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…
JP Koning
/ November 15, 2012“There are to ways to curb such inflationary pressures. Either you allow your currency to strengthen or you introduce price controls.”
You can also engage in sterilization. I’m reading this paper at the moment:
http://mpra.ub.uni-muenchen.de/30804/1/MPRA_paper_30804.pdf
It discusses BNM monetary policy. Sterilization was at the core of it:
“Although sterilization has often been dismissed or viewed skeptically as a long-term instrument, BNM‘s success in restraining excessive money creation and containing inflation via intensive sterilization over two decades suggests that sterilization may be a more effective policy instrument than commonly expected.”
Lars Christensen
/ November 15, 2012JPK, Or that might be the illusion created by price controls? I am not sure about that, but I am always skeptical when somebody claim that they can get around gravity with economic regulation.
Anyway I will have a look the paper – I might learn something, but hopefully not too much because then I would have to write another blog post on that;-)
hishamh
/ November 16, 2012Lars,
Thanks for the blurb, and the link to my blog – it’s not often our little corner of the world gets any recognition in the economics blogosphere. I’m hoping to go over some of these points with you later today if we get a chance to meet up:
1. I’ve known about the discrepancy between the deflator and CPI for quite a long time now, but your perspective on it is new to me. Yes, price controls (and consumer and producer subsidies) effectively limit the usefulness of the CPI as an indicator of economic activity – about a third of the CPI basket is price-controlled in Malaysia, though the proportion varies since some of these controls are only effective during festival seasons (of which we have a quite a few). While sugar and staples such as rice and chicken are good examples, the main problem is with oil & gas. Pump prices in Malaysia are a full third below international (ex-tax) market levels, and gas subsidies are even higher – there have been gas shortages for both industrial and energy-generation use sine the Great Recession. Fully 10% of the government’s budget next year will be devoted to capping petrol pump prices. The gas subsidy is largely hidden since its mostly borne directly by the state oil company Petronas and energy producer Tenaga Nasional. Smuggling of both refined petrol, diesel and natural gas are, as you can imagine, a problem.
2. I’m not sure about the effectiveness of using an exchange rate target in Malaysia’s case. A couple of nuances to the Malaysian scenario for your info:
a. To the best of my knowledge, BNM is not using a target reference rate against the USD or any currency basket, and has not done so since the float in 2005. For all intents and purposes, the Ringgit is on a free float, with occasional central bank intervention to smooth volatility (the IMF de facto regime classification is a rather unhelpful “other”).
b. JPK’s point is I think a valid one – where BNM has intervened in a big way during the float period, its largely been to meet or reduce forex liquidity in the banking system. Sterilisation/forex liquidity operations are functionally equivalent to intervention, even if the motives are different. There’s been little to no movement in the level of international reserves over the past two years.
The question then is – if the Ringgit is indeed floating, how does Malaysia maintain a sizeable current account surplus and why has there not been a much stronger adjustment of the Ringgit upwards?
Offhand, I’ve got two hypotheses:
a. The Ringgit market is onshore only – although the the Ringgit was de-pegged against the USD at the same time as the RMB, international convertibility was not reinstituted at the same time. Trading and convertibility of the Ringgit remains within the local banking system only, and thus relatively inefficient.
b. The structure of trade – there’s two components to Malaysia’s exports. The commodity component (oil & gas, palm oil, rubber) behaves as you would expect with relation to forex movements, although the income effect tends to dominate. The non-commodity component is however largely inelastic and actually comprises the majority. What’s interesting here is that non-commodity exports (electronics for instance) and imports of intermediate goods are co-integrated.
Malaysia’s manufacturing sector is dominated by MNCs for which Malaysia is only one part of a global supply chain. In other words, there’s a structural component to the current account surplus that won’t adjust to changes in relative prices in Ringgit terms. But that in turn implies that the Ringgit’s value is effectively stronger than if we are evaluating it on the basis of the aggregate current account alone. (Another implication: the Ringgit market is actually efficient). Here’s one reference for this problem:
http://papers.nber.org/papers/w18498
If this hypothesis is true (and I’ve found some of the same effects with Malaysia’s exports to Europe i.e. a large portion is not forex sensitive or subject to European final demand), there’s bound to be complications using a commodity price peg as a forex anchor – monetary policy using this instrument might be prone to overshooting.
I’d love your thoughts on any or all these issues.
Lars Christensen
/ November 16, 2012Thanks hishamh,
Your comments are very helpful – and clearly clarifies some of my points and correct a few of my mistakes.
In terms of the ringgit float, yes it is correct that it is officially freely floating, but if compared it to the other freely floating currencies – both in Asia – for the won or the yen or for that matter the Australian dollar – the fluctuations is much smaller. Furthermore, if you compare it with other commodity exporters such as Norway or Canada the link to commodity prices is much weaker. That to me is an indication that the renggit is only floating in name.
It is obvious that the BNM is intervening and of course currency and capital restrictions continue to play a role, but equally important the market expectations that the BNM will not allow “excessive” fluctuations in the renggit probably also have a significant effect. The fear-of-floating and the market expectations of this keeps the renggit from fluctuating. I have discussed these issues for example here:
http://marketmonetarist.com/category/fear-of-floating-2/
and here: http://marketmonetarist.com/2012/05/09/fear-of-floating-misallocation-and-the-law-of-comparative-advantages/
and here: http://marketmonetarist.com/2012/05/08/exchange-rates-are-not-truly-floating-when-we-target-inflation/
I strongly believe a “export price norm” (or Peg to the Export Price) would work well for Malaysia. I am no fan of traditional pegs, where you peg your currency against another currency, but I do believe that it could make sense to peg the currency against the price of your main exports. That of course in the case of Malaysia would mean a lot more currency fluctuations than is presently the case.
I hope in the common time to try to illustrate my point, but for starter – try to plot the price of rubber measured in renggit (year-on-year growth rate) against the yearly growth rate of NGDP. I am sure you will find a fairly hight correlation. That would mean that if you stabilize the price of rubber in renggit (by pegging the renggit to rubber) then you would stabilize NGDP growth. Hence, that would automatically give Malaysia a NGDP targeting regime.
Saturos
/ November 17, 2012Lars, you might also want to note that there has been significant divergence in Australia between CPI and GDP deflator, probably leading to the false complacency of the RBA during the NGDP/RGDP boom just prior to the crash. That is, they loosened money too far, only realizing that inflation was a concern in early 08. But then they admirably performed forward-looking policy as the world economy tanked later that year, and avoided having too little inflation…
Happy Diwali to the Christensen family! http://cdn.theatlantic.com/static/infocus/diwali111312/d27_56254456.jpg
Lars Christensen
/ November 18, 2012Thanks Saturos,
Interesting stuff. I have actually been thinking about writing a post on Australia. The RBA has managed well, but I think there is a lot of luck here. Hence, I am slightly less positive about RBA’s performance than our friend Lorezo who has this interesting post on RBA’s performance.
The best monetary policy indicator for Australia in my view is the CRB index measured in Aussie dollars. If RBA keeps CRB measured in AUD stable then it will more or less also keep NGDP growing at a stable rate. That is at least what I plan to write a post on…
Saturos
/ November 17, 2012Just subscribed to hishamh’s blog. Sorry, you guys call it Deepavali, right? Actually kind of makes more literal sense in Hindi (and I think also Sanskrit?)
Lars Christensen
/ November 18, 2012Saturos, good for you! It is a awesome blog and I am happy to report he is a nice guy as well – with a lovely family. I think my nearly 3 year old son is in love with Hishamh’s somewhat older daughter;-)
hishamh
/ November 21, 2012LOL, my daughter’s still blushing every time we mention Mattias. She’s embarrassed he wanted to kiss her. She told us the other day, quote, “He’ll make a very good boyfriend when he grows up, because he’s so attentive”.
Hope you’re enjoying your stay in Langkawi. It’s a fantastic place for a holiday.
hishamh
/ November 21, 2012Yes, it’s generally called Deepavali, although there’s more people calling it Diwali now.
JP Koning
/ November 23, 2012Jumping back in, but very interesting commentary from all. Lars, you’re doing a great job reminding everyone that there’s more to understanding monetary economics than just the Fed and the ECB. Keep up the good work.
Lars Christensen
/ November 23, 2012JPK,
Thanks – I do think it is extremely important to study monetary policy in other countries than just the US and the ECB as well as studying monetary history.
My inspiration is clearly Milton Friedman’s excellent little book “Money Mischief”. I hope my blog can be modern internet version of that book.