EFFECTIVE EXCHANGE RATE WEIGHTS AND THE COMPETITIVENESS OF THE SINGAPORE ECONOMY

Abstract

This paper attempts to examine the relationship between the effective exchange rate weights and the competitiveness of the Singapore economy. Different stages of international monetary developments have been integrated into the empirical analysis to expound on the possibility of an undervaluation or overvaluation of the Singapore dollar in the foreign exchange market.

It was found that in the early 1970s, just after the dismantling of the Bretton Woods system of adjustable peg, currency weights assigned to the US dollar was large in Singapore's basket peg regime of exchange rate determination. Though the Singapore dollar was officially on a managed float mechanism, it behaved as if a single currency peg existed between itself and the US currency. The undervaluation of the US dollar could have possibly led to the undervaluation of the Singapore currency. The effect of such firm anchorage to the former resulted in rising imported inflation. Current account deficit subsequently deteriorated further as rising production costs of local manufacturing exports severely hampered the competitiveness of the economy.

The degree of close alignment of the Singapore currency against the US dollar strengthened in the early 1980s. The movements of Singapore dollar had been restricted by the US dollar since weightage given to the latter in the trade-weighted currency basket had increased from 1981 to 1986. Empirical evidence showed that currencies had deviated from their long run path of exchange rate. In addition, unit labour costs denominated in currencies, which had depreciated against the Singapore dollar, escalated. Moreover, it was found that substantial loss in international competitiveness of the domestic economy due to an overvalued dollar was partly responsible for the 1985 recession.

Recent developments after the 1985 recession have seen the Japanese Yen assuming a pivotal role in influencing the movements of the Singapore dollar in the foreign exchange market. Empirical results presented in this paper suggests that there has been a shift towards closer alignment to the Yen. With the assistance of a study conducted by the National Westminister Bank, it is concluded that the Singapore dollar could be potentially undervalued at present due the a sizable share occupied by the Yen in the currency basket.