Sunday, August 20, 2017

The depreciating kyat-dollar exchange rate issue

Myanmar has adopted a managed float exchange rate system. How does this system work? A useful way to find out is to look at how China has used such a system to fix the exchange rate of its currency the renminbi (RMB) against US currency the dollar ($). To illustrate, we begin by considering the US’s balance of trade with China as provided in the table below.

Table (1) shows the US buys (imports) goods and services from China more than it sells (exports) goods and services to China for 10 years from 2001 to 2010. That is, the US has had a balance of trade deficits with China for 10 years in a row. This affects the exchange rate  between the $ and RMB. There are two foreign exchange markets to show how this takes place. First is the exchange market for RMB in the US. And second is the exchange market for dollars in China.

RMB exchange market in US is presented in Figure (1). For illustrative purpose, start with  demand and supply curves of D(r)0 and S(r)0 that give rise to exchange rate of $0 per RMB.

Now consider what happens when US balance of trade deficits as shown in Table (1) comes into play. US consumers are now buying goods and services far in excess of what the US is selling to the consumers in China. Buying more Chinese goods and services implies an increase US demand for RMB. As a result, the demand curve of the US for RMB shifts upwards to D(r)1. With supply curve of RMB remaining the same at S(r)0 the RMB dollar exchange rate will appreciate to $1.

US trade deficit with China will mean a trade surplus with US from China’s point of view. The  impact of China’s balance of trade surplus with US on the dollar exchange rate in the exchange market in China is presented in Figure (1a). Here again for illustrative purpose, we start with demand and supply curves D($)0 and S($)0 in the dollar exchange market, and the $/RMB ($ per RMB) exchange rate is R0. With such a balance of trade surplus the in-flow of dollars  exceed the outflows of dollars into China and supply curve for dollars increases and shifts to the right to S($)1. This in turn causes the $ per RMB exchange rate to decline to R1.

To summarise the presentation up to now, two countries, USA and China, are engaging in trade. The US came to have a large balance of trade deficit in this engagement. The trade deficit will cause a rise in demand for RMB in the US and the $/RMB exchange rate will appreciate in that country. This appreciating RMB exchange rate will raise prices of imports from China and reduce these imports into the US as time passes.

In the case of China, a trade surplus with the US will increase the supply of dollars in its economy, which leads the RMB/$ exchange rate to depreciate, makes American goods and services cheaper for Chinese consumers, and leads to higher demand and increasing US exports to China.

The final outcome: as imports from China are reduced in the US and at the same time exports from US to China are increased, the trade imbalance between the two countries will narrow as time passes and ultimately disappear.

But as we can see in Table (1), the trade imbalance did not narrow or disappear. On the contrary, the US balance of trade deficit with China continued for 10 years and the size of the deficit increased every year except in 2009 when there was a recession in the US. The  question is – WHY?

The reason: the Central Bank of China did not allow a free float of its currency against the US dollar as mentioned in the paragraphs above. Instead, it prevented its currency from appreciating against the dollar, and also for the dollar to depreciate against the RMB. This is done by China’s Central Bank’s managed float action that involves buying billions of dollars worth of US treasury (government) bonds. As can be seen in Figure (1) such purchases by China floods the US with large inflows of RMB, causing the supply curve S(r)0 to rise to S(r)1. This results in the $/RMB exchange rate falling from $1 back to its original rate $0.

Likewise, China’s Central Bank buying billions of US treasury bonds will lead to an increase in demand for dollars in the country’s dollar market. As shown in Figure (1a), demand curve for dollars will rise in China from D($)0 to D($)1. This increase in demand for dollars causes the RMB/$ exchange rate to rise back to the original R0.

Resort to import of financial assets such as US treasury bonds plays the crucial role in the managed float of China’s currency exchange rate. On December 31, 2014, US treasury bonds held by foreigners amounted to $6.15 trillion. Of this China held $2.24 trillion, the largest amount which accounted for 36 percent of the total.

Why did China from 2001 to 2010 engage in managed float and prevent the RMB to  appreciate with respect to the dollar? The simple answer: Maintaining high exports to the US is good for its economic performance and creating employment for its workers.

Goods sold in the US market are produced in China by US multinationals. Multinationals gave  technology, know-how, enterprise, capital, management and marketing skills to China to make laptop computers, digital cameras, washing machines, out-sourcing services, etc, using cheap labour. These improved productivity, employment, incomes and living standards in China.  Purchasing US treasury bonds in fact amounts to giving loans to the US. Interest is earned on these bonds and risks are low as they are backed by the US government and the dollar is a relatively stable currency.

Now, coming to the managed float exchange rate system in Myanmar, many reasons have been given for the present depreciation of the kyat-dollar exchange rate over the past months. Among them, one popular reason given is Myanmar’s rising balance of trade deficit. This can be seen in Table (2). The table shows Myanmar’s balance of trade deficit has increased substantially over the past three years, from $92 million in fiscal year 2012-13 to $2.6 billion in 2013-14 and to $4.1 billion in 2014-15.

Since the kyat-dollar exchange rate depreciation has occurred over the past months, Table (3) presents the monthly balance of trade deficits from May 2014 to April 2015. There have been continuous deficits at the monthly level as well, except in August 2014, when a surplus of $84 million was recorded.

Taking account of Myanmar’s balance of trade deficits with the rest of the world given in Tables (2) and (3) above, Figure (2) sets out the US dollar exchange market in Myanmar. For illustrative purpose, we start with D($)0 the demand curve for dollars, and S($)0 the supply curve which results in the exchange rate of K1000 per dollar. Now when Myanmar imports goods and services from abroad far greater than what it is exporting, the demand for dollars to buy these imports will increase in the dollar exchange market in Myanmar. Suppose demand curve increases to D($)1. Assume also that under a free float system the exchange rate will result in K1300 per dollar. But the authorities who are running the show in Myanmar had reservations with such a free float outcome. In latter half of June 2015, attempts were made to hold the exchange rate at K1105 per dollar (+/- 0.8pc). What is the reason for this?

The reason may be provided by approaching the matter by means of a branch of study known as behavioural economics. Behavioural economics is defined as a study of psychological, cognitive, social and emotional factors ineconomic decision making of individuals and institutions.1

To put it simply in looking at our situation, the authorities who are currently taking care of the exchange rate and monetary policy are also those who have been performing the same tasks  under the previous regime. Under the past regime, Myanmar was inward-looking, not in the  good books of major economic powers, was isolated, and under economic sanctions for many years. These had an impact on the behaviour and mindset of key economic policy-makers in the country at that time.

Due to sanctions and other discriminatory acts, foreign exchange such as the dollar was scarce in those days and care has to be exercised in meeting three demands for its use. These are:

(a) Transaction demand: to meet demand for dollars – to buy and sell in the world market;
(b) Precautionary demand: to have dollars in store for security and to meet unexpected events and emergencies; and
(c) Speculative demand: to have dollars to speculate in the foreign exchange, commodity, stock and financial markets.

Among the three, priority has been given in the past to meet precautionary demand – to have sufficient foreign exchange reserves to take care of emergencies, man-made and natural disasters and huge economic disturbances coming from across the border due to regional and global financial crises. Similarly, as currency speculation has been a source of exchange rate instability in the country, cracking down on such activities has been a well-established measure that continues up to now, although with limited success.

Hence, priority concerns of those in charge of foreign exchange management in present day Myanmar seem to be devoted to precautionary and speculative demands. Sufficient attention does not appear to be given to transaction demand, in order to ensure adequate foreign  exchange is allocated for the smooth functioning of the external trade sector.

The need for the public sector to be more liberal with its foreign exchange earnings in support of the private sector is also highlighted by Table (4). It shows 57pc of the country’s receipts  from exports of goods and services are obtained by the public sector, while the expenditure for buying 83pc of imports of goods and services are met by the private sector.

Figure (2) illustrates a managed float aimed at fixing the exchange rate at K1105 per dollar will result in a dollar shortfall amounting to ab. This shortfall will need to be further examined and analysed, and corrective measures properly thought out, planned and implemented. Some  ideas to undertake such a task are given below.

First, administrative measures that instruct banks and financial community to abide by the managed float reference exchange rate set by the Central Bank of Myanmar (CBM), and issuing warnings and threats of persecution if they fail to do so, is not a good idea. It will amount to going back to an old solution to resolve a new problem and will be looked upon as a major set-back to establish an exchange rate that is relatively stable, market-determined and meets ASEAN and international standards.

Second, Myanmar is no longer isolated and doing its own thing without bothering with what is going on among its neighbours and in the rest of the world. The re-engagement with the outside world has far exceeded expectations and advantage should be taken of opportunities it has presented to us, in the reforms underway including the exchange rate issue.

Third, it is not sufficient to look primarily at the balance of trade. Other items in our economic and financial relations with the outside world will need to be looked into in considering the exchange rate issue. These include inflows of dollars such as remittance from millions of our migrants working in foreign countries, net foreign investment inflows, foreign aid and loans, etc. Information on these should be made available in the current, financial and capital accounts of the balance of payments.

Fourth, there are several types of exchange rates. What we have been concerned with is the nominal exchange rate. Another type which should be of interest is the real exchange rate  which is influenced by inflation in the country. Drawing attention to inflation leads us into the  need to take account of macroeconomic policy – fiscal and monetary – on the exchange rate.

Fifth, keeping the exchange rate much below the market rate by administrative measures will  give incentive for people with foreign currency deposits in the domestic banks to withdraw their dollars and sell them on the free market to make handsome profits. This is not sustainable and a stage will be reached when just one bank runs out of dollars, cannot meet its obligations to its depositors, it could trigger a bank run, not only with respect to withdrawal of dollars but herd behaviour and withdrawal disease infects the kyat, and ending up with a serious banking  crisis.

Sixth, there should be more reliable, timely and easily accessible statistics with respect to our trade and economic relations with the outside world to enable us to analyse and make recommendations on how to move forward on the exchange rate front.

Seventh, with general elections just four months away, this is not a good time to have a banking crisis and our financial sector in turmoil. Instead, this is an opportune time for CBM to demonstrate that it is independent, it has clout, it is incharge, and is playing the lead role in dealing with the kyat-dollar exchange rate depreciation issue facing us today. It should not be standing on the sideline, allowing our managed float system being turned into a mis-managed float system, doing more harm than good. It should move away from being overly concerned with the precautionary and speculative demands for dollars and instead devote attention it  deserves to transaction demand to enable the private sector to play a more positive role in our international economic relations with the outside world. As noted earlier, the private sector  accounts for 43pc of the country’s export earnings, but takes care of 83pc of expenditures on our imports.

Eighth, to show that CBM is taking charge, it should set its reference dollar exchange rate closer to the market rate, by allowing it to have access to the 57pc of export earnings of the public sector. Setting the reference rate say at K1200 per dollar may be a good start to achieve this objective.

Finally, a few thoughts on how we might go forward with improving our foreign exchange management are given below:

(a) First, the mandated independence of CBM must be nurtured and respected. This independence was won recently. As usual a newly independent entity faces a host of difficult problems. My hope is CBM will do a better job than what we did soon after our country got  independence in 1948.

(b) Second, for CBM to be independent other powerful authorities should refrain, to the extent possible, from interfering in what are clearly falling within the area of competence and responsibility of CBM.

(c) Third, CBM must exercise the independence to make decisions granted to it. It must implement measures and make decisions based on its assessment and analysis of critical issues in the banking and financial sector that require response and remedial action.

(d) Fourth, CBM to perform this task, the person who is in charge – the Governor – must be willing and able to take on such a responsibility. Union Bank of Burma Act 1952, conferred upon CBM, the usual functions of a central bank. Hence, CBM has a long history. Over these years it has notable successes. It has also faced serious challenges. CBM’s governors and staff have learnt many lessons from this experience – the good and the bad, what to do and what to avoid. Hence, we still have in this country, dedicated banking and financial experts and their staff who can take on the challenges currently facing us, provided they are assured CBM will be an independent organisation and making decisions based on their knowledge and experience.

(e) Fifth, as we all know after years of inaction and neglect, capacity of CBM like in other institutions in the country has fallen much below regional and international standards. CBM governor and his staff will need support. I propose support should come in the form of advisory team led by a foreign expert central banker to be attached to (or embedded in) the CBM to impart to our officials the knowledge and technical expertise to enable our central bank to play as an equal partner with other central banks in the region and beyond.

(f ) Sixth, I believe the bilateral and multilateral donors will be ready to support such an initiative to meet the challenges facing CBM at present. But the initiative must come from us. The request for help and technical assistance must come from us.

(g) Seventh, I believe our people in CBM has the capacity to prepare a request that gives well reasoned arguments and clearly indicates our commitment to cooperate closely with such an expert team not only to take care of the exchange rate problem but to enable the CBM to become a key institution for economic reforms in the country. Serious consideration should therefore be given to undertake such an initiative at present.

(h) Eighth, why should we not give serious consideration to this initiative? Our neighbour Singapore at one time had a foreign central bank expert running the Monetary Authority of Singapore (central bank). The Bank of England, one of the great central banks in the world began operations in 1694. It had 120 governors from that date up to now. Among them 119 are British. The present one, the 120th appointed in 2013 is a Canadian. We are not mature enough to have a foreign central bank expert to serve as governor of CBM. So the second best solution I am suggesting is that we should appoint a Myanmar national who is dedicated and has technical and administrative capacity to run CBM. Perhaps we can count such individuals with our fingers, but they are there. This governor will be independently running the CBM and making decisions regarding crucial issues facing our banking and financial sector. In performing this task he will be assisted and take advice from a team led by an expert foreign central banker. Given our declared intent to reform the CBM, I do not believe this is too much to ask for.

Note: U Myint is the President’s Chief Economic Advisor and Director, Tun Foundation Bank


1 Please see Sendhil Mullainnathan & Eldar Shafir, Scarcity the true cost of not having enough (Penguin Books: London, 2013).