Analysis of Exchange Rate Movements: A Case Study of Singapore

Alisan Chia & John G Bauer

Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore 2263 Fax: +(65) 792.4217, Tel: +(65) 799.5676, Email: ajbauer@ntuvax.ntu.ac.sg

Abstract This study provides a holistic perspective of Singapores exchange rate determination by integrating theory, econometrics and institutional realities. We show how external conditions, economic fundamentals and MAS intervention have affected the Singapore dollar. Because the Singapore dollar is strongly managed, it is difficult to forecast exchange rate trends using an ARIMA model. Therefore, one has to turn to more judgmental methods to predict exchange rate trends.

1 INTRODUCTION Singapore is an open economy undergoing intense globalisation, hence an understanding of its exchange rate is important. This study attempts to give a holistic perspective of Singapores exchange rate determination by integrating theory, econometrics and institutional realities. It attempts to provide guidance as to what factors need to be considered when attempting to understand and forecast Singapores exchange rate trends. Most of the paper focuses on the nominal bilateral US$/Singapore$ exchange rate because this is the rate most relevant to businesses. The nominal US$/S$ exchange rate is critical since the US is Singapores major trading partner. Moreover, this rate is vital to the financial sector. Capital flows in and out of Singapore and transactions in the Asian-dollar market and Asian-bond market typically involve US dollars. The period under study is from 1975 to 1994, and the data for the figures presented and for the econometrics performed are from the International Financial Statistics (IFS). Quarterly data series are used wherever possible, but we face data constraints as some of the series are only available annually. There is a wealth of literature touching on the different aspects of exchange rate determination, and this literature is addressed when relevant in the body of the paper. We briefly mention here, however, the few sources which are particularly useful. Duc-Tho Nguyen and Yao Chye Chiang (1989) demonstrate that a synthesised monetary and portfolio balance model is most suited for Singapore. Hence, we examine the impacts of the variables which are pertinent to these models. Also, Abeysinghe and Lee Kok Hong (1992) found that purchasing power parity (PPP) holds for the Singapore to US dollar exchange rate, so an extensive discussion of PPP is also included in the study. PPP is calculated using the long run averaging method based on a paper by Kenichi Ohno (1990). Our discussion of factors that are difficult to model is culled from various Monetary Authority of Singapore (MAS) Annual Reports as well as the volume Public Policies in Singapore edited by Linda Low and Toh Mun Heng (1992). Finally, our regression analysis is modeled after Pilbeam (1992).

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The paper begins with a short summary of the evolution of Singapores exchange rate regimes. This is followed by a summary of Singapores exchange rate movements during the past two decades. Attempts are then made to explain these movements. Explanations are made by considering time honoured exchange rate theories such as purchasing power parity. The role of the Monetary Authority of Singapore in influencing exchange rate movements is also considered. Next the paper looks at the impact external economic conditions have on the exchange rate. Economic fundamentals are also included as part of the explanation of Singapores exchange rate trends. Finally we attempt to forecast the nominal US$/S$ exchange rate with an ARIMA model. 2 BACKGROUND: EVOLUTION OF SINGAPORES EXCHANGE RATE REGIME 1 The fixed exchange rate regime which Singapore chose to adopt after gaining independence from the British in 1965 was based on previous ties with Britain. Under this system the Singapore dollar was pegged to the pound sterling, and this parity to the pound was maintained through strict exchange controls. Capital flows out of the Sterling Area Countries/ Scheduled Territories (of which Singapore was a member country) were heavily regulated. Parity was maintained until the devaluation of the pound in November 1967. This devaluation prompted the governments decision to peg the Singapore dollar to the US dollar and gold. In June 1972, following the floating of the pound, the Monetary Authority of Singapore (MAS) replaced the pound with the US dollar as Singapores intervention currency (Lim & Associates (1988)). The year 1973 marked a turning point in the history of Singapores exchange rate regime. In February 1973, there was a heavy inflow of US dollars into Singapore. Under the fixed exchange rate regime, Singapore had to mop up this excess of US dollars at the floor rate. This was equivalent to a devaluation of the Singapore dollara devaluation which left the country vulnerable to inflation. As a result of this, in June of 1973, MAS made the decision to replace Singapores fixed exchange rate regime with a managed float (Lim & Associates (1988)). From June 1973 to September 1975, the Singapore dollar was devalued by approximately 5.6% against the US dollar. But from September 1975 onwards, the Singapore dollar has been managed by relating it to an undisclosed basket of trade-weighted currencies (with the weights varying from time to time). MAS keeps the exchange rate within a set target band by intervening in the foreign exchange market. These interventions are usually conducted with US dollars. In June 1978, Singapores exchange controls were completely liberalised. This move was sparked off by the devaluation of the pound and Singapores exclusion from the Sterling Area Countries.

Lim Chong Yah and Associates (1988), Chapter 11.

Analysis of Exchange Rate Movements: A Case Study of Singapore 3 BRIEF DESCRIPTION OF EXCHANGE RATE TRENDS: NOMINAL US$/S$, REER, NEER, REAL US$/S$

3.1 NOMINAL BILATERAL RATE (US$/S$): FIGURE 1 This study focuses on the Singapore-US bilateral exchange rate because the United States is a major trading partner of Singapore. Moreover the US$/S$ rate is critical to the financial sector, since capital flows in and out of Singapore and transactions in the Asiandollar market and Asian-bond markets typically involve US dollars. MAS intervention in the foreign exchange market is also carried out with US dollars.
3.1.1 Trends in Exchange Rate

The US$/S$ exchange rate was stable from the beginning of 1975 through mid-1975 (Figure 1).2 This was followed by a depreciation in the middle of 1975. After which there was relative stability until 1977. An appreciation of approximately 10% was recorded between September 1977 to the January of 1979. The period from 1979 to 1986 was characterised by slight fluctuations within the band of 0.45 to 0.48. Appreciation began again in earnest from January 1987, and this rise of the Singapore dollar has continued to the present.
3.1.2 Points of Interest

An analysis of the US$/S$ exchange rate should, therefore, explain three things. First, is the appreciation of the Singapore dollar during 1977 and 1978. Second, is the strong and steady appreciation since 1987, and third are the fluctuations (within the band of 0.45 0.48) of the exchange rate from 1979 to 1986. These fluctuations are of particular interest because the US dollar was appreciating during the early 80s, yet the US$/S$ rate was held within these rather narrow bands. 3.2 REAL EFFECTIVE EXCHANGE RATE (REER) The REER is important because it defines Singapores overall competitiveness as affected by changes in Singapores exchange rates with major trading partners as well as relative price movements. It is therefore unfortunate that data on the REER is not readily available. Calculation of the REER is not possible given data constraints. Teh Kok Peng and Tharman Shanmugaratnam (1992) provide a brief summary of REER estimates. These estimates were obtained by deflating the nominal effective exchange rate (NEER) using unit labour costs, rather than price levels. Their summary suggests that the broad trends in the REER are similar to those of the NEER, except that the degrees of appreciation/ depreciation of the REER are more pronounced. 3.3 NOMINAL EFFECTIVE EXCHANGE RATE (NEER): FIGURE 2 Because data on the REER are not available, we examine trends in the NEER in order to gauge trends in Singapores competitiveness. The NEER is not as good an indicator as the REER of course, because it does not take relative price changes into account. However, as noted above, movements in the REER appear to follow movements in the NEER for Singapore. In Singapores context, the basket of currencies to which the dollar is related is not disclosed. The NEER that is used to produce Figure 2 is taken from International Financial
2

Data for this and all subsequent charts was taken from the International Financial Statistics (IFS).

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Statistics (IFS) estimates, rather than the official MAS rate. Figure 2 plots movements in the NEER and the bilateral US$/S$ rate.
3.3.1 Trends in the Exchange Rate

The NEER began appreciating in the first quarter of 1981 and peaked around the first quarter of 1985. This was followed by a depreciation that lasted till the end of 1987. Since the first quarter of 1987 the appreciation of the NEER has been tracked by an appreciation of the nominal bilateral rate (US$/S$). This indicates the importance of the Singapore-US bilateral exchange rate.
3.3.2 Points of Interest

As noted above, we would expect the NEER and the US$/S$ rate to move together because of the heavy weight that must be allocated to the US in the basket of currencies on which the NEER is based. The divergence between the two rates during the early 1980s, therefore, is of interest. The reason for the divergence must be that the Singapore dollar was appreciating by more, relative to the other currencies in the basket than to the US dollar. The Singapore dollar did appreciate against the yen during this period. In 1981, for example, it appreciated by 11% against the yen, whereas it appreciated only 2% against the US dollar. The fact that the NEER appreciated strongly during the early 1980s, while the US$/S$ rate remained more stable suggests that the MAS was maintaining some kind of parity with the US dollar. In any case, the NEER and the US$/S$ rates converged during 1985-86, and have tended to move together since 1987. Since 1991, the bilateral rate has appreciated more rapidly than the NEER. Once again, the explanation for the disparity must be that some other currency in the NEER has tempered the appreciation in the US dollar. The yen was depreciating against the Singapore dollar from 1992-93. This might have slowed down the appreciation of the NEER. 3.4 REAL BILATERAL EXCHANGE RATE (US$/S$): FIGURE 3 Because data on the REER are not available we estimate the real bilateral US$/S$ rate and use it as an indicator of Singapores competitiveness. This may be problematic during periods when the NEER and the US$/S$ rates diverged (in the early 1980s), however this divergence was temporary. In any case, the real US$/S$ rate is of obvious importance given that the US is Singapores major trading partner and investor.
3.4.1 Calculation of the Real Bilateral Exchange Rate

The real exchange rate was calculated based on the following equation: (US$/S$)real = (US$/S$)nominal * [PriceSpore / PriceUS] (1) The wholesale price indices (WPI) for the two countries were used, rather than the CPIs, since the WPIs are more pertinent to trade competitiveness.
3.4.2 Trends in the Exchange Rate (Figure 3)

From 1975 to the first quarter of 1981 the nominal and the real bilateral exchange rates tracked each other relatively well. In the period beginning the first quarter of 1981 to the second quarter of 1986, the nominal exchange rate was fairly stable while the real bilateral

Analysis of Exchange Rate Movements: A Case Study of Singapore

rate fell sharply. Despite the strong appreciation in the nominal rate since the first quarter of 1987, the real bilateral rate has remained fairly stable.
3.4.3 Points of Interest

Deviations of the nominal exchange rate from the real exchange rate can be explained by movements in relative prices. For instance, the depreciation of the real rate from 1981 Q1 to 1986 Q2 was a result of rising prices in the US. The deviations in the real and the nominal bilateral rates suggest that the nominal bilateral rates do not always determine competitiveness. Although the nominal rate was relatively stable from 1981 Q1 to 1986 Q2, for example, the real exchange rate fell, resulting in an increase in Singapores competitiveness. Also because the real exchange rate has been stable since 1987, the appreciation of the nominal exchange rate has not eroded Singapores competitiveness. 4 THE MONETARY AUTHORITY OF SINGAPORE (MAS)

4.1 BACKGROUND The Authority was established in January 1971 and serves as Singapores central bank. One of its primary objectives is to maintain a reasonably stable exchange rate for noninflationary economic growth. Prior to 1981, MAS targeted money supply and interest rates to keep inflation at bay. In 1981, however, exchange rate policy replaced monetary policy as the Authoritys main anti-inflationary tool (MAS Annual Report, 1981/1982). Given the Authoritys objective, MAS intervenes in the foreign exchange market whenever there is a threat that Singapores exchange rate may move out of an undisclosed target band. The setting of the target band is subject to policy considerations and not market forces. Market forces do, however, play an indirect role in the setting of the band. If the band were set too high, for instance, then Singapores exports and investments from abroad would suffer. Market forces are allowed to prevail within the target band (MAS Annual Report 1984/1985). In order to understand movements in the Singapore dollar, one must understand the objectives and actions of the MAS; the following sections provide some relevant background. 4.2 COSTS OF INFLATION The MAS is very much concerned with guarding against inflation, this concern arises for several reasons. First of all, inflation is socially divisive because it results in an arbitrary redistribution of income and wealth. Debtors gain as they pay back less in real terms, and creditors lose out as a result. Individuals drawing a fixed income (e.g.; pensioners) suffer as the purchasing power of the dollar falls. Low income earners who do not make enough to invest in assets to hedge against inflation also suffer (Teh and Shanmugaratnam (1992)). Secondly, inflation distorts prices. This leads to economic inefficiency because prices are an integral part of market signaling. Inflation could also lead to more frequent renegotiation of wages, as workers fight to keep their real wages from falling. Inflation also makes investment decisions more difficult. Inflation, especially high rates of inflation, generates a high level of uncertainty in terms of costs and prices. A wage-price spiral might be sparked off by high rates of inflation as workers bid up wages in anticipation of future price rises.

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Thirdly, interest rates will be bid up to compensate for expected inflation. Higher interest rates represent higher investment costs. Also because of the uncertainty of the dollars value investors will opt for short term instead of long term investments. This may lead to lesser income-generating investment and greater investments that yield gains in an inflationary environment (e.g.; property and real estate). Finally, persistent inflation leads to an overvalued exchange rate (MAS Annual Report, 1991/1992, p. 18). The real exchange rate is determined by the nominal exchange rate and relative prices. Hence, inflation leads to an appreciation in the real exchange rate and this dampens export growth. The currency would then have to be devalued, and this would induce capital outflows and cause a slow down in foreign direct investments. Inflation generally results in a loss of confidence in the economy. 4.3 EXCHANGE RATE POLICY AS AN ANTI-INFLATIONARY TOOL The MAS replaced monetary policy with exchange rate policy as the main anti-inflationary tool (Teh and Shanmugaratnam (1992)). Singapore has virtually no control over capital flows, because in addition to not having exchange controls, it also has a liberal policy towards foreign direct investment. Moreover, capital movements are very sensitive to interest differentials, especially to that of the United States. This makes it difficult for MAS to target the interest rate. Interest rates are largely determined by foreign interest rates and expectations of the future appreciation of the Singapore dollar. If the Authority attempts to raise or lower interest rates while world interest rates remain unchanged, then capital flows will return interest rates to their original level. High capital mobility suggests that the MAS can seek to influence either the exchange rate or interest rates, but not both. It is also difficult for MAS to target money supply. This is because changes in money supply are determined mainly by the net flow of funds from accounts from abroad (Teh and Shanmugaratnam (1992)). Also, because of Singapores openness, money supply and interest rates do not affect price stability as directly as does the exchange rate. In many developed countries interest rates play an important role in determining the level of investment but in Singapore, because of the large external sector, the cost of domestic borrowing is less important. For all these reasons, MAS turned to exchange-rate targeting as an anti-inflationary tool. Singapore is a price taker in the international market. It is unable to influence prices because of its small size. This and the countrys heavy reliance on trade makes the economy vulnerable to imported inflation. The high import content in Singapores manufactured goods makes it especially susceptible to cost-push inflation. Estimates show that for every 1 percent increase in import prices, Singapores consumer price index (CPI) goes up by 0.5 percent (Teh and Shanmugaratnam (1992)). The effect of rising import prices, however, can be offset by allowing the Singapore dollar to strengthen. The exchange rate also has an impact on internally generated inflation. Because a large proportion of demand in Singapore is made up of imports, the exchange rate has a considerable impact on domestic demand (at least in the short term). By influencing demand, the exchange rate also influences the demand for resources; in particular the demand for labour. A weak exchange rate could lead to an overheated economy, and a tight labour market, bidding up wages and other costs of production.

Analysis of Exchange Rate Movements: A Case Study of Singapore

4.4 THE EXCHANGE RATE & EXPORT COMPETITIVENESS It would seem that a strong Singapore dollar, while being an anti-inflationary tool might hurt exports. An appreciation of the exchange rate to offset imported inflation might result in a loss of competitiveness as Singapores exports become relatively more expensive. The MAS argues, however, that this would only be true in the short run, and that the exchange rate is not a good tool for maintaining export competitiveness (MAS Annual Report, 1991/1992, p. 3). Consider a depreciation of the Singapore dollar. In the short run Singapores exports become cheaper since relative unit labour costs are cheaper. However, Singapores exports have a high import content, and the cost of imported inputs rise as the exchange rate depreciates. Also over the middle term, wages increase as consumer prices increase and the labour market tightens because of the exchange rate depreciation. Therefore, there is less reason to consider export competitiveness when formulating medium to long term exchange rate policies. It should also be remembered that other factors besides price of exports (as determined by the exchange rate) determine export competitiveness. These factors include, for example, after sales service and good product quality. 4.5 WORKINGS OF EXCHANGE RATE POLICY The Singapore dollar is managed by relating it to an undisclosed trade-weighted basket of exchange rates. It is important to note that, strictly speaking, the Singapore-US bilateral exchange rate alone does not determine the rate of imported inflation. However since the US is such an important trading partner with Singapore it is safe to say that it must have a high weighting in determining the countrys nominal effective exchange rate (NEER). Officially, MAS does not maintain a parity either against the US dollar or a basket of currencies. Instead the NEER is allowed to float within an undisclosed target band. CPF funds and government surpluses are deposited with MAS. This reduces liquidity in the banking system, and there is constant pressure on the Singapore dollar to appreciate. MAS neutralises this pressure by restoring the liquidity in the banking system by buying US dollars through the creation of reserves. The extent of intervention depends on the target band and the prevailing exchange rate, and the target band is based on projected and prevailing rates of external and domestic inflation. A major objective, is to keep CPI inflation low and stable. 4.6 EXCHANGE RATE POLICY IN ACTION It is useful to observe how MAS has reacted under different conditions. Since the Authority began using exchange rate policy as an anti-inflationary tool in 1981, we focus on its reactions during the 1980s and 90s
4.6.1 1981 - 1985: Second Oil Shock and the 1985 Recession

The shift in the focus of monetary policy from money supply and interest rate targeting to exchange rate targeting took place in the inflationary environment of 1981. The second oil shock in 1979 led to the world inflation rate being over 8 percent in 1981-1982. A strong exchange rate was adopted to relieve inflationary pressures and to further the government policy of upgrading and restructuring the economy (MAS Annual Report, 1981/1982). Rapid increases in nominal wages contributed to domestic inflation. During 1979 - 1981 the government initiated a high wage policy to encourage industries to move to more

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capital and skill- intensive activities. The policy resulted in productivity growth but this growth did not completely offset wage increases, and unit labour costs (ULC) rose. The appreciation of the NEER in 1981 did not prevent the inflation rate from rising. It did, however, curb import inflation, and the inflation rate in 1981 - 1982 was lower in Singapore than in OECD countries. As world inflation came down and the NEER continued to appreciate, Singapore experienced negative import inflation in 1982. Wages, however, continued to increase after 1981 because of the increase in CPF contribution rates and a tighter labour market. Unit labour costs increased. Inflation in the early 80s, after 1981, was the result of domestic factors. If the exchange rate had not appreciated, inflation would have been much worse since import inflation would have contributed to the inflation in Singapore (MAS Annual Report, 1990/1991). Because ULCs increased more rapidly than those of competitors and as a result of the appreciating NEER, the real effective exchange rate (REER) also appreciated. Singapores competitiveness declined and contributed to the recession in 1985. A fall in external and domestic demand were other contributing factors.
4.6.2 1985 - 1988: Era of Deflation

Domestic inflationary pressures were relieved by the effects of economic recession and a series of costs and tax cuts. In 1986 there was a 15 percent reduction in the CPF contribution rate. Wage restraint was practised and ULCs declined. Meanwhile, world oil and commodity prices began to fall from late 1985 onwards bringing down world inflation. Hence during 1985 -1987, MAS could allow the exchange rate to ease without worrying about inflation. The fall in ULCs and the NEER laid the ground for economic recovery in 1986 (Teh and Shanmugaratnam (1992)).
4.6.3 1988 - 1991: An Overheated Economy

In mid-1988 the NEER began to appreciate again, reflecting worries of both internal and external inflationary pressures. Faced with a strong external demand, Singapores economy began to overheat. In 1989 unemployment fell below 2.5 percent, well below what is normally regarded as full-employment. The labour market tightened and wage growth grew to a rate that was above productivity growth. By the end of the decade, ULCs were increasing by 6 percent per annum. This resulted in domestic inflationary pressures. During the late 1980s foreign inflationary pressures had also increased. However, the appreciation of the exchange rate since 1988 offset this. Exchange rate policy was so effective that by 1991 import prices had a dampening effect on CPI inflation. The stronger exchange rate also cooled the tight labour market. Simulations that have been performed using the MAS econometric model suggest that if the exchange rate had not appreciated since 1988, inflation would have averaged 6 percent per annum from 1989 to 1991, instead of the actual rate of 3 percent (Teh and Shanmugaratnam (1992)). It is also claimed that any competitive enhancement brought about by a weaker exchange rate would have been temporary, being eroded by eventual inflation in the long term. The MAS stance is that a loss of competitiveness in the face of an overheated labour market cannot be relieved by weakening the exchange rate, since an appreciation of the REER would be inevitable. The alternative to an appreciation of the nominal exchange rate would be an increase in ULCs.

Analysis of Exchange Rate Movements: A Case Study of Singapore

4.6.4 1990s: Slow Down in Labor Force Growth

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As Singapores labour force growth slows, the economys potential economic growth will probably fall to 5 percent - 6 percent over the 90s. Supply-side growth will become more limited and the economy will become more vulnerable to demand induced overheating and inflationary pressures (MAS Annual Report 1991/1992, p. 14). There is therefore a need to moderate growth in GDP such that it does not exceed its sustainable level. By doing so inflationary pressures will be relieved thereby ensuring a more sustainable growth. Therefore a strong exchange rate policy could be followed to ensure moderate GDP growth and keep inflation at bay. If price stability were traded off for the purpose of sustaining short-term economic growth above the economys potential, growth itself will ultimately be lowered (Teh and Shanmugaratnam, 1992, p. 301). 5 PURCHASING POWER PARITY This section looks at the purchasing power parity between Singapore and the United States. PPP is an important model of exchange rate determination and it is often used to predict long run movements in exchange rates. We focus on the Singapore - US dollar PPP because of the importance of this bilateral rate. Also it has been verified by Abeysinghe and Lee (1992) that PPP between the Singapore and US dollars does hold. 5.1 THEORY PPP theory is based on the law of one price; i.e.; arbitrage forces will lead to the equalisation of goods prices internationally once the prices of goods are measured in the same currency (Pilbeam, 1992, p. 142). Assumptions made under the theory are: (1) perfect competition and (2) no transaction costs (e.g.; transportation costs, barriers to trade and imperfect information). There are two basic forms of PPP: absolute PPP (strong form) and relative PPP (weak form). Absolute PPP states that the prices of a similar good A in two countries are equal when denoted in the same currency. Absolute PPP can be expressed algebraically as, S = P / P* (2) where S is the exchange rate (domestic currency units per unit of foreign currency); P is the price of a bundle of goods denoted in the domestic currency and P* is the price of a bundle of goods denoted in the foreign currency. The strong form is not likely to hold since the assumptions made are unlikely to hold. Relative PPP states that the exchange rate adjusts according to the difference in the inflation rates of the 2 countries. Relative PPP can be expressed algebraically as, %S = %P - %P* (3) where %S is the percentage change in the exchange rate; %P is the domestic inflation rate and %P* is the foreign inflation rate. A weakness of relative PPP is that it does not take into consideration the difference between tradables and non-tradables. Inflation rates do not distinguish between the two. But PPP is more applicable to tradable goods since they are open to international competition.

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5.2 MEASUREMENT PROBLEMS IN PPP There are several problems associated with estimating PPP exchange rates. These issues are discussed below.
5.2.1 Distinction Between Tradable and Non-Tradable

The distinction between tradable an non-tradable goods is blurred because of the linkages between the two prices. Imported inputs are sometimes used in the production of nontradable goods and non-traded goods are sometimes used in the production of tradables. Therefore PPP may be applicable, to some extent, to both tradable and non-tradable goods and there may be cause to use a more general price level (Pilbeam (1992)). The wholesale price index (WPI) is generally used when PPP is expected to hold for tradables. The consumer price index (CPI) is used when it is expected to hold for both tradable and non-tradable goods. In our calculations of the PPP, WPI was used since we believe that PPP should assert itself more strongly for tradables.
5.2.2 Time Required for PPP to Assert Itself

There is disagreement over the period when PPP can be expected to prevail. Strong versions of PPP suggest that PPP might hold on a monthly basis whilst progressively weaker versions would suggest a longer period of time. Because of Singapores openness and relative price flexibility we chose to calculate PPP on a quarterly basis.
5.2.3 The Base Year Problem

This is perhaps the most pressing problem faced by those who wish to calculate PPP. It would be ideal if we had the absolute Singapore dollar and US dollar prices (Pa and Pa* respectively) for an identical basket of goods, since PPP is expected to hold only for identical baskets of goods (Ohno (1990)). Then the absolute PPP exchange rate would be: SPPP = Pa / Pa* Such uniformity is, however, not found in the real world. Ohno (1990) discusses the problem as follows. Consider the relative PPP: SPPP P / P* (4)

(5)

where SPPP is the relative PPP exchange rate (domestic currency units per unit of foreign currency) and is an unknown scale factor that links the relative prices P and P*. P and P* are domestic and foreign prices of baskets of goods that are similar in content but of different sizes (i.e., the base year of the two prices could be different). Note that this is only an approximation because the two baskets need not have the same weights. The base year problem is essentially to find the right value for . The problem is illustrated below. 5.3 CALCULATION OF PPP There are different methods that are used to solve the base year problem (and hence calculate PPP). We present two methods: (1) the Cassel-Keynes Method and (2) Long-Run Averaging.
5.3.1 Cassel-Keynes Method

This method begins by choosing a base year when the exchange rate can be assumed to be at PPP. Then later movements in the relative prices are used to update the base periods

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exchange rate in order to obtain the new estimate of PPP. There are however several base years that may be chosen. We chose 1975 as our base year since Singapores current account deficit in that year roughly in balance. Note, however that the resulting PPP estimates are sensitive to the choice of the base year.
5.3.1.1 Calculation

We estimated PPP rates, using the following equation: EPPP = E0[(Pt* / P0*) / (Pt / P0)] (6) where E0 is the actual and PPP exchange rate (foreign currency units per unit of domestic currency) at time = 0 (1975). P denotes prices (in this context WPI), * denotes foreign variables (US) and the subscript following P denotes time period. Note that in this formula, = E0 (P0 / P0*). The WPIs for Singapore and US were indexed at 1990. An index with 1975 as the base year was achieved by dividing WPIt with WPI1975 for the US and Singapore price indices.
5.3.1.2 Trend and Analysis

Our estimates in Figure 4 suggest that the nominal exchange rate was over-valued from 1979 to 1981, and that it has been undervalued since 1983. But the degree of undervaluation has been fairly stable. This implies that whereas there may be pressure on the Singapore dollar to appreciate because of the undervaluation, this pressure has not been increasing. The appreciation of the Singapore dollar since 1986 is roughly in line with PPP.
5.3.2 Long-Run Averaging

Another way to solve the base year problem is to take the long run average of past relative prices instead of a single base year as in the Cassel-Keynes Method. The assumption is that there is an equal chance of the exchange rate being over or undervalued in the long run. Although there may be times when the exchange rate is under or overvalued for a long period of time, it is doubtful if this could continue for long. This is because the exchange rate would be under pressure to appreciate or depreciate accordingly. Hence we may assume that over the long run exchange rates are aligned with PPP. Ohno (1990) suggests that the long run average PPP could be calculated as far back as 1975 (when general floating began). 1973-1974 should be left out since they were transitional periods. Note that there may be a problem in using the long run averaging method since different countries use different ways to adjust for quality changes, etc. This would result in a permanent measurement bias.
5.3.2.1 Calculation

The calculation of the long-run average PPP is similar to the calculation for the CasselKeynes Method. The same equation is used with the exception that instead of using the exchange rate and prices prevailing in the base year, their average values are used. The long-run average PPP was calculated from 1975 to 1994.
5.3.2.2 Trend and Analysis

Our estimates presented in Figure 5 suggest that the Singapore dollar was overvalued from 1975 to the mid-80s, especially in 1979-1981. The currency has been undervalued since

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1985. The degree of undervaluation varies. Whereas there has not been a general trend towards convergence, it would seem that the undervaluation in recent years is not as large as it used to be. Also, the nominal and PPP rates have moved together since the mid-80s, suggesting that relative price changes have played an important role in the Singapore dollars appreciation. 6 EXCHANGE RATES AND THE EXTERNAL SECTOR This section examines trends in the current account, exports, capital account, balance of payments and foreign exchange reserves and their relationships with the various exchange rates. The focus is on the period from the early 1980s onwards, since this is when MAS began exchange rate targeting. 6.1 SUMMARY OF EXCHANGE RATE TRENDS It may be useful to summarise trends in the bilateral and effective exchange rates before examining the external sector. Table 1 provides this summary. 6.2 CURRENT ACCOUNT: FIGURE 6 Broadly speaking, the current account is made up of the trade balance, the service balance and net transfer payments. But because net transfer payments are a relatively small component, they do not have much of an impact on the general movements in the current account. We would expect the current account to respond to movements in the REER, since the REER is an indicator of a countrys overall competitiveness. The current account should worsen as the REER appreciates and improve as it depreciates. From the summary of exchange rate trends given above, we see that during the 1981-1993 period, the REER experienced a series of appreciations and depreciations. However, the current account in general improved through out this period. This runs contrary to our expectations, and the remainder of this section attempts to explain why the current account continued to improve even during periods of REER appreciation.
6.2.1 Appreciation in 1981Q1-1985Q1 6.2.1.1 Improvement in Net Service Earnings

An improvement in net service earnings can explain part of the rise in the current account despite the REER appreciation. In 1981, net earnings from services financed 73 percent of the trade deficit compared with 64 percent in 1980 and 53 percent in 1972. These earnings were from: provision of transportation, technical and financial services; oil processing and other professional services. In 1982 net earnings from services expanded by a further 20 percent (MAS Annual Report, 1982/1983). It can be argued that competitiveness in services is less based on low prices than is export competitiveness. The level of expertise and service is more important. Besides there are certain services, such as financial services, in which Singapore may have comparative advantage. Therefore, the improvement in the current account despite the REER, appreciation could be partially explained by the rising importance of the service sector.
6.2.1.2 Importance of the United States

The importance of the US as a major importer of Singapores exports could also help to explain the improvement in the current account. While the REER was appreciating during

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1981-85, the Singapore-US bilateral exchange rate was depreciating. Moreover, income growth in the US was strong, as was US demand for imports. Consider the situation in 1983. Whereas earnings from services fell by 12 percent, Singapores current account improved because of rising exports and falling imports. This might seem inconsistent with the rising REER. Note, however, that the recovery in exports was uneven. Exports to the US grew by 50 percent, while exports to Japan, Hong Kong, West Asia and Australia declined. The rise in exports to the US was encouraged by both the depreciating real bilateral exchange rate and the strong economic growth in the US.
6.2.2 Appreciation from 1987 6.2.2.1 Improvement in Net Service Earnings

As before, net service earnings help to explain the improvement in the current account despite the appreciation of the REER. The service balance began to recover in 1987, following a decline during 1983-1986. In 1987, travel receipts alone rose by 21 percent. In fact the surplus in the current account in 1987 can be attributed to the improvement in the service balance. The service balance also accounted for the improvement of the current account in 1989. And in 1990 the widening of the merchandise deficit was cushioned by a burgeoning of net service receipts to $14.2 billion (MAS Annual Report, 1990/1991, p. 27). So once again, the dramatic increase in the current account, despite the rise in REER and nominal bilateral rate, can to a large extent be explained by the growing importance of the service sector.
6.2.2.2 Reduction in the Import Content of the Export Sector

In the last decade there has also been an increase in the domestic value-added per unit of exports. This has reduced the import content of the export sector and helped to improve the trade balance. In addition, non-oil domestic export growth has been more powerful than oil or entreport exports, which have relatively low domestic value-added margins.
6.2.2.3 Exports

We expect a worsening of the current account when the REER appreciates largely because of the resulting fall in exports. This section has attempted to explain why the current account has improved, despite the REER appreciation by discussing service earnings. However, there have been periods when a rise in exports helped to improve the current account. Therefore, the next section examines the relationship between exports and exchange rates more closely. 6.3 EXPORTS: FIGURE 7 We would expect total exports to increase when there is a depreciation in the REER and vice versa. Moreover, we would expect exports to the US to be affected by the real Singapore-US bilateral rate. To some extent this is what we see in Figure 7.
6.3.1 Appreciation in 1981Q1-1985Q1

Exports remained relatively stable despite the appreciation of the REER. In 1981, export growth moderated to 7 percent from a high of 34 percent in 1980. The moderation of export growth continued into 1982. But non-oil exports and domestic exports rebounded growing by 14 percent and 20 percent respectively in 1983. The depreciating real bilateral US$/S$ exchange rate should have also encouraged exports to the US.

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In 1985, when the REER peaked, total exports fell by 2 percent. The situation might not have been as bad if electronics exports to the US had held up. However, although the Singapore-US bilateral rate was still depreciating, electronic exports to the US could not be sustained because of the global overproduction of electronic components (MAS Annual Report, 1985/1986).
6.3.2 Appreciation from 1987

The REER and nominal US$/S$ rates have appreciated since 1987, though the real bilateral US$/S$ rate has remained fairly stable. Exports, however, have grown strongly since the late 1980s. Hence, we conclude that the rise in exports must have been for reasons other than exchange rate movements. One major reason seems to be the rapidly growing demand from the Asia-Pacific region since the mid-1980s. The share of Asia-Pacific markets in Singapores non-oil domestic exports has increased from 28 percent in 1986 to 36 percent by 1992 (MAS Annual Report, 1992/1993). Singapore has become an increasingly important supplier of inputs for the production of manufactured exports in the regional economies. These exports in turn depend to a large degree on final demand from the US. Therefore, the relatively low and stable Singapore-US real bilateral rate gives inputs supplied by Singapore (for US bound exports) a competitive advantage.
6.3.3 Summary

A strong exchange rate policy is constrained by the detrimental effects such a policy might have on exports. We see this happening in 1985 when the strong exchange rate policy was abandoned to stimulate export growth. The easing of the exchange rate happened to coincide with a period of deflationary pressure. Export growth has been healthy since 1987. There has, therefore, been little or no pressure on the MAS to subordinate their primary objective of price stability to stimulate export growth. 6.4 CAPITAL ACCOUNT & BALANCE OF PAYMENTS: FIGURES 8 TO 14 Capital flows should have a strong impact on exchange rates. This appears to be the case in Singapore. Movements in the capital account largely determine Balance of Payments (BOP) patterns for Singapore, and BOP trends put pressure on a currency. As we will see below there is a very close relationship between movements in capital flows and the nominal bilateral US$/S$ exchange rate. From Figure 8, we see that from the late 70s to the early 80s, large capital inflows were associated with an appreciation of the Singapore dollar. And the worsening in the capital account during 1984-1985 was associated with a depreciation. The dramatic surge of capital inflows from 1986 onwards appears to have been an important cause of the increase in nominal bilateral exchange rate. Figure 9, indicates that trends in the BOP are, on the whole, similar to those of the capital account and hence relate to the exchange rate in much the same way. This is what we would expect, since the capital account largely determines Singapores BOP. Singapores capital account includes four categories of capital flows: direct investment, portfolio investment, other long term capital and other short term capital. Direct investment has been the largest component of the capital account (save for a few years). Moreover, direct investment is the flow that seems to be the most closely associated with movements in the exchange rate. Trends in direct investment flows track movements in the

Analysis of Exchange Rate Movements: A Case Study of Singapore

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bilateral exchange rate very closely (Figure 10). Figure 11 shows the strong positive relation between direct investment and the US$/S$ rate. An increase in direct investment exerts strong pressure on the Singapore dollar to appreciate. The relationships between the exchange rate and the other categories of capital flows are not as strong. From Figure 12, we see that other short-term capital does fairly well in tracking the movements in the nominal bilateral exchange rate, but it does not do as well as direct investment. From Figures 13 and 14, we see that other long term capital and portfolio investment do not do well in tracking movements in the nominal bilateral exchange rate. For example, both of these capital flows declined in the late 80s, whereas the Singapore dollar appreciated strongly.
6.4.1 Summary

It appears that capital flows do have a strong impact on the nominal bilateral US$/S$ exchange rate. Levels of direct investment appear to have been especially important. 6.5 FOREIGN EXCHANGE RESERVES: FIGURE 15 The level of a countrys foreign exchange reserves could limit a central banks ability to intervene in the foreign exchange market. This is especially so when the bank is attempting to maintain an exchange rate when the currency is overvalued. But this does not appear to be the case in Singapore. Foreign exchange rate reserves have risen steadily since the mid70s. And they have increased dramatically since the late 1980s (Figure 15). Singapores budgetary surplus and the accumulation of funds from the CPF (Central Provident Fund) have contributed to the growth in reserves. Budgetary surpluses and CPF funds are deposited in the MAS. This results in a loss of liquidity from the private banking sector, and results in a constant pressure on the Singapore dollar to appreciate. In order to moderate the loss of liquidity and the pressure on the dollar, the MAS intervenes by selling Singapore dollars and buying US dollars. Foreign exchange reserves rise in the process. 7 ECONOMIC FUNDAMENTALS

7.1 INTRODUCTION Standard models of exchange rate determination, such as various versions of the monetary model, state that four variables influence exchange rate movements. They are: 1. relative inflation levels; 2. relative interest rates; 3. relative rates of economic growth and 4. relative growth in money supply. This section examines the impact of these variables on the nominal bilateral US$/S$ rate. We begin with a brief description of two common monetary models: the flexible price monetary model and the Dornbusch sticky price monetarist model (see Pilbeam, 1992, for a more extensive discussion). 7.2 MONETARY MODELS In monetary models the key determinants of exchange rate movements are money supply and money demand. Monetary models also share a common assumption: that domestic and

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foreign bonds are homogenous and, therefore, that the Uncovered Interest Parity (UIP) condition holds.
7.2.1 The Flexible Price Monetary Model

This model also makes the following assumptions: (1) PPP holds continuously and (2) prices are flexible. The premise of the model is that relative money stocks determine relative prices which in turn determine the exchange rate via PPP. An increase in the domestic money supply leads to an increase in domestic prices. And because PPP holds continuously, this leads to a depreciation of the domestic currency. A rise in foreign money supply leads to an appreciation of the domestic currency. A rise in domestic income leads to a rise in transactionary money demand. With money supply and interest rates held constant, the increased demand for real money balances can only be met by a fall in prices. To maintain PPP, the home currency must appreciate. Conversely, an increase in foreign income leads to a fall in foreign prices and therefore a depreciation of the home currency to maintain PPP. The equation linking real and nominal interest rates is as follows: r = i + Pe
e

(7)

where r is the nominal interest rate, i is the real interest rate and P is the expected rate of price inflation. Note that under UIP, real interest rates are equated across countries (i = i*). An increase in domestic inflation expectations leads to a corresponding rise in r. The increase in domestic inflation expectations leads to a fall in money demand and a rise in spending. Both these factors serve to drive up prices. To maintain PPP, the home currency would have to depreciate. Monetary models, therefore, predict an increase in nominal interest rates to be associated with a depreciation of the currency. Note that this runs counter to the more conventional predictionhigher interest rates result in capital inflows and a currency appreciation.
7.2.2 The Dornbusch Sticky Price Monetarist Model

This model explains large and prolonged deviations of the exchange rate from PPP. It only assumes that PPP holds in the long run. The premise for the sticky price model is that prices in the goods and labour markets are sticky while prices in the exchange rate markets are flexible. This leads to exchange rate overshooting which explains deviations from PPP. The model assumes that UIP holds. If the domestic interest rate is less than the foreign rate then there must be a proportionate expected rate of appreciation of the home currency to compensate for the lower interest. An increase in domestic money supply, with prices unchanged, implies that interest rates would have to fall to equilibrate the money market. The decline in the domestic interest rate requires a proportionate expected rate of appreciation of the home currency to compensate for the lower interest rate. Therefore the exchange rate overshoots in the short run (i.e., it depreciates to a level lower than that required to maintain PPP) in order to generate an expected rate of appreciation.

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A rise in home income leads to an increase in transactionary demand for money. This would cause the domestic currency to appreciate, as in the flexible price model. The effects of a rise in domestic interest rates have already been described above. 7.3 TREND ANALYSIS We begin with a brief graphical examination of the monetary model variables, before presenting a regression analysis.
7.3.1 Money Growth and the Nominal US$/S$ Exchange Rate: Figure 16

Theory suggests that more rapid money supply growth in Singapore relative to the US should lead to a depreciation of the Singapore dollar. This does not appear to be the case. Instead, we see in Figure 16 that, as Singapores money supply growth increases, the exchange rate tends to appreciate. The observation may be due to the nature of monetary policy in Singapore. As a result of CPF and government surpluses being deposited with the MAS and the large capital inflows, the Singapore dollar is under constant pressure to appreciate. To keep the exchange rate within the target band, the MAS sells Singapore dollars and buys US dollars. This necessarily leads to an increase in the monetary base. Hence, we tend to see a rise in the money supply when the Singapore dollar is under strong pressure to appreciate.
7.3.2 Interest Rates and the Nominal US$/S$ Exchange Rate: Figures 17-18

Monetary models suggest that an increase in the nominal interest rate will cause a currency to depreciate. The more conventional view is that higher interest rates will generate capital inflows and a currency appreciation. Our graphical analysis, unfortunately, does not tend to support either view. There are times when the interest rate (and the interest rate differential) moves together with the exchange rate and there are times when they do not (Figures 17 and 18). We also generated scatter plots of interest rate differentials (i.e., US bank prime loan rate less Singapores minimum lending rate) and the currencys appreciation/depreciation rate. These plots also showed no clear relationship between movements in the Singapore dollar and relative interest rates.
7.3.3 Income Growth and the Nominal US$/S$ Exchange Rate: Figure 19

Standard theory predicts that higher domestic income growth leads to an appreciation of the domestic currency. In Figure 19, we define the income growth differential as the US GDP growth rate less Singapores GDP growth rate. Hence, we expect there to be an inverse relation between the growth differential and the US$/S$ rate. Figure 19 suggests that, in general, this relationship is observed. The more rapid growth in Singapore during the late 1970s was associated with an appreciation of the Singapore dollar. The US$/S$ rate stopped appreciating in the early 1980s and depreciated in the mid-1980s as relative GDP growth in Singapore declined. Singapores relative GDP growth increased after 1986 and the Singapore dollar started to appreciate once again.
7.3.4 Inflation and the Nominal US$/S$ Exchange Rate: Figures 20

Standard theory predicts that a higher domestic inflation leads to a depreciation of the domestic currency. We may not observe this in Singapore, however. Since the exchange rate has been used as an anti-inflationary tool by the MAS since 1981, MAS intervention may result in the exchange rate appreciating whenever inflationary pressures mount.

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Indeed, Figure 20 suggests that from 1976 to mid-1981 the exchange rate appreciated as inflationary pressure increased. However, since MAS did not begin exchange rate targeting until 1981, it is difficult to attribute this deviation from theory to MAS intervention. From 1981 to 1990, the figure does suggest that the US$/S$ rate depreciated as inflationary pressures eased and appreciated when inflationary pressures were strong. Since 1990, the strong appreciation in the Singapore dollar appears to have dampened inflation. 7.4 REGRESSION ANALYSIS In order to examine the impacts of money supply growth, income growth, interest rate differentials and inflation on the US$/S$ exchange rate, we estimate the following equation using annual data from 1975 to 1993. The hope is that this multivariate analysis will uncover these relationships more completely than the trend analysis. The regression equation is as follows: lnER = 0 + 1ln(Mus/Ms) + 2ln(Ys/Yus) + 3(rs-rus) + 4(Pus-Ps) where: lnER is the log of the nominal US$/S$ exchange rate ln(Mus/Ms) is the log of relative money supplies; ln(Ys/Yus) is the log of relative income (GDP); rs-rus is the nominal interest rate differential and Pus-Ps is the inflation rate differential. The interest rates used to calculate rs-rus are Singapores 3 month inter-bank rate and the US prime loan rate. The CPIs are used to calculate Pus-Ps. Income (GDP) is at 1990 constant prices. Note that the monetary model estimates often include expected inflation, rather than actual inflation. For simplicity, we assume rational expectations and take the actual inflation rates to approximate expectations. We expect, based on monetary models, the signs of the coefficients to be as follows: 1 > 0; 2 > 0; 3 < 0; 4 > 0 (or 4 = 0 in the Dornbusch sticky- price model). The OLS estimates of equation (8) are as follows: lnER = -0.961 - 0.357ln(Mus/Ms) +0.363ln(Ys/Yus) + 0.013(rs-rus) + 0.0095(Pus-Ps) t-ratio: (-1.01) (-2.43) (4.59) (1.63) (1.16) R2 = 0.9118; R2adj = 0.8866 Judging by the R2, the model represents a fairly good fit of the data.3 The estimated coefficient for ln(Mus/Ms) was negative rather than positive as theory would suggest. A potential reason for this result, as discussed in the previous section, is the nature of MAS intervention. The coefficient on ln(Ys/Yus) is positive and significant as expected. More rapid GDP growth in Singapore is associated with an appreciation of the Singapore dollar. (8)

The model was also run without the relative price variable, as suggested by the Dornbusch sticky-price model. This did not change the coefficients or significance levels of the other variables substantially. Omitting the constant term also had little effect. Note that this regression was not the primary focus of our study, and we did not attempt to estimate more complicated error correction models.

Analysis of Exchange Rate Movements: A Case Study of Singapore

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The coefficient on (rs-rus) is positive, though not significant. This is not in line with monetary model predictions, but it is consistent with the general view that higher interest rates induce capital flows and a currency appreciation. Given that Singapore is a lowinflation environment, it is not that surprising that the monetary model expectation does not hold. The inflation rate differential does not appear to have a significant effect, although the coefficient is positive as expected. The insignificance of the coefficient is consistent with the Dornbusch model. 8 FORECASTINGARIMA A simple time series forecasting model of the nominal US$/S$ exchange rate is developed in this section.4 8.1 DATA Monthly data for the nominal US$/S$ exchange rate from January 1975 to September 1994 was used to estimate an ARIMA model. All data were taken from the International Financial Statistics (IFS). 8.2 ORDER OF INTEGRATION The autocorrelation function of the exchange rate data series does not rapidly decline to zero, suggesting that the series is non-stationary. A Dickey-Fuller test confirmed the nonstationarity of the series. Having decided that the original series was non-stationary, the data were differenced once. A plot of the autocorrelation function of the first differenced series was then generated. This time the function fell rapidly to zero after one lag. The unit root test was then performed again. The results of the test are as follows: Null Hypothesis No constant, no trend A(1) = 0 (I) A(1) = 0 (II) Test Statistic -157.00 -10.855 Critical Value 10% rho = 0.3319 -5.68 -1.62

Both the Z and t test statistics (denoted by (I) and (II) respectively) reject the null hypothesis of non-stationarity. Based on the preliminary examination of the autocorrelation function and the Dickey-Fuller test, we proceed with a model of integration order 1. 8.3 DEGREE OF MOVING AVERAGE (MA) AND AUTOREGRESSION (AR) The moving average and autoregressive structures were determined by looking at the plots of the autocorrelation and partial autocorrelation functions generated from the first differenced series. These plots suggest the model to be an ARIMA (1,1,1). 8.4 MODEL EVALUATIONDIAGNOSTIC CHECKING The final model choice, however, was based on a comparison of t and Q statistics. We started with a model structure of (1,1,1) based on our preliminary examination. But
4

All computations were done with the software package, Shazam.

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because the t-statistics for the coefficients of the ARIMA (1,1,1) are very low other models were also examined. We estimated other model structures such as (0,1,1), (1,1,0), and (1,1,3). Each proved to be a potentially good model. Pertinent statistics of the four models are presented below: ARIMA (1,1,1) Q(12)= 5.8 DF=10 P=.835 Q(24)= 18.5 DF=22 P=.679 Q(36)= 32.1 DF=34 P=.561 PARAMETER AR(1) MA(1) CONSTANT ARIMA (1,1,3) Q(12)= 4.4 DF= 8 P=.816 Q(24)= 16.4 DF=20 P=.689 Q(36)= 29.1 DF=32 P=.614 PARAMETER AR( 1) MA( 1) MA( 2) MA( 3) CONSTANT ARIMA (1,1,0) Q(12)= 7.1 DF=11 P=.792 Q(24)= 20.3 DF=23 P=.625 Q(36)= 33.4 DF=35 P=.544 PARAMETER AR( 1) CONSTANT ARIMA (0,1,1) Q(12)= 6.4 DF=11 P=.845 Q(24)= 19.3 DF=23 P=.682 Q(36)= 33.0 DF=35 P=.564 PARAMETER MA( 1) CONSTANT ESTIMATES -0.32796 0.10270E-02 STD ERROR 0.6177E-01 0.4578E-03 T-STAT -5.310 2.243 ESTIMATES 0.31384 0.71221E-03 STD ERROR 0.6197E-01 0.3512E-03 T-STAT 5.065 2.028 ESTIMATES 0.69761 0.35987 0.22280 0.86420E-01 0.30607E-03 STD ERROR 0.3520 0.3543 0.1255 T-STAT 1.982 1.016 1.775 ESTIMATES 0.97404E-01 -0.24434 0.93077E-03 STD ERROR T-STAT 0.1930 0.1882 0.4725E-03 0.5047 -1.298 1.970

0.6813E-01 1.268 0.3808E-03 0.8037

The ARIMA structure (1,1,3) gave the lowest Q statistic. Note, however that Box-PierceLjung Portmanteau p-values for the other models are also greater than 0.05. Thus we need not reject the null hypothesis that the residuals of the other models are white noise, and the other models are also acceptable on this basis.

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Our next selection criteria was the t-statistics of the coefficients. Models (1,1,0) and (0,1,1) are better models than models (1,1,3) and (1,1,1) since their coefficients are more statistically significant. But the acid test for the best model is to look at how well the models perform in forecasting. Figures 21-24 show how the models perform. In fact we see that the forecasts from all four models are fairly constant. The predicted values do not vary about the mean. Hence, we conclude that there is no one model amongst the four that is superior. The lackluster performance of the forecasts might be due to MAS intervention in the foreign exchange market to keep the exchange rate within its target band, thereby reducing exchange rate volatility. Hence the exchange rate series may contain very little useful ARIMA structure, and time series techniques may not be especially useful for predicting exchange rate trends. When an exchange rate is strongly managed there is less information available to formulate a time series model. Therefore more judgmental methods of forecasting would seem to provide a better means of predicting Singapores exchange rate trends. In other words, one should concentrate more on factors that might trigger MAS intervention and other economic factors outside of MAS control that might affect the exchange rate. 9 SUMMARY & CONCLUSIONS In this study, we have seen how external conditions, economic fundamentals and MAS intervention have affected the Singapore dollar. Because the Singapore dollar is strongly managed, it is difficult to forecast exchange rate trends using an ARIMA model. Therefore, one has to turn to more judgmental methods to predict exchange rate trends. One should certainly try to anticipate MASs responses to various stimuli. We know that the Authoritys primary objective is to maintain price stability. Hence, in times of strong inflationary pressures (either internally or externally generated) we can expect MAS to maintain a strong Singapore dollar. The Authority is not likely to subordinate its primary objective even if export growth suffers. The MAS views the beneficial impact of a depreciation, under inflationary conditions, to be only temporary. Rising wages and higher costs of imported inputs would erode export competitiveness in the long term. If, however, the threat of inflation is low the Authority is willing to weaken the exchange rate to boost the exports when necessary, as it did during the mid-1980s. This is not likely in the foreseeable future. Supply-side constraints, strong export growth and the resultant overheating of the economy are concerns. Therefore, we expect the Singapore dollar to continue appreciating. Other findings of this study include the following. The real US$/S$ exchange rate has remained fairly stable since 1987, despite the nominal appreciation of the Singapore dollar. According to our estimates, the nominal bilateral US-Singapore exchange rate has tended to move in accordance with PPP trends. The relationship between trends in the current account and movements in both the bilateral and real effective exchange rates are not always consistent with the predictions of standard theory. For example, the current account has improved strongly since 1987 despite the appreciation of the REER. Factors accounting for this apparent inconsistency include

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growth in net service earnings, a reduction in the import content of exports, and rising demand for Singapores exports in the Asia-Pacific region. Trends in the capital account do appear to have had an impact on the US$/S$ exchange rate. The large capital inflows from 1977 to 1982 and since 1987 have been associated with appreciations in the Singapore dollar. Among the various components of the capital account, levels of direct investment appear to have had the strongest impact on the currency. These capital flows, along with CPF savings and government surpluses, have put strong upward pressure on the Singapore dollar. Monetary models suggest that differentials in inflation rates, money supply growth rates, interest rates, and income growth rates determine movements in the exchange rate. Our analysis does not tend to support these models. Money supply growth and interest rate differentials do not seem to be useful indicators of movements in the US$/S$ exchange rate. The Singapore dollar, as noted above, tends to appreciate more rapidly when inflationary pressures are high. Relative GDP growth, on the other hand, does have the expected impact on the bilateral rate. The Singapore dollar tends to appreciate when income growth in Singapore is relatively stronger.

Analysis of Exchange Rate Movements: A Case Study of Singapore REFERENCES

25

Abeysinghe, Tilak and Lee Kok Hong (1992), Singapores Strong Dollar Policy and Purchasing Power Parity, Singapore Economic Review, Vol 37 No. 1, April 70-79. Duc-Tho, Nguyen and Yao Chye Chiang (1989), Exchange Rate Determination: the Case of Singapore, (Adelaide, University of Adelaide). Lim Chong Yah and Associates (1988), Policy Options for the Singapore Economy, McGraw Hill. Monetary Authority of Singapore, MAS Annual Report: 1975/76 to 1993/94. Ohno, Kenichi (1990), Estimating Yen/Dollar and Mark/Dollar Purchasing Power Parities, International Monetary Fund Staff Papers, Vol 37, No. 3 September, International Monetary Fund, 700-705. Pilbeam, Keith (1992), International Finance, Macmillian, (London, City University). Pindyck, S. Robert and Rubinfeld, L. Daniel (1991), Econometric Models and Economic Forecasts, McGraw Hill, (New York). Teh Kok Peng and Shanmugaratnam, Tharman (1992), Exchange Rate Policy: Philosophy and Conduct over the Past Decade, in Linda Low and Toh Mun Heng eds., Public Policies in SingaporeChanges in the 1980s and Future of Singapore, Times Academic Press, 285-314.

26 TABLE 1 EXCHANGE RATE TRENDS Nominal Bilateral Rate (US$/S$) 1979-86: 1987 onwards: Real Bilateral Rate 1981-86: 1987 onwards: US$/S$ rate was fairly stable; US$/S$ rate appreciated strongly. (US$/S$) real rate depreciated; real rate was fairly stable.

Chia and Bauer

Nominal Effective Exchange Rate (NEER) 1981-85: 1985-1988: 1988 onwards: NEER appreciated and peaked in 1985; NEER depreciated; NEER appreciated strongly.

Real Effective Exchange Rate (REER) 1981-85: 1985-1987: 1987 onwards: REER appreciated and peaked in 1985; REER depreciated; REER appreciated strongly.

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FGURE 1: I

N OM N I AL US$/S$ E XC AN H GE RATE

0 .7

0 .6 5

0 .6

0 .5 5

0 .5

0 .4 5

0 .4

FGURE 2: I

N OM N I AL E F C V E E F E TI XC AN H GE RATE I DE N X &N OM N I AL US$/S$

E XC AN E RATE I DE H G N X (B ASE 1990) :

120

120

115

115

110

NEER Ind e x

110

105

105

100

100

95

95

90

90

85

85

80

Nom i na US$ /S$ R a l te Inde x

80

75

75

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FGURE 3: I

RE ALUS$/S$ E XC AN H GE RATE I DE N X &N OM N I ALUS$/S$ E XC AN H GE

RATE I DE N X (B ASE 1975Q1) :

150

140

130 Nom i na US$ /S$ R a l te Inde x 120

110

100

90

80

70 R e a US$ /S$ R a l te Ind e x 60

50

FGURE 4: I 1975)

P URC ASI G P H N OW E P R ARI TY (P P C P ), ASSE - E N S M TH LK Y E E OD (B ASE :

0 .8

0 .8

0 .7 5

0 .7 5

0 .7

0 .7

0 .6 5 P P US$ /S$ Excha P ng e R a te

0 .6 5

0 .6

0 .6

0 .5 5

0 .5 5

0 .5

0 .5

0 .4 5

0 .4 5

0 .4 Nom i na US$ /S$ Excha l ng e R a te 0 .3 5

0 .4

0 .3 5

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FGURE 5: I

P URC ASI G P H N OW E P R ARI TY L , ON G RUN AV E RAGI G M TH N E OD

0 .7

0 .7

0 .6 5

0 .6 5

0 .6 P P US$ /S$ Excha P ng e R a te 0 .5 5

0 .6

0 .5 5

0 .5

0 .5

0 .4 5

0 .4 5

0 .4

Nom i na US$ /S$ Excha l ng e R a te

0 .4

0 .3 5

0 .3 5

FGURE 6: I

C URRE T AC OUN N C T

4000000000

3000000000

2000000000

1000000000

- 000000000 1

- 000000000 2

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FGURE 7: I

E XP ORT & RE ALUS$/S$ E XC AN H GE RATE I DE N X &N OM N I AL US$/S$

E XC AN E RATE I DE H G N X (B ASE 1975Q1) :

150

25000000000

140 20000000000 130

120

Nom i na US$ /S$ R a l te Inde x

15000000000

110

100 R e a US$ /S$ R a l te Ind e x 90

10000000000

5000000000 80 Expor t 70 0

FGURE 8: I

C APTALAC OUN & N I C T OM N I ALUS$/S$ E XC AN H GE RATE I DE N X

(B ASE 1975) :

10000000000

155

9000000000 145

8000000000

7000000000 135 6000000000 Nom i na US$ /S$ R a l te Inde x

5000000000 125 4000000000

3000000000 Ne t Ca pita Fow s l l 2000000000 115

1000000000

105

- 000000000 1

95

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FGURE 9: I

B AL AN E OFP C AY E TS & N M N OM N I ALUS$/S$ E XC AN E RATE I DE H G N X

(B ASE 1975) :

8000000000

145 7000000000

6000000000

135

5000000000 125 4000000000 Nom i na US$ /S$ R a l te Inde x

3000000000

115

2000000000 105 1000000000 Ba a l nce of P y e nts a m

95

FGURE 10: DI I RE T I V E C N STM N & N E T OM N I ALUS$/S$ E XC AN E RATE I DE H G N X (B ASE 1975) :

6000000000

145

5000000000 135

4000000000 125 3000000000 Nom i na US$ /S$ R a l te Inde x 115 2000000000

1000000000 D i e ct Inv s r e tm e nt

105

95

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FGURE 11: I

DI RE T I V E C N STM N V S N E T OM N I AL US$/S$ E XC AN H GE RATE I DE N X

(B ASE 1975) :

6000000000

5000000000

4000000000

3000000000

2000000000

1000000000

0 95 105 115 125 US$ /S$ Ind e x 135 145

FGURE 12: I

OTH R SH E ORTTE RM C APTAL& N I OM N I ALUS$/S$ E XC AN H GE RATE

I DE N X (B ASE 1975) :

5500000000

145 4500000000 Nom i na US$ /S$ R a l te Inde x

3500000000

135

2500000000

125 1500000000 Othe r Shor Te r tm Ca ta pi l

500000000

115

- 00000000 5 105 - 500000000 1

- 500000000 2

95

Analysis of Exchange Rate Movements: A Case Study of Singapore

33

FGURE 13: I

OTH R L E ON GTE RM C APTAL& N I OM N I ALUS$/S$ E XC AN H GE RATE

I DE N X (B ASE 1975) :

500000000 Othe r L ong Te r m Ca pita l

145

135 0

125

- 00000000 5

115

- 000000000 1 105 Nom i na US$ /S$ R a l te Inde x

- 500000000 1

95

FGURE 14: I

P ORTF OLO I V E I N STM N & N E T OM N I AL US$/S$ E XC AN H GE RATE

I DE N X (B ASE 1975) :

400000000

145 200000000 P tf io Inv s or ol e tm e nt

135

- 00000000 2

125 - 00000000 4

- 00000000 6

115

- 00000000 8 105 - 000000000 1 Nom i na US$ /S$ R a l te Inde x

- 200000000 1

95

34

Chia and Bauer

FGURE 15: I

TOTALRE SE RV E M N S I US GOL D

50000000000

40000000000

30000000000

20000000000

10000000000

FGURE 16: I

M ON Y SUP L RATI E PY O I DE N X (M Sus /M Ss & N ) OM N I AL US$/S$

E XC AN E RATE I DE H G N X (B ASE 1975Q1) :

145

145

135

135

125

Nom i na US$ /S$ R a l te Inde x

125

115

115

105

105

95 MS R a o Ind e x ti 85

95

85

75

75

65

65

55

55

Analysis of Exchange Rate Movements: A Case Study of Singapore

35

FGURE 17: I

SI GAP N ORE S M N M ' I I UM L N E DI G RATE & N N OM N I ALUS$/S$

E XC AN E RATE I DE H G N X (B ASE 1975Q1) :

15 Mi nim um 14 L ndi e ng R a te

145

140

13 Nom i na US$ /S$ R a l te Inde x 12

135

130

11

125

10

120

115

110

105

100

95

FGURE 18: I

I TE N RE ST RATE DI F RE TI FE N AL(US: B AN KP M L RI E OAN RATE -

S' ORE M N M P : I I UM L N E DI G RATE & N N ) OM N I ALUS$/S$ E XC AN E RATE I DE H G N X (B ASE 1975Q1) :

150

6 Inte r s R a e t te D i f r ntia fe e l 5

Nom i na US$ /S$ R a l te Inde x 140

130 4 120 3 110 2

100

90

36

Chia and Bauer

FGURE 19: I

I C N OM GROW TH DI F RE TI E FE N AL(GDP s G DP a 1990 P C S) & u s t RI E

N OM N I ALUS$/S$ E XC AN H GE RATE I DE N X (B ASE 1975) :

3 .5 Incom e G r ow th D if e r nti l f e a

145

1 .5 135

- .5 0

125 - .5 2

- .5 4

115

- .5 6 105 - .5 8 Nom i na US$ /S$ R a l te Inde x

- 0 .5 1

95

FGURE 20: I

AN UALZ D C I I F ATI N I E P N L ON & N OM N I ALUS$/S$ E XC AN H GE RATE

I DE N X (B ASE 1975Q1) :

2 .5

CP Inf a on I l ti

140

Nom i na US$ /S$ R a l te Inde x 1 .5

130

120 1

110 0 .5

100

- .5 0

90

Analysis of Exchange Rate Movements: A Case Study of Singapore

37

FGURE 21: I

ARI A (0,1,1) - AC M TUAL LM TS & F , I I ORE AST C

0 .7

0 .6 9

0 .6 8

0 .6 7 Actua l 0 .6 6

0 .6 5

0 .6 4 F e ca t or s 0 .6 3

0 .6 2

9 5 % Conf de nce Inte r a i v l

0 .6 1

0 .6 1994 MAY 1994 J UN 1994 J UL 1994 AUG 1994 SEP 1994 OCT 1994 NOV 1994 D EC 1995 J AN

FGURE 22: I

ARI A (1,1,0) - AC M TUAL LM TS, F , I I ORE AST C

0 .7

0 .6 9

0 .6 8

0 .6 7 Actua l 0 .6 6

0 .6 5

0 .6 4

F e ca t or s

0 .6 3

0 .6 2

9 5 % Conf de nce Inte r a i v l

0 .6 1

0 .6 1994 MAY 1994 J UN 1994 J UL 1994 AUG 1994 SEP 1994 OCT 1994 NOV 1994 D EC 1995 J AN

38

Chia and Bauer

FGURE 23: I

ARI A (1,1,1) - AC M TUAL LM TS & F , I I ORE AST C

0 .7

0 .6 9

0 .6 8

0 .6 7 Actua l

0 .6 6

0 .6 5

0 .6 4 F e ca t or s 0 .6 3

0 .6 2

9 5 % Conf de nce Inte r a i v l

0 .6 1

0 .6 1994 MAY 1994 J UN 1994 J UL 1994 AUG 1994 SEP 1994 OCT 1994 NOV 1994 D EC 1995 J AN

FGURE 24: I

ARI A (1,1,3) - AC M TUAL LM TS, F , I I ORE AST C

0 .6 9

0 .6 8

0 .6 7

0 .6 6

Actua l

0 .6 5

0 .6 4 F e ca t or s 0 .6 3

0 .6 2 9 5 % Conf de nce Inte r a i v l 0 .6 1

0 .6 1994 MAY 1994 J UN 1994 J UL 1994 AUG 1994 SEP 1994 OCT 1994 NOV 1994 D EC 1995 J AN