currency – the _

[2723] Is the weaker ringgit contributing to domestic inflation?

I have read in the media of allegation that the weaker ringgit is contributing to the rising inflation in Malaysia.^[1]

The allegation makes sense. If Malaysia imports stuff, which the country does, and if the ringgit gets weaker, which it has (at least against several currencies and namely the US dollar), a weaker ringgit should contribute to domestic inflation. In the absence of data, I would support the idea of weaker currency is contributing to inflation.

Except, I am not entirely convinced by the data. In fact, the data is possibly telling me something to the opposite.

I have done some modeling in the past and it is hard to get a relationship between currency and inflation. At least, my modeling skills are not there yet, I would suppose. Even if I ignore all those econometric tests which the models failed, the effect of currency fluctuation under normal times, as I remember from those models, are so small that I would rather ignore them.

But here is something that does not rely on my econometrics. It is more straight forward in answering whether a weaker ringgit is contributing to domestic inflation. There are two possible proofs dismissing the role of the weaker ringgit.

The first is the producer price index (PPI) for imports. Crazily enough, it is still deflating and it has been deflating since January 2013 at the very least:

20140211PPIImportsDecember

One would expect, if the weaker ringgit was contributing to domestic inflation, the PPI for imports would increase and from there, the PPI inflation would somehow transmit to the consumers, affecting the CPI. I have not modeled this but the result for the a priori expectation that one needs to make the assumption that the weaker ringgit is contributing to domestic inflation is not going well here.

The second involves the import value and import volume growth. I have not thought of this thoroughly but if a weaker currency is contributing to domestic inflation, I would expect faster growth on import value than import volume growth. But in December, total import value (the one you see often in the press) rose 14.8% YoY. Volume grew 15.1% YoY. That means imports really are getting cheaper, corroborating the signal from the PPI imports.

So, is the depreciating ringgit contributing to the rising domestic inflation?

No. On the contrary, imports are a counteracting factor against inflation.

Again, this is just a preliminary thought that I just had. If my thinking holds, then I do not think the weaker ringgit is contributing to domestic inflation. At least not yet.

Right now, it seems, the rising CPI inflation in Malaysia is all caused subsidy cuts and domestic demand.

Mohd Hafiz Noor Shams. Some rights reserved

[1] — A weakening ringgit currency, which is down 1.5 per cent since the start of the year and at five-month lows against the dollar, could add to upward pressure on prices through more expensive imports, and reinforce the case for raising interest rates. [Malaysia inflation jumps as government feels heat over living costs. Reuters. The Malay Mail Online. January 22 2014]

[2641] Will fewer zeroes do something positive to the rupiah?

I learned a few things in Indonesia. One of them involved the discussion of cutting down the zeroes in the Indonesian bills. Prices of goods and services will be adjusted accordingly as well.

Right now, the Indonesian currency the rupiah is denominated in the thousands and it is quite common to round up any price to the nearest 500 even when there are 200 rupiah coins circulating. And sometimes, even to the nearest thousands. As a foreigner unfamiliar with the rupiah, I almost protested each time that happened to me at the store in the three weeks I was there. Had I protested, I would have looked silly.

But what is the point of cutting down the zeroes?

There are several popular arguments for that and the biggest of among those is inflation. There is a belief that by cutting down the zeroes, inflation will happen at a more comfortable pace.

I do have trouble with that. Yes, I sat down on Kuta beach and thought of the problem, drawing chart in the sand under the Balinese sun. The water was cheery, the wind was nice and the sun was warm. The trees were swaying gently and the sand was fine.

Before I digress too much, the cutting down exercise essentially shifts the price level down. It does not specifically change the factors that cause inflation, like demand and supply. However the currency is denominated, if demand is strong and supply is short, inflation will be there.

A 4% to 5% inflation, the band which the Indonesia inflation has hovered in recent times, will still be 4% to 5% inflation whether the rupiah is denominated in the thousands, millions or tens. The absolute value will be big at the higher level but then again, the right denomination can address that painlessly: it makes inflation independent of the denomination.

Then, I started to think about the possibility of heteroskedasticity. That mouthful word describes a situation where there is more volatility at greater level. For example, at the level of 1, the data may fluctuate by 5% around the number 1. At the level of 1 million, it may fluctuate by 10% of around the number 1 million. This is known to happen with a lot of financial data. I am unsure if it is true for inflation as well and I have not checked it. I did a search on it and… things that came up are not stuff I want to read at the moment. All I want to do right now is blog and not mess up my head by too much.

Theoretically, it is hard for me to see how the level may affect inflation. The empiric may have something else to say.

The theoretically respectable way to have a change in level to affect inflation is to use the expectations channel. Consumers must somehow believe that a change in level affect inflation so that post-change, inflation will be lower. But there is a problem with this: like I said, the factors that affect inflation does not change (given the denomination is optimal, which is easy to achieve) and the issuer of the new money, Bank Indonesia, will still be as credible as the issuer of the old money. So, how exactly will a new denomination affect expectations?

I do not know.

So, the realistic way is to follow the empirical route and see if there is heteroskedasticity. But I am abusing the term a bit here. I am not thinking specifically about heteroskedasticity. I am just thinking that inflationary pressure or expectations might be greater at higher levels.

If that is the case, then the exercise may help fight inflation. If it does not, then I think the exercise is not ideal.

The next big point of it is really cumbersomeness of big bills. But during the weeks I was in Java and Bali, I found that the rupiah was easy to use. Indonesians and others have adapted to the denomination and the price level quite well. I would think given the prevailing price level in Indonesia, everybody would carry big bills around like during the disastrous era of the Weimar Republic or Japanese Malaya. But inflation in Indonesia is respectably okay at the moment. So while Indonesian denomination is big compared to Malaysia, stable prices mean these Indonesian bills will not lose its value quickly. The big numbers on the bills mean something, unlike in the Weimar Republic in the 1930s.

When I was there, I typically brought along 50,000 bills mostly because that is the lowest denomination the ATM spits out. Apparently, the optimal bills to carry around are 5,000 and 10,000. And it is not really cumbersome. I had 2 million rupiah in the wallet and the wallet looked thin.

Given the price level, the denomination of the Indonesian currency and the current inflation rate, the society is adapting extremely well to the situation. So, there is no need to cut down the zero. It is, after all, just zeroes on pieces of papers that appears to exact negligible cost to economic activities. Things are going fine as it is. So, I do not think the one-off adjustment cost associated with the cutting exercise is worth the effort, if cumbersomeness is the concern.

p/s – in fact, Bank Indonesia plans to re-denominate the rupiah beginning from 2014. The exercise may be completed by 2016. The current denomination will be slashed by the thousands i.e. 1,000,000 will become be 1,000 once the exercise is complete.