Singapore Case Paper

  1. Why does the Monetary Authority of Singapore do what it does?
  2. How does the Monetary Authority of Singapore do what it does?
  3. Do you think Singapore is a ‘currency manipulator’, viewing that term in a derogatory sense?

9 – 2 0 4 – 0 3 7 J A N U A R Y 6 , 2 0 0 4

________________________________________________________________________________________________________________ Professor Mihir A. Desai and Research Associate Mark F. Veblen prepared this case. Authors would like to thank Dr. Khor Hoe Ee, Asistant Managing Director (Economic Research and Financial Stability), Mr. Wong Fot Chyi, Executive Director (Macroeconomic Surveillance), Mr. Edward Robinson, Principal Economist (Economic Policy Department) and Dr. Chow Hwee Kwan (Economic Policy Department) for the series of discussion meetings on which this case study was based and their comments on an earlier draft. However, the case study is meant to be pedagogic and any reference to specific individual, department or institution is meant to be purely illustrative. Any inaccuraccies or misrepresentations in the case study should not be attributed to the MAS. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

M I H I R A . D E S A I

M A R K F . V E B L E N

Exchange Rate Policy at the Monetary Authority of Singapore

Dr. Khor Hoe Ee, Assistant Managing Director, Monetary Authority of Singapore (MAS), reviewed the year-end economic data for 2001. He had just met with a number of his colleagues and now paged through the statistics they had discussed. Dr. Khor wondered whether the monetary system that has served Singapore so well since the late 1970s—and had filled the void left by the collapse of the Bretton Woods currency system—was still the best model for Singapore to follow. Singapore’s managed float, sometimes referred to by journalists as a “dirty float,” stood in contrast to the systems used by some of its neighbors: Hong Kong had remained strongly committed to its peg against the U.S. dollar, and Australia had just recently shifted to a completely floating regime. A key item on the agenda for the Monetary Policy Committee meeting at the end of January was to review and set monetary policy in response to the changing economic environment. As head of the MAS’s Economics Department, Dr. Khor knew that he was responsible for recommending a policy response that would be consistent with Singapore’s strategy for sustainable economic growth with price stability as well as supporting Singapore’s role as a major global financial center.

A great deal had happened in the domain of monetary policy in the last five years, much of which posed challenges for Singapore. Since the massive currency depreciations of the Asian Financial Crisis, major reforms were either implemented or being considered across Asia. Singapore was surrounded by neighbouring countries whose domestic economies were faltering. One commentator even quipped that Singapore’s best hope of returning to the heady growth rates of the past was “If Singapore could just sail north and land near Hong Kong or Taiwan.” Furthermore, Southeast Asia had watched its share of foreign direct investment decline as FDI increasingly shifted to China. To make matters worse, the frequency of economic shocks had increased dramatically after 1997, creating a much less stable environment than the one that accompanied Singapore’s rapid growth years earlier.

Dr. Khor was confident that Singapore’s economy—with its high savings rate, vast stock of foreign reserves, strong trading relationships, and sterling reputation in international markets—was fundamentally strong. At the same time, he was conscious of the rapidly changing economic environment, and would like Singapore to be seen as proactive in responding.

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Singapore’s Unique Situation

Legacy as a Trading Center

Singapore was still heavily influenced by its legacy as a trading port established in the colonial days of the British Empire in connection with the British East India Company. For centuries, monetary considerations—such as maintaining a payment system that inspired confidence among its trading partners—were at the forefront of the minds of government planners. Singapore’s small size and lack of abundant natural resources reinforced the importance of the trading sector. Before gaining its independence, Singapore anchored its currency to the British Sterling, which in turn was on the gold standard.

In 1965, however, Singapore became an independent state and took on the responsibilities of self- government. Leaders at the time formulated three developmental imperatives: (1) reduce unemployment, (2) promote industrialization, and (3) become a globally competitive off-shore financial center. The first two imperatives were ultimately met through an export-led1 economic growth strategy. While such a strategy might have suggested holding the currency value down artificially, the third imperative required freedom from capital constraints and a stable currency with the confidence of traders and investors.

The MAS was established in 1971, and at that time Singapore operated a currency board system. However, with the collapse of the Bretton Woods system in the early 1970s (ending the gold standard that had prevailed since the late nineteenth century), world currencies began to fluctuate against one another, and Singapore struggled to develop its own monetary policy framework. Nearly a decade later, a new framework centered on the management of exchange rate was developed: in response to the oil shocks that rattled global markets in the mid- and late 1970s, Singapore developed a managed float system that one analyst dubbed an “inflation killer.”

Government Guided Growth

Presiding over Singapore’s robust economic growth after the Second World War was a government extensively involved in the economy. In addition to its ties to and ownership of local companies across many industries, the government stimulated high savings rates through a mandated social insurance system, the Central Provident Fund (funded through equal employee and employer contributions). This, combined with steady public savings through persistent budget surpluses (see Exhibit 1) since the mid-80s, supported a high savings rate (see Exhibit 2) and a large accumulation of foreign reserves (see Exhibit 3). As a result, Singapore became a net creditor to the rest of the world. The savings accumulation in excess of domestic investment demand helped to produce a long-term real appreciation of the Singapore dollar. (The large stock of savings also gave MAS a powerful incentive to maintain the value of the Singapore dollar in order to maintain the international purchasing power of the savings of Singaporean citizens.)

1 Singapore determined that its position as a small economy prevented it from effectively pursuing an import substitution model, where the domestic economy would over time develop the ability to produce goods that otherwise needed to be imported. Its reasoning was that because of its small size, it would never have the ability to produce all of the goods it needed. Instead it focused on markets where it possessed a comparative advantage and became a strong exporter of those products.

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Overview of the Monetary Authority of Singapore

The Monetary Authority of Singapore Act of 1970 consolidated the government branches and agencies that had previously been performing the functions normally associated with a central bank into a single entity. A Board of Directors composed of nine members, including Chairman, Deputy Chairman, and a Managing Director, the last of whom was responsible for the day-to-day operations of the MAS (see organizational chart in Exhibit 4). Monetary policy functions were handled by the Economics Department and the Monetary Management Division, while the Financial Supervision & Promotion group was charged with overseeing the financial sector. On January 1, 1971 the Monetary Authority of Singapore officially took on the following responsibilities:

Monetary and exchange rate policy The central banking functions consolidated into the MAS included responsibility for formulating and implementing the appropriate monetary policies to achieve price stability. Over the years, the MAS built a reputation for rigorous economic analysis and a strong commitment to its stated policies. Historically, Singapore had kept inflation near or below 2% per year (see Exhibit 5).

Financial sector supervision The MAS had regulatory authority over the financial sector, determining such policies as banking capital requirements and other measures designed to prevent large-scale failures of financial institutions that might threaten the stability of the domestic financial system. In recent years, the MAS had sought to issue guidelines focusing on controlling systematic risk, while encouraging a flexible environment where banks could compete with other large financial centers.

Banker to financial institutions The MAS maintained Singapore’s centralized payment system, the conduit through which banks transferred funds amongst themselves on behalf of their customers. A sophisticated transaction-by-transaction settlement system reduced systemic credit risk in comparison to end-of-day netting systems, because banks no longer had to wait until the end of the business day to find out whether their counterparty would be able to make payment.

Financial agent of the government In the ordinary course of conducting its affairs, the government required the same sorts of deposit and capital raising facilities for which a corporation might turn to a commercial bank. The MAS provided these services for the government.

Financial sector development Beyond regulating and supervising Singapore’s financial institutions, the MAS played an active role in assuring that the business climate in Singapore was favorable to such things as financial innovation in order to ensure that Singapore maintained its position as a major global money-center.

Procedure for Conducting Monetary Policy

The monetary policy process involved three distinct phases: formulation by the Economics Department, approval by the monetary policy committee, and implementation by the Monetary Management Division.

Formulation The Economics Department relied on a formal econometric model of the Singapore economy for different exchange rate policy scenarios. Crucial variables they considered in

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predicting possible developments in the Singapore economy included foreign GDP growth, foreign inflation, and commodity prices.2

Approval The Monetary and Investment Policy Meeting, headed by the Chairman of the MAS, met twice a year in order to give Singapore’s monetary policy a comprehensive review and decide on the monetary policy stance for the period ahead. The group also convened on a weekly basis to discuss economic and financial developments around the world that could impact Singapore’s economy.

Implementation The Monetary Management Division (MMD) handled the transactions designed to maintain the desired exchange rate band for the Singapore dollar. MMD monitored the movements in the exchange rate closely and ensured that it moved in an orderly fashion within the policy band specified by the monetary policy committee.

MMD relies largely on intervention in the foreign exchange markets, as and when necessary, mainly through the purchase or sale of U.S. dollars against the Singapore dollar. By influencing the value of the S$/US$ exchange rate, the values of the bilateral exchange rate between the Singapore dollar and the other currencies in the trade-weighted basket will also be determined, given their independent movements against the U.S. dollar.

— Senior MMD official

In order to increase the transparency of monetary policy formulation and conduct, the MAS released a Monetary Policy Statement and the Macroeconomic Review semiannually. The MPS provided an assessment of the MAS’s outlook on the economy and announced the monetary policy stance for the period ahead, while the Macroeconomic Review provided the analysis and assessments of the GDP growth and inflation developments in the Singapore economy, thereby presenting the basis for the policy decision. In addition, the MAS released various publications, which articulated the framework of monetary policy to the market and provided information on the background analysis and on Singapore’s economic outlook. This transparency was in line with the code of “good practices,” which the International Monetary Fund (IMF) established in the wake of the Asian financial crisis of 1997/98.

Monetary Policy Formulation

Policy Tools

In achieving its goal of maintaining price stability, the MAS faced a decision as to what variable to use as its policy tool. It could, like central banks in larger economies, influence domestic interest rates by increasing or decreasing the domestic money supply or simply establish a benchmark policy interest rate. Alternatively, it could influence exchange rates by effecting an appreciation or depreciation in the currency. The MAS could not, however, simultaneously control interest rates, exchange rates, and maintain an open capital account (i.e., allow free and continuous conversion of the currency). This trilemma was commonly referred to among economists as the “unholy trinity.”

Determining which variable would be most effective as a monetary policy tool required examining the structure of the underlying economy. Singapore was a price taker in international 2 For a more comprehensive description of the methodology, see Monetary Authority of Singapore, Economics Explorer #5: Implementation of Monetary Policy (Singapore: February 2000), available at <http://www.mas.gov.sg/>.

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markets and maintained openness to both trade and capital flows. Trade was at the heart of nearly every aspect of the Singaporean economy: of every GDP dollar, 70 cents was based on external demand, and 57 cents stemmed from imports. Both import and export volumes consistently exceeded total GDP (see Exhibit 6). Furthermore, although Singapore was a financial hub, the domestic banking market was quite small. As a consequence, interest rate impacts trickled slowly through the economy, and exchange rate changes immediately impacted expenditures.3 This made the exchange rate the natural policy tool.

Rather than manage the Singapore dollar against the U.S. dollar—by far Singapore’s largest direct and indirect4 currency exposure—the MAS developed a synthetic currency, an index tracking a “trade-weighted” basket of currencies. This would give the MAS a more precise tool for measuring and controlling the relationship between exchange rates and the domestic price level. The basket was composed of the currencies of Singapore’s major trading partners, and the currencies were weighted in the basket in porportion to how much of imports and exports was sourced from or destined to a particular country.

Singapore was particularly susceptible to import inflation. Any slide in the value of the Singapore dollar meant that the prices of imported goods were effectively higher, thus raising the local CPI. Similarly, an increase in relative foreign prices, a rise in the price of Thai rice for example, reduced the purchasing power of local currency. At the same time, Singapore’s labor market was extremely tight. Thus, any significant rise in external demand would require Singaporean factories to pay premiums to hire additional workers as they strove to increase output. Such increases in incomes with the domestic economy already at full employment could produce wage inflation. The effects could cause real misallocations of resources that the MAS wished to avoid through cushioning the economy from any misalignment in exchange rates.

The current policy: “Band-Basket-Crawl”

The band-basket-crawl characteristics in the managed float system in Singapore represented a middle ground between (i) a fixed regime pegged to a particular currency at a specific rate, and (ii) a floating exchange rate regime freely convertible at rates determined on a continuous basis by the market. The band was centered around the target exchange rate. It was designed to “crawl” (historically upwards in Singapore’s case) over time, allowing the band to reflect the long-term changes in economic fundamentals. Short-term stability was accomplished by enforcing the upper and lower bounds of the band within which the currency was allowed to float. As one analyst commented, “It is never a game between the central bank and speculators. It is a game between the central bank and the economy.” For the two decades leading up to the Asian crisis, the MAS had successfully deterred speculators from attacking the currency by enforcing the band, and had accommodated long-term market trends by providing enough flexibility for real variables in the economy to impact on the equilibrium level of the exchange rate.

Had the exchange rate been fixed at some historical level, over time pressures from the real economy—increasing productivity, high savings rates, and sustained economy growth—would have shifted the currency into a position of being undervalued in real terms. This would have led to 3 Singapore dollar interest rates had long tracked U.S. dollar rates very closely. They had consistently remained slightly lower because of the constantly anticipated appreciation of the Singapore dollar. This anticipation reflected two decades of steady real appreciation of the Singapore dollar.

4 Many of Singapore’s trading partners either pegged their currencies directly to the U.S. dollar or observed significant correlations with the U.S. dollar. Exposures to these currencies magnified the effects of the U.S. dollar on the Singaporean economy.

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higher increases in wages and prices given the openness of the economy. On the other hand, had the exchange rate been allowed to float freely against foreign currencies, short-term deviations from the MAS’s chosen optimal exchange rate path would have been both more frequent and more pronounced. An increase in the volatility of the currency would certainly have hindered Singapore’s efforts to develop into a financial hub for global markets and would also have made it more difficult for businesses that were inherently trade-dependent to plan for the future.

Understanding the Environment: Econometric Model of the Singaporean Economy

In order to project the optimal exchange rate path for Singapore, MAS economists needed a sophisticated model of both the Singaporean economy and of the linkages that govern exchange rate determination in the markets. This monetary policy model utilized econometric techniques to estimate likely outcomes based on empirical data. MAS economists forecasted both a “bottom up” aggregation of sectoral estimates from internal industry specialists over a three to five year horizon and economy-wide growth projections. (This “bottom up” aggregation served as an alternative short-term economy-wide growth forecast.) Using this as a framework for the structural elements of the Singaporean economy, the model then simulated possible outcomes for economic growth and the exchange rate based on fundamental parity relationships. These included two “no arbitrage” conditions which held in the long run: uncovered interest parity and purchasing power parity. The first held that spot rates (prices for immediately completed transactions) and prevailing interest rates would align themselves such that interest rate differentials compensated investors only for anticipated appreciations or depreciations in the respective currencies. The second held that in the long run, nominal exchange rates would reflect relative inflation rates and relative real economic growth rates across countries.

Based on these predictions and simulations, MAS economists chose the target exchange rate with the objective of balancing a number of goals:

! Inflation should not exceed a maximum threshold, implicitly around 2%

! Unemployment should remain in line with the “non-accelerating inflation rate of unemployment” (NAIRU)

! Wages should keep pace with productivity improvements

! Subject to these conditions, maximize economic growth while retaining the flexibility to absorb possible external shocks

Scenario analysis The Economics Department spent a great deal of time performing scenario analysis and asking “what if” questions for potential shocks that might impact the economy. Examples of shocks economists considered were “What if the high equity valuations and especially technology-related equity valuations in the United States collapse suddenly?” or “What if China devalues the renminbi?” or “What if our exchange rate appreciates x%?” In considering all these options, the MAS was searching for the exchange rate level that would best create the conditions for price stability over the medium term.

Effects of a Prolonged Real Appreciation

Singapore had experienced a 4% per year real appreciation in its currency from 1980 to 1997. The steady real exchange rate appreciation was consistent with two facts that both reflected strong and improving fundamentals in the real economy:

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! Singapore’s average annual productivity growth, at around 5%, exceeded that of its trading partners by a factor of more than two

! Singapore’s high savings and investment (current account surpluses were on the order of 20% of GDP beginning in 1986) led to a massive accumulation of net foreign assets

During the 1980s and 90s, the MAS focused on inflation and not on using the exchange rate as a competitive tool—they did not keep the value of the currency low in order to spur exports. Singaporean industry, as a result, faced competitors from abroad whose costs relative to Singaporean companies fell every year simply because of the real appreciation in the Singapore dollar. This forced Singaporean companies to either become more efficient or constantly move up the value chain to focus on higher value-added goods and services where low-cost foreign producers were not able to compete directly. This process was normally unpopular in other countries because it frequently resulted in job losses. It proved sustainable in Singapore, however, because the labor market was very tight and the economy operated consistently at full employment.

Real vs. nominal The 4% annual real appreciation was not a measure of the exchange rate between currencies observed in the market (the nominal exchange rate), but rather a measure of the exchange rate between “goods” across countries (the real exchange rate). The nominal exchange rate measured the ratio at which Singapore dollars were traded for other currencies in the spot market. It fluctuated continuously. The real exchange rate measured the ratio at which Singapore dollars were equivalent to other currencies in purchasing power terms. In other words, the real exchange rate took into account relative inflation levels. For example, if Singapore experienced inflation of 2% more than one of its trading partners, and the Singapore dollar depreciated by 2% with respect to that trading partner’s currency, the real exchange rate would not have changed.

By adjusting the observed nominal exchange rate changes for changes in relative price levels (e.g., the inflation level in Singapore as compared to the inflation level in the U.S.), MAS economists could compute changes in the real exchange rate. Exhibit 7a reports the evolution of the real and nominal exchange rates for the Singapore dollar over time. Exhibit 7b highlights the corresponding interest rate differentials after 1980.

MAS Operations and Policy Implementation

After the Monetary Policy Committee had approved a policy stance proposed by the Economics Department, the Monetary Management Division was tasked with executing the strategy. The MMD was responsible for (1) implementing monetary policy, (2) conducting money market operations, (3) acting as the fiscal agent for the government (issuing Singapore Government Securities), and (4) providing ancillary banking services to the government.

Managing the entire basket… The first task centered on intervening, if necessary, in the foreign exchange markets to influence the trade-weighted Singapore dollar exchange rate. Such interventions might occur while the exchange rate was within the band, with activity escalating as the exchange rate moved closer to the outer bounds of the band. Although the MAS did not publish either the list of currencies in the basket or the weightings of each currency in the basket, equity research analysts had come close to replicating the basket by backing into a model basket using published import and export data for Singapore with its major trading partners. (Exhibit 8a and Exhibit 8b provide past exchange rates and trade volume data that were helpful to analysts in replicating the MAS’s calculations.)

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Specifically, the trade-weighted index was computed using a similar framework to the following stylized representation: as the product across each foreign currency of the number of units of foreign currency per Singapore dollar:

” #

$ % &

‘ ( )#

n

i

iw i

SGD SGD x

TWI 1

The following stylized example proceeds on the simplifying assumption of a central bank contemplating a basket of only three currencies. This serves as a conceptual discussion of how intervention directed at bilateral rates can influence the outcome of the domestic currency on a trade- weighted basis.

…through a single exchange rate One important aspect of this formula was that Singapore could accomplish all of its intervention activities by intervening in the U.S. dollar/Singapore dollar foreign exchange market only.5 This principle was best explained using the following logic. Beginning with the trade-weighted index, it was possible to isolate a single currency (the U.S. dollar exchange market provided the most liquidity) in which to transact as outlined in Table 1.

Table 1 Managing the Entire Basket … through a Single Exchange Rate

EURJPY

EURJPYEURJPYUSD

EURJPYUSD

EURJPYUSD

ww

wwwww

www

www

USD EUR

USD JPY

SGD USD

TWI

USD EUR

USD JPY

SGD USD

TWI

SGD USD

USD EUR

SGD USD

USD JPY

SGD USD

TWI

SGD EUR

SGD JPY

SGD USD

TWI

$ % &

‘ ( )*$

% &

‘ ( )*$

% &

‘ ( )#

$ % &

‘ ( )

*$ % &

‘ ( )

*$ % &

‘ ( )

#

$ % &

‘ ( ) **$

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*$ % &

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1. Hypothetically, the central bank identified three currency exposures (U.S. dollars, yen and euros) to manage and assigned each a weight depending on each currency’s importance to Singapore’s trading relationships. The weights summed to 1.

2. The central bank decomposed each foreign exchange rate into cross rates through the U.S. dollar.

3. The central bank extracted all of the USD exposure.

4. The central bank could now use a single variable (USD/SGD exchange rate), scaled by observable market levels, as a lever to control its target (the TWI).

Source: Casewriter

5 This assumed that Singapore was a small economy that did not impact the exchange rates of other foreign currencies vis-à-vis one another.

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The actual transactions in the foreign exchange markets were conducted through eleven primary dealer banks, three of which were local financial institutions and the remaining eight of which were foreign banks. These eleven banks handled all of the MAS’s transactions in Singapore Government Securities (SGS), and some subset of them might be used in the event of an intervention.

As the MAS built up its credibility in world markets, interventions became less frequent, because market players became mindful of the MAS’s intentions. In effect, investor confidence instilled in the market a sort of self-imposed discipline. As the exchange rate moved toward the bounds of the band, traders anticipated interventions by the MAS and therefore stopped pushing the currency’s value further away from the (perceived) center of the band.

Money market operations The MAS needed assurance that at any given time there were sufficient funds in circulation in the domestic economy to keep the financial system functioning smoothly. All banks in Singapore maintained cash balances with MAS for the purpose of meeting their reserve requirements and settlement of interbank transactions. The cash balances with MAS— called the Minimum Cash Balance (MCB)—were set equivalent to 3% of the banks’ liabilities bases. While MCB for banks was allowed to fluctuate between 2% and 4% of their liability bases on a day- to-day basis, they had to ensure that the average MCB ratio for any two-week maintenance period was not less than 3%. (The percentage did not vary with the duration of the deposit, e.g., checking accounts versus time deposits.) Every morning, the MAS also received from the government agencies a summary of expected funds transfers for the day. Daily fluctuations in transfer payments for retirement benefits, for example, could significantly impact daily liquidity needs.

As monetary policy was centered on the management of the trade-weighted exchange rate, the MAS conducted money market operations to ensure sufficient liquidity in the banking system to meet banks’ demand for reserve and settlement balances. The amount of liquidity to inject or withdraw from the banking system depended on the net liquidity impact of:

1. the MAS’ foreign exchange operations, if any, and its maturing money market operations;

2. changes in banks’ liabilities base and hence, their MCB requirements;

3. net changes in currency demand;

4. net issuance of government securities; and

5. the government’s funds transfers.

Based on historical experience, banks maintained average cash balances with MAS of 3.1%-3.3% of their liability bases. Within this range, the overnight interbank rate would remain fairly stable, although its volatility might also depend on the distribution of funds in the banking system. If figures from the government suggested that the money supply might dip below 3% of bank liabilities, the MAS could step into the market and inject additional funds. Conversely, at levels above 3%, the MAS could withdraw funds from the economy. The instruments used for money market operations included (1) SGS repos/reverse repos (2) FX swaps and reverse swaps, and (3) direct borrowing and lending. (See Appendix A for a description of the transactions used in implementing money market operations.) The MAS dealt exclusively with the eleven primary dealers for money market operations.

Benchmark yield curve In its capacity as the financial agent of the government, the MAS regularly issued SGS of varying maturities. As a matter of fiscal policy, the government had no need for public borrowing, but the MAS consciously wished to create a liquid market in domestic fixed income securities. In order to support such a market, a benchmark yield curve in government

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securities was required—this set pricing levels for corporate debt. This was partially motivated by a desire to encourage the use of bonds, a longer duration, and therefore more stable, source of capital as an alternative to bank debt. Furthermore, it created the possibility that foreign issuers would turn to Singapore to raise SGD-denominated debt. This market had, in fact, experienced significant growth over the course of the previous few years (see Exhibit 9).

Recent Developments

In 1997, heightened concern about Thailand’s ability to service its foreign debt began a string of speculative attacks on regional currencies in East and Southeast Asia. For most of the countries impacted, the underlying concerns stemmed from a belief that (1) domestic debt denominated in foreign currency would no longer be serviceable if the currencies were allowed to float, and (2) the central banks could no longer artificially sustain then prevailing exchange rates. Countries such as Hong Kong and Singapore, however, had demonstrated foreign reserves that indicated that they would, in fact, be able to defend the currency against such a speculative attack. While both were ultimately successful in averting the economic turmoil inflicted upon their neighbors, both were deeply impacted.

MAS economists realized that real exchange rates across the region would need to fall and that there were two ways in which this could be accomplished. Either the nominal exchange rate had to fall, or relative prices in the domestic economy had to adjust.6 The MAS felt that, in a market that was so influenced by expectations and where credibility was crucial, sending the right signals would be an important element to weathering the storm. In particular, the MAS signaled a willingness to allow the nominal exchange rate to depreciate somewhat, but in an orderly manner. In an unusual move, the MAS widened the band within which the exchange rate would be allowed to fluctuate. Contemporaneously, fiscal policy was adjusted, implementing significant cost-cutting budgetary measures. In particular, employer contribution rates to the Central Provident Fund were reduced, thus lowering the effective cost of labor. More subtle cost reductions methods took the form of altering pay schedules for civil servants, whose pay scales often served as a benchmark for the private sector. The government was also the largest landlord, and influenced property prices depending on the rate at which it built residential and commercial real estate and released land for sale into the market.

While the MAS was legally independent (separating monetary policy from fiscal policy), one consequence of Singapore being a small country was that the group of people making high-level policy decisions was quite small, so quick and coordinated fiscal and monetary actions were possible. In the aftermath of the Asian Financial Crisis, the fundamental cause of economic weakness was not so much one of monetary policy but rather a much lower level of external demand. While MAS policies could temporarily affect imbalances of these sorts, real economic problems required real economic solutions rather than tweaks to foreign exchange policies.

The Intersection of Fiscal and Monetary Policy

During the period of sustained exchange rate appreciation, it was economically accurate to attribute much of the strength in the Singapore dollar to improving economic fundamentals. In some

6 This corresponds perfectly to the mathematical relationship between real and nominal exchange rates: the product of changes in the price level (inflation) and changes in the real exchange rate determined the nominal exchange rate.

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sense, this created an association between a strong currency and a strong economy and similarly to strong politics. Under such a framework, periods of appreciation (to combat inflationary pressures) might have been much easier for the MAS to accommodate than periods when conditions called for a depreciation.

MAS economists contended that deflationary shocks were largely cyclical and did not need to be considered by a central bank that was concerned with intermediate- to long-term price stability. Analysts responded that whether cyclical or not, the impact on a small open economy was the same, and as such, monetary policy could be used to accommodate some of the shock. However, there were limitations to the extent that domestic monetary policy could influence foreign demand, especially when Singapore’s exports tended to be many times more income elastic than price elastic.

MAS economists also asserted that a monetary easing would have “pass through” effects. These longer term effects of allowing the currency to fall included increased exports, increased employment, increased income, increased money supply, and finally increased domestic prices. MAS believed that the “pass through” effects from an easing would eventually have appeared as inflation down the road.

The “Gap” Model: Considering Fiscal Effects

Singapore’s rapid economic growth and industrialization played a key part in the sustained real appreciation of the Singapore dollar prior to the Asian Crisis. Dr. Khor was, however, aware of a theory recently endorsed by some of Singapore academic community. The “Gap” model pointed to another underlying driver of the currency appreciation: persistent annual budget surpluses (on the order of 12% of GDP) beginning in 1985. Economically, this represented a net withdrawal of funds from the domestic economy that created a need for obtaining capital from abroad to make up for shrinking liquidity. This in turn bid up the value of the Singapore dollar, creating deflationary pressure. (As the purchasing power of the Singapore dollar in terms of traded goods rose, the corresponding prices of domestic, non-traded goods had to fall to maintain purchasing power parity.) This deflationary pressure risked significant detrimental effects on the domestic economy, and was seen in dropping property values, stock market values, and asset prices (so-called “triple deflation”). These falling values were important because many of the assets were pledged as collateral for loans.

According to the theory, however, it was not merely the budget surplus, but the gap between the budget surplus and foreign direct investment (FDI) that flowed into the country. FDI—while it was pouring in the in 1980s and 90s—had the effect of offsetting the deflationary pressures created by the surpluses. Although the manufacturing sector continued to attract large foreign investments, levels of FDI did not mirror the previous growth trend. Unlike in the West, fiscal policy has not been regularly used as an activist tool for economic stimulus.

Alternative Approaches: Hong Kong

In contrast to Singapore’s policy of managing its exchange rate, Hong Kong had operated under a currency board since 1984, with its exchange rate fixed at HK$7.8 per US$1. Under this regime, Hong Kong’s central bank stood ready to exchange US dollars for Hong Kong dollars at this rate. The supply of outstanding Hong Kong dollars thus fluctuated in response demand for its currency in world markets. The peg to the U.S. dollar was taken on largely for political reasons: an experiment with floating rates had proven quite volatile and with the handover back to China in 1997 hanging

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This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

12

over it, choosing a system that inspired investor confidence was crucial. A more discretionary system would have provided more flexibility in buffering shocks, but it would not have afforded any protection from the risk that Hong Kong would not be able to maintain a monetary policy truly independent of China.

This led to very different inflation patterns since the mid-1980s, a period during which both Hong Kong and Singapore experienced rapid economic growth, and also to radically different reactions to the Asian financial crisis of 1997/98. Exhibit 10 provides data to compare the real exchange rate movements and inflation in Hong Kong and Singapore. While the real exchange rate appreciation in Hong Kong led to inflation in the 5-10% per year range, inflation in Singapore hovered between 0-3%. Where the exchange rate acted as a buffer for Singapore, Hong Kong absorbed the appreciation directly in terms of internal price appreciation (inflation and a property value bubble).

During the Asian financial crisis, when both currencies came under pressure, Hong Kong experienced a severe deflation as the money supply contracted. During the Asian financial crisis, investors feared that Hong Kong might devalue its currency—that the government’s pledge to maintain the pegged exchange rate was not credible. Though the value of stocks in Hong Kong fell by nearly 25%, the government raised interest rates to entice foreign investors to hold Hong Kong dollars. Hong Kong ultimately succeeded at maintaining its peg to the U.S. dollar. The high interest rates, however, imposed a real cost to the economy as it slid into recession.

More generally, Singapore had cultivated extensive expertise among its central bankers and economists. This group actively reviewed and amended policies as appropriate. Hong Kong, on the other hand, was saddled with a system that was politically difficult to change. The comparison of these two different paths demonstrated how important such policy choices could be for the real economy.

Conclusion

Dr. Khor had a wealth of information to review before making a recommendation to be considered by the Monetary Policy Committee. He was also a long-time MAS veteran who understood that Singapore’s anti-inflation vigilance through exchange rate policy had been a large part of Singapore’s monetary and economic success. He shared the long-held view among MAS economists that there was no single exchange rate system that was appropriate for all times and countries, and even individual countries might find one regime more appropriate at some times than others. Khor recognized that a number of factors—a deterioration in regional terms of trade, the cyclical downturn in the electronics and semiconductor industries, the reduced economic influence of ASEAN, the unemployment induced by allowing financial sector consolidation, and the emergence of China with its reforms—had made his policy decisions much more difficult. Knowing the limitations of having only monetary tools at his disposal, he nonetheless had high hopes for creating the conditions necessary for price stability. Whether this meant financial deregulation, a more flexible float, or something else, Khor expected a grilling at January’s policy meeting about the significant risks involved in a major shift in monetary policy.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Appendix A: Liquidity Considerations in Implementing Monetary Policy in a Small Open Economy

Trading foreign exchange directly involved buying and selling US$ for S$. When the MAS bought S$ using US$, that had the effect of lowering the supply of S$ in the economy and thus reducing domestic liquidity. The Monetary Management Division had a number of tools at its disposal to counteract the impact on domestic liquidity:

Foreign exchange (reverse) swaps – The MAS could simultaneously sell (purchase) a S$ for spot delivery and purchase (sell) S$ for forward delivery. In such a swap, the MAS lent S$ and borrowed US$ at the execution date by selling S$ in exchange for US$ on the spot market and simultaneously entered into a forward contract to buy (sell) the same amount of S$ for delivery in the future, effectively reversing the original lending (borrowing).7

Direct lending to or borrowing from banks – The MAS also had the option of lending (borrowing) funds at interbank interest rates directly to Singaporean banks to increase (decrease) liquidity.

Direct purchases and sales of Singapore Government Securities (SGS) – Similarly, the MAS could transact with banks for SGS. The purchase (sale) by the MAS of such securities had the effect of injecting funds into (withdrawing funds from) the financial system.

Repurchase or reverse repurchase agreements on SGS – In a “repo” transaction, a bank lent the MAS Singapore Government Securities in exchange for S$ and agreed to later repurchase those securities. This had the effect of temporarily injecting S$ into the financial system.

Two other policies influenced the MAS’s liquidity interventions. As described earlier, contributions to the Central Provident Fund amounted to a withdrawal of funds from the economy. Additionally, conservative fiscal policies resulted in continued budget surpluses, providing a second contractionary pressure on domestic liquidity.

7 For further detail, see , Richard M Levich., International Financial Markets: Prices and Policies, Second Edition, (New York: 1991).

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This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

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Exhibit 1 Government Budget Surpluses (billions of Singapore dollars)

0

5

10

15

20

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

0%

5%

10%

15%

20%

Budget Surplus % of GDP

Source: Monetary Authority of Singapore and casewriter calculations.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Exhibit 2 Gross National Savings Rate, Singapore (as % of GDP)

0%

10%

20%

30%

40%

50%

60%

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001

Source: Monetary Authority of Singapore.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

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Exhibit 3 Foreign Reserves (billions of Singapore dollars)

0

30

60

90

120

150

180

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

0%

20%

40%

60%

80%

100%

120%

Foreign Currency Reserves % of GDP

Source: Monetary Authority of Singapore and casewriter calculations.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

17

Exhibit 4 MAS Organizational Chart

Corporate Services

Human Resources

Information Technology

Finance

Securities & Futures

Banking

Insurance

Risk & Technology

Supervisory Policy

Supervisory Legal Services

Reserve Management

Monetary Management

Economics

International Relations

Corporate Support Financial Supervision

Internal Audit

Financial Sector Promotion

Monetary Authority of Singapore — Managing Director

Source: Monetary Authority of Singapore, 2001.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

18

Exhibit 5 Inflation in Singapore as Compared to an Index of Industrialized Countries

-2%

0%

2%

4%

6%

8%

10%

12%

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

Singapore Industrial Countries

Source: Created by casewriter based on data from the International Monetary Fund, Bureau of Labor Statistics.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Exhibit 6 Trading Sector Compared to Economy Overall

0%

50%

100%

150%

200%

250%

1965 1970 1975 1980 1985 1990 1995 2000

Exports as % of GDP Imports as % of GDP

Source: Monetary Authority of Singapore, 2001.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

20

Exhibit 7a Real and Nominal Exchange Rate, Singapore Dollar vs. U.S. Dollar

50

100

150

200

250

300

350

400

1965 1970 1975 1980 1985 1990 1995 2000

Nominal Exchange Rate

Real Exchange Rate

Indexed Value

Source: Created by casewriter based on data from the International Monetary Fund, Bureau of Labor Statistics.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Exhibit 7b Treasury Bill Rate, Singapore and the United States (3-month rate)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Singapore United States

Source: Created by casewriter based on data from the International Monetary Fund, Bureau of Labor Statistics.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

22

Exhibit 8a Exchange Rates Against Currencies of Major Trading Partners

0

100

200

300

400

500

600

700

800

900

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

USA JPN DEU GBR MYS THA HKG KOR TAI CHN

Source: Monetary Authority of Singapore, crossed rates based on data from the International Monetary Fund, International Financial Statistics.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Exhibit 8b Trade Volumes with Respect to Major Trading Partners

Country (billions of US$)

Singapore Exports to Country, 1998

Singapore Imports from Country, 1998

China 5.0 3.8

Germany 3.5 3.1

Hong Kong 8.9 4.3

Japan 7.0 16.0

Malaysia 15.2 13.8

South Korea 2.6 4.2

Taiwan 4.9 4.0

Thailand 4.3 4.9

United Kingdom 4.1 2.8

United States 22.0 17.0

Total 77.5 73.9

Source: Created by casewriter based on United Nations bilateral trade data available through Statistics Canada.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

204-037 Exchange Rate Policy at the Monetary Authority of Singapore

24

Exhibit 9 Issuance of Singapore Dollar Denominated Bonds by Non-Singaporean Companies (millions of U.S. dollars)

1 1 1 1

1

22

24

25

0

300

600

900

1,200

1,500

1,800

1982 1986 1987 1993 1998 1999 2000 2001

Aggregate Value (Number of Deals)

Source: Thomson Financial Securities Data.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

Exchange Rate Policy at the Monetary Authority of Singapore 204-037

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Exhibit 10 Real Exchange Rate Evolution, Hong Kong vs. Singapore

Panel 1: Real Exchange Rates (vs. U.S. dollar)

50

70

90

110

130

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Singapore Dollar

Hong Kong Dollar

Indexed Value

Panel 2: Inflation

-5%

0%

5%

10%

15%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Singapore

Hong Kong

Panel 3: Money supply

0

5

10

15

20

25

30

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Singapore

Hong Kong

Billions of USD

Source: Created by casewriter based on data from the International Monetary Fund, Bureau of Labor Statistics.

For the exclusive use of M. Chen, 2021.

This document is authorized for use only by Meng Chen in FIN557 International Finance – Spring 2021 taught by ROBERT GROSS, DePaul University from Mar 2021 to Jun 2021.

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