I was going to give this article a pass, but I had a little epiphany over the weekend that makes it worthwhile commenting on - not so much the article itself, but rather the example Tan Sri Lin See Yan makes of The Economist's Big Mac Index (here and here for the latest readings).
The Big Mac Index was based on a simple idea: since the Big Mac is relatively homogeneous (same ingredients, and almost the same in terms of other inputs), differences in pricing across countries should illustrate differences in purchasing power, and thus gives a clue as to the relative strength or weakness of exchange rates.
For example, the average USD price of the Big Mac is $3.57 while the average EUR price is €3.31 as at July 13th, which gives an implied USDEUR exchange rate of USD1.08. Comparing this to the actual USDEUR exchange rate of USD1.39, according to this measure the EUR is 29% overvalued against the USD.
If we take Malaysia as an example instead, with a local price of RM6.77 we get an implied-PPP exchange rate of RM1.896 compared to the actual of RM3.60, giving an undervaluation of 47%. If you look at most East Asian countries, you'll find a greater or lesser degree of undervaluation.
This type of analysis has therefore tended to confirm the stylised notion that East Asian economies are currency manipulators, and have kept their currencies cheap in relation to the USD to boost their export-growth models. I won't delve into more formal proofs (and dis-proofs) of this notion, but rather go into the potential hazards of relying on the Big Mac index as a PPP measure.
The standard critique is that Big Macs incorporate local inputs, which are generally composed of non-tradables (land, labour, localised taxes etc). I'd also add the potential for price differentiation from local supplies of tradables, particularly the ingredients themselves - beef, bread, vegetables etc, although the sauce as I understand it is a McDonalds monopoly.
This could explain much of the gross difference between countries, if you've followed my arguments based on the tradables/non-tradables model of exchange rate determination. Also, The Economist themselves warn that the Index should only be relied upon when comparing economies with similar income levels, a finding that is also derived from the same model - high-income countries have higher price levels, and would therefore have stronger currencies in relation to lower-income economies. Looking at the index, we do indeed find developing economies in general having derived-PPP levels lower than that of advanced economies.
The epiphany I was talking about earlier focused on something quite different, which could also strengthen the argument against a Big Mac Index as a PPP measure. When I was a student in London in the late 1980s, I was struck by the fact that Coca-Cola and many other global food and beverage brands had very similar prices to Malaysia's (admission: I'm a Coke addict) - on the face of it, this would imply the intuition behind the Big Mac Index was correct.
But looking at McDonalds' menu prices a different story emerged: Big Macs were indeed more expensive in the UK (and not just in London). Here's the kicker. While Big Macs were more expensive, Filet o'Fish were actually cheaper in the UK than in KL, on par with the humble Hamburger.
What that suggests to me are a few additional economic explanations, over and above the conventional critique:
1. The difference in prices between low-income and high-income economies can also be attributed to differences in the ability to purchase higher-protein diets. As countries shift from low-income to high-income, the protein intake of the population increases raising demand (and prices) for beef.
2. Differences in prices can also be attributed to consumer preferences for different types of protein. Honestly, how often do you see Asians eating beef as compared to chicken, fish or pork?
3. As a corollary to the above, access to alternative supplies of protein (for instance, access to the seas) would also impact beef demand.
Just as important as these factors are that Big Macs are not tradable - there's no price arbitration across borders because Big Macs are a perishable good, unlike for instance a can of Coke. Also, McDonalds is a multi-national corporation with a globally-recognisable brand. To me that suggests that it also likely practices price differentiation across markets, which is a characteristic of monopolies.
So there are quite a few more factors involved than just the conventional economic explanations for differences in purchasing power based on the Big Mac Index, and hence implied-PPP evaluations of exchange rates. A Filet O'Fish Index for instance could paint a very different picture of PPP between East and West.
Proving all these formally might take some doing, but I think I'm going to make a stab at it. It'd make for a decent publishable paper.
Tuesday, August 4, 2009
Monday, August 3, 2009
June 2009 Monetary Policy Update
Since Bank Negara have left the Official Policy Rate unchanged for the last few months, monetary conditions have largely settled down. Growth in M2 and M3 have begun to turn up, despite base money growth decelerating (log annual changes):
However, we're beginning to hear some noises that BNM may be contemplating a further cut, largely I think due to the continuing steepening in the MGS yield curve:
June saw RM4b in MGS and RM5.5b in GII in new issues, which represented an approximate 3% increase in net government debt, on top of the RM13.8b issued in May - which helps to explain the rise in long term rates. We're not looking (yet) at any particular hurdle to further public borrowing as auction yields continue to be near historical lows, while the banking system still has considerable excess cash. But the rate at which the yield curve is steepening, when funding for the stimulus packages as well as the budgeted development spending deficit for this year has yet to be fully met, must be worrying the Treasury and Bank Negara.
Other money market instrument rates are also creeping up, as are retail deposit and lending rates, albeit not to the same degree. FD rates are averaging 1bp higher than in May and average lending rates are 2bp higher, while the yield curves on BNM bills and T-Bills are also steepening. Loan growth has dropped a shade under 8%, which is the lowest level since July 2007 (log annual changes):
I'm still trying to work out how, or if, core inflation is figuring into BNM's calculations. I've worked out a longer span for the core inflation rate (CPI less food and transport) I talked about here, but I find my synthetic index a little unconvincing, especially since it spans a change in base year as well as components in 2005 (log annual changes; 2000=100):
This makes a little more sense than CPI inflation as a guide to the monetary policy stance:
...but I think it needs a little more work. Taking away the broad food and transport categories is a little drastic, since those two put together encompass more than half the CPI. What I probably need to do is deconstruct the broad categories further, but that would require a bit more leg work than I've got time to do right now unfortunately. Stay tuned on that score.
Getting back to what's going on, I don't know if a further interest rate cut is going to be at all effective - short term rates are right on BNM's policy rate, and all the (bad) action is happening at the longer end of the curve. Cutting the OPR won't effect those rates much, if at all. Quantitative easing might work, but that's not going to go down at all well with investors or the public. In any case, the 5-10 year MGS is probably where the bulk of issuance will happen, and yields on those tenures are still more than palatable. So any interest rate cut would probably be only on the cards if 5yr MGS yields move over say 5% - the last time that happened was during the 2000 downturn.
However, we're beginning to hear some noises that BNM may be contemplating a further cut, largely I think due to the continuing steepening in the MGS yield curve:
June saw RM4b in MGS and RM5.5b in GII in new issues, which represented an approximate 3% increase in net government debt, on top of the RM13.8b issued in May - which helps to explain the rise in long term rates. We're not looking (yet) at any particular hurdle to further public borrowing as auction yields continue to be near historical lows, while the banking system still has considerable excess cash. But the rate at which the yield curve is steepening, when funding for the stimulus packages as well as the budgeted development spending deficit for this year has yet to be fully met, must be worrying the Treasury and Bank Negara.
Other money market instrument rates are also creeping up, as are retail deposit and lending rates, albeit not to the same degree. FD rates are averaging 1bp higher than in May and average lending rates are 2bp higher, while the yield curves on BNM bills and T-Bills are also steepening. Loan growth has dropped a shade under 8%, which is the lowest level since July 2007 (log annual changes):
I'm still trying to work out how, or if, core inflation is figuring into BNM's calculations. I've worked out a longer span for the core inflation rate (CPI less food and transport) I talked about here, but I find my synthetic index a little unconvincing, especially since it spans a change in base year as well as components in 2005 (log annual changes; 2000=100):
This makes a little more sense than CPI inflation as a guide to the monetary policy stance:
...but I think it needs a little more work. Taking away the broad food and transport categories is a little drastic, since those two put together encompass more than half the CPI. What I probably need to do is deconstruct the broad categories further, but that would require a bit more leg work than I've got time to do right now unfortunately. Stay tuned on that score.
Getting back to what's going on, I don't know if a further interest rate cut is going to be at all effective - short term rates are right on BNM's policy rate, and all the (bad) action is happening at the longer end of the curve. Cutting the OPR won't effect those rates much, if at all. Quantitative easing might work, but that's not going to go down at all well with investors or the public. In any case, the 5-10 year MGS is probably where the bulk of issuance will happen, and yields on those tenures are still more than palatable. So any interest rate cut would probably be only on the cards if 5yr MGS yields move over say 5% - the last time that happened was during the 2000 downturn.
Sunday, August 2, 2009
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
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
Friday, July 31, 2009
Thursday, July 30, 2009
Inflation? What Inflation?
I've spent the last couple days sitting in a seminar at INTAN on 1Malaysia. So far its been an interesting experience, with some good thoughtful speakers (as well as some not so good ones). There are some takeaways I'd like to talk about here, not so much on 1Malaysia but some of the nuggets that got bandied about, particularly on distributional issues. But this post will be tangential to that.
The seminar was supposed to be opened by the Chief Secretary to the Government yesterday, but due to a scheduling conflict, INTAN replaced the morning session with an impromptu 1hr talk by Lee Heng Guie, head of economic research at CIMB Investment.
No big surprises in his MY economic outlook - weak recovery in developed economies, and Malaysia should see positive growth in the second half of this year. He gave me some ideas that I'd like to follow up on statistically (US PMI as a leading indicator for MY exports for instance), but he repeated a stylized fact that is unfortunately all too common - quantitative easing (aka printing money) in the US will lead to higher inflation and a depreciating USD going forward. I'll buy (with reservations) the depreciating USD story, but inflation is by no means a given and its source will not be due to the Fed's liquidity injections or printing presses.
I'm seeing this high inflation story a lot in both the press and the blogosphere - this BusinessWeek article is one mild example of inflation hysteria (on a sidenote - Arthur Laffer is a prominent economist? Prominent maybe, but calling him an economist of any standing outside conservative circles had me choking).
You can get even more extreme drivel if you do a Google search for "libertarian gold nut" or Ross Perot. If I sound caustic on this subject, it's because I have little patience for a seriously outmoded form of monetary system that is so obviously economically unbeneficial (you can find my thoughts on gold here and here). Zimbabwe and the Weimar Republic frequently appear as models of comparison - as if the situations are at all comparable. The Fed is very far from triggering increased inflation, much less hyperinflation.
But what's wrong with the popular picture of QE driving inflation expectations? On the face of it, higher inflation is what we should expect: basic economic theory says that an expansion of the monetary base for a given level of output will necessarily turn up as an equivalent increase in the price level. As the saying goes, too much money chasing too few goods.
There's no doubt that the Fed, along with other major central banks have indeed conducted liquidity operations and QE on an unprecedented scale during the depths of the crisis. And under ordinary circumstances, this should indeed put upward pressure on the price level. The problem with this narrative is that it is essentially a static equilibrium analysis, which ignores two things:
1. The level of output has fallen below potential
2. The demand for money has increased
With slack in the economy, increases in the money supply will not cause inflation as both firms and workers lack pricing power. Firms can't increase prices without suffering loss in demand (and therefore profits), while workers can't demand higher wages in the presence of high unemployment. Also, under the present circumstances, firms and consumers prefer holding money rather than spending or investing it, which raises the amount of money supply that can be supported at a given level of output - again non-inflationary, as money velocity has fallen.
Most economists intuitively understand these factors, so much of the serious discussion is concentrated on what could happen after a recovery. If output closes on its long term potential and velocity rises back to its normal range in the next couple of years, won't the increase in the monetary base push inflation expectations along?
This is where the central banks' exit strategy becomes important. I've become far more sanguine on the ability of the Fed and ECB to unwind their balance sheet expansion than I was just a few months ago. There are a few reasons for my thoughts on this:
1. The monetary transmission mechanism is and will continue to be broken
The Fed's liquidity operations are not having an impact on the broader economy. The "massive" increase in the monetary base is not turning up as a corresponding increase in the broader money supply - the money multiplier has fallen. In fact M2 growth is hovering around its long term average of around 7% despite double-digit M1 growth (log annual changes; 1960-2009):
There are a few things going on here, of which the first is the increase in the demand for money I mentioned above. Secondly, banks are still recovering from the shellacking of the past year, and aren't that eager to lend especially as house prices are still trying to find a stable bottom and unemployment continues to increase. This situation is something that will in all probability take a few years to resolve, which gives time for the Fed to reverse its purchases of securities. Third is that the ongoing deleveraging of the shadow banking industry will continue to exert downward pressure on liquidity. And finally, the Fed (and a few other central banks) are using some unorthodox methods, which leads to my next point.
2. Paying interest on reserves
It used to be that banking reserves kept at the central bank attracted no income. This meant that banks would immediately utilise any excess over statutory reserve requirements, as reserves still had to be funded - reserve money was a dead loss. Now the Fed is paying overnight rates on all reserve funds, which means that banks should be indifferent to keeping their money in their reserve account or the money market. The importance of this is that the Fed can fine tune their control over the timing of shrinking their balance sheet. They don't need to mass dump securities on the market to mop up excess liquidity and potentially take a loss - they can raise the interest rate on reserve funds instead.
3. The Fed isn't actually printing money (at least, not so much you'd notice)
QE is such a bad couple of words that any hint of it has inflation hawks yelling blue murder. But how much monetization of government debt is the Fed actually doing? They have on their books just under US$700 billion, or something like RM2 trillion, worth of treasuries. On an absolute scale that sounds like a lot of money - it's rather larger than for example twice the entire M3 money supply of Malaysia. But scaled against the actual US national debt, it's somewhat less than massive at under 9% of estimated treasuries outstanding (held by the public) for 2009. If you include official holdings of treasuries, the ratio is even less. More importantly, the Fed is buying T-bills off the open market rather than at auction, so the effect on the monetary base is actually net zero and also has the impact of capping long term interest rates.
Based on these factors, I don't think monetary expansion will support a rise in inflationary expectations over the medium term - inflation is more likely to come about from elevated commodity prices. What I think will happen however is a general rise in interest rates, especially at longer tenures as the Fed only directly controls the 1 month rate.
I don't think the Fed has that much appetite for more QE than it absolutely has to - they're committed to another US$300 billion by September, but there's lukewarm support on the FOMC for continuing that program if I'm reading the signs right. And higher interest rates will also provide some notional support for the USD - which makes the USD collapse story less likely as well.
Technical Notes:
US money supply data from the Federal Reserve, estimates of US national debt from the Congressional Budget Office. The Fed's current holdings of treasuries is available here.
The seminar was supposed to be opened by the Chief Secretary to the Government yesterday, but due to a scheduling conflict, INTAN replaced the morning session with an impromptu 1hr talk by Lee Heng Guie, head of economic research at CIMB Investment.
No big surprises in his MY economic outlook - weak recovery in developed economies, and Malaysia should see positive growth in the second half of this year. He gave me some ideas that I'd like to follow up on statistically (US PMI as a leading indicator for MY exports for instance), but he repeated a stylized fact that is unfortunately all too common - quantitative easing (aka printing money) in the US will lead to higher inflation and a depreciating USD going forward. I'll buy (with reservations) the depreciating USD story, but inflation is by no means a given and its source will not be due to the Fed's liquidity injections or printing presses.
I'm seeing this high inflation story a lot in both the press and the blogosphere - this BusinessWeek article is one mild example of inflation hysteria (on a sidenote - Arthur Laffer is a prominent economist? Prominent maybe, but calling him an economist of any standing outside conservative circles had me choking).
You can get even more extreme drivel if you do a Google search for "libertarian gold nut" or Ross Perot. If I sound caustic on this subject, it's because I have little patience for a seriously outmoded form of monetary system that is so obviously economically unbeneficial (you can find my thoughts on gold here and here). Zimbabwe and the Weimar Republic frequently appear as models of comparison - as if the situations are at all comparable. The Fed is very far from triggering increased inflation, much less hyperinflation.
But what's wrong with the popular picture of QE driving inflation expectations? On the face of it, higher inflation is what we should expect: basic economic theory says that an expansion of the monetary base for a given level of output will necessarily turn up as an equivalent increase in the price level. As the saying goes, too much money chasing too few goods.
There's no doubt that the Fed, along with other major central banks have indeed conducted liquidity operations and QE on an unprecedented scale during the depths of the crisis. And under ordinary circumstances, this should indeed put upward pressure on the price level. The problem with this narrative is that it is essentially a static equilibrium analysis, which ignores two things:
1. The level of output has fallen below potential
2. The demand for money has increased
With slack in the economy, increases in the money supply will not cause inflation as both firms and workers lack pricing power. Firms can't increase prices without suffering loss in demand (and therefore profits), while workers can't demand higher wages in the presence of high unemployment. Also, under the present circumstances, firms and consumers prefer holding money rather than spending or investing it, which raises the amount of money supply that can be supported at a given level of output - again non-inflationary, as money velocity has fallen.
Most economists intuitively understand these factors, so much of the serious discussion is concentrated on what could happen after a recovery. If output closes on its long term potential and velocity rises back to its normal range in the next couple of years, won't the increase in the monetary base push inflation expectations along?
This is where the central banks' exit strategy becomes important. I've become far more sanguine on the ability of the Fed and ECB to unwind their balance sheet expansion than I was just a few months ago. There are a few reasons for my thoughts on this:
1. The monetary transmission mechanism is and will continue to be broken
The Fed's liquidity operations are not having an impact on the broader economy. The "massive" increase in the monetary base is not turning up as a corresponding increase in the broader money supply - the money multiplier has fallen. In fact M2 growth is hovering around its long term average of around 7% despite double-digit M1 growth (log annual changes; 1960-2009):
There are a few things going on here, of which the first is the increase in the demand for money I mentioned above. Secondly, banks are still recovering from the shellacking of the past year, and aren't that eager to lend especially as house prices are still trying to find a stable bottom and unemployment continues to increase. This situation is something that will in all probability take a few years to resolve, which gives time for the Fed to reverse its purchases of securities. Third is that the ongoing deleveraging of the shadow banking industry will continue to exert downward pressure on liquidity. And finally, the Fed (and a few other central banks) are using some unorthodox methods, which leads to my next point.
2. Paying interest on reserves
It used to be that banking reserves kept at the central bank attracted no income. This meant that banks would immediately utilise any excess over statutory reserve requirements, as reserves still had to be funded - reserve money was a dead loss. Now the Fed is paying overnight rates on all reserve funds, which means that banks should be indifferent to keeping their money in their reserve account or the money market. The importance of this is that the Fed can fine tune their control over the timing of shrinking their balance sheet. They don't need to mass dump securities on the market to mop up excess liquidity and potentially take a loss - they can raise the interest rate on reserve funds instead.
3. The Fed isn't actually printing money (at least, not so much you'd notice)
QE is such a bad couple of words that any hint of it has inflation hawks yelling blue murder. But how much monetization of government debt is the Fed actually doing? They have on their books just under US$700 billion, or something like RM2 trillion, worth of treasuries. On an absolute scale that sounds like a lot of money - it's rather larger than for example twice the entire M3 money supply of Malaysia. But scaled against the actual US national debt, it's somewhat less than massive at under 9% of estimated treasuries outstanding (held by the public) for 2009. If you include official holdings of treasuries, the ratio is even less. More importantly, the Fed is buying T-bills off the open market rather than at auction, so the effect on the monetary base is actually net zero and also has the impact of capping long term interest rates.
Based on these factors, I don't think monetary expansion will support a rise in inflationary expectations over the medium term - inflation is more likely to come about from elevated commodity prices. What I think will happen however is a general rise in interest rates, especially at longer tenures as the Fed only directly controls the 1 month rate.
I don't think the Fed has that much appetite for more QE than it absolutely has to - they're committed to another US$300 billion by September, but there's lukewarm support on the FOMC for continuing that program if I'm reading the signs right. And higher interest rates will also provide some notional support for the USD - which makes the USD collapse story less likely as well.
Technical Notes:
US money supply data from the Federal Reserve, estimates of US national debt from the Congressional Budget Office. The Fed's current holdings of treasuries is available here.
Thursday, July 23, 2009
One Good Reason Why Central Banks Should Be Independent: Politicians Don't Understand Monetary Policy
This article on Bloomberg caught my eye yesterday. The relevant passage is:
"Representative Alan Grayson, a Florida Democrat, questioned what authority the Fed used to lend hundreds of billions of dollars through currency swaps to central banks around the world.
'One of the arrangements is $9 billion for New Zealand -- that works out to $3,000 for every single person who lives in New Zealand,' Grayson said. 'Wouldn’t it have been better to extend that kind of credit to Americans rather than New Zealanders?'"
Here's Bernanke's reply:
"Bernanke countered that 'we are lending to all U.S. financial institutions in exactly the same way' and that 'we have a longstanding legal authority to do swaps with other central banks.'"
...which is a nice way of saying Rep. Grayson doesn't have a clue of what he was talking about.
What happens when central banks do a swap? Using the NZ example, the Fed loaned the RBNZ US$9b. Can the RBNZ use this to increase credit in the NZ economy? How so when the USD is not legal tender in New Zealand? Getting that USD into the NZ banking system in NZD form implies a contraction of the domestic portion of the money supply, not an expansion, unless it's fully sterilised. So why do the swap?
Because NZ, just like everybody else in the aftermath of the Lehman collapse, faced a flight to safety of foreign investment and domestic capital which caused a spike in USD demand. There was a currency mismatch between the foreign currency assets and liabilities of the banking system. If the central bank's international USD reserves were also insufficient, then NZ banks would have failed to meet their international obligations. This would have an impact not only on NZ's credit standing, but also on the counterparties on the other side of the transactions.
Not so bad if you're domestic: all that happens is that your capital can't leave. But what about foreign creditors? And all those hedge funds and banks who played the forex carry trade (remember NZ's high deposit rates? Was it only last year?)? The swap lines the Fed engineered allowed US firms to call back their foreign-based capital and bolster both cash and capital reserves right when they needed it most.
Failure to meet USD obligations would have greatly exacerbated the liquidity and credit crunch of late-2008. The NZ swap line of US$9b was relatively small - the ECB got US$200b.
The net actual effect is that the Fed and participating central banks transformed private sector USD liabilities into official sector USD liabilities, with the corresponding increase in credit worthiness. It also meant that any USD the Fed actually lent out through the swap lines came right back to the US.
Having Congress overlooking the Fed's shoulders gives me the willies. If Rep. Grayson is any example of the average level of economic competence there, politicians and monetary policy shouldn't mix - and that goes double for BNM and Parliament.
Update
Mark Thoma at Economist's View has a video and a nice discussion going on about the same subject of Bernanke's testimony. Plus a correction: RBNZ's swap line was $15b (of which none was actually utilised!), and the ECB got $300b not $200b.
"Representative Alan Grayson, a Florida Democrat, questioned what authority the Fed used to lend hundreds of billions of dollars through currency swaps to central banks around the world.
'One of the arrangements is $9 billion for New Zealand -- that works out to $3,000 for every single person who lives in New Zealand,' Grayson said. 'Wouldn’t it have been better to extend that kind of credit to Americans rather than New Zealanders?'"
Here's Bernanke's reply:
"Bernanke countered that 'we are lending to all U.S. financial institutions in exactly the same way' and that 'we have a longstanding legal authority to do swaps with other central banks.'"
...which is a nice way of saying Rep. Grayson doesn't have a clue of what he was talking about.
What happens when central banks do a swap? Using the NZ example, the Fed loaned the RBNZ US$9b. Can the RBNZ use this to increase credit in the NZ economy? How so when the USD is not legal tender in New Zealand? Getting that USD into the NZ banking system in NZD form implies a contraction of the domestic portion of the money supply, not an expansion, unless it's fully sterilised. So why do the swap?
Because NZ, just like everybody else in the aftermath of the Lehman collapse, faced a flight to safety of foreign investment and domestic capital which caused a spike in USD demand. There was a currency mismatch between the foreign currency assets and liabilities of the banking system. If the central bank's international USD reserves were also insufficient, then NZ banks would have failed to meet their international obligations. This would have an impact not only on NZ's credit standing, but also on the counterparties on the other side of the transactions.
Not so bad if you're domestic: all that happens is that your capital can't leave. But what about foreign creditors? And all those hedge funds and banks who played the forex carry trade (remember NZ's high deposit rates? Was it only last year?)? The swap lines the Fed engineered allowed US firms to call back their foreign-based capital and bolster both cash and capital reserves right when they needed it most.
Failure to meet USD obligations would have greatly exacerbated the liquidity and credit crunch of late-2008. The NZ swap line of US$9b was relatively small - the ECB got US$200b.
The net actual effect is that the Fed and participating central banks transformed private sector USD liabilities into official sector USD liabilities, with the corresponding increase in credit worthiness. It also meant that any USD the Fed actually lent out through the swap lines came right back to the US.
Having Congress overlooking the Fed's shoulders gives me the willies. If Rep. Grayson is any example of the average level of economic competence there, politicians and monetary policy shouldn't mix - and that goes double for BNM and Parliament.
Update
Mark Thoma at Economist's View has a video and a nice discussion going on about the same subject of Bernanke's testimony. Plus a correction: RBNZ's swap line was $15b (of which none was actually utilised!), and the ECB got $300b not $200b.
Wednesday, July 22, 2009
Deflation? What Deflation?
Today's CPI report from DOS brings some positive news: inflation is back, albeit very mildly. Don't pay any attention to the year-on-year number (log annual change; 2005=100):
Disinflation was always on the cards after last year's runup in petrol prices. What matters now is that the price level appears to have stabilised:
And monthly price level changes are positive for the second month running, the first time that has happened since last August (log monthly change; 2005=100):
Why is inflation at this juncture positive news? Because it signals recovery in domestic demand. To underscore this point, rising prices in June are not due to food or petrol price increases but is rather more broadly based.
To check this I stripped the (volatile) food and transport categories out of the CPI, which leaves an approximate measure for "core" CPI. In retrospect, looking at the core inflation trend shows that Malaysia was in little danger of a deflationary spiral this year (log annual changes; 2005=100):
Mea culpa - I should've done this earlier. I'm going to try and extend the core measure back as far as I can, and it will probably force me to reassess BNM's monetary policy moves as well as real interest rate measures. The lower core inflation indicates that monetary policy is in fact tighter pre-2009, and looser this year, than I thought it was.
Technical Note:
I used an arithmetic average of the remaining weights after stripping out Food (31.4%) and Transport (15.9%). That approach is probably questionable - I prefer using geometric averages when I can, but time constraints did not permit. Plus stripping away what amounts to half the CPI is also grounds for caution - but the core measure does explain why BNM was relatively unmoved by the commodity bubble of 2006-2008, so I'm going to keep calculating this and see where it leads.
Disinflation was always on the cards after last year's runup in petrol prices. What matters now is that the price level appears to have stabilised:
And monthly price level changes are positive for the second month running, the first time that has happened since last August (log monthly change; 2005=100):
Why is inflation at this juncture positive news? Because it signals recovery in domestic demand. To underscore this point, rising prices in June are not due to food or petrol price increases but is rather more broadly based.
To check this I stripped the (volatile) food and transport categories out of the CPI, which leaves an approximate measure for "core" CPI. In retrospect, looking at the core inflation trend shows that Malaysia was in little danger of a deflationary spiral this year (log annual changes; 2005=100):
Mea culpa - I should've done this earlier. I'm going to try and extend the core measure back as far as I can, and it will probably force me to reassess BNM's monetary policy moves as well as real interest rate measures. The lower core inflation indicates that monetary policy is in fact tighter pre-2009, and looser this year, than I thought it was.
Technical Note:
I used an arithmetic average of the remaining weights after stripping out Food (31.4%) and Transport (15.9%). That approach is probably questionable - I prefer using geometric averages when I can, but time constraints did not permit. Plus stripping away what amounts to half the CPI is also grounds for caution - but the core measure does explain why BNM was relatively unmoved by the commodity bubble of 2006-2008, so I'm going to keep calculating this and see where it leads.
Thursday, July 9, 2009
May IPI: Still No Heartbeat
Today's industrial production release has both good news and bad news.
The good news is that the decline in production has essentially stopped (in levels; 2000=100):
The major component indices have all stabilised, which seems to confirm we've reached a bottom, or at least a plateau from which further declines are possible but unlikely.
The bad news is that there's precious little evidence of a recovery as yet (monthly log changes):
Looking at the breakdown of the manufacturing sub-sectors, it appears consumption and contruction related industries are starting to see some action, but electronics and electricals (which has the highest weighting) is still trending downwards. China's huge stimulus package, implemented since December last year, may explain some part of this improvement; but I'm wondering how sustainable that is, since some of it leaked out into asset markets (both house prices and the stock markets have staged impressive recoveries from their lows).
Anecdotal evidence suggests that there may have been a reversal in E&E production last month, so hopefully we'll see some improvement when the data actually comes out for June.
The good news is that the decline in production has essentially stopped (in levels; 2000=100):
The major component indices have all stabilised, which seems to confirm we've reached a bottom, or at least a plateau from which further declines are possible but unlikely.
The bad news is that there's precious little evidence of a recovery as yet (monthly log changes):
Looking at the breakdown of the manufacturing sub-sectors, it appears consumption and contruction related industries are starting to see some action, but electronics and electricals (which has the highest weighting) is still trending downwards. China's huge stimulus package, implemented since December last year, may explain some part of this improvement; but I'm wondering how sustainable that is, since some of it leaked out into asset markets (both house prices and the stock markets have staged impressive recoveries from their lows).
Anecdotal evidence suggests that there may have been a reversal in E&E production last month, so hopefully we'll see some improvement when the data actually comes out for June.
Tuesday, July 7, 2009
Banks: Leverage and the Interest Rate Spread
I've been railing against the slow adjustment in the interest rate margin between what Malaysian banks are charging and their cost of funds (proxied by the overnight interbank rate). Turns out they're not alone in doing this.
An article on VoxEU* examines the profit record of banks during the Great Depression, and makes some telling comparisons with current developments. To make a long story short, commercial banks are probably going to remain relatively healthy (at least, those that don't actually go bust), especially compared to their investment banking brethren. What really caught my eye though is the remarks about the interest rate margin - Euro area and US commercial banks are charging approximately between 2.5%-3.0% above their cost of funds, which is suffcient to handle an average loan portfolio default of about 5% over the next four years. That actually corresponds nicely with what Malaysian banks are charging:
If that's the case, the spread's likely to remain pretty much as it is until we get a handle on actual default rates later this year. Since we're looking at the bottom probably occuring in 2Q2009, that means defaults should peak some time in 1Q2010 assuming a sustainable recovery emerges in the second half of the year.
So we're at or close to the bottom as far as lending rates are concerned, though I still think banks could have cut faster in response to the cuts in the OPR.
In another VoxEU article**, the Research Dept of the Bank of Italy looks at leverage ratios in the global banking industry over the last ten years or so. As you may know, leverage before the crisis, which is the multiple of assets over the underlying capital base (or alternatively your gearing level)***, was sky high in some of the more badly affected banks - the US investment banks were allowed from 2004 to leverage their balance sheet up to 30x, which to my mind was insane.
If you like big numbers, that's 3000% of their capital base. I was surprised to learn that the Euro area banks actually had much higher leverage ratios (one bank exceeded 60x), which may explain why the European banking system was as badly affected as that of the US and UK. In any case, it's clear that leverage was a contributory factor in the fragility of the international financial system.
What are the leverage ratios in Malaysia? Not that bad by comparison:
Of course, this doesn't include off-balance sheet assets, but since domestic banking institutions haven't been that active internationally, I don't think the risk element is any higher than what is implied by the "official" numbers. Having said that, this is one metric I'm going to pay attention to in future.
Technical Notes
*"Lessons from banking profits in the Great Depression", Daniel Gros
**"Financial sector pro-cyclicality: Lessons from the crisis, Part I", Columba, F; Cornacchia, W; and Salleo, C
***There's a difference between leverage as defined here and the risk weighted capital ratio (RWCR), which is a reciprocal of the leverage ratio but with a difference in calculation. The RWCR (min: 8% under Basle I, equivalent to approximately 12x leverage) is based on risk weighted assets, where certain asset classes attract lower risk weights, which effectively reduces the value of assets used in the calculation.
An article on VoxEU* examines the profit record of banks during the Great Depression, and makes some telling comparisons with current developments. To make a long story short, commercial banks are probably going to remain relatively healthy (at least, those that don't actually go bust), especially compared to their investment banking brethren. What really caught my eye though is the remarks about the interest rate margin - Euro area and US commercial banks are charging approximately between 2.5%-3.0% above their cost of funds, which is suffcient to handle an average loan portfolio default of about 5% over the next four years. That actually corresponds nicely with what Malaysian banks are charging:
If that's the case, the spread's likely to remain pretty much as it is until we get a handle on actual default rates later this year. Since we're looking at the bottom probably occuring in 2Q2009, that means defaults should peak some time in 1Q2010 assuming a sustainable recovery emerges in the second half of the year.
So we're at or close to the bottom as far as lending rates are concerned, though I still think banks could have cut faster in response to the cuts in the OPR.
In another VoxEU article**, the Research Dept of the Bank of Italy looks at leverage ratios in the global banking industry over the last ten years or so. As you may know, leverage before the crisis, which is the multiple of assets over the underlying capital base (or alternatively your gearing level)***, was sky high in some of the more badly affected banks - the US investment banks were allowed from 2004 to leverage their balance sheet up to 30x, which to my mind was insane.
If you like big numbers, that's 3000% of their capital base. I was surprised to learn that the Euro area banks actually had much higher leverage ratios (one bank exceeded 60x), which may explain why the European banking system was as badly affected as that of the US and UK. In any case, it's clear that leverage was a contributory factor in the fragility of the international financial system.
What are the leverage ratios in Malaysia? Not that bad by comparison:
Of course, this doesn't include off-balance sheet assets, but since domestic banking institutions haven't been that active internationally, I don't think the risk element is any higher than what is implied by the "official" numbers. Having said that, this is one metric I'm going to pay attention to in future.
Technical Notes
*"Lessons from banking profits in the Great Depression", Daniel Gros
**"Financial sector pro-cyclicality: Lessons from the crisis, Part I", Columba, F; Cornacchia, W; and Salleo, C
***There's a difference between leverage as defined here and the risk weighted capital ratio (RWCR), which is a reciprocal of the leverage ratio but with a difference in calculation. The RWCR (min: 8% under Basle I, equivalent to approximately 12x leverage) is based on risk weighted assets, where certain asset classes attract lower risk weights, which effectively reduces the value of assets used in the calculation.
Monday, July 6, 2009
Trade in May: It's A Bumpy Ride At The Bottom
According to an economists' poll conducted by Bloomberg, May trade data was worse than expected. I'm left wondering how many of these guys actually run models, even ridiculously simple ones like I've used in this blog.
My two models rather neatly bracketed the actual results for May which came in as RM42946 for exports (-35.2% yoy log difference), with the forecast for the model based on seasonally adjusted data at RM42237, and the seasonal effect model forecasting RM43255. I'll have to agree however, that the results aren't that encouraging:
Log annual changes
Log monthly changes
Trade levels, seasonally adjusted
More or less what I expected - a bumpy ride on the bottom. While I won't go back on my April call for a turnaround, the other side of what I think will happen is also pretty clear - we're sitting on the bottom instead of rising to the surface. In short, any talk of recovery is still premature: I'm still thinking in terms of the past few months being more of an inventory adjustment than a sustainable uptick in economic activity. I'd say the odds are against a further worsening in conditions, but that doesn't necessarily equate to any meaningful closing of the output gap.
If my models' forecasts continue to be right, then trade is going to continue to be bumpy:
Seasonally Adjusted Model
Seasonal Effect Model
June forecasts from the models are as below:
Seasonally Adjusted Model:
Point forecast:RM39529, Range forecast:RM44427-RM34631
Seasonal Effect Model:
Point forecast:RM42499, Range forecast:RM47858-RM37140
Technical Notes:
June trade data from Matrade. Details on how the models were constructed are here.
My two models rather neatly bracketed the actual results for May which came in as RM42946 for exports (-35.2% yoy log difference), with the forecast for the model based on seasonally adjusted data at RM42237, and the seasonal effect model forecasting RM43255. I'll have to agree however, that the results aren't that encouraging:
Log monthly changes
Trade levels, seasonally adjusted
More or less what I expected - a bumpy ride on the bottom. While I won't go back on my April call for a turnaround, the other side of what I think will happen is also pretty clear - we're sitting on the bottom instead of rising to the surface. In short, any talk of recovery is still premature: I'm still thinking in terms of the past few months being more of an inventory adjustment than a sustainable uptick in economic activity. I'd say the odds are against a further worsening in conditions, but that doesn't necessarily equate to any meaningful closing of the output gap.
If my models' forecasts continue to be right, then trade is going to continue to be bumpy:
Seasonal Effect Model
June forecasts from the models are as below:
Seasonally Adjusted Model:
Point forecast:RM39529, Range forecast:RM44427-RM34631
Seasonal Effect Model:
Point forecast:RM42499, Range forecast:RM47858-RM37140
Technical Notes:
June trade data from Matrade. Details on how the models were constructed are here.
Wednesday, July 1, 2009
May 2009 Monetary Policy Update
BNM at the latest MPC meeting kept the Official Policy Rate (OPR) at 2%, but average lending rates have thankfully kept coming down:
The latest May data shows average lending rates just a hair over 5%, which is the lowest on record (at least since 1980), although on a real basis, it's still fairly high at about 2.6%. The spread on lending (based on interbank overnight rates) is also nearer "normal" levels, but still too high for my comfort given the current circumstances:
Money supply growth has responded to lower deposit rates, continuing to decelerate (log annual changes):
But so have loans (log annual changes):
That's the first time loans have seen net repayments since Dec 2007. In the money market, the MGS yield curve has continued to steepen, particularly at the long end:
That's factoring in a lack of demand for longer tenures due to uncertainty, as well as a lack of supply. I'm a little unsure what to make of the evolution of the MGS yield curve. On the one hand, it approximates the spreads seen between 1999-2005, and as such might conceivably be seen as "normal" in one sense. On the other, the compression in spreads between 2005-2008 suggest that the lifting of capital controls and the float of the MYR allowed for greater interest and participation from foreign investors; which immediately suggests that the widening we're seeing now is a function of the pullout by foreign investors over the last year, and that we should see the yield curve flatten again once conditions stabilise. I prefer the latter explanation, but the other could equally be true.
The latest May data shows average lending rates just a hair over 5%, which is the lowest on record (at least since 1980), although on a real basis, it's still fairly high at about 2.6%. The spread on lending (based on interbank overnight rates) is also nearer "normal" levels, but still too high for my comfort given the current circumstances:
Money supply growth has responded to lower deposit rates, continuing to decelerate (log annual changes):
But so have loans (log annual changes):
That's the first time loans have seen net repayments since Dec 2007. In the money market, the MGS yield curve has continued to steepen, particularly at the long end:
That's factoring in a lack of demand for longer tenures due to uncertainty, as well as a lack of supply. I'm a little unsure what to make of the evolution of the MGS yield curve. On the one hand, it approximates the spreads seen between 1999-2005, and as such might conceivably be seen as "normal" in one sense. On the other, the compression in spreads between 2005-2008 suggest that the lifting of capital controls and the float of the MYR allowed for greater interest and participation from foreign investors; which immediately suggests that the widening we're seeing now is a function of the pullout by foreign investors over the last year, and that we should see the yield curve flatten again once conditions stabilise. I prefer the latter explanation, but the other could equally be true.
Thursday, June 25, 2009
Exchange Rate Concepts IV: Forex Regimes
This post is long overdue, for which I won’t apologise. Regime choice is a murky and extremely complex area that has bedeviled policymakers, multilateral institutions and the man on the street for many years, and I wasn’t particularly eager to begin this post.
Part of the problem is that while there are only three main categories of regime – fixed, floating, and intermediate – there are a large number of variations that could with justice be called categories of their own. A second issue that makes this topic difficult to cover is the difference between de jure and de facto regimes: as much as half the currencies in the world follow exchange rate regimes at odds with what they officially report. The IMF thus tracks 13 (!) different regime categories, with currency categories defined not by their reported regime but rather by the actual behavior of their exchange rates:
The choice of regime is not a cut and dried matter – what works for one country may not work for another. Also, what works at one point in time might not be an appropriate regime down the road. Some of the influences include the size of the country involved, its openness to trade and the relative size of the tradable sector, the structure of its trade (few or many trade partners), colonial ties, capital account openness, depth and breadth of the domestic money market etc. etc. etc.
Generally speaking, the larger and more developed a country and the deeper its financial markets, the more desirable it is to have a floating exchange rate regime. Which suggests the opposite is true – the smaller and less-developed a country, the more likely a fixed regime is the better choice, especially if trade is dominated by one counter-party and the capital account is relatively closed. These are gross generalizations, and there’s plenty of literature available for those who want to dig deeper.
The main criterion of regime choice is fairly clear though, at least for those countries integrated into the international financial system – it’s a choice between control over domestic monetary conditions or external prices. An exchange rate regime biased towards being fixed implies less control over interest rates and the money supply, and by extension domestic inflation and growth. A fixed exchange rate regime means a country can be at the mercy of policy decisions in the reserve currency country, which may be at odds with local monetary conditions. Conversely, a regime biased toward floating implies less control over the external price of tradables, which is important for commodity producers or small open economies, as well as suffer greater volatility in the exchange rate.
A regime choice in the middle therefore sometimes seems attractive – allowing for some degree of control over domestic monetary conditions, while also exercising some control over external prices. In practice however a intermediate regime is the worst possible choice as it means a constant balancing act between policy objectives: you can’t have your cake and eat it too. Under most circumstances, a soft peg regime combined with capital account liberalization has typically led to a financial crisis in developing countries – just as happened in East Asia in 1997-98 and in Mexico before that, and even in the European Exchange Rate Mechanism (ERM: the precursor to Euro monetary union). How so? Two main reasons why – divergent macro-policies, and capital flows.
The almost-collapse in the ERM is an interesting case, more so since it involved advanced economies. The currencies in the ERM were on fixed parity with the Deutschmark, with a small trading band to account for fluctuations. This was fine when all the countries had similar macro conditions and inflation rates. Then something momentous occurred – the Berlin wall came down, and Germany emerged as one nation. The reconstruction and integration effort required a massive dose of fiscal spending, which in turn ignited inflation. In response the BundesBank hiked interest rates, which of course meant that the DEM appreciated, and dragged the rest of the currencies in the ERM with it.
But some of the other ERM countries were already in the midst of an economic slowdown (particularly the UK), and needed lower not higher interest rates. This inconsistency in monetary policies meant that forex traders everywhere sold ERM currencies and bought DMK (with the notable and unfortunate exception of BNM), putting even more pressure on the ERM parities. This was a sure-fire, one-way bet – if the ERM held, then traders gained on the interest differential. If it didn’t, then massive profits could be made in the devalued currencies, which in fact occurred when GBP, NOK, SEK eventually pulled out of the ERM.
The East Asian case is different, but with similar results. The proximate causes was a secular inflow of portfolio and direct investment, and less well-known, a sharp devaluation of the Renminbi. This had two effects: on the one hand, the inflow of capital expanded domestic money supply while keeping exchange rates elevated, and on the other trade competitiveness was lost. Central banks were unable to fully sterilise the incoming money*, and banks responded by going on a lending spree. The resulting investment boom fed on itself, triggering current account deficits and incipient inflation, which necessitated raising interest rates and boosting exchange rates further. This in turn of course attracted even more capital, which resulted in economies overheating.
*BNM basically gave up in late 1995, coincidentally the same month Anwar Ibrahim became Finance Minister.
This is the point where inconsistency between pegged exchange rates and macro-conditions created a financial crisis. Higher inflation and current account deficits suggested these currencies needed to depreciate. The fact that returns on investment were also getting poorer also helped foster a lower valuation of these currencies, at odds with prevailing exchange rates. Much as in the case of the ERM, speculators were faced with a one-way, no-lose bet with predictable results.
Based on these experiences, bipolar solutions appear to be the best choices – at the very least hard pegs for developing countries, or at least managed floats for higher income countries. But many countries continue to run intermediate regimes with some success, primarily I think because their capital accounts are much less open.
This is really not option available to Malaysia with our degree of exposure to global trade and our aspirations for creating an international centre for Islamic banking. The current regime choice is appropriate in my view, especially since the policy instrument of choice is now short-term interbank rates. The financial sector is far deeper now than it was pre-1997, with better developed capital markets and the capacity to absorb larger capital flows.
Evolution of MYR Exchange Rate Regimes
Technical Note:
The chart of IMF de facto exchange rate regime categories comes from ”The Evolution of Exchange Rate Regimes Since 1990: Evidence From De Facto Policies”, Bubula, Andrea & Ötker, Inci, International Monetary Fund Working Paper 02/155 (2002), pg14. An explanation of the regime categories can also be found in the same paper on pg 15. The latest classification of regime categories of IMF members can be found here.
The table on the evolution of Malaysia’s exchange rate regime comes from a variety of references. From 1990-2008, the sources are the IMF references quoted above.
Information for prior years comes from:
1. Umezaki, S., 2006. “Monetary and Exchange Rate Policy in Malaysia Before the Asian Crisis”, Discussion Paper No 79, Institute of Developing Economies (2006); and
2. “Wang dan Urusan Bank di Malaysia: Edisi Ulang Tahun ke-35 1959-1994”, Bank Negara Malaysia, (1994)
Part of the problem is that while there are only three main categories of regime – fixed, floating, and intermediate – there are a large number of variations that could with justice be called categories of their own. A second issue that makes this topic difficult to cover is the difference between de jure and de facto regimes: as much as half the currencies in the world follow exchange rate regimes at odds with what they officially report. The IMF thus tracks 13 (!) different regime categories, with currency categories defined not by their reported regime but rather by the actual behavior of their exchange rates:
The choice of regime is not a cut and dried matter – what works for one country may not work for another. Also, what works at one point in time might not be an appropriate regime down the road. Some of the influences include the size of the country involved, its openness to trade and the relative size of the tradable sector, the structure of its trade (few or many trade partners), colonial ties, capital account openness, depth and breadth of the domestic money market etc. etc. etc.
Generally speaking, the larger and more developed a country and the deeper its financial markets, the more desirable it is to have a floating exchange rate regime. Which suggests the opposite is true – the smaller and less-developed a country, the more likely a fixed regime is the better choice, especially if trade is dominated by one counter-party and the capital account is relatively closed. These are gross generalizations, and there’s plenty of literature available for those who want to dig deeper.
The main criterion of regime choice is fairly clear though, at least for those countries integrated into the international financial system – it’s a choice between control over domestic monetary conditions or external prices. An exchange rate regime biased towards being fixed implies less control over interest rates and the money supply, and by extension domestic inflation and growth. A fixed exchange rate regime means a country can be at the mercy of policy decisions in the reserve currency country, which may be at odds with local monetary conditions. Conversely, a regime biased toward floating implies less control over the external price of tradables, which is important for commodity producers or small open economies, as well as suffer greater volatility in the exchange rate.
A regime choice in the middle therefore sometimes seems attractive – allowing for some degree of control over domestic monetary conditions, while also exercising some control over external prices. In practice however a intermediate regime is the worst possible choice as it means a constant balancing act between policy objectives: you can’t have your cake and eat it too. Under most circumstances, a soft peg regime combined with capital account liberalization has typically led to a financial crisis in developing countries – just as happened in East Asia in 1997-98 and in Mexico before that, and even in the European Exchange Rate Mechanism (ERM: the precursor to Euro monetary union). How so? Two main reasons why – divergent macro-policies, and capital flows.
The almost-collapse in the ERM is an interesting case, more so since it involved advanced economies. The currencies in the ERM were on fixed parity with the Deutschmark, with a small trading band to account for fluctuations. This was fine when all the countries had similar macro conditions and inflation rates. Then something momentous occurred – the Berlin wall came down, and Germany emerged as one nation. The reconstruction and integration effort required a massive dose of fiscal spending, which in turn ignited inflation. In response the BundesBank hiked interest rates, which of course meant that the DEM appreciated, and dragged the rest of the currencies in the ERM with it.
But some of the other ERM countries were already in the midst of an economic slowdown (particularly the UK), and needed lower not higher interest rates. This inconsistency in monetary policies meant that forex traders everywhere sold ERM currencies and bought DMK (with the notable and unfortunate exception of BNM), putting even more pressure on the ERM parities. This was a sure-fire, one-way bet – if the ERM held, then traders gained on the interest differential. If it didn’t, then massive profits could be made in the devalued currencies, which in fact occurred when GBP, NOK, SEK eventually pulled out of the ERM.
The East Asian case is different, but with similar results. The proximate causes was a secular inflow of portfolio and direct investment, and less well-known, a sharp devaluation of the Renminbi. This had two effects: on the one hand, the inflow of capital expanded domestic money supply while keeping exchange rates elevated, and on the other trade competitiveness was lost. Central banks were unable to fully sterilise the incoming money*, and banks responded by going on a lending spree. The resulting investment boom fed on itself, triggering current account deficits and incipient inflation, which necessitated raising interest rates and boosting exchange rates further. This in turn of course attracted even more capital, which resulted in economies overheating.
*BNM basically gave up in late 1995, coincidentally the same month Anwar Ibrahim became Finance Minister.
This is the point where inconsistency between pegged exchange rates and macro-conditions created a financial crisis. Higher inflation and current account deficits suggested these currencies needed to depreciate. The fact that returns on investment were also getting poorer also helped foster a lower valuation of these currencies, at odds with prevailing exchange rates. Much as in the case of the ERM, speculators were faced with a one-way, no-lose bet with predictable results.
Based on these experiences, bipolar solutions appear to be the best choices – at the very least hard pegs for developing countries, or at least managed floats for higher income countries. But many countries continue to run intermediate regimes with some success, primarily I think because their capital accounts are much less open.
This is really not option available to Malaysia with our degree of exposure to global trade and our aspirations for creating an international centre for Islamic banking. The current regime choice is appropriate in my view, especially since the policy instrument of choice is now short-term interbank rates. The financial sector is far deeper now than it was pre-1997, with better developed capital markets and the capacity to absorb larger capital flows.
Evolution of MYR Exchange Rate Regimes
| Period | Regime category | Remarks |
| Independence to 1972 | Currency Board | Parity to GBP. Also 1967-1973 one-to-one convertibility with Singapore Dollar (SGD) and Brunei Dollar (BND). 1967 also saw the Ringgit Malaysia replace the Malayan Dollar |
| 1973-1975 | Crawling Peg | Parity shifted to USD, with an intervention band of 4.5% |
| 1975-1990 | Crawling Peg | Parity to a basket of currencies. Umezaki (2006) characterizes the 1975-1985 period as one of a de facto peg against the SGD, and against the USD thereafter |
| 1991-1997 | Managed Float | Intervention increased in 1995-1996, changing the classification slightly to a tightly managed float |
| 1998-2005 | Fixed Peg | Parity to the USD |
| 2005 onwards | Managed Float |
Technical Note:
The chart of IMF de facto exchange rate regime categories comes from ”The Evolution of Exchange Rate Regimes Since 1990: Evidence From De Facto Policies”, Bubula, Andrea & Ötker, Inci, International Monetary Fund Working Paper 02/155 (2002), pg14. An explanation of the regime categories can also be found in the same paper on pg 15. The latest classification of regime categories of IMF members can be found here.
The table on the evolution of Malaysia’s exchange rate regime comes from a variety of references. From 1990-2008, the sources are the IMF references quoted above.
Information for prior years comes from:
1. Umezaki, S., 2006. “Monetary and Exchange Rate Policy in Malaysia Before the Asian Crisis”, Discussion Paper No 79, Institute of Developing Economies (2006); and
2. “Wang dan Urusan Bank di Malaysia: Edisi Ulang Tahun ke-35 1959-1994”, Bank Negara Malaysia, (1994)
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