Monetary Policy Operations since the Asian Crisis

V.1 Policy Reactions during the Asian Crisis

Notwithstanding a generally sound domestic environment, contagion from neighboring crisis-hit countries could mean that the fallout from volatile capital flows is unavoidable. A case in point is the Asian crisis, when Singapore's GDP dropped by 0.9% while both the equity and property markets plunged. The Straits Times Index of stock prices fell by 60% from a high of 2055.44 in January 1997 to 856.43 in September 1998. Meanwhile, the private property price index suffered a drop of 40% from 270 in quarter one of 1997 to 163.7 in quarter four of 1998 (Chan and Ngiam, 1998). Aware that the rigidity of the exchange rate was a channel of vulnerability, Singapore accepted market-driven depreciations in the wake of and amid the deepening of the crisis in tandem with deteriorating fundamentals. The Singapore dollar fell by 18.3% against the US dollar from S$1.43 per US$ the day before the float of the baht, to S$1.75 per US$ on 7 January 1998 (Kapur, 2005).⁹

The immediate market-driven depreciations brought about a sufficiently depreciated Singapore dollar that would have reduced the gains from further speculation. This lowered the incentive for currency speculators to engineer an over-depreciation in the domestic currency (Yip, 2005). Had Singapore adhered to a fixed currency peg and defended the currency from the beginning, greater adjustments—and thus, higher volatility in the real economy—would have been necessary. Instead, the MAS widened the boundaries of the policy band as it met with increased uncertainty during the crisis to allow for greater flexibility in managing the exchange rate. Subsequently, when the volatility in the regional markets subsided, the width of the band was narrowed. The quick reaction of the authorities as well as the flexibility in the exchange rate system have been advantageous in aligning the domestic currency with changing economic fundamentals and allowing the new equilibrium to emerge rapidly. No doubt, this contributes to the credibility of Singapore's exchange rate system and is one of the factors that helped to lessen the severity of the crisis.

The depreciation of the Singapore dollar during the 1997 Asian crisis (as well as during other major economic downturns) was accompanied by wage cuts in the form of downward adjustments in the contribution rates to the Central Provident Fund (CPF), which is a government administered compulsory saving scheme. Prior to the crisis, employees and employers were each required to contribute 20 percent of the employees' income to the CPF. With the outbreak of the crisis, the employer's CPF contribution rate was reduced to 10 percent coupled with a two-year wage restraint to bring down labor costs. In addition, other administrative policy measures such as costcutting and budgetary measures were employed.

Such coordination of wage adjustments and cost-cutting measures with the concurrent depreciation of the domestic currency alleviates the need for a bigger NEER depreciation targeted at preserving Singapore's international competitiveness edge. In this way, monetary policy in Singapore is complemented by a proactive and flexible wage policy, whereby real depreciations in the Singapore dollar are partly effected through deflationary wage and price adjustments when the economy is hit by severe negative shocks.

V.2 Monetary Policy during the Post-Crisis Period

We next examine the conduct of monetary policy during the post-crisis period. Prior to 2001, the MAS would disclose the general thrust of its exchange rate policy stance via occasional policy announcements made by senior central bank officials. In early 2001, the MAS formalized the announcement of the exchange rate policy stance through a Monetary Policy Statement in conjunction with its semiannual exchange rate policy cycle. Table 1 traces Singapore's exchange rate policy stance since the Asian crisis.

We observe from Table 1 [ PDF 29.4KB | 1 pages ] the various forms of adjustments to the TWI allowed by the BBC exchange rate regime. First, changes to width of the band can be carried out (as announced in the 11 September 2001 statement) in response to periods of heightened volatility. Second, there can be a re-centering of the policy band (as announced in the July 2003 statement) and third, a change to the slope of the crawl in the central parity can be effected (as announced in the October 2007 statement). These different ways of adjustments demonstrate the flexibility accorded by the exchange rate system, which allows the MAS to use the exchange rate to accommodate shocks to as well as structural changes in the economy (Khor et al., 2007).

Since the BBC exchange rate system has functioned well for Singapore, a natural question arises as to whether it should be recommended for the other regional economies. To adopt this exchange rate arrangement, countries should have the capacity required to operate the system. This involves a good sense of what the equilibrium exchange rate level is and how it is evolving; the ability to resist intervention within a sufficiently wide policy band; having the latitude to carry out prompt large-scale intervention operations to defend the band; and possessing good judgment of what market conditions require the widening the policy band. Nevertheless, it is still possible that the flexibility accorded by the BBC regime may not be sufficient to deal with extremely severe external shocks. A case in point is Indonesia, which had to abandon its BBC regime when hit by contagion from Thailand during the Asian crisis (Williamson, 2007).

V.3 Management of Domestic Liquidity

What impact do foreign exchange interventions—carried out mostly to moderate the appreciation of the Singapore dollar—have on domestic liquidity? Defending appreciations usually leads to an increase in foreign reserves and a rise in the monetary base, thereby raising inflationary pressures in the domestic economy unless the central bank carries out sterilization. Indeed, excessive credit growth and the high costs of sterilized foreign exchange interventions are well-recognized challenges posed by large capital inflows.

However, instead of having to manage excess domestic liquidity and withdraw funds, the MAS is generally in the position to supply funds to the domestic banking system. The first reason for this is prudent fiscal management—the Singapore government has continued to run budget surpluses averaging around 5% of GDP since the crisis. As the government's financial agent, the MAS is in receipt of public sector surpluses from the government, which in effect removes liquidity from the domestic economy. The second reason is that the contributions to the CPF tend to be in excess of withdrawals, and these positive net contributions to the CPF also effectively represent a withdrawal of funds from the domestic financial system. In fact, both the public funds transfers and the CPF net contributions channel substantial liquidity out of the economy, causing the money supply to shrink and putting pressure on the Singapore dollar to appreciate.

The MAS can actively offset this liquidity drain through foreign exchange operations that use the Singapore dollar to purchase the US dollar. In this way, funds are channeled back to ensure an appropriate level of liquidity in the domestic banking system, thereby offsetting the effect on the exchange rate. In fact, the MAS can achieve a wide range of exchange rate appreciation or depreciation by controlling the amount of liquidity reinjection. By the same token, the MAS can exert a limited degree of control over domestic interest rates by varying the amount of liquidity re-injections, particularly when the TWI is “floating” within the prescribed policy band. For instance, if the economy is deemed to be overheating, less liquidity could be re-injected into the market. The relative reduction in the money supply would raise domestic interest rates, which would in turn help to cool the economy. Conversely, if the economy is slowing down, the MAS could re-inject more liquidity into the economy with an attendant reduction in the domestic interest rates, which would help to stimulate the economy.

It is evident in Figure 15 [ PDF 35.1KB | 1 pages ] that domestic interest rates in Singapore are generally lower than US interest rates, reflecting investor expectations of an appreciation of the domestic currency. However, Figure 16 [ PDF 36.9KB | 1 pages ], which depicts the ex post three-month uncovered interest differential, reveals that the differentials are quite different from zero and as pointed out by Yip (2003) they are substantially larger in magnitude compared with corresponding figures from Hong Kong, China. Hence, the fluctuations in the differentials are indicative of some autonomy in the interest rate policy, albeit to a rather limited extent. This is because Singapore's extensive network of international financial and trade linkages results in such huge and rapid capital flows that domestic interest rates are largely determined by foreign interest rates and market expectations of the future value of the Singapore dollar.¹⁰

To complement its exchange rate policy, the MAS conducts money market operations in order to foster orderly money market conditions. The MAS adds or withdraws funds from the market using instruments such as foreign exchange (reverse) swaps, direct lending to or borrowing from banks, direct purchase or sales of Singapore Government Securities (SGS), and repurchase agreements on SGS (MAS, 2003). With the use of such money market operations, the MAS is able to pump in or mop up liquidity from the domestic banking system on a massive scale in response to economic and financial developments. For instance, the MAS injected S$2.5 billion into the domestic banking system in the immediate aftermath of the September 11 terrorist attacks to forestall turmoil in the local financial markets.

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