Executive Summary

1         In contrast to countries which import capital to finance their current account deficits, Singapore has had a growing current account surplus, and has been exporting capital abroad. As a result, the domestic interest rate has been generally lower than international interest rates. This paper analyses the relationship between the openness of Singapore's financial markets, its position as a net capital exporter, and the structure of its capital account, and draws implications for the conduct of exchange rate policy and the exercise of monetary autonomy.

2         Underpinned by the absence of formal trade barriers and exchange controls, Singapore is highly open to trade and investment, and is also an international financial centre. In the absence of exchange restrictions, covered interest arbitrage eliminates risk-free differences between the returns on Singapore Dollar and foreign currency assets. Indeed, if we allow for transaction costs, covered interest parity is found to hold on average during the period from December 1988 to September 1998.

3         To determine the structure of Singapore's capital account, we examine each of its components, and categorise them into 'hot' (volatile and easily reversible) or 'cold' flows. In the fifth edition of the IMF's Balance of Payments Manual, the overall capital account is labelled the capital and financial account balance. Under this are the capital and financial accounts. The capital account balance is the net sum of capital transfers and the acquisition and disposal of non-produced and non-financial assets, while the financial account balance is the net sum of net foreign direct investment, net portfolio investment and net other investment flows.

4         To categorise capital flows into 'hot' or 'cold', we examine their persistence and reversability characteristics by calculating autocorrelations for quarterly flows between 1986Q1 and 1998Q2. Large and positive autocorrelations for several quarterly lags indicate that capital account and net portfolio flows show signs of persistence. One reason for the persistence of portfolio flows is that a substantial proportion of these flows represent long-term investments by both public and private entities abroad. The autocorrelations for net foreign direct investment flows suggest a transitory series, contradicting the notion that direct investment is not easily reversible. However, in Singapore, where the volume of outward direct investment is also large, the timing of the outward flows may tend to offset the relatively stable inward flows such that, on a net basis, the overall series appears to lack persistence. Alternating autocorrelations for other investment flows point to the quick reversal of fund flows in and out of the banking system.

5         The coexistence of excess domestic saving over investment, net capital outflow and lower domestic interest rates relative to international rates in Singapore contrasts with the situation in the majority of East Asian and Latin American countries in the first half of the 1990s. The gap between the domestic interbank rate and the US$ SIBOR rate widened substantially since 1994 until the onset of the Asian currency crisis in July 1997. This coincided with the acceleration in efforts to increase portfolio and direct investments abroad since 1993.

6         The differential between the domestic interbank rate and the US$ SIBOR rate may be thought of as due to two factors - an exchange rate risk premium and expected appreciation of the Singapore Dollar. Through formal testing, we find that the data suggests the presence of a time-varying risk premium on foreign currency-denominated assets. This implies that the expected returns on foreign currency-denominated assets must be higher than those on Singapore Dollar-denominated assets in order to encourage residents to channel their savings into an increasing stock of net foreign assets.

7         The other source of the relatively low domestic interest rates is the expected appreciation of the Singapore Dollar. The trend appreciation of the currency stems from the high savings by both the public and private sectors. Much of the public sector surplus is held by the MAS, while a substantial proportion of private sector savings is held in the form of CPF contributions, over 90% of which is typically placed as advanced deposits with the MAS for the purchase of future issues of government bonds. This causes a contraction in the monetary base, thus providing a basis for the appreciation of the Singapore Dollar. The MAS offsets the contractionary effect of the public sector deposit placement by intervening in the foreign exchange market to sell the Singapore Dollar for the US Dollar. The extent to which this is done is determined by the targeted level of the trade-weighted nominal effective exchange rate.

8         The expected appreciation of the Singapore dollar dominates the exchange rate risk premium in explaining the interest rate differential between nominal Singapore and US Dollar interbank offer rates. We find that, on average, the mean and variance of the expected change in the spot exchange rate were larger than the mean and variance of the exchange rate risk premium.

9         Finally, we analyse the extent to which the MAS can influence domestic liquidity conditions without compromising its exchange rate target. This is thought to be virtually impossible. We find that capital flows move to entirely offset any changes in net domestic assets of the MAS within one quarter. This is consistent with earlier findings of perfect capital mobility and a relatively small risk premium underlying the interest rate differential. A relatively small risk premium implies that domestic and foreign currency assets are fairly close substitutes.