Malaysia: Pegged Exchange Rate?

Some quarters have expressed preference for the pegged exchange rate abandoned by the govt in July 2005. Is that the best recourse?

The recent fluctuation of the US dollar/ringgit exchange rate has brought the debate about the suitability of our ringgit foreign-exchange regime (FXR). Many have expressed their preference for the pegged exchange rate abandoned by the government in July 2005.

While the public remains puzzled about the choice made by our policy setters to adopt the floating exchange regime, particularly in the present economic environment. Clarifying the different types of exchange rate regimes is a good start to shed light on this complex area in simple terms.

The easily understood FXR is the floating exchange system, where the exchange rate is determined through shifts in supply and demand of ringgit predominantly by private transactions. This keeps the balance of payments (BoP) in equilibrium.

The soundness and confidence of the government monetary policies and fundamentals of the economy play a huge role in the floating exchange system.

An impure form of a floating system is the managed float, where the central banking occasionally intervenes to affect the exchange rate.

The weakness of this system can bring substantial capital flows, creating disruptive swings.

The next FXR regime is the fixed exchange system. An easily understood exchange rate under this system is the gold standard, where the currency is fixed against the precious metal. The fixed rate is maintained through the BoP account, where in the event of a BOP surplus, gold will flow in, increasing the money supply, raising expenditure and eventually removing the surplus.

This can be done through a currency board too, where the exchange of the domestic currency for foreign currency is fixed. The Brunei Darussalam dollar is a classic example of a currency board for its dollar-to-dollar interchangeability with the Singapore dollar.

The other FXR is the pegged exchange rate system. It has a lot of similarities with the fixed exchange system but fundamentally differs as central banks are involved in sterilisation operations — the purchase or sale of foreign currency and government securities to maintain the exchange rate and monetary base. The Hong Kong dollar is a good example of this.

It is notable from the above that both fixed and pegged FXR suffer the consequences of the base currency’s monetary policies as it will affect the direction of fund flows, eg, the flow of funds resulting from interest rate differentials or flight for safety.

This results in the respective central banks being burdened to defend their fixed or pegged exchange rate, and the ammunition comes from the foreign-exchange reserves vault bankrolled by current account surpluses and foreign direct investments (FDIs).

In the case of ringgit at present, our Bank Negara Malaysia (BNM) is not burdened with this, with the floating exchange system we have embraced since 2005.

Each one of the FXR regimes has its weaknesses, and Nobel laureate Robert Mundell proposed that an ideal currency shall have all three of the following characteristics:

• Exchange rate stability, where the value is fixed to major currencies.
• Full financial integration for easy international movement of funds.
• Monetary policy independence to suit the domestic policy of the country.

Unfortunately, it is also fondly known as The Impossible Trinity, as countries must give up one of the three goals, as summarised in Figure 1.

Next comes the million-dollar question: Can we afford to return to the pegged exchange system to give us a stable exchange rate?

The simple answer lies in our competitiveness as a nation — are we what we were during the Asian Financial Crises (AFC) in 1997?

Back then, we were able to export our way out of the crisis with the strong demand growth of our export markets and muster foreign reserves to defend the peg. However, in the present day, our international competitiveness has diminished considerably for over a decade, evidenced by the fall of the current account-to-GDP ratio, shown in Figure 2. The global economic weather isn’t encouraging either for exports or FDIs.

Where would the foreign reserves come to defend the ringgit with the significant decrease in current account surpluses for over a decade? No wise man would deplete the BNM’s foreign reserves to defend the ringgit to concoct another more serious financial crisis.

The best option is not to change the status quo and play fire with the exchange rate regime. The stakes are just too high.

This article was first published by The Malaysian Reserve ?print edition on 13 November 2023. The views expressed here are the writer's own and do not reflect the opinions and views of any organisation or its members.