2016 - Hope - Having only positive expectations

AS the ringgit trades with a 4 handle to the US dollar, its spectacular depreciation over the years, in particular since July 2015 is a classic case of ignoring the basics.

In 2015, there were too many views to suggest factors affecting the ringgit but in fact it was the trading arbitrage and lack of liquidity in the currency and local financial system that was and is the main driver for the ringgit’s depreciation.

Some of the effects of ignoring the basics, saw negative perception trades being played out, in particular in the credit default swaps (CDS) market, giving rise to a shift in liquidity from bond to credit default swap markets.

Malaysia still faces a US dollar shortage in its system, and with limited dollar inflow, the cost of converting ringgit obtained from the sale of underlying financial instruments (bonds) back to the US dollar has become prohibitively high.

In situations such as this, the CDS comes into play as CDS traders treat Malaysian debt papers close to junk.

A favourite past time in recent years have been the verbal barrage of “Malaysia’s fundamentals is intact and strong”. The inability to differentiate fundamentals, from sentiment and market mechanism gave rise to blind spots in the Malaysian economy.

These concepts have been interchangeably used on many occasions by market practitioners and policy makers without having to pay heed that there is a world of difference in all three.

When market mechanism and the tools that are traded are skewed towards pricing in risk at levels that is disproportion to fundamentals, market sentiment was swayed to the weak side and this process is likely to repeat in 2016.

Malaysia’s predicament lies in its fiscal policy, whereby the short-term challenge for fiscal policy in natural resource exporting economies stems from the volatility and unpredictability of natural resource prices, such as oil.

The price of crude oil has declined significantly over the past few months. This means that public finances are dependent on a volatile variable that is largely beyond the authorities’ control. This poses a challenge to both macroeconomic management and fiscal planning.

The volatility of oil prices, and hence government revenue, tends to contribute to a pro-cyclical pattern of government expenditure, and to abrupt changes in government spending, which may translate into macroeconomic volatility and reduced growth prospects in the near term.

With fiscal policy uncertain, the Achilles heel of Malaysia however is its financial and banking sector.

In the midst of the US Federal Reserve Bank normalising monetary policy, deposits in Malaysia’s banking sector come under close scrutiny.

When Malaysian corporates were awash with cash due to easy external financing conditions, they increased their wholesale deposits with local investment banks.

A rise in such deposits allowed bank credit to expand. The problem is that such deposits are flighty whereby a worsening of external financing conditions for corporates can make it difficult for domestic investment banks to fund themselves at home, drying up liquidity rapidly.

The deposits of non-financial corporates are more pro-cyclical than other bank deposits, given the exposure these corporates face when monetary policy is normalised by the US Federal Reserve.

Thus for 2016, we should not be surprised the local banking and financial sector come under acute pressure from funding costs, narrowing of profit margins, resulting in an increase in non-performing loans.

It is obvious that Malaysia will face increased headwinds going forward and with liquidity an issue in the domestic financial markets, it is time to use unorthodox approaches. A key proposal that is worth looking into is attracting non-resident Malaysians’ deposits.

Bank Negara could liberalise bank deposit schemes in offshore Malaysian financial institutions by raising interest rates for non-resident Malaysians.

To spur banks to attract more dollar deposits from non-residents, the central bank could exempt these deposits from the cash reserve ratio and statutory liquidity ratio requirements for a specific period.

Another proposal is to establish a facility with interest rates that are between 200 basis points to 300 basis points above policy rates for financial institutions needing liquidity.

The move should be also seen as providing an avenue to remove any form of shift in deposits by large corporates into foreign currency accounts. This limits the outflow of funds from normal ringgit accounts to foreign currency accounts and curbs the exchange of ringgit into foreign currencies.

Having only positive expectations for 2016, Dr Suresh Ramanathan can be contacted at [e-mail]