Tuesday, October 8, 2013

How MAS conducts its monetary policy in Singapore?


Central banks around the world use monetary policy to gear the domestic economy into a certain direction. Monetary policy helps a country to combat inflationary pressures and also increase growth in the economy. Monetary policy is therefore defined as the action of a central bank, that determines the rate and growth of the money supply which in turn affects the interest rates.

Many countries in the world, including United States and China, adopt an interest rate policy where central banks increase or decrease interest rates or change the amount of minimum bank reserve requirement rate.
However, in the case of Singapore, its monetary policy stance is different from that of other major economies around the world. This has given Singapore the name of an: “unique monetary policy system”

Singapore’s Monetary Policy

Before we discuss on the recent direction of monetary policy in Singapore, let’s look at how Singapore manages its monetary policy to get a better understanding. In simple terms, Singapore adopts an exchange rate policy instead of an interest rate policy. This has been the case since 1981. The primarily objective of this policy is to maintain price stability and sustainable economic growth.

There are a few key features of the Singapore’s exchange rate policy:

Trade-weighted exchange rate

Firstly, the value of SGD has to be measured against something. Rather than using one single currency as a benchmark like what Hong Kong is doing, the MAS uses a basket of currencies of our major trading partners. It is trade weighted such that the currencies of our larger trading partners’ bears more weight and make up a more integral part of the index. This is reviewed periodically and the weight may be changed as out trade pattern changes. This means the SGD is measured against a basket of currencies and not one single currency.

Managed float regime and the S$NEER

Secondly, unlike most countries which adopt either a float or fixed exchange rate regime, Singapore’s policy is a hybrid of both. The Singapore dollar (SGD) is allowed to float freely, and the MAS will monitor the strength of the currency based on the S$NEER. The S$NEER is the Singapore Dollar Nominal Effective Exchange Rate which comprises of a basket of currencies as discussed earlier.

Every year in April and October, the Monetary Authority of Singapore will release a statement on the current economic trend in Singapore and the direction of its monetary policy. This is released on a bi-monthly basis. In the statement report, MAS will indicate its action on the S$NEER policy band.

MAS focus on three aspects of the band
a) The slope of the band
b) The width of the band
c) The level the band is centred

Within the band, the SGD is subjected to day to day fluctuations just like any other currency. Businesses from overseas can buy or sell SGD to pay local companies for goods required. Institutions can buy or sell the currency to hedge against future movements. Speculators and traders can trade it freely in the Forex market. This freedom is essential for an open economy like ours to flourish.

However, once the SGD is deemed to be trading beyond the band, MAS will step in to buy or sell SGD to maintain its trajectory within the S$NEER band.  What MAS is doing is essentially modulating the strength of the SGD against the $SNEER.

The band prevents the currency from becoming too strong, making exports more expensive to foreign countries or too weak, which will lead to decreasing purchasing power in the domestic country. The width of the band determines how much volatility or movement the SGD can manoeuvre in. By narrowing the band, the SGD will have less room to manoeuvre before MAS intervenes.

The slope of the band gives an indication of how aggressive the MAS want its policy to be over the next six months. By increasing the slope of the band, SGD can appreciate at a faster pace.

Why is Singapore different? Neither fixed nor float (Managed Float)

Singapore is a small and open economy. If the currency were to float freely, MAS would not have the flexibility to deal with shocks and thus not able to maintain the purchasing power of the SGD. A floating system would cause the SGD to be too volatile in the short run leading to undesirable consequences.
If we have a fixed currency regime, the SGD will be pegged to a single foreign currency. This has consequences with it as the business cycle of both economies may be different. For example in the case of Hong Kong which was peg to the USD, they experienced an asset price bubble in the 1990s when its economy was growing rapidly but there was a economic slowdown in the US leading to lower interest rates.
A fixed exchange rate would not allow the MAS to adjust the value of the SGD to counter shocks from abroad. During the Asian financial crisis, regional currencies depreciated sharply against the USD. The SGD depreciated against the USD also but by much lesser. In fact, the SGD appreciated moderately in trade weighted terms as MAS had the flexibility to allow the NEER to rise above its policy band.

Exchange rate as monetary policy
In a monograph published by the MAS in 2001 titled Singapore’s Exchange Rate policy, the central bank recognizes that in order to manage the currency, it will have to relinquish control over the interest rates of the country.

“The choice of exchange rates as the immediate target of monetary policy implies that MAS has given up control over domestic interest rates (and money supply). In the context of free capital movement, interest rates are largely determined by foreign interest rates and investor expectations of the future movement of the Singapore dollar.” (MAS – Singapore’s Exchange Rate policy 2001, pp.2)

This exchange rate policy has been proven effective over the years. The SGD has appreciated against its major trading partners currencies. This indicates a strong economy with high productivity growth and high savings rate. (MAS – Singapore’s Exchange Rate policy 2001, pp.3)

Comparing the interest rates of the US and Singapore, Singapore’s domestic interbank rate have been relatively lower than that of the US interest rates since the 1980s (as shown in chart 1 and 2 below) reflecting market expectations of an appreciation of the S$.

Chart 1: Singapore Interbank Rate

Chart 2: United States Interest Rates

In fact, a study by MAS indicates that exchange rate is the most effective way to keep inflation low. It was shown that exchange rate has a greater leverage effect than interest rates on the Singapore economy. Therefore, the appreciation of the SGD has a greater impact on GDP, exports and CPI as compared to interest rates.

Singapore’s Monetary Policy Direction

After discussing on how Singapore’s monetary policy is conducted, we now have a better understanding of how MAS governs its policy. We can now look at the recent developments in the Singapore economy and how MAS has implemented its policy with regards to the economic conditions in 2011 and 2012. Has the policy being implemented been effective in the recent past few years? Let’s discuss this in detail

As we know, the main objective of the central bank policy is to maintain price stability and sustainable growth. In recent years, many citizens in Singapore have been voicing concerns about higher cost of living especially on transportation and housing cost.

Economic conditions in Singapore

2011 was a tough year for the global economy. The debt crisis in Europe and the fear of US not being able to raise its debt ceiling caused a loss of confidence in the markets. Major stock market indices declined. The straits times index (STI) also declined from a high of 3300 to a low of 2520 in October 2011.

Singapore’s purchasing managers index (PMI), also declined to 49.2. The PMI is an indicator of the economic health of the manufacturing sector. A reading of more than 50 indicates an expansion while a reading below 50 indicates a contraction. (Cited: http://www.investopedia.com/terms/p/pmi.asp). In this case, Singapore’s export was badly affected by the slow growth in US and the crisis in Europe as most of our exports are to that region.

To regain confidence back into the economy, the US Federal Reserve launched 3 rounds of quantitative easing (QE) as seen in the timeline below. This will drive interest rates down in the US. As interest rates go down, many people could borrow more money easily resulting in an increase in spending causing prices to go up. Especially in many Asian countries including Singapore, hot money flow from the US increased the risk of inflation.

With the low interest rates environment globally, Singapore’s 3 month interbank rate also went to a low of below 0.5%. Liquidity in Singapore banks increased as money flowed in from abroad. Loans were easy to secure and coupled with low interest rates, inflation started to climb.

Forecasting a higher inflation ahead, MAS increased the slope of the S$NEER policy band in 2011. By increasing the slope of the S$NEER policy band, the Sing Dollar is able to appreciate at a faster pace. The appreciation of the S$ dollar will make it more expensive for foreigners to buy Singapore’s assets and at the same time increase export prices thus slowing down the economy and bringing down inflation.

MAS Monetary policy direction 2012

April 2012

Over the last six months, the S$NEER was trading along the lower half of the band. As seen in the diagram below, the drop in the S$NEER towards the end of 2011 was due to the uncertainty in the global economy. It has since appreciated from January 2012 as fear of a global recession subsides. The economy started to recover in 2012.

The IMF and ECB have implemented many measures to contain the debt crisis in the Euro Zone. Bailout packages have been handed out to prevent the troubled European countries from defaulting. In the US, policy makers have put in effort to create jobs and business sentiments have improved. Japan has since slowly recovered from the earthquake and trade disruptions have been restored.

With the improved sentiments and most of the risks being contained, Singapore’s economy expanded 9.9% in Q1 2012 as compared to the contraction of 2.5% in the last quarter of 2011. This improvement in the global economy was somewhat unexpected.

As the economic conditions improved, core inflationary pressures persisted. MAS core inflation continued to rise from 2.4% in Q4 2011 to 3.2%. This was mainly due to higher wage costs causing the increase in prices passed down to consumers. Meanwhile, CPI headline inflation moderated from 5.5% in Q4 2011 to 4.7%. This decrease was due to the smaller increase in COE premiums.

With inflation continue to be high and the global economy recovering, MAS has decided to increase the slope of the policy band slightly with no change to the level it is centred. MAS will also narrow the width of the policy band

October 2012

The S$NEER has appreciated to the upper side of the policy band as the uncertainty in US and Europe gradually subsides.

In Singapore, growth slowed in Q3 of 2012 with GDP declining by 1.5% as compared to the marginal growth of 0.2% in Q2 2012. Exports continue to take the hit as manufacturing continue to slump. This is partly due to the austerity measures being imposed on European countries. However, these austerity measures have helped to reduce the risks of a severe global economic recession if the Euro zone were to breakdown.

Amid the uncertainty and the low economic growth in US and Europe, MAS core inflation averaged 2.3% compared to 3.1% in Q1 2012. CPI All-Items inflation also moderated from 5.3% in Q2 2012 to 3.9%.
With slower growth expected and inflation moderating, MAS has decided to maintain its policy of a modest and gradual appreciation of the S$NEER policy band. There will be no change to the slope, width and the level it is centred.

Has MAS policy been effective?
Let’s look at the overview of inflation and GDP growth rate in Singapore for the past 3 years.

Inflation rate peaked in later half of 2011 and has since moderated downwards to around the 4% level. It is currently at a low of 2-3%. The S$ appreciation has helped to maintain price stability amid hot money inflows and also low interest rates globally.

However, Singapore’s GDP growth rate has declined from 2010 due to uncertainty in the global economic conditions. This proved to be a challenge to MAS policy as the appreciation of the S$ may continue to stagnate growth in the Singapore’s economy or even possibly cause Singapore to go into a recession.

MAS other policy tools

Besides using exchange rate as monetary policy to stabilize the economy, MAS has other tools also. One such tool is restricting the loan to value percentage and tenure of the loan. As discussed earlier, housing and private transportation prices are the two main contributors to the high inflation in Singapore. If these two components can be lowered, inflation will go down to more sustainable levels. MAS have implemented measures to restrict loans on housing and cars so as to further bring down the inflation level.

Two such examples are discussed below:
In 2011, a 50 year mortgage loan was introduced by one of the big banks in Singapore. MAS stepped in to restrict the maximum loan tenure to 35 years as long tenure loans will fuel the increase in property prices. This was also done to ensure prudent lending in case of an increase in interest rates that may lead to adverse effects.

In February 2012, MAS stepped in to restrict the maximum loan to value (LTV) of cars to 50%. In addition, the maximum loan tenure will also be capped at 5 years. After this announcement, certificate of entitlement (COE) prices decreased the following month.

The past 3 years has been a challenge to MAS policy makers as Singapore faced a unique phenomenon called stagflation. With relatively higher inflation and slower growth at the same time, any appreciation or depreciation of the S$ will create negative effects in the economy. MAS has therefore maintained a neutral stance in its latest policy statement in April 2013 with no change to its S$NEER policy band.
In Singapore, consumers are still feeling the higher costs of living pressures and increasingly higher cost in housing prices. The future ahead is challenging to the government as well as to the central bank. Singapore will continue to experience slower growth in 2013 as various policies are already in place to reduce the price level in the economy. Once inflation is more sustainable, growth in the economy can be at a healthier level.
The latest cooling measures to restrict loans for cars and curbs on the property market will bring down the inflation level in Singapore as these two categories contribute significantly to the CPI. This will make the Singapore economy more sustainable and MAS policies more effective in the long run.

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  1. hi there! nice write up you have! may i have the permission to use your graph for the inflation as a reference for our project?

    1. Hi Jermain,

      Sure, feel free to use. The graphs can be found in tradingeconomics.com. I use it a lot for my essays and projects.

  2. Nice article and examples you have there. Thank you!

  3. Regarding changing the slope of the band, what are the axis of the chart? Is it SGD on the x-axis vs USD on the y-axis? Or something else? Because when slope is mentioned usually its on a graph, but I can
    to find any article that points out what are the axes at all.

    1. Hi,

      The y axis looks like its an index which MAS tracks. I would think the index would be made up of a basket of currencies vs the SGD. The x axis is the timeline.

  4. Great article but avoid phrases like we,us and our. Economic articles are meant to be independent and not biased