The angst over the ringgit exchange rate

The ringgit’s depreciation against the US dollar (USD) has created anxiety over the falling value of the ringgit. Such concern is understandable given that the USD is the major currency for international trade and investment. However, the ringgit is not alone in facing this situation. What surprises me is that officialdom has been rather quiet on this issue, allowing all sorts of half-baked analysis to proliferate.

The current movements in the foreign exchange rates of most economies are related more to what is happening in the United States, rather than to the factors related to these economies. Charts 1 and 2 clearly show that the appreciation of the USD is broad-based, with the US currency appreciating against other major currencies as well as regional currencies.

What is happening now is the opposite of what happened when the major economies were on their super-easing cycle and doing QE. Other countries were forced to lower their interest rates too or risk seeing their currencies appreciate to levels that could undermine the competitiveness of their exports. Remember the heated discussions on "currency wars?"

Now, the major economies, especially the US, are aggressively trying to increase their interest rates in an attempt to prevent inflation from getting out of control. This is creating a redirection of financial flows which is putting pressure on the currencies of many other economies, at a time when a depreciation of the national exchange rate against major trading partners could have an adverse effect on domestic inflation as well as consumer and business sentiments. Where government and private sector external indebtedness (especially in USD) is high, the depreciation of the national currency creates a substantial vulnerability. Even for countries where external indebtedness is low, but domestic indebtedness is high, the resulting political pressure on the central bank to keep interest rates low will have consequences for the exchange rate and domestic inflation.

It is important to understand that the major determinant of exchange rates today is financial flows and not trade flows. Among the factors that determine such financial flows are interest rate differentials and the assessment of the prospects for the exchange rate, both of which can provide profitable opportunities for financial bets across economies and currencies.??It is for this reason that the BOJ found itself intervening to support the Yen right after announcing the decision of its monetary policy board to not raise interest rates.

The exchange rate is also affected by changes in government policies and expectations of the consequent impact on risks/returns for investors –?something the UK government found out recently when its announcement of a large fiscal stimulus package caused a large scale divestment out of British financial assets and a sharp drop in the sterling pound.

For developing countries, as I mentioned in my earlier article (https://www.dhirubhai.net/pulse/high-inflation-difficult-policy-choices-emerging-markets-singh), the current situation creates a quandary. As interest differentials between the the developing economies and developed economies narrow, the currencies of developing economies can be expected to come under increasing pressure. Some central banks are trying to avert this through more rapid increases in their domestic interest rates. Others are raising interest rates modestly but finding it necessary to intervene in the foreign exchange markets more frequently to support their currencies. It has been noted in the financial press that a number of regional central banks have seen quite significant declines in their foreign exchange reserves. If countries want to keep interest rates low, then they can expect interest differentials with other countries to widen, contributing to pressure on the exchange rate which will need to be countered by increased intervention, leading to further erosion of the country's foreign exchange reserves.?

Turning back to the ringgit, Chart 3 shows the performance of the ringgit exchange rate against some major and regional currencies. Overall, it has in fact appreciated against the major non-USD currencies as well as some regional currencies.

The ringgit is not alone in its depreciation against the USD –?many other currencies have also depreciated against the USD, many exceeding the depreciation of the ringgit. The pressure on currencies is likely to continue as long as US interest rates are on an upward cycle and countries will have to manage the situation. And while many currencies have depreciated against the USD, the magnitude of the depreciation will defer across currencies, depending on the individual characteristics of each economy and the policies deployed by its policymakers.

If the global economy goes into a recession, economies like Malaysia will face multiple challenges in the form of a depreciated exchange rate, higher inflation, lower exports, and lower domestic growth. We can prepare for that eventuality by carefully calibrating our policy choices and focusing on reducing domestic vulnerabilities as much as possible. The first of these policy choices will relate to managing the extent of the depreciation through a sharing of burden between interest rate increases and foreign exchange intervention. Domestic indebtedness and government finances are clear areas of vulnerability. As I have previously indicated, fiscal policy has not been well-used in Malaysia, often aiming for political rather than economic outcomes; this has reduced fiscal flexibility and made public finance more highly dependent on debt. Economic resilience needs to be built in good times to prepare for exactly such times of adversity. Structural reforms (that I have written about in a previous article) are a very necessary component of reducing national vulnerabilities and building economic resilience. Prudent management of the sources of national foreign exchange reserves, as well as large financial outflows, would also be within the scope of policies to manage the situation. Currencies and economies are like boats floating in rough seas –? those that are better built and have better sailors are less likely to capsize.