Monday, November 9, 2009

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.

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