Economic Development A’la McDonalds

I promised to write a post on a Bloomberg article I read a couple of days ago, but was too busy to get down to it (you’ll see why in the next post).

But this article – really about the working paper its based on – is pretty fascinating (extract):

The Big Mac Theory of Development

It’s a question richer people have about their poorer neighbors: Why are they poor? Is it circumstances, or is it some kind of moral or intellectual failing? Is it that they never had a chance to cross from the wrong side to the right side of the tracks, or that they never had the motivation to cross? The subject colors thinking about international development as well. Is poverty in Africa and Asia the result of something about individual Kenyans or Pakistanis, or is it instead something about Kenya or Pakistan? Is it about the people, or the place?

A new paper by Princeton Economist Orley Ashenfelter for the National Bureau of Economic Research sheds some light on this debate. It compares the wages earned by staff working at McDonald’s (MCD) franchises around the world. Ashenfelter studies what McDonald’s employees earn against the cost of a Big Mac in their local franchise. The Big Mac is a standard product, and the way it’s made worldwide is highly standardized. The skill level involved in making it (such as it is) is the same everywhere. And yet, depending on where they live, crew members from all parts of the world earn dramatically different amounts in terms of Big Macs per hour…

Say What? Redux

One of my aims with this blog is to approach the question of economic policy from the “wrong” side of the bed – in a manner of speaking. Instead of using the more usual way of applying theory to try to explain what’s happening in Malaysia and the world, I prefer to follow the opposite route which is to look at the stats and then see which theory really fits the numbers.

To be honest, you really need to use both approaches to arrive at appropriate policy decisions, but I think you make less egregious mistakes by looking at reality first.

Case in point: in an article today at the Malaysian Insider, Datuk Jema Khan is calling for a repeg of the Ringgit to preserve “economic competitiveness” (emphasis added):

Beware the ringgit

…Our ringgit is the best performing currency in Asia for 2010, having risen by more than nine per cent whereas China’s yuan has only appreciated by two per cent as a result of its central bank’s intervention.…

…The major economies of the US, Japan and the UK are flooding the world with liquidity and that liquidity is coming to Asia. For Asia, that is not necessarily a bad thing as it means more inward FDI inflows, but unfortunately it appears that Malaysia is not benefitting from it.

The NEM In Numbers: Nominal Versus Real

I’ve been meaning to cover this issue for some time now, but haven’t had the time. It’s very late to be talking about this, but I suppose better late than never.

One of the things that has been bothering me about the New Economic Model is that the public discourse revolves around trying to reach over 6% real growth. That’s largely false, or to be more precise, largely misleading.

Impressions of Dubai: Lessons for the NEM

I’m back after spending close to a week in Dubai and an interesting trip it was. The United Arab Emirates (of which Dubai is a part) has one of the highest per capita incomes in the world – ranked third in real terms after Qatar and Luxembourg in 2007 according to the latest Penn World Tables (Malaysia is ranked 53rd by comparison).

Dubai has an interesting economy and its development perhaps holds some lessons for Malaysia, never mind their recent debt crisis (stemming largely from an overheated property sector). You would think that a gulf nation like Dubai would be awash in oil, but oil revenues now comprise less than 10% of the economy. They’ve managed to nicely avoid being infected with Dutch disease and the economy has maintained its high income despite the lack of any other significant natural resources.

How was this done? Largely by going the services route – Dubai is intent on being the financial centre for the Gulf, as well as a prime tourist and shopping destination. Duties and taxes on goods is virtually nonexistent as is individual and corporate income tax, which is a strong draw for expatriates and multinationals. Dubai is also a centre for trade in the region, even if it produces next to nothing on its own.

This focus on non-tradables means labour incomes, being restricted to competition within the emirate, are continuously bid up – I read about low to mid-level executives earning at least AED10k a month (or about MYR9,000).

The flip-side to high labour incomes can also be seen – Dubai is an expensive city when you are talking about anything other than tangible goods. A smallish apartment costs around AED70k a year to rent (the hotel room I stayed was rated at AED2500 a night), transportation costs an arm and a leg, and it’s clear that a lot of that high labour income is being eaten up by higher (much higher) costs. No doubt “things” are cheap relative to labour income – from walking around some of Dubai’s many shopping malls, there’s little to choose from in terms of prices between Dubai and Kuala Lumpur. But in terms of other costs – housing, transportation, even fast food – Dubai has all the hallmarks of the Balassa-Samuelson effect.

That’s one of my main concerns with the New Economic Model and high-income status for Malaysia in that higher labour income necessarily means higher costs in everything except material goods. Which means if we’re not careful, we’ll still be dealing with the same issues of inequality and relative poverty as we have now, except your roti canai and nasi lemak will cost double what it does today.

Before I leave this topic, one last observation – Dubai’s fortunes are being built on the backs of immigrants. If it weren’t for the signage and the scorching desert heat, it’s pretty hard to tell you’re in the Middle East. English is the lingua franca and most people I met and spoke to were from as near as Kuwait and as far afield as the Philippines – 85% of the population come from somewhere else. I’m told that “locals” are slow and complacent – sound familiar?

Currencies and Current Account Adjustments Part II

I did a post about six months ago on an article in VoxEU (link) that evaluated exchange rate imbalances between the USD and Asian currencies, which suggested that the MYR was as much as 1/3 too low against the USD. I criticised the paper on both methodological and procedural grounds.

Now another article on VoxEU is also basically challenging the findings of that article (excerpts):

On the renminbi and economic convergence

“Many economists agree that the build-up and maintenance of international imbalances, with their accompanying capital flows, contributed to the overleveraging of finance and underpricing of risk. How to rebalance then? Many observers are increasingly emphasising that China should let its exchange rate appreciate.

For example, Cline and Williamson (2009) have recently estimated “fundamental equilibrium exchange rates” compatible with moderating external imbalances. They estimate that the required renminbi appreciation is more than 20% in real effective terms and 40% relative to the dollar. Ferguson and Schularick (2009) point to the manufacturing wage unit-costs to estimate the degree of undervaluation of the renminbi relative to the dollar and come up with the figure of 30% and 50%. Finally, the Bank of China’s continuous intervention in the foreign exchange market also suggests that the renminbi would appreciate significantly if let loose; this intervention has accumulated $2.3 trillion of foreign exchange reserves.

…

To be sure, poor-country currencies are normally undervalued in terms of purchasing power parity with rich countries. In fact, poorer countries do have undervalued exchange rates (due to the Balassa-Samuelson effect), and convergence will imply considerable correction of that undervaluation. Services (and wages) are cheap in poor countries and expensive in rich countries, while prices for internationally traded goods are roughly equalised in a common currency. When the productivity in traded goods rises (while productivity growth for haircuts and other services are very limited), more income is generated and spent on services. The price ratio of non-traded to traded goods will rise. In other words, the real exchange rate will appreciate. Hence, part of the undervaluation ascribed to China’s and other currencies results from market forces that make non-traded goods relatively cheap in poor countries, rather than from deliberate currency manipulation by China’s authorities.

While growing and converging fast, China is still poor. Its per capita income in 2008 was 6.2% of the US’s at market rates and 12.8% at PPP-adjusted rates, according to World Development Indicator data. Figure 1 relates the log of real per capita GDP as a fraction of the US level and the deviations of current market exchange rates per US dollar from PPP rates for the year 2008. It shows strong support for the Balassa-Samuelson effect and suggests a well-determined elasticity (0.2) by which the undervaluation of the currency will be eroded during the catch-up toward the US per capita income level. Real exchange rates can thus be expected to appreciate as economies grow, approaching PPP exchange rates as economies converge with US living standards, as posited by the Balassa-Samuelson effect.

Figure 1. Income convergence and exchange rates appreciation

To gauge a converging country’s degree of undervaluation, the appropriate yardstick cannot be purchasing power parity; it should rather be the regression (over 145 countries) that provides the best fit for the Balassa-Samuelson effect. While the renminbi was undervalued by 60% in PPP terms, it was merely undervalued by 12%, if the regression fitted value for China’s per capita income level is compared to the current value in 2008. Note that India and South Africa (which had a current account deficit) were more undervalued than China by that Balassa-Samuelson benchmark, by 16% and 20%, respectively, in 2008. The currencies of Brazil and Russia were appropriately valued, i.e. close to the regression line.”

My kind of guy! Have a read through - there's some interesting policy conclusions as well.

Strong Vs Weak Ringgit Again

Izwan Idris asks if we should have a stronger Ringgit:

"One theory why the ringgit is limping behind its regional peers is that the ringgit basket is US dollar-heavy.

This explains why the currency continues to track the US dollar movement closely under the current 'managed float' system, rather than reflecting Malaysia’s own economic health.

Typically, a weak ringgit, in a way, works as a subsidy for local exporters by way of keeping export prices “competitive” against manufacturers based in other countries. This strategy helps local manufacturers earn more ringgit for every dollar sold but, on the flip side, Malaysians will have to pay more in ringgit for imported goods and services."

There are so many problems with this post I don't even know where to begin (and I'm not even going to comment on the grammar and tense usage mistakes).

So from the top (my comments in blue for legibility):

1. "The ringgit was officially de-pegged against the US dollar from a fixed rate of 3.80 on July 21, 2005 and, like the Singapore dollar, is currently under a float system tied to a basket of currencies."

Plain wrong. MAS follow an explicit exchange rate policy with interest rates and money supply free to vary (within limits), so that part is correct. BNM focuses on short term interest rates (the Official Policy Rate or OPR), with the exchange rate and money supply free to vary within limits in terms of volatility - so that part is false.

Fail.

2. "Economists estimate that the United States accounts for about 20% of Malaysia’s total trade, but as much of 80% of the country’s foreign transactions are denominated in US dollar."

I'll concede the latter statement (in the absence of firm evidence), but the former needs to be substantiated. Malaysia's direct trade with the US was last at 20% of total trade 10 years ago (the peak was 20.9% in 1998). As of last year, the US trade share has fallen to 11.8% - behind Singapore and approximately on par with Japan and China.

Big fail.

3. "One theory why the ringgit is limping behind its regional peers is that the ringgit basket is US dollar-heavy.

This explains why the currency continues to track the US dollar movement closely under the current “managed float” system, rather than reflecting Malaysia’s own economic health."

This is not a theory - it's a hypothesis, and an easily disproved one at that. First, as I pointed out in point 1. above, officially the Ringgit is in a free-float system, with the policy focus on interest rates rather than the exchange rate.

Second, if the Ringgit is truly tracking the USD then from a statistical perspective the MYRUSD rate should have a smaller standard deviation compared to other MYR cross rates. Out of the currencies of our major trading partners (sample 2005:6 to 2009:9, daily frequencies), the USD only ranks a distant third behind EUR and SGD, and only very marginally in front of CAD, GBP and SWF. Hardly conclusive evidence that we have a de facto peg to a USD-heavy basket.

Looking at the period when BNM was actively managing the exchange rate back in the 1980s bears this result out. For the sample 1980:1 to 1989:12 (again, daily frequencies), the USDMYR standard deviation was far and away the lowest by a couple of orders of magnitude, followed distantly by CAD and GBP, and even more distantly by the SGD, AUD, and ECU.

[Edit]: I should also point out that current MYRUSD volatility (as measured by the standard deviation) is 5x greater than it was in the 1980s.

Given relative movements and volatility in currencies against MYR over the past four years, if BNM is using a currency basket to "manage" the Ringgit, it's a very, very strange one.

Again, fail.

4. "The US dollar had fallen 15% against a basket of six major currencies since March, based on the performance of the US dollar index traded in New York. During this period, the won shot up 34% against the US dollar, followed by the rupiah’s 27% appreciation over the same period. The rupee gained 12%, while the Singapore dollar strengthened by 11%.

The ringgit lagged behind with a 10% rise, which was slightly better than the baht’s 9% advance."

This appears to imply (rather disingenuously) that MYR is being deliberately kept weak as regional currencies have advanced more than the MYR. In academic economic circles, this is an example of "data-mining" - selecting the data or the model that best supports your hypothesis or preconceptions, and hang the bigger picture.

To show what I mean, here are the percentage movements in the 2008:9 to 2009:2 timeframe (i.e. from the beginning of the financial meltdown to approximately the lowest point):

a. USD Major Currencies Index = +13.1%
b. KRW = -40.8%
c. IDR = -30.8%
d. INR = -17.6%
e. SGD = -9.1%
f. MYR = -9.2%
g. THB = -5.6%

We have an almost mirror image from the statistics quoted in the article. MYR hasn't gained much in the last six months or so, for the simple reason that it didn't fall as much during the worse of the crisis.

As Benjamin Disraeli was once purported to have said, "There are three kinds of lies: lies, damned lies, and statistics."

Fail.

5. "At near-0% interest, the US dollar is a cheap currency to borrow, but yields almost nothing to keep. Savvy international investors lend money in the United States and use the cash to buy assets elsewhere."

Let's be charitable - I can only think of this (emphasis mine) as a typo. It should be borrow not lend.

6. "Commodities and Asian equities are the big winners. Gold, which is the traditional hedge, is now trading at record high of US$1,065 an ounce.

Indonesian stocks have the highest return in US dollar terms year-to-date. The Jakarta Composite Index rose 84% in its local currency, but shot up 122% if the gains are reflected in US dollar.

At 1,265 points yesterday, the FBM KL Composite’s 48% rise year-to-date was the least among other regional stock indices."

Same as point 4 above - we haven't risen as much, because we didn't lose so much during the depths of the crisis either. Using the same sample period as my currency example (Oct 2008-Feb 2009), the JKSE fell 40.6% during that period and was 54.6% off its all time high. The KLCI by comparison fell just 19.1%, and was 41.3% off its all time high. A more regional comparison also holds - the KLCI was among the better performers in terms of holding its value in the past two years.

Do I sense a pattern here? Fail.

7. "High income equals to high purchasing power. To achieve this, it will require shifting the whole economy away from its current low-cost manufacturing base to a more service-oriented one, which is more or less what Singaporeans had done."

Finally a sensible statement - which unfortunately completely missed the connection between a stronger exchange value and having a services-based, high income economy. The latter begets the former, not the other way around. Singapore has an appreciating currency vis-à-vis Malaysia, because they have a stronger services (non-tradables) sector. There's also the demographic angle: countries with higher youth dependency ratios tend to have "weaker" currencies, and Singapore is "aging" faster than Malaysia is.

Going for a strong currency policy without improvement in the non-tradables sector is a triumph of form over substance.

8. "Keeping the ringgit undervalue against its regional counterpart may be counter-productive in the longer run, as it will only fuel our addiction to cheap exports industries that only attract unskilled foreign labour."

What's truly ironic is that having a "cheap" currency is not necessarily an advantage when you have low-value added export industries (i.e. with high import content), and especially not when a portion of your exports is commodity based. I'll touch on this when I get around to posting on trade elasticities. He made the point earlier when talking about the effect of exchange rates on exports and imports (see quote at the top of this post), but again missed the connection.

But as I've extensively written on before (for instance here, here, and here), I do not believe the Ringgit is substantially undervalued based on Malaysia's economic structure and current fundamentals (like terms of trade, services/exports shares, trade barriers, capital and financial stocks and flows etc). Nor do I believe that there is an implicit policy to keep the MYR undervalued relative to any currency. As far as I'm concerned, MYR is close to its trade-weighted fair value with a bias towards appreciation as the country increasingly shifts towards services as the growth sector.

Technical Notes:
1. MYRUSD exchange rates and MYR cross rates against other currencies derived from the Federal Reserve's Report H.10, except for IDR, where data was sourced from Pacific Exchange Rate Service.

2. Stock market index data from Yahoo! Finance.

What Will A Service-Based Malaysian Economy Look Like?

One of the things running to my mind with all this discussion of KPIs, KRAs and a new economic model for Malaysia is that while this may put us on the road to becoming the high income economy that everyone wants, we will have to handle a fresh set of challenges and structural changes along the way.

I`ve described what one of those changes will be: taking into account the Balassa-Samuelson hypothesis (BSH), a strategy encompassing services (which is mainly composed of non-tradables) as the engine of growth will have the impact of putting upward pressure on the MYR exchange rate. That is a consequence of labour arbitrage that is less subject to international competition, and thus less subject to the downward pressure on wages and prices exerted by low-cost economies such as China. An economy that is biased toward services would therefore be better able to support an elevated exchange rate than one concentrated on export manufacturing, all else being equal. Productivity differentials would of course have an impact (Germany and Japan for example), but the general rule remains valid.

But BSH was originally proposed for something quite different – an appreciated exchange rate for high-income, service led economies is just one of the consequences. The original research by Bela Balassa* and Paul Samuelson** (yes, that Paul Samuelson) was an attempt at explaining an emprirical regularity that was inconsistent with purchasing power parity. That emprirical truism was that high-income economies were also high cost economies.

In other words, high income economies also characteristically have high general price levels.

So one of the consequences of pursuing a services-led economy is that as incomes rise so will the price level of non-tradables, which will have the effect of raising living costs generally (housing for instance). That in turn brings to mind the probable impact on income and wealth distribution. Given that Malaysia already has high income inequality, we have a potential problem in the making - one that is not at all being discussed in the rush towards defining a new economic model.

One thing I'd like to point out is that a high-income economy doesn't necessarily marginalise the “low” income group – insofar as job creation will be concentrated in the services sector, where wages are less subject to international arbitrage, low-skilled work can be had in the services sector that could potentially provide a relatively sufficient level of income to accommodate the higher price level. Having a high-income economy does not imply that all jobs must also be high-value added with a high knowledge and skill-base requirement, as some have automatically assumed. Look at how much garbage collectors and electricians earn in advanced economies for instance.

But does not mean we won’t have a problem. For one, those working in sectors which produce tradable goods would find their purchasing power eroded as the structure of the economy shifts. This covers not only manufacturing, but also agriculture (think food, not plantations). Also, given the high immigrant worker population we have, wages in the services sector might not increase enough to cover increasing costs of living.

So creating equitable income distribution will become increasingly important as the services sector gains momentum. How we solve that is going to be ticklish, especially with the racial and urban/rural divide that already bedevils Malaysian society.

In the 1Malaysia session I talked about earlier, Tan Sri Lee Lam Thye raised the question of introducing a minimum wage requirement – I think it’s about time Malaysia thinks about this seriously. As an economist, my first instinct is to say that a minimum wage introduces distortions into the labour market, as well as another avenue for unwelcome government intervention into the economy. I’m also worried about administration of a minimum wage, given the disparities in costs and incomes between rural and urban areas, as well as the political economy dimensions it will involve. But ensuring sufficient income to keep pace with increases in the price level might be called for, if the price in terms of lower profits and unemployment are low enough.

I’m thinking that part of the "tsunami" that was the 12th General Election occurred because the political battleground has shifted from eradicating absolute poverty, to handling relative poverty instead. I don’t think disgust with rentiers and economic elites is the real issue, no matter what the rhetoric of the opposition. To my mind it’s rather the relative stagnation of purchasing power and job creation for the bottom income quartiles in the face of increases in the cost of living. It is the lower-middle class and the working class who have been most affected, and this issue will become more acute if and when Malaysia makes the transition to developed status, where living costs will become higher even without the kind of commodity-led inflation we’ve seen in the past three years. This is not to say that poverty is a dead issue, but rather that the poor should no longer be the sole distributional focus for government assistance and policies.

Beyond distribution issues, we will also have to deal with changes in employment structure. Self-employment and temporary employment will increasingly play a role in the labour market – this website caught my eye the other day, and seems indicative of the kind of changes we will see. But this in turn means that mechanisms of savings, access to financial products and healthcare will need to be adjusted to the realities of the labour market. For instance, how do you apply for a housing loan without salary slips or a big chunk of wad in fixed deposits? I’m encouraged by the government’s current move to provide alternative private pension schemes, which will help narrow this gap at least in the realm of retirement planning.

But more needs to be done, and there are no easy answers.

Technical Notes:
*Bela Balassa, "The Purchasing-Power Parity Doctrine: A Reappraisal", The Journal of Political Economy Vol 72, No 6 (Dec 1964) pp584-596
**Paul A Samuelson, "Theoretical Notes on Trade Problems", The Review of Economics and Statistics Vol 46 No 2, (May 1964) pp145-154

Exchange Rate Targeting: "Weak" and "Strong" are not equal

Etheorist has issued a follow-up of his thoughts in his original post outlining his support for a stronger Ringgit level. My critique of his ideas are contained in this post, where my position is essentially that a stronger MYR level is fine provided it is consistent with changes in the economy, but not otherwise.

I find myself having problems with his new post as well. My main contentions are two-fold: first with reference to the central bank "engineering" an appreciation of the exchange rate, which has monetary implications, and second the likely impact on the economy of an artificial appreciation of the exchange rate from the Balassa-Samuelson based model I described before, which has real economy implications. I also have some different interpretations of economic developments of the past decade, but since this post is going to be long and a bit technical, I will deal with those in a following post.

First, to deal with the problem of engineering a non-secular appreciation of the exchange rate. To understand the issues here, one must first have an understanding of how a central bank influences the exchange rate above or below the market determined rate. Let's first examine the case of weakening the currency, since everyone appears to believe the stylized fact that the MYR is below its long term equilibrium level.

To achieve a lower exchange rate requires the central bank to sell domestic currency for foreign currency. On the central bank's balance sheet, this appears as an increase in international reserves (+assets), in exchange for depositing money in the banking system's accounts with the central bank (+liabilities). This results in an expansion of the money supply, which if unsterilised could trigger an undesired credit expansion and demand-fed inflation, exacerbated by the lower short term nominal interest rates from the monetary injection.

Sterilisation refers to central bank open market operations designed to keep interest rates and money supply stable in conjunction with central bank forex transactions. It’s similar to normal liquidity management operations in the sense that the mechanism is the same.

Since in this example a monetary injection was the result of the forex transaction, the central bank must drain liquidity from the interbank market. This is done by selling the central bank's holdings of securities to the banking system, enough to fully or partially offset the monetary injection. Since the central bank in our example is interested in weakening the exchange rate of the domestic currency, unsterilised intervention is also an option at the risk of higher inflation, but also with the potential benefit of higher economic growth.

Thus the practical limits of weakening the exchange rate are: what constitutes an acceptable level of higher inflation; or if sterilisation is resorted to, the borrowing capacity of the central bank. At least that's the case if you don't want to create another Zimbabwe – the central bank’s credibility in keeping the soundness of the domestic currency is at stake.

Strengthening a currency’s exchange rate over its market-determined rate operates in the opposite fashion: the central bank buys domestic currency in return for foreign exchange. This appears as a drop in international reserves on the asset side of the central bank’s balance sheet, and as a drop in the banking system’s cash balances with the central bank. This is also ipso facto a contraction in the money supply, and pushes up short term interest rates.

An engineered appreciation of the exchange rate is thus inherently deflationary, both in terms of the domestic money supply as well as in terms of import prices. If this is undesirable, for instance when inflation and growth are already too low or negative, the central bank can again resort to full or partial sterilization via a purchase of securities from the banking system, thereby injecting funds into the banking system.

From the above it’s easy to see the limits of artificially boosting the exchange rate level beyond the market clearing level: it is limited by the amount of international reserves at the central bank, as well as the supply of available securities in the banking system. This further implies that a strengthening operation is unlikely to succeed for long without a fairly deep supply of public debt.

In both weakening and strengthening operations, if the degree of misalignment in the target exchange rate is far enough away from the fundamental equilibrium rate, the central bank must continually intervene to maintain its target parity which puts it up against the limits of intervention that much faster. Note also that increasing or decreasing the amount of foreign currency in the system does not have any impact on the banking system’s capacity to lend, since loans can only be made to residents in domestic currency.

A second implication is that by virtue of targeting the exchange rate, volatility of either or both money supply and interest rates will become an order of magnitude greater, because the central bank cannot target all three. This is actually easy to see from the pre- and post-2005 Malaysian experience, where interest rates were higher and spreads far wider pre-2005.

A third implication is that artificially weakening the exchange rate is far easier than strengthening it, because of the nature of the limits imposed by the mechanisms employed. In extremis, a central bank can print money to fund forex purchases, which is not an option the other way around – the level of international reserves is a hard limit.

Are there ways around these limits though? For strengthening the exchange rate, yes there is – you can partially or fully close the capital account. But since this entails a general withdrawal from global financial integration, it also means closing access to foreign investment (particularly portfolio) as well as turning our backs on development. I’ll return to the topic of intervention and sterilisation in a future blog post.

A second less painful way around this is to simultaneously engineer an increase in the equilibrium rate. That ensures that misalignments between the equilibrium rate and the nominal rate aren’t too far apart. What are the elements that need to be pushed to achieve this objective? This leads me back to the Balassa-Samuelson Hypothesis model I described before.

To summarise, an economy can be divided into two producing sectors – tradables and non-tradables. Domestic prices (adjusted for the exchange rate) in the tradable sector are everywhere equalized internationally, since demand and supply are determined on a global basis. Domestic prices in the non-tradable sector however are determined purely by local conditions. Labour and capital are the production inputs, where the former is immobile but the latter fully mobile across international borders.

The effect on exchange rates can be described as follows: say for instance that there is an exogenous expansion in the non-tradable sector. This bids up wages across the whole economy, which reduces the relative productivity in the tradable sector. There is thus upward pressure on prices in the tradable sector. However, since prices in the tradable sector are set internationally, the end result is ceterus paribus an appreciation in the real exchange rate of the domestic currency to equate the international prices of tradables. Note that this effect arises from structural changes in the domestic economy rather than changes in international relative prices.

Now that we have that in mind, what’s the impact of an artificially raised exchange rate without these structural changes? An appreciation in the exchange rate creates an identical reduction in relative productivity for the tradable sector as in my example above. However, since there has been no corresponding increase in total domestic demand within the economy, the result is a reduction in the total demand for labour thus putting downward pressure on wages and prices in the tradable sector. This in turn will tend to depreciate the exchange rate. The net result is a tendency to revert to the equilibrium exchange rate, but with higher unemployment.

The opposite is true of an artificially weakened exchange rate. You get an increase in relative productivity of the tradable sector, which has the effect of putting upward pressure on prices and wages in the tradable sector since total demand is also higher. This will have the effect of putting upward pressure on the exchange rate, with the net result a return towards the equilibrium rate but with higher employment.

In short, exchange rate appreciation above the equilibrium level, as a policy tool, won’t result in a rise in incomes but rather the reverse. If I can resort to that hoary old chestnut phrase, “correlation does not imply causality”. In this case, one must distinguish between productivity in the non-tradable sector which is not subject to international competition, and productivity in the tradable sector which is subject to international price pressures. An increase in the former results in a depreciating exchange rate, while for the latter the opposite is true.

More to come!

Exchange Rates and Purchasing Power Parity: Why PPP Only (Sort Of) Works

I made a couple of assertions in my previous post that deserve some clarification.

First, I said taking some absolute level of the exchange rate as the equilibrium level, and thus making it the reference point at which you can judge whether a particular exchange rate is “weak” or “strong”, only works if you believe purchasing power parity (PPP) actually holds. Since PPP in its absolute form does not in fact empirically hold, this sort of analysis is inherently flawed. Second, I gave the opinion that since Malaysia appears to be shifting to a deliberate policy of promoting the services sector as the future engine of growth, the exchange rate must necessarily appreciate. These two statements are in fact intimately related, and actually come from the same analytical framework.

To begin, let’s examine the underlying principles of PPP. Take a world with two economic actors and two different currencies– a small open economy (A) and the Rest of the World (B). Only one good is produced and consumed (called W), and that good is globally traded with no friction (i.e. no transport costs, tariffs or taxes). The price of the good is then determined by global supply and demand, and applies to everyone equally (since A is small and thus a price-taker). There are only two factors of production, capital and labour, with constant returns to scale technology and where capital is freely mobile but labour is not. The exchange rate between currencies A and B will simply be the relative price of good W in A and B – in other words, the exchange rate equates the local price of W in both economy A and economy B. That in essence is what PPP says – prices of goods should be equal anywhere in the world after adjusting for the exchange rate. Extend that to the factors of production and in equilibrium, wages and interest rates should also be equal.

Adding complications to this model doesn’t change the underlying principle – trade friction and inflation only adjust the exchange rate required to equalize prices. You can even add stuff like foreign risk premiums or productivity differentials, but nothing fundamental will change – prices should still be equal after these additional costs are taken into account. You can see why PPP is both a powerful and seductive concept: it makes sense, and appeals to people’s sense of symmetry and fairness.

If structural and policy changes to economies happen simultaneously and symmetrically, then absolute PPP will hold – i.e. there is some level of the exchange rate than can be called the relative true value of each currency. If changes do not occur homogeneously, then weak-form or relative PPP will hold – i.e. changes in variables will cause relative changes to the exchange rate. For instance, higher inflation in A would require a weakening of the exchange rate relative to B, but the domestic prices would still equalize to their previous level.

Empirical testing for weak form PPP is thus fairly simple – all you have to do is prove that the real exchange rate (the nominal exchange rate adjusted for inflation) is stationary i.e. it reverts to its previous equilibrium level. Proof for strong form PPP is obtained if the equilibrium level is also equal to unity.*

*If anybody wants to find out how this is done, drop me a line in the comments.

Empirically however, proving PPP has been highly problematical – real exchange rates don’t revert; or if they do, the movement is so slow that it can’t be proven that PPP holds. In fact, most early alternative models of exchange rate determination found little evidence that any single factor actually determines exchange rate movements (e.g. interest rate parity and monetary models).

One possible explanation for the empirical failure of PPP to hold is what’s known as the Balassa-Sameulson hypothesis (henceforth BSH for short). To illustrate the concept, let’s extend our model by adding another good, X, which is produced in both A and B, but is not tradable. The domestic price of X will be determined by local supply and demand, and not at the global level. This implies that the price of X can only be equalized globally under very special circumstances. Why this matters is the impact on the returns to the factors of production – if the price of X is not equalized, then wages cannot also be equalized globally (under the assumption of capital mobility, real interest rates would).

If demand for good X is higher in economy B, then wages would be uniformly higher in economy B relative to A, which reduces the productivity of B in the tradable sector (the production of W) because production costs are now higher - B's supply curve for W shifts left, because of the competition for labour for production of X. Since the supply of W is now lower and wages are higher in economy B, B’s domestic price of W will rise. In response, since PPP still applies to good W, the exchange rate of currency B relative to A must necessarily rise to equate the domestic prices. A will ceterus paribus produce more of W which will be exported to B, producing a trade surplus and a relatively weaker currency for A.

The only point at which the exchange rate would be identical to our first PPP model is if the relative size of the non-tradable sector to the tradable sector in A and B are the same. If they are not, then the equilibrium exchange rate must necessarily be different from the PPP model, and PPP will not hold for all goods and wages.

Here are some of the main implications of BSH:

1. A country with the tradable sector growing faster than the non-tradable sector will have a depreciating real exchange rate, and vice versa;

2. A positive productivity shock in the tradable sector (thus lowering production costs and prices) will result in a weaker real exchange rate, and vice versa;

3. A positive productivity shock in the non-tradable sector will result in a stronger real exchange rate, and vice versa;

4. It is not possible for the absolute form of PPP to apply to all goods, which rules out some notional nominal value of the exchange rate as a permanent, time-invariant equilibrium exchange rate;

5. The equilibrium exchange rate is thus time-varying, depending on the relative strengths of the non-tradable sector in each economy and their growth paths. QED

Thus, when applied to Malaysia, saying for instance that RM2.70 to the USD is the true equilibrium rate for the MYR may have been true in the early 1990s, but is unlikely to be correct now – continuing trade liberalization (which reduces the external price of our tradables), a faster growing tradable sector, and the increasing service sector orientation of the US economy necessarily implies that the equilibrium exchange rate between the MYR and the USD has been falling. In reference to the MYR-USD peg from 1998-2005, BSH also suggests that far from having a “weak” currency policy, Malaysia’s USD exchange rate was actually closing on the equilibrium real rate despite being nominally fixed.

If we consider the multilateral rate (the real effective exchange rate), it’s thus not obvious whether Malaysia ever had a “weak” currency policy that lasted much longer than 1998-2001 – strength in the USD to that point also meant an appreciation of the MYR relative to other floating currencies, which effectively negated any price advantage in export markets and in fact put us at a disadvantage by 2002. To take another example of BSH in action, Singapore shifted to a more service-oriented economy in the wake of the 1997-98 crisis; it is thus no accident that in real terms SGD has appreciated against the MYR since then. BSH also explains why the Indian Rupee continues to have an elevated value, when other metrics suggest it ought to be considerably lower – a strong service orientation as well as relatively high tariff barriers support a more appreciated currency.

This neatly leads into the second assertion in my previous post that I wanted to discuss. The services sector is generally taken to be composed of non-tradables – it is usually difficult to trade services, particularly personal services (the example usually given in text books is that of barbers). Exceptions of course exist, like segments of the transportation sector (port services and airlines for example) or tourism, but generally speaking prices of services are determined mostly by local factors rather than global ones. Thus a future strategy that places the services sector as the engine for growth (as likely to be followed by Malaysia in the coming years), will ceterus paribus result in an appreciation of the true equilibrium exchange rate. Since BNM policy appears to be neutral relative to the level of the MYR (as opposed to its volatility) the nominal rate will also appreciate.

Therefore, a deliberate policy of strengthening the currency to raise domestic incomes is unnecessary – the currency will strengthen anyway with a more services-oriented economy, as local wages are bid up by labour demand from industries which do not suffer from international price arbitrage. Nor is targeting some mythical nominal value of the exchange rate (particularly against the USD) economically sensible or viable – the equilibrium exchange rate can and will vary, depending on the relative balance between the tradable and non-tradable sectors in Malaysia as well as in each of our trade partners.

Of course, evidence of BSH is as hard to find as that of PPP, hence the reason it remains labeled a hypothesis rather than a theory. The main hurdle is fairly simple to articulate but almost impossible to overcome – it is extremely hard to make a distinction between what constitutes a tradable good and a non-tradable good. Government consumption is typically used to proxy the effect of BSH in empirical models, but that is under the (sometimes dubious) assumption that most of government spending falls on non-tradables. Some services sectors are subject to international competition as mentioned before, while most tradable goods contain elements of non-tradable inputs.

Nevertheless, BSH does appear to explain much of why exchange rates tend to persistently resist reverting to PPP values, as well as why some currencies are “stronger” than others. And it also explains why I have no faith in PPP-based judgements of “weakness” or “strength” in any currency.

Exchange Rate Policy 1: Concepts

If it seems I’ve taken a break from blogging, it’s because I’ve been hard at work reconstructing my MYR exchange rate indexes. Since I’m still in the midst of refining them, this post should serve as a holdover until that’s done.

Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):



Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.

The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.

Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.

One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.

Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.

The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:

X(t) = X(t-1) + ε

Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!

So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.