The ringgit: What we need to understand

THE Malaysian ringgit is undergoing a transition period of weakening momentum against the US dollar, the world’s dominant currency for trade and financial settlement.

The faster pace of monetary policy tightening by the Federal Reserve (Fed) starting in March 2022 has caused a strong appreciation of the US dollar and directly suppressed emerging market currencies, including the ringgit.

Exchange rate pressures arise from both global and local factors and related interest rate differentials are one of the dominant factors.

Other main factors influencing the behavior of exchange rates are relative price levels (inflation), balance of payments (in simpler terms, exports more than imports), balance in budget and government debt, as well as other non-economic risks (political and governance conditions).

The challenge is to understand how changes in these fundamental factors influence market psychology or sentiment or expectations about the movement of the ringgit against the US dollar in particular, and other regional currencies in general.

In our assessment, the ringgit faces significant exchange rate pressures driven primarily by external factors.

This includes a combination of aggressive monetary policy tightening in advanced economies and tighter funding conditions, as well as greater global risk aversion (concerns over rising interest rates and strong negative US dollar spillover effect in emerging markets; China’s stuttering recovery) reducing net capital inflows to the region and pricing in emerging economies, including Malaysia from global capital markets.

Under the managed float system against a basket of currencies, the ringgit’s exchange rate is largely determined by the demand and supply of the ringgit in the foreign exchange market.

Malaysia’s economy does not function in isolation from the rest of the world. While the objectives of monetary policy are largely domestic considerations in terms of economic growth, inflation and employment, the influence on monetary management is both domestic and global.

Of the global influence on monetary policy setting, the most obvious point is that Malaysia’s overnight policy rate (OPR) of 3% is between 200 basis points and 225 basis points lower than the Fed funds rate (5% -5.25% ).

On a regional comparison basis, our OPR is the second lowest in the region after Thailand.

The negative interest rate gap (Malaysia-US differential) was partly driven by financial capital inflows to the country with relatively higher real interest rates as investors flocked in search of higher rates. of income.

Capital outflows pushed the ringgit lower against the US dollar and other currencies. Other regional currencies also suffered the same fate.

The gradual normalization of domestic interest rates (such as the OPR benchmark) to an appropriate level is a pre-emptive measure to support the economy while keeping inflation at bay.

It is not intended to cause excessive economic adjustment amid concerns about downside risks to the global economy.

Under a flexible exchange rate regime and freer capital mobility, the ringgit will fluctuate in a volatile manner, and exceed levels during periods of uncertainty and weak market sentiment.

A flexible exchange rate is prone to misalignment with its underlying fundamentals; and will eventually return to its fair or fundamental value when negative sentiment dissipates with reasonable expectations.

In our view, the overshooting of the ringgit exchange rate does not reflect the underlying economic and financial fundamentals of the country.

> Positive initial economic conditions. The Malaysian economy ended 2022 with a strong economic growth of 8.9% and registered a 5.6% expansion in the first quarter of 2023 (1Q23).

Amid concerns about the global economy, we expect the domestic economy to continue growing, albeit at a modest pace in recent months due to falling exports.

Growth in domestic demand though will continue to normalize – it should continue to hold the economy.

> Keeping inflation at bay. Headline inflation continued to decline to 2.8% in May from 4.7% in August 2022.

However, core inflation remains persistent. Labor market conditions remain stable with the unemployment rate steady at 3.5% in May 2023.

> Still running a comfortable trade and current account surplus, albeit shrinking. The current account surplus is expected to be between 2% and 3% of gross domestic product (GDP) in 2023 (2.6% of GDP in 2022).

Net foreign direct investment (FDI) inflows expanded higher to RM74.6bil in 2022 and RM50.4bil in 2021 compared to RM13.2bil in 2020. In 1Q23, net FDI inflows reached RM12bil.

Higher approved investment projects of RM71.4bil were seen in 1Q23 and an average of RM288.6bil per year in 2021-2022.

> The banking system remained well capitalized, strengthening the banks’ capacity to support lending activity and absorb unexpected losses.

The banking system’s total capital ratio remained strong at 18.8% as of December 2022, with capital buffers of RM134.8bil above the regulatory minimum.

The domestic capital market is deep and efficient to mitigate the impact of capital flow volatility. Malaysia’s participation in regional and global international finance adds another layer of buffer against foreign currency liquidity crisis.

> Maintaining accumulated reserves is important. Foreign reserves stood at US$111.4bil (RM508bil) at the end of June 2023, covering five months of retained imports and one time of short-term debt.

Excluding the foreign currency forward position of US$23.7bil (RM108bil) in May, foreign reserves remain comfortable at US$87.7bil (RM399.7bil).

> The government must remain committed to consolidating its budget and rebuilding fiscal space through revenue enhancement, rationalization and expenditure restraint as well as debt restraint under the Medium-Term Fiscal Framework (MTFF).

The budget deficit is forecast to decrease to 5% of GDP in 2023 from 5.6% in 2022; and more than 4.1% of GDP in 2024 and 3.2% of GDP in 2025 assuming about 5% of GDP growth per year for five years.

Bank Negara’s foreign exchange intervention focuses on maintaining sound foreign exchange market conditions.

Foreign exchange intervention is to contain excessive movements in the ringgit; to counter short-term trends or volatility in exchange rates; and to restore the misaligned exchange rate to its fundamental path.

In an independent monetary policy regime, the exchange rate will act as a shock absorber in the face of asymmetric shocks most of the time and in most circumstances.

Exchange rate depreciation is necessary to facilitate adjustment to external shocks that are durable, such as higher interest rates in advanced economies; risk avoidance; and portfolio flows are that sensitive to market sentiment.

These are the main factors that influence the volatility of the ringgit, and it often exceeds the fundamentals.

Exchange rate adjustments provide price signals that help all economic agents in the economy adjust and adapt.

Experience has shown that Bank Negara is capable of mitigating the volatility of the ringgit, maintaining the smooth functioning of the market and reducing any destabilizing effects on the real economy.

We have weathered the ringgit’s volatility well even though the ringgit’s weakening will have a temporary impact on households and businesses in the form of higher imported inflation and imported raw materials, respectively.

The cost of servicing foreign currency denominated loans will increase.

Malaysia has experienced several episodes of large and volatile capital flow fluctuations, which have affected international reserves and the ringgit.

The Global Financial Crisis of 2008-2009 saw portfolio outflows of US$26bil (RM119bil) from 3Q08 to 1Q09, with the ringgit depreciating by 28% while the 2014-2015 oil price shock saw portfolio outflows worth US$13.7bil (RM62. 4bil) between 3Q14 and 3Q15.

Since 2015, when the Fed raised its policy rate nine times by 225 basis points, the ringgit has fallen about 50% from RM2.9675 per US dollar in May 2013 to the trough of RM4. 4995 per US dollar thereafter.

Post-Covid-19 pandemic, since the Fed began its aggressive rate hikes in March 2022 to combat rising inflation, the ringgit has appreciated by as much as 11.5% between the end of March and early November, before it appreciated towards the end of the year.

For the period March 2022 to the end of June 2023, the ringgit depreciated by 10.2% against the US dollar.

The US dollar index is now weakening as easing inflation strengthens the case for the Fed to wind down its rate hike campaign in the coming months.

However, there are arguments in favor of renewed strength in the dollar, which include the Fed keeping rates higher for longer if inflation does not return within its target; and global risk aversion may cause investors to seek refuge in the dollar.

The strength of the ringgit will depend on how well Malaysia maintains its economic growth in an environment of price and financial stability; fix the budget deficit and contain debt and liabilities; rebuild the confidence of domestic and foreign investors; stimulate domestic investment; and attract inflows of reliable long-term FDI as well as making the domestic equities market attractive to portfolio investors.

We must continue to focus on strengthening economic resilience against external shocks through stronger fundamentals and pursue structural reforms to keep Malaysia’s economy sustainably competitive and support the ringgit.

Lee Heng Guie is executive director of the Socio-Economic Research Center. The views expressed here are the writer’s own.

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