Singapore's monetary policy

Why SG cannot use interest rates?

Why SGP cannot use interest rates?

1. Singapore cannot adopt interest rate policy because Singapore is an interest rate price-taker as she is a small economy. (Small economy means population size is small so domestic market is small. Land is small so there is a lack of natural resources) It will be very difficult, if not impossible, for MAS to control the interest rate as the small size of the Singapore economy makes Singapore a mere price-taker in the world market for funds. This makes Singapore’s interest rates very much influenced by the interest rates of larger economies such as the USA. The USA happens to be Singapore’s largest trade partner, so we follow the interest rates of the US.

2. Inability to control the interest rate due to openness to international capital flows

In addition to a large external trade sector, a vast network of international financial linkages exists as a pre-requisite for Singapore’s role as a financial centre. It is important that Singapore maintains relatively free movement of financial capital to enable it to function as an international financial centre. The result is an open economy with free capital mobility into and out of Singapore. Small differences between domestic and foreign interest rates can lead to large and quick movements of funds. (When US raises interest rate, short term capital inflow into US rises. Short term capital outflow from US reduces. This also means that short term capital or hot money will leave Singapore and move into US because the interest rate is higher. This increases the supply of SGD in the foreign exchange market. This leads to depreciation of the SGD, which may bring about imported inflation, especially in times of rising energy and commodities prices. Therefore, when US raises interest rate, Singapore also follow to raise the interest rate to prevent outflow of short term capital from Singapore.). This makes it difficult to target interest rates in Singapore. Any attempt by the MAS to raise or lower domestic interest rates will be thwarted by a movement of funds into or out of Singapore. Due to the free movement of financial capital, interest rates in Singapore are largely determined by foreign interest rates.

For the above reasons, Singapore has chosen to focus on managing its exchange rate as its monetary policy tool. As it also prioritises financial capital mobility due to its international financial hub status, Singapore must relinquish its control over interest rates. The ability of economies to only achieve only 2 of the following 3 targets – managing interest rate, managing exchange rate and maintaining international financial capital, is known as the Open Economy Trilemma.

The use of exchange rates allows Singapore to best achieve the stated objective of promoting price stability as a sound basis for sustained economic growth in the long run.

Why SGP has to use exchange rate?

1. Susceptible to imported inflation

Singapore’s lack of natural resources means that it has to import even the most basic daily requirements, such as food items including eggs and vegetables. This implies that Singapore’s cost of living is significantly affected by the prices of imported final goods and services.

In addition, Singapore also relies significantly on importing raw material and intermediate goods to produce final goods and services. For example, we import natural gas to generate electricity. Due to the high import content of its output, cost of production of Singapore firms are significantly affected by the prices of imported raw material and intermediate goods. Changes in world prices or in the exchange rate have a significant and direct influence on costs of production and general price levels in the economy. Given that Singapore is a small economy and hence a price -taker in the global market, it cannot affect the foreign prices of its imports. However, it can manage its exchange rate to influence the domestic price of it imports which in turn affects the cost of production of Singapore firms. The exchange rate is thus a powerful tool to moderate imported inflation.

b. High dependence on external sector

Imports and Exports each amount to more than 100% of Singapore’s GDP, and total trade (i.e. X+M) is around 400% of its GDP.

Singapore’s economic development strategy has always focused on producing exports for the rest of the world, where exports or external demand makes up about three-quarters of total demand in Singapore. Singapore’s exchange rate affects the foreign price of Singapore’s exports which in turn affects its price competitiveness and the amount of exports sold (i.e. X in AD). The importance of exports means that the exchange rate can have an important influence on its aggregate demand, equilibrium real national income and the derived demand for domestic resources, especially the demand for labour.

Hence, the exchange rate is the policy of choice as it directly affects the largest component of Singapore’s aggregate demand, X.  

[When question asks why Singapore cannot use interest rate, must answer why Singapore cannot use interest rate + why Singapore must use exchange rate (4 reasons).]

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