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View from Davos January 2 2014

The economic restructuring of Singapore

An ageing population and shrinking labour pool have put a strain on Singapore's economy, leading to calls for it to be restructured to raise productivity and bring about price stability. This will come through more productivity-led growth and a stronger focus on macroprudential policies.
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The economic restructuring of Singapore

The Singapore economy is facing a new paradigm. Externally, the extraordinarily loose monetary policies in advanced economies have created a wall of money that has led to a surge in credit growth and asset prices in many parts of Asia. Domestically, Singapore is heading towards a demographic cliff, with resident labour force growth declining and the capacity to absorb foreign labour reaching its limits, creating wage and cost pressures. 

The Monetary Authority of Singapore (MAS) has been taking a judicious approach to securing economic and financial stability in this new normal of an economy restructuring to reduce labour dependency amid a global environment of slow growth and easy money. In most respects, this approach builds on the existing framework for monetary policy; but in other respects, it takes a more comprehensive view of macro stability and incorporates policy innovations to deal with the new realities.

Containing inflation amid economic restructuring

Singapore is facing a demographic double-whammy: the effects of low birth rates over the past two decades and the entry into retirement of the baby-boom generation. The overall impact is unmistakable: Singapore’s resident labour force growth has fallen over the past few years and is expected to experience a more significant deceleration in the next decade. At the same time, it is not sustainable to continue to grow the foreign workforce at historical rates, given Singapore’s physical constraints. The upshot is that Singapore will face significant domestic cost pressures arising from a tight labour market.

The key is to restructure the economy and raise productivity. If restructuring is successful, Singapore can grow at a slower but more sustainable pace with a moderate increase in costs and prices. Otherwise, costs will escalate, competitiveness will erode, and growth will dip sharply amid higher inflation.  

The transition to productivity-led growth will be neither smooth nor easy. As labour supply tightens, wages will rise, prompting an adoption of labour-saving technologies or a shift of resources to activities that utilise less labour. The increase in wages – which represents a longer-term shift in relative price – is a necessary part of the restructuring process. But it will feed through more generally into prices, especially for a range of domestic consumer services which had hitherto depended heavily on foreign labour. Inflation will be temporarily higher, as productivity-enhancing measures take time to bear fruit.

The role of monetary policy

Monetary policy must play a key role during this transition. MAS has, since the early 1980s, focused on the exchange rate as its instrument of monetary policy, given the small and extremely open economy. Total exports and imports of goods are each well in excess of 100% of gross domestic product. Imports account for 40% of domestic consumption, while exports are the chief driver of economic growth. This exchange rate-centred framework has served Singapore well over the past three decades. Inflation has averaged 1.6% a year between 1985 and 2010, alongside economic growth averaging an annual 6.6% during this period — one of the best macroeconomic records in the world.  

However, inflation has picked up sharply in recent years, averaging 4.2% between 2010 and 2012. This is the longest stretch of time since the early 1980s where inflation has stayed above 4% in Singapore. Inflation was driven almost entirely by domestic cost factors: namely, rapid increases in residential property prices being reflected in accommodation costs, and a tight labour market feeding through to wage-cost pressures. With an exchange rate-centred monetary policy and no restrictions on capital movements, Singapore has no control over domestic interest rates, which have fallen to very low levels and aggravated asset price inflation, especially in real estate.

This has led some observers to question the effectiveness of the exchange rate as the instrument of monetary policy and suggest a shift towards an interest rate-targeting regime instead. 

Regime switch doubts

Such a regime switch would be ill-advised. First, the exchange rate continues to be the most appropriate tool for sustaining price stability in Singapore. The country's high degree of openness and trade dependence has not diminished, with the exchange rate playing a dominant role in household and business decisions.  

Second, it is not clear that a switch to an interest rate regime will necessarily bring about the desired outcomes. In an open economy with no capital account restrictions, raising domestic interest rates will attract even more capital inflows. As recent research has shown, open economies have limited ability to insulate themselves from the vagaries of global capital flows, irrespective of their monetary policy regimes. 

Third, the hike in interest rates necessary to dampen demand for credit and tame asset prices would have to be very aggressive. This would mean a sharp appreciation in the exchange rate, which would impose significant collateral damage on the broader economy. 

The chief consideration underpinning MAS’s monetary policy stance in recent years has been to anchor inflation expectations and guard against the risk of a wage-price spiral arising from the short-term effects of economic restructuring. At the same time, policy should not be so tight as to hinder the ability of firms to restructure. 

Since April 2010, the policy band of the Singapore dollar nominal effective exchange rate has been on a modest and gradual appreciation path. Within this overall tightening stance, MAS has allowed a temporary increase in core inflation to accommodate some of the changes in relative prices to signal resource scarcity and encourage the necessary behavioural shifts. This policy is now bearing fruit. Inflation has moderated and is expected to have averaged about 2.5% in 2013. Inflation expectations remain well anchored.   

Complementing monetary policy 

The conventional thinking before the global financial crisis was based on two assumptions: First, asset prices did not matter much. Central banks therefore focused on consumer prices and placed less emphasis on asset prices. Second, financial stability could be secured by microprudential supervision aimed at keeping individual financial institutions safe and sound. 

The collapse of the real estate markets in the US and Europe, the breakout of the global financial crisis, and the contagion of risk to seemingly sound financial institutions – against a backdrop of relative macroeconomic stability – showed both assumptions to be wrong.  

There is now growing interest in macroprudential policy – which focuses on the health of the financial system as a whole and its interactions with the macroeconomy, particularly developments in credit cycles, liquidity, leverage and asset markets. In Singapore, macroprudential policy has become an important complement to monetary policy to help secure economic and financial stability. 

MAS has always taken the position that asset prices matter, for both economic and financial stability. Rapid increases in real estate prices directly affect rentals and accommodation costs and can lead to a rise in overall inflation expectations. Volatile asset prices also pose a risk to financial stability, especially when financed by easy credit.

Property demand

In the aftermath of the global financial crisis, the confluence of low interest rates, sustained income growth and supply shortages has led to strong gains in Singapore’s residential property prices. Private property prices rose by 18% in 2010 and a further 6% in 2011. If domestic income growth falters or if the global interest rate cycle turns abruptly, mortgage financing burdens would increase. If home prices fall sharply and a large number of borrowers are affected, the health of financial institutions could be impaired, threatening overall financial stability.

With monetary policy focused on consumer price stability, MAS worked with other government agencies to implement a series of macroprudential policy measures, to rein in the demand for property and promote greater financial prudence among borrowers. However, unlike monetary policy, which has a single instrument, macroprudential policy has required a multi-dimensional approach with several policy measures acting in concert. These include restrictions on loan-to-value ratios, caps on mortgage service ratios for public apartments, and levies on property transactions, among others. The co-ordinated series of macroprudential measures has succeeded in dampening the rate of property price increases. Property transaction volumes have slowed and the rate of increase in private residential prices is expected to have been about 2% in 2013.     

As in many other jurisdictions, macroprudential policy in Singapore remains a work in progress. There are still many unknowns in the theory and practice of macroprudential policy, and its interactions with monetary policy. We need to better understand the transmission mechanisms, their inter-relationships and collateral effects.  

Singapore’s macroeconomic landscape has become more complex, with external and domestic forces interacting in unprecedented ways. Monetary and macroprudential policies will need to be on heightened alert to ensure that macroeconomic and financial stability are maintained as Singapore navigates this new environment. 

Ravi Menon is the managing director of the Monetary Authority of Singapore. 

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