Time to relook monetary policy in Singapore?

Singapore's exchange rate-centred monetary policy was implemented in 1981 when Goh Keng Swee was the chairman of the Monetary Authority of Singapore (MAS).

Prior to this, in the 1970s, MAS took a more eclectic approach to monetary policy, monitoring multiple indicators such as interest rates, the monetary base, credit growth and exchange rates.

To recap, since 1981, MAS has operated a Band, Basket and Crawl (BBC) regime.

In particular, the Singapore dollar is managed against an undisclosed basket of currencies (trade-weighted exchange rate) rather than a single currency.

Recognising the importance of ensuring some flexibility to accommodate global and regional shocks, the currency is managed within an undisclosed band.

MAS intervenes in the foreign exchange market when the trade-weighted currency index is about to reach the edge of the policy band or sometimes within the band if there are concerns about "excessive" volatility.

In addition, during normal circumstances, the Singapore dollar has been allowed to appreciate, ie crawl upwards.

This has been done for various reasons, including in response to the underlying structure of the economy whereby there are net liquidity withdrawals due to the government's budget surpluses and the CPF scheme, the belief that a strong currency gives a fillip to the Republic's reputation as a major trading and financial centre, and to keep a lid on imported inflation.

Of particular significance is the asymmetric manner in which MAS has historically managed the BBC regime, at least prior to the global financial crisis.

While the bias has always been for a gradually appreciating Singapore dollar, there has been a willingness to allow for a faster rate of appreciation of the currency during boom periods, to curb inflation.

However, there has been a reluctance to allow the currency to depreciate in the event of a downturn unless there are exceptional situations (such as the Asian or global financial crises).

Absent a crisis-like situation, MAS policy has been to keep the domestic currency stable on a trade-weighted basis in the event of a moderate downturn.

This effective bias towards a strong Singapore dollar was based largely on the belief that the high import content of exports made currency depreciation a relatively inefficient, if not ineffective, tool to manage a downturn.

Conversely, a strengthened Singapore dollar has made it a highly effective anti-inflationary tool as an appreciation has a mild effect on exports and growth relative to its mitigating impact on inflation.

The managed floating regime as well as the Republic's fiscal prudence have been the bedrocks of the country's low inflationary environment.

Annual CPI inflation has averaged around 2 per cent from 1981 until 2008, with relatively low volatility as inflation expectations have been effectively anchored.

Very few countries in the world have been able to maintain such low and stable inflation alongside rapid growth and structural transformation.

The over-riding macroeconomic concerns from the late 1970s until the global financial crisis were threefold.

One, to ensure that the economy did not overheat while on its fast-growth trajectory.

Two, to facilitate the shift of limited resources to their best uses to ensure sustained long-term growth.

Three, to shelter the domestic economy from the global inflationary pressures which were especially prevalent from the early 1970s till the mid-to-late 1990s.

This made the use of the exchange rate as an anti-inflationary tool especially effective.

Downturns, being few and far between (eg 1985 and 1999), were effectively managed using ad hoc supply-side policies such as reducing employer contributions to the CPF, lowering corporate tax rates and other steps to reduce the cost of doing business.

In severe downturns, expansionary fiscal policy has been used (such as in 2009). Recessionary periods were historically also viewed as opportunities to undertake necessary restructuring and resource reallocation rather than artificially stimulate the economy, a sort of Schumpeterian view of the world (ie need for "creative destruction").

CHANGING CONTEXT

This set of policies worked very well in an era when the economy was growing rapidly and per capita incomes were rising substantially as Singapore moved rapidly from being middle income to high income and the main sources of inflation were externally induced.

However, the global and domestic context has changed quite significantly.

Since the late 2000s, growth has become more volatile and the external environment is characterised as one of stagnation and deflation.

The economy's medium and long-term growth rate is now much lower, at about 3 per cent per year, on average (even if the Republic restructures successfully to a new productivity-led growth model).

Coupled with this slowing trend growth, the economy has been faced with not-infrequent bouts of relatively high inflation (compared to its enviable historical average) since 2008 and the inflation rate has become more volatile.

A large part of the inflationary pressures in recent times have been driven by domestic rather than external factors, including increases in housing costs (imputed rentals), transport costs due to Certificate of Entitlement (COE) premiums and wage costs due to tighter controls over foreign labour flows without corresponding gains in productivity.

MAS has managed these periods of inflationary pressures via a combination of exchange rate appreciation and micro and macro-prudential policies.

However, if one expects that the sources of inflation shocks going forward are more likely to be domestic than external, there may be a need for a more effective and less ad hoc set of policy instruments.

In fact, as consumption patterns change with a wealthier local population and non-tradables rise in importance in the Consumer Price Inflation (CPI) basket - as they seem to be doing - the effectiveness of the exchange rate as an anti-inflationary tool can be expected to become more blunted over time, requiring more frequent use of prudential policies.

These repeated ad hoc measures to suppress inflationary pressures can lead to unintended consequences.

Similarly, in the case of downturns, as the economy has become much more market-led and wage growth is of somewhat greater concern, the government is likely to be more circumspect about using some of the supply-side policies such as CPF employer wage cuts in the event of downturns.

This leaves fiscal policy to do much of the heavy lifting to offset downturns.

However, apart from the time-lags involved in the use of fiscal policy, the conventional wisdom has been that the fiscal policy multiplier is quite small given the highly open nature of the Singapore economy.

In addition, growing populist pressures for more welfare spending and structural trends such as an ageing society suggest that Singapore's fiscal space may decline over time, hence limiting the use of expansionary fiscal policy as a first line of defence against a prolonged domestic slump.

While there is adequate fiscal space today, thanks to government prudence in the past, a few years of deep deficit financing could very quickly change this scenario.

All of this suggests that, as the country attempts to move to a more productivity-led model of growth, there may concurrently be a need to reconsider the macroeconomic policy mix to deal with the much-altered environment.

More exchange rate flexibility (though not benign neglect) allows greater domestic control over short-term interest rates.

MAS has in place the necessary infrastructure to undertake money market operations to manage an interest rate target if it so desires.

Singapore has never shied away from making hard decisions and accepting the need to re-examine its policies if and when the need arises, no matter how successful the policies may have been in the past.

Has such a need arisen in the case of monetary policy?

Is it just possible that the hitherto highly successful exchange rate-centred monetary policy has reached its "use-by-date"?

This article was first published on January 18, 2017.
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