Stronger ringgit by year-end?

High chance it may end the year at between RM3.50 and RM3.60 per US dollar

The ringgit hit a 10-year low of RM3.78 per US dollar in June 2015 amid heightened international market concerns of the Greece crisis fallout and expectations of a sovereign credit rating downgrade from Fitch Ratings, the latter which did not materialise after all. Moving forward, the pace of ringgit’s recovery remains to be seen.

Does the current ringgit exchange rate reflect economic fundamentals?

Since September 2014 to end-June 2015, the ringgit has depreciated 16.4% against the greenback whereas the Indonesian rupiah and the Singapore dollar have depreciated 12.2% and 7.3% respectively during the same period.

However, in real effective exchange rate terms according to the Bank for International Settlements, that is, taking into account relative inflation rates and the currency weighted against bilateral trade exchange rates, the ringgit has only depreciated around 4% since last September to May 2015.

For one, the market should not be too bearish on the ringgit. The current weakness largely stems from external volatilities. The ringgit is weak mostly on the back of perception issues rather than major flaws in our fundamental economic structure.

There needs to be proper understanding of the macro context and external environment before drawing credible inferences on the state of the economy.

Keep in mind that the Malaysian economy still achieves a healthy gross domestic product (GDP) growth on the back of resilient domestic demand and investments, steady current account surpluses, and continued government commitment to fiscal consolidation.

Three main reasons have largely been attributed to the cause of the weakening ringgit – crude oil price plunge, US dollar appreciation and negative sentiments.

Around 30% of the government’s fiscal revenue in the past five years was from the oil and gas sector, while close to 20% of our exports are oil and gas commodities. There is no doubt the depressed crude oil price will weigh down on our economy – but that is not the whole story.

The ringgit’s depreciation has been taking place during a time of strong US dollar appreciation. In short, the US Federal Reserve has been timing its Federal funds rate hike by end-2015 or early next year to normalise its benchmark interest rate from its current historic low of 0.25% since the global financial crisis. Therefore, there have been strong interests in the US dollar and capital flow back to US in anticipation of higher yields in the US when the benchmark interest rate rises.

In fact, the Federal Reserve estimated that the US dollar strength index measured against its major trading currencies had appreciated almost 13% between September 2014 and June 2015.

Back in Malaysia, our economy is expected to remain healthy with a GDP growth trajectory of around 5% to 6% per annum until the end of the decade while inflation rate is expected to be kept around 3% in the coming years.

As Bank Negara and government officials have repeatedly assured Malaysians, our long-run economic fundamentals are intact. Our financial markets are nowhere near Greece’s situation nor are our government debt (52.1% to GDP as of first quarter this year) at the levels of Japan (234% to its GDP in 2014) or the UK (92% to its GDP in 2014).

However, that does not vindicate the fact that the ringgit’s exchange rate has been weak. To an extent, the rate has been affected badly on the back of negative sentiments on the Malaysian economic outlook.

By the end of June 2015, Fitch Ratings appeared convinced of the fiscal and structural reforms that the economy had been undertaking in the past year and thereby reversed its intention for a sovereign credit rating downgrade. While Fitch Ratings has some confidence in Malaysia’s external finances, it remained somewhat cautious over the state of public finance – contingent liability, fiscal position and government debt levels – and these structural issues are not to be taken lightly.

Bearish sentiments

Unfortunately, bearish sentiments from current developments take hold of the market mentality, even as the government attempts to reassure the market that the real economic and market fundamentals remain strong and resilient.

However, we should take note that there are few other forces affecting the volatility of the ringgit exchange rate. The expectation of the global recovery has come in weaker than expected, as the international agencies like the World Bank, International Monetary Fund and the Organisation for Economic Co-operation and Development have already lowered their growth forecasts for 2015.

More importantly, there is a widening divergence in international monetary policies. The US Federal Reserve has set sight for their interest rate liftoff at a time when the Bank of Japan and the European Central Bank are pursuing respective quantitative easing programmes.

Just recently at end-June, the People’s Bank of China cut its benchmark interest rates for the fourth time since last November.

Although these monetary policy adjustments are necessary to stabilise the countries’ respective real economies, collectively, the widening differences in yields and returns have caused much volatility in international financial markets, especially the exchange rate markets.

For Malaysia, as an open economy reliant on trade and international capital flow for its growth, these external developments have one way or another weighed down on the outlook on the ringgit exchange rate.

According to Bloomberg foreign exchange model forecasts, market expectations for the ringgit’s exchange rate by the last quarter of the year remains bearish, ranging between RM3.50 per US dollar and RM4.10 per US dollar. It would take time and effort for the ringgit to recover from its current weak levels.

While the market has to be patient on this matter, confidence in the government’s commitments to strengthen its balance sheet would be helpful to the ringgit exchange rate recovery.

As long as the Malaysian economy remains diversified and continues to expand as outlined in the 11th Malaysia Plan, the country has a convincing good growth story to attract and retain foreign investors’ interests.

Besides, the US dollar appreciation is an external factor beyond any single entity’s control.

From the Federal Reserves’ latest June monetary policy meeting guidance, there might be one to two Federal funds rate hike by the end of the year, depending on the US macro environment.

Unless the US economic recovery takes an unexpected dive at this point, the US dollar rally seems set to continue for a while. In view of Fitch Ratings’ fair view on our economic prospects in the coming months, there is high chance that the ringgit may close stronger between RM3.50 and RM3.60 per US dollar by year-end.

While a weak ringgit promises better exports competiveness in the short-run, the subdued global demand environment, in light of the slowdown in China remains a dampener.

Given that Malaysia is just a few years away from achieving high-income nation status, the government and the domestic market players should rally hand in hand through this short-term volatility without compromising our long run potential growth.

There are more reasons than not for the ringgit to revert back to its fair value level when the dust settles.

Manokaran Mottain is the Chief Economist at Alliance Bank Malaysia Bhd.