Effective Exchange Rates: A New Measurement

One of the problems with measuring the “correct” value of exchange rates is that we’re talking about a relative price against a whole bunch of other relative prices. For example, though the most often quoted exchange rate (and the one with the highest turnover) the world over is against the USD, this is really a remnant from the Bretton Woods era and is more customary rather than economic – Malaysia’s direct trade with the US is somewhat less than 12%.

One way around this is to calculate “effective” exchange rates, which is a weighted average exchange rate typically using the value of trade as a weighting scheme. For the MYR, the current weights would be about 14% for the SGD and CNY, 13% for the JPY, 12% for the USD and about 11% for the EUR. Those five currencies alone denominate two-thirds of Malaysia’s trade, even if invoicing and settlement are primarily in USD.

However, this approach has a problem when you’re comparing exchange rates. There’s an underlying assumption that goods traded between each country are “independent” or unique, i.e. that they are produced fully in each of the trading countries. In practice of course, this is not true – many goods are inputs into other goods. For example, PCBs from Singapore, memory chips from Korea, processors from Malaysia and the Philippines, designs from the US, all go into laptops assembled in China. Something like two-thirds of Malaysia’s imports are intermediate goods, goods that are used as inputs into final products or into other intermediate goods.

Zeti Says: No Sudden Moves

On Bloomberg today:

Malaysia’s Zeti Doesn’t Want ‘Sudden’ Currency Moves

Oct. 27 (Bloomberg) -- Malaysian central bank Governor Zeti Akhtar Aziz said she doesn’t want to see sudden currency moves and expressed concern that global policy makers may rely too much on exchange-rate changes to deliver sustainable growth…

…Bank Negara Malaysia should watch the ringgit’s “underlying trend” and wants gradual moves, Zeti said. Malaysia’s currency reached a 13-year high this month.

Currency Wars Part IV

Tun Dr Mahathir fires a shot, with his usual candour:

THE CURRENCY WAR

1. Malaysians, including Malaysian monetary authorities seem quite happy over the appreciation of the Ringgit against the US Dollar. We think that when our currency strengthens it must be because our economy is strong. Therefore we are doing well.

2. But are we doing well? Is it the Ringgit which is appreciating or is it the US Dollar which is devaluing?

3. Actually it is the US Dollar which is devaluing. It is devaluing against most other currencies, especially against China's currency.

2Q 2010 Exchange Rates Review

I haven’t done one of these in a while (in fact, very nearly a year), and there’s been a lot of movement on the Ringgit front in the meantime, even if the controversies over its valuation have somewhat died down.

I thought a few months back that the Ringgit’s appreciation would be contained over the near term, and so it has (index numbers; 2000=100):

On a real trade-weighted basis, the MYR is almost back to its pre-crisis heights, and it’s remained there for the last three months. But that recovery hides an awful lot of extreme volatility in the underlying exchange rates with our major trade partners.

Research Roundup

Highlighting some interesting research that I’ve come across recently, and worth a read (excerpts/abstracts):

1. Dealing with Volatile Capital Flows - “How have emerging-market countries dealt with capital flow volatility in the current crisis? What is the appropriate level of reserves for emerging-market countries? How can international crisis-lending and liquidity-provision arrangements be improved? What role can financial regulation and capital controls play in dealing with volatile capital flows? Olivier Jeanne discusses these and other important questions that are useful to keep in mind when thinking about the reform of international liquidity provision for emerging-market countries to deal with volatile capital flows.”
   
   I’ve talked about the dangers of unregulated capital flows before (here and more extensively here), and this new article just reinforces my view that open capital accounts aren’t necessarily beneficial for economic development.
   
   Jeanne, Olivier, "Dealing with Volatile Capital Flows", Peterson Institute for International Economics, Policy Brief 10-18, July 2010
   
   
2. Estimates of Fundamental Equilibrium Exchange Rates, May 2010 - "The fundamental question explored is what pattern of exchange rates is consistent with satisfactory medium-term evolution of the world economy, interpreted as achieving those objectives while maintaining internal balance in each country...The big disequilibrium in the pattern of exchange rates remains the undervaluation of the renminbi and the overvaluation of the dollar. The size of this disequilibrium is, however, less than previously estimated (now 15 percent on an effective basis and 24 percent bilaterally with respect to the dollar), due to the decline in the IMF's estimate of China's prospective current account surplus."
   
   Cline and Williamson update their estimates of the real effective exchange rate against the USD for a range of countries, and find some pretty significant changes from last year. Their methodology suggests that the MYR should be at RM2.52 to the USD, up from 2.63 last year. I covered their previous research, and what I think is wrong with it, here. Read this post for an alternative view.
   
   Cline, William R., and John Williamson, "Estimates of Fundamental Equilibrium Exchange Rates, May 2010", Peterson Institute for International Economics, Policy Brief 10-15, June 2010
   
   
3. Do Consumer Price Subsidies Really Improve Nutrition? - Many developing countries use food-price subsidies or price controls to improve the nutrition of the poor. However, subsidizing goods on which households spend a high proportion of their budget can create large wealth effects. Consumers may then substitute towards foods with higher non-nutritional attributes (e.g., taste), but lower nutritional content per unit of currency, weakening or perhaps even reversing the intended impact of the subsidy. We analyze data from a randomized program of large price subsidies for poor households in two provinces of China and find no evidence that the subsidies improved nutrition. In fact, it may have had a negative impact for some households.
   
   Another example of subsidies and market distortions creating perverse incentives, though with a different approach (and implications) than that which I tried to show.
   
   Jensen, Robert T., and Nolan H. Miller, "Do Consumer Price Subsidies Really Improve Nutrition?", NBER Working Paper No. 16102, June 2010
   
   
4. Calling Recessions in Real Time - "This paper surveys efforts to automate the dating of business cycle turning points. Doing this on a real time, out-of-sample basis is a bigger challenge than many academics might presume due to factors such as data revisions and changes in economic relationships over time. The paper stresses the value of both simulated real-time analysis-- looking at what the inference of a proposed model would have been using data as they were actually released at the time-- and actual real-time analysis, in which a researcher stakes his or her reputation on publicly using the model to generate out-of-sample, real-time predictions. The immediate publication capabilities of the internet make the latter a realistic option for researchers today, and many are taking advantage of it. The paper reviews a number of approaches to dating business cycle turning points and emphasizes the fundamental trade-off between parsimony-- trying to keep the model as simple and robust as possible-- and making full use of available information. Different approaches have different advantages, and the paper concludes that there may be gains from combining the best features of several different approaches."
   
   Prof Hamilton is one of the two bloggers behind Econbrowser, which is one of my favourite reads. And he isn’t afraid to put his research to the test either – you can find his recession indicator index on the Econbrowser frontpage, complete with emoticon (details here and here).
   
   James D. Hamilton, "Calling Recessions in Real Time", NBER Working Paper No. 16162, July 2010
   
   
5. Moving Holiday Effects Adjustment for Malaysian Economic Time Series - The dates of holidays such as Eid-ul Fitr, Eid-ul Adha, Chinese New Year and Deepavali vary from one year to the next and non-fixed date can affect time series data. The moving holidays need to be taken into consideration in the seasonal adjustment process to avoid misleading interpretations on the seasonally adjusted and trend estimates. Hence, by removing the moving holiday effect, the important features of economic series, such as the turning points can be easily identified. Seasonally adjusted data also allows meaningful comparisons to be made over a shorter time frame and it also reflects real economic movements. Currently, there are various methods applied for seasonal adjustment such as the X-12 ARIMA. However, these methods can only be used to adjust for the North American Easter effect and there is no such method which can deal with holiday effects in Malaysia such as Eid-ul Fitr, Eid-ul Adha, Chinese New Year and Deepavali. Due to these limitations, this paper proposes a procedure for seasonal adjustment of moving holiday effects in Malaysian economic time series data called SEAM (Seasonal Adjustment for Malaysia). The procedure involves estimating the irregular components using the X-12 ARIMA program and subsequently removing the moving holiday effects using a regression method. Three types of regressors namely, REG1 (using one weight variable), REG2 (using two weight variables) and REG3 (using three weight variables) are proposed in this study to measure the Eid-ul Fitr, Chinese New Year and Deepavali effects. Overall, it is found that SEAM is an effective method in removing the Malaysian moving holiday effects.
   
   Data in most advanced economies is seasonally adjusted i.e. smoothened to take out seasonal effects from holidays, structural peaks and troughs in consumption and production (and thus demand and supply), and other "regular" shocks to data. But Malaysian data is not seasonally adjusted, which is a failing I've tried to remedy in part through this blog. While doing some research on the subject, I stumbled on this paper, which explains how to account for Malaysian specific holidays that aren't included in standard statistical seasonal adjustment programs – since these holidays aren’t specific to any date in the standard Georgian calendar, you can introduce bias into seasonally adjusted series. The procedure outlined isn't earth-shatteringly new from my reading, but since it is known and available, I'm somewhat nonplussed that DOS still hasn't applied seasonal adjustment to Malaysian data. So what about it, DOS?
   
   Update: Hah! Seems I spoke too soon. I just checked the revised external trade data for May which has just come out on the DOS website, and Table 17 includes seasonally adjusted data for exports and imports. I await with bated breath for seasonal adjustment to be applied to the rest of Malaysian time series.
   
   Norhayati Shuja, Mohd Alias Lazim and Yap Bee Wah, "Moving Holiday Effects Adjustment for Malaysian Economic Time Series", Journal of the Department of Statistics Malaysia, Volume 1 2007 (Warning: pdf link)

2009 International Investment Position

The Department of Statistics last week issued Malaysia’s IIP report for 2009, which shows the level of Malaysian ownership of foreign assets matched against foreign ownership of Malaysian-domiciled assets. If you want a simpler business-type analogy, the balance of payments is our external cash flow report while the IIP is our external balance sheet report.

I’ve noted before that Malaysia has become a net creditor nation in 2008 – we own more foreign assets than foreigners own our assets – and for the first time since independence. The 2009 data more than confirms this trend (RM millions):

We’re now RM120 billion to the good, compared with around negative RM140 billion in the early part of this decade, and worlds away from the more than RM700 billion in the red in 1986 (source: see note 2).

Now whether this is good or bad depends on your point of view. The rapid increase in foreign asset accumulation in the last 5-6 years has largely been driven by direct investment (and reinvestment of earnings) abroad by Malaysian companies (RM millions):

…compared with relative stability in foreign accumulation of Malaysian assets (RM millions):

…apart from portfolio capital which remains highly volatile (RM millions):

 

The problem here is that Malaysian companies are investing abroad corporate savings that might have been invested domestically – one reason why private investment growth has been so poor since the 1997-98 crisis, and why we have not been able to match the growth rates in GDP that we saw pre-1997. The outflow of funds (we’re talking about half a trillion Ringgit over the last ten years) has also played a role in dampening appreciation of the Ringgit.

The flip side of this is of course, that our income account in the balance of payments is going to improve over time as investments (hopefully) bear fruit – a source of foreign exchange which will be non-trade related, and thus reduce our external vulnerability.

One further side effect of this is that it reduces the incentive for massive accumulation of foreign exchange as an insurance policy against capital outflows, which can be expensive. Luckily, BNM has more or less ceased forex intervention (with some notable exceptions) since the float of the Ringgit in 2005, but there are still structural factors which will inhibit reducing our reserves over the short run – liquidity of foreign portfolio assets for starters, as well as the relatively higher proportion of foreign ownership of Malaysian equities and debt.

But this development does mean that one of the underpinnings of the Ringgit’s valuation is long term positive.

Technical Notes:

1. 2009 International Investment Position from the Department of Statistics
2. Lane, Philip R. & Milesi-Ferretti, Gian Maria, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004”, International Monetary Fund Working Paper 06/69, March 2006

Exchange Rate Valuation

Menzie Chinn (Professor of Public Affairs and Economics at the University of Wisconsin, Madison) has a nice roundup of exchange rate valuation approaches, with the pros and cons of each. Worth a read if you’re interested in the subject (as I am).

Goldman Sachs Thinks The Yuan Is Overvalued. Wow.

"Goldman Sachs Says Buy ‘Overvalued’ BRIC Currencies"

This is completely against the grain – but from the brief description that was given, it appears Goldman is using a long-term valuation model. And when I say long term, I mean it in the strictest academic sense – a pure equilibrium stock model (no flows).

Currencies and Current Account Adjustments Part II

I did a post about six months ago on an article in VoxEU (link) that evaluated exchange rate imbalances between the USD and Asian currencies, which suggested that the MYR was as much as 1/3 too low against the USD. I criticised the paper on both methodological and procedural grounds.

Now another article on VoxEU is also basically challenging the findings of that article (excerpts):

On the renminbi and economic convergence

“Many economists agree that the build-up and maintenance of international imbalances, with their accompanying capital flows, contributed to the overleveraging of finance and underpricing of risk. How to rebalance then? Many observers are increasingly emphasising that China should let its exchange rate appreciate.

For example, Cline and Williamson (2009) have recently estimated “fundamental equilibrium exchange rates” compatible with moderating external imbalances. They estimate that the required renminbi appreciation is more than 20% in real effective terms and 40% relative to the dollar. Ferguson and Schularick (2009) point to the manufacturing wage unit-costs to estimate the degree of undervaluation of the renminbi relative to the dollar and come up with the figure of 30% and 50%. Finally, the Bank of China’s continuous intervention in the foreign exchange market also suggests that the renminbi would appreciate significantly if let loose; this intervention has accumulated $2.3 trillion of foreign exchange reserves.

…

To be sure, poor-country currencies are normally undervalued in terms of purchasing power parity with rich countries. In fact, poorer countries do have undervalued exchange rates (due to the Balassa-Samuelson effect), and convergence will imply considerable correction of that undervaluation. Services (and wages) are cheap in poor countries and expensive in rich countries, while prices for internationally traded goods are roughly equalised in a common currency. When the productivity in traded goods rises (while productivity growth for haircuts and other services are very limited), more income is generated and spent on services. The price ratio of non-traded to traded goods will rise. In other words, the real exchange rate will appreciate. Hence, part of the undervaluation ascribed to China’s and other currencies results from market forces that make non-traded goods relatively cheap in poor countries, rather than from deliberate currency manipulation by China’s authorities.

While growing and converging fast, China is still poor. Its per capita income in 2008 was 6.2% of the US’s at market rates and 12.8% at PPP-adjusted rates, according to World Development Indicator data. Figure 1 relates the log of real per capita GDP as a fraction of the US level and the deviations of current market exchange rates per US dollar from PPP rates for the year 2008. It shows strong support for the Balassa-Samuelson effect and suggests a well-determined elasticity (0.2) by which the undervaluation of the currency will be eroded during the catch-up toward the US per capita income level. Real exchange rates can thus be expected to appreciate as economies grow, approaching PPP exchange rates as economies converge with US living standards, as posited by the Balassa-Samuelson effect.

Figure 1. Income convergence and exchange rates appreciation

To gauge a converging country’s degree of undervaluation, the appropriate yardstick cannot be purchasing power parity; it should rather be the regression (over 145 countries) that provides the best fit for the Balassa-Samuelson effect. While the renminbi was undervalued by 60% in PPP terms, it was merely undervalued by 12%, if the regression fitted value for China’s per capita income level is compared to the current value in 2008. Note that India and South Africa (which had a current account deficit) were more undervalued than China by that Balassa-Samuelson benchmark, by 16% and 20%, respectively, in 2008. The currencies of Brazil and Russia were appropriately valued, i.e. close to the regression line.”

My kind of guy! Have a read through - there's some interesting policy conclusions as well.

Want An Independent Assessment Of The Malaysian Economy? Try The IMF

I stumbled across the IMF’s latest country report on Malaysia the other day while culling my email. Article IV consultations are conducted with all IMF member states on a regular basis – read this article on the background of IMF surveillance. A summary of the report is available here, if you don’t want to wade through the entire 60-page report.

Interesting reading even if its a bit dated, particularly in the differences in assessing policy between IMF and Malaysian authorities (Treasury and BNM). I’d particular point out pages 15-23, which covers future policy paths (liberalisation, private investment, reducing oil revenue dependency, abolishing subsidies, and fiscal consolidation), and a very interesting box article on page 21 which assesses BNM’s exchange rate intervention post-2005 (summary: it was two-sided, and not intended to force a particular exchange rate level).

Also of interest is a projection of the public sector debt path from pages 3-5 of the Informational Annexe (72% of GDP by 2014).

Not surprisingly, the biggest area of disagreement is on the level of the exchange rate. With the IMF’s three-prong statistical methodology, the Ringgit is considered undervalued though not extremely so, but the policy approach was “broadly appropriate”. Malaysia’s rebuttal is on pages 35-36, which is echoed by the IMF executive director for Malaysia’s statement at the end of the document (pgs 6-7). Here’s an interesting, and highly pertinent, quote from the latter:

“Secondly, while the current account surplus is sizeable, Malaysia is a commodity producer.  Over two-thirds of the current account surplus can be attributed to commodities including oil.  It is fundamentally inappropriate to apply the 3-model CGER estimations when an economy is a significant producer of non-renewable resources.  A Fund working paper by Thomas, Kim and Aslam (2008) estimated that by applying an alternative methodology for assessing the external balance in countries with large stocks of non-renewable resources, the non-oil current account position for Malaysia was in fact in equilibrium, as oil resources can be expected to be depleted in the future.  Our authorities would also welcome accelerated work on the commodity-based CGER approaches that we understand is being undertaken at the Fund. “

Technical Notes:

“Malaysia: 2009 Article IV Consultation - Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Malaysia”, International Monetary Fund, August 2009

Big Mac Index Yet Again

Someone else responded to Mr Gunasegaram's article and thinks a "strong" currency is not a good idea:

"First of all, I believe this is a crazy and short-sighted idea. It likely leads to a recession. When our currency is strong, everything we import seems to be at a discount and this encourages people to spend more on foreign goods and services through imports.

Strong currency also discourages our usual foreign trade partners to buy goods from us, thus export value will drop.

It also causes a country to lose its competitive advantage in attracting foreign investments.

At a time when inflow of money is significantly less than outflow, a serious current account deficit occurs in a broader sense. Malaysia will then be in deep trouble, after a short period of delusive wealth."

...and...

"If the ringgit were to be strengthen to a level of one for one US dollar, I would say good luck to everyone in Malaysia, welcome to the “burgernomics club”.

We will be staring with mouths watering at the Big Mac burger with an attractive price of RM3.54 in Malaysia just to find that our wallet is empty. And conveniently, if you want some money, IMF out there is willingly to lend you plenty.

There is no free lunch. Permanent and sustainable wealth does not come from currency rate delusion."

He's a bit less polite than I was though.

Ye Gods, Not Again: The Big Mac Index And The Ringgit

What is it about The Star and a "weak" Ringgit?

I thought I'd done with the Ringgit for a while, but P Gunasegaram repeats that tired old mantra that Purchasing Power Parity is a valid theory, again quoting The Economist magazine's Big Mac Index. I've covered the weaknesses of the BMI here and here, and I'm not about to go into that again except to note that PPP as a guide to currency value is at best a hypothesis, not a theory. A theory requires that the underlying hypothesis is supported by empirical data, which conspicuously is lacking for PPP.

Mr Gunasegaram also repeats that other tired mantra that an increase in reserves indicates a de facto attempt to devalue the currency. Again, this is not necessarily true as it completely ignores the potential impact of trade and capital flows on the domestic monetary aggregates (and thus inflation), which would necessitate central bank intervention. Since this intervention is functionally equivalent to currency intervention, what looks like an attempt to weaken the currency is actually something quite different.

We're also ignoring recent history here. Here's the log annual change in reserves and the MYRUSD exchange rate (where a negative change indicates appreciation) since 2000:



Two things to note here - first during the fixed rate period, reserve accumulation was volatile. If PPP was in fact operative and the Ringgit is substantially undervalued against the USD then reserve accumulation according to Mr Gunasegaram's hypothesis should have been consistently positive - it was not.

Second during the floating rate period, reserve accumulation had the opposite sign to what his hypothesis suggests. In other words, reserves increased when the Ringgit appreciated, and decreased when the Ringgit depreciated. That's a rather big hole in the "weak" currency meme, but is consistent with BNM's stated policy of ameliorating currency volatility (and not aiming for a target level) when necessary.

If BNM was intervening to create a "weak" Ringgit, then there would be no call to intervene when the Ringgit started weakening last year - which in fact actually happened. And the intervention conducted was more a factor of demand for USD (a response to domestic monetary conditions), rather than to achieve some target rate for the exchange rate.

You can find my extended critique of the "weak" currency meme here and especially here.

On another note, while a "strong" currency policy would indeed have the effect of increasing de facto individual incomes, there's an underlying assumption that nothing else will change. I roughly calculated trade elasticities with respect to the exchange rate in an earlier post - a 1% appreciation in the exchange rate resulted in approximately a 1.55% to 1.57% drop in exports.

Think about that for a minute - if my estimates are correct (and to be fair I'm not all that certain), since the drop in exports exceeds the rise in the exchange rate that implies a drop in export volumes. Since volumes will drop and there is no endogenous change in the supply for labour in the tradables sector, you'll get your higher income at the cost of higher unemployment (and since we're talking about low-cost production, also higher income inequality).

Let's just say I don't think pushing for a "strong", as opposed to a fairly valued exchange rate, is a good policy.

Technical Notes:
1. Data for reserves and MYRUSD exchange rate from BNM's Monthly Statistical Bulletin.

Strong Vs Weak Ringgit Again

Izwan Idris asks if we should have a stronger Ringgit:

"One theory why the ringgit is limping behind its regional peers is that the ringgit basket is US dollar-heavy.

This explains why the currency continues to track the US dollar movement closely under the current 'managed float' system, rather than reflecting Malaysia’s own economic health.

Typically, a weak ringgit, in a way, works as a subsidy for local exporters by way of keeping export prices “competitive” against manufacturers based in other countries. This strategy helps local manufacturers earn more ringgit for every dollar sold but, on the flip side, Malaysians will have to pay more in ringgit for imported goods and services."

There are so many problems with this post I don't even know where to begin (and I'm not even going to comment on the grammar and tense usage mistakes).

So from the top (my comments in blue for legibility):

1. "The ringgit was officially de-pegged against the US dollar from a fixed rate of 3.80 on July 21, 2005 and, like the Singapore dollar, is currently under a float system tied to a basket of currencies."

Plain wrong. MAS follow an explicit exchange rate policy with interest rates and money supply free to vary (within limits), so that part is correct. BNM focuses on short term interest rates (the Official Policy Rate or OPR), with the exchange rate and money supply free to vary within limits in terms of volatility - so that part is false.

Fail.

2. "Economists estimate that the United States accounts for about 20% of Malaysia’s total trade, but as much of 80% of the country’s foreign transactions are denominated in US dollar."

I'll concede the latter statement (in the absence of firm evidence), but the former needs to be substantiated. Malaysia's direct trade with the US was last at 20% of total trade 10 years ago (the peak was 20.9% in 1998). As of last year, the US trade share has fallen to 11.8% - behind Singapore and approximately on par with Japan and China.

Big fail.

3. "One theory why the ringgit is limping behind its regional peers is that the ringgit basket is US dollar-heavy.

This explains why the currency continues to track the US dollar movement closely under the current “managed float” system, rather than reflecting Malaysia’s own economic health."

This is not a theory - it's a hypothesis, and an easily disproved one at that. First, as I pointed out in point 1. above, officially the Ringgit is in a free-float system, with the policy focus on interest rates rather than the exchange rate.

Second, if the Ringgit is truly tracking the USD then from a statistical perspective the MYRUSD rate should have a smaller standard deviation compared to other MYR cross rates. Out of the currencies of our major trading partners (sample 2005:6 to 2009:9, daily frequencies), the USD only ranks a distant third behind EUR and SGD, and only very marginally in front of CAD, GBP and SWF. Hardly conclusive evidence that we have a de facto peg to a USD-heavy basket.

Looking at the period when BNM was actively managing the exchange rate back in the 1980s bears this result out. For the sample 1980:1 to 1989:12 (again, daily frequencies), the USDMYR standard deviation was far and away the lowest by a couple of orders of magnitude, followed distantly by CAD and GBP, and even more distantly by the SGD, AUD, and ECU.

[Edit]: I should also point out that current MYRUSD volatility (as measured by the standard deviation) is 5x greater than it was in the 1980s.

Given relative movements and volatility in currencies against MYR over the past four years, if BNM is using a currency basket to "manage" the Ringgit, it's a very, very strange one.

Again, fail.

4. "The US dollar had fallen 15% against a basket of six major currencies since March, based on the performance of the US dollar index traded in New York. During this period, the won shot up 34% against the US dollar, followed by the rupiah’s 27% appreciation over the same period. The rupee gained 12%, while the Singapore dollar strengthened by 11%.

The ringgit lagged behind with a 10% rise, which was slightly better than the baht’s 9% advance."

This appears to imply (rather disingenuously) that MYR is being deliberately kept weak as regional currencies have advanced more than the MYR. In academic economic circles, this is an example of "data-mining" - selecting the data or the model that best supports your hypothesis or preconceptions, and hang the bigger picture.

To show what I mean, here are the percentage movements in the 2008:9 to 2009:2 timeframe (i.e. from the beginning of the financial meltdown to approximately the lowest point):

a. USD Major Currencies Index = +13.1%
b. KRW = -40.8%
c. IDR = -30.8%
d. INR = -17.6%
e. SGD = -9.1%
f. MYR = -9.2%
g. THB = -5.6%

We have an almost mirror image from the statistics quoted in the article. MYR hasn't gained much in the last six months or so, for the simple reason that it didn't fall as much during the worse of the crisis.

As Benjamin Disraeli was once purported to have said, "There are three kinds of lies: lies, damned lies, and statistics."

Fail.

5. "At near-0% interest, the US dollar is a cheap currency to borrow, but yields almost nothing to keep. Savvy international investors lend money in the United States and use the cash to buy assets elsewhere."

Let's be charitable - I can only think of this (emphasis mine) as a typo. It should be borrow not lend.

6. "Commodities and Asian equities are the big winners. Gold, which is the traditional hedge, is now trading at record high of US$1,065 an ounce.

Indonesian stocks have the highest return in US dollar terms year-to-date. The Jakarta Composite Index rose 84% in its local currency, but shot up 122% if the gains are reflected in US dollar.

At 1,265 points yesterday, the FBM KL Composite’s 48% rise year-to-date was the least among other regional stock indices."

Same as point 4 above - we haven't risen as much, because we didn't lose so much during the depths of the crisis either. Using the same sample period as my currency example (Oct 2008-Feb 2009), the JKSE fell 40.6% during that period and was 54.6% off its all time high. The KLCI by comparison fell just 19.1%, and was 41.3% off its all time high. A more regional comparison also holds - the KLCI was among the better performers in terms of holding its value in the past two years.

Do I sense a pattern here? Fail.

7. "High income equals to high purchasing power. To achieve this, it will require shifting the whole economy away from its current low-cost manufacturing base to a more service-oriented one, which is more or less what Singaporeans had done."

Finally a sensible statement - which unfortunately completely missed the connection between a stronger exchange value and having a services-based, high income economy. The latter begets the former, not the other way around. Singapore has an appreciating currency vis-à-vis Malaysia, because they have a stronger services (non-tradables) sector. There's also the demographic angle: countries with higher youth dependency ratios tend to have "weaker" currencies, and Singapore is "aging" faster than Malaysia is.

Going for a strong currency policy without improvement in the non-tradables sector is a triumph of form over substance.

8. "Keeping the ringgit undervalue against its regional counterpart may be counter-productive in the longer run, as it will only fuel our addiction to cheap exports industries that only attract unskilled foreign labour."

What's truly ironic is that having a "cheap" currency is not necessarily an advantage when you have low-value added export industries (i.e. with high import content), and especially not when a portion of your exports is commodity based. I'll touch on this when I get around to posting on trade elasticities. He made the point earlier when talking about the effect of exchange rates on exports and imports (see quote at the top of this post), but again missed the connection.

But as I've extensively written on before (for instance here, here, and here), I do not believe the Ringgit is substantially undervalued based on Malaysia's economic structure and current fundamentals (like terms of trade, services/exports shares, trade barriers, capital and financial stocks and flows etc). Nor do I believe that there is an implicit policy to keep the MYR undervalued relative to any currency. As far as I'm concerned, MYR is close to its trade-weighted fair value with a bias towards appreciation as the country increasingly shifts towards services as the growth sector.

Technical Notes:
1. MYRUSD exchange rates and MYR cross rates against other currencies derived from the Federal Reserve's Report H.10, except for IDR, where data was sourced from Pacific Exchange Rate Service.

2. Stock market index data from Yahoo! Finance.

Tan Sri Governor's Thoughts On MYR...

...are the same as mine:

"Asked if the ringgit should not be allowed to appreciate too much as economic growth could be affected, she said the current level of the currency actually reflected the country's economic fundamentals.

'I want to emphasise that our export sector has been resilient despite the appreciation of the ringgit,' she said."

Read the rest of her comments here. Regardless of this consistently given message (I've heard this same comment from her quite a few times in the past four years), I don't think any diehards are going to change their position that the Ringgit is undervalued.

I'm still working on the promised post on trade elasticities - or rather, trying to find the time to work on it - but my first impressions were correct.

Yup, my initial work-ups were wrong.

I was looking primarily at the time series properties of exports and imports as they relate to the exchange rate. After a quick run through of the literature, turns out that you should actually do fully-specified export and import demand models. Since that's beyond the scope of this blog, I'm working on reduced-form models (only essential variables, not too many lags). At the moment I'm getting some unexpected results, even by my stubbornly contrarian standards.

What's this to do with exchange rates? It has to do with the second part of her comment, on trade. Stay tuned.

Why The IMF Thinks MYR Is Undervalued

In keeping with the forex theme this week, in my last post I pointed out that Singapore is accumulating international reserves at a faster pace than Malaysia, but yet is considered to have a "strong" currency. Later I linked to research that suggested that SGD was as undervalued as the MYR, while the IMF suggested SGD was only slightly undervalued. Why the divergence in opinion?

There is of course the difference in methodologies used to determine currency misalignments (which I talked about here, here and here). But what I'd like to point out today are two potential issues that may be affecting MYR currency misalignment analysis.

The first issue lies with differences in calculating the real effective exchange rate index (REER) itself which may be to blame. To illustrate, here are my calculated nominal and real indexes, compared with the published IMF calculated indexes:





Notice that the nominal indexes are more or less equivalent, with any differences attributable to the currencies included in the basket as well as changes in the weighting scheme. I calculate my indexes with weights changing on a quarterly basis, while the IMF changes once every five-ten years or so - but doesn't appear to make a significant difference here.

There is however a substantial divergence in the REER indexes, with the IMF REER much higher in 2008 - and thus indicating that the nominal rate is too low, and the exchange rate is undervalued. The main difference between the real and nominal indexes is the application of price deflators in the real index, which are used to adjust currency values based on inflation. For the IMF index, CPI inflation is generally used for most countries except for OECD members, where unit labour costs are substituted.

Since CPI inflation can more readily go negative than unit labour costs (as we've seen this past year), that puts an upward bias into the IMF's REER index in periods of disinflation or deflation, especially with OECD countries taking more than a third of the total weight in the MYR index.

Another issue is one of export structure. Most analysis, including the one I linked to in the last post, use aggregate exports when running regressions (heck, so do I). The problem here is that when there is a commodity bubble, prices might go up without output necessarily increasing to the same degree. For example, palm oil and rubber (log annual changes, export volumes and values):




If the increase represents a transitory change, then the degree of currency adjustment required to rebalance the current account will be inflated - hence current account approaches to exchange rate determination, such as used in the aforementioned paper and in two of the three methodologies used by the IMF, would tend to overstate the equilibrium level of the exchange rate.

As an aside, I made the point in my last post that positive terms of trade shocks would see the income effect dominate, and would not reduce volumes very much. The behaviour of agricultural commodity exports over the past few years is certainly suggestive that my conjecture is worth considering.

Stronger Exchange Rate ≠ Strong Exchange Rate Policy

Jagdev Singh Sidhu over at The Star thinks we should pursue a strong currency policy because:

"A stronger ringgit will force Malaysians, both employees and employers, to be more efficient and that is something the economy needs to do as I feel it is somewhat in an economic mid-life crisis."

He also makes the statement that:

"The current preference of using interest rates to drive economic growth may be due for a re-think in favour of the currency as the lower-than-normal rates in Malaysia since the Asian financial crisis haven’t really worked."

And third:

"A stronger ringgit is no guarantee that the country will be able to make that transition to a high-income economy but there are a couple of examples nearby which we should look at.

Singapore and Taiwan endured short-term pains when they allowed their currencies to appreciate but they did make the adjustment to incorporate more skills and capital in manufacturing processes. The stronger currency was also a boost for the service sector in those countries."

As you can imagine, I’m going to pick a few holes in this argument.

The first statement assumes that the substitution effect dominates the income effect in the terms of trade (the purchasing power of money we receive from exports, relative to what we can buy of imports). In other words, a stronger exhange rate reduces our competitiveness and we have to become more efficient to continue to sell to external markets.

The general consensus and the empirical evidence in the research literature finds just the opposite. In other words, higher terms of trade (which is what you get with a stronger exchange rate) actually increases export revenues more than the loss coming from reduced demand. So there won’t be much impact in terms of forcing Malaysians to “be more efficient”. In fact, given the relative share of primary resources in exports, there’s probably going to be even less incentive to improve productivity.

A second point is that because of our low value-added industries and with multi-nationals involved in exports, strengthening the exchange rate should in fact have only marginal effects on incomes and trade volume because there’s little local currency pass-through. A higher exchange rate not only reduces the local currency value of exports, but at the same time reduces the local currency value of imported inputs. Assuming the exchange rate elasticities are equivalent, then there will be roughly no change in returns to local content.

Third, given the two effects above, it’s not obvious or automatic that a stronger exchange rate would raise labour incomes in the export sector. Because the income effect dominates, trade volumes will change very little in the manufactured sector, so demand for labour will not change much or at all – which means whatever excess returns are generated from a higher exchange rate will benefit owners of capital, not labour. This also true to a lesser degree for the primary resources sector, where the ratio of imported inputs (e.g. in CPO) is actually quite high. This is not a recipe for raising domestic income levels.

The second statement is really about the conduct of monetary policy in pursuing price stability and economic growth, with the priority on the former as it is also a precondition for the latter. The choices a central bank can make here are setting the monetary base (money supply targeting), setting the price of money (interest rate targeting), and setting the relative price of money (exchange rate targeting). More recently, some central banks have experimented with direct inflation targeting with some success, but our statistical capabilities have to be upgraded for that to happen here.

The first option is a proven failure after experimentation in the early 1980s in the US and UK, and gave rise to Goodhart’s Law. The second has had relative success in maintaining price stability over the past twenty years.

The third is only advisable for relatively small economies with high external exposure or for countries with no external credibility, because in essence it means abdication of any influence over domestic monetary conditions. That’s fairly obvious from the experience of both Singapore and Hong Kong, the two countries in East Asia that use exchange-rate targeting – interest rates and monetary aggregates are subject to far more volatility than countries that use interest rate targeting. It’s also interesting to note that Malaysia’s aggregate economic record in the last decade is marginally better than Singapore’s and much better than Hong Kong’s.

Given this weakness, I don’t see any advantages for Malaysia, with its much more diversified economy, to follow this route. Since the first option is also out, that leaves only interest rate, and potentially, inflation targeting as the basis for monetary policy.

Also, from a currency perspective, it’s not the nominal interest rate that matters but the real interest rate differential. While both nominal and real interest rates have been low across the last decade, that’s consistent with the rest of the world (trade-weighted, real interest rate differential):



In fact, it looks remarkably stable to me since 1990. The implication of course is that with interest rate targeting, both the exchange rate and money supply growth would be inherently more volatile, which has indeed been the case:

Growth in Monetary Aggregates (log annual changes)


Nominal and Real Effective Exchange Rate Indexes (2000=100)


On that basis, since 2005 it’s hard to say that BNM has any currency policy at all, apart from occasional intervention to smoothen volatility as happened this past week.

Now, one might argue that the accumulation of foreign exchange reserves in the past 10 years is a sure sign that the currency is weak, and that the central bank is intervening to prevent currency appreciation. That’s only true if you think the standard open-economy model applies. But that makes it hard to reconcile Singapore’s reserve accumulation with their alleged strong currency policy:

Singapore's International Reserves


My critique is that many who take reserve accumulation as proof of a weak currency policy are ignoring the money supply implication of a trade surplus and capital flows, and the potential for financial fragility inherent with a large accumulation of foreign exchange deposits in the banking system (FX deposits are included in both M2 and M3).

On a more practical basis, it also makes sense for banks to sell their excess forex deposits to BNM since you can’t spend or lend those deposits within Malaysia. Hence inflows of foreign exchange raises demand for local currency, which causes interest rates to rise. Since we have an interest rate targeting regime, that requires the central bank to increase liquidity which damps pressure on interest rates, and incidentally involves selling Ringgit in return for foreign exchange.

Rather than a sign of currency intervention, accumulation of reserves then becomes a form of insurance, in short making sure enough foreign exchange is on hand in case of liquidity emergencies, such as occurred late last year when investor flight to quality caused a USD shortage the world over:

Net Official Reserves


Change in Net Official Reserves


The problem is that open market liquidity operations to manage money supply volatility, conducted in foreign exchange, is functional equivalent to foreign exchange rate intervention and vice-versa. You can’t tell the difference, and it is hardly proof that the central bank is taking any particular stance with respect to the currency, as opposed to domestic liquidity.

On the third statement, you can only accept that Singapore and Taiwan have “strong currency policies” if you believe that Purchasing Power Parity applies (PPP). Otherwise, the latest IMF Article IV consultation with Singapore indicates the SGD to be undervalued and other research (this for instance) indicates that both SGD and NTD are as undervalued as the MYR. The equivalent, opposite statement can actually be made about the USD - its highly overvalued and ought to depreciate relative to everybody else. The truth is probably somewhere in the middle.

And if you followed my writings at all, you’ll know that I believe that the causality between the services sector and the exchange rate runs the opposite from what is stated in the article – a stronger services sector creates an appreciation of the currency, not the other way around.

Bottom line? I don’t believe we have a currency policy at all – the preponderance of evidence suggests that BNM is only concerned with currency volatility, not its level or stability. On that basis, the MYR will continue to trade at or close to its short term, time-varying equilibrium (barring intervention) and gently move towards its medium term, fundamentally consistent equilibrium over the medium term (4-5 years) – which at the present time means an appreciation.

That doesn’t mean there won’t be large currency moves, against the USD for instance which has a lot of structural problems. But interference in the exchange rate won’t solve our structural problems – in fact a strong currency policy is more likely to paper over the problems we have than become a force for change. The MYR will get stronger, but as a consequence of a services-based economic growth strategy. As the fundamentals change, so will the equilibrium exchange rate level.

Q3 2009 MYR Exchange Rates Review

I realized a couple of days ago that I hadn’t done an update on the Ringgit for quite some time. As I got started I remembered why – out of all the data I’m tracking, forex is by far the hardest and most complex to manage.

First because (unlike most) my approach goes beyond the USD exchange rate, and second is because I calculate the trade-weighted indexes, the data problems can occasion some hair-pulling. The actual forex and trade data are easy to get even across the fifteen currencies I use in the broad nominal index, but getting timely up-to-date information on price deflators for calculating the inflation adjusted index isn’t.

For instance, Australia (of all people) only publishes quarterly series for their CPI, which requires interpolation to the monthly frequencies I’m using. China on the other hand does publish monthly but only for year-on-year index movements, which means actual monthly inflation is really a matter of guesswork.

Both these countries matter because without more granular info on Australian CPI I can only calculate the real effective (inflation adjusted, trade-weighted) index once a quarter and with a lag of up to two months, and because movement in the Yuan accounts for nearly 15% of the real index. Having inaccuracies in either of these currency cross rates would increase the error rate of the calculated indexes, and incidentally my own peace of mind.

Having said that, there’s been quite a bit of change on the forex front especially over the past month, so a review would be useful. I also took the time to work a bit more on exchange rate elasticities as it relates to trade, and the results are fascinating to say the least – assuming of course, I’m doing this at all correctly. But trade elasticities will have to wait, as this post will be long enough already.

First, the overall view (2000=100):



The MYR has lost quite a bit of ground since the end of 2007, but there are signs things are turning around. My view (which by all accounts isn’t very popular) is that MYR was overvalued at the end of 2007, and the retracement was justified, if a bit overdone. That’s fairly common in currency markets – the overshooting I mean. Right now we’re probably a little (2%-3%) under the short term equilibrium, and just a bit more (4%-5%) under the medium term equilibrium level.

I have to digress here to explain the equilibrium terminology:

1. Short term equilibrium is the market-clearing equilibrium, where demand and supply of currency match. It’s also the equilibrium consistent with relative real interest rates.

2. Medium term equilibrium refers to the equilibrium justified by flow fundamentals – like changes in terms of trade, government spending, GDP and the current account.

3. Long term equilibrium is a stock equilibrium, which is the point the exchange rate is consistent with holdings of both (financial and real) assets and liabilities.

It’s hard to put a time period to any of these definitions, as they differ according to the structure of a country’s economy, its external exposure, and the dynamics of its exchange rate, but generally short-term means 1 year or less, medium term is anywhere up to 4-5 years, and long term any period over that. Of course, any change in economic fundamentals means that any given equilibrium is a moving target – again not a very popular view outside of academia.

But to get back to what’s happening with MYR, here’s MYR movements against the major currencies (2000=100):






Note that the MYR is close to its short-term fair value against both USD and especially EUR, but grossly undervalued against the JPY. I’m interpreting it in this fashion based on the differential between the nominal and real indexes here – the general rule of thumb is that the nominal rate should move towards the real rate. I’m also using the year 2000 as an equilibrium reference point, which believe it or not is the consensus among the studies I’ve seen, including the IMF’s.

The reason for the JPY gap can squarely by blamed on the JPY carry trade, which involves borrowing in JPY and investing in higher yielding currencies (e.g. AUD and NZD). In currency trading terms, that means short JPY and long AUD for instance. One interesting thing going on now is that the carry trade business is increasingly moving to USD (hence the general JPY strengthening trend), so we’re likely to see MYR overshoot above its equilibrium level against the USD – that ought to make all the “weak currency policy” conspiracy theorists happy.

The two other major currencies of importance to MYR are CNY and SGD (2000=100):




These five currencies each have a weight exceeding 10% in my indexes, and collectively form about two-thirds of the movements. The CNY rate is fairly close if a little undervalued, but for SGD, MYR does look more than a little overvalued. That appears to be consistent with recent IMF assessment of the SGD, in that the SGD is undervalued relative to its medium term level.

As for the rest of the currencies in the basket, I won’t post detailed charts unless someone asks for them, except to note that there has been a general trend of appreciation in the MYR particularly against the GBP and Indian Rupee (INR), except for against the AUD which went through a roller-coaster ride over the last year (2000=100):



Again, this has been a function of the carry trade, in which the AUD was one of the main targets. The onset of the financial crisis in August last year caused a sharp pullback in risk taking among international investors, including unwinding of currency positions. That helped boost the JPY, and prompted a selldown of target currencies like the AUD. As normalcy returned, so did the carry trade – hence the recovery in AUD.

I should note here that the INR, IDR (Indonesian Rupiah), PHP (Philippines Peso) and VND (Vietnam Dong) all look overvalued relative to the MYR to me, but that’s consistent with their relatively smaller trade exposure and regulated capital accounts. Unless the latter is opened up, these currencies should keep their elevated status. On the other hand, MYR appears overvalued against both HKD and TWD.

Technical Notes:
1. Forex data from the Pacific Exchange Rate Service.
2. CPI data from DOS, International Labour Organization, Eurostat, Australian Bureau of Statistics, and the General Statistics Office of Vietnam.

Big Macs Again

*Sigh*

The Economist states upfront (with tongue firmly in cheek) that the Big Mac Index is "a lighthearted guide to valuing currencies" and "It is arguably the world's most accurate financial indicator to be based on a fast-food item."

The joke here is that it's the only financial indicator based on a fast food item.

The Star however apparently takes this seriously:

"According to the latest Big Mac Index, arguably the world’s most accurate financial indicator to be based on a popular burger, most Asian currencies are undervalued against the US dollar.

The ringgit is undervalued by 47% against the greenback, which was at the same level as the Thai baht.

Only Hong Kong (52%) and China (49%) were lower than Malaysia and Thailand among Asian countries."

I've ruminated on this subject before, and I'm not inclined to go through it again - but PPP-based exchange rate measures are simply not an empirically valid way to evaluate exchange rate levels or movements.

Burgernomics: Where's The Beef?

I was going to give this article a pass, but I had a little epiphany over the weekend that makes it worthwhile commenting on - not so much the article itself, but rather the example Tan Sri Lin See Yan makes of The Economist's Big Mac Index (here and here for the latest readings).

The Big Mac Index was based on a simple idea: since the Big Mac is relatively homogeneous (same ingredients, and almost the same in terms of other inputs), differences in pricing across countries should illustrate differences in purchasing power, and thus gives a clue as to the relative strength or weakness of exchange rates.

For example, the average USD price of the Big Mac is $3.57 while the average EUR price is €3.31 as at July 13th, which gives an implied USDEUR exchange rate of USD1.08. Comparing this to the actual USDEUR exchange rate of USD1.39, according to this measure the EUR is 29% overvalued against the USD.

If we take Malaysia as an example instead, with a local price of RM6.77 we get an implied-PPP exchange rate of RM1.896 compared to the actual of RM3.60, giving an undervaluation of 47%. If you look at most East Asian countries, you'll find a greater or lesser degree of undervaluation.

This type of analysis has therefore tended to confirm the stylised notion that East Asian economies are currency manipulators, and have kept their currencies cheap in relation to the USD to boost their export-growth models. I won't delve into more formal proofs (and dis-proofs) of this notion, but rather go into the potential hazards of relying on the Big Mac index as a PPP measure.

The standard critique is that Big Macs incorporate local inputs, which are generally composed of non-tradables (land, labour, localised taxes etc). I'd also add the potential for price differentiation from local supplies of tradables, particularly the ingredients themselves - beef, bread, vegetables etc, although the sauce as I understand it is a McDonalds monopoly.

This could explain much of the gross difference between countries, if you've followed my arguments based on the tradables/non-tradables model of exchange rate determination. Also, The Economist themselves warn that the Index should only be relied upon when comparing economies with similar income levels, a finding that is also derived from the same model - high-income countries have higher price levels, and would therefore have stronger currencies in relation to lower-income economies. Looking at the index, we do indeed find developing economies in general having derived-PPP levels lower than that of advanced economies.

The epiphany I was talking about earlier focused on something quite different, which could also strengthen the argument against a Big Mac Index as a PPP measure. When I was a student in London in the late 1980s, I was struck by the fact that Coca-Cola and many other global food and beverage brands had very similar prices to Malaysia's (admission: I'm a Coke addict) - on the face of it, this would imply the intuition behind the Big Mac Index was correct.

But looking at McDonalds' menu prices a different story emerged: Big Macs were indeed more expensive in the UK (and not just in London). Here's the kicker. While Big Macs were more expensive, Filet o'Fish were actually cheaper in the UK than in KL, on par with the humble Hamburger.

What that suggests to me are a few additional economic explanations, over and above the conventional critique:

1. The difference in prices between low-income and high-income economies can also be attributed to differences in the ability to purchase higher-protein diets. As countries shift from low-income to high-income, the protein intake of the population increases raising demand (and prices) for beef.

2. Differences in prices can also be attributed to consumer preferences for different types of protein. Honestly, how often do you see Asians eating beef as compared to chicken, fish or pork?

3. As a corollary to the above, access to alternative supplies of protein (for instance, access to the seas) would also impact beef demand.

Just as important as these factors are that Big Macs are not tradable - there's no price arbitration across borders because Big Macs are a perishable good, unlike for instance a can of Coke. Also, McDonalds is a multi-national corporation with a globally-recognisable brand. To me that suggests that it also likely practices price differentiation across markets, which is a characteristic of monopolies.

So there are quite a few more factors involved than just the conventional economic explanations for differences in purchasing power based on the Big Mac Index, and hence implied-PPP evaluations of exchange rates. A Filet O'Fish Index for instance could paint a very different picture of PPP between East and West.

Proving all these formally might take some doing, but I think I'm going to make a stab at it. It'd make for a decent publishable paper.

Exchange Rate Targeting: "Weak" and "Strong" are not equal

Etheorist has issued a follow-up of his thoughts in his original post outlining his support for a stronger Ringgit level. My critique of his ideas are contained in this post, where my position is essentially that a stronger MYR level is fine provided it is consistent with changes in the economy, but not otherwise.

I find myself having problems with his new post as well. My main contentions are two-fold: first with reference to the central bank "engineering" an appreciation of the exchange rate, which has monetary implications, and second the likely impact on the economy of an artificial appreciation of the exchange rate from the Balassa-Samuelson based model I described before, which has real economy implications. I also have some different interpretations of economic developments of the past decade, but since this post is going to be long and a bit technical, I will deal with those in a following post.

First, to deal with the problem of engineering a non-secular appreciation of the exchange rate. To understand the issues here, one must first have an understanding of how a central bank influences the exchange rate above or below the market determined rate. Let's first examine the case of weakening the currency, since everyone appears to believe the stylized fact that the MYR is below its long term equilibrium level.

To achieve a lower exchange rate requires the central bank to sell domestic currency for foreign currency. On the central bank's balance sheet, this appears as an increase in international reserves (+assets), in exchange for depositing money in the banking system's accounts with the central bank (+liabilities). This results in an expansion of the money supply, which if unsterilised could trigger an undesired credit expansion and demand-fed inflation, exacerbated by the lower short term nominal interest rates from the monetary injection.

Sterilisation refers to central bank open market operations designed to keep interest rates and money supply stable in conjunction with central bank forex transactions. It’s similar to normal liquidity management operations in the sense that the mechanism is the same.

Since in this example a monetary injection was the result of the forex transaction, the central bank must drain liquidity from the interbank market. This is done by selling the central bank's holdings of securities to the banking system, enough to fully or partially offset the monetary injection. Since the central bank in our example is interested in weakening the exchange rate of the domestic currency, unsterilised intervention is also an option at the risk of higher inflation, but also with the potential benefit of higher economic growth.

Thus the practical limits of weakening the exchange rate are: what constitutes an acceptable level of higher inflation; or if sterilisation is resorted to, the borrowing capacity of the central bank. At least that's the case if you don't want to create another Zimbabwe – the central bank’s credibility in keeping the soundness of the domestic currency is at stake.

Strengthening a currency’s exchange rate over its market-determined rate operates in the opposite fashion: the central bank buys domestic currency in return for foreign exchange. This appears as a drop in international reserves on the asset side of the central bank’s balance sheet, and as a drop in the banking system’s cash balances with the central bank. This is also ipso facto a contraction in the money supply, and pushes up short term interest rates.

An engineered appreciation of the exchange rate is thus inherently deflationary, both in terms of the domestic money supply as well as in terms of import prices. If this is undesirable, for instance when inflation and growth are already too low or negative, the central bank can again resort to full or partial sterilization via a purchase of securities from the banking system, thereby injecting funds into the banking system.

From the above it’s easy to see the limits of artificially boosting the exchange rate level beyond the market clearing level: it is limited by the amount of international reserves at the central bank, as well as the supply of available securities in the banking system. This further implies that a strengthening operation is unlikely to succeed for long without a fairly deep supply of public debt.

In both weakening and strengthening operations, if the degree of misalignment in the target exchange rate is far enough away from the fundamental equilibrium rate, the central bank must continually intervene to maintain its target parity which puts it up against the limits of intervention that much faster. Note also that increasing or decreasing the amount of foreign currency in the system does not have any impact on the banking system’s capacity to lend, since loans can only be made to residents in domestic currency.

A second implication is that by virtue of targeting the exchange rate, volatility of either or both money supply and interest rates will become an order of magnitude greater, because the central bank cannot target all three. This is actually easy to see from the pre- and post-2005 Malaysian experience, where interest rates were higher and spreads far wider pre-2005.

A third implication is that artificially weakening the exchange rate is far easier than strengthening it, because of the nature of the limits imposed by the mechanisms employed. In extremis, a central bank can print money to fund forex purchases, which is not an option the other way around – the level of international reserves is a hard limit.

Are there ways around these limits though? For strengthening the exchange rate, yes there is – you can partially or fully close the capital account. But since this entails a general withdrawal from global financial integration, it also means closing access to foreign investment (particularly portfolio) as well as turning our backs on development. I’ll return to the topic of intervention and sterilisation in a future blog post.

A second less painful way around this is to simultaneously engineer an increase in the equilibrium rate. That ensures that misalignments between the equilibrium rate and the nominal rate aren’t too far apart. What are the elements that need to be pushed to achieve this objective? This leads me back to the Balassa-Samuelson Hypothesis model I described before.

To summarise, an economy can be divided into two producing sectors – tradables and non-tradables. Domestic prices (adjusted for the exchange rate) in the tradable sector are everywhere equalized internationally, since demand and supply are determined on a global basis. Domestic prices in the non-tradable sector however are determined purely by local conditions. Labour and capital are the production inputs, where the former is immobile but the latter fully mobile across international borders.

The effect on exchange rates can be described as follows: say for instance that there is an exogenous expansion in the non-tradable sector. This bids up wages across the whole economy, which reduces the relative productivity in the tradable sector. There is thus upward pressure on prices in the tradable sector. However, since prices in the tradable sector are set internationally, the end result is ceterus paribus an appreciation in the real exchange rate of the domestic currency to equate the international prices of tradables. Note that this effect arises from structural changes in the domestic economy rather than changes in international relative prices.

Now that we have that in mind, what’s the impact of an artificially raised exchange rate without these structural changes? An appreciation in the exchange rate creates an identical reduction in relative productivity for the tradable sector as in my example above. However, since there has been no corresponding increase in total domestic demand within the economy, the result is a reduction in the total demand for labour thus putting downward pressure on wages and prices in the tradable sector. This in turn will tend to depreciate the exchange rate. The net result is a tendency to revert to the equilibrium exchange rate, but with higher unemployment.

The opposite is true of an artificially weakened exchange rate. You get an increase in relative productivity of the tradable sector, which has the effect of putting upward pressure on prices and wages in the tradable sector since total demand is also higher. This will have the effect of putting upward pressure on the exchange rate, with the net result a return towards the equilibrium rate but with higher employment.

In short, exchange rate appreciation above the equilibrium level, as a policy tool, won’t result in a rise in incomes but rather the reverse. If I can resort to that hoary old chestnut phrase, “correlation does not imply causality”. In this case, one must distinguish between productivity in the non-tradable sector which is not subject to international competition, and productivity in the tradable sector which is subject to international price pressures. An increase in the former results in a depreciating exchange rate, while for the latter the opposite is true.

More to come!