SINGAPORE For all the ambiguity afforded to Singapore by its unique currency-based monetary policy, its central bank will still have to effectively devalue the currency if it wants to meaningfully achieve lower interest rates.
Singapore's central bank announces its policy after a six-month hiatus next week, and barely anyone doubts that authorities will have to ease monetary settings to shore up an economy that is already in recession and toying with deflation.
Loosening policy via the currency has never been straightforward, but this time it seems particularly complicated.
The economy has been hit severely, more by collapsing external demand than an overvalued currency, while expectations of the latter being weakened have pushed short-term rates uncomfortably higher.
Shifting the Singapore dollar's trade-weighted trading band down in one go, effectively a devaluation, would be the least ambiguous way of easing policy, said Emmanuel Ng, a strategist at OCBC Bank in Singapore.
That seems to be the consensus view, simply because other options could have some undesirable side-effects. The Monetary Authority of Singapore (MAS) could for instance allow the Singapore dollar to trade in a wider band, or gradually steer the centre of the band lower at a pre-determined pace so as to let the currency depreciate over time.
The former throws policy open to the whims of a market that could drive the currency up or down rather quickly, while the latter could push up market yields.
"We would view a downward change in the slope of the policy band as akin to quantitative easing by other central banks," said Claudio Piron, a strategist at JPMorgan Chase.
Ng believes it will be "policy suicide" for the MAS to put the Singapore dollar on a gradual depreciation path.
"A depreciation policy was never a serious consideration. It would put the forwards permanently at a premium," Ng said, in a discussion on Reuters Markets Buzz chatroom.
In other words, if market participants believed the Singapore dollar will keep depreciating, they would sell the currency in the forward market. That would push up swap rates which are derived from these forwards, and elevate short-term rates across the board in the tiny, open economy.
Already, the Singapore 6-month swap offered rate (SOR), a benchmark for mortgage and commercial lending in the economy, has climbed 65 basis points in just over two months. The 3-month SOR is above U.S. dollar interbank rates -- just like it was during the 1998 financial crisis and for the first time in the past decade.
The central bank's predicament has its roots in both Singapore's openness to trade -- exports account for nearly 200 percent of economic output -- and its free capital account.
This dilemma, referred to in economic jargon as the impossible trinity, states that because of its open capital account, Singapore can fix its currency or its interest rates, not both at the same time.
Singapore operates policy through a secret trade-weighted currency band and the central bank intervenes to defend that band. That in turn influences the amount of Singapore dollars in the banking system and leaves yields to market forces.
In addition, expectations of appreciation or depreciation for the currency tend to influence forward markets, and therefore rates such as the SOR.
"Rising SOR imposes a penalty for speculative shorting of Singapore dollars, and so is a natural stabiliser," said Deutsche Bank's strategist Mirza Baig. "But it can act at cross-purposes with policy if it drives up the cost of borrowing for the local corporate sector."
Which is why, economists suspect, Singapore has never had a policy encouraging a lasting depreciation of the currency in previous downturns. It widened the band in 2001, after the Sept. 11 attacks, and devalued the currency in 2002 and in 2003, after the technology bubble burst and during the SARS crisis.
This time though, well into the deepest recession on record, Singapore's authorities ought to do far more than merely announce a weakening of the currency, analysts reckon.
Policy was kept tight from April to October, and has been on neutral mode since then despite the severity of the downturn.
That has meant Singapore is one of a handful of countries in Asia where monetary conditions, measured by real exchange and interest rates, are tightening.
Analysts point to the central bank's forward book -- a tally of its holdings of U.S. dollar swaps -- which indicates that the MAS has kept a firm grip on money supply, probably because a fiscal stimulus comprising handouts and tax cuts is in place.
From a net long position of about $85 billion in June, the forward book has dropped to a net long $33 billion in January, which meant Singapore dollars were being released back into the system but at a slower pace than analysts deem necessary.
Its options may be limited, but Singapore's monetary authority could still do something dramatic, such as devalue the currency by as much as 5 to 10 percent in one stroke.
"It is not that they are limited by the effectiveness of the tool that they have, they are limited by convention, history and the politics of international currency markets," said Piron.