Any economist predicting a volatile RMB exchange rate before August 2015 would be considered either a lunatic or a China basher. In the years before the August 11, 2015 devaluation, the RMB was one of the most stable major international currencies. It was well on its way to becoming the fifth component currency of the IMF’s Special Drawing Rights (SDR) basket. China is going to run the world’s largest merchandise trade surplus in recent memory of around USD 600 billion as well as a huge current account surplus of USD 300 billion in 2015. More than anything else, it possessed almost USD 4 trillion of foreign exchange reserves that exceeded any immediate need from the economy. Although the economy has slowed down from its breakneck growth rates in recent years, China still grew at a respectable 7.3 percent in 2014 and its 2015 growth target of 7 percent looks achievable. The soft landing scenario of China’s economic transition prevails.
Pressure had built up on the RMB since the second half of 2014 with the incessant appreciation of the USD forcing the RMB to rise from the multiyear Real Effective Exchange Rate (REER). Signs of China’s economic slowdown become more apparent also in mid-2015. Regardless of the cracks, there was still consensus that the Chinese government had the ability to engineer a smooth transition in the "New Normal" and that the People's Bank of China (PBoC) with its huge arsenal could guide the exchange rate to an orderly depreciation to assist the export sector.
Market volatility started on August 11 when the RMB dropped 1.8 percent from 6.2097 to 6.3250 and subsequently another 1.2 percent to 6.3982 the next day. Emerging market currencies crashed as the move was perceived as an attempt by the PBoC to accelerate the depreciation of the RMB to compensate for the REER appreciation of the RMB in recent years. Market was rife with talk of competitive devaluations and senior Chinese leaders were forced to state that the RMB enjoyed good fundamentals and should not devalue. In order to defend the RMB, China’s forex reserves dropped from USD 3.65 trillion at the end of July 2015 to USD 3.23 trillion at Jan 2016. The country’s forex dropped USD 100 billion each in December 2015 and January 2016. Such a scale of forex reserve loss is unprecedented in recent memory and was truly amazing for a country whose capital account is still not fully open.
There are many works analyzing this "black swan event" from all points of view, ranging from political conspiracy theories to undercut the current leadership, to the shifting economic belief of an impending Chinese economic crash. Many reputable figures such as IMF's Christine Lagarde believed that the volatility was due to the Chinese monetary authority's failure to communicate the intention and merits of its exchange rate policy. Extreme market volatility is likely a blend of many factors and how important is said view in explaining the RMB rout will only become clear after the whole episode is over. In any case, senior Chinese policy makers used the G20 meeting in Shanghai in February to explain its exchange rate policy intention and the market apparently has bought the argument. Hopefully, the extreme global currency volatility emanating from RMB instability has halted from here and a full account of the episode later will provide a valuable lesson to policy makers to prevent future undue recurrence.
In the absence of a full account of the RMB story, I would like to look at the successful defense of the Singapore dollar against depreciation pressure in 1985 and draw lessons from that said exercise. The case happened more than 30 years ago and detailed analysis is now available. There are valuable lessons that policy makers can draw from the exercise and interestingly, the case bear many resemblances to the RMB situation today.
1985 Singapore Dollar Defense
Singapore is one of the economic miracles of Asia. From the founding of the republic in 1965, it had enjoyed a continuous GDP growth of 8.5 percent annually until 1984. In 1985, Singapore experienced its first post-independence recession due to a confluence of internal and external factors. Prior to the economic decline, early warning signs of a slowing economy were already evident in 1984, but a booming construction industry bolstered the macroeconomic numbers. By mid 1985, major construction works were complete and few new projects were in the pipeline. Singapore was heading towards a recession.
There were a number of external factors that caused the recession in 1985. First, the industrialized economies were slowing down, in particular the United States. Second, neighboring countries increasingly moved to direct trade and reduced Singapore's role as an entrepot. Indonesia, Thailand and the Philippines had implemented exit taxes, and Malaysia introduced a 50 percent tax on goods bought from Singapore by residents. Third, Singapore's key industries such as the oil refining and marine sectors performed poorly against the new regional competitors.
Internally, the high wage policy initiated by the government in the early 1980s to promote industrial upgrading made Singapore less competitive in the global market, as labor productivity growth failed to catch up behind the annual double digit wage growth.
By the second quarter of 1985, Singapore posted a growth rate of -1.4 percent, which dropped to -3.5 percent in the third quarter. The sharp and sudden downturn took many by surprise. Amid news of companies going bankrupt and the retrenchment of workers, Singapore’s unemployment figure rose to 4.1 percent in June 1985 from 2.9 percent in the previous four years. As such, international currency speculators made bets that the Singapore government would allow the SGD to depreciate to boost exports.
Between 1981-1984, the SGD traded at a band of 2.05 to 2.20. In July 1985, speculation against the SGD started and the SGD moved from 2.175 all the way up to 2.31 in September 12. Many currency technical chart analysts pointed to 2.41 as the target in the near term.
The Monetary Authority of Singapore (MAS) under then vice chairman Dr. Goh Keng Swee fought back. He issued a public statement on September 16 to explain the government's case for supporting a strong Singapore dollar in the face of economic recession. The government intervened at the same time in the currency market by selling USD. This caused the Singapore dollar overnight interest rate to surge to over 100 percent on September 17 and 18. The triple action cooled down the market and inflicted heavy losses on the currency speculators. Singapore dollar settled at 2.25 on September 16 and appreciated to 2.193 on September 18.
The defense of Singapore dollar lasted a week and the outcome is decisive. The currency remained stable since then and closed at 2.1185 at the end of 1985.
Singapore is the most prominent country in the world to have implemented an exchange rate centered monetary policy framework. This is in contrast to most other countries that rest their monetary policies on their domestic economic outlook.
The Singapore government quickly initiated a series of economic reforms on CPF contribution reduction, tax rebates, and wage restraint. The economy made a swift recovery in mid-1986 and posted a second quarter growth of 1.2 percent and ended 1986 with an annual growth of 1.33 percent after a -0.69 percent GDP growth in 1985. The next 10 years show Singapore’s economy recovering to a hyper growth era with an average annual growth rate of 9.3 percent.
Ever since the 1985 defense, nobody has dared to speculate against the Singapore dollar and the currency is one of the most stable currencies in the world. Its volatility is only one-third of that of the Yen, the Euro, and Pound Sterling against the USD.
Singapore is the most prominent country in the world to have implemented an exchange rate centered monetary policy framework. The country has adopted this anchor policy since 1981, and this is in contrast to most other countries that rest their monetary policies on their domestic economic outlook. The reason for the unusual anchor is the high external dependency of the island's open economy and rapid transmission of exchange rate to inflation and the growth outlook. Foreign trade accounts for 400 percent of its GDP and is one of the highest in the global economy. The importance of a stable exchange rate is critical to the long term economic stability of Singapore. The successful defense of the Singapore dollar in 1985 thus laid the foundation of the benign macroeconomic setting of Singapore until now.
MAS Analysis of the 1985 Defense
First, the Singapore government possesses a hefty reserve position to defend the currency. At the time of the crisis in August 1985, a foreign exchange reserve of USD 11 billion was almost one to one versus its M2. Once the Singapore government decided to defend its currency, no speculator could match its arsenal.
Second, the non-internationalization of the Singapore dollar prevented the accumulation of the currency for speculative purposes.
Third, the currency's strength is backed by genuine economic fundamentals. Timely reforms restored the economic momentum and the downturn was short term, which resulted in a decade of strong growth.
Fourth, Dr Goh had a tenacious personality and unusual communications skills to address the issue. He was willing to push interest rates to over 100 percent to squeeze the speculators and committed all government resources to fend off speculators, something unheard of at that time. Out of the USD 11 billion in reserve, he was willing to commit a good chunk to defend the currency. His less than 270 words, 12 paragraph dissection of the economic benefit of keeping a strong Singapore dollar is a classic in communication to the market during uncertainty. As Dr Goh mentioned in his 1985 statement during the Singapore Dollar defense: "... a cheaper dollar will benefit our export industries. Both the belief and the argument are wrong ... A 20 per cent devaluation of the Singapore dollar will reduce manufacturing costs in foreign currency only by 4 per cent; it will increase the cost of imports in Singapore dollars by 20 per cent. Since most of our consumer goods, including food, are imported, the cost of living will eventually rise by between 12 per cent and 15 per cent ... Recently, there has been a sustained speculative attack on the Singapore dollar. The Monetary Authority of Singapore is taking action to repel the attack."
Lessons from the Singapore Dollar Defense
1. The attack revealed an unsettling reality of the currency market. Currency market players often focus on short term fluctuations in the economy to exploit opportunities for profit, disregarding the long term fundamentals of the country.
The Singapore dollar had one of the strongest fundamentals of any currency and yet it was not immune from speculative attacks in 1985. The basic conflict of interest between currency speculators and the government is always present and all governments must be on the lookout for a possible currency attack. The government should punish the speculators in an attack to prevent a recurrence.
2. Massive reserves are critical in a currency defense. The markets will look at the ability of the government to back up its pronouncements with deeds. Huge reserves are reassuring and it will limit the final cost tabulation, Singapore only spent USD 100m in the 1985 defense.
3. Follow up economic reform to restore growth momentum is critical in sustaining the currency’s value. The combination of short term intervention and long term reform is critical to restore and sustain currency value.
4. Strong economic fundamentals behind the currency are a long term deliberate system setup. The Singapore dollar refrained from internationalization to limit the speculators’ ability to hold the currency to speculate against it. A country must decide its policy priority in the long term system setup.
5. Communication to the market on the economic rationale of keeping the currency value stable under an attack is important. Currency speculators always use economic rationales to justify a depreciation stand and create false market beliefs. The most effective way to stop the false beliefs is come out publicly to expose the defective logic behind the false beliefs. Central bank credibility is the most cost effective way to turn around market beliefs.
6. No single measure will work alone in a currency attack. All responses must be synchronized to achieve both the psychological aspect of turning around market beliefs and the physical aspect of currency value. The demonstrated ability of a central bank to handle speculative attacks will enhance the invaluable credibility of the central bank. The Singapore dollar has since enjoyed more than 30 years relative stability after the 1985 attacks.