The exchange rate has always been an important topic of discussion, more so since the rapid decline in the value of the ringgit against the US dollar and Singapore dollar, and of late against the euro and pound sterling. A rapidly depreciating ringgit is cause for concern as it translates into falling purchasing power of the currency in global markets. This has broad implications for the people, as it means higher prices for imported goods and services — including commodities like animal feedstock, energy and food staples, capital equipment and intermediate goods as well as consumer goods — that will eventually translate into higher prices across the domestic economy. Yes, inflation. For instance, even the price of locally reared chicken will go up as the cost of imported feed like corn and soybean meal rises. This is what is happening today, a major factor that is driving up the cost of living. And there are many parents supporting the education of their children abroad. It is all the more worrying for households whose income growth is stagnating.
A few months ago, we articulated in detail the main factors that determine the exchange rate between two currencies — currencies are always traded in pairs — in the foreign exchange market. You can scan the accompanying QR codes for the two articles (published on April 10 and 17, 2023) for a quick refresher.
One of the key factors is the interest rate differential between the two countries, which drives cross-border fund flows. The country with a comparatively higher interest rate (higher returns) would attract more foreign capital, all else being equal, which means relatively stronger demand and exchange rate for its currency. And this is how it has played out over the past weeks, as major central banks around the world diverge on their interest rate policies (see Chart 1).
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Central banks set their monetary policies (primarily interest rate) based on the underlying domestic economic conditions, and in particular, in response to inflation and growth. (Their primary objectives are to maintain price stability, sustainable economic growth and employment as well as financial system stability.)
The US Federal Reserve was the most aggressive in hiking interest rates last year, which was reflected in the broad US dollar strength against almost all other currencies in the world. However, the Fed opted for a pause at its latest Federal Open Market Committee meeting, while the European Central Bank (ECB) and Bank of England (BoE) continued to hike interest rates. Both the ECB and BoE signalled that they remain on the tightening path.
According to ECB president Christine Lagarde, “We are not thinking about pausing”. The ECB underscored its intention by revising upwards its 2024/25 inflation expectations. The market currently expects UK interest rates to rise as high as 5.5% to 6% over the coming months, up from the 4.5% today. Interestingly, even though the Fed had also raised its expected projected Fed funds rate — to an average of 5.6% (5.1% previously) from the current 5% to 5.25% — the market is convinced that this will not happen. Indeed, many in the market continue to believe that the Fed will start cutting interest rates soon.
While headline inflation numbers have been falling, the pace of decline in the eurozone and the UK has been far slower than in the US. US inflation has fallen from its peak of 9.1% in June 2022 to 4% in May 2023. By comparison, inflation in the eurozone remains relatively higher at 6.1% (down from a peak of 10.6% in October 2022) while prices are rising at an even faster clip of 8.7% in the UK (from a peak of 11.1% last October) — well above the central banks’ 2% target. We suspect this is due, in part, to the region’s previous heavy reliance on cheap Russian gas. Gas is much cheaper in the US, thanks to growing production in the country. The US is now one of the world’s largest gas exporters.
As in the US, the labour market in the eurozone is very tight, and even more so in the UK. Unemployment rates are the lowest in at least 30 years. BoE governor Andrew Bailey warned that the UK is fighting a wage-price spiral that is driving sticky second-round effects on inflation. And according to Chancellor Jeremy Hunt, “We have to do everything we can as a government, as a country, to support the Bank of England in their mission to squeeze inflation out of the system.”
The forex market reacted by pushing up bond yields in the eurozone and the UK, which means comparatively higher interest rates — and as a result, both the euro and pound sterling strengthened against the US dollar. Similarly, expectations of a wider interest rate differential between the eurozone-UK and Malaysia drove the euro and pound sterling sharply higher against the ringgit over the past couple of weeks.
Conversely, the yen weakened further against the US dollar after the Bank of Japan (BoJ), in its latest meeting on June 16, stuck to its extremely low interest rate of -0.1% and maintained the yield curve control on 10-year bonds at 0%. The BoJ is the only major central bank in the world that has maintained ultra-loose monetary policy, as the country struggles to protect nascent inflation — which is forecast to stay below the 2% target this year — and economic recovery. (Japan desperately needs inflation to stimulate domestic demand. Its economy has been stagnant for decades, plagued by deflation since the asset bubble burst in the early 1990s.) The yen has depreciated against the greenback since the Fed started its interest rate hike cycle in March 2022 — as the interest rate differential between the two countries widened. (Yes, a weak yen helps create domestic inflation.) The above factors account for the sharp rally in Japanese equities.
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Similarly, the Chinese yuan has been in a downtrend against the greenback, as its economic cycle and monetary policy diverged from that in the US. The People’s Bank of China (PBOC) cut several of its policy rates this month, as economic recovery from the Covid lockdown fizzled. The Chinese government has signalled increased policy support as the economy faces challenges on multiple fronts. Slowing global demand for goods is putting pressure on manufacturing exports while the recovery in domestic consumption has been weaker than expected. The property sector remains in a slump after the government clamped down on excessive speculation and high private sector indebtedness is weighing on business and household confidence. Youth unemployment is at a record high of 20.8% — although we think this is an overestimation, given the high number of young self-employed on social media. The challenge for China is a highly leveraged private sector.
In summary, the currency movements we are seeing in the forex market today underline the strong positive correlation between interest rates and exchange rates. In this respect, Singapore is an exception. The country adopts a managed float exchange rate system instead of interest rate as its primary monetary policy tool. The Monetary Authority of Singapore keeps the Singapore dollar exchange rate within a policy band based on a basket of currencies of its major trading partners and competitors. Over the years, however, the strength of the Singapore dollar has been increasingly driven by its burgeoning current account surplus, which has risen from a deficit of 18.2% of the gross domestic product (GDP) in 1972 to a surplus of 19.3% of GDP in 2022, underpinned by inflows from both trade and investments. Less positively, this has also fuelled increases in housing prices, although the fact that 80% of its citizens live in HDB complexes mitigate its effect.
As we have explained in previous articles, Singapore accounts for the lion’s share of foreign direct investment (FDI) flows into Asean as the designated regional business and financial hub. The country is also an increasingly popular family office-wealth management and migration destination for ultra-high-net-worth individuals. Singapore has been very successful in cultivating a business- and investor-friendly environment with its strong emphasis on the rule of law, transparency and governance as well as a competitive tax regime. And it is widely perceived to be free of systemic corruption. There is strong economic freedom and protection of equal rights and equal opportunities for individuals to succeed. As we wrote last week, inclusive political and economic institutions foster innovation, productivity, economic growth and prosperity.
Malaysia’s inflation is cost-push, not demand-pull, due to falling ringgit
What we have highlighted above is how interest rate expectations, in the current environment, drive currency movements in the forex market. The ringgit is losing value against the US dollar, Singapore dollar, euro and pound sterling, in part because Bank Negara Malaysia has been far less aggressive in raising interest rates. (There are other factors, as we explained in our two previous articles, some of which are long-term secular issues.) Why?
For starters, there is intense political pressure to keep the interest rate low. Raising the cost of borrowing for the people is inherently unpopular. But, quite frankly, there is limited room for Bank Negara to raise interest rates, without risking a larger debt servicing problem, or worse, in the country.
Both the private and public sectors are highly leveraged. Household debt is 81% of GDP. And unlike in the rich world, most of our mortgages — the largest debt component for most households — are based on a floating rate. That means any interest rate hike will immediately translate into higher monthly repayments for households, which will only worsen their growing financial strain.
The government, too, is overleveraged, with outstanding debts totalling more than RM1.12 trillion, not including another RM317 billion in debt guarantees. A higher cost of borrowing will increase the budget deficit and/or reduce the ability to spend in other areas, including healthcare and education.
Let’s face it, the challenges to the falling ringgit and the wider economy are mostly secular in nature. We have written extensively on this, including in our article last week. The chart on the ringgit against a few selected currencies confirms the narrative (see Chart 2).
What it means is that any real solution will trigger huge short-term pain, while the positive effects will only be realised in the longer term. How many democratically elected governments will have the vision, mandate, honesty and bravery to undertake such an arduous task?
Inevitably, populist governments take the “easy” way out — kick the can down the road. Making no decision is still making a decision — the decision to choose not to make a decision. But make no mistake, there is a price to pay. And that price is the ringgit — the pressure relief valve, so to speak.
When the domestic interest rate does not keep pace with global interest rates, the ringgit falls. This is particularly true when the net interest rate for savers is NEGATIVE — interest earned is less than inflation.
Chart 3 shows the 12-month fixed deposit rates and consumer price index (CPI), and how the spread has narrowed. We all know Malaysia’s official CPI figure is a gross underestimation of the real cost of living. And we show a couple of proxies to illustrate our point (see Chart 4).
A depreciating ringgit is an indirect tax on savings. This is no surprise, given that Malaysian households and government are overleveraged. Those with net savings are subsidising others, including the government. Over time, how will smart savers respond? Exactly what they are doing now — they will, increasingly, keep their savings in foreign currencies. We showed this in Chart 7 in the April 17, 2023, article, “The dichotomy of words and actions on the ringgit”.
In the short term, there will be additional downward pressure on the ringgit due to weaker exports, which translate into a smaller trade surplus. The current slowdown in global demand for goods will persist for some time and weaker economies (especially China’s) will keep the price of oil and commodities, including crude palm oil, low.
We have been warning of ringgit weakness, and the reasons behind it, for some time now in a series of articles. That has come to pass. Sadly, looking at all the events and variables, we cannot see why the trajectory will change any time soon.
As we said at the start of this article, the current cost of living inflation is almost entirely due to rising costs, primarily as a result of the ringgit depreciation. There is no wage-price spiral due to the record low unemployment rate nor is there overly robust consumer demand pulling prices up. There is no huge pile of excess savings from the government’s pandemic handouts. In fact, anecdotal evidence suggests that consumer demand is falling as inflation eats into disposable incomes.
As we have repeatedly stressed, reversing the secular weakness in the ringgit requires real, fundamental reforms — in the form of bold strategic policies to restore confidence, attract foreign and domestic investments that will enhance productivity and create new jobs, reduce government deficit and so on. What we have seen so far — small, insubstantial changes at the margin — simply will not cut it. Arresting the secular decline in the ringgit requires bold, decisive actions.
The Malaysian Portfolio fell 3.2% last week, on the back of losses for Star Media Group (-7.5%), KUB Malaysia (-2%) and Insas (-3%). As a result, total portfolio returns were pared to 156.2% since inception. Nonetheless, this portfolio is still outperforming the benchmark FBM KLCI, which is down 23.8%, by a long, long way.
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