Ringgit Fallacies: Imported Inflation and International Reserves

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

Spare The Float, Ruin The Economy

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

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

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

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

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

Forex Fallacy

[This post is loooong. For those without patience, you can skip to the end without missing too much]

Tong Kooi Ong talks forex policy and promptly makes a meal of it:

How the middle class is subsidizing the Corporate Elites and why it has to stop

There is a feeling that Malaysia’s middle class are generally not a happy lot. Many moan about the rising cost of living, education and healthcare, their relatively low wages and rising debt as they borrow more to buy homes and cars…

…A major problem lies in the weak ringgit, which results in different purchasing power for the two “middle classes”…

The Asian Financial Crisis…15 Years Ago Today

On July 2 1997, the Bank of Thailand gave up the struggle to maintain their currency peg and let the Thai Baht devalue against the US dollar. Thus began one of the worst regional crises in the post-WWII era.

The reasons were complex and continue to be the subject of controversy, but the popular and official notion that the AFC was the result of foreign currency speculators alone is in my view very far off the mark. While hedge funds are known for taking risky bets, in this case it was a virtually no-risk bet. Pegged currencies that were over valued, current account deficits, unsustainable real estate bubbles (both residential and commercial), out-of-control bank lending, runaway money supply growth, and high external corporate borrowing provided ample grounds for a sell-down of Asian currencies.

It was a once-in-a-lifetime opportunity.

I’d also like to point out that with the exception of the Indonesian Rupiah, the three major currencies affected by the crisis – the Malaysian Ringgit, the Korean Won and the Thai Baht – all ended up post-crisis at close to the same levels against the Yuan as they had been before China’s 1993 devaluation. Now isn’t that suggestive (cross rates against the Yuan; higher values indicate appreciation):

But whether you believe the crisis was a result of a foreign conspiracy, external pressures and hot money flows, or the cumulative results of policy mistakes, this was a seminal event in the economic and financial development of East Asia.

May we never forget that it happened or the lessons that we’ve from it.

Someone Talking Sense About Exchange Rates, For Once

Nobel Laureate Michael Spence on CNYUSD:

The Exchange-Rate Delusion

MILAN – If one looks at the trade patterns of the global economy’s two biggest players, two facts leap out. One is that, while the United States runs a trade deficit with almost everyone, including Canada, Mexico, China, Germany, France, Japan, South Korea, and Taiwan, not to mention the oil-exporting countries, the largest deficit is with China. If trade data were re-calculated to reflect the country of origin of various components of value-added, the general picture would not change, but the relative magnitudes would: higher US deficits with Germany, South Korea, Taiwan, and Japan, and a dramatically lower deficit with China.

3Q Forex Update

What a difference a few months make. With increasing uncertainty over global growth and the threat of defaults in the Euro area, there’s been a general retreat from emerging market currencies to “safe-haven” currencies such as the Yen, the Swiss Franc and especially the USD.

No surprise then that the trade-weighted indexes have both dropped (index numbers; 2000=100):

Currency Wars

Over the last two weeks, rhetoric has been building up over currency “manipulation” among major trading nations. The biggest target is of course China, with the turtle-slow adjustment of the CNY-USD exchange rate, but their far from the only ones. The Bank of Japan intervened in the Yen market in a big way last month, and Brazil, South Korea and Indonesia have instituted capital controls to a greater or lesser degree. Nor is currency intervention limited to emerging or Asian markets, as Adam Kritzer talks about in this blog post:

Currency War: Who are the Winners and Losers?

It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies....

…That brings me to my final point, which is that all currency intervention is futile in the long term, because most Central Banks have limited capacity to intervene. If they print too much money to hold down their currencies, they risk stoking inflation…For Central Banks to successfully manipulate their currencies on the spot market, they must fight against the Trillions of Dollars in daily forex turnover. Eventually, every Central Bank must reckon with this truism.

Big Mac Index Yet Again

Someone else responded to Mr Gunasegaram's article and thinks a "strong" currency is not a good idea:

"First of all, I believe this is a crazy and short-sighted idea. It likely leads to a recession. When our currency is strong, everything we import seems to be at a discount and this encourages people to spend more on foreign goods and services through imports.

Strong currency also discourages our usual foreign trade partners to buy goods from us, thus export value will drop.

It also causes a country to lose its competitive advantage in attracting foreign investments.

At a time when inflow of money is significantly less than outflow, a serious current account deficit occurs in a broader sense. Malaysia will then be in deep trouble, after a short period of delusive wealth."

...and...

"If the ringgit were to be strengthen to a level of one for one US dollar, I would say good luck to everyone in Malaysia, welcome to the “burgernomics club”.

We will be staring with mouths watering at the Big Mac burger with an attractive price of RM3.54 in Malaysia just to find that our wallet is empty. And conveniently, if you want some money, IMF out there is willingly to lend you plenty.

There is no free lunch. Permanent and sustainable wealth does not come from currency rate delusion."

He's a bit less polite than I was though.

Ye Gods, Not Again: The Big Mac Index And The Ringgit

What is it about The Star and a "weak" Ringgit?

I thought I'd done with the Ringgit for a while, but P Gunasegaram repeats that tired old mantra that Purchasing Power Parity is a valid theory, again quoting The Economist magazine's Big Mac Index. I've covered the weaknesses of the BMI here and here, and I'm not about to go into that again except to note that PPP as a guide to currency value is at best a hypothesis, not a theory. A theory requires that the underlying hypothesis is supported by empirical data, which conspicuously is lacking for PPP.

Mr Gunasegaram also repeats that other tired mantra that an increase in reserves indicates a de facto attempt to devalue the currency. Again, this is not necessarily true as it completely ignores the potential impact of trade and capital flows on the domestic monetary aggregates (and thus inflation), which would necessitate central bank intervention. Since this intervention is functionally equivalent to currency intervention, what looks like an attempt to weaken the currency is actually something quite different.

We're also ignoring recent history here. Here's the log annual change in reserves and the MYRUSD exchange rate (where a negative change indicates appreciation) since 2000:



Two things to note here - first during the fixed rate period, reserve accumulation was volatile. If PPP was in fact operative and the Ringgit is substantially undervalued against the USD then reserve accumulation according to Mr Gunasegaram's hypothesis should have been consistently positive - it was not.

Second during the floating rate period, reserve accumulation had the opposite sign to what his hypothesis suggests. In other words, reserves increased when the Ringgit appreciated, and decreased when the Ringgit depreciated. That's a rather big hole in the "weak" currency meme, but is consistent with BNM's stated policy of ameliorating currency volatility (and not aiming for a target level) when necessary.

If BNM was intervening to create a "weak" Ringgit, then there would be no call to intervene when the Ringgit started weakening last year - which in fact actually happened. And the intervention conducted was more a factor of demand for USD (a response to domestic monetary conditions), rather than to achieve some target rate for the exchange rate.

You can find my extended critique of the "weak" currency meme here and especially here.

On another note, while a "strong" currency policy would indeed have the effect of increasing de facto individual incomes, there's an underlying assumption that nothing else will change. I roughly calculated trade elasticities with respect to the exchange rate in an earlier post - a 1% appreciation in the exchange rate resulted in approximately a 1.55% to 1.57% drop in exports.

Think about that for a minute - if my estimates are correct (and to be fair I'm not all that certain), since the drop in exports exceeds the rise in the exchange rate that implies a drop in export volumes. Since volumes will drop and there is no endogenous change in the supply for labour in the tradables sector, you'll get your higher income at the cost of higher unemployment (and since we're talking about low-cost production, also higher income inequality).

Let's just say I don't think pushing for a "strong", as opposed to a fairly valued exchange rate, is a good policy.

Technical Notes:
1. Data for reserves and MYRUSD exchange rate from BNM's Monthly Statistical Bulletin.

Trade Elasticities and the Ringgit

This post ought to make happy those who think that the Ringgit should appreciate to force Malaysian firms to be more competitive, as well as those who think the currency is being manipulated for export competitiveness.

Some background is called for here. What’s an elasticity? In simple terms, it’s the response of one variable to a change in another. In the present post, I’m calculating the response of exports and imports to a change in demand and supply variables, specifically the exchange rate (both nominal and real trade-weighted indexes), Malaysian GDP, as well as external GDP.

In the literature, for a change in the exchange rate to affect the trade balance, then the sum of the absolute values of the exchange elasticity of exports and imports have to be greater than unity (1). This is known as the Marshall-Lerner condition.

Since my formulation of exchange rates is different (for simplification purposes I use the reciprocal of the normal definition), then for the Marshall-Lerner condition to hold my calculated sum of exchange elasticities should be less than -1.

Some disclaimers before proceeding: I’m not using any lag structure (past values of variables), even though I really ought to – economic variables do not respond instantaneously to changes in other economic variables.

Also by rights, the variables should be used within a vector autoregression model rather than the single equation estimates I’m using here, to capture feedback effects and dynamics – but the models I’ve tried so far were unstable and generated some perverse results (Malaysian GDP granger causing World GDP for instance). I’m going to continue working on that, as using a VAR is the more technically correct approach (you run up straight against the Lucas critique otherwise), but the current estimates will have to do for now.

The demand model specifications are:

Log(exports) = log(exchange rate) + log(World GDP) + monthly seasonal dummies

Log(imports) = log(exchange rate) + log(Malaysian GDP) + log(exports) + monthly seasonal dummies

Data is at monthly frequencies (with interpolated GDP data), and the sample period is 2000:1 to 2007:12. World GDP was proxied by using a trade-weighted geometric average of US, Japan, EU, China and Singapore GDP (Malaysia’s five biggest trading partners). For the import demand functions, I had to use an ARCH model rather than standard OLS.

So what did I get?

For nominal exchange rates:

Exports
A 1% appreciation in the exchange rate results in a 1.55% fall in exports

A 1% rise in world GDP results in a 1.50% rise in exports

Imports
A 1% appreciation in the exchange rate results in a 0.28% rise in imports

A 1% rise in exports results in a 0.97% rise in imports

Changes in Malaysian GDP had no significant effects on imports

For real exchange rates:

Exports
A 1% appreciation in the exchange rate results in a 1.57% fall in exports

A 1% rise in world GDP results in a 1.49% rise in exports

Imports
A 1% appreciation in the exchange rate results in a 0.34% rise in imports

A 1% rise in exports results in a 0.99% rise in imports

Changes in Malaysian GDP had no significant effects on imports

So a depreciation in the exchange rate (“weaker” if you will) does result in an increase in the trade balance, as the Marshall-Lerner condition holds for both nominal and real exchange rates. Adding the export elasticity with the import elasticity yields:

Nominal
-1.55 - 0.28 = -1.83

Real
-1.57 – 0.34 = -1.91

…so both sums are less than -1.

Equally, an appreciation of the exchange rate will result in a deterioration of the trade balance, as exports fall faster than imports. At least, that’s what these figures suggest.

However, because I haven’t modeled feedback effects (except through the inclusion of the export series in the import demand equation), you should probably take these results with a bucket of salt. The fact that exports cause a one-to-one change in imports suggests that adding dynamics might change the picture dramatically, but I haven’t yet come up with a model I’m happy with.

I’m also working on breaking down the components of both exports and imports, which might yield further insights. One preliminary result that seems to be holding up: the exchange rate has no impact on imports of consumption or intermediate goods, which also suggests that the import demand functions I’ve estimated are questionable.

Technical Notes
1. Trade data from DOS
2. GDP data from IMF International Financial Statistics

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.