Is the Exchange Rate-Based Monetary Policy Framework Still Relevant for Singapore?

An Evaluation Chow Hwee Kwan

Xie Taojun

Singapore Management University

Friday, November 4, 2016

Presentation Outline

1. Background on Singapore’s Monetary Policy Framework

2. Disconnect between interest rate and exchange rate

3. Exchange rate framework nominal anchor

4. Lessons and Challenges

Background

• Singapore is a small, ultra-open economy:

• trade to GDP ratio > 3 since the early 1970s

• free capital mobility as a major financial center

• Open capital account means the central bank (MAS) needs to choose between interest rate vis-à-vis exchange rate as intermediate target

• Exchange rate-centered monetary policy framework was formally adopted since 1981 3

Exchange Rate as Policy Operating Tool

• High import content (60% of domestic consumption) & being a price taker in international markets means economy is susceptible to imported inflation

• High dependence on external demand, externally oriented manufacturing & services > 1/2 of GDP; exchange rate has a significant impact on the level of economic activity

• Exchange rate is deemed to be more effective for stabilizing inflation, see Chow (2014)

4

Why Not Interest Rate

• By contrast, Singapore’s economy is less interest rate sensitive; heavy dependence on FDI limits impact of the domestic cost of borrowing

• Reflecting its openness to capital flows, Singapore is in a sense too small to control domestic interest rate

• Which is determined by foreign interest rates & investors’ expectation of future value of S$

5

• Monetary policy operations are carried out by managing the S$ under a basket-band-crawl system

• Value of S$ is monitored against trade-weighted basket of currencies (S$NEER), representing various sources of imported inflation & competition in export markets

• A policy band centered at target exchange rate for S$NEER is allowed to adjust gradually over time to prevent currency misalignment

6

Basket-Band-Crawl Exchange Rate System

• The S$NEER is allowed to float within the prescribed policy band to allow for short-term fluctuations in the forex markets

• When it approaches or exceeds band limits, MAS may carry out interventions to “lean against the wind” & defend the band

• MAS avoids intervening within the band except to smooth out unwarranted short term volatility which could impair confidence in the currency

7

Foreign Exchange Intervention

• In its semiannual monetary policy formulation cycle, MAS would announce its exchange rate policy stance

• Appropriate changes are made to the level, slope & width of the policy band based on an assessment of prevailing & outlook of economic/ market conditions,

• Eg, MAS widened the policy band to meet with increased uncertainty during the Asian crisis; MAS flattened its policy band & re-centered it at a lower level during the global financial crisis.

8

Monetary Policy Formulation

Presentation Outline

1. Background on Singapore’s Monetary Policy Framework

2. Disconnect between interest rate and exchange rate

3. Exchange rate framework nominal anchor

4. Lessons and Challenges

Exchange rate vs Short-term Interest rate

0

1

2

3

4

5

6

7

85

90

95

100

105

110

115

120

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Singapore US NEER (RHS)

2a. Short-term interest rates

1

2

3

4

5

6

7

85

90

95

100

105

110

115

120

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Singapore US NEER (RHS)

2b. Long-term interest rates

• Upward trend in S$ from mid-2000s due to large capital inflows arising from the low external interest rate environment

• Short term interest rates fell in Singapore with the onset of the crisis, following US short term interest rate

Exchange rate vs Long-term Interest rate

0

1

2

3

4

5

6

7

85

90

95

100

105

110

115

120

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Singapore US NEER (RHS)

2a. Short-term interest rates

1

2

3

4

5

6

7

85

90

95

100

105

110

115

120

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Singapore US NEER (RHS)

2b. Long-term interest rates

• Also see clear divergence after the onset of the global financial crisis

• Singapore’s government bond yield exhibits a declining long-term trend in tandem with the fall in US government bond yield

Correlation: NEER vs interest rates

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

1a. NEER and 3-month interbank rate

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

03 04 05 06 07 08 09 10 11 12 13 14 15 16

1b. NEER and 10-year SGS bond yield

• No co-movements between NEER and interest rates up till 2013; Movements in opposite directions thereafter

• Does the disconnect between exchange rate and interest rate weaken the monetary transmission mechanism?

• Might this lower effectiveness of monetary policy?

Burden of Adjustment

• Management of the exchange rate means burden of adjustment to foreign monetary policy shocks is on domestic interest rates

• Argument goes that switching to a flexible exchange rate would insulate domestic interest rates from foreign transmission

• Could MAS regain control over domestic interest rates by switching to a flexible exchange rate regime for the Singapore dollar?

• Surge in capital flows constrains monetary independence of countries that are financially open, regardless of their exchange rate regimes

• Rey (2015) showed empirically that gross capital flows, asset prices and credit growth across countries tend to co-move

• Presence of a strong global dimension in these financial cycles driven by the level of risk aversion which is linked to monetary policy in the advanced countries

Empirical Evidence from Literature

Spillovers in Policy Rates

• Studies that examine domestic interest rate sensitivity to US interest rate for Asian countries which use the benchmark interest rate as monetary policy instrument

oSpencer (2013) Foreign interest rate is significant in monetary reactions functions for most Asian countries

oHofmann and Bogdanova (2012) Asian central banks set lower policy rates than otherwise in reaction to monetary expansion overseas in order to lessen the pressure on currency appreciation

oGray (2013), Edwards (2015) and Takáts and Vela (2014) provide empirical evidence of significant spillovers in policy rates

• Cross-border portfolio rebalancing effects: major central banks purchase of domestic bonds to lower their long-term rates, international investors suffering from a duration mismatch in their portfolios buy similar bonds in other markets.

oChen et al. (2012) conducts an event study to demonstrate that bond yields in the region followed US yields lower around the time when the Federal Reserve made announcements on domestic bond-buying

oMiyajima et al (2014) also reports significant interest rate transmission to Asia in long-term rate

oTurner (2014) and Obstfeld (2015) find strong correlations and potential spillovers via long-term rates.

Spillovers in Long Term Rates

• Open capital markets can render monetary policy ineffective despite fully flexible exchange rates

• As an international financial center, Singapore needs to maintain an open capital account so that switching away from the exchange rate-based monetary policy will not likely be helpful

Application to Singapore

Presentation Outline

1. Background on Singapore’s Monetary Policy Framework

2. Disconnect between interest rate and exchange rate

3. Exchange rate framework nominal anchor

4. Lessons and Challenges

“Mishkin (1999) argues that the nominal anchor is a constraint on the value of the domestic currency. It provides the conditions that

uniquely determine the price level, and therefore lays the foundation for price stability.”

“It is the discipline and credibility imbued in the $SNEER framework that now serves as the nominal anchor for Singapore”.

Two Quotes from MAS Macroeconomic Review, April 2016,

“Singapore’s Monetary History: The Quest for a Nominal Anchor”

Exchange Rate as a Nominal Anchor

• The exchange rate path should reflect Singapore’s long term economic fundamentals

• However, determining the equilibrium value of the Singapore dollar has become more of a challenge:

• Exchange rate is like an asset price

• Financial factors have become more volatile

• Has the long-run relationship between economic fundamentals and exchange rate remained the same over time?

Behavioural Equilibrium Exchange Rate (BEER) in MacDonald (2004)

• MacDonald (2004) estimated the LR equilibrium exchange rate for Singapore in 1983Q1:2003Q2

• Economic fundamentals are used

• Vector-error correction model (VECM)

• Assessment of SGD misalignment

• Other competing approaches

Uncovered Interest Parity

• The uncovered interest parity (UIP)

• 𝑠𝑡: log of exchange rate (increase => appreciation)

• 𝑖𝑡: a nominal interest rate

• 𝐸𝑡: conditional expectations operator

𝐸𝑡 𝑠𝑡+𝑘 − 𝑠𝑡 = − 𝑖𝑡 − 𝑖𝑡∗

UIP Condition (cont’d)

• UIP condition: 𝐸𝑡 𝑠𝑡+𝑘 − 𝑠𝑡 = − 𝑖𝑡 − 𝑖𝑡∗

• Adding the expected inflation differential, 𝐸𝑡 ∆𝑝𝑡+𝑘 − ∆𝑝𝑡+𝑘

∗ , to both sides of the equation, we have

• 𝑞𝑡: real exchange rate defined as 𝑞𝑡 = 𝑠𝑡 + 𝑝𝑡 − 𝑝𝑡∗

• 𝑟𝑡: home real interest rate defined as 𝑟𝑡 = 𝑖𝑡 − 𝐸𝑡 ∆𝑝𝑡+𝑘

• 𝑒𝑡: disturbance term

𝑞𝑡 = 𝐸𝑡 𝑞𝑡+𝑘 + 𝑟𝑡 − 𝑟𝑡∗ + 𝑒𝑡

BEER

• Two components determining the current equilibrium real exchange rate, 𝑞𝑡

′:

• A systematic component 𝑞 𝑡

• Real interest rate differential

• The systematic component represents the influence of fundamentals exclusive of interest rates on the equilibrium exchange rate

𝑞𝑡′ = 𝑞 𝑡 + 𝑟𝑡 − 𝑟𝑡

∗

Empirical Strategy

• We test the long-run relationship in two samples:

• 1983Q1:2003Q2

• 2000Q1:2015Q4

• Auto-regressive distributed lag (ARDL) model instead of VECM

• Economic fundamentals to be included:

• Terms of trade

• Property price

• Trade openness

• Net foreign assets to GDP ratio

Data

4.4

4.5

4.6

4.7

4.8

1985 1990 1995 2000 2005 2010 2015

REER

0.8

1.0

1.2

1.4

1.6

1.8

1985 1990 1995 2000 2005 2010 2015

Terms of trade

3.0

3.5

4.0

4.5

5.0

5.5

1985 1990 1995 2000 2005 2010 2015

Property price

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1985 1990 1995 2000 2005 2010 2015

Net foreign assets/GDP

2.0

2.4

2.8

3.2

3.6

4.0

1985 1990 1995 2000 2005 2010 2015

Trade openness

Sources: CEIC Database, Lane and Milesi-Ferretti (2007), DOS Singapore and authors' calculations.

Long run relationship: 𝑞 𝑡 = 𝑓 𝑙𝑡𝑜𝑡𝑡 , 𝑙𝑝𝑟𝑜𝑝𝑡, 𝑙𝑡𝑜𝑡𝑡𝑎𝑡 , 𝑛𝑓𝑎𝑡

• We extend the NFA data series from DOS backwards from 2004 with the data from Lane and Milesi-Ferretti (2007)

• Interpolation is carried out with the “Denton” package in Stata

0

100

200

300

400

500

600

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

LMF DOS

Net foreign asset data from LMF and DOS Singapore

0

20

40

60

80

100

120

140

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Interpolated net foreign asset data

Sources: Lane and Milesi-Ferretti (2007), DOS Singapore and authors' calculations.

ARDL Model

• Also known as bounds test in Pesaran et al. (2001)

• Gives rise to higher degrees of freedom that tends to result in more accurate estimates

• Does not require all the data series to be 𝐼 1 processes

• The tests confirm the long-run relationships in both sample periods

LR Equations of Real Exchange Rate

1983Q1 – 2003Q2 2000Q1 – 2015Q4

Coefficient Std. err. Coefficient Std. err.

Terms of trade .823 ** .325 -.009 .260

Property price .328 *** .080 .362 *** .096

NFA/GDP -.053 .059 -.071 * .042

Openness .081 .122 .016 .046

Intercept 1.962 ** .847 3.016 *** .793

No. of obs. 82 64

LR relationship Yes Yes

Note: *, ** and *** denote significance at 10%, 5% and 1%, respectively.

Re-Export Economy

.25

.30

.35

.40

.45

.50

.55

.60

1985 1990 1995 2000 2005 2010 2015

Re-exports/Exports

Re-exports/Imports

Sources: CEIC Database and authors' calculations.

• Choy (2009) proves the re-export economy hypothesis for Singapore that its imports and exports move together

• The high re-export content could have muted the impact of trade openness on the real exchange rate

REER and Net Foreign Assets

4.40

4.45

4.50

4.55

4.60

4.65

4.70

4.75

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1985 1990 1995 2000 2005 2010 2015

REER Net foreign assets/GDP

REER and net foreign assets

-1.00

-0.75

-0.50

-0.25

0.00

0.25

0.50

0.75

1.00

1985 1990 1995 2000 2005 2010 2015

Correlations between REER and net foreign assets

Sources: CEIC and authors' calculations

• Correlations between REER and net foreign assets are negative in the second sample

Findings from BEER

• The BEER model used in MacDonald (2004) is no longer appropriate in the more recent period

• The accuracy of BEER depends on whether the fundamental variables are at their respective equilibrium levels

• The more connected world and stronger spillovers have made the assessment of exchange rate misalignments a more complex task

Presentation Outline

1. Background on Singapore’s Monetary Policy Framework

2. Disconnect between interest rate and exchange rate

3. Exchange rate framework nominal anchor

4. Lessons and Challenges

International Transmission of Interest Rate

• Surge in global liquidity and the extension of financial linkages lead to greater co-movement in long-term interest rates or policy rates across many countries

• As an international financial centre, Singapore has to remain open

• Switching away from the exchange rate-based monetary policy framework will not likely be helpful

• Exchange rate still exerts a great leverage than on GDP and inflation in view of our small and very open economy

Effects of Fundamentals on Real Exchange Rate

• Financial factors dominate trade factors

• Fundamentals are themselves not at their equilibria

• More connected and uncertain global economy

• Greater monitoring is needed

• Implementing the current policy framework is more difficult, but not less necessary

When Would the Current Policy Framework Become Irrelevant?

• Chow et al. (2014) simulate a counterfactual scenario in which Taylor rule is in place

• Only when domestic productivity shocks become the major source of real volatility then a floating exchange rate with Taylor rule may become more appropriate

• Export price shocks have been a major source of output volatility in Singapore

• Exchange rate management works better in an environment of net capital inflows than capital outflows in terms of preserving foreign currency reserves

References • Chen Q., A. Filardo, D. He and F. Zhu (2012) “International spillovers of

central bank balance sheet policies,” BIS Papers No. 66, October: 220–264, Bank of International Settlements.

• Chow, H.K., G.C. Lim and P. McNelis (2014) “Monetary Regime Choice in Singapore: Would a Tayor Rule Outperform Exchange-Rate Management?” Journal of Asian Economics, 30, 2014, 63-81.

• Choy, K.M (2009) “Trade Cycles in a Re-Export Economy: The Case of Singapore”. Economic Growth Centre Working Paper Series, No: 2009/05.

• Edwards, S (2015) “Monetary policy independence under flexible exchange rates: an illusion?”, The World Economy, vol 38(5), May, 773–87.

• Gray, C (2013) ”Responding to a monetary superpower: investigating the behavioral spillovers of US monetary policy”, Atlantic Economic Journal, vol 41(2), June, 173–84.

• Lane, P.R., Milesi-Ferretti, G.M. (2007) “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities”, 1970-2004. J. Int. Econ. 73, 223 – 250.

• MacDonald, R. (2004) “The Long-Run Real Effective Exchange Rate of Singapore: A Behavioural Approach”, No. 36, MAS Staff Paper. Monetary Authority of Singapore.

References Cont’d • Mishkin, F S (1999), “International Experiences with Different Monetary

Policy Regimes”, Journal of Monetary Economics, Vol. 43(3), pp. 579–605.

• Miyajima, K, M Mohanty and J Yetman (2014): “Spillovers of US unconventional monetary policy to Asia: the role of long-term interest rates”, BIS Working Papers, No. 478, December.

• Obstfeld, M (2015): “Trilemmas and trade-offs: living with financial globalisation”, BIS Working Papers, no 480, January.

• Pesaran, M.H., Shin, Y., Smith, R.J. (2001) “Bounds testing approaches to the analysis of level relationships”. J. Appl. Econom. 16, 289–326. doi:10.1002/jae.616

• Rey H. (2015) “Dilemma, not trilemma: The global financial cycle and monetary policy independence,” NBER Working Paper No. 21162.

• Spencer, M. (2013) “Updating Asian ‘Taylor rules’,” Deutsche Bank Global Economic Perspectives, 28 March.

• Takáts, E and A Vela (2014) “International monetary policy transmission”, BIS Papers, No. 78, August, 25–44.

• Turner, P. (2014) “The global long-term interest rate, financial risks and policy choices in EMEs,” BIS Working Papers No. 441.