INFLATION, INTEREST RATES, EXCHANGE RATES, INTERNATIONAL TRADE - WHAT THE HECK IS GOING ON

Currently, every nation in the world is battling the same enemy -- INFLATION. Other than World War II, there has never been a time when inflation visits all countries at the same time. First world or third world, advanced or emerging economies, all are facing inflation although to different extent. This is a global inflation.

Inflation can be demand driven -- higher national growth makes people richer, economy heats up, consumerism prevails, and more demands chasing the same goods and services. Inflation may be supply side problems -- depletion of extractive commodities, crop failures from natural disasters, etc resulting in same demand chasing after too little supply. Or it could be the result of printing too much money, turning the country into a banana republic, like Weimar Republic or Argentina,

In his first month in office, Joe Biden set in motion inflationary pressures by cancelling the Keystone pipeline project. By further crippling the US fracking industry, Biden turned US from a net-energy exporter to a buyer, which set the path for the rise in price of oil and gas. The supply chain was badly disrupted by the pandemic lockdowns. Now the war in Europe has brought oil prices to greater heights and threatens to cripple supply chains, leading to food shortages and price increases in other commodities. With the Fed primed to increase interest rates up to 2.75% by year end, the US is ready to add to the woes of other countries by exporting their inflation.

US inflation in March was 8.5%, the highest it has ever been since 1982. Singapore inflation was 5.419% in April, the highest since 2011.

With rising inflation, wealth gets eroded. And if pay cheques remain the same, rising cost of living becomes a social problem. As price levels rise, people's purchasing power diminishes. Businesses loose customers and the economy takes a hit. It's a nasty cycle.

Central banks fight inflation in one of 2 ways -- increase interest rates, or adjust their exchange rates. MAS uses the exchange rate to manage price levels. By allowing the SGD to appreciate, our imported goods will be cheaper and thus keep prices down. This assumes that general inflation is an exogenous problem. Of course there may be some specific price increases due to other causation that needs different solution. Other central banks, like the Fed, increase interest rates which has the same effect as strengthening their currency, as well as cooling an overheated economy as funding costs become more expensive for businesses. In a global inflation, with all central banks tending to work in the same direction, the situation may be exacerbated.

As a matured economy, productivity is no longer the workhorse to push growth for Singapore. The government resorted to rely on what worked in the past -- keeping exchange rates down and cheaper imported labour to stay competitive. As the economy remains strong, the upward pressure on the SGD rate is natural. MAS controls this by ensuring volatility stays within an official band. With pressure on the upper bands, MAS had to persistently intervene in the FX markets to buy foreign currencies and sell SGD to keep the rates down. This resulted in MAS built up of high foreign reserves. Persistent high foreign reserves has 2 effects:

    (1) Those who don't understand finances think this is highly positive. In fact, many erroneously think this foreign reserves is MAS profit and Singapore reserves, such as one popular Singapore-based Polish blogger and his cohort of supporters in his Facebook echo chamber who sucker up his fawning articles on all government policies. When MAS persistently buys foreign currencies to keep the rates down, it is indicative of currency manipulation.  MAS had chosen to be opaque about these activities. The recent amendment to the MAS Act to facilitate the transfer of excess foreign reserves to GIC so it can be better invested, could in part be due to the desire to camouflage the excessive balances. Currency manipulation attracts negative responses and tariff wars. The US has placed Singapore on the watch list for currency manipulation on quite a few years. It was only in April 2020 that MAS started to publish a report on their market intervention transactions. The adoption of more transparency was obviously a consequence of external pressures.

    (2) MAS has unlimited capacity to buy foreign currencies because it simply prints SGD to pay for it. To avoid excessive money supply which causes inflation, MAS sterilises its SGD printing by issuing MAS bills. This means that in reality, it is domestic savings that is used to purchase the foreign reserves. Suppressing the strength of SGD in this manner cannot go on forever. While this mechanism controls the volatility of the exchange rate and keeps the aggregate supply of SGD intact, the increase in public debt has a downward pressure on interest rates and impacts the SGD yield curve. 

Thus MAS has to adjust the bands to allow the SGD to appreciate from time to time. It did this in October 2021 and again in January 2022.

In 2021 Singapore exported goods of US$451B (S$614B) vs imports of US$401B (S$546B). We had a trade surplus of US$50B. Our trade in services for 2021 was more or less even - export of US$227B (S$309B) vs imports of US$220B (S$300B). Trade surpluses underlie the strength of an economy and its currency.

Let's take a look at the table below which shows SGD rates and trade figures with some countries and try to make some sense of it.

(1) SGD appreciated against most major currencies. It is in line with the narrative for the build up of foreign reserves by MAS. In its April 2022 policy statement, MAS expects a continued monetary tightening stance to slow the momentum of inflation. Expect further appreciation of the SGD.

(2) The general explanation that currency appreciation is due to trade imbalances does not seem to work out here. The glaring examples are Japan, Taiwan, Malaysia, EU and UK where Singapore had huge trade deficits and yet SGD appreciated against their currencies. On the other hand, with Indonesia and Hongkong, we had huge trade surpluses but the SGD depreciated.

(3) Data for trade in services are hard to come by. However, with the exception of US, inclusion of trade in services is unlikely to significantly alter the trade surplus or deficit status in (2) above.

(4) The huge depreciation of Yen, Won, Eur and Gbp clearly reflects underlying economic weaknesses and problems in these countries.

(5) The rise of the RUB is a one-trick pony play. Rxxxxx has a commodity in great demand in the world. Buyers are forced to pay in RUBs for gas, demand for the currency forces it to strengthen.

(6) The strength of the USD seems puzzling amidst the many expert predictions for the demise of the greenback soon. I expand on this below.

How does FX rates come about? We need to differentiate forward and spot rates.

In the case of forward rates, the interest parity principle applies. Eg if SGD/MYR rate is now 3.2000 and 3 month interest is MYR at 5% pa, SGD at 1% pa. You have SGD100,000 which you convert to MYR and place the MYR320,000 on 3-month fixed deposit to earn higher interest. To play safe, you hedge the 3 month exposure with a forward contract to buy back the SGD. The forward rate is computed at (principal + interest of MYR320,000 x 5% x 3 months) / (principal + interest of SGD100,000 x 1% x 3 months) = (324,000/100,250) = 3.2319202. At the end of 3 months the P+I of MRY324,000 converted back at the hedged rate of 3.2319202 = SGD100,250. This is exactly the same value if you had simply kept your funds in SGD and place it for 3 months at 1% pa. This is the interest parity. Thus a fully hedged swap offers no additional gains. If you bet the spot rate in 3 months time will remain the same then you may want to swap the currencies without hedging with a forward deal. In 3 months time, if the spot rate indeed remains unchanged at 3.2000, then the P+I MYR324,000 converted back at 3.2000 is SGD101,250, which provides an additional return of SGD1,000. That's the risk reward.

The spot rates are driven by the market forces of supply and demand. The foreign exchange market is the single biggest financial market, bigger than all the other markets combined, and more. And the SGD is one of the most highly traded currency, in both the fiat and the crypto markets. Whilst the vitality of a country's economy underlies the strength of its currency, the market forces at play are not simply international trade. In other words, the FX market is not driven solely by commercial transactions. In fact, of daily global FX turnover of USD6.6T (per BIS in April 2019), commercial-based transactions comprised only 7%. Hedging, arbitraging and speculative trades make up 93% of daily turnover. This is a fact that most people outside the industry do not understand. It explains for the anomaly in (2) above. Understanding this separates the ivory tower economists from the treasury and operations folks who work in the trenches of trading rooms. This, I'm afraid, is also something the popular Polish blogger refuses to accept as fact.

Now about the strength of the USD.

The USDT index measures the strength of the USD against a basket of currencies with 100 as the base. Since 2003 the USDT has been hovering at the 90s level, breaking the 100 level for a short while in 2017 and 2020 (when Trump delivered good GDP numbers).  Since mid 2021, the USDT began its upward swing and breached the 100 mark in early April this year. It peaked at 104 on May 8, and has dropped back to 102 at time of writing. The USD strengthened on market expectation of Fed raising rates. Rates were raised by 25 basis points in March and 50 basis points on May 4. Fed Chair Jerome Powell has indicated further hikes up to 2.75% by year end.

You can see how interest rates easily impact USD strength in the Paul Volcker years as Fed chair. President Jimmy Carter mismanaged the economy and brought inflation to a high of 14.5% in 1980. To fight the inflation, Volcker audaciously raised Fed rates from 11.2% in 1979 to 20% in 1981. That caused massive unemployment and recession, but finally tamed the beast of runaway inflation. The USDT climbed from the 80s level in 1979 to peak at 114 in 1981 under Volcker..

Reaganomics took the USDT to its record highest of 162 in 1985 on the back of good economic numbers and balanced budgets. Thereafter it was downhill all the way as USD printing madness and the era of cheap money and deficit budgets took over to where the country is today, USD30T in national debt.

Is the rate increase by Powell a right move to tame US inflation? Here, we are in strictly personal opinion territory.

The market was jittery about a possible Volcker style massive increase in rates. Fed Chair Powell and Treasury Secretary Janet Yellen played down the hype by talks of the inflation as transitory. Following the May 4 hike of 50 basis points, Powell announced a one time hike of 75% is not in play. That was well received by a massively over-sold market and equities. However, many felt the US is already in recession. Q1 of 2022 has already registered negative GDP. If Q2 registers another negative number, it will officially be in recession. It seems the market has factored this in as equities have taken a beating in the past 3 weeks. Housing market is still holding up due to low inventory and increase in more expensive mortgage rates have not yet bitten in. Not to forget Powell had also indicated that he will start Quantitative Tightening, probably in June. There was still Quantitative Easing this month, but only a small aggregate. With Quantitative Tightening, the Fed starts shrinking balance sheet selling government securities, thus sucking liquidity out of the market. Leveraged plays will exit in droves forcing lowered asset valuations. Equities and housing market may tank.

The Fed is known to do things too little, too late. This time, it might even be totally wrong. This inflation is supply-driven, not a heated economy. No amount of increase in interest rates is going to bring down the price of gas, fertilisers or wheat. When it becomes apparent this 50 basis points increase is not working, Powell will be forced with further increases. As higher funding cost works its way into the economy, marginal business will be forced to close, exacerbating the recession. All this at a time when massive Democrat spending spree brings fear of currency over-printing, a contumelious attitude to the overhang of the huge national debt. When many countries are taking defensive steps to marginalise the use of USD, it may well be the catalyst to bring the mighty Dollar down at last, a fate that many analyst have been warning for the past several years.

Is currency appreciation a good or bad thing?

It depends on whether you are an importer or exporter, and the elasticity of the products. For importers, the cost of goods are lowered, but for exports, the products become more expensive and less competitive to sell. Elasticity refers to the stickiness of demand. A product is inelastic if the demand remands more or less the same despite price changes. In the case of SGD appreciation, the cost of imported foodstuff is lowered, which is good. But Singapore's exports are finished products which are now more costly, making it less competitive. This is a problem because manufactured products are elastic. Buyers will seek out other sources. It helps if major components are imported which reduces the overall cost of finished product. In the case of Rxxxxx, it is laughing all the way to the bank. The RUB has appreciated tremendously, but their major exports are gas, fertilisers and agri-products which are in-elastic and their customers continue to come to shop. Their imports are now at record cheap prices in terms of RUB.

The impact of persistent currency appreciation comes with huge problems in the long run. Cheaper import substitutes out-compete producers for domestic consumption which hollows out local industry. The export industry can no longer compete and is forced to relocate overseas, resulting in loss of jobs. This was the experience of Japan in the 1980s which they have never recovered from.


What a pity that the pain of global inflation is festered upon the whole world by one single person, an incoherent old man sitting in the White House, who is incapable of understanding what he has done.