FOR emerging market (EM) economies, central banks care about the exchange rate as it is core determinant of the nominal anchor in a small open economy.
Central banks are mandated to maintain price stability and preserve the value of money, so as to retain the people’s purchasing power.
Hence, both monetary and exchange rate stability are the cornerstone of orderly economic activity.
Higher US interest rates supporting the US dollar’s strength is reverberating through trade and financial channels around the world, and will have macroeconomic implications on emerging countries, given the dominance of the dollar in the international trade and finance.
Large and volatile capital flows are a permanent feature of the global financial landscape. Managing large and volatile capital flows that have exerted significant pressures on exchange rates has been remained a central economic challenge in Asian EM economies.
In an open international capital flows market, which allows a two-way flow of capital across borders, while the exchange rate can be an absorber of economic shocks, it can act as a shock amplifier.
Persistent and large exchange rate depreciation can cause negative implications on prices, investment and growth.
Asian economies have to manage the risks and transitory disruptions induced by wide swings in the exchange rate and tighter financial conditions as they retain control over exchange rates and monetary conditions amid keeping a flexible exchange rate regime to avoid significant exchange rate realignment.
Countries with weak economic fundamentals and corporates with high foreign currencies denominated debt, domestic exchange rate depreciation can aggravate their economic and financial vulnerabilities due to a sharp capital reversal, and induced domestic exchange rate and asset prices volatility (equity and bond) if domestic capital markets are shallow and illiquid to intermediate the capital outflows and there are limiting hedging opportunities.
Malaysia has a managed floating exchange rate, which means that movements in the ringgit exchange rate are determined by the demand and supply of the ringgit in the foreign exchange market.
Since the ringgit was depegged to the US dollar at RM3.80 in 2005, it had depreciated by an average of 0.9% per annum against the US dollar from 2005 to 2022, of which it has had recorded an appreciation in nine years (2005, 2006, 2007, 2009, 2010, 2012, 2017, 2019, 2020) out of a total of 17 years throughout the period.
Based on end-period, the ringgit ended a high of RM3.0583 to the US dollar at end-2012; and had hit a low of RM4.4860 at end-December 2016.
The Real Effective Exchange Rate (REER) index, is a better measure of general trends in the exchange rate than against the US dollar bilateral exchange rate, since the ringgit could be depreciating against the US dollar but appreciating against other currencies.
The REER index measures the ringgit in terms of a weighted average of a basket of currencies of Malaysia’s trading partners is subject to less pronounced swings in value compared with the bilateral exchange rate against the US dollar. In terms of REER, the ringgit had depreciated by 0.6% pa in 2005-2022.
Domestic and international pull and push drivers (short-and long-term) can influence the value of the ringgit against major foreign currencies, in particular, the US dollar, the world’s largest reserve currency, which is also widely used in the financial market and trade settlement.
These drivers can be domestic economic (economic prospects, inflation, monetary policy, budget deficit and debt, balance of payments, durable foreign capital inflows and foreign reserves accumulation) and international drivers (economic and financial shocks ad well as policy risk in the advanced economies).
Domestic non-economic factors are political condition, the level of confidence, investors’ sentiment and speculative induced.
Interest rate is one of the key determinants of nominal exchange rate. Ceteris paribus, an increase in the interest rate would cause the value of a currency to rise as higher interest rates offer investors a higher return relative to other currencies.
In an environment whereby global central banks have normalised their interest rate from low levels, with the Federal Reserve leading the pack on an aggressive monetary stance, it is inevitably that the US dollar will command a strong appreciation against major and minor foreign currencies, including the ringgit due to higher interest rate differentials (better yield) in the dollar’s favour.
One can imagine that significant downward pressure would exert on the ringgit would be if domestic interest rate was not normalised gradually from the low levels during the pandemic, leading to a far wider interest-rate differentials with the United States.
Negative sentiment
It is undeniable that the ringgit’s weakness against the dollar was due to negative sentiment concerning the state of the US economy (regional banks turmoil and a temporary resolution of the US debt ceiling); relative interest rate gap between domestic interest rate and the Fed rate as well as the expectations of continued interest rate hike by the Fed; concerns about the state of global economy and a seemingly weak China recovery post reopening; falling domestic exports that would weigh down Malaysia’s current account surplus.
Concerns about political stability, the delayed overhang reforms, worries about fiscal and debt sustainability push up not only the currency and equity risk premium but also the volatilities of the ringgit induced by a two-ways capital flows on the back of investors concerned about the Government’s political commitment of making the reforms happen.
With the economy recovering from the Covid-19 pandemic crisis, there is no compelling need to keep interest rate at low levels, and hence, a need to remove the ultra-monetary accommodation to rebuild monetary buffer against future shocks.
Nevertheless, we believe that Bank Negara will tread carefully in balancing between maintaining price and financial stability and sustaining the economy.
It will manage the impact of interest rate normalisation on domestic economy, businesses and households to ensure a soft landing and not to “overkill” the economy.
Absorbing shocks
It is an impossible trinity of having a strong ringgit and keeping low interest rates. Under a flexible exchange rate regime vis-a-vis the US dollar, the ringgit could go up or down in value and be used to absorb the shocks though it entails cost adjustment for businesses and households.
Malaysia must continue to enhance economic and financial resilience through sound macroeconomic policies (sustainable economic growth, price stability, healthy balance of payment, sustainable fiscal and debt management); strong and well capitalised banking system as well as maintained a deep and liquid capital market; and the accumulation of strong foreign reserves war chest against the external shocks.
Malaysia had experienced various episodes of sizeable capital reversals, which impacted foreign reserves and the ringgit:
> The Fed’s Taper tantrum (May 22 to Aug 23, 2013) suffered net outflows of US$19.1bil (RM88bil); a decline of US$6.7bil (RM31bil) in foreign reserves and the ringgit depreciated by 9.7%,
> Oil price decline (net outflows of US$28.6bil (RM132bil); a decline of US$38.7bil (RM178bil) in foreign reserves; the ringgit depreciated by 29.6%) and
> Donald Trump’s victory (net outflows of US$10.1bil (RM46.6bil); a smaller decline of US$3.3bil (RM15bil) in foreign reserves and the ringgit down 6.5%.
There remain unfinished reforms agenda on political system, institutional and economic. The policymakers need to consider measures to reduce the vulnerability of our country to exchange rate gyrations.
Structural reforms are a tool of supporting higher economic dividends.
Tackling obstacles
They tackle obstacles to the fundamental drivers of growth and productivity would boost Malaysia’s growth potential, enhance resilience and competitiveness in trade, doing business and attracting investment, and hence ensuring the sustainability of nominal and real exchange rate.
Reforms pressures have been piling up on the need to undertake structural reforms in policy areas identified as priorities for growth: fiscal and debt sustainability, product and labour market regulations, tax system, investment climate, education, skills and training, as well as innovation.
The government had incurred 26th consecutive year of budget deficit since 1998 on a narrow revenue base relative to high commitment of operating expenditure (largely unsustainable subsidies); federal government’s debt and liabilities have risen significantly since 2015, from RM808bil (RM3.7 trillion) or 68.7% of GDP to RM1.4 trillion or 80.6% of GDP at end-2022.
The current account surplus of the balance of payments have narrowed substantially from between 10.1% and 17.1% of GDP in 2003-2011 to a single-digit of between 2.3% and 5.2% of GDP in 2012-2022. Foreign reserves accumulation has risen, albeit lower compared to regional peers.
Lee Heng Guie is Socio-Economic Research Centre executive director. The views expressed here are the writer’s own.
