The Study Of Singapore's Exchange Rate-centred Monetary Policy

The issue of growth for developing economies have been one of the most studied topics for development economists since the beginning of the Post-WWII reconstruction when more countries became politically and economically independent. During then, economic development in these nascent economies were greatly influenced by theories and hypothesis such as "Prebisch-Singer Hypothesis" (1950), Arthur Lewis' "dual economy" (1954), Robert Solow's "Theory of Growth", Walt Rostow's "Take-off Model" (1960), and Theodore Schultz's concept of "human capital" (1960s).Until the 1970s, many developed countries focused their strategies on accelerating the rate of capital accumulation and technological adoption, with government playing an active role in both the allocation of resources as well as the redistribution of benefits from growth.By 1980s, however, it was clear to economists that the costs associated with government intervention in the markets were considerably larger than the cost of market failures. The disenchantment over the social democratic model heralded a new era of free market and innovation, led in particular by the US and the UK. Along with developed countries, many developing countries implemented reform policies and emerged with more open and competitive economies, lower inflation, lower fiscal deficits, smaller governments, fewer restrictions on private sector activities, and more market-based financial sectors. The results of the 1990s, however, were far from universal. According to Easterly (2001), policies improved both in the 1980s and 1990s relative to other decades, but growth performance remained well below that of the 1960s and 1970s.Amidst the mounting debates as to what the'right' development strategy was for developing countries, a group of East Asian economies was singled out and dubbed the "East Asian Miracle" by the World Bank in 1993 for their ability to overcome crises and promote long-term sustainable growth. And Singapore, whose transformation from an entrepot trading centre to a first world economy was nothing less than extraordinarily, became one of the most earnestly studied examples in particular for other similarly small and open developing economies not endowed with rich natural resources.One specific area that has drawn admiration is Singapore government's effectual management of its monetary policy. Against this background, this dissertation sets out to shed lights on the roles of Singapore's exchange rate-centred monetary policy in promoting growth and overcoming crises.To begin with, the dissertation reviews the literatures on two critical concepts that guide the design and implementation of Singapore's monetary policy:(1) the Tinbergen-Theil Policy Framework and (2) Mundell-Fleming Theorem of Impossible Trinity. This is followed by a detailed explanation of why Singapore's central bank, the Monetary Authority of Singapore (MAS) adopted exchange rate, by the early 1980s, to replace the monetary stock and interest rates as the nominal anchor of Singapore's monetary policy as well as a description outlining the basket-band-crawl (BBC) features of the monetary policy。In Chapter 3, the dissertation explains the process of Singapore monetary policy's formulation and implementation as well as its transmission mechanism within the economy. This is followed by a detailed analysis of how the conduct of the monetary policy impacts on the money supply and interest rates and how these impacts are managed by the MAS.Next, in Chapter 4, the dissertation explores the role played by the monetary policy in promoting sustainable economic growth. This is done first by explaining the conceptual links behind exchange rate management and economic growth. In particular, it explains how the exchange rate-centred monetary policy helps to facilitate economic development by (1) suppressing imported inflation through the controlled appreciation of Singdollar, (2) providing a low interest rate environment conducive for business planning and investment, (3) keeping Singdollar marginally undervalued to maintain export competitiveness, (4) maintaining a mildly undervalued Singdollar to pre-empt speculative attack on the currency, (5) using a strong Singdollar as an impetus for economic upgrading and restructuring, and (6) using the carefully-managed Singdollar as an automatic counterbalancing tool during both recessionary and inflationary times. After which, the dissertation outlines the monetary policy measures adopted by the policymakers at different phases of Singapore's economic development since its independence in 1965 and the effects brought about by the implementation of such measures.Besides promoting economic growth, the exchange rate-centred monetary policy also plays an increasingly important role in helping to overcome financial and real economic crises. In particular, Chapter 5 looks into the countercyclical monetary, fiscal and administrative policy measures adopted by Singapore government in overcoming the Asian Financial Crisis and the Global Financial Crisis. From there, it attempts to identify a 4-phase 7-point overall strategy consistently adopted by the city-state in fighting crises:(1) using the exchange rate-centred monetary policy as the first line of defence to quickly ameliorate the initial adverse impacts of a crisis. (2) injecting liquidity promptly into the system to prevent a liquidity crunch, (3) sharing credit risks with financial intermediaries to prevent a credit crunch, (4) implementing budgetary and off budgetary rescues packages that are aimed primarily at minimizing job losses, as turmoil deepens, (5) adopting specific administrative measures or microeconomic policy measures to address imbalances in specific sectors, (6) withdrawing or watering-down short-term rescue measures that have outlived their usefulness when external environment stabilizes and the economy recovers, and (7) adopting new economic strategies to enable Singapore to exploit emerging opportunities in the new economic landscape re-shaped by the crisis.The 7-point strategy reflects Singapore internal constraints in overcoming economic and financial crises. Given the limited size of the domestic economy, there is little the government can do by adopting Keynesians measures of fiscal stimulations to build a sustainable internally-generated growth momentum. For Singapore's economy to recover, external demand must return and the monetary policy has no lever on that. That is why MAS does not resort to lowering of interest rate, as the Fed does, to stimulate the economy in times of a recession that is induced by an external shock. It also explains why Singapore's strategy in overcoming an exogenous crisis starts with quick containment using monetary policy to ameliorate the initial adverse impacts of the shocks, followed by fiscal and other administrative adjustments to bring in line any disequilibrium within the systems, and then wait for the recovery of the external environment before the economy can resume its growth path. Indeed, so far, in response to changes in market demand and supply, the government has preferred a less activist foreign exchange policy and opted for micro responses to allow the economy to adjust and deflate internally. MAS has repeatedly reiterated its stance of not using competitive devaluation as a means of increasing export for two reasons. Firstly, empirical studies have shown that Singapore's exports are far more income elastic and less price elastic than previously thought. As a result, there is limited role for short-term activist demand management using the foreign exchange-centred monetary policy. Secondly, there is a growing recognition that the internal price flexibility of the economy has structurally improved, driven by government-led supply-side reforms. More importantly, the trend of appreciating Singdollar is in effect a natural selection process that elimtnates firms that could not adapt to the strengthening currency. Limited resources could then be released from such firms and redeployed into other new areas of growth. In other words, the strengthening Singdollar provides an impetus that drives the process of structural upgrading of the Singapore economy. Only then can Singapore workers enjoy strong income growth and living standards.Finally, the study of Singapore's efforts in overcoming crisis ends with a section that looks into the impacts of the Global Financial Crisis on the future conduct of Singapore's monetary policy.Despite the indelible contributions of the exchange rate-centred monetary policy in helping to underpin macroeconomic stability and promote growth, criticisms have also been levelled against the monetary policy in recent years.First, some economists think that the monetary policy has a systemic bias to tightness which explains why Singapore's inflation rate has been persistently much lower than the average for countries of the OECD. The price of the low inflation is a decline in export competitiveness caused by the strong Singdollar.Second, the perceived inflexibility of the policymakers in keeping Singdollar within predefined band gives rise to the fear that the monetary policy framework may at times exaggerate, not smoothen, an internal disequilibrium. For example, as a result of both cyclical and structural factors, inflation can rise while nominal interest rates fall on the back of a rising balance of payment. Cyclically, the relatively higher real interest rates and an inflexible exchange rate often attract massive acceleration in inflows into Singdollar assets in anticipation of a steeper appreciation of the Singdollar. Structurally, there has also been a shift of global portfolio into the Singdollar as a reserve currency asset. All the capital inflows can add to the pressure for Singdollar to appreciate. In response, MAS has to buy up US dollar to hold the Singdollar within its arbitrary target zone. Given the policy trilemma limitation, the resultant increase in money supply will lead to a fall in interest rates. The easy monetary policy therefore will send a conflicting signal to the private sector just as inflation expectation is climbing.Another criticism often levelled against the exchange rate-centred monetary policy is the disproportionate impact the real exchange rate level might have on the local businesses. The local manufacturing companies are mostly SMEs that could afford limited capital investment and are therefore less able to exploit economies of scale from their operations. At the same time, their workers are also less well-trained than those in MNCs. As a result, local manufacturers suffer from lower productivity, higher cost and lower profit margin. Their lower value-add operations also mean that that they are less able to absorb the rise in costs due to stronger Singdollar. As for SMEs in the services sectors, they could be even harder hit by the appreciating Singdollar. This is because unlike manufacturing where the negative impact on domestic costs of a rise in the exchange rate can be partly offset by cheaper imported inputs, services have a much larger domestic cost content. This has resulted in falling profitability within the services sector over the years. This is particularly worrying since the services sector, which account for 60% of national employment, is crucial to Singapore as it eases into a more matured stage of economic development.Finally, the monetary policy has been criticised for its failure in addressing the issues of rising domestic inflation and asset prices as a result increasing demand of nontradable goods and services arising from a greater influx of foreign businesses and workers in recent years.In responses to the criticisms, the monetary policymakers put up a vehement defence of the monetary policy.To start with, econometric modelling of the equilibrium exchange rate indicates that the Singdollar is not out of line with the equilibrium rate.Second, weakening Singdollar may not necessarily enhance Singapore's export competitiveness. Recent studies have shown that the biggest factor influencing export is the GDP of Singapore's trading partners, not Singdollar exchange rate. Furthermore, the depreciation of Singdollar entails different impacts on different export products. The best option is therefore to let Singdollar maintain price stability and help to enhance Singapore's export competitiveness through other means.Third, the objectives of price stability and export competitiveness need not always be mutually exclusive. In times of low inflation, in particular during recessionary times, Singdollar can indeed be weakened to boost external demand and raise output. Conversely, in times of high inflation, Singdollar can oe strengtnenea to reauce imported inflation, lower external demand and hence cutting output to reduce inflationary pressures.Fourth, the strong capital inflows into Singapore have been driven more by the re-rating of Singapore's economic prospects than by Singdollar's appreciation.Fifth, empirical findings show that asset prices in Singapore are largely driven by income effects rather than price (or cost of funds) effects of a strengthening Singdollar.Next, switching from using exchange rate to using money stock or interest rates as the anchor for monetary policies is likely to create a host of new problems. Recent studies still show that the MAS's exchange-rate targeting policy appears to satisfy the criteria of maintaining medium term price stability better than the money stock or interest rates. Detailed studies must also be made as to whether an activist interest rate policy is the most appropriate tool to prevent excessive asset price inflation and on the collateral damages on all otner areas of economic activities. Even it an activist interest rate policy has been found feasible for Singapore, it would be very difficult to implement as the neutral level of interest rates has to be determined first. Also, the effectiveness of open market operations is severely limited by the small domestic secondary market for government securities. With a prominent position of foreign financial institutions in the domestic marKet, a large proportion of cnanges in the domestic quantity of money are attributable to flows in the external sector making M2 and M3 neither stable nor controllable.Finally, it was noted that other countries with entirely different monetary policy frameworks such as inflation targeting or interest rate-based reglmes were also suffering similar problems. Thus, it was argued that the root of the problem was not so much the monetary policy framework as other factors, such as the shortage of financial assets for investment in Asia, causing liquidity to be trapped in Asia and boosting the prices of the few assets available such as real estate and equities.Hence, based on the above analysis, this dissertation concludes that exchange rate remains the most effective anchor for the conduct of monetary policy, despite its various shortcomings. To mitigate these shortcomings, the dissertation ends by making several recommendations.First, it is not realistic to expect MAS's exchange rate-centred monetary policy to achieve the maintenance of both the internal and external equilibria of the economy. To address the dilemma and seek Pareto efficiency, MAS needs to work closely with other government agencies to come up with comprehensive and co-ordinated solutions to address any side-effects created by the monetary policy.Second, no currency can keep on appreciating without limits. In the post-crisis macro-environment, the persistently high inflation caused by excessive liquidity creates pressure for Singdollar to keep appreciating. The question is how much more rising room does Singdollar have before its adverse impact on Singapore's export competitiveness becomes unbearable. Hence, policymakers need to seek out other means to reduce imported inflation so that pressures on the Singdollar to rise can be alleviated. Possible measures include the building of agricultural parks in foreign land or high-rise hydroponics or aeroponics farms on local soil. At the same time, Singapore needs to develop an energy-efficient economy and explore the feasibility of harnessing nuclear energy. These measures will help to reduce Singapore's dependence on foreign food and energy supplies whose prices have rocketed in recent years and are expected to remain high at least in the medium term. This will in turn helps to alleviate pressure for Singdollar to appreciate in order to keep imported inflation in check.Third, the need for a strong Singdollar inevitably leads to a decline in export competitiveness. Singapore's economy must therefore seek to reduce its dependence on a cheap Singdollar for its export competitiveness. Instead, the economy needs to continue its incessant process of structural upgrading so that its products remain relevant and competitive in international markets. The problem, however, is that Singapore is facing an aging workforce that is becoming increasingly tedious to train. Hence, the government needs to speed up its controversial programme of foreign talent recruitment so that the upgrading process can be sped up. Only then can Singapore not fall into the trap of needing a depreciating currency to enhance export competitiveness.Next, given the increasing external volatility, MAS needs to enhance its ability to respond to fast changing external environment. The current system of varying the width of the band, re-positioning the band and changing the slope of the appreciation offers enough flexibility to the policymakers. However, economists have often argued that the practice of reviewing the monetary policy every 6 months should be replaced with quarterly reviews in view of the increasingly volatile macroeconomic environment. Doing so will not only allow enterprises and hence the economy to respond quicker to changing circumstances. It will also prevent over-cautious policy changes to result in overshooting of exchangement rate movements.Fifth, Singapore policymakers have sped up the development of the domestic bond markets after the Asian Financial Crisis to spread systemic risk that arose from the over-concentration on bank financing. Since then there have been regular bond issues by government agencies to set benchmark yields. Unfortunately, because of the small domestic market size, the bond markets lack both breadth and depth. To speed up the development of its bond market, reforms can be hastened so that the public can be allowed to invest in the bond market in smaller lots. Doing so will also not only provide, for small investors, another investment avenue that offers higher yield than bank interests but also create another channel that can divert excess funds away from the volatile and speculative equity and property markets and prevent the formation of asset bubbles. Sixth, even though the recent global financial crisis reveals the follies of US government's hands-free approach, Singapore needs to continue its reform and opening of its financial market. Doing so will allow domestic financial intermediaries to become more competitive as they evolve to become international players. Notwithstanding, MAS needs to enhance its regulatory capabilities especially relating to speculative financial derivative products, based on lessons learned from the recent global financial crisis. At the same time, with Singapore emerging as the premier wealth management centre, financial regulators need to remain vigilant with the possibility of city-state becoming a locus of speculative activities as foreign financial intermediaries exit from the Western markets and set up shops here. In particular, regulators need to look into the development of any new and complex financial derivative products that have no relevance to the working of the real economy. At the same time, MAS needs to monitor dealings between banking institutions to prevent hidden systemic risks. MAS also needs to enhance and enforce disclosure policies to improve transparency so that investors can make informed decisions and take responsibility for making their investments.Seventh, it is increasingly costly and risky for MAS to intervene in the currency market followed by sterilizing the intervention in the money market. MAS needs to seek other ways of reducing excess market liquidity. For example, the existing and new SWFs could be allowed to issue shares or debts to absorb excess liquidity. The funds can then be reinvested in emerging markets. In addition, given that Singapore cannot impose capital controls for inflow of funds, MAS can consider relaxing outflow controls that prevent the internationalization of Singdollar.Finally, the contagious effect of the Asian Financial Crisis demonstrates that Singapore's economy can be adversely affected by a regional crisis, despite the city-state's fundamental economic strength. To mitigate such risks, Singapore needs to step up its efforts in putting together bilateral and multilateral cooperative arrangements within regional economies so that regional funds, independent of IMF and World Bank, can be established to provide assistance to Asian countries in needs. Singapore can also exploit its position as a regional financial centre to channel excess funds within the region into infrastructural development of Asean countries. This will also help to enhance the economic competitiveness of the grouping as it gravitates towards the formation of the Asean Economic Community in 2015.