The loss of S$7.4 billion announced by the Monetary Authority of Singapore (MAS) seems to have gotten a lot of Singaporeans excited. How did that happen, and why is it a necessary trade-off to fight inflation?
Macroeconomics is a super complicated subject. The politicians may have been factually correct in what they say, but I feel they haven’t done a good job at explaining it to the public.
In this article, I will try to simplify everything, with layman examples, so that it can be understood by the layman.
- Why we have Official Foreign Reserves (OFR)
- The Purpose of OFR
- Investment Gain is the By-Product, not the Objective
- What is Currency Translation Loss
- The trade-off between Inflation and Currency Translation Loss
- Why Currency Translation Loss is Not Important for MAS
- In Conclusion
Why we have Official Foreign Reserves (OFR)
Singapore is a net exporter country, which means we sell more products overseas than we import.
Singapore exporters earn in Singapore Dollars (SGD) or in another global trade currency (e.g. USD).
Customers that pay in SGD need to use their foreign currency to buy SGD. If the customer pays in USD, the exporter will eventually sell their foreign currency for SGD in order to pay their workers, rent, and bring their profits back to Singapore for spending. This creates demand for SGD.
On the flip side, Singapore importers need to sell their SGD for foreign currencies to pay their suppliers. For example, our fresh chicken importers may need to use SGD to buy Malaysian Ringgit (MYR) to pay chicken farmers in Malaysia. This creates supply for SGD.
Since we export more than we import, the demand for SGD is perpetually greater than the supply. If left unchecked, maybe the SGD value will shoot “to the moon” faster than Bitcoin! (Just kidding 🤣!)
But that’s a good thing, right? Then we can travel all over the world with less money?
If SGD’s value shoots to the moon, our products become more expensive to overseas customers.
Let’s say there’s a factory making and exporting frozen chicken rice. Its production cost is S$2.00 per packet. It sells to its customer in the USA for US$1.50 per packet.
If the exchange rate is 1 USD = 1.40 SGD, the factory can exchange its US$1.50 earning for S$2.10 (1.50 x 1.40). It makes a profit of S$0.10 per packet.
But if next month the SGD appreciates against USD to 1 USD = 1.30 SGD, the factory will make a loss. Its US$1.50 can only exchange for S$1.95. He will lose S$0.05 per packet.
To earn back the S$0.10 profit, the factory must increase its price to US$1.62 per packet, which at an exchange rate of 1.30 can earn him S$2.106 per packet.
However, his USA customer buay song about the price increase, go and buy frozen chicken rice from his Malaysia competitor instead.
The factory owner now has no business and is forced to close his factory and retrench workers.
Multiply this effect by tens of thousands of factories and products, and you’ll get a lot of retrenched workers and a recession in Singapore.
Exports decline, reducing demand for SGD, causing the SGD to depreciate because now we turn from a net exporter country to a net importer.
This in turn revives demand for exports because the SGD is now cheaper, making us a net exporter country again. And then the whole cycle repeats.
But if the cycles are frequent and deep, it causes a lot of problems.
The factory owner may have taken 20 years to build up its capabilities and clientele. If he must close down and start from scratch again, he may not be able to compete effectively against exporters from other countries.
Therefore, the MAS intervenes in foreign exchange markets to keep the SGD from appreciating or depreciating too fast.
It is trying to ensure the SGD’s value is stable enough to facilitate global trade by smoothening the business cycles and preventing them from becoming too extreme.
You’ve heard about MAS’s “policy band”, right? Those are the “extremes” that I’m talking about.
MAS allows SGD’s value to trade only between the upper and lower limits of the policy band to prevent the wild cyclical swings from causing permanent damage to the economy.
It will intervene if SGD’s value breaches either of those limits, either by selling or buying SGD in the open market.
You may also have heard that their long-term policy is to allow “slow and gradual appreciation of the SGD”.
MAS also recognizes that it cannot ignore economic fundamentals and keep SGD’s value artificially low forever. Therefore, the policy band slopes upwards, allowing the SGD to appreciate in a controlled manner that doesn’t create wild cyclical swings.
This target long-term rate of appreciation is what MAS calls the “slope of its policy band”.
How does MAS accumulate foreign reserves?
Because Singapore is a net exporter in most years, SGD hits the upper limits of the policy band far more often than the lower limits.
To stop it from going above the upper limit, MAS works on the supply side of the equation. It sells SGD to buy the currencies of our other trade partners, such as USD, JPY, EUR, MYR, CNY, GBP, etc.
This increases the supply of SGD and slows down the rate at which SGD appreciates against other currencies.
What happens to all the foreign currencies that we buy? Will MAS distribute it to Singaporeans so that we can travel all over the world free of charge??
Yah …. you wish! Nice fantasy though.
All that money goes into MAS’s bank accounts and becomes our Official Foreign Reserves (OFR), more commonly referred to simply as “foreign reserves”. They are called “foreign ” because they are held in foreign currencies, and not SGD.
Therefore, foreign reserves are the result of net exporter countries intervening in forex markets to artificially devalue their currency. That is why net exporters like China and Japan have the most foreign reserves.
The Purpose of OFR
In 1985, the economy in Singapore was weak, and there was a speculative attack by short sellers against SGD.
That means sellers flooded the market with SGD to devalue it with the intention of buying it back later at a lower rate, pocketing the difference as profit.
MAS tried to intervene by selling USD to buy SGD but failed. Back then, Singapore’s OFR was only a paltry US$ 12.85 billion.
I suspect that as a result of this experience, as well as that of other currencies that came under short attacks (e.g. Asian Financial Crisis of 1997), MAS has been slowly and steadily building up its OFR. As at the end of 2021, it stood at US$ 425.1 billion.
MAS keeps what it believes is sufficient to defend against speculative attacks, which is about 65% to 75% of GDP.
It transfers the extra to the government for longer-term management by the Government of Singapore Investment Corporation (GIC), using a very “cheem” mechanism called Reserves Management Government Securities (RMGS).
It’s basically MAS lending excess foreign currencies to GIC so that GIC can make a higher return than the interest MAS charges it.
Investment Gain is the By-Product, not the Objective
In short, the OFR is held mainly for the purpose of defending against speculative attacks on the SGD. Investment gain is not the main objective, though it is a nice bonus.
You hear a lot about Singapore’s “reserves” and how they were used to fund our COVID support packages. What exactly are these reserves?
Singapore’s reserves are held by three entities:
- Temasek Holdings
MAS holds the foreign reserves. As explained above, the foreign reserves are held mainly as a deterrent against speculative attacks on SGD.
Its mandate is to ensure stability in the financial system, not investment gain. That mandate is given to the other two entities, GIC and Temasek.
To ensure stability, MAS must be able to access its foreign currencies at short notice and sell them if necessary to buy SGD in the event of a speculative attack. Therefore, its assets must always be highly LIQUID.
However, to hold them all as cash in a bank is also a waste. Hence, most of the money is spent on highly liquid, low-risk, and low-interest securities such as Treasury Bills and bonds issued by foreign governments.
For example, if MAS held US$ 100 billion in its bank account and for the next 1 year doesn’t need to sell it to defend against an attack, at the end of the year, it will have US$ 100 billion.
But if it buys US$ 100 billion worth of 1-year US Treasury Bills at 3% interest, at the end of the year it would have made an investment gain of US$ 3 billion based on the interest collected. Its bank account will have inflated to US$ 103 billion.
In the investment world, there is an inverse correlation between liquidity and returns, as well as a positive correlation between risk and returns. The more liquid or low-risk an asset is, the lower the returns.
US Treasury Bills are issued by the US Government and are therefore safe from default. They can also be quickly converted to cash by selling on the open market.
However, the trade-off for such liquidity and lower risk is lower returns.
For the MAS, making sure that the foreign reserves are liquid and safe is far more important than trying to make investment gains.
Investment gains are a mere by-product, and not the objective, which remains as ensuring stability in the financial markets.
What is Currency Translation Loss
Using the same example above, let’s say MAS had US$ 100 billion, which is equivalent to S$ 140 billion today at 1 USD = 1.40 SGD
Let’s say next year, SGD appreciates, and the exchange rate becomes 1 USD = 1.35 SGD. The US$ 100 billion marked-to-market value will now be worth S$ 135 billion.
In Singapore Dollar terms, our OFR has dropped S$ 5 billion from S$ 140 billion to S$ 135 billion. This S$ 5 billion is the Foreign Currency Translation Loss everybody is talking about.
But did we really lose money?
Not really, because it’s the same US$ 100 billion sitting in the bank account.
Let’s look at a more advanced example.
Let’s say MAS bought the 1-year US Treasury Bills at 3% interest as stated in the previous example. By next year, it will have US$ 103 billion in the bank account, consisting of the US$ 100 billion principal as well as US$ 3 billion in interest earned.
However, in mark-to-market reporting, it is still a net loss, because US$ 103 billion at a 1.35 exchange rate will now be reported as worth S$ 139.05 billion. There is still a net loss of S$ 0.95 billion.
The actual numbers for the 2021/2022 financial year were this:
Investment gain: S$ 4 billion
Foreign Currency Translation Loss: – S$ 8.7 billion
Operating Loss: – S$ 4.7 billion.
Less: Interest and Operating Expenses: – S$ 2.7 billion
Net Loss: – S$7.4 billion
The MAS did in fact make an investment gain of S$ 4 billion.
However, it was more than offset by the translation loss of S$ 8.7 billion, resulting in an operating loss of S$ 4.7 billion.
An additional S$ 2.7 billion was spent on interest and operating expenses, resulting in a total net loss of S$ 7.4 billion.
But if you ignore the translation loss, and add S$ 8.7 billion back to the bottom line, MAS actually made a net profit of S$ 1.3 billion.
The trade-off between Inflation and Currency Translation Loss
Singapore is a small country that imports most of the goods it consumes. Thus, unlike bigger countries like USA and UK, MAS uses exchange rates as its primary weapon for fighting inflation.
For a more detailed explanation of why this is so, you can refer to my earlier article on Using Interest Rates to fight Inflation.
By allowing the SGD to strengthen against other currencies, imports become cheaper.
Nowadays you find it cheaper to travel to places like Japan, Europe, and Malaysia, don’t you? At the time of this writing, some money changers in Singapore have run out of the Malaysian Ringgit because Singaporeans are exchanging for them in droves.
By the same measure, a stronger SGD results in imports becoming cheaper. Or rather, their prices increase less quickly since inflation is still fundamentally high.
Now we’re seeing inflation rates of 3 to 4 %. If the SGD wasn’t allowed to strengthen, you may see inflation rates doubling to 6 to 8%!
However, if the SGD appreciates, it necessarily also means other currencies depreciate relative to SGD, which results in a higher translation loss from our OFR.
So, which problem would you rather have?
Higher inflation? Or a higher OFR translation loss?
The answer is quite clear, isn’t it?
Inflation affects the lives of millions of Singaporeans. But a paper loss on OFR, which are financial assets overseas, has little or no impact.
OFR loss is not going to make your daily kopi siu dai and chicken rice more expensive.
But a weaker SGD will because coffee powder and chicken imports become more costly.
Why Currency Translation Loss is Not Important for MAS
I stress again, that MAS’ mandate is not investment gain, it is financial stability.
The OFR exists for actual use, which is to defend SGD against speculative attacks when necessary.
OFR does not exist for the purpose of investment gains. Therefore, the bulk of it cannot and should not be used to do risky things that forex traders do to make money e.g. hedging, shorting, trading, etc.
Doing so is like converting the entire Singapore Armed Forces (SAF) to focus on forex trading instead of watching our borders and defending against terrorist threats.
Translation loss is only meaningful if you buy a foreign asset for the purpose of investment gain. But not if you are buying it for your own use.
Let’s say two Singaporeans each buy a house in Johor Bahru (JB), side by side.
Mary buys the house for the purpose of staying and commutes to Singapore to work every day. She plans to stay in JB when she retires. So she will never sell the house.
Ali buys the house for investment purposes and plans to sell the house in the future for a profit, exchange it for SGD, and use this SGD for his retirement in Singapore.
In real terms, there is no change in the value of the house year-on-year, because it’s the same house.
In MYR terms, there may be fluctuation depending on whether property prices go up or down.
In SGD terms, the volatility is greater, because the fluctuation depends on both movements in property prices as well as exchange rate changes.
Thus, the value of the house, in SGD terms, changes every year. Some years there is a gain, other years there is a loss.
But it’s still the same house. The house didn’t grow or shrink.
Let’s say next year, both houses suffer a loss due to foreign currency translation.
Does this affect Mary?
Not really, because regardless of its paper value in SGD terms, it’s still the same house! The house doesn’t shrink just because MYR shrank against SGD, right?
But does it affect Ali?
Yes, because even if the house value appreciates by 10% in MYR terms, Ali will still lose money if MYR depreciates by more than 10% against SGD.
Mary is an analogy for MAS, and Ali is an analogy for GIC and Temasek.
MAS holds the reserves for the purpose of using those reserves. Whether those reserves make a net return or not in SGD terms is not important.
To Mary, it is the same house. To MAS, the US$ 100 billion in its bank is still the same US$ 100 billion. How much those assets are worth on paper in SGD terms is meaningless.
The same cannot be said for Ali, GIC, or Temasek. Their stated objective is to generate investment returns. Thus, any loss, even translation loss, is a real investment loss for them.
It all boils down to a choice of fighting inflation or having OFR translation losses.
Given Singapore’s economic situation, there is no way to fight inflation without suffering higher OFR translation losses.
Though I would argue that perhaps MAS can also use raising interest rates as a secondary tool to fight inflation instead of relying solely on exchange rates.
But that also has its own side effects, like increasing borrowing costs for companies and slowing economic growth, and possibly even causing a recession.
In fact, we are in a very fortunate situation compared to some other small countries. Our exports are still strong, and the organic demand for SGD is already good enough to strengthen it. There is no need to deplete our foreign reserves.
A small country that’s a net importer like Sri Lanka doesn’t have such a luxury. One of the reasons why Sri Lanka’s foreign reserves were depleted was because it spent US$ 736 million in a failed attempt to maintain a 1 USD = 200 Sri Lankan Rupee peg.
So as a Singaporean, I’m actually quite grateful that our inflation is not as high compared to some other small countries.
And I also foresee that it’s possible MAS may have another year of loss as the SGD strengthens to fight inflation.
But for the reasons stated above, I’m not worried even if it happens.