Printed in The Edge, 27th. June 2022
The strengthening of the US Dollar (USD) against the Ringgit earlier this year had all parts of the Malaysian economy up in arms. It wasn’t anything new. The same level was reached in 2020 as the chart below shows but for different reasons:
Chart 1 Malaysian Ringgit vs. US Dollar
Source: US Federal Reserve
The volatility of the Ringgit caused former two-time Prime Minister Tun Dr. Mahathir to advocate pegging the Ringgit again, presumably against the USD like it was done from 1998 to 2005 during his first tenure. The central bank, Bank Negara Malaysia (BNM) responded by saying it was not in the country’s best interest.
How true is this? Given that inflation in the US is unabated at the time of writing, and the Federal Reserve is almost certain to combat inflation with raising its interest rates, this will likely see the Ringgit continually fall unless BNM raises rates in lockstep. It is worth relooking at this issue. Over the next two articles, we examine whether fixed exchange rates (pegging it to another currency) or free-floating exchange rates are (which many believe is what Malaysia is on) are best for the country. But wait! There is a third option, managed float regimes. Would this be the best?
As we begin, it is worth remembering that economics is a game of perspectives and relativity; that an interpretation can often be biased towards the interpreter’s own background knowledge and purpose of writing. Whether the person interpreting the facts for a developed, developing or even a less-developed country’s perspective, for example, is a question that must be answered. This isn’t even going into the different schools of thought like Keynesianism, Neo-Keynesianism, Monetarist, Classical, Neo-Classical, Marxian, Austrian School, and so on. It would be quite extraordinary to find an economist who knows, never mind, understands the nuances of all these schools of thought.
Yet, much of economics is read as if it is in absolute terms, i.e., applicable to all. A clear example are the writings of Adam and Keynes, being done at a time when Britain was already the most developed nation on earth, and hence their writings and advice have had limited use and impact for developing and less-developed nations. It gets very confusing and obfuscating. Many things simply slip through the cracks. In the words of HM Queen Elizabeth of Great Britain when asking about the failure to predict 2007 and 2008 Great Financial Crisis,
“Why did nobody notice it?”
The startled silence that followed is legendary.
Only recently have theorists given thought to these distinctions and impacts as to different levels of development of countries; the Mundell-Fleming model, for example, makes differences for how its model works, for example, for small, open economies as compared to large, developed economies.
Malaysia is indeed such an economy, open to trade to a fault and yes, it is small. In financial macroeconomics terms, nonetheless, “small, open economies” means, inter alia, that the economy has no ability to influence world interest rates.
To be blunt, small, open economies like Malaysia are buffeted by capital flows, be they caused by trade or by portfolio (aka “hot money”) flows. This then tends to cause the Ringgit to fluctuate, particularly against the world’s highest use currency, the USD (see the previous chart above). Fluctuations of the Ringgit caused by trade flows are easily visible, via its Current Account Balance
Chart 2 Malaysia Current Account Balance
Source: IMF WEO April 2022
Not so easy to see are hot money flows, as data on it is not collected by governments by and large. Perhaps they should.
Why would any of this be so important to the ordinary Malaysian? Two reasons: one is inflation. This chart below says it all; as the Ringgit falls, the CPI (Consumer Price Index) goes up (and vice versa). Goods, especially imported ones and even domestic final products with substantial imported components just gets more expensive (“cost push inflation” as economists call it). Chicken is an example, with its feed, corn, fully imported. Data scientists might note the 2 years or so lag between the Ringgit and inflation, most probably due to the inventory replacement cycle. Also note that the major outlier event in 2019 to early 2021 is, of course, the lockdowns caused by CoVid-19 when Malaysia went through a deflationary period. The 2007-8 CPI spike was during the Global Financial Crisis, and the one in 1997-8 was due to the Asian Financial Crisis.
Chart 3 Ringgit/ US Dollar exchange rate and Malaysian CPI
Source: IMF WEO April 2022 and US Federal Reserve
The other source of concern for Malaysians are interest rates. The key strategy to combat inflation is to raise interest rates, making it more expensive for borrowers. While Malaysian corporates are renowned for having low gearing ratios (a 0.22 times debt to equity ratio based on BNM numbers recently), Malaysian households are highly geared, hence rising interest rates would add to their misery.
A free-floating currency regime simply means that the central bank of a country would allow its currency’s exchange rate to be determined by the market without intervention. This would essentially absolve the central bank of any responsibility for the exchange rate at any point. However, in reality it isn’t an absolute thing; no central bank will stand by and do nothing while its own currency collapses and wealth destruction razes the economy to the ground.
One of the key requirements for having a free-floating currency is that the country has a deep enough market for currency exchange such that the open market can absorb any transactions to be done, without substantially skewing the exchange rate in so doing. Otherwise, to maintain currency stability, the central bank has to step in. This is usually the province of developed countries. This explains why the United Kingdom, for example, the sixth largest economy in the world, has a measly forex (foreign exchange) reserve of US$31 billion at the end of March 2022, for a country whose GDP (Gross Domestic Product) is US$3.32 trillion in 2021. It is a forex reserve over GDP ratio of less than 0.01 times.
Without a deep currency market, the currency would fall to high volatility and be subject to predatory attacks, at the country’s expense.
For developing and less-developed countries to seek to have a free-floating currency regime might be very dangerous wishful thinking indeed. In the next article, we examine the fixed exchange rate and managed float regimes, as well as the results of statistical studies on which stands out best on volatility, inflation, and economic growth.