EXCHANGE RATE POLICY

Exchange Rate
Amount of one currency that can be exchanged for the currency of another country;
i.e. the price of one currency in terms of another

Determination of Exchange Rate

  • Determined by interaction of DD and SS in the foreign exchange mkt
  • y axis: foreign currency/dom. currency; as move up y axis, value of dom. currency increases
  • x axis: quantity of dom. currency
  • title: market for dom. currency

Demand for a currency

  • Arises from DD from foreign currencies for SG exports, services and assets
  • G&S must be paid for in dom. currency, hence ctys must buy dom. currency to pay for their purchases.

Supply for a currency

  • Arises from SG's demand for imports, services, and foreign assets
  • SG have to pay for imports from Jpan in Yen, therefore sell SGD in the forex mkt for Yen
  • Increases SS of SGD

Determinants of Exchange Rate

Interest Rate

  • High i/r offer lenders higher return relative to other ctys
  • Higher i/r attract foreign capital, financial capital inflow, DD for dom. currency increase
  • Exchange rate rise (i.e. appreciation)

Inflation Rate

  • Consistently low inflation rate = rising currency value
  • As its PP relative to other currencies increases relative to other ctys

Managing Exchange Rate

  • managed-float regime, occasional interventino by MAS

Basket

  • SGD managed against undisclosed basket of currencies of SG's main trading partners
  • Each assigned different degree of importance/weight, depending on SG trade exposure to the currency
  • Reduces volatility, compared to pegged to a single currency

Why SG uses Exchange Rate Policy/Doesn't use MP
(nature of SG economy)

Openness to capital flows

  • International financial centre; easy for residents to borrow, lend, invest in foreign assets, easy for non-residents to invest in domestic assets
  • A price taker in global mkts, hence cannot set our i/r to deviate too much from bigger economies
  • Attempts to do so will be negated by hot money flows, rendering initial change in i/r ineffective
  • e.g. if CB raises i/r to reduce inflation, higher i/r attracts hot money inflows, hence rise in Ms, causing i/r to fall; initial rise in i/r negated

Relatively undeveloped securities mkt

  • Large percentage of govt securities held by CPF board; and non-bank public sector holders of govt securities hold securities to satisfy reserve requirement
  • Unlikely for MAS to make use of dom. open market operations to bring substantial change in Ms
  • Monetary tools largely ineffective in SG. Only moral suasion works as com. banks take MAS advice seriously

Relatively weak impact of change in i/r on I

  • Even if can change i/r, impact on level of I is minimal
  • SG I comprise largely FDI, financed by retained profits or funds from their source country ($ don't come from SGeans)
  • Foreign investors unlikely to be affected by i/r in SG due to reduced need to borrow from SG banks
  • Hence does not substantially affect I; weak impact on AD and NY

More strategic to use Exchange Rate

  • Lack of natural resources, SG imports most foodstuff, raw materials and fuel
  • Managing exchange rate more strategic as directly affects Px SG pays for imported final G and raw materials
    By keeping SGD on gradual appreciating stance,
  • keep Px of imports in SGD low, prevents imported inflation
  • keeps COP low, helps maintain export competitiveness given high import content for the exports (impt bc X are the main engine of SG economic growth!
  • dampens DD-pull inflation as it increase Px of X in foreign currency, moderates external DD for our G&S
  • lower NX and AD, lower GPL

Band

  • Exchange rate allowed to float within an undisclosed policy band
  • Where necessary, MAS directly intervenes to maintain exchange rate within band
  • Absorbs short-term mkt volatility and fluctuations, provides flexibility

Crawl

  • Band reviewed twice a year
  • MAS allows currency to crawl by adjusting slope of the band and the level at which it is centered
  • By adjusting the slope, width and level, the MAS allows currency to "crawl" higher or lower, rather than forcing it to move sharply

Intervention in forex mkt

  • When $NEER reaches the edge of the policy band on either side, MAS intervenes
    At lower limit
  • SGD has depreciated rapidly to below lower limit
  • MAS intervenes by selling part of its reserves of foreign currency to buy SGD in forex mkt
  • Removes excess SS
  • Increase DD of SGD so that SGD appreciates to lower support limit

SG's ERP

  • Any movement in value of SGD due to mkt forces are restricted as it is managed w/in a band against a trade-weighted basket of currencies of major trading partners
  • Impact is smaller compared to free floating ERP

Zero-appreciation

  • Instead of depreciating
  • So as to prevent Med inflation so that X remain X competitive

Gradual Appreciation Stance

  • Impact on SG economy not so aggressive
    How it works:
  • Px of X in FC becomes relatively more ex than during zero-ap stance, Px of M in DM becomes relatively more cheaper than during zero-ap stance
  • Assuming MLC holds, NX decrease, AD NY decrease
    Main benefits:
  1. Imported inflation: Lower Pm; cheaper imports of final G&S for conrs directly (like Korean ramen)
  2. Cost push inflation: Lower Pm of raw mat.s for producer, lower COP, lower final Px of mfged gds
  3. DD-pull inflation: Bc MLC satisfied in SG, stronger SGD leads to fall in NX, moderating any increase in AD and keep out DD-pull inf. (Note: not to stress too much on fall in AD)
  • A stronger SGD also naturally moderates external DD for our X, easing the DD for domestic resources(e.g. labour, capital), as firms will not have to bid up the prices of these resources (i.e. raising wages) to produce X
    (Ref: Prelim II Q5b)

Exports and Imports

  • If there's a sudden fall in demand for A's X, there will be a fall in DD for Currency A; leading to fall in value of Currency A (i.e. depreciation)

Even if i/r can be changed

  • There will be small change in C and I
  • because C/GDP and I/GDP are small
  • Bc we are reliany on FDI, and foreigners are unaffected by our change in i/r
  • Hence limited effect on AD

Notes
Effect on X comp.

  • Reduced price of Med inputs will not improve X comp.
  • Bc the appreciation of SGD will inevitably result in a fall in X comp.
  • This fall, will be partially mitigated by the fall in price of inputs
    Effect on FDI
  • Appn of SGD deters FDI into SG as more home currency required to buy the same amt of SGD
  • higher costs of operating in SG
  • less inflow of FDI into SG
  • decrease AD NY N etc
  • debit item in FINANCIAL ACC of BOP
  • decrease qty and qly of lbr, affects pot growth
    Other possible benefits
  1. Can lower dom. i/r, which will tackle the need for excessive wage increment (as donnid keep increasing wage to maintain their PP)
  • Keeps unit lbr cost low, keeps it a competitive destination for investment
  1. Appn can force firms to move up value chain or seek more pdtive methods, bc the higher currency will make it hard for firms to compete in global mkt using their current pdtn techniques
  • Hence may in the LR lead to better qly goods (won't complete offset, but mitigates the fall in X comp)

Other countries

  • Depreciation may lead to a fall in I confidence, causing a fall in I
    Note for CSQ
  • Appn of a currency may lead to Px of goods being higher in FC, however this depends on strategies undertaken by the firm, whether they wish to pass on the increase in Px,
  • Or fix the price at the particular foreign currency, e.g. Swiss hotel fixes the Px of room at 100 USD, regardless of appn of Swiss Franc

GO-TO Limitations

  1. Impact lag
  • Takes time before the effects of appn of SGD can benefit the importers
  • Bc price of Ms are fixed by LT contracts
  1. Depletion of foreign reserves
  • Keeping a strong SGD requires continual selling of reserves of foreign currency to buy SGD
  • If prolonged, can lead to depletion of foreign reserves
    EV: Solutions
  • Diversify sources of Ms; Reduce exposure to high commodity prices from specific trading partners
  • But may not be applicable for increase in world food Px
  • Reduce dependence on oil by seeking alternative sources of energy, e.g. solar
  1. EV Overtime
  • Changing structure of SG econ.; becoming more svc-oriented
  • May reduce eff. of ERP in curbing M inflation, bc svc sector has low M content and is more lbr-intensive than mfg sector
  • Strong SGD may hence not work to maintain cost-comp.

Problems of

Depreciation

  1. Inflation
  • Price of M in DC increases, hence Px of Med raw mats or final G&S will increase
  • PED for raw mat <1, hence less than prop. fall in Qdd
  • Overall, COP for firms that rely on Med inputs increase
  • Increase risk of cost-push inflation, Med inflation
  • Inflation then leads to erosion in real value of $, hence citizens afford less G&S, fall mat SOL
  1. Erosion of investor's confidence
  • Depreciation due to fall in DD for currency, hence represents a flaw in X sector
  • May have been due to falling X competitiveness, resulting in falling EG
  • Investors become reluctant/cautious abt investing in cty w depreciating Xchange rate, esp if depreciation is persistent
  • eventually impacts LRAS, potential growth

Appreciation: Fall in AD due to fall in N, fall in NX

  1. Fall in NX
  2. Domestic industries
  • Locals find imported goods more attractive in terms of price, start importing more
  • Threat to dom. industries that produce gds in direct competition (i.e. are substitutes) to these goods, hence pdn will slow down for dom industries
  • Fall in N

EV

  • Depends on root cause; if appreciation is due to healthy BOP, investor's confidence and X competitiveness, then its not a big prob
  • Especially if govt can adopt policies to mititgate it
  • Appn is a good problem, it means that the economy is performing well in external market