MAS(Final)

8/13/2019 MAS(Final)

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INDIAN INSTITUTE OF MANAGEMENT

LUCKNOW

Exchange Rate Pol icy at Monetary Author i ty at Singapore

Submitted to

Prof. T. Srivinas an

Submitted by:

IPMX04 - Group 6

Ajay Sharma-IPMX04004

Amit Kumar- IPMX04005

Ashish Singh-IPMX04014


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Exchange Rate Policy at the Monetary Authority of Singapore

Contents1. Introduction ................................................................................................................................ 3

2. MAS' Mission ............................................................................................................................... 3

3. MAS' Objectives .......................................................................................................................... 3

4. Economic Scenario of Singapore ................................................................................................. 3

5. MAS Responsibilities ................................................................................................................... 3

6. MAS Policy Procedure ................................................................................................................. 4

7. Drivers for Monetary Policy ........................................................................................................ 5

8. Exchange Rate Management Policy: Band- Basket Crawl ........................................................... 5

9. 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


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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 financialservices 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' MissionMAS 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 reservesand the issuance of government securities;

To supervise the banking, insurance, securities and futures industries, and develop strategiesin 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 unemploymentb.) Promote industrializationc.) 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, madethe 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 ResponsibilitiesA few of major responsibilities of MAS are:


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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 capitalrequirements 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.


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7. Drivers for Monetary Policy

MA S can maintain price stability the using two variables:

a.) Domestic interest rateb.) Maintain exchange rate by appreciating and depreciation the domestic currencyEven 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 lowerbound 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 parityb. Purchasing power parity

Based on model simulations, MAS economists chose target exchange rates to achieve following

goals:

a. Maintain inflation (


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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

Changed economic scenarios:

Asian Financial Crisis of 1997 putting pressure on currencies of East and Southeast Asiacountries.

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.

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 inthe 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, or2. 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 ProvidentFund, thus lowering the effective cost of labor. Also the pay schedules for civilservants were altered.


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

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 anddecline 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 policymakingalso 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 Hong Kong

Exchange rate regime Monetary Authority ofSingapore

Currency board

Exchange rate regime Managed float

(Band-Basket Crawl)

Pegged against US$ $ (1 US$=

HK$7.8

Inflation outcome Higher average Lower average growth

Output gap Slower adjustment to mean;

Std deviation 0.015

Faster adjustment to mean;

Std deviation of 0.015

Interest rate 1.7% from 1981-2001

Lower than US rate

5.2% from 1981-2001

Close to US rate

Unemployment Lower (1981-2004) Higher(1981-2004)


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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 promotingglobal 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 needed3. Requires economic discipline

Disadvantages of a fixed exchange rate system is that:

1. No Flexibility: no independent monetary policy2. 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 arefed 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 goodsbecome uncompetitive as compared with comparable products elsewhere.

6. A central bank is forced to intervene in order to keep the rate fixed. These currencymanipulations 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.


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Flexible Exchange Rate

Floating exchange rate regimes are market determined exchange rates in whichvalue 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 suchas 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 shocks4. 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 lossesoccur.

The disadvantages of floating rate system are:

1. It creates uncertainty for importers and exporters when it comes to planning forfuture 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. Fundamentalovervaluation (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 unemployment2. Promote industrialization3. 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 exchangerates, prices.


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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 inturn make the imports costly fueling inflation further.


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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 FirmsExchange rate impacts international firm by exposing it to currency risk.

If firm is in exportbusiness, 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 importbusiness, local currency depreciation will make the import expensive. Thiswill 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 FirmsIf 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, businessesprocess to lower product cost.

Firms may move up the value chain to have products with higher product margin, inwhich case it can absorb adverse shocks of currency fluctuations.


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References

MAS(Final)

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