Causes of a Fall in a Currency's Value, and the Impact of a Weaker Yuan on Singapore

Answer

Part (a)

In a floating regime, a currency’s exchange rate is set by the demand for and supply of the currency in the foreign-exchange (FOREX) market. A fall in its value — a depreciation — follows from a rise in supply of the currency, a fall in demand for it, or both. Three causes drive these shifts.

Relative income change. If a country’s national income grows faster than its trading partners’, its residents demand more imports — many of which are normal, positively income-elastic goods. To pay for imports, residents supply more of their own currency in the FOREX market in exchange for foreign currency, shifting the supply curve rightward. Meanwhile, if partner incomes grow more slowly, foreign demand for the country’s exports — and hence demand for its currency — is weaker. The rise in supply and fall in demand create a surplus of the currency, putting downward pressure on its value.

FOREX market for the domestic currency: a faster rise in domestic income raises supply (S₀→S₁) and softens demand (D₀→D₁), creating a surplus that lowers the exchange rate from e₀ to e₁.

Relative change in price level. Higher domestic inflation than abroad makes exports less price-competitive, so foreign demand for the currency falls (demand shifts left). At the same time, imports become relatively cheaper, so residents supply more of their currency to buy them (supply shifts right). Both movements lower the exchange rate.

Relative interest rate. Interest-rate differentials drive short-term financial flows — “hot money”. If domestic short-term interest rates fall below those abroad, speculative investors shift funds out of the currency to earn higher returns elsewhere. The resulting capital outflow raises the supply of the currency and lowers demand for it, depressing its value.

In sum, a currency falls when relative income, relative inflation, or relative interest rates move so as to raise the supply of, or lower the demand for, the currency in the FOREX market.

Part (b)

A fall in the value of the Chinese yuan affects Singapore through trade and capital channels, because China is one of Singapore’s major trading partners. My thesis is that the impact is likely large and negative on balance in the short run, given the weight of external demand in Singapore’s GDP — but its size is mitigated by the composition of Singapore’s exports, and it carries one offsetting benefit for price stability.

Negative impact on actual growth and unemployment. A weaker yuan makes goods produced in China cheaper relative to imports, so Chinese firms and consumers switch from imported goods to domestic substitutes — including substituting away from Singapore’s exports. Singapore’s export revenue $X$ falls. Simultaneously, the cheaper yuan makes Chinese goods more attractive to Singaporean buyers, raising Singapore’s import expenditure $M$ . With $AD = C + I + G + (X-M)$ , net exports fall and aggregate demand falls, lowering real national income through the multiplier. Depressed national income implies slower actual growth and higher demand-deficient unemployment.

Impact on Singapore: weaker net exports shift AD₀ to AD₁ in the intermediate range, lowering output from Y₀ to Y₁; a separate fall in imported input costs shifts SRAS₀ to SRAS₁, lowering the price level — actual growth and unemployment worsen while inflation eases.

Evaluation. The fall in demand for Singapore’s exports may be limited because Singapore exports high-tech, capital-intensive manufactures and services — telecommunications, computer and information services — for which Chinese demand is less easily substituted by domestic production. This mitigates the loss of export revenue.

Negative impact on the balance of payments. A weaker yuan raises the Singapore-dollar cost to Chinese firms of expanding operations in Singapore, reducing long-term capital and foreign direct investment inflows. This worsens the financial account and Singapore’s overall balance of payments.

Negative impact on potential growth. Lower FDI from China means less capital-goods investment in Singapore, slowing the expansion of productive capacity and thus potential growth.

Positive impact on inflation. Against these costs, the cheaper yuan lowers the price of imports from China, reducing firms’ unit costs of production. SRAS shifts rightward and the general price level falls, easing cost-push inflation — a benefit for a small, import-reliant economy.

Judgement. The net impact is likely large and negative in the short run, because external demand is so significant to Singapore’s GDP and China is a major trading partner, so changes in China’s exchange-rate position transmit strongly. The mitigating factors — the differentiated, less-substitutable character of Singapore’s exports, and the relief to imported-cost inflation — soften but do not reverse the verdict. If the yuan remains persistently undervalued, the drag on Singapore’s growth and external balance is sustained, and Singapore must continually adapt its policy mix — exchange-rate management and supply-side measures to preserve competitiveness — to offset external shocks of this kind.