Malaysia has a freely floating Renggit – and thank god for that!

The Chinese surprise devaluation yesterday and has put currencies across Asia further under pressure. This is only a natural and the most stupid thing local Asian central bankers could do would be to fight it. Rather as China moves closer to a freely floating exchange rate it should inspire other Asian countries to do the same thing and I am therefore happy to see that the Vietnamese central bank this morning has widened the fluctuation band for the Dong and in that sense moved a bit closer to a freely floating Dong. Even though the hand has been forced somewhat by the PBoC’s devaluation yesterday it is nonetheless positive that we are seeing a move towards more freely floating exchange rates in Asia.

In that since it is not a “currency war”, but rather a liberation war, which in the end hopefully will secure monetary sovereignty to Asian nations such as Vietnam.

The floating Renggit is a blessing – also when it drops

This morning we are also seeing big moves in the Malaysian Renggit and the Renggit has already been under some pressure recently on the back of a worsening of Malaysia’s terms-of-trade and increased political uncertainty.

The sell-off in the Renggit has sparked some local concerns and the demands for the central bank to “do something” to prop up the Renggit are surely on the rise. However, it is extremely important to remember that the problem for Malaysia is not that the Renggit is weakening. Rarther the Renggit-weakness is a symptom of the shocks that have hit the Malaysian economy – lower commodity prices (Malaysia is a commodity exporter), increased political uncertainty and Chinese growth concerns.

None of this is good news for the Malaysian economy, but the fact that this is reflected in the Renggit is not a problem. Rather it would be a massive problem if Malaysia today had had a fixed exchange rate regime has was the case during the Asian crisis in 1997.

So the Malaysian central bank (BNM) should be saluted for sticking to the floating exchange rate policy, which has served Malaysia very well for nearly exactly a decade.

In fact BNM should move even closer to a purely free float and waste no opportunity to stress again and again that the value of the Renggit is determined by market forces and that the BNM’s sole purpose of monetary policy is to ensure nominal stability. The BNM should of course observe exchange rate developments in the sense it gives useful information about the monetary stance, but never again should the BNM try to peg or quasi-peg the Renggit to a foreign currency. That would be the recipe for disaster. As would such stupid ideas as currency and capital controls.

My friend Hishamh over at the Economics Malaysia blog has an extremely good post on his take on the Renggit situation. You should really read all of it. The post not only tells you why the freely floating Renggit is the right thing for Malaysia, but it is also extremely good in terms of making you understand why every (ok most…) countries in Asia should move in the direction of the kind of currency regime that they have in Malaysia.

Here is a bit of Hishamh’s excellent comments:

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

….

In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

… Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

…All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

…The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.

Bravo! Please follow Hishamh! His blog posts are always good and insightful.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Malaysia should peg the renggit to the price of rubber and natural gas

The Christensen family arrived in Malaysia yesterday. It is vacation time! So since I am in Malaysia I was thinking I would write a small piece on Malaysian monetary policy, but frankly speaking I don’t know much about the Malaysian economy and I do not follow it on a daily basis. So my account of how the Malaysian economy is at best going to be a second hand account.

However, when I looked at the Malaysian data something nonetheless caught my eye. Looking at the monetary policy of a country I find it useful to compare the development in real GDP (RGDP) and nominal GDP (NGDP). I did the same thing for Malaysia. The RGDP numbers didn’t surprise me – I knew that from the research I from time to time would read on the Malaysian economy. However, most economists are still not writing much about the development in NGDP.

In my head trend RGDP growth is around 5% in Malaysia and from most of the research I have read on the Malaysian economy I have gotten the impression that inflation is pretty much under control and is around 2-3% – so I would have expected NGDP growth to have been around 7-8%. However, for most of the past decade NGDP growth in Malaysia has been much higher – 10-15%. The only exception is 2009 when NGDP growth contracted nearly 8%!

How could I be so wrong? Well, the most important explanation is that I don’t follow the Malaysian economy very closely on a daily basis. However, another much more important reason is the difference between how inflation is measured. The most common measure of inflation is the consumer price index (CPI). However, another measure, which is much closer to what the central bank controls is the GDP deflator – the difference between NGDP and RGDP.

In previous posts I have argued that if one looks at the GDP deflator rather than on CPI then monetary policy in Japan and the euro zone has been much more deflationary than CPI would indicate and the fact that the Bank of Japan and the ECB have been more focused on CPI than on the GDP deflator have  led to serious negative economic consequences. However, it turns out that the story of Malaysian inflation is exactly the opposite!

While Malaysian inflation seems well-behaved and is growing around 2% the GDP deflator tells a completely different story. The graph below illustrates this.

As the graph shows inflation measured by the GDP deflator averaged nearly 7% in the 2004-2008 period. In the same period CPI inflation was around 3%. So why do we have such a massive difference between the two measures of inflation? The GDP deflator is basically the price level of domestically produced goods, while CPI is the price level of domestically consumed goods. The main difference between the two is therefore that CPI includes indirect taxes and import prices.

However, another difference that we seldom talk about is the difference between the domestic price and the export price of the same good. Hence, if the price of a certain good – for example natural gas – increased internationally, but not domestically then if the country is an natural gas producer – as Malaysia is – then the GDP deflator will increase faster than CPI.

I think this explains the difference between CPI and GDP deflator inflation Malaysia in the last 10-12 years – there is simply a large difference between the domestic price and the international price development of a lot of goods in Malaysia and the reason is price controls. The Malaysian government has implemented price controls on a number of goods, which is artificially keeping prices from rising on these goods.

The difference between CPI and the GDP deflator therefore is a reflection of a massive misallocation of economic resources in the Malaysian economy and inflation is in reality much larger than indicated by CPI. While the inflation is not showing up in CPI – due to price controls – it is showing up in shortages. As any economist knows if you limit prices from rising when demand outpaces supply then you will get shortages (Bob Murphy explains that quite well).

Here is an 2010 Malaysian news story:

PETALING JAYA: There is an acute shortage of sugar in the country.

Consumers and traders in several states have voiced their frustration in getting supply of the essential commodity, describing the shortage as the “worst so far”.

A check at several grocery shops here revealed that no sugar had been on sale for over a week…

…Fomca secretary-general Muhd Sha’ani Abdullah said it had received complaints in various areas including Kuantan, Muar, Klang and Temerloh since a month ago.

He said the problem was not due to retailers hoarding sugar but the smuggling of the item to other countries, especially Thailand.

Federation of Sundry Goods Merchants president Lean Hing Chuan said the shortage nationwide was caused by manufacturers halving production, adding that its members started noticing the slowdown in April.

“Factories might be slowing down their production to keep their costs down until subsidies for sugar are withdrawn,” Lean said.

I got this from the excellent local blog “Malaysia Economics” in which the economics of price controls is explained very well (See this post). By the way the author of Malaysia Economics has a lot of sympathy for Market Monetarism – so I am happy to quote his blog.

So while the problem in Japan and the euro zone is hidden deflation the problem in Malaysia is hidden inflation. The consequence of hidden inflation is always problems with shortages and as it is always the case with such shortages you will get problems with a ever increasing black economy with smuggling and corruption. This is also the case in Malaysia.

I believe the source of these problems has to be found in the Malaysian authorities response to the 1997 Asian crisis. Malaysia came out of the Asian crisis faster than most of other South East Asian countries due to among other things fairly aggressive monetary policy easing. Any Market Monetarist would tell you that that probably was the right response – however, the problem is that the Malaysian central bank (BNM) kept easing monetary policy well after the Malaysian economy had recovered from the crisis by keeping the Malaysian ringgit artificially weak.

The graph below clearly shows how the price level measured with the GDP deflator and CPI started to diverge in 1997-98.

As global commodity prices started to rise around a decade ago the price of a lot of Malaysia’s main export goods – such as rubber, petroleum and liquified natural gas – started to rise strongly. However, until 2005 the BNM kept the Malaysian ringgit more less fixed against the US dollar. Therefore, to keep the renggit from strengthen the BNM had to increase the money supply as Malaysian export prices were increasing. This obviously is inflationary.

There are to ways to curb such inflationary pressures. Either you allow your currency to strengthen or you introduce price controls. The one is the solution of economists – the other is the solution of politicians. After 2005 the BNM has moved closer to a floating renggit, but it is still has fairly tightly managed currency and the renggit has not strengthened nearly as much as the rise in export prices would have dictated. As a consequence inflationary pressures have remained high.

Two possible monetary policy changes for Malaysia

Overall I believe the the combination of price controls and overly easy monetary policy is damaging the for the Malaysian economy. As I see it there are two possible changes that could be made to Malaysian monetary policy. Both solutions, however, would have to involve a scrapping of price controls and subsidies in the Malaysian economy. The Malaysian government has been moving in that direction in the last couple of years and there clearly are fewer price controls today than just a few years ago.

The fact that price controls are being eased is having a positive effect (and GDP deflator inflation and CPI inflation also is much more in line with each other than earlier). See for example this recent news story on how easing price controls on sugar has led to a sharp drop in smuggling of sugar. It is impossible to conduct monetary policy in a proper fashion if prices are massively distorted by price controls and regulations. The liberalization of price in Malaysia is therefore good news for monetary reform in Malaysia.

The first option for monetary reform is simply to allow the renggit to float completely freely and then target some domestic nominal variable like inflation (the GDP deflator!), the price level or preferably the NGDP level. This is more or less the direction BNM has been moving in since 2005, but we still seems to be far away from a truly freely floating renggit.

Another possibility is to move closer to policy closer to Jeff Frankel’s idea of Pegging the exchange rate to the Export Price (PEP). In many ways I think such a proposal would be suitable for Malaysia – especially in a situation where price controls have not been fully liberalized and where the authorities clearly are uncomfortable with a freely floating renggit.

A major advantage of PEP compared to a freely floating currency is that the central bank needs a lot less macroeconomic data to conduct monetary policy. This obviously would be an advantage in Malaysia where macroeconomic data still is distorted by price controls and subsidies. Second, PEP also means that monetary policy automatically would be rule based. Third, compared to a strict FX peg a variation of PEP would not lead to boom-bust cycles when export prices rise and fall as the currency would “automatically” appreciate and depreciate in line with changes in export prices.

Another reason why a variation of PEP might be a good solution for Malaysia is that the prices of the country’s main export goods such as rubber, petroleum and liquified natural gas are highly correlated with internationally traded commodity prices. Hence, it would be very easy to construct a real-time basket of international traded commodity prices that would be nearly perfectly correlated with Malaysian export prices.

The BNM is already managing the renggit against a basket of currencies. It would be very simply to include a basket of international traded commodity prices – which is correlated with Malaysian export prices (I have made a similar suggestion for Russia – see here). This I believe would give the same advantage as a floating exchange rate, but with less need for potentially distorted macroeconomic data while at the same time avoiding the disadvantages of a fixed exchange rate.

Had the BNM operated such a PEP style monetary policy over the last decade the renggit would had strengthened significantly more than was the case from 2000 until 2008. However, the renggit would have weaken sharply in 2008 when commodity prices plummeted at the onset of the Great Recession. Since 2009 the renggit would then had started strengthening again (more than has been the case). This in my view would have lead to a significantly more stable development in nominal GDP (and real GDP).

And price controls would not have been “needed”. Hence, while commodity prices were rising the renggit would also have been strengthening significantly more than actually was the case and as a consequences import prices would have dropped sharply and therefore push down consumer prices (CPI). Hence, the Malaysian consumers would have been the primary beneficiaries of rising export prices. In that sense my suggestion would have been a Malaysian version of George Selgin’s “productivity norm” – or rather a “export price norm” (maybe we should call PEP that in the future?).

But now I should be heading back to the pool – I am on vacation after all…

PS I got a challenge to my clever readers: Construct a basket of US dollars and oil prices (or rubber and natural gas) against the renggit that would have stabilized NGDP growth in Malaysia at 5-7% since 2000. I think it is possible…

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