Apr 19 2010
Bouncing back to inflation, and managed exchange rates in Singapore.
Published by Andrew McCarthy at 5:20 pm under Exchange Rates,Foreign exchange markets,Inflation,Monetary Policy,Uncategorized
As the Singapore economy rebounded spectacularly this week ,the government moved to limit inflationary pressures. This was after year-on-year economic growth reached 13.1% in the first quarter of 2010. This strong performance was related to the increased demand for electronic components and growth in the pharmaceutical industry.
The Singapore government operates a managed exchange rate regime. The Singapore dollar is pegged to a trade-weighted index of five currencies. The exact make-up of the index is kept secret, but the rate is allowed to fluctuate within a four percent target range. This ambiguity leads to less speculation by currency traders, and what is known as a basket, band and crawl method of currency management. Overtime, this has allowed the government to steadily appreciate the currency as demand for exports surged. Since 1980’s the value of the Singapore dollar versus the US Dollar has appreciated by nearly 80%.
This exchange rate mechanism is also how the government controls the rate of inflation in the small city-state. Because Singapore’s net exports make up over 100% of GDP, a subtle appreciation of the exchange rate leads to less imported inflation and less demand for exports. The effect of a 1.3% appreciation of the currency band this week, is expected to reduce inflationary pressure over the next 12 months.
The approach is something that the Chinese government is maybe looking towards. The Yuan is pegged directly to the US Dollar and has been since mid-2007. China has been able to maintain this peg by selling vast amounts of yuan to purchase US Treasury Bonds, and to thereby create large foreign currency reserves. As widely reported, the Chinese government has been under pressure to appreciate the yuan by anything up to 60% compared to the US dollar. How the government achieves this shift is complicated but may lead to a significant loss of export competitiveness and imported inflation.
However as Wei Gu from Reuters reports,
“This (Singapore) approach is not open to China, whose inflationary pressures are home-grown, and whose exchange rate looks more undervalued. Nevertheless, Beijing can learn from Singapore’s model, which offers a better balance between stability and flexibility”
Of course, there are huge differences between a city-state and the world’s third-largest economy. Singapore, whose foreign trade is three times its GDP, has to allow enough freedom in its exchange rate to achieve domestic price stability. China, where foreign trade accounts for 50 percent of GDP, that incentive is much smaller.
Moreover, China could not adopt Singapore’s approach without a one-time appreciation in its currency. Otherwise it would be hard to create a two-way trade: China currently restricts the yuan’s movement against the dollar to just 0.5 percent every day. Nevertheless, as China considers making its exchange rate more flexible without abandoning stability, the Singaporean model is worth studying.”
Discussion Questions:
- What are the advantages and disadvantages of a floating exchange rate?
- What are the advantages and disadvantages of a fixed exchange rate?
- What is the common tool used by many governments to control inflation. Why can’t all countries use the Singapore approach?
- Can a country use both Monetary Policy and a managed exchange rate to control inflation? Do trade-offs exist?
- Evaluate the effects on the Chinese economy of an appreciation of the yuan.
About the author: Andrew is an International School educator based in Singapore, who specialises in teaching Economics and leading change in a 1:1 Apple laptop environment. He enjoys teaching the International Baccalaureate curriculum and has taught the Diploma Economics course to both Higher and Standard Level students. Previously Andrew taught in New Zealand as a Geography and Economics teacher and eLearning coach. He is an adventurous New Zealander, who enjoys running, travelling and spending time with friends and family.
Andrew is currently the head of Educational Technology at the United World College of Southeast Asia. Read more posts by this authorRelated posts:
- How do changing interest rates affect exchange rates? The example of the RMB
- Exchange rates, currency manipulations, and the balance of trade
- Exchange rates and trade: a delicate balancing act, currently out of balance!
- Another question from the Help Desk: Relative price levels as a determinant of exchange rates
- Will the Fed’s easy money policy fuel global inflation?
By managing their exchange rates Singapore ended up moving into inflation. Most governments don't use this way, but instead try to lowere them by their own intervention. Singapore's way represents a way that can be easier to bring an economy into inflation. They allowed the currency to appreciate and the demand for exports slowly moved up which caused the price level to increase.
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A fixed exchange rate allows buyers and sellers to agree on a set price that remains unchanged and with this they have a built-in incentive not to follow inflationary policies. Disadvantages are that the inflation rate may rise in relation to that country and this creates less competition. The effects on China with an appreciation of their currency would have more of a negative effect on the economy than as with Singapore. China already has a well established economy and as stated above trade counts for only 50 percent of their GDP which is much less an incentive than Singapore's foreign trade that is three times its GDP.
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@Angela:
NO. Appreciation of Singapore dollar makes:
(1) Singaporean goods more expensive for exports, resulting in fall in exports. As a result, Singapore's aggregate demand falls, and economic output decreases as well.
(2) Imports cheaper for Singaporeans, resulting in increasing their purchasing power. Since food inflation is a prominent factor in price-level inflation of Singapore, this reduces inflation in the country.
So, of course, MAS has got to give priority over either economic output or inflation. Seeing the increase in food prices in 2007, MAS had improved Singapore's exchange rate. It can also use that whenever it feels the effects of "overheating" — high output with high inflation.
Empirically, it appears that this model has worked well for Singapore.
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