Exchange Rate-Centered Monetary Policy Framework

IV.1 Exchange Rate as Key Monetary Policy Instrument

Despite the recent increase in capital flows, the Singapore nominal effective exchange rate has been relatively stable. To advance our understanding on how the central bank retains control over the exchange rate, we consider the monetary policy framework. A unique feature of Singapore's monetary policy framework is the use of the exchange rate instead of the more conventional benchmark policy interest rate as the key policy operating tool. Singapore, as an international financial center, has opted for free capital mobility. With reference to the open-economy trilemma,⁸ it follows that the central bank can choose to use as its key policy instrument only one nominal variable: the exchange rate, the interest rate, or a monetary aggregate. The Monetary Authority of Singapore (MAS) has chosen to use the exchange rate instead of the interest rate as an intermediate target since the early 1980s.

The rationale of this decision is clear. A high import content of about 60% in domestic consumption as well as being a price taker in the international markets imply that Singapore is highly susceptible to imported inflation. It is thus unsurprising that the exchange rate is considered to be a more effective tool than the interest rate for stabilizing inflation. The other main influence on domestic cost pressures has been labor supply. While the tightness of the labor market has been somewhat eased by immigration policies, the exchange rate policy has helped to dampen aggregate demand thereby reining in wage inflation. In a study on Singapore's monetary transmission mechanism, Chow (2005) found that the exchange rate has a highly significant impact on the level of economic activity. Such a result is not in the least unexpected in view of the substantial contribution of external demand to growth—exports account for around two-thirds of total demand.

By contrast, the Singapore economy is less sensitive to interest rates. Firstly, domestic investment is not very sensitive to the interest rate because Singapore's heavy reliance on foreign direct investment limits the impact of the cost of domestic borrowing. Secondly, a decline in housing wealth plausibly caused by a rise in mortgage rates does not seem to have significant dampening effects on aggregate consumption, even though houses are a major component of personal wealth in Singapore (Abeysinghe and Choy, 2004). This rather unusual finding has been attributed to the illiquid nature of Singapore's housing assets as well as the strong bequest motives of Singaporean households (Phang, 2004). It is thus unsurprising that interest rates are deemed to have a relatively weaker effect than exchange rates on price stability, which is the final policy target.

Given the economy's vulnerability to external shocks, it is pertinent for Singapore's monetary policy to play a counter cyclical role in minimizing the impact of these and other shocks on the domestic economy. Parrado (2004) investigated the counter cyclical nature of Singapore's monetary policy through the use of a monetary reaction function. A variant of the Taylor rule (Taylor, 1993) was estimated, using changes in the exchange rate instead of the interest rate as the policy variable to reflect the use of the exchange rate as the key monetary policy instrument. The two target variables were inflation and output gap measures. The results suggest that monetary policy in Singapore does have a forward-looking orientation aimed at dampening inflation and output volatility. This finding concurs with the stated objective of the monetary policy of the MAS, which is “to ensure low inflation as a sound basis for sustained economic growth.”

In a related study by McCallum (2007), a similar Taylor type policy rule was estimated. In that study, deviations of the real exchange rate from its equilibrium were included as an additional target variable. While the real exchange rate deviation variable turned out to have no explanatory power, the inflation variable remained highly important and the output gap variable was significant. The empirical evidence suggests that the real exchange rate does not play a role as an independent macroeconomic objective, but that adjustments in the policy variable are consistent with a policy designed to stabilize inflation and output around their desired target levels. In other words, Singapore's monetary policy framework is like a variant of inflation targeting.

The past track record of low inflation and prolonged economic growth attests to the effectiveness of using the exchange rate as a key policy instrument for an ultra open economy like Singapore, albeit with the support of flexible factor markets and strong institutions.

IV.2 Basket-Band-Crawl Exchange Rate Regime

In implementing the exchange rate-centered monetary policy, the MAS manages the Singapore dollar under a basket-band-crawl (BBC) system (Khor et al, 2004; Williamson, 1999). Under this intermediate exchange rate regime the MAS monitors the value of the Singapore dollar in terms of a basket of currencies. Given Singapore's diversified trade pattern, targeting a currency basket instead of a single foreign currency will result in a more stable effective exchange rate. The currency basket, termed the trade-weighted index (TWI), is a trade-weighted average of the currencies of Singapore's major trading partners and competitors. These represent the various sources of imported inflation as well as competition in the export markets, with the basket weights reflecting their degree of importance. Neither the constituent currencies nor their assigned weights in the basket are made public by the MAS.

The MAS uses a prescribed policy band centered at a parity that is the target exchange rate for the TWI. The target rate reflects the long-run equilibrium exchange rate and is allowed to adjust gradually over time, keeping the policy band in tandem with Singapore's slowly changing long-term economic fundamentals. It is critical not to make parity changes in occasional large steps like in an adjustable peg exchange rate regime as this attracts large capital flows speculating on an impending change. The crawl circumvents the emergence of a situation where the currency becomes significantly misaligned. It thereby reduces the incentive for speculative attacks against the currency. Notably, MacDonald (2004) and Lee (1999) amongst others have found no sustained deviation of Singapore's real exchange rate from its equilibrium level even when the equilibrium value of the currency is measured using different approaches.

The TWI is allowed to float within the prescribed policy band to allow for short-term fluctuations in the foreign exchange markets. Like the central rates, the band limits are undisclosed. The MAS can directly influence the value of the currency and defend the band by carrying out intervention operations in the foreign exchange markets. When the TWI approaches or exceeds the boundaries of the policy band, the MAS may carry out intervention to “lean against the wind,” which means resisting the recent trend of the exchange rate, thereby preventing the bounds from being breached. Such intervention operations always resist misalignments and push the TWI towards its estimated equilibrium value like in the reference rate proposal (Williamson, 2007). Additionally, the MAS can also intervene within the band to smooth out short-term exchange rate volatility as the latter could impair confidence in the currency.

We highlight two key features regarding the policy band that help to discourage destabilizing speculative flows. First, the band is sufficiently wide so that market participants cannot be sure of making a profit even when they correctly speculate on an impeding change. Second, a BBC with hard bands, whereby the central bank is obliged to carry out intervention whenever the limits are reached, is avoided. This type of exchange rate regime is akin to a crawling band and, based on empirical evidence, could provoke a crisis. Hence, a BBC with soft margins is used instead.

Under the managed float system, it is pertinent to have large foreign reserves ready for use to defend the currency. The Singapore dollar is more than fully backed by foreign reserves (see Figure 14 [ PDF 33.4KB | 1 pages ]). In any case, the central bank enjoys high credibility earned from its track record in maintaining low inflation and a strong domestic currency. Consequently, most market participants are convinced that the MAS is committed to enforcing the policy band and they thus tend to keep within the bounds. Such market discipline in turn reduces the need for frequent central bank intervention operations (Krugman, 1991). Contrary to the conventional wisdom at the time of the Asian crisis that intermediate exchange rate regimes are not viable, the MAS has deterred speculators from attacking the domestic currency and has successfully maintained a managed float over the past few decades.

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