Monday, 14 April 2008

Singapore dollar jumps as the MAS tries to get ahead of the curve

Last week, the Singapore dollar posted its biggest weekly gain against the United States dollar in almost a decade after the country's central bank announced that it was raising the band within which the currency was allowed to trade in what looks like a determined attempt to rein in inflation.

The Singapore dollar rose 1.9 percent against the US dollar last week. It finished the week at S$1.3586 per US dollar after touching a record high of S$1.3553. It also rose over one percent against both the euro and the Japanese yen.

The decision by the Monetary Authority of Singapore (MAS) represents an attempt by the central bank to bring under control an inflation rate that has been accelerating to multi-decade highs over the past year in a country where inflation had been almost non-existent over the previous ten years.

Just last month, the International Monetary Fund (IMF) had released to the public its country report on Singapore which had been completed on 15 June 2007. The report looked into various aspects of the Singapore economy, including its monetary policy.

The report noted that the monetary policy stance had been kept on a tightening bias since April 2004, targeting a modest and gradual appreciation of the Singapore dollar. The authors noted that "Singapore’s monetary policy framework centered on the management of the exchange rate has served the economy well, keeping inflation low in support of impressive growth" and with "inflation expectations well anchored, there is no compelling reason to change the current monetary policy stance".

Subsequent developments were to show that they spoke too soon.

However, at the time the report was written, inflation in Singapore was indeed low. In fact, it had been low for the past ten years. From 1996 to 2006, the consumer price index (CPI) had risen at an average annual rate of just 0.7 percent.

Then in April 2004, after the CPI had risen just 0.5 percent the previous year, the MAS nevertheless shifted policy from a zero percent appreciation path to a policy of modest and gradual appreciation of the Singapore dollar.

This move proved prescient. The inflation rate picked up to 1.7 percent in 2004, the highest rate since 1997, but fell back to 0.5 percent in 2005.

At that point, MAS policy-makers looked like maestros. Even the IMF could not find much wrong with monetary policy in Singapore.

However, central bank maestros tend to shed their reputations rather quickly nowadays.

From the middle of 2007, Singapore's inflation rate started to accelerate. That year, consumer prices rose 2.1 percent, accelerating especially in the latter half of the year. Then in January 2008, consumer price inflation hit 6.6 percent on a year-on-year basis, the highest rate since 1982, before pulling back a little to 6.5 percent in February.

Part of the reason for the increase in the rate of consumer price inflation was an increase in the goods and services tax by two percentage points in July 2007 from 5 percent to 7 percent. However, this only accounts for a relatively small portion of the increase in the inflation rate.

The more important reason is that the Singapore economy was overheating.

Over the past four years, the economy has grown by at least 7 percent in each and every year for an average annual rate of 8 percent. This is above the 4-6 percent range that the Singapore government considers to be the economy's underlying potential growth rate.

With the high rate of growth, the labour market has tightened. The unemployment rate fell to just 1.6 percent at the end of 2007, one of the lowest in the world.

Macroeconomic policy in Singapore had become too expansionary. The economy grew too rapidly, putting pressure on domestic resources and resulting in rising prices.

Rising inflation, however, has been a global phenomenon. Expansionary policies pursued by many countries have raised inflation rates all around the world -- from emerging economies like China to rich economies like the US and even to deflation-prone economies like Japan. While the MAS has allowed the Singapore dollar to appreciate in the past few years, it has not done so to a degree sufficient to shield the Singapore economy from global inflationary pressures.

Corrective action was attempted in October 2007 when the MAS raised the rate of appreciation of the Singapore dollar in an attempt to tighten monetary conditions. The continued rise in the inflation rate subsequently must have convinced the MAS that it was not enough.

So on 10 April, the MAS decided to tighten again, this time by raising the band within which it allows the currency to fluctuate. This was tantamount to a revaluation and, as Joseph Tan of Fortis Bank pointed out to CNBC on the day of the decision, is a signal that the MAS has fallen behind the curve.

A rebound in Singapore's economy in the first quarter probably emboldened the MAS in making the move. On the same day as the MAS announcement of the tightening, the Ministry of Trade and Industry reported that its advance estimates show that Singapore's real gross domestic product expanded by 16.9 percent in the first quarter on a quarter-on-quarter seasonally-adjusted annualised basis after having declined by 4.8 percent in the previous quarter.

In the policy statement released to announce its decision, the MAS noted that inflation was being driven from both external and domestic sources. The former includes elevated global oil and food prices. Domestic inflationary pressures came from capacity constraints in certain segments of the economy.

According to its statement, the MAS expects inflation to moderate in the second half of the year. For 2008 as a whole, it projects CPI inflation to come in at the upper half of the 4.5-5.5 percent forecast range.

The MAS probably cannot afford to take its eye off the ball any more. Even if the inflation rate falls to the bottom end of its projected range, it would still be substantially above the yields on government securities, which today range from just above 3 percent at the long end to below 1 percent at the short end.

Prolonged negative real interest rates cannot form a sound basis for economic growth.

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