Analysis of Exchange Rate Movements:

A Case Study of Singapore

Alisan Chia
&
John G Bauer

Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore 2263
Fax: +(65) 792.4217, Tel: +(65) 799.5676, Email: ajbauer@ntuvax.ntu.ac.sg

Abstract This study provides a holistic perspective of Singapore’s exchange rate determination by
integrating theory, econometrics and institutional realities. We show how external conditions, economic
fundamentals and MAS intervention have affected the Singapore dollar. Because the Singapore dollar is
strongly managed, it is difficult to forecast exchange rate trends using an ARIMA model. Therefore, one has
to turn to more judgmental methods to ‘predict’ exchange rate trends.

1 INTRODUCTION
Singapore is an open economy undergoing intense globalisation, hence an understanding
of its exchange rate is important. This study attempts to give a holistic perspective of
Singapore’s exchange rate determination by integrating theory, econometrics and
institutional realities. It attempts to provide guidance as to what factors need to be
considered when attempting to understand and forecast Singapore’s exchange rate trends.
Most of the paper focuses on the nominal bilateral US$/Singapore$ exchange rate because
this is the rate most relevant to businesses. The nominal US$/S$ exchange rate is critical
since the US is Singapore’s major trading partner. Moreover, this rate is vital to the
financial sector. Capital flows in and out of Singapore and transactions in the Asian-dollar
market and Asian-bond market typically involve US dollars.
The period under study is from 1975 to 1994, and the data for the figures presented and for
the econometrics performed are from the International Financial Statistics (IFS). Quarterly
data series are used wherever possible, but we face data constraints as some of the series
are only available annually.
There is a wealth of literature touching on the different aspects of exchange rate
determination, and this literature is addressed when relevant in the body of the paper. We
briefly mention here, however, the few sources which are particularly useful. Duc-Tho
Nguyen and Yao Chye Chiang (1989) demonstrate that a synthesised monetary and
portfolio balance model is most suited for Singapore. Hence, we examine the impacts of
the variables which are pertinent to these models. Also, Abeysinghe and Lee Kok Hong
(1992) found that purchasing power parity (PPP) holds for the Singapore to US dollar
exchange rate, so an extensive discussion of PPP is also included in the study. PPP is
calculated using the ‘long run averaging’ method based on a paper by Kenichi Ohno
(1990).
Our discussion of factors that are difficult to model is culled from various Monetary
Authority of Singapore (MAS) Annual Reports as well as the volume Public Policies in
Singapore edited by Linda Low and Toh Mun Heng (1992). Finally, our regression
analysis is modeled after Pilbeam (1992).
4 Chia and Bauer

The paper begins with a short summary of the evolution of Singapore’s exchange rate
regimes. This is followed by a summary of Singapore’s exchange rate movements during
the past two decades. Attempts are then made to explain these movements. Explanations
are made by considering time honoured exchange rate theories such as purchasing power
parity. The role of the Monetary Authority of Singapore in influencing exchange rate
movements is also considered. Next the paper looks at the impact external economic
conditions have on the exchange rate. Economic fundamentals are also included as part of
the explanation of Singapore’s exchange rate trends. Finally we attempt to forecast the
nominal US$/S$ exchange rate with an ARIMA model.

2 BACKGROUND: EVOLUTION OF SINGAPORE’S EXCHANGE RATE

REGIME 1
The fixed exchange rate regime which Singapore chose to adopt after gaining
independence from the British in 1965 was based on previous ties with Britain. Under this
system the Singapore dollar was pegged to the pound sterling, and this parity to the pound
was maintained through strict exchange controls. Capital flows out of the Sterling Area
Countries/ Scheduled Territories (of which Singapore was a member country) were heavily
regulated.
Parity was maintained until the devaluation of the pound in November 1967. This
devaluation prompted the government’s decision to peg the Singapore dollar to the US
dollar and gold. In June 1972, following the floating of the pound, the Monetary Authority
of Singapore (MAS) replaced the pound with the US dollar as Singapore’s intervention
currency (Lim & Associates (1988)).
The year 1973 marked a turning point in the history of Singapore’s exchange rate regime.
In February 1973, there was a heavy inflow of US dollars into Singapore. Under the fixed
exchange rate regime, Singapore had to mop up this excess of US dollars at the ‘floor
rate’. This was equivalent to a devaluation of the Singapore dollar—a devaluation which
left the country vulnerable to inflation. As a result of this, in June of 1973, MAS made the
decision to replace Singapore’s fixed exchange rate regime with a managed float (Lim &
Associates (1988)).
From June 1973 to September 1975, the Singapore dollar was devalued by approximately
5.6% against the US dollar. But from September 1975 onwards, the Singapore dollar has
been managed by relating it to an undisclosed basket of trade-weighted currencies (with
the weights varying from time to time). MAS keeps the exchange rate within a set target
band by intervening in the foreign exchange market. These interventions are usually
conducted with US dollars.
In June 1978, Singapore’s exchange controls were ‘completely liberalised’. This move was
sparked off by the devaluation of the pound and Singapore’s exclusion from the Sterling
Area Countries.

1
Lim Chong Yah and Associates (1988), Chapter 11.
Analysis of Exchange Rate Movements: A Case Study of Singapore 5

3 BRIEF DESCRIPTION OF EXCHANGE RATE TRENDS: NOMINAL

US$/S$, REER, NEER, REAL US$/S$
3.1 NOMINAL BILATERAL RATE (US$/S$): FIGURE 1
This study focuses on the Singapore-US bilateral exchange rate because the United States
is a major trading partner of Singapore. Moreover the US$/S$ rate is critical to the
financial sector, since capital flows in and out of Singapore and transactions in the Asian-
dollar market and Asian-bond markets typically involve US dollars. MAS intervention in
the foreign exchange market is also carried out with US dollars.

3.1.1 Trends in Exchange Rate

The US$/S$ exchange rate was stable from the beginning of 1975 through mid-1975
(Figure 1).2 This was followed by a depreciation in the middle of 1975. After which there
was relative stability until 1977. An appreciation of approximately 10% was recorded
between September 1977 to the January of 1979. The period from 1979 to 1986 was
characterised by slight fluctuations within the band of 0.45 to 0.48. Appreciation began
again in earnest from January 1987, and this rise of the Singapore dollar has continued to
the present.

3.1.2 Points of Interest

An analysis of the US$/S$ exchange rate should, therefore, explain three things. First, is
the appreciation of the Singapore dollar during 1977 and 1978. Second, is the strong and
steady appreciation since 1987, and third are the fluctuations (within the band of 0.45 -
0.48) of the exchange rate from 1979 to 1986. These fluctuations are of particular interest
because the US dollar was appreciating during the early 80’s, yet the US$/S$ rate was held
within these rather narrow bands.

3.2 REAL EFFECTIVE EXCHANGE RATE (REER)

The REER is important because it defines Singapore’s overall competitiveness as affected
by changes in Singapore’s exchange rates with major trading partners as well as relative
price movements. It is therefore unfortunate that data on the REER is not readily available.
Calculation of the REER is not possible given data constraints. Teh Kok Peng and
Tharman Shanmugaratnam (1992) provide a brief summary of REER estimates. These
estimates were obtained by deflating the nominal effective exchange rate (NEER) using
unit labour costs, rather than price levels. Their summary suggests that the broad trends in
the REER are similar to those of the NEER, except that the degrees of appreciation/
depreciation of the REER are more pronounced.

3.3 NOMINAL EFFECTIVE EXCHANGE RATE (NEER): FIGURE 2

Because data on the REER are not available, we examine trends in the NEER in order to
gauge trends in Singapore’s competitiveness. The NEER is not as good an indicator as the
REER of course, because it does not take relative price changes into account. However, as
noted above, movements in the REER appear to follow movements in the NEER for
Singapore.
In Singapore’s context, the basket of currencies to which the dollar is related is not
disclosed. The NEER that is used to produce Figure 2 is taken from International Financial

2
Data for this and all subsequent charts was taken from the International Financial Statistics (IFS).
6 Chia and Bauer

Statistics (IFS) estimates, rather than the official MAS rate. Figure 2 plots movements in
the NEER and the bilateral US$/S$ rate.

3.3.1 Trends in the Exchange Rate

The NEER began appreciating in the first quarter of 1981 and peaked around the first
quarter of 1985. This was followed by a depreciation that lasted till the end of 1987. Since
the first quarter of 1987 the appreciation of the NEER has been tracked by an appreciation
of the nominal bilateral rate (US$/S$). This indicates the importance of the Singapore-US
bilateral exchange rate.

3.3.2 Points of Interest

As noted above, we would expect the NEER and the US$/S$ rate to move together
because of the heavy weight that must be allocated to the US in the basket of currencies on
which the NEER is based. The divergence between the two rates during the early 1980s,
therefore, is of interest. The reason for the divergence must be that the Singapore dollar
was appreciating by more, relative to the other currencies in the basket than to the US
dollar. The Singapore dollar did appreciate against the yen during this period. In 1981, for
example, it appreciated by 11% against the yen, whereas it appreciated only 2% against the
US dollar.
The fact that the NEER appreciated strongly during the early 1980’s, while the US$/S$
rate remained more stable suggests that the MAS was maintaining some kind of parity
with the US dollar.
In any case, the NEER and the US$/S$ rates converged during 1985-86, and have tended
to move together since 1987. Since 1991, the bilateral rate has appreciated more rapidly
than the NEER. Once again, the explanation for the disparity must be that some other
currency in the NEER has tempered the appreciation in the US dollar. The yen was
depreciating against the Singapore dollar from 1992-93. This might have slowed down the
appreciation of the NEER.

3.4 REAL BILATERAL EXCHANGE RATE (US$/S$): FIGURE 3

Because data on the REER are not available we estimate the real bilateral US$/S$ rate and
use it as an indicator of Singapore’s competitiveness. This may be problematic during
periods when the NEER and the US$/S$ rates diverged (in the early 1980’s), however this
divergence was temporary. In any case, the real US$/S$ rate is of obvious importance
given that the US is Singapore’s major trading partner and investor.

3.4.1 Calculation of the Real Bilateral Exchange Rate

The real exchange rate was calculated based on the following equation:
(US$/S$)real = (US$/S$)nominal * [PriceS’pore / PriceUS] (1)
The wholesale price indices (WPI) for the two countries were used, rather than the CPIs,
since the WPIs are more pertinent to trade competitiveness.

3.4.2 Trends in the Exchange Rate (Figure 3)

From 1975 to the first quarter of 1981 the nominal and the real bilateral exchange rates
tracked each other relatively well. In the period beginning the first quarter of 1981 to the
second quarter of 1986, the nominal exchange rate was fairly stable while the real bilateral
Analysis of Exchange Rate Movements: A Case Study of Singapore 7

rate fell sharply. Despite the strong appreciation in the nominal rate since the first quarter
of 1987, the real bilateral rate has remained fairly stable.

3.4.3 Points of Interest

Deviations of the nominal exchange rate from the real exchange rate can be explained by
movements in relative prices. For instance, the depreciation of the real rate from 1981 Q1
to 1986 Q2 was a result of rising prices in the US.
The deviations in the real and the nominal bilateral rates suggest that the nominal bilateral
rates do not always determine competitiveness. Although the nominal rate was relatively
stable from 1981 Q1 to 1986 Q2, for example, the real exchange rate fell, resulting in an
increase in Singapore’s competitiveness. Also because the real exchange rate has been
stable since 1987, the appreciation of the nominal exchange rate has not eroded
Singapore’s competitiveness.

4 THE MONETARY AUTHORITY OF SINGAPORE (MAS)

4.1 BACKGROUND
The Authority was established in January 1971 and serves as Singapore’s central bank.
One of its primary objectives is to maintain a reasonably stable exchange rate for non-
inflationary economic growth. Prior to 1981, MAS targeted money supply and interest
rates to keep inflation at bay. In 1981, however, exchange rate policy replaced monetary
policy as the Authority’s main anti-inflationary tool (MAS Annual Report, 1981/1982).
Given the Authority’s objective, MAS intervenes in the foreign exchange market
whenever there is a threat that Singapore’s exchange rate may move out of an undisclosed
target band. The setting of the target band is subject to policy considerations and not
market forces. Market forces do, however, play an indirect role in the setting of the band.
If the band were set too high, for instance, then Singapore’s exports and investments from
abroad would suffer. Market forces are allowed to prevail within the target band (MAS
Annual Report 1984/1985).
In order to understand movements in the Singapore dollar, one must understand the
objectives and actions of the MAS; the following sections provide some relevant
background.

4.2 COSTS OF INFLATION

The MAS is very much concerned with guarding against inflation, this concern arises for
several reasons. First of all, inflation is socially divisive because it results in an arbitrary
redistribution of income and wealth. Debtors gain as they pay back less in real terms, and
creditors lose out as a result. Individuals drawing a fixed income (e.g.; pensioners) suffer
as the purchasing power of the dollar falls. Low income earners who do not make enough
to invest in assets to hedge against inflation also suffer (Teh and Shanmugaratnam (1992)).
Secondly, inflation distorts prices. This leads to economic inefficiency because prices are
an integral part of market signaling. Inflation could also lead to more frequent re-
negotiation of wages, as workers fight to keep their real wages from falling. Inflation also
makes investment decisions more difficult. Inflation, especially high rates of inflation,
generates a high level of uncertainty in terms of costs and prices. A wage-price spiral
might be sparked off by high rates of inflation as workers bid up wages in anticipation of
future price rises.
8 Chia and Bauer

Thirdly, interest rates will be bid up to compensate for expected inflation. Higher interest
rates represent higher investment costs. Also because of the uncertainty of the dollar’s
value investors will opt for short term instead of long term investments. This may lead to
lesser income-generating investment and greater investments that yield gains in an
inflationary environment (e.g.; property and real estate).
Finally, ‘persistent inflation leads to an overvalued exchange rate’ (MAS Annual Report,
1991/1992, p. 18). The real exchange rate is determined by the nominal exchange rate and
relative prices. Hence, inflation leads to an appreciation in the real exchange rate and this
dampens export growth. The currency would then have to be devalued, and this would
induce capital outflows and cause a slow down in foreign direct investments. Inflation
generally results in a loss of confidence in the economy.

4.3 EXCHANGE RATE POLICY AS AN ANTI-INFLATIONARY TOOL

The MAS replaced monetary policy with exchange rate policy as the main anti-inflationary
tool (Teh and Shanmugaratnam (1992)). Singapore has virtually no control over capital
flows, because in addition to not having exchange controls, it also has a liberal policy
towards foreign direct investment. Moreover, capital movements are very sensitive to
interest differentials, especially to that of the United States.
This makes it difficult for MAS to target the interest rate. Interest rates are largely
determined by foreign interest rates and expectations of the future appreciation of the
Singapore dollar. If the Authority attempts to raise or lower interest rates while world
interest rates remain unchanged, then capital flows will return interest rates to their
original level. High capital mobility suggests that the MAS can seek to influence either the
exchange rate or interest rates, but not both.
It is also difficult for MAS to target money supply. This is because changes in money
supply are determined mainly by the net flow of funds from accounts from ‘abroad’ (Teh
and Shanmugaratnam (1992)). Also, because of Singapore’s ‘openness,’ money supply and
interest rates do not affect price stability as directly as does the exchange rate. In many
developed countries interest rates play an important role in determining the level of
investment but in Singapore, because of the large external sector, the cost of domestic
borrowing is less important. For all these reasons, MAS turned to exchange-rate ‘targeting’
as an anti-inflationary tool.
Singapore is a price taker in the international market. It is unable to influence prices
because of its small size. This and the country’s heavy reliance on trade makes the
economy vulnerable to imported inflation. The high import content in Singapore’s
manufactured goods makes it especially susceptible to cost-push inflation. Estimates show
that for every 1 percent increase in import prices, Singapore’s consumer price index (CPI)
goes up by 0.5 percent (Teh and Shanmugaratnam (1992)). The effect of rising import
prices, however, can be offset by allowing the Singapore dollar to strengthen.
The exchange rate also has an impact on internally generated inflation. Because a large
proportion of demand in Singapore is made up of imports, the exchange rate has a
considerable impact on domestic demand (at least in the short term). By influencing
demand, the exchange rate also influences the demand for resources; in particular the
demand for labour. A weak exchange rate could lead to an overheated economy, and a
tight labour market, bidding up wages and other costs of production.
Analysis of Exchange Rate Movements: A Case Study of Singapore 9

4.4 THE EXCHANGE RATE & EXPORT COMPETITIVENESS

It would seem that a strong Singapore dollar, while being an anti-inflationary tool might
hurt exports. An appreciation of the exchange rate to offset imported inflation might result
in a loss of competitiveness as Singapore’s exports become relatively more expensive.
The MAS argues, however, that this would only be true in the short run, and that the
exchange rate is not a good tool for maintaining export competitiveness (MAS Annual
Report, 1991/1992, p. 3). Consider a depreciation of the Singapore dollar. In the short run
Singapore’s exports become cheaper since relative unit labour costs are cheaper. However,
Singapore’s exports have a high import content, and the cost of imported inputs rise as the
exchange rate depreciates. Also over the middle term, wages increase as consumer prices
increase and the labour market tightens because of the exchange rate depreciation.
Therefore, there is less reason to consider export competitiveness when formulating
medium to long term exchange rate policies.
It should also be remembered that other factors besides price of exports (as determined by
the exchange rate) determine export competitiveness. These factors include, for example,
after sales service and good product quality.

4.5 WORKINGS OF EXCHANGE RATE POLICY

The Singapore dollar is managed by relating it to an undisclosed trade-weighted basket of
exchange rates. It is important to note that, strictly speaking, the Singapore-US bilateral
exchange rate alone does not determine the rate of imported inflation. However since the
US is such an important trading partner with Singapore it is safe to say that it must have a
high weighting in determining the country’s nominal effective exchange rate (NEER).
Officially, MAS does not maintain a parity either against the US dollar or a basket of
currencies. Instead the NEER is allowed to float within an undisclosed target band.
CPF funds and government surpluses are deposited with MAS. This reduces liquidity in
the banking system, and there is constant pressure on the Singapore dollar to appreciate.
MAS neutralises this pressure by restoring the liquidity in the banking system by buying
US dollars through the creation of reserves. The extent of intervention depends on the
target band and the prevailing exchange rate, and the target band is based on projected and
prevailing rates of external and domestic inflation. A major objective, is to keep CPI
inflation low and stable.

4.6 EXCHANGE RATE POLICY IN ACTION

It is useful to observe how MAS has reacted under different conditions. Since the
Authority began using exchange rate policy as an anti-inflationary tool in 1981, we focus
on its reactions during the 1980’s and 90’s

4.6.1 1981 - 1985: Second Oil Shock and the 1985 Recession
The shift in the focus of monetary policy from money supply and interest rate targeting to
exchange rate ‘targeting’ took place in the inflationary environment of 1981. The second
oil shock in 1979 led to the world inflation rate being over 8 percent in 1981-1982. A
strong exchange rate was adopted to relieve inflationary pressures and to further the
government policy of upgrading and restructuring the economy (MAS Annual Report,
1981/1982).
Rapid increases in nominal wages contributed to domestic inflation. During 1979 - 1981
the government initiated a ‘high wage policy’ to encourage industries to move to more
10 Chia and Bauer

capital and skill- intensive activities. The policy resulted in productivity growth but this
growth did not completely offset wage increases, and unit labour costs (ULC) rose. The
appreciation of the NEER in 1981 did not prevent the inflation rate from rising. It did,
however, curb import inflation, and the inflation rate in 1981 - 1982 was lower in
Singapore than in OECD countries.
As world inflation came down and the NEER continued to appreciate, Singapore
experienced negative import inflation in 1982. Wages, however, continued to increase
after 1981 because of the increase in CPF contribution rates and a tighter labour market.
Unit labour costs increased. Inflation in the early 80’s, after 1981, was the result of
domestic factors. If the exchange rate had not appreciated, inflation would have been much
worse since import inflation would have contributed to the inflation in Singapore (MAS
Annual Report, 1990/1991).
Because ULCs increased more rapidly than those of competitors and as a result of the
appreciating NEER, the real effective exchange rate (REER) also appreciated. Singapore’s
competitiveness declined and contributed to the recession in 1985. A fall in external and
domestic demand were other contributing factors.

4.6.2 1985 - 1988: Era of Deflation

Domestic inflationary pressures were relieved by the effects of economic recession and a
series of costs and tax cuts. In 1986 there was a 15 percent reduction in the CPF
contribution rate. Wage restraint was practised and ULCs declined. Meanwhile, world oil
and commodity prices began to fall from late 1985 onwards bringing down world inflation.
Hence during 1985 -1987, MAS could allow the exchange rate to ease without worrying
about inflation. The fall in ULCs and the NEER laid the ground for economic recovery in
1986 (Teh and Shanmugaratnam (1992)).

4.6.3 1988 - 1991: An Overheated Economy

In mid-1988 the NEER began to appreciate again, reflecting worries of both internal and
external inflationary pressures. Faced with a strong external demand, Singapore’s economy
began to overheat. In 1989 unemployment fell below 2.5 percent, well below what is
normally regarded as full-employment. The labour market tightened and wage growth
grew to a rate that was above productivity growth. By the end of the decade, ULCs were
increasing by 6 percent per annum. This resulted in domestic inflationary pressures.
During the late 1980’s foreign inflationary pressures had also increased. However, the
appreciation of the exchange rate since 1988 offset this. Exchange rate policy was so
effective that by 1991 import prices had a dampening effect on CPI inflation. The stronger
exchange rate also cooled the tight labour market. Simulations that have been performed
using the MAS econometric model suggest that if the exchange rate had not appreciated
since 1988, inflation would have averaged 6 percent per annum from 1989 to 1991, instead
of the actual rate of 3 percent (Teh and Shanmugaratnam (1992)).
It is also claimed that any competitive enhancement brought about by a weaker exchange
rate would have been temporary, being eroded by eventual inflation in the long term. The
MAS stance is that a loss of competitiveness in the face of an overheated labour market
cannot be relieved by weakening the exchange rate, since an appreciation of the REER
would be inevitable. The alternative to an appreciation of the nominal exchange rate would
be an increase in ULCs.
Analysis of Exchange Rate Movements: A Case Study of Singapore 11

4.6.4 1990’s: Slow Down in Labor Force Growth

As Singapore’s labour force growth slows, the economy’s potential economic growth will
probably fall to 5 percent - 6 percent over the 90’s. Supply-side growth will become more
limited and the economy will become more vulnerable to ‘demand induced overheating
and inflationary pressures’ (MAS Annual Report 1991/1992, p. 14). There is therefore a
need to moderate growth in GDP such that it does not exceed its sustainable level. By
doing so inflationary pressures will be relieved thereby ensuring a more sustainable
growth. Therefore a strong exchange rate policy could be followed to ensure moderate
GDP growth and keep inflation at bay. ‘If price stability were traded off for the purpose of
sustaining short-term economic growth above the economy’s potential, growth itself will
ultimately be lowered’ (Teh and Shanmugaratnam, 1992, p. 301).

5 PURCHASING POWER PARITY

This section looks at the purchasing power parity between Singapore and the United
States. PPP is an important model of exchange rate determination and it is often used to
predict long run movements in exchange rates. We focus on the Singapore - US dollar PPP
because of the importance of this bilateral rate. Also it has been verified by Abeysinghe
and Lee (1992) that PPP between the Singapore and US dollars does hold.

5.1 THEORY
PPP theory is based on the law of one price; i.e.; ‘arbitrage forces will lead to the
equalisation of goods prices internationally once the prices of goods are measured in the
same currency’ (Pilbeam, 1992, p. 142). Assumptions made under the theory are: (1)
perfect competition and (2) no transaction costs (e.g.; transportation costs, barriers to trade
and imperfect information).
There are two basic forms of PPP: absolute PPP (strong form) and relative PPP (weak
form). Absolute PPP states that the prices of a similar good A in two countries are equal
when denoted in the same currency. Absolute PPP can be expressed algebraically as,
S = P / P* (2)
where S is the exchange rate (domestic currency units per unit of foreign currency); P is
the price of a bundle of goods denoted in the domestic currency and P* is the price of a
bundle of goods denoted in the foreign currency.
The strong form is not likely to hold since the assumptions made are unlikely to hold.
Relative PPP states that the exchange rate adjusts according to the difference in the
inflation rates of the 2 countries. Relative PPP can be expressed algebraically as,
%∆S = %∆P - %∆P* (3)
where %∆S is the percentage change in the exchange rate; %∆P is the domestic inflation
rate and %∆P* is the foreign inflation rate.
A weakness of relative PPP is that it does not take into consideration the difference
between tradables and non-tradables. Inflation rates do not distinguish between the two.
But PPP is more applicable to tradable goods since they are open to international
competition.
12 Chia and Bauer

5.2 MEASUREMENT PROBLEMS IN PPP

There are several problems associated with estimating PPP exchange rates. These issues
are discussed below.

5.2.1 Distinction Between Tradable and Non-Tradable

The distinction between tradable an non-tradable goods is blurred because of the linkages
between the two prices. Imported inputs are sometimes used in the production of non-
tradable goods and non-traded goods are sometimes used in the production of tradables.
Therefore PPP may be applicable, to some extent, to both tradable and non-tradable goods
and there may be cause to use a more general price level (Pilbeam (1992)).
The wholesale price index (WPI) is generally used when PPP is expected to hold for
tradables. The consumer price index (CPI) is used when it is expected to hold for both
tradable and non-tradable goods. In our calculations of the PPP, WPI was used since we
believe that PPP should assert itself more strongly for tradables.

5.2.2 Time Required for PPP to Assert Itself

There is disagreement over the period when PPP can be expected to prevail. Strong
versions of PPP suggest that PPP might hold on a monthly basis whilst progressively
weaker versions would suggest a longer period of time. Because of Singapore’s openness
and relative price flexibility we chose to calculate PPP on a quarterly basis.

5.2.3 The ‘Base Year’ Problem

This is perhaps the most pressing problem faced by those who wish to calculate PPP. It
would be ideal if we had the absolute Singapore dollar and US dollar prices (Pa and Pa*
respectively) for an identical basket of goods, since PPP is expected to hold only for
identical baskets of goods (Ohno (1990)). Then the absolute PPP exchange rate would
be:
SPPP = Pa / Pa* (4)
Such uniformity is, however, not found in the real world.
Ohno (1990) discusses the problem as follows. Consider the ‘relative’ PPP:
SPPP ≈ θP / P* (5)
where SPPP is the ‘relative’ PPP exchange rate (domestic currency units per unit of foreign
currency) and θ is an unknown scale factor that links the relative prices P and P*. P and P*
are domestic and foreign prices of baskets of goods that are similar in content but of
different sizes (i.e., the base year of the two prices could be different). Note that this is
only an approximation because the two baskets need not have the same weights. The base
year ‘problem’ is essentially to find the right value for θ. The problem is illustrated below.

5.3 CALCULATION OF PPP

There are different methods that are used to solve the base year problem (and hence
calculate PPP). We present two methods: (1) the Cassel-Keynes Method and (2) Long-Run
Averaging.

5.3.1 Cassel-Keynes Method

This method begins by choosing a base year when the exchange rate can be assumed to be
at PPP. Then later movements in the relative prices are used to update the base period’s
Analysis of Exchange Rate Movements: A Case Study of Singapore 13

exchange rate in order to obtain the new estimate of PPP. There are however several base
years that may be chosen. We chose 1975 as our base year since Singapore’s current
account deficit in that year roughly in balance. Note, however that the resulting PPP
estimates are sensitive to the choice of the base year.
5.3.1.1 Calculation
We estimated PPP rates, using the following equation:
EPPP = E0[(Pt* / P0*) / (Pt / P0)] (6)
where E0 is the actual and PPP exchange rate (foreign currency units per unit of domestic
currency) at time = 0 (1975). P denotes prices (in this context WPI), * denotes foreign
variables (US) and the subscript following P denotes time period. Note that in this
formula, θ = E0 (P0 / P0*).
The WPIs for Singapore and US were indexed at 1990. An index with 1975 as the base
year was achieved by dividing WPIt with WPI1975 for the US and Singapore price
indices.
5.3.1.2 Trend and Analysis
Our estimates in Figure 4 suggest that the nominal exchange rate was over-valued from
1979 to 1981, and that it has been undervalued since 1983. But the degree of
undervaluation has been fairly stable. This implies that whereas there may be pressure on
the Singapore dollar to appreciate because of the undervaluation, this pressure has not been
increasing. The appreciation of the Singapore dollar since 1986 is roughly in line with
PPP.

5.3.2 Long-Run Averaging

Another way to solve the ‘base year’ problem is to take the long run average of past
relative prices instead of a single base year as in the Cassel-Keynes Method. The
assumption is that there is an equal chance of the exchange rate being over or undervalued
in the long run. Although there may be times when the exchange rate is under or
overvalued for a long period of time, it is doubtful if this could continue for long. This is
because the exchange rate would be under pressure to appreciate or depreciate accordingly.
Hence we may assume that over the long run exchange rates are aligned with PPP.
Ohno (1990) suggests that the long run average PPP could be calculated as far back as
1975 (when general floating began). 1973-1974 should be left out since they were
transitional periods.
Note that there may be a problem in using the long run averaging method since different
countries use different ways to adjust for quality changes, etc. This would result in a
permanent measurement bias.
5.3.2.1 Calculation
The calculation of the long-run average PPP is similar to the calculation for the Cassel-
Keynes Method. The same equation is used with the exception that instead of using the
exchange rate and prices prevailing in the base year, their average values are used. The
long-run average PPP was calculated from 1975 to 1994.
5.3.2.2 Trend and Analysis
Our estimates presented in Figure 5 suggest that the Singapore dollar was overvalued from
1975 to the mid-80’s, especially in 1979-1981. The currency has been undervalued since
14 Chia and Bauer

1985. The degree of undervaluation varies. Whereas there has not been a general trend
towards convergence, it would seem that the undervaluation in recent years is not as large
as it used to be. Also, the nominal and PPP rates have moved together since the mid-80’s,
suggesting that relative price changes have played an important role in the Singapore
dollar’s appreciation.

6 EXCHANGE RATES AND THE EXTERNAL SECTOR

This section examines trends in the current account, exports, capital account, balance of
payments and foreign exchange reserves and their relationships with the various exchange
rates. The focus is on the period from the early 1980’s onwards, since this is when MAS
began exchange rate ‘targeting’.

6.1 SUMMARY OF EXCHANGE RATE TRENDS

It may be useful to summarise trends in the bilateral and effective exchange rates before
examining the external sector. Table 1 provides this summary.

6.2 CURRENT ACCOUNT: FIGURE 6

Broadly speaking, the current account is made up of the trade balance, the service balance
and net transfer payments. But because net transfer payments are a relatively small
component, they do not have much of an impact on the general movements in the current
account.
We would expect the current account to respond to movements in the REER, since the
REER is an indicator of a country’s overall competitiveness. The current account should
worsen as the REER appreciates and improve as it depreciates. From the summary of
exchange rate trends given above, we see that during the 1981-1993 period, the REER
experienced a series of appreciations and depreciations. However, the current account in
general improved through out this period. This runs contrary to our expectations, and the
remainder of this section attempts to explain why the current account continued to improve
even during periods of REER appreciation.

6.2.1 Appreciation in 1981Q1-1985Q1

6.2.1.1 Improvement in Net Service Earnings
An improvement in net service earnings can explain part of the rise in the current account
despite the REER appreciation. In 1981, net earnings from services financed 73 percent of
the trade deficit compared with 64 percent in 1980 and 53 percent in 1972. These earnings
were from: provision of transportation, technical and financial services; oil processing and
other professional services. In 1982 net earnings from services expanded by a further 20
percent (MAS Annual Report, 1982/1983).
It can be argued that competitiveness in services is less based on low prices than is export
competitiveness. The level of expertise and service is more important. Besides there are
certain services, such as financial services, in which Singapore may have comparative
advantage. Therefore, the improvement in the current account despite the REER,
appreciation could be partially explained by the rising importance of the service sector.
6.2.1.2 Importance of the United States
The importance of the US as a major importer of Singapore’s exports could also help to
explain the improvement in the current account. While the REER was appreciating during
Analysis of Exchange Rate Movements: A Case Study of Singapore 15

1981-85, the Singapore-US bilateral exchange rate was depreciating. Moreover, income
growth in the US was strong, as was US demand for imports.
Consider the situation in 1983. Whereas earnings from services fell by 12 percent,
Singapore’s current account improved because of rising exports and falling imports. This
might seem inconsistent with the rising REER. Note, however, that the recovery in exports
was uneven. Exports to the US grew by 50 percent, while exports to Japan, Hong Kong,
West Asia and Australia declined. The rise in exports to the US was encouraged by both
the depreciating real bilateral exchange rate and the strong economic growth in the US.

6.2.2 Appreciation from 1987

6.2.2.1 Improvement in Net Service Earnings
As before, net service earnings help to explain the improvement in the current account
despite the appreciation of the REER. The service balance began to recover in 1987,
following a decline during 1983-1986. In 1987, travel receipts alone rose by 21 percent. In
fact the surplus in the current account in 1987 can be attributed to the improvement in the
service balance. The service balance also accounted for the improvement of the current
account in 1989. And in 1990 ‘the widening of the merchandise deficit was cushioned by a
burgeoning of net service receipts to $14.2 billion’ (MAS Annual Report, 1990/1991, p.
27).
So once again, the dramatic increase in the current account, despite the rise in REER and
nominal bilateral rate, can to a large extent be explained by the growing importance of the
service sector.
6.2.2.2 Reduction in the Import Content of the Export Sector
In the last decade there has also been an increase in the domestic value-added per unit of
exports. This has reduced the import content of the export sector and helped to improve
the trade balance. In addition, non-oil domestic export growth has been more powerful
than oil or entreport exports, which have relatively low domestic value-added margins.
6.2.2.3 Exports
We expect a worsening of the current account when the REER appreciates largely because
of the resulting fall in exports. This section has attempted to explain why the current
account has improved, despite the REER appreciation by discussing service earnings.
However, there have been periods when a rise in exports helped to improve the current
account. Therefore, the next section examines the relationship between exports and
exchange rates more closely.

6.3 EXPORTS: FIGURE 7

We would expect total exports to increase when there is a depreciation in the REER and
vice versa. Moreover, we would expect exports to the US to be affected by the real
Singapore-US bilateral rate. To some extent this is what we see in Figure 7.

6.3.1 Appreciation in 1981Q1-1985Q1

Exports remained relatively stable despite the appreciation of the REER. In 1981, export
growth moderated to 7 percent from a high of 34 percent in 1980. The moderation of
export growth continued into 1982. But non-oil exports and domestic exports rebounded
growing by 14 percent and 20 percent respectively in 1983. The depreciating real bilateral
US$/S$ exchange rate should have also encouraged exports to the US.
16 Chia and Bauer

In 1985, when the REER peaked, total exports fell by 2 percent. The situation might not
have been as bad if electronics exports to the US had held up. However, although the
Singapore-US bilateral rate was still depreciating, electronic exports to the US could not
be sustained because of the global overproduction of electronic components (MAS Annual
Report, 1985/1986).

6.3.2 Appreciation from 1987

The REER and nominal US$/S$ rates have appreciated since 1987, though the real
bilateral US$/S$ rate has remained fairly stable. Exports, however, have grown strongly
since the late 1980’s. Hence, we conclude that the rise in exports must have been for
reasons other than exchange rate movements.
One major reason seems to be the rapidly growing demand from the Asia-Pacific region
since the mid-1980’s. The share of Asia-Pacific markets in Singapore’s non-oil domestic
exports has increased from 28 percent in 1986 to 36 percent by 1992 (MAS Annual
Report, 1992/1993). Singapore has become an increasingly important supplier of inputs for
the production of manufactured exports in the regional economies. These exports in turn
depend to a large degree on final demand from the US. Therefore, the relatively low and
stable Singapore-US real bilateral rate gives inputs supplied by Singapore (for US bound
exports) a competitive advantage.

6.3.3 Summary
A strong exchange rate policy is constrained by the ‘detrimental’ effects such a policy
might have on exports. We see this happening in 1985 when the strong exchange rate
policy was abandoned to stimulate export growth. The easing of the exchange rate
happened to coincide with a period of deflationary pressure. Export growth has been
healthy since 1987. There has, therefore, been little or no pressure on the MAS to
subordinate their primary objective of price stability to stimulate export growth.

6.4 CAPITAL ACCOUNT & BALANCE OF PAYMENTS: FIGURES 8 TO 14

Capital flows should have a strong impact on exchange rates. This appears to be the case
in Singapore. Movements in the capital account largely determine Balance of Payments
(BOP) patterns for Singapore, and BOP trends put pressure on a currency. As we will see
below there is a very close relationship between movements in capital flows and the
nominal bilateral US$/S$ exchange rate.
From Figure 8, we see that from the late 70’s to the early 80’s, large capital inflows were
associated with an appreciation of the Singapore dollar. And the worsening in the capital
account during 1984-1985 was associated with a depreciation. The dramatic surge of
capital inflows from 1986 onwards appears to have been an important cause of the increase
in nominal bilateral exchange rate.
Figure 9, indicates that trends in the BOP are, on the whole, similar to those of the capital
account and hence relate to the exchange rate in much the same way. This is what we
would expect, since the capital account largely determines Singapore’s BOP.
Singapore’s capital account includes four categories of capital flows: direct investment,
portfolio investment, other long term capital and other short term capital. Direct
investment has been the largest component of the capital account (save for a few years).
Moreover, direct investment is the flow that seems to be the most closely associated with
movements in the exchange rate. Trends in direct investment flows track movements in the
Analysis of Exchange Rate Movements: A Case Study of Singapore 17

bilateral exchange rate very closely (Figure 10). Figure 11 shows the strong positive
relation between direct investment and the US$/S$ rate. An increase in direct investment
exerts strong pressure on the Singapore dollar to appreciate.
The relationships between the exchange rate and the other categories of capital flows are
not as strong. From Figure 12, we see that other short-term capital does fairly well in
tracking the movements in the nominal bilateral exchange rate, but it does not do as well
as direct investment. From Figures 13 and 14, we see that other long term capital and
portfolio investment do not do well in tracking movements in the nominal bilateral
exchange rate. For example, both of these capital flows declined in the late 80’s, whereas
the Singapore dollar appreciated strongly.

6.4.1 Summary
It appears that capital flows do have a strong impact on the nominal bilateral US$/S$
exchange rate. Levels of direct investment appear to have been especially important.

6.5 FOREIGN EXCHANGE RESERVES: FIGURE 15

The level of a country’s foreign exchange reserves could limit a central bank’s ability to
intervene in the foreign exchange market. This is especially so when the bank is attempting
to maintain an exchange rate when the currency is overvalued. But this does not appear to
be the case in Singapore. Foreign exchange rate reserves have risen steadily since the mid-
70’s. And they have increased dramatically since the late 1980’s (Figure 15).
Singapore’s budgetary surplus and the accumulation of funds from the CPF (Central
Provident Fund) have contributed to the growth in reserves. Budgetary surpluses and CPF
funds are deposited in the MAS. This results in a loss of liquidity from the private banking
sector, and results in a constant pressure on the Singapore dollar to appreciate. In order to
moderate the loss of liquidity and the pressure on the dollar, the MAS intervenes by selling
Singapore dollars and buying US dollars. Foreign exchange reserves rise in the process.

7 ECONOMIC FUNDAMENTALS
7.1 INTRODUCTION
Standard models of exchange rate determination, such as various versions of the monetary
model, state that four variables influence exchange rate movements.
They are:
1. relative inflation levels;
2. relative interest rates;
3. relative rates of economic growth and
4. relative growth in money supply.
This section examines the impact of these variables on the nominal bilateral US$/S$ rate.
We begin with a brief description of two common monetary models: the flexible price
monetary model and the Dornbusch sticky price monetarist model (see Pilbeam, 1992, for
a more extensive discussion).

7.2 MONETARY MODELS

In monetary models the key determinants of exchange rate movements are money supply
and money demand. Monetary models also share a common assumption: that domestic and
18 Chia and Bauer

foreign bonds are homogenous and, therefore, that the Uncovered Interest Parity (UIP)
condition holds.

7.2.1 The Flexible Price Monetary Model

This model also makes the following assumptions: (1) PPP holds continuously and (2)
prices are flexible. The premise of the model is that relative money stocks determine
relative prices which in turn determine the exchange rate via PPP.
An increase in the domestic money supply leads to an increase in domestic prices. And
because PPP holds continuously, this leads to a depreciation of the domestic currency. A
rise in foreign money supply leads to an appreciation of the domestic currency.
A rise in domestic income leads to a rise in transactionary money demand. With money
supply and interest rates held constant, the increased demand for real money balances can
only be met by a fall in prices. To maintain PPP, the home currency must appreciate.
Conversely, an increase in foreign income leads to a fall in foreign prices and therefore a
depreciation of the home currency to maintain PPP.
The equation linking real and nominal interest rates is as follows:
r = i + Pe (7)
e
where r is the nominal interest rate, i is the real interest rate and P is the expected rate of
price inflation. Note that under UIP, real interest rates are equated across countries
(i = i*).
An increase in domestic inflation expectations leads to a corresponding rise in r. The
increase in domestic inflation expectations leads to a fall in money demand and a rise in
spending. Both these factors serve to drive up prices. To maintain PPP, the home currency
would have to depreciate. Monetary models, therefore, predict an increase in nominal
interest rates to be associated with a depreciation of the currency. Note that this runs
counter to the more conventional prediction—higher interest rates result in capital inflows
and a currency appreciation.

7.2.2 The Dornbusch Sticky Price Monetarist Model

This model explains large and prolonged deviations of the exchange rate from PPP. It only
assumes that PPP holds in the long run. The premise for the sticky price model is that
prices in the goods and labour markets are sticky while prices in the exchange rate markets
are flexible. This leads to exchange rate ‘overshooting’ which explains deviations from
PPP.
The model assumes that UIP holds. If the domestic interest rate is less than the foreign rate
then there must be a proportionate expected rate of appreciation of the home currency to
compensate for the lower interest.
An increase in domestic money supply, with prices unchanged, implies that interest rates
would have to fall to equilibrate the money market. The decline in the domestic interest
rate requires a proportionate expected rate of appreciation of the home currency to
compensate for the lower interest rate. Therefore the exchange rate overshoots in the short
run (i.e., it depreciates to a level lower than that required to maintain PPP) in order to
generate an expected rate of appreciation.
Analysis of Exchange Rate Movements: A Case Study of Singapore 19

A rise in home income leads to an increase in transactionary demand for money. This
would cause the domestic currency to appreciate, as in the flexible price model. The
effects of a rise in domestic interest rates have already been described above.

7.3 TREND ANALYSIS

We begin with a brief graphical examination of the monetary model variables, before
presenting a regression analysis.

7.3.1 Money Growth and the Nominal US$/S$ Exchange Rate: Figure 16
Theory suggests that more rapid money supply growth in Singapore relative to the US
should lead to a depreciation of the Singapore dollar. This does not appear to be the case.
Instead, we see in Figure 16 that, as Singapore’s money supply growth increases, the
exchange rate tends to appreciate.
The observation may be due to the nature of monetary policy in Singapore. As a result of
CPF and government surpluses being deposited with the MAS and the large capital
inflows, the Singapore dollar is under constant pressure to appreciate. To keep the
exchange rate within the target band, the MAS sells Singapore dollars and buys US
dollars. This necessarily leads to an increase in the monetary base. Hence, we tend to see a
rise in the money supply when the Singapore dollar is under strong pressure to appreciate.

7.3.2 Interest Rates and the Nominal US$/S$ Exchange Rate: Figures 17-18
Monetary models suggest that an increase in the nominal interest rate will cause a currency
to depreciate. The more conventional view is that higher interest rates will generate capital
inflows and a currency appreciation. Our graphical analysis, unfortunately, does not tend to
support either view. There are times when the interest rate (and the interest rate
differential) moves together with the exchange rate and there are times when they do not
(Figures 17 and 18). We also generated scatter plots of interest rate differentials (i.e., US
bank prime loan rate less Singapore’s minimum lending rate) and the currency’s
appreciation/depreciation rate. These plots also showed no clear relationship between
movements in the Singapore dollar and relative interest rates.

7.3.3 Income Growth and the Nominal US$/S$ Exchange Rate: Figure 19
Standard theory predicts that higher domestic income growth leads to an appreciation of
the domestic currency. In Figure 19, we define the income growth differential as the US
GDP growth rate less Singapore’s GDP growth rate. Hence, we expect there to be an
inverse relation between the growth differential and the US$/S$ rate.
Figure 19 suggests that, in general, this relationship is observed. The more rapid growth in
Singapore during the late 1970s was associated with an appreciation of the Singapore
dollar. The US$/S$ rate stopped appreciating in the early 1980s and depreciated in the
mid-1980s as relative GDP growth in Singapore declined. Singapore’s relative GDP
growth increased after 1986 and the Singapore dollar started to appreciate once again.

7.3.4 Inflation and the Nominal US$/S$ Exchange Rate: Figures 20

Standard theory predicts that a higher domestic inflation leads to a depreciation of the
domestic currency. We may not observe this in Singapore, however. Since the exchange
rate has been used as an anti-inflationary tool by the MAS since 1981, MAS intervention
may result in the exchange rate appreciating whenever inflationary pressures mount.
20 Chia and Bauer

Indeed, Figure 20 suggests that from 1976 to mid-1981 the exchange rate appreciated as
inflationary pressure increased. However, since MAS did not begin exchange rate targeting
until 1981, it is difficult to attribute this deviation from theory to MAS intervention. From
1981 to 1990, the figure does suggest that the US$/S$ rate depreciated as inflationary
pressures eased and appreciated when inflationary pressures were strong. Since 1990, the
strong appreciation in the Singapore dollar appears to have dampened inflation.

7.4 REGRESSION ANALYSIS

In order to examine the impacts of money supply growth, income growth, interest rate
differentials and inflation on the US$/S$ exchange rate, we estimate the following
equation using annual data from 1975 to 1993. The hope is that this multivariate analysis
will uncover these relationships more completely than the trend analysis.
The regression equation is as follows:
lnER = β0 + β1ln(Mus/Ms) + β2ln(Ys/Yus) + β3(rs-rus) + β4(Pus-Ps) (8)
where: lnER is the log of the nominal US$/S$ exchange rate
ln(Mus/Ms) is the log of relative money supplies;
ln(Ys/Yus) is the log of relative income (GDP);
rs-rus is the nominal interest rate differential and
Pus-Ps is the inflation rate differential.
The interest rates used to calculate rs-rus are Singapore’s 3 month inter-bank rate and the
US prime loan rate. The CPIs are used to calculate Pus-Ps. Income (GDP) is at 1990
constant prices. Note that the monetary model estimates often include expected inflation,
rather than actual inflation. For simplicity, we assume rational expectations and take the
actual inflation rates to approximate expectations.
We expect, based on monetary models, the signs of the coefficients to be as follows:
β1 > 0; β2 > 0; β3 < 0; β4 > 0 (or β4 = 0 in the Dornbusch sticky- price model). The
OLS estimates of equation (8) are as follows:
lnER = -0.961 - 0.357ln(Mus/Ms) +0.363ln(Ys/Yus) + 0.013(rs-rus) + 0.0095(Pus-Ps)
t-ratio: (-1.01) (-2.43) (4.59) (1.63) (1.16)
R2 = 0.9118; R2adj = 0.8866
Judging by the R2, the model represents a fairly good fit of the data.3
The estimated coefficient for ln(Mus/Ms) was negative rather than positive as theory
would suggest. A potential reason for this result, as discussed in the previous section, is
the nature of MAS intervention.
The coefficient on ln(Ys/Yus) is positive and significant as expected. More rapid GDP
growth in Singapore is associated with an appreciation of the Singapore dollar.

3
The model was also run without the relative price variable, as suggested by the Dornbusch sticky-price
model. This did not change the coefficients or significance levels of the other variables substantially.
Omitting the constant term also had little effect. Note that this regression was not the primary focus of our
study, and we did not attempt to estimate more complicated error correction models.
Analysis of Exchange Rate Movements: A Case Study of Singapore 21

The coefficient on (rs-rus) is positive, though not significant. This is not in line with
monetary model predictions, but it is consistent with the general view that higher interest
rates induce capital flows and a currency appreciation. Given that Singapore is a low-
inflation environment, it is not that surprising that the monetary model expectation does
not hold.
The inflation rate differential does not appear to have a significant effect, although the
coefficient is positive as expected. The insignificance of the coefficient is consistent with
the Dornbusch model.

8 FORECASTING—ARIMA
A simple time series forecasting model of the nominal US$/S$ exchange rate is developed
in this section.4

8.1 DATA
Monthly data for the nominal US$/S$ exchange rate from January 1975 to September
1994 was used to estimate an ARIMA model. All data were taken from the International
Financial Statistics (IFS).

8.2 ORDER OF INTEGRATION

The autocorrelation function of the exchange rate data series does not rapidly decline to
zero, suggesting that the series is non-stationary. A Dickey-Fuller test confirmed the non-
stationarity of the series.
Having decided that the original series was non-stationary, the data were differenced once.
A plot of the autocorrelation function of the first differenced series was then generated.
This time the function fell rapidly to zero after one lag. The unit root test was then
performed again. The results of the test are as follows:
Null Hypothesis Test Statistic Critical Value 10%
No constant, no trend rho = 0.3319
A(1) = 0 (I) -157.00 -5.68
A(1) = 0 (II) -10.855 -1.62

Both the Z and t test statistics (denoted by (I) and (II) respectively) reject the null
hypothesis of non-stationarity. Based on the preliminary examination of the
autocorrelation function and the Dickey-Fuller test, we proceed with a model of integration
order 1.

8.3 DEGREE OF MOVING AVERAGE (MA) AND AUTOREGRESSION (AR)

The moving average and autoregressive structures were determined by looking at the plots
of the autocorrelation and partial autocorrelation functions generated from the first
differenced series. These plots suggest the model to be an ARIMA (1,1,1).

8.4 MODEL EVALUATION—DIAGNOSTIC CHECKING

The final model choice, however, was based on a comparison of t and Q statistics. We
started with a model structure of (1,1,1) based on our preliminary examination. But

4
All computations were done with the software package, Shazam.
22 Chia and Bauer

because the t-statistics for the coefficients of the ARIMA (1,1,1) are very low other models
were also examined. We estimated other model structures such as (0,1,1), (1,1,0), and
(1,1,3). Each proved to be a potentially good model. Pertinent statistics of the four
models are presented below:
ARIMA (1,1,1)
Q(12)= 5.8 DF=10 P=.835 Q(24)= 18.5 DF=22 P=.679 Q(36)= 32.1 DF=34 P=.561
PARAMETER ESTIMATES STD ERROR T-STAT
AR(1) 0.97404E-01 0.1930 0.5047
MA(1) -0.24434 0.1882 -1.298
CONSTANT 0.93077E-03 0.4725E-03 1.970

ARIMA (1,1,3)
Q(12)= 4.4 DF= 8 P=.816 Q(24)= 16.4 DF=20 P=.689 Q(36)= 29.1 DF=32 P=.614
PARAMETER ESTIMATES STD ERROR T-STAT
AR( 1) 0.69761 0.3520 1.982
MA( 1) 0.35987 0.3543 1.016
MA( 2) 0.22280 0.1255 1.775
MA( 3) 0.86420E-01 0.6813E-01 1.268
CONSTANT 0.30607E-03 0.3808E-03 0.8037

ARIMA (1,1,0)
Q(12)= 7.1 DF=11 P=.792 Q(24)= 20.3 DF=23 P=.625 Q(36)= 33.4 DF=35 P=.544
PARAMETER ESTIMATES STD ERROR T-STAT
AR( 1) 0.31384 0.6197E-01 5.065
CONSTANT 0.71221E-03 0.3512E-03 2.028

ARIMA (0,1,1)
Q(12)= 6.4 DF=11 P=.845 Q(24)= 19.3 DF=23 P=.682 Q(36)= 33.0 DF=35 P=.564
PARAMETER ESTIMATES STD ERROR T-STAT
MA( 1) -0.32796 0.6177E-01 -5.310
CONSTANT 0.10270E-02 0.4578E-03 2.243
The ARIMA structure (1,1,3) gave the lowest Q statistic. Note, however that Box-Pierce-
Ljung Portmanteau p-values for the other models are also greater than 0.05. Thus we need
not reject the null hypothesis that the residuals of the other models are white noise, and the
other models are also acceptable on this basis.
Analysis of Exchange Rate Movements: A Case Study of Singapore 23

Our next selection criteria was the t-statistics of the coefficients. Models (1,1,0) and
(0,1,1) are better models than models (1,1,3) and (1,1,1) since their coefficients are more
statistically significant.
But the acid test for the best model is to look at how well the models perform in
forecasting. Figures 21-24 show how the models perform. In fact we see that the forecasts
from all four models are fairly constant. The predicted values do not vary about the mean.
Hence, we conclude that there is no one model amongst the four that is superior.
The lackluster performance of the forecasts might be due to MAS intervention in the
foreign exchange market to keep the exchange rate within its target band, thereby reducing
exchange rate volatility. Hence the exchange rate series may contain very little useful
ARIMA structure, and time series techniques may not be especially useful for predicting
exchange rate trends. When an exchange rate is strongly managed there is less
‘information’ available to formulate a time series model.
Therefore more judgmental methods of forecasting would seem to provide a better means
of predicting Singapore’s exchange rate trends. In other words, one should concentrate
more on factors that might trigger MAS intervention and other economic factors outside of
MAS control that might affect the exchange rate.

9 SUMMARY & CONCLUSIONS

In this study, we have seen how external conditions, economic fundamentals and MAS
intervention have affected the Singapore dollar. Because the Singapore dollar is strongly
managed, it is difficult to forecast exchange rate trends using an ARIMA model.
Therefore, one has to turn to more judgmental methods to ‘predict’ exchange rate trends.
One should certainly try to anticipate MAS’s responses to various stimuli.
We know that the Authority’s primary objective is to maintain price stability. Hence, in
times of strong inflationary pressures (either internally or externally generated) we can
expect MAS to maintain a strong Singapore dollar. The Authority is not likely to
subordinate its primary objective even if export growth suffers. The MAS views the
beneficial impact of a depreciation, under inflationary conditions, to be only temporary.
Rising wages and higher costs of imported inputs would erode export competitiveness in
the long term.
If, however, the threat of inflation is low the Authority is willing to weaken the exchange
rate to boost the exports when necessary, as it did during the mid-1980s. This is not likely
in the foreseeable future. Supply-side constraints, strong export growth and the resultant
overheating of the economy are concerns. Therefore, we expect the Singapore dollar to
continue appreciating.
Other findings of this study include the following. The real US$/S$ exchange rate has
remained fairly stable since 1987, despite the nominal appreciation of the Singapore dollar.
According to our estimates, the nominal bilateral US-Singapore exchange rate has tended
to move in accordance with PPP trends.
The relationship between trends in the current account and movements in both the bilateral
and real effective exchange rates are not always consistent with the predictions of standard
theory. For example, the current account has improved strongly since 1987 despite the
appreciation of the REER. Factors accounting for this apparent inconsistency include
24 Chia and Bauer

growth in net service earnings, a reduction in the import content of exports, and rising
demand for Singapore’s exports in the Asia-Pacific region.
Trends in the capital account do appear to have had an impact on the US$/S$ exchange
rate. The large capital inflows from 1977 to 1982 and since 1987 have been associated
with appreciations in the Singapore dollar. Among the various components of the capital
account, levels of direct investment appear to have had the strongest impact on the
currency. These capital flows, along with CPF savings and government surpluses, have put
strong upward pressure on the Singapore dollar.
Monetary models suggest that differentials in inflation rates, money supply growth rates,
interest rates, and income growth rates determine movements in the exchange rate. Our
analysis does not tend to support these models. Money supply growth and interest rate
differentials do not seem to be useful indicators of movements in the US$/S$ exchange
rate. The Singapore dollar, as noted above, tends to appreciate more rapidly when
inflationary pressures are high. Relative GDP growth, on the other hand, does have the
expected impact on the bilateral rate. The Singapore dollar tends to appreciate when
income growth in Singapore is relatively stronger.
Analysis of Exchange Rate Movements: A Case Study of Singapore 25

REFERENCES
Abeysinghe, Tilak and Lee Kok Hong (1992), “Singapore’s Strong Dollar Policy and
Purchasing Power Parity”, Singapore Economic Review, Vol 37 No. 1, April 70-79.
Duc-Tho, Nguyen and Yao Chye Chiang (1989), “Exchange Rate Determination: the Case
of Singapore”, (Adelaide, University of Adelaide).
Lim Chong Yah and Associates (1988), Policy Options for the Singapore Economy,
McGraw Hill.
Monetary Authority of Singapore, MAS Annual Report: 1975/76 to 1993/94.
Ohno, Kenichi (1990), “Estimating Yen/Dollar and Mark/Dollar Purchasing Power
Parities”, International Monetary Fund Staff Papers, Vol 37, No. 3 September,
International Monetary Fund, 700-705.
Pilbeam, Keith (1992), International Finance, Macmillian, (London, City University).
Pindyck, S. Robert and Rubinfeld, L. Daniel (1991), Econometric Models and Economic
Forecasts, McGraw Hill, (New York).
Teh Kok Peng and Shanmugaratnam, Tharman (1992), “Exchange Rate Policy:
Philosophy and Conduct over the Past Decade”, in Linda Low and Toh Mun Heng
eds., Public Policies in Singapore—Changes in the 1980’s and Future of Singapore,
Times Academic Press, 285-314.
26 Chia and Bauer

TABLE 1
EXCHANGE RATE TRENDS
Nominal Bilateral Rate (US$/S$)
1979-86: US$/S$ rate was fairly stable;
1987 onwards: US$/S$ rate appreciated strongly.

Real Bilateral Rate (US$/S$)

1981-86: real rate depreciated;
1987 onwards: real rate was fairly stable.

Nominal Effective Exchange Rate (NEER)

1981-85: NEER appreciated and peaked in 1985;
1985-1988: NEER depreciated;
1988 onwards: NEER appreciated strongly.

Real Effective Exchange Rate (REER)

1981-85: REER appreciated and peaked in 1985;
1985-1987: REER depreciated;
1987 onwards: REER appreciated strongly.
Analysis of Exchange Rate Movements: A Case Study of Singapore 27

FIGURE 1: NOMINAL US$/S$ EXCHANGE RATE

0 .7

0 .6 5

0 .6

0 .5 5

0 .5

0 .4 5

0 .4

FIGURE 2: NOMINAL EFFECTIV E EXCHANGE RATE INDEX & NOMINAL US$/S$

EXCHANG E RATE INDEX (BASE: 1990)

120 120

115 115

110 110
NEER Ind e x

105 105

100 100

95 95

90 90

85 85

80 Nom inalUS$ /S$ R ate Inde x 80

75 75
28 Chia and Bauer

FIGURE 3: REALUS$/S$ EXCHANGE RATE INDEX & NOMINALUS$/S$ EXCHANGE

RATE INDEX (BASE: 1975Q1)

150

140

130

Nom inalUS$ /S$ R ate Inde x

120

110

100

90

80

70

R e alUS$ /S$ R ate Ind e x

60

50

FIGURE 4: PURCHASING POW ER PARITY (PPP), CASSEL-KEYNES METHOD (BASE:

1975)

0 .8 0 .8

0 .7 5 0 .7 5

0 .7 0 .7

0 .6 5 0 .6 5

PPP US$ /S$ Exchang e R ate

0 .6 0 .6

0 .5 5 0 .5 5

0 .5 0 .5

0 .4 5 0 .4 5

0 .4 0 .4
Nom inalUS$ /S$ Exchang e R ate

0 .3 5 0 .3 5
Analysis of Exchange Rate Movements: A Case Study of Singapore 29

FIGURE 5: PURCHASING POW ER PARITY, LONG -

RUN AV ERAGING METHOD

0 .7 0 .7

0 .6 5 0 .6 5

0 .6 0 .6

PPP US$ /S$ Exchang e R ate

0 .5 5 0 .5 5

0 .5 0 .5

0 .4 5 0 .4 5

Nom inalUS$ /S$ Exchang e R ate

0 .4 0 .4

0 .3 5 0 .3 5

FIGURE 6: CURRENT ACCOUNT

4000000000

3000000000

2000000000

1000000000

-1 0 0 0 0 0 0 0 0 0

-2 0 0 0 0 0 0 0 0 0
30 Chia and Bauer

FIGURE 7: EXPORT & REALUS$/S$ EXCHANGE RATE INDEX & NOMINAL US$/S$

EXCHANG E RATE INDEX (BASE: 1975Q1)

150 25000000000

140

20000000000

130

120
Nom inalUS$ /S$ R ate Inde x 15000000000

110

10000000000
100

R e alUS$ /S$ R ate Ind e x

90

5000000000

80

Export

70 0

FIGURE 8: CAPITALACCOUNT & NOMINALUS$/S$ EXCHANGE RATE INDEX

(BASE: 1975)

10000000000 155

9000000000

145
8000000000

7000000000

135
6000000000
Nom inalUS$ /S$ R ate Inde x

5000000000

125

4000000000

3000000000
Ne t CapitalFl
ow s 115

2000000000

1000000000
105

-1 0 0 0 0 0 0 0 0 0 95
Analysis of Exchange Rate Movements: A Case Study of Singapore 31

FIGURE 9: BALANCE OFPAYMENTS & NOMINALUS$/S$ EXCHANG E RATE INDEX

(BASE: 1975)

8000000000

145
7000000000

6000000000
135

5000000000

125

4000000000
Nom inalUS$ /S$ R ate Inde x

3000000000 115

2000000000

105

1000000000
Bal
ance of Paym e nts

0 95

FIGURE 10: DIRECT INV ESTMENT & NOMINALUS$/S$ EXCHANG E RATE INDEX

(BASE: 1975)

6000000000
145

5000000000
135

4000000000

125

3000000000
Nom inalUS$ /S$ R ate Inde x

115

2000000000

105
1000000000

D ire ct Inve stm e nt

0 95
32 Chia and Bauer

FIGURE 11: DIRECT INV ESTMENT V S NOMINAL US$/S$ EXCHANGE RATE INDEX

(BASE: 1975)

6000000000

5000000000

4000000000

3000000000

2000000000

1000000000

95 105 115 125 135 145

US$ /S$ Ind e x

FIGURE 12: OTHER SHORT-

TERM CAPITAL& NOMINALUS$/S$ EXCHANGE RATE

INDEX (BASE: 1975)

5500000000

145
4500000000
Nom inalUS$ /S$ R ate Inde x

3500000000
135

2500000000

125
Othe r Short-Te rm Capital
1500000000

500000000
115

-5 0 0 0 0 0 0 0 0

105

-1 5 0 0 0 0 0 0 0 0

-2 5 0 0 0 0 0 0 0 0 95
Analysis of Exchange Rate Movements: A Case Study of Singapore 33

FIGURE 13: OTHER LONG-

TERM CAPITAL& NOMINALUS$/S$ EXCHANGE RATE

INDEX (BASE: 1975)

500000000 145

Othe r Long -Te rm Capital

135

125

-5 0 0 0 0 0 0 0 0

115

-1 0 0 0 0 0 0 0 0 0

105

Nom inalUS$ /S$ R ate Inde x

-1 5 0 0 0 0 0 0 0 0 95

FIGURE 14: PORTFOLIO INV ESTMENT & NOMINAL US$/S$ EXCHANGE RATE

INDEX (BASE: 1975)

400000000

145
200000000

Portfol
io Inve stm e nt

0
135

-2 0 0 0 0 0 0 0 0

125

-4 0 0 0 0 0 0 0 0

-6 0 0 0 0 0 0 0 0
115

-8 0 0 0 0 0 0 0 0

105

Nom inalUS$ /S$ R ate Inde x

-1 0 0 0 0 0 0 0 0 0

-1 2 0 0 0 0 0 0 0 0 95
34 Chia and Bauer

FIGURE 15: TOTALRESERV ES MINUS GOLD

50000000000

40000000000

30000000000

20000000000

10000000000

FIGURE 16: MONEY SUPPLY RATIO INDEX (MSus/MSs) & NOMINAL US$/S$

EXCHANG E RATE INDEX (BASE: 1975Q1)

145 145

135 135

125 Nom inalUS$ /S$ R ate Inde x 125

115 115

105 105

95 95

MS R atio Ind e x

85 85

75 75

65 65

55 55
Analysis of Exchange Rate Movements: A Case Study of Singapore 35

FIGURE 17: SINGAPORE'S MINIMUM LENDING RATE & NOMINALUS$/S$

EXCHANG E RATE INDEX (BASE: 1975Q1)

15 145
Minim um Le nding R ate

14 140

13 135
Nom inalUS$ /S$ R ate Inde x

12 130

11 125

10 120

9 115

8 110

7 105

6 100

5 95

FIGURE 18: INTEREST RATE DIFFERENTIAL(US: BANK PRIME LOAN RATE-

S'PORE: MINIMUM LENDING RATE) & NOMINALUS$/S$ EXCHANG E RATE INDEX

(BASE: 1975Q1)

7 150

6 Nom inalUS$ /S$ R ate Inde x

140
Inte re st R ate D iffe re ntial

5
130

120

110
2

100
1

0 90
36 Chia and Bauer

FIGURE 19: INCOME GROW TH DIFFERENTIAL(GDPus-

G DPs at 1990 PRICES) &

NOMINALUS$/S$ EXCHANGE RATE INDEX (BASE: 1975)

3 .5 145

Incom e G row th D iffe re ntial

1 .5

135

-0 . 5

125
-2 . 5

-4 . 5
115

-6 . 5

105

-8 . 5

Nom inalUS$ /S$ R ate Inde x

-1 0 .5 95

FIGURE 20: ANNUALIZED CPI INFLATION & NOMINALUS$/S$ EXCHANGE RATE

INDEX (BASE: 1975Q1)

2 .5

CPI Infl
ation 140

Nom inalUS$ /S$ R ate Inde x

130

1 .5

120

110
0 .5

100
0

-0 . 5 90
Analysis of Exchange Rate Movements: A Case Study of Singapore 37

FIGURE 21: ARIMA (0,1,1) -

-ACTUAL, LIMITS & FORECAST

0 .7

0 .6 9

0 .6 8

0 .6 7

Actual

0 .6 6

0 .6 5

0 .6 4

Fore cast

0 .6 3

0 .6 2
9 5 % Confide nce Inte rval

0 .6 1

0 .6

1994 1994 1994 1994 1994 1994 1994 1994 1995

MAY JUN JUL AUG SEP OCT NOV D EC JAN

FIGURE 22: ARIMA (1,1,0) -

-ACTUAL, LIMITS, FORECAST

0 .7

0 .6 9

0 .6 8

0 .6 7

Actual
0 .6 6

0 .6 5

0 .6 4
Fore cast

0 .6 3

0 .6 2 9 5 % Confide nce Inte rval

0 .6 1

0 .6

1994 1994 1994 1994 1994 1994 1994 1994 1995

MAY JUN JUL AUG SEP OCT NOV D EC JAN

38 Chia and Bauer

FIGURE 23: ARIMA (1,1,1) -

-ACTUAL, LIMITS & FORECAST

0 .7

0 .6 9

0 .6 8

0 .6 7

Actual
0 .6 6

0 .6 5

0 .6 4

Fore cast

0 .6 3

0 .6 2 9 5 % Confide nce Inte rval

0 .6 1

0 .6

1994 1994 1994 1994 1994 1994 1994 1994 1995

MAY JUN JUL AUG SEP OCT NOV D EC JAN

FIGURE 24: ARIMA (1,1,3) -

-ACTUAL, LIMITS, FORECAST

0 .6 9

0 .6 8

0 .6 7

0 .6 6
Actual

0 .6 5

0 .6 4

Fore cast

0 .6 3

0 .6 2

9 5 % Confide nce Inte rval

0 .6 1

0 .6

1994 1994 1994 1994 1994 1994 1994 1994 1995

MAY JUN JUL AUG SEP OCT NOV D EC JAN