPUR: The ringgit should be pegged at RM2.80 to the US dollar in order to create an environment of certainty in the market, said former Prime Minister Tun Dr Mahathir Mohamad.

Dr Mahathir said the peg would also help businesses manage the rising costs of doing business.

"If the exchange rate is fixed at one rate, it will help businesses plan their budgets for the year, knowing exactly that there the value of the ringgit will not change," he said….

…To recap, in 1998, the ringgit was pegged at 3.80 to the US dollar after the local unit substantially depreciated during the 1997 Asian financial crisis.

He said at one time, when the ringgit was fixed at RM3.80 the country had recovered and was able to compete with the neighbours and businesses generally grew.

Dr Mahathir said the current floating system of ringgit only created uncertainty, which could lead to the rising business costs because the businessmen had to hedge against possible inflation.

However, he said, by now the ringgit should be about RM2.80 against the US dollar….

Standard macro, which most economic students learn at undergraduate level, says you can only control two out of the three monetary policy variables. These are domestic monetary conditions, the capital account, and the exchange rate.

Right now with a floating exchange rate, we have control over domestic monetary policy and an open capital account. This stabilises the domestic environment and helps attract FDI and portfolio flows, at the cost of external uncertainty. With a peg however, we have a difficult choice – forego foreign investment (and domestic investment abroad), or forego monetary sovereignty.

Assuming we opt for keeping an open capital account, domestic interest rates would be effectively determined by the US Federal Reserve, which is exactly what is happening now in Singapore and Hong Kong. Assuming we opt for a closed capital account instead, we reduce the efficiency of capital investment, because all those massive savings we have would need to be invested locally, with obvious effects on returns and asset price inflation.

Details count too – much of Malaysia’s merchandise exports aren’t actually exchange rate sensitive. 70% of the manufacturing sector is foreign owned, and are part of the global supply chain. Both output and imported inputs are priced in foreign currency – the exchange value of the Ringgit doesn’t matter much.

For the rest of our exports, which is mainly in commodities, a floating exchange rate actually helps. When global commodity prices fall, the Ringgit should fall in tandem – that helps to keep nominal domestic incomes stable, because the relative value of exports in domestic currency terms should stay much the same. And vice versa – rising global commodity prices should strengthen the Ringgit, which weakens the inflow of foreign exchange receipts and reduces inflationary pressure.

The 1998 peg wasn’t a big factor in helping Malaysia recover, in my not so humble opinion. Fixed exchange rate enthusiasts often don’t realise that exchange rates are relative prices, not absolute ones. The USD can and often is under or over-valued as well. This would matter less if the US were Malaysia’s biggest trade partner, but they are not – the US comes in fifth, behind China, Singapore, Japan and Europe. A peg would boost competitiveness when the USD is undervalued, but would have the opposite effect when it is overvalued.

That in fact is what happened to the USD in the five years after 1998; it got progressively stronger until about 2002, after which it started deteriorating again. Malaysia’s “recovery” lasted a bare three years, before we became uncompetitive once more, and export growth started tailing off, requiring the government to deploy fiscal policy to keep the economy going. The accession of China to the WTO in 2004 hastened our deindustrialisation, and by 2006 manufacturing export growth had more or less plateaued. The commodity boom that followed saved the economy, but Malaysian manufacturing is only just starting to recover again, more due to China’s growing uncompetitiveness than anything else.

One last point: how many people remember that at the time that the Ringgit was pegged to the USD at 3.80 in September 1998, it had already strengthened by 20%? The peak was 4.73 on 8th January 1998; the average for the month of August 1998 was 4.20, and the lowest for the year was 3.54 in late March. As the economy recovered, there was every prospect that the exchange rate would have floated its way back sooner or later.

While the proximate cause of the crisis was speculative attacks on the currency, the underlying factor was an exchange rate that was overvalued and uncompetitive at RM2.50. Remember that, along with government fiscal surpluses, Malaysia ran a large current account deficit in those years as well. With commodity prices weak and expected to weaken further over the coming years, a peg at RM2.80 thus risks recreating the very same pathology that led to the 1997-98 crisis in the first place.

“Those who cannot remember the past are condemned to repeat it.” George Santayana