INDIAN INSTITUTE OF MANAGEMENT LUCKNOW

Exchange Rate Policy at Monetary Authority at Singapore

Submitted to Prof. T. Srivinasan

Submitted by: IPMX04 - Group 6

Ajay Sharma-IPMX04004 Amit Kumar- IPMX04005 Ashish Singh-IPMX04014

Exchange Rate Policy at the Monetary Authority of Singapore

Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction ................................................................................................................................ 3 MAS' Mission............................................................................................................................... 3 MAS' Objectives .......................................................................................................................... 3 Economic Scenario of Singapore................................................................................................. 3 MAS Responsibilities ................................................................................................................... 3 MAS Policy Procedure ................................................................................................................. 4 Drivers for Monetary Policy ........................................................................................................ 5 Exchange Rate Management Policy: Band- Basket Crawl........................................................... 5 Econometric Model of the Economy .......................................................................................... 5

10. Critical Success Factors ............................................................................................................... 6 11. Dr. Khors Dilemma ..................................................................................................................... 6 12. Current Scenario ......................................................................................................................... 6 13. Comparison of Monetary Policy of Singapore and Hongkong .................................................... 7 14. Question1 .................................................................................................................................... 8 15. Question2 .................................................................................................................................. 10 16. Question3 .................................................................................................................................. 10 17. Question4 .................................................................................................................................. 10 18. Question5 .................................................................................................................................. 11 References ........................................................................................................................................ 12

Exchange Rate Policy at the Monetary Authority of Singapore

1. Introduction
Monetary Authority of Singapore (MAS) is the central bank of Singapore. It formulates and executes Singapore's monetary and exchange rate policy, and issues Singapore currency. As banker and financial agent to the Government, MAS manages the country's official foreign reserves and issues government securities. As supervisor and regulator of Singapore's financial services sector, MAS has prudential oversight over the banking, securities, futures and insurance industries. It is also responsible for the development and promotion of Singapore as an international financial centre. 2. MAS' Mission MAS mission is to promote sustained non-inflationary economic growth, promote industrialization and become a globally competitive off-shore financial center.

3. MAS' Objectives

To conduct monetary policy and issue currency, and to manage the official foreign reserves and the issuance of government securities; To supervise the banking, insurance, securities and futures industries, and develop strategies in partnership with the private sector to promote Singapore as an international financial centre; and To build a cohesive and integrated organization of excellence.

4. Economic Scenario of Singapore

Singapore became an independent state in 1965. It chose export led economic growth strategy with price stability with following three developmental objectives: a.) Reduce unemployment b.) Promote industrialization c.) Become globally competitive off-shore financial center. Trade was at the heart of nearly every aspect of the Singapore economy. In order to provide stable exchange rates, required to instill confidence among the traders, Singapore adopted managed float system of exchange rate. Government stimulated high saving rates through mandated social insurance system and Central Provident Fund. Singapore was price taker in the international market and maintained openness to both trade and capital flows. This led to the budget surplus and large accumulation of foreign reserves, leading to the appreciation of the Singapore dollar. Singapore being the financial hub with small domestic banking market, made the exchange rate as natural policy tool. Singapores labour market was very tight and operated at full employment. During 1980s and 1990s used inflation as a competitive tool to its advantage. On account of appreciating Singapore dollar domestic companies faced competition from abroad, whose cost fell every year because of real appreciation in Singapore dollar. This forced Singaporean companies to become more efficient and move up the value chain and services where low cost foreign producers were not able to compete directly.

5. MAS Responsibilities
A few of major responsibilities of MAS are:

Exchange Rate Policy at the Monetary Authority of Singapore

5.1. Monetary and Exchange Rate Policy One of the implicit goals of MAS was to maintain price stability. Though various triggers (interest rates, exchange rate, and free currency conversion) could be used for the purpose, but considering export oriented nature of Singapore economy and small domestic banking market, MAS used exchange rate as the policy tool. Using the trade-weighted basket of currencies, MAS managed the exchange rate. MAS policy of managed float was often termed as dirty float or inflation killer. Singapore kept inflation near or below 2% over the decade. 5.2. Financial Sector Supervision Being a regulatory authority, MAS designed policies of banking capital requirements and prevent large scale failure of domestic financial system. Off-late, MAS also designed guidelines enabling domestic banks compete globally. 5.3. Banker to Financial Institutions The MAS maintained sophisticated centralized payment system enabling bank to maintain inter-bank transactions in real time and make better assessment of their capital requirements and inter-bank loan credit risk. 5.4. Financial Agent to the Government The MAS offered services to Government to fulfill its need of deposit and capital raising facilities. 5.5. Financial Sector Development The MAS played key role in developing business environment for financial innovation so as to enable Singapore maintain its leading global financial sector position. 5.6. Managing industrialization Singapore being a small size country with lack of natural resources, MAS promoted the policies which were more inclined towards promoting trading sector. 5.7. Managing foreign exchange flow To promote Singapore as the global competitive off-shore financial center, MAS needed a policy to have constraint free capital flow as well as stable currency to have confidence of investors and traders.

6. MAS Policy Procedure

Monetary policy implementation process involved three distinct phases: 1. Formulation by the Economics Department (ED) Crucial factors considered by ED for formulation of exchange rate policies were: foreign GDP growth, foreign inflation, and commodity prices 2. Approval by Monetary Policy Committee (MPC) MPC performed comprehensive review of formulated policies in context of worlds economic and financial developments. 3. Implementation by Monetary Management Division (MMD) MMD worked largely by intervening in the foreign exchange market to keep the S$ within the desired band.

Exchange Rate Policy at the Monetary Authority of Singapore

7. Drivers for Monetary Policy
MA S can maintain price stability the using two variables: a.) Domestic interest rate b.) Maintain exchange rate by appreciating and depreciation the domestic currency Even though the Singapore was the financial hub but domestic banking market was very small. This interest rate impacts trickled slowly through the economy and was not considered as viable option. Singapore had a very tight labour market and economy was highly dependent on the trade. An exchange rate change immediately impacted expenditures and hence was the natural policy tool. S$() Price of imported goods() Purchasing power () S$ () Price of exported goods() Demand of Singapore goods () wages () as labour market is tight

8. Exchange Rate Management Policy: Band- Basket Crawl

MAS managed exchange rate using synthetic currency, an index tracking a trade weighted basket of currencies. This basket comprises of the currencies of major trading partners and weights were in proportion to the imports from & exports to respective countries. Singapore maintained its exchange rate around the target exchange rate and allowed it to crawl within a band. The band reflected the long term changes in economic fundamentals. Short term stability was accomplished by allowing the currency to float with in a upper bound and lower bound of the band, within which currency was allowed to float. This system provided the stability by deterring speculation and accommodated long-term market trends by providing enough flexibility for real variables in the economy, impacting equilibrium level of exchange rate.

9.

Econometric Model of the Economy

To develop optimal exchange rate, the MAS economist developed sophisticated model which linked Singapore economy and foreign exchange market. Using the analysts industry forecast of 3-5 years as a reference framework, model simulated possible economic growth and possible exchange rate using principles of parity relationships : a. Uncovered interest parity b. Purchasing power parity

Based on model simulations, MAS economists chose target exchange rates to achieve following goals: a. b. c. d. Maintain inflation (<2%) Maintain unemployment Maintain wages as per the productivity increases Maximize economic growth and flexibility to absorb possible external shocks

Exchange Rate Policy at the Monetary Authority of Singapore

10.

Critical Success Factors

10.1. Government policy of mandated social insurance systems (Central Provident Fund) combined with budget surpluses supported a high saving rate and large foreign exchange reserves, enabling Singapore to become a net creditor to the world. This resulted in real appreciation of S$.

11.

Dr. Khors Dilemma

Asian Financial Crisis of 1997 putting pressure on currencies of East and Southeast Asia countries. Appreciation of Singapore dollar in real terms by about 4% in 1997. Southeast Asia was experiencing declining FDI as the same was being moved to China. Political environment was getting unstable due to increased economic shocks in the region.

Changed economic scenarios:

MAS is studying factors that have led to the real appreciation of S$. A few are: 1. Rapid economic growth 2. Industrialization 3. Persistent budget surpluses over the year Dr. Khor, Assistant Managing Director of MAS, is contemplating about taking the right policy decision to keep the Singapore on growth path while keeping an eye on development imperatives of MAS, and tool at this disposal is managing monetary policy

12.

Current Scenario

Currently MAS defines the currency rate fluctuation band through an indexed approach. The trade weighted index is computed as the product across each foreign currency, defined as num unit foreign currency / per SG$. Although Singapore had foreign reserve surplus, but in 1997 as its neighboring countries were in the verge of default of US$ payments, the same was reflected as an issue for Singapore as well. As the real exchange rate had risen considerably, MAS economist realized the real exchange rate across the region need to fall. It can be accomplished in following two ways. 1. Either nominal exchange rate had to fall, or 2. Relative prices in the domestic economy had to adjust This was achieved in two ways. 1. Fiscal measure: by cutting down on employer contribution rates to Central Provident Fund, thus lowering the effective cost of labor. Also the pay schedules for civil servants were altered.

Exchange Rate Policy at the Monetary Authority of Singapore

2. Monetary measure: the monetary easing was done to allow the currency to depreciate.

13.

Comparison of Monetary Policy of Singapore and Hongkong

Hong Kong and Singapore economies are similar in important ways: they are extremely small, highly open to international trade and very advanced. Both economies trade intensively with their immediate neighbours, mainland China and Malaysia, respectively. Changes in demand in one economy are rapidly transmitted through the international trading system to the regional economies. Eventhough both economies are similar but are follow a very different Monetary policies. Hongkong operated under the under currency board with exchanged rate pegged against US$ (1 US$= HK$7.8), since 1984. The supply of Hongkong dollars fluctuated in response to the demand of ots currency in the world market. During the Asian financial crisis, when both Singapore and Hongkong came under crisis, the value of stocks in Hongkong fell by 25%(approx.). To hold the HK$ dollars government enticed the foreign investors by raising the interest rate, sliding the economy under recession. Hong Kong faced sharper adjustment in real output and employment because the exchange rate was fixed against the US dollar. Singapore was able to effectively use the exchange rate as a nominal anchor to counter inflationary pressures and thereby achieve a lower and more stable rate of inflation. Indeed, the monetary policy objective in Singapore is to attain low inflation in order to promote sustained non-inflationary economic growth. In Singapore, the depreciation of the exchange rate and decline in wages helped to cushion the impact of the shock on the real sector. MASs policy reaction function allows NEER to appreciate strongly in response to inflation in Singapore but not in Hong Kong. MASs credibility in policymaking also enables inflation expectation to be firmly anchored. In contrast Hong Kong does not trigger any countervailing policy reaction and hence are likely to lead to stronger response in the inflation rate.

Singapore Exchange rate regime Exchange rate regime Inflation outcome Output gap Interest rate Monetary Authority of Singapore Managed float (Band-Basket Crawl) Higher average Slower adjustment to mean; Std deviation 0.015 1.7% from 1981-2001 Lower than US rate Lower (1981-2004)

Hong Kong Currency board Pegged against US$ $ (1 US$= HK$7.8 Lower average growth Faster adjustment to mean; Std deviation of 0.015 5.2% from 1981-2001 Close to US rate Higher(1981-2004)

Unemployment

Exchange Rate Policy at the Monetary Authority of Singapore

14. Question1

What are the advantages and disadvantages of a fixed versus floating exchange rate systems? Answer: Fixed Exchange Rate In the fixed rate regime, the central bank of country is responsible for maintenance of exchange rate at predetermined price with the help of different monetary policies. A nation with fixed exchange rates must enforce those rates. An early form of fixed exchange rates was to specify the value of a nation's currency in terms of gold (the "gold standard"). In a fixed exchange rate system, the currencies are fixed for a certain period of time (for example, 6 months, or a year). The main economic advantage of fixed exchange rates is the 1. Stability: No exchange rate volatility, eliminating exchange rate risk thus promoting global trade and investment by gaining trust of corporate and investors as they know government is there to control all the risk associated with exchange rates. 2. Potential for nominal anchor to economy if needed 3. Requires economic discipline

Disadvantages of a fixed exchange rate system is that: 1. No Flexibility: no independent monetary policy 2. Currencies usually do not have their true market value. 3. Surplus or shortage of currency: The government does not allow the market price to rise, and a shortage of the dollar occurs in the market, leading to surpluses or shortages of the currency. 4. Monetary policy cannot react to domestic shocks and shocks in the foreign country are fed to the domestic economy without being buffered by an exchange rate adjustment 5. If a countrys inflation rate are higher than its trading partners, the countrys goods become uncompetitive as compared with comparable products elsewhere. 6. A central bank is forced to intervene in order to keep the rate fixed. These currency manipulations are costly, especially after a devaluation or revaluation of the fixed rate. 7. It also leads to speculation in the currency. If the market demand for dollars increases, then the market price of the dollar increases. Speculators then anticipate that at some point in the future, the governments will increase the fixed value (revaluation). This expectation further increases the demand for the dollar. Eventually the pressure on the dollar becomes so strong that the governments, indeed, do revaluate (increase) the value of the dollar. Before the revaluation, the central banks had been purchasing the weaker currency and selling the stronger currency in an effort to avoid shortages and surpluses. After the revaluation of the stronger currency, the central banks experience significant losses due to the decrease in the value (devaluation) of the weaker currency they had been purchasing.

Exchange Rate Policy at the Monetary Authority of Singapore

Flexible Exchange Rate

Floating exchange rate regimes are market determined exchange rates in which value of currency fluctuates with market conditions, based on the demand and supply forces, similar to demand and supply changes in the market for products. In a flexible exchange rate system currency values change on a real time basis. Most economists, therefore, prefer a flexible exchange rate system over a fixed exchange rate system, because a flexible exchange rate system has the following advantages: 1. It leaves the monetary and fiscal authorities free to concentrate on internal goals such as employment, stable growth and commodities prices because in this case free floating exchange rate works as an automatic stabilizer to control the value of currency. 2. The currency has its true market value. 3. It dampen the effects of external shocks 4. The value is determined by the supply and demand of suppliers and buyers. If buyers place a high value on a currency, its demand increases and the value of the currency increases, and vice versa. 5. There are no long-term surpluses or shortages of the currency. The market will always correct short-term surpluses and shortages by allowing the value to fluctuate. 6. No government central bank interference is necessary, and no central bank losses occur. The disadvantages of floating rate system are: 1. It creates uncertainty for importers and exporters when it comes to planning for future trades. However, buyers and sellers of currencies can "hedge" their risk from fluctuating exchange rates using various derivative instruments. Futures markets can, therefore, provide certainty regarding the future value of the currency even in a flexible system.
2. Overly volatile exchange rates reduce trade and financial transactions. Fundamental overvaluation (undervaluation) of a currency can have severe negative (positive, in the short-run at least) effects on the international competitiveness of a country. Moreover, depreciating currency could import inflation.

Exchange rate regime in Singapore and impact of changeover to fixed and floating regime Singapore after getting independence from UK had three developmental imperatives to counter: 1. Reduce unemployment 2. Promote industrialization 3. Become a globally competitive off-shore financial sector. In order to succeed in their objectives Singapore adopted managed float system of exchange rate regime, using band and basket crawl mechanism which allows exchange rates to vary within a certain band which assured foreign investors that there is government to take care of exchange rates, prices.

Exchange Rate Policy at the Monetary Authority of Singapore

By having floating exchange rate government would not be able to control inflation. So this can hamper their first two objectives to reduce unemployment and to promote industrialization. Free floating Singapore Dollar (SGD) would become highly volatile in short run; leading to misallocation of resources in long run. Singapore economy is the financial hub, so fixing exchange rate would mean aligning currency to other currencies. This will leave Singapore exposed to the shocks external to the home economy.

15.

Question2

What is a real exchange rate? Real Exchange Rate (RER) is reflective of the purchasing power of a currency as compared to a foreign currency. RER takes into account the relative inflation in the countries of two currencies. As the inflation is generally in reference to a base year, this base year needs to be same for both the countries. For example, if country A experiences a inflation 5% more than then country B, but currency of country A depreciates by same amount of 5%, real exchange rate of currency of country A and country B would not change. Hypothetically, if goods are freely moving between two countries and markets in two countries are in stable equilibrium, residents of two countries should be purchasing same basket of goods with same amount of countries i.e. RER would be constant and equal to 1. This is based on the purchasing power parity (PPP) principal. Mathematically: RER = NER x (Price foreign / Price local)
Where, NER = Nominal Exchange Rate RER = Real Exchange Rate

16.

Question3

What do you think determines exchange rates in the short term (less than six months), medium term (six months to several years), and long term? In short term, exchange rate is mostly driven by market sentiments in a floating rate regime. In medium term it is determined by the trade balance, inflation rates and fiscal policies of the government. In long term it is determined by the productivity improvement in a country; i.e. technological advancements.

17.

Question4

How do exchange rates interact with trade balances, inflation rates, and fiscal policies? A falling exchange rate supports export but has negative effect on the import and a rising currency can have exactly the opposite effect on the trade balance. A weaker currency implies cheaper export but expensive import. An export oriented country will benefit from this situation. High inflation in such country will lead to increased cost of export that will lead to further devaluation of currency to maintain the competitive advantage. But that can in turn make the imports costly fueling inflation further.

Exchange Rate Policy at the Monetary Authority of Singapore

High budget deficit will fuel increased interest rates and that will lead to devaluation of the currency in medium to long term.

18.

Question5

Q. How do exchange rate impact firms? In todays global business environment, firms profitability gets impacted by the exchange rate fluctuations. For a firm, two possible business scenarios exists: a. International Firms Exchange rate impacts international firm by exposing it to currency risk. If firm is in export business, exchange rate fluctuations can make firms product competitive abroad if local currency depreciates as product will be cheaper abroad and vice-versa. If firm is in import business, local currency depreciation will make the import expensive. This will either eat into firms profit or firm will have to increase product price to sustain its business. Increase in price can make firm loose the market share and can have adverse impact in the long run if local currency keeps depreciating. Appreciation of local currency will benefit the firm as cheaper imports make the product cost cheaper and better margins. b. Domestic Firms If a firm is not in the business of import-export, indirect impacts of currency fluctuations happen: Raw material cost may change: imported raw materials or substitutes Energy cost may change e.g. oil/fuel import is expensive Imported goods may become cheaper In general, in the adverse cases of currency fluctuations (as mentioned above), firms need to adopt strategically to stay competitive: Firms become more efficient by being innovative about their products, businesses process to lower product cost. Firms may move up the value chain to have products with higher product margin, in which case it can absorb adverse shocks of currency fluctuations.

Exchange Rate Policy at the Monetary Authority of Singapore

References