Reserves, Capital Flows and the Ringgit

Confession time: ten years ago, I’d have probably made the same analysis…and I’d be just as wrong. But with age comes wisdom, I hope.

Two statements in yesterday’s paper caught my eye. First from RAM Holdings chief economist Dr Yeah Kim Leng:

Ringgit is getting stronger, US$ to continue decline

...“With the ringgit strengthening, our manufacturers will be forced to become more productive and innovative.

“This will help get us out of the industrialisation trap,” Yeah said...

…and then from CIMB Investment Bank head of economics Lee Heng Guie:

M'sian international reserves hit record level

…CIMB Research in a note yesterday said reserves were boosted by substantial inflows of short term money and that positive economic vibes had contributed to the fundamental reasons for such inflows…

It’s nice to note that there’s some corroboration for my interpretation of BNM’s intervention in the forex markets last month. But to deal with these statements:

1. The Ringgit hasn’t actually strengthened much, if at all. This is USD weakness, not Ringgit strength. If our currency appreciates faster than that of our competitors, then there’s some basis for the opinion that producers would be forced to increase capital intensity (and thus worker productivity). But that’s simply not the case right now (index numbers; nominal and real effective exchange rates; 2000=100):
   
   On a trade weighted basis, the Ringgit has barely budged since April 2010. That means that from a competitive standpoint, there’s been no relative change in terms of the external pricing of Malaysia’s exports, and hence no pressure on exporters to change their ways.
   
2. There’s no direct link between international reserves and capital flows (or any kind of external money flows) unless you’re operating a fixed exchange rate regime. With certain exceptions (most spectacularly last month), BNM has let the Ringgit float. Changes in international reserves requires active intervention by the central bank - there's no passive conduit directly from external inflows or outflows into BNM's foreign currency reserves. Maybe old habits of thinking die hard…but I expected better of CIMB.

Currencies: Tarred With The Same Brush

In Bloomberg today (excerpts):

Currency Controls Mount in Asia as Euro Hurts Exports

June 11 (Bloomberg) -- The world’s biggest expected swings in foreign-exchange markets and the euro’s record depreciation are prompting Asian exporters to seek currency controls.

TLtek Co., a South Korean exporter of auto-part making machines, called on policy makers to limit volatility caused by “gambling” on the won. Kuala Lumpur-based Sime Darby Bhd., the world’s biggest publicly traded palm-oil producer, needs to revise its business plan to account for the euro’s 19 percent drop against the ringgit. Taipei-based Maestro Innovations Corp., which makes infrared lamps for muscle pain, said curbs on the Taiwan dollar and China’s yuan would support orders.

Policy makers in South Korea, Taiwan and China are responding to Europe’s debt crisis by selling their own currencies, limiting investment inflows and delaying interest- rate increases. Goldman Sachs Group Inc. slashed its three-month Indian rupee forecast by 7 percent yesterday, Westpac Banking Corp. cut its year-end estimate for the won by 8 percent and ING Groep NV said the yuan won’t be revalued for a year.

“With the euro plunging, some central banks seem to be quite aggressive in stemming gains in their currencies,” said Kenichiro Ikezawa, who oversees about $3 billion as a fund manager at Daiwa SB Investments Ltd. in Tokyo and favors Brazilian and Australian debt over emerging-market Asian bonds. “China may delay revaluation and that, together with low yields in Asia, give little incentive to buy them.”

The South Korean won’s one-month implied volatility, a measure of exchange-rate swings used to price options, climbed 162 percent this quarter, the second-biggest jump among 47 currencies tracked by Bloomberg. Nine of the 10 biggest increases are in Asia. The won has the widest expected fluctuations at 24 percent, compared with 13 percent for the Indonesian rupiah and 12 percent for the Malaysian ringgit.

Exporters are seeking help from policy makers because the 10 most-active currencies in Asia outside Japan have strengthened an average of 19 percent against the euro this year. Shipments to the European Union fell in April from a month earlier, ranging from 5.6 percent for Malaysia to 19.5 percent for Thailand, according to government statistics. Europe took in 27 percent of India’s exports and 23 percent of China’s.

Sime Darby will have to revise its plans after the ringgit rose beyond 4 per euro for the first time since 2003, 13 percent stronger than its estimate, Chief Financial Officer Tong Poh Keow said in an interview on May 14 in Kuala Lumpur.

“We are doing our management plan and we will adjust based on our full-year expectations,” she said. “The decline in the euro will affect us.”…

…The Bank of Korea intervened at least twice in late May to stop the won gaining beyond 1,200 per dollar, a level 8 percent weaker than its 19-month high of 1,102 on April 26, according to traders who asked not to be identified as policy makers don’t discuss specifics of intervention. South Korea will introduce measures to reduce volatility in capital flows “soon,” Vice Finance Minister Yim Jong Yong said in a June 9 interview. The central bank will “act energetically” in the market to curb volatility, Governor Kim Choong Soo said today.

The Central Bank of the Republic of China (Taiwan) has stepped into the market to buy dollars almost every day in the past month, helping weaken the island’s currency by 1.6 percent to NT$32.35, said traders familiar with its operations, who also declined to be identified. In January, policy makers set a one- week deadline for money brought into the country to be invested or repatriated and in April ordered a review of loans to expose speculators. Governor Perng Fai-nan told reporters on June 4 the exchange rate will be “determined by market supply and demand.” …

…“Traders report Korea and Taiwan’s central banks have been in the market almost daily,” said Sean Callow, a strategist at Westpac in Sydney. “Ranges have been so wide over the past month and all the lines in the sand have been washed away.” …

…Bangkok-based Thai Union Frozen Pcl, the world’s second- largest tuna canner, wants the Bank of Thailand to restrain the baht to give it time to shift sales to “better markets,” President Thiraphong Chansiri said in a May 12 interview…

…Policy makers may seek to safeguard Asia’s growth potential by delaying rate increases, Tadashi Tsukaguchi, a fund manager in Tokyo at Sparx Group Co., the region’s biggest hedge fund with $7.3 billion in assets, said yesterday.

“A slowdown in Europe means countries like China, Korea and Southeast Asia have close to zero chance of raising rates,” said Tsukaguchi, who has taken short positions against some Asian currencies that profit from declines.

There’s no doubt that the fall in the Euro stemming from the zone’s ongoing fiscal problems will hurt local exporters. But the flip side to that is that a depreciation in the currency is one of the few mechanisms the Eurozone has to fend off complete economic collapse in the PIGS, which is in no one’s interest.

The action of China, Korea and Taiwan (there’s no mention of any of the other central banks among the countries affected) is tantamount to competitive devaluation, which really helps no one either.

Is BNM intervening in the market to depress the MYR? Not hardly – international reserves was virtually unchanged between April and May 2010, which means if there was intervention it was two-way. But current events do reinforce my belief that July’s Monetary Policy Meeting will see a pause in “normalisation” of the Official Policy Rate.

Death of the Washington Consensus?

The IMF last week issued a staff position report (warning: pdf link) that represents something of a mea culpa and a retreat from the Washington Consensus. Taken from the conclusion:

“The crisis was not triggered primarily by macroeconomic policy. But it has exposed flaws in the precrisis policy framework, forced policymakers to explore new policies during the crisis, and forces us to think about the architecture of postcrisis macroeconomic policy.

In many ways, the general policy framework should remain the same. The ultimate goals should be to achieve a stable output gap and stable inflation. But the crisis has made clear that policymakers have to watch many targets, including the composition of output, the behavior of asset prices, and the leverage of different agents. It has also made clear that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way. The combination of traditional monetary policy and regulation tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes. These need to be explored further.

Finally, the crisis has also reinforced lessons that we were always aware of, but with greater experience now internalize more strongly. Low public debt in good times creates room to act forcefully when needed. Good plumbing, in terms of prudential regulation, and transparent data in the monetary, financial, and fiscal areas are critical to our economic system functioning well. Capitalizing on the experience of the crisis, our job will be not only to come up with creative policy innovations, but also to help make the case with the public at large for the difficult but necessary adjustment and reforms that stem from those lessons.”

Nothing controversial about any of the above, but the devil is in the details. There are some pretty conventional prescriptions that the paper advocates – providing banking system liquidity as needed, fiscal prudence during good times, and strengthening automatic stabilisers aka transfers (tax-rebates, handouts) to the poor; but how about these bombshells:

1.  Should the Inflation Target Be Raised? - “Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?”
2. Combining Monetary and Regulatory Policy - “If leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be introduced and, if needed, increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be increased.”
3. Inflation Targeting and Foreign Exchange Intervention - “Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function. This does not imply that inflation targeting should be abandoned. Indeed, at least in the short term, imperfect capital mobility endows central banks with a second instrument in the form of reserve accumulation and sterilized intervention. This tool can help control the external target while domestic objectives are left to the policy rate.”

Gosh.

In case you’re not clear about what they’re talking about, in plain English the IMF are calling for:

1. A higher average inflation rate target and by extension, a higher than average policy interest rate as well. The basic goal of central banks worldwide in the last thirty or so years has been price stability, which in real-world terms (taking into account structural issues and a buffer for real money supply growth) has translated into an average inflation goal of around 2%. Higher inflation would have distortive effects on business and personal decisions, such as on investment and savings.
2. Capital controls and market intervention. Can I say, we told you so?
3. Exchange rate intervention. Can I say…oh, I said that already.

In short, this is a retreat from the free market fundamentalism that has characterised IMF and World Bank policy approaches for decades. What a comedown. There’s also the unspoken acknowledgement here that every country is different, and that the one-size-fits-all approach (or in business-school-speak – using “best practices”) to remedial policies is suboptimal, er, won’t work.

I’m not knocking the basic conclusion that free markets are the best method of organising economic activity. But I do think we have to be pragmatic and recognise that real-world markets everywhere are distorted by asymmetric information and differing levels of pricing power between buyers and sellers. It should also be recognised that while the price discovery process through the interaction of supply and demand is the best way to obtain a Pareto-optimal allocation, nothing says that any given equilibrium point is “first-best”.

Technical notes:

1. “Rethinking Macroeconomic Policy”, Blancard, O. and Giovanni Dell’Ariccia and Paolo Mauro, IMF Staff Position Note, SPN/10/03, International Monetary Fund
2. INTERVIEW WITH OLIVIER BLANCHARD, “IMF Explores Contours of Future Macroeconomic Policy”, IMF Survey Magazine

Lies, Damn Lies Part II

I thought I might take a little time to clarify a few things from my previous post.

First, why does the exchange rate regime matter in terms of movements in reserves? In theory, a fixed exchange rate regime requires that a central bank buys and sells foreign currency to maintain the exchange rate parity between the domestic currency and the target currency, which is typically either the USD (a'la Bretton Woods arrangements from 1944-1972) or a "basket" of currencies. Both China (implict) and Hong Kong (very explicit) use fixed rate regimes. Singapore is slightly different - MAS uses an exchange rate target to manage domestic monetary conditions, although the mechanism is similar.

With a fixed rate target, reserves will accumulate or be lost with changes in trade and capital flows - if there is an excess of inflows (trade surplus, or portfolio inflows), then demand for local currency exceeds foreign currency and the exchange rate should appreciate.

To maintain parity, the central bank creates domestic money (yes, out of thin air - it's only an accounting entry), and uses this to buy foreign currency. This has the effect of meeting the increased demand for local currency, as well as simultaneously creating greater demand for foreign currency, and hopefully balancing out the market exchange rate. In this scenario, the foreign currency bought by the central bank goes into its foreign exchange reserves account (on the asset side of the central bank's balance sheet), while liabilities (domestic cash) increases by the same portion.

A secondary effect of these transactions is thus a de facto increase in the domestic money supply and downward pressure on interest rates, since money was created to buy the foreign currency. If this is a concern to the central bank, then it "sterilises" the intervention by draining liquidity from the money market through the issue of securities. The total net effect of a full intervention and sterilisation exercise is thus an increase in reserves (assets) and an increase in issued securities (on the liabilities side), with the money supply staying pat.

The reverse happens when there is an outflow and full intervention - reduction in reserves (asset side) and a reduction in money supply (liabilities) in the case of non-sterilisation, or reduction in securities (liabilities) in the case of sterilisation.

There's actually only one effective difference between money and securities - they're both liabilities of the central bank, but from the banking system's perspective only money can be used to further credit (i.e. loans to you and me). Hence, in a fixed rate regime, domestic monetary policy operations are far more complicated.

Under a free float regime, of course, there's no apparent necessity for intervention at all and thus no incentive to accumulate reserves, except for one big reason I'll cover later.

So given the narrative above, here's what happened in Malaysia in 2008:

1. Big changes in inflows and outflows

First the run-up in commodity prices increased Malaysia's exports earnings beyond the average, up to about the middle of 2008 (trade balance, balance of payments basis, RM millions):

Then, as the financial crisis took hold in the latter half of 2008, there was a huge flight to safety by foreign investors:

2. And here's what the commodity and financial markets were doing:

Notice the symmetry between all the markets. Also note that investors (the smart money) had already begun to pull out before the markets peaked.

3. The impact on financial institutions:

Here's one good reason why a central bank would accumulate reserves even under a floating regime - if foreign liabilities exceeds assets, then there is the potential for an external default in either the private sector or within the banking system itself - not from insolvency, but through lack of liquidity. You have the money, but not the right kind of money. To avoid that, you save up on the right kinds of external money to make sure you can meet all your external obligations i.e. accumulate reserves.

Another way of having this insurance is by doing swap agreements with other central banks, thus creating a collective pool of external reserves i.e. what we're doing now under the Chiang Mai Initiative. This reduces the cost of hoarding on your own.

4. And this what BNM did to manage the whole shebang (all items from BNM's balance sheet, RM millions):

Note how this fits into the narrative above. With upward pressure on the Ringgit in 2007-2008, BNM intervened by supplying Ringgit to the market in exchange for foreign currency, while simultaneously issuing BNM bills to limit growth in the domestic money supply. After commodity prices started dropping, and portfolio investors started pulling out, the opposite happened - intervention to support the Ringgit, and buying and cancelling of bills to ensure the domestic money market remain liquid.

While BNM does not have an exchange rate target (at least I don't think they do), from comments by the Governor they have made a commitment to reduce volatility - in other words, they won't stop a depreciation or appreciation but they will limit excessive movements.

Since the inflow of trade receipts in 2007 and early 2008 weren't viewed as sustainable, they obviously felt that upward pressure on the Ringgit had to be capped to avoid a sharp depreciation afterward. And when inflows did turn into outflows, BNM also acted to limit the downward movement. These operations are consistent with a managed float regime, where volatility reduction is a goal.

Hence the sharp changes in reserves, as well as the changes in BNM bills left outstanding in the market - intervention was also sterilised to maintain BNM's real target, which is the short-term domestic interest rate:

5. One last point on the statutory reserve requirement:

The money multiplier (see this post on what this means) based on banks' reserve deposit assets:

...and reserve deposits as a percentage of loans:

As I said in the last post, banks aren't basing credit expansion on the reserve ratio, but rather on the capital ratio:

A statutory reserve requirement of 1% implies a potential money multiplier of 100x, while 0.5% implies 200x. The actual average is actually only around 4x, in contrast to the leverage ratio which was almost right to the limit of what's allowable.

Lies, Damn Lies, and Then There Are Statistics

UBS Securities Asia Ltd has issued a report that has generated a bit of a buzz in the online media titled "Malaysia - Another Bizarre Story" (try here, alternate here). The headlines in the online media however are less timid:

“Money leaving Malaysia in massive amounts and bizarre fashion”

“Malaysia's Disastrous Capital Flight”

Ye Gods.

I’ve covered the issue of capital flight before in this post (read the comments for an interesting discussion). There’s no doubt that capital has been leaving the country in the aftermath of 1997-98, which in my opinion and from anecdotal evidence is largely due to domestic investment abroad. However, this UBS report is highly misleading as it purports to show that large amounts of capital left the country in 2009, which isn’t the case at all - at least, not any worse than it usually has.

Here’s my view (point by point, in blue) of where this report went wrong.

“Question: which Asian country had the biggest FX reserve losses in 2009? The answer is Malaysia, and by a very wide margin; we estimate that official reserves fell by well more than one-quarter on a valuation-adjusted basis.”

This is the main evidence that the report uses to justify its conclusion. But note that the basis of this estimate is from peak 2008 levels against current levels, which is more than a little disingenuous (look at notes for the first chart in the report). The assessment of “more than a quarter” loss suffers from what’s called the “base” effect – if you use a period with a high denominator, you can get negative growth even if the actual levels are increasing (international reserves, RM millions):

I put in a longer sample period so it’s easier to see what’s going on. Using a more conventional year on year calculation, this is what you get (log annual changes):

See what I mean? For most of 2009 growth in reserves was negative, despite the fact that the actual level of reserves was largely flat to increasing. Malaysia suffered technical deflation for much of 2009 for much the same reason, but I don’t hear anyone crowing over consumer prices falling.


Here's what monthly growth looked like (log monthly changes):

Through the whole of 2009, we've had exactly three months where reserve growth was negative, while the rest of the year saw reserves rising. This type of problem is the reason why I've consistently advocated looking at levels rather than growth metrics during times of violent change. You simply miss a lot of what's going on by using a period-to-period percentage change approach.


I’m also a little suspicious of the claim that the estimates were valuation adjusted – BNM already books revaluation losses and gains every quarter. If you revalue again based on published statistics, that would constitute double counting and would exacerbate movements in reserves.

“Other structural surplus neighbors like China, Hong Kong, Singapore, Taiwan and Thailand have all seen sizeable increases in FX reserves over the past 12 months … and yet Malaysian reserves nearly collapsed.”

Sloppy analysis – reserves at end 2008 stood at RM317.5 billion, versus RM331.3 billion at end 2009, including a revaluation loss of over RM10 billion for 2009 as a whole. That means a net increase of RM13.8 billion over a 12 month period – sure doesn’t look like a collapse to me.

More important, the first three countries listed all have an explicit exchange rate target. China has effectively halted Yuan appreciation against the USD in the last year and a half, Hong Kong has a currency board arrangement with the USD which effectively means forex reserves back the money supply, and Singapore explicitly uses the exchange rate as the instrument for implementing monetary policy unlike the more conventional interest rate target as used in Malaysia. I don’t know off-hand how Taiwan manages monetary policy (Taiwan is not an IMF member, and aren’t categorized within the IMF’s exchange regime framework), but Thailand uses a managed float with an inflation target, also implying intervention in foreign exchange markets.

Why this is important is that the countries listed all accumulate or lose reserves due to implicit or explicit exchange rate targets. Malaysia does not fall under that category under either a de facto or de jure basis, and I’ve gone on record to state that I don’t think BNM has an exchange rate target for the Ringgit at all. Hence, if there is no intervention, there should be effectively little to no change in reserves – which is what happened in 2009.

So what’s the story for 2008, because there was a massive loss in reserves back then? Looking at the reserve levels, you see a mild run-up from 2005 to 2006, and then acceleration from end-2006 to about mid-2008. Not coincidentally, reserve accumulation happened simultaneously with the commodity bubble of those years:

That's the main difference between Malaysia and the other countries we were compared to in the report - we are a commodity exporting country, none of the others are. Given that exports of commodities didn’t change much in volume but export receipts did, we had an abnormal influx of income that was more nominal than real. In the aftermath of the collapse in prices post July 2008, we had a drop in income that was also more nominal than real. Hence, from BNM’s perspective, the appreciation of the exchange rate (as well as the money supply impact of the inflow of trade receipts) warranted intervention to mitigate the Ringgit’s (and the money supply's) rise during the boom, and limit the Ringgit’s (sharp) fall (and the potential contraction in the money supply) in its aftermath. In addition, BNM had to meet the sudden demand for USD from the banking system as depositors and investors pulled out:

If you look at newspaper reports at the time (4Q 2008), BNM as good as admitted buying MYR against USD to support the currency:

Now if these factors are taken away – receipts from a commodity bubble boosting forex supply within the banking system and forcing an overshooting appreciation of the exchange rate, we would not have had reserve accumulation in 2007-2008 in the first place, and reserve accumulation would simply be on the same trend as it was from 2005-2006. And we wouldn't be arguing about a loss of reserves we probably shouldn't have had in the first place.

3.       “And this despite a massive, unprecedented decline in high-powered “base” money, as shown in Chart 4. Indeed, over the past 12 months Malaysia recorded one of the biggest base money contractions in the entire EM world, matched only by the Baltic states (Chart 5). This is in part because the Malaysian central bank responded with a sharp drop in reserve requirements to keep banks liquid … but still, we can’t help but note that the domestic financial system seems uniquely unaffected by apparent capital outflows.”

This one’s a bit funny – the writer was obviously not referring to M1 (currency + demand deposits) (RM millions; and log annual changes):

He’s referring to base money which is a bit different – currency + bank reserve deposits. This is a rather funny metric to use, because under a modern regulatory system, bank reserve deposits are barely relevant. As long as the statutory reserve ratio is below the risk-weighted capital ratio (8% under the original Basle requirements, somewhat more nebulous under Basle II), then the money multiplier is effectively limited by the capital ratio and not the reserve ratio.


Hence BNM’s cut in the reserve ratio was a token and not an effective policy change, unlike the situation in China for instance where the reserve ratio is one of the primary instruments for managing the supply of credit (because it's double the capital ratio). BNM hasn’t seriously used the reserve ratio as a policy instrument since before the 1997 crisis.

What’s even funnier is the description of the cut as “sharp” – it was a 50% cut, which sounds big until you realize that it was from 1% to 0.5%. And the banks have more or less ignored the reserve requirement anyway – the banking system has been flush with cash for years, and they haven’t bothered to lend out the excess (banking system deposits with BNM in RM millions; loan-deposit ratio):

Hence there should be no surprise that interest rates have trended lower in 2009 – there hasn’t actually been a large outflow of capital (and hence a contraction in the money supply), there hasn’t been a massive loss of reserves, and...there isn’t really a story here except maybe UBS wanting to sell something.


(H/T Hafiz Noor Shams - free plug for you, mate!)

Exchange Rate Policy 2: Measurement

In Malaysia, it’s common to take the bilateral rate of the Ringgit (MYR) against the US Dollar (USD) as the exchange rate. This is understandable because not only does Malaysia have substantial trade links with the USA, the USD is important as a reserve currency and as the currency of international trade contracts. However, the USD bilateral rate is not the sole influence on MYR movements – other countries like Singapore also have substantial trade and capital links. How then to capture the multiplicity of influences on a currency? What we need is a single composite measure of a currency, an index of movement.

Let’s take the example of Malaysian trade with Aruba. Since this trade is pretty much non-existent, the exchange rate between the Ringgit (MYR) and the Arubian guilder (AWG) shouldn’t matter to Malaysia very much. From this example we can take the basic principle for constructing a composite view of the Ringgit or any other currency – taking the trade share* as the basis of a weighting scheme. Obviously, the greater the trade share, the more important a particular currency should be. The general rule is that weights don’t need to be changed very often (the IMF changes weights every ten years or so), although if a country’s trade patterns change substantially you can get gross errors in the index without knowing it.

* A more complicated scheme also uses the concept of third-country export competition as part of the weights. The IMF and Federal Reserve incorporate this in their currency indexes, but most do not. New Zealand uses share of global GDP as a proxy.

There is also a choice to be made at this point – which currencies to put in the “basket”. The more currencies involved the more work is required in gathering data and calculations, but the more accurate the measurement. The Federal Reserve uses a 0.5% export or import share threshold for their broad index, while the BOJ uses 1% overall trade share. I favour using 1% of exports or imports as giving a broad enough selection of currencies, without losing too much information – 15 currencies altogether based on 2007 Malaysian trade data. This also nicely allows me to avoid tracking Middle East countries, where data holes are a serious problem.

Having gathered the required trade and exchange rate data, we now have enough to construct a nominal effective exchange rate index. This is what MYR has been doing for last eight years (2000=100):



Ideally of course, real prices (net of inflation) are more important, so inflation data has to be incorporated in our measurement. This is complicated by having multiple types of inflation – consumer inflation (Consumer Price Index), producer inflation (Producer Price Index or Wholesale Price Index), and whole economy inflation (GDP deflator). Since trade competitiveness is the basis of our exchange rate measurement, PPI** is probably the best series to use (CPI and the GDP Deflator include non-tradable goods inflation). Unfortunately, PPI is not often available particularly in emerging markets, so CPI is often used as a proxy. In practice, most researchers have found that the price series used doesn’t really matter.

** The OECD use changes in real manufacturing wages

Deflating each currency by their respective inflation measures, we arrive at the real effective exchange rate index, here contrasted with the nominal index:



There's little to choose from between the two, which suggests the MYR is tracking pretty well with the currencies of our trade partners.

So now we have a pretty accurate idea of MYR movements holistically. Unfortunately, this still doesn’t tell our poor central banker very much, because all it shows is the movements of the currency relative to any other specific period - it says nothing of where the currency should be. While it’s better than nothing, he still has no idea of the valuation of the currency relative to all the others. This is where econometric models come in, which I'll cover in my next post.

However, even using the nominal and real charts can tell us something. First, here's a graph of trade shares (exports and imports), relative to the trade within the currency basket I'm using:



Note the massive decline in trade share to and from the US and the corresponding rise of China. Next, the nominal and real exchange rates against the G3 currencies:







The general interpretation is that if there is a difference in inflation experience between two currencies, there will be pressure for the nominal rate to close on the real rate. By that standard, MYR is about 17% overvalued against the JPY, but close to even with USD and EUR. Not surprising since Bank of Japan intervention to prevent JPY appreciation is common. This second batch of currencies also shows relatively high misalignments relative to the real rate:







The MYR appears overvalued against the HKD and TWD, but undervalued against the KRW, on about the same order as the misalignment against the JPY.

This last batch is so ridiculous, I had to triple check my calculations (please note the respective scales):









The differences here range from 33% against the PHP and IDR, to 87% (!!!) against the INR. These are serious misalignments that can only be explained by highly restricted capital accounts or heavy intervention (definitely true for the Reserve Bank of India). Given that the MYR is relatively close to “fair value” against the G3 currencies, it follows that the four currencies above are seriously out of whack with the rest of the world too.

Bear in mind, however, that I’m using inflation as the only currency alignment metric here – other forces can be at work as well that may explain these gross divergences.

Either that or you’re looking at the next good candidates for speculative attacks. I suspect the Rupee especially, might be in for some rough times ahead.

Update:

I should point out that because these are index numbers, measuring misalignments can be problematical because the index year has an impact on the perceived divergence. If I had taken 2005 as the base year for example, the misalignments would appear considerably smaller. The underlying assumption behind the analysis I'm using here is that currencies were largely in alignment in 2000. This weakness doesn't apply to econometric models.

Also forgot the acknowledgements:

1. (Free) foreign exchange data from the PACIFIC Exchange Rate Service. Forex data used are monthly averages.
2. CPI data from IMF International Financial Statistics (IFS) and the International Labour Organization, supplemented by national sources where necessary.
3. Trade data is from DOS and various issues of BNM Monthly Statistical Bulletins.