An Obsession With Surpluses

No, I’m not addressing the government deficit. Rather this is about Malaysia’s (slowly) diminishing current account surplus. I wrote about it at length last year (link), but here’s another flavour of the same argument (abstract):

Current Account Deficits:The Australian Debate
Rochelle Belkar, Lynne Cockerell and Christopher Kent

This paper documents the clear change of view, which has taken place in Australia over the past three decades or so, concerning the relevance of the current account deficit for policy. Historical experience under a fixed exchange rate regime suggested that large persistent deficits were unsustainable and could leave the economy vulnerable to sudden reversals in sentiment. These concerns persisted after the floating of the Australian dollar and financial deregulation, and it was thought that all arms of policy should help to rein in the then much larger current account deficits. However, these policies were shown to be ineffective and, by the early 1990s, the argument that current account deficits represent the optimal outcomes of decisions made by ‘consenting adults’ gained wide support. This paper presents some empirical evidence consistent with optimal smoothing in the face of temporary shocks; the persistence of the deficit is attributed to a modest degree of impatience relative to the rest of the world. Although it is now widely accepted that policy should not seek to influence the current account balance, the issue of external vulnerability remains of interest. Here, country-specific considerations are important, and it is argued that the factors that have made Australia relatively resilient to external shocks are also those that helped to attract foreign capital in the first place.

It's an old paper, but still relevant. I'll note in passing here two things:

1. The underlying argument is similar to my own – whether the current account is in surplus or deficit (and the extent of that imbalance) is primarily driven by factors in the domestic economy, not the external sector or the exchange rate;
2. Australia now has almost no FX reserves to speak of, despite being heavily exposed to trade and commodity prices, and a foreign presence in their bond market that exceeds ours. IIRC, they barely have one month cover of retained imports.

The implication is that all adjustments take place in prices instead of levels i.e. the AUD exchange rate adjusts, not their level of reserves. Despite this difference, the MYRAUD cross rate is one of the most stable I’ve ever seen outside of a pegged exchange rate. Or to put it more bluntly – despite not having accumulated “insurance” (FX reserves) against capital outflows, and thus deliberately exposing the exchange rate to greater volatility, the AUD does not appear to be any more volatile than the MYR is. There was an exception to this, running roughly from October 2008-May 2009, coinciding with the collapse of Lehman Brothers and running to the beginnings of the global recovery. But this was more the exception that proved the rule.

Notes:

Rochelle Belkar, Lynne Cockerell and Christopher Kent, "Current Account Deficits:The Australian Debate", Reserve Bank of Australia Discussion Paper 2007-02, March 2007

Current Account Confusion

This came out about a month ago, but the subject is important enough that it’s worth revisiting (excerpt):

The Malaysian economic indicator that is raising red flags

OF all the statistics trotted out to show the health of the economy, one indicator is causing some concern among economists, who said it spells trouble for every Malaysian over the long term.

The current account balance is a gauge for the state of the economy and if it goes into a deficit for an extended period, it affects everything from wages to the price of vegetables.

Malaysia’s current account balance still shows a surplus but the bad news is that it has been declining steadily from 2014.

Graeber on Sectoral Balances

I touched on this a few times before, but here’s David Graeber on sectoral balances and flows (excerpt):

Britain is heading for another 2008 crash: here’s why
David Graeber

British public life has always been riddled with taboos, and nowhere is this more true than in the realm of economics. You can say anything you like about sex nowadays, but the moment the topic turns to fiscal policy, there are endless things that everyone knows, that are even written up in textbooks and scholarly articles, but no one is supposed to talk about in public. It’s a real problem. Because of these taboos, it’s impossible to talk about the real reasons for the 2008 crash, and this makes it almost certain something like it will happen again.

I’d like to talk today about the greatest taboo of all. Let’s call it the Peter-Paul principle: the less the government is in debt, the more everybody else is. I call it this because it’s based on very simple mathematics. Say there are 40 poker chips. Peter holds half, Paul the other. Obviously if Peter gets 10 more, Paul has 10 less. Now look at this: it’s a diagram of the balance between the public and private sectors in our economy:

Living Beyond One’s Means

Overspending is fairly straightforward when it comes to households. It’s a little more nuanced with corporates, but its a lot more convoluted when it comes to governments and nation states.

Here’s a quick rule of thumb, when it comes to governments:

1. A country is living beyond its means when its running a current account deficit
2. A country is living within its means when its running a current account surplus

How does this relate to governments? It doesn’t.

A country can be running a surplus or a deficit irrespective of whether the government is running a surplus or deficit. It’s really about the balance in the flow of funds between the different sectors in an economy – governments, households and corporations. Just because a government runs a deficit says nothing about whether the country as a whole is living beyond its means.

Ringgit Under Pressure? Markets Are Irrational

I was going to write about this last week, but it got put on the back burner by the suspension of the fuel subsidy (excerpt):

Ringgit down to four-and-half-year low

KUALA LUMPUR: The ringgit has fallen to a fresh multi-year low against the US dollar, as sentiment has been somewhat dented by Malaysia’s shrinking current account surplus and slower economic growth in the third quarter of 2014.

At 5pm yesterday, the ringgit was being traded at 3.3565 against the greenback – the weakest level since May 2010. The ringgit is the second-worst performer in the region after the Singapore dollar so far this year. Over the last two weeks, it had declined 2% against the greenback….

…Analysts said the narrowing current account surplus put Malaysia in a less favourable position compared with the other countries….

How To Spin With Statistics: Compare And Contrast

From Jesse Colombo to the Dallas Fed (excerpt):

Asia Recalls 1997 Crisis as Investors Await Fed Tapering

The 2007–09 global financial crisis triggered unprecedented central bank policy intervention in the U.S. and elsewhere. The Federal Reserve, after cutting short-term interest rates to near zero, embarked upon three rounds of unconventional monetary policy known as quantitative easing, or QE. These measures involve the purchase of long-term securities and aim to stimulate the economy by lowering long-term borrowing costs…

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.

Currencies and Current Account Adjustments

A recent article by Cline & Williamson (2009)* on VoxEU.org investigates the state of play in terms of global currency misalignments, particularly against the USD. The results aren’t too surprising:

“The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies…Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.”

For the MYR, Cline and Williamson suggest an undervaluation of 17.7% in the real effective exchange rate, and 33.2% against the USD, with a medium term target rate of RM2.63. That’s a substantial movement for MYR, and will have a pretty massive impact on Malaysia’s external demand as well as the current account.

The modeling framework takes its cue from Williamson’s earlier work, which substantially helped launch non-purchasing power parity (PPP) based assessments of exchange rate valuations more than twenty years ago.

Some background is in order here. I’ve posted on these alternative models before, but the model used in this article is a variant of what’s called the Fundamental Equilibrium Exchange Rate (FEER) approach (aka Macroeconomic Balance approach), which uses a medium term current account target as a measure of a currency’s misalignment. Using an elasticity model, the extent of under or over valuation can then be calculated as the movement in the exchange rate required to bring the current account from its forecast level to the model’s target level over the medium term.

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

1. FEER models have a normative component – the target rate is selected by the researcher (admittedly based on global historical norms), rather than that inherent to each economy. In other words, the extent of misalignment derives directly from what the researcher considers a “sustainable” current account surplus/deficit. For instance, Williamson’s early work used a 2% band rather than the 3% used in the article - a tighter band implies a greater required adjustment. Since the current account covers both trade in goods and services as well as income flows, applying one number to all countries (or even one country at different points of time) isn’t obviously logical. The article attempts to account for this by incorporating a net foreign assets measure where required (essentially replacing a flow variable with a long-term stock variable), but the same critique applies.

2. Secondly, FEER models assume that all adjustments are made solely through exchange rates, which of course isn’t necessarily true. Demand and supply shocks, terms of trade shocks, secular changes in consumer preferences, productivity improvements, changes in portfolio holdings – all can have an impact on the current account without necessarily impacting the exchange rate at all.

3. FEER models don’t incorporate dynamics, which describes the interrelationship between the model variables across time. In short, you know your destination but you have no idea how to get there.

Lastly, I have a procedural criticism – the REERs used as reference points for the article are taken from the IMF International Financial Statistics Database. To my knowledge, the trade weights on these were last changed in 2006 based on averaged trade data from 1999-2001 (and thus accounting for the introduction of the Euro).
Ordinarily, I’d have no problem with this as trade weights rarely evolve much in any given 5-10 year span.

In this case however, I think the IMF REER indexes from about 2003 onwards are flawed – the emergence of China has had such far reaching effects on trade patterns that substantial changes in trade weights are warranted. That in turn implies that movements in the IMF REER indexes are too biased towards the G3 currencies, and not enough to emerging markets.

The effective difference doesn’t amount to a lot in an absolute sense – a few points at most on the index scale – but those few points do matter in terms of determining the threshold for possible policy action, and would matter even more if emerging market currencies were more volatile against the USD. In this case, the difference tends to support the article’s primary thesis of USD overvaluation against many Asian currencies.

To illustrate, here’s how the trade weights for the top 5 currencies in my own calculated MYR indexes have evolved during the same period:



Note that there are three different groupings: the EUR has been relatively stable; JPY, SGD and especially USD have been declining; and CNY has been steadily rising, with a big jump in 2003. The IMF static weights for these currencies for MYR are 14%, 15%, 6% (lumping SGD with all other ASEAN currencies), 24% and 5%; the latest weights for mine are 11.2%, 13.5%, 13.2%, 12.8%, and 13.7%. So there have been some pretty big changes in terms of which currencies are more important within a multilateral trade framework.

To illustrate the difference, here’s a comparison of the different indexes:




So, do I believe that MYR is that much undervalued? No, for a few reasons, not least of which are the flaws in the modeling framework I’ve pointed out above. But since this post is getting over long, I’ll save that for later.

*"Equilibrium exchange rates", William R. Cline & John Williamson