Monday, August 28, 2023

KEEP RESERVES SECRET TO PROTECT SGD IS A FALLACY - SGD CANNOT BE ATTACKED



16 September 1992 was a day of infamy for Britain which came to be known as Black Wednesday. That was the day Bank of England threw in the towel on a battle against currency speculators and took UK out of the ERM (exchange rate mechanism of the European Union) and pound sterling crashed.


Traditional description of a speculative currency attack is speculators keep selling the currency which pushes the rate down, forcing the central bank to keep buying to maintain the rate. The central bank uses its foreign reserves to buy back the domestic currency. When the foreign reserves run out, the central bank can no longer maintain the rate and the currency crashes. Speculators then buy back cheap and make a killing. It’s now folklore how George Soros made US$6b betting against GBP in 1992. The government has consistently explained the need to keep the size of Singapore's reserves a secret in order to protect the SGD. The rationale is when speculators do not know the size of MAS’ reserves, they are less inclined to launch an attack on the SGD.

The problem with Singaporeans is nobody questions an official narrative. Argumentum ab auctoritate, anything from the authorities must be true, don’t ask. If we do not question, how are we going to learn. I watched the Pavlovian explanation of Ng Kok Song recently when he recanted ad verbatim and forcefully the reason for keeping reserves a secret. On that performance alone, I rated him 100% PAP man.

Black Wednesday 16 Sep 1992

After struggling for decades and unable to find a monetary policy that can tame inflation and bring price stability, Britain finally joined the ERM in October of 1990. This meant anchoring Pound Sterling to German Deutschemark within a range of 6%. By pegging GBP to DEM, Britain was obligated to intervene in the FX market to keep within the range. The idea for pegging to DEM was the stability of the German currency will help Britain tame its own persistent inflation. Britain joined the ERM with GBP/DEM rate at 2.95 and interest rate at 12% compared to 9% in Germany. Market sentiment felt Britain joined at too high a rate as were other weaker EU countries like Italy. When the Danish electorate rejected the referendum on the Maastritch Treaty (for EU currency union) in June 1990, that was more or less when market downward pressure against GBP gained momentum. The Brits had no choice but keep buying as speculators shorted GBP. West-East German reunification caused massive fiscal expansion which forced Germany to increase interest rate. The consequence was all ERM currencies appreciated against USD causing balance of payment problems in EU counties as their exports weakened. Italy was forced to devalue the Lira. The only way out was for Germany to decrease its interest rate. On 14 Sep 1992, Germany shaved off a tiny and ineffective 25 basis point on interest rate as Bundesbank President, Helmut Schlesinger, indicated that in his view a wider realignment was still required. That was the death knell. The market knew the game was over and all hell broke loose as speculators poured everything they had to short GBP. In 2 days, Britain lost GBP16b to protect the pound sterling and almost emptied their Exchange Equalisation Account of foreign reserves. On 16 Sep morning Britain raised interest rate from 10% to 12% and later to 15%. They could not stop the dumping of GBP and by 7pm Norman Lamont (Chancellor of the Exchequer) announced Britain had quit the ERM. GBP went into free fall and found its new equilibrium at the 2.50s level.

Mexican Peso 22 Dec 1994

In Janary1994 Mexico signed the North American Free Trade Agreement (NAFTA). These gave it new found investor confidence. 1994 was an election year which traditionally sees an expansionary budget. To pay for fiscal spending, Treasury issued MXN denominated securities but guaranteed repayment in USD. Because peso interest rate was higher, these securities were popular with investors. However the assassination of a presidential candidate and some violent protests increased political instability and downward pressure on the peso. As MXN was pegged to USD, Banco de Mexico had to buy up pesos to maintain the fixed rate. It did so by way of issuing foreign currency denominated securities. As the peso was propped up, it became over-valued. Its strength caused trade deficits that further increased downward pressure on the peso. Capital flight follows and in an election year, it was political suicide to raise interest rates. To inject foreign currency liquidity to the market, the central bank used its foreign reserves to buy back its own securities which were either foreign currency denominated or peso securities but guaranteed payment in foreign currency. By December 1994 Banco de Mexico had depleted its foreign reserves. On Dec 20 Mexico devalued MXN and forced to increase interest rates. Still unable to stop capital exodus and faced with default, the USD peg was cut on Dec 22, peso became free float and suffered huge depreciation. This Mexican episode was not exactly speculative currency attack but capital flight. The effects are nevertheless similar.

Thai Baht 2 Jul 1997

In 1980s and early 90s, the glowing economy of Thailand attracted massive capital inflows. Private foreign debt rose to record levels with capital going into unproductive sector of real estate and stock market. The inflow of hot money caused huge increase in valuation. The massive foreign debt was a structural imbalance with extreme currency liquidity risks. Currency traders saw the opportunity and began shorting the Baht. Because the Baht was pegged to the USD, Bank of Thailand had to intervene in the forex market to buy up what the market was unloading. By 2 Jul the Central Bank had depleted its foreign reserves and the Baht went into free float. That triggered more panic and hot money headed for the exit exacerbating the downward pressure on the Baht. When the dust settled, the Baht had loss 53% of its value.

The attack on the Baht spreaded to other East and Southeast countries which raised fears of a contagion effect. These countries had more of less similar structural imbalances of massive hot money and private foreign debt. Indonesia and South Korea governments suffered huge losses in foreign reserves because like Thailand, they had fixed rate currencies. Riots in Indonesia forced strongman Suharto to step down after decades in office. Other countries like Malaysia, Singapore, Philippines. Vietnam and Taiwan did not suffer as much.

Hongkong $ 28 Aug 1998

On 1 Jul 1997, one day before the collapse of Thai Baht, Britain's lease on Hongkong expired and the island was returned to China. There was great political uncertainty over the future of HK. As the Asian Financial crisis spread east, speculators turned their attention on HK. Some felt the days of HK’s role as international financial hub was over. Therefore the HKD was primed for an inevitable plunge. Speculators made a 2-pronged attack by shorting both HKD and the Hang Seng Stock Exchange. HKD is pegged to USD. The HK Monetary Authority responded by raising interest rates. At one point the overnight rate hit 300% which failed to halt the attack. On 13 Aug the Hang Seng Index fell 60%. China responded by declaring it will not devalue Renmenbi which was pegged at 8.3 to USD and that it will let HK avail its USD130b foreign reserves if needed. With this assurance, Finance Secretary Donald Tsang went to war on Aug 14. HKMA spent USD10b of its USD90b foreign reserves buying up HK shares and pushed the Hang Seng Index up again. By Aug 28 it was over. Speculators ran, licking their wounds, including George Soros.

Anatomy of currency attack

If the secrecy narrative were true, then history would have been a graveyard of small economies who fail to hide their mediocre reserves. All these countries would have been attacked and destroyed by currency speculators. These has not happened. Where governments are managing well, nobody wants to attack and do them in.

A country with monetary mismanagement and structural weaknesses sends an open invitation to currency traders and speculators to exploit. In the case of HK, it was a perceived weakness.

Fixed rate regimes experience a partial loss of monetary sovereignty. They surrender the important monetary tool of exchange rate management and are obligated to use foreign reserves to maintain the anchor rate. Floating rate regimes let the rate find its new equilibrium, using interest adjustments to bear influence, thus avoiding a drain on foreign reserves.

Currency attacks mostly result from foreign currency liquidity crunch due to trade deficits or credit bubbles arising from endogenous factors of economic and monetary mismanagement.

Exogenous factor applies with fixed rate regimes when there is mis-aligned economies of the two currency countries such as Britain and Germany.

Contrary to our Government’s narrative for secrecy, HK’s experience shows that if you have lots of it, flaunt it, foreign reserves that is. And Singapore has lots of it.

Poker game anecdote

The thinking is if speculators do not known how big a central bank’s war chest is, they are unlikely to attack the currency. The attack on HKD and the fact no country other than Singapore hides its reserves suggest a questionable validity of its premise.

Singaporeans like to repeat public officials use of the poker game for keeping the size of the reserves secret. I often wonder how many has actually played the game. There are many variations the way poker is played in casinos. But in local social settings there are basically two ways. One is open table where players have their capital on the table. You play with what’s on the table. The other is no limit. You do not show what capital you have with you. The setting is akin to the issue of reserves – you show it or you don’t.

The psychology of the game is debatable. It seems more to me that with open table, if you have lots of capital, players are less likely to challenge you. The analogy to reserves is if you have lots of it, flaunt it. It is a deterrence strategy that worked in the HKD incident.

Not showing your capital, or reserves, is an ambiguity strategy that at its core, seeks to punish. Come try me and you will get a bloody nose. It invites adventurism.

Singapore is a managed float regime

Singapore is a managed float, or lag rate regime. Spot rate volatility is a function of market liquidity. It swings up and down within the allowed band during the course of the day. MAS intervenes in the forex market only to prevent a breach of the upper or lower band. If upward or downward pressure persists due to new equilibrium, MAS will tighten or loosen the band and let the rate float accordingly.

Why SGD cannot be attacked

This is something government officials never tell you. Perhaps some officials do not even understand. It tears the secrecy narrative to shreds.

A reader of my blogs insulted my integrity to truth when he pronounced my work is based on references to some blogs instead of reputable financial institutional sources. I write with some research, and then interpret based on my own worldview and my own understanding of subject matter. What is the point of blogging if I have no personal opinions to share. That reader’s derogatory mention of other bloggers pay no respect to hundreds of thousands of bloggers out there sharing their professional views on various matter, some of them with huge paid subscriber base. Now yours truly, a nobody blogger, is going to share with you why effectively, and 100% definitely, the SGD will never be attacked. This is the first time anyone has spoken about it and you hear of it here.

Currency speculators attack in two ways. They short the currency in the FX market or the shares in equity market, or both. In above examples, the attacks were in the FX market except for Hongkong where speculators attacked the Hang Seng Stock Exchange.

To attack SGD, speculators first need lots and lots of SGD. And where do they go to get SGD? The debt market. And this is where they meet the first road block, a credit restriction.

Singapore is an important international financial centre. We are known to be an open market, but we are actually not quite as open as most folks think. As the size of the economy is small, Singapore needs to guard against the internationalization of the SGD. MAS Notice 757 sets out the restrictions on lending of SGD to non-resident financial institutions.

1. SGD lending to non-resident financial institutions is capped at SGD5m per borrower.
2. Where aggregate lending has exceeded SGD5m, lender bank must ensure that if the funds are to be used outside Singapore, it has to be swapped or converted into a foreign currency at drawdown.
3. Banks must ensure temporary overdrafts on SGD Vostro accounts are covered within 2 days.
4. Bank must not extend SGD credit facilities to non-resident financial institutions if there is reason to believe that the SGD proceeds may be used for SGD currency speculation.

So there you are. No money, no honey. No finance, no attack.

Now why didn’t anybody tell you this before?

Should the would-be speculator turn to the SGX, he will face roadblock number 2. He will need to contend with the Exchange’s regulations for delivery in 2 days. He may have facilities for borrowing scripts but he needs SGD financing.

FX Trading platforms

There is a way that speculators can play without access to SGD war chest. That is by using online FX trading platforms. Whether a currency attack on a scale in the above illustrations can be conducted in this manner has never been tried before. The best advantage is the huge leverage offered. But there are issues. Massive numbers are involved. Can the speculators take the credit risk on the platform. It is unlikely the speculators can be market makers using an online platform. High frequency trading involving small lots is inefficient and may not be good enough in a fast moving market. Platform trading is non-delivery and trades are closed out by evening. To carry the trade the rollover cost will pile up. Once the central bank retaliates and hike overnight interest rate, its game over. The carry cost will kill the speculators.

Conclusion

The truth of the matter is the narrative that keeping the size of our reserves serves to protect the value of SGD is a fallacy. Singaporeans have been hoodwinked for decades because nobody has the temerity to ask nor think for himself.



A parting shout out :

Plato said:
“The price good men pay for indifference to public affairs is to be ruled by evil men.”
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