Secular decline in ringgit’s value due mainly to falling relative competitiveness

In other words, exchange rates are a RELATIVE phenomenon. It is the price of one currency relative to another. It is what you pay for a product or service in one currency relative to another. How are exchange rates determined? By the world’s most massive voting machine, the people — with their real money — who demand and supply the currencies, be it for income or trade or investments or speculations. It is foolish to bet against the sum total of this knowledge. In short, it is mostly right.

The second principle is short term versus long term. The price of a currency, the exchange rate, can be influenced by short-term factors, such as interest rate differentials, near-term exports or immediate inflows of capital for investments. Or, for that matter, the central bank’s intervention. But is there also a secular trend, driven by critical, longer-term fundamental macroeconomic factors? The misdiagnosis between these two often leads to exacerbating the problem.

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The third principle, taught in the introductory undergraduate economics course in universities, is that prices (including exchange rates) are determined by rate of change — not absolutes. Current account or capital inflows can be positive, but if it is experiencing a rapid decline, the consequences on the exchange rate would still be negative, even if the absolute number is still positive.

At the end of 2023 and the beginning of this year, analysts, fund managers and economists were almost unanimous in predicting that the ringgit would strengthen in 2024. This forecast was based largely on the assumption that the US Federal Reserve would reduce interest rates and the resulting fall in the interest rate differential between the USD and the ringgit would mean capital flows into Malaysia, thereby raising demand for the ringgit. We were a rare contrarian then, as archived in the articles we have published. And in just over the last 50 days (at the point of writing), the ringgit had fallen sharply, by almost 5% against the USD.

Not surprisingly, over the last two weeks, there has been a deluge of views and opinions to explain why the ringgit is not going the way they had expected. Rightly so. A confidence crisis must be avoided. Malaysians should not have to bear the pain of further speculations and political jostling. Yes, as we have said often, narratives follow facts. Many of these views and opinions are reasonable and plausible, and it is likely that there are many factors that drive the ringgit exchange rates. After all, there are many ringgit exchange rates (against different currencies) and there is such a huge number of actors buying and selling that, surely, there will be either divergent or complementary reasons among these actors.

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The classic parable of the blind men and elephant illustrates the limitation of individual perceptions, that reality can be perceived differently. One touches the tail and describes it as a snake. Another feels the leg and describes a tree trunk. In other words, the reasons that the ringgit should do better — whether it be favourable current account balances, positive net exports, strong Bank Negara Malaysia reserves, strong indications of foreign direct investments (FDIs), positive and likely better economic growth, high real interest rates or the effect from the anticipated lowering of US interest rates — may all well be true, but each describes only a small part of the totality of the challenges that the economy — and hence the ringgit — faces. This is why we chose to use this parable. It is because there is “an elephant in the room” that many choose not to acknowledge or cannot relate to the ringgit outlook.

Malaysians, by and large, do not want confrontation. We say a lot of nasty things behind a person’s back, but rarely speak truth to power. Take the recent spin by the chief statistician Datuk Seri Uzir Mahidin on the brain drain and loss of talent in Malaysia. He reframed it as a “brain circulation”, where these talents will be trained abroad and return to serve the nation in later years. It is our inability to accept truth, to acknowledge facts, that makes it difficult for us to find the right solutions. We readily accept political expediency as an excuse for failures, theft, dishonesty and negligence.

Relationship between productivity, wages and exchange rates

The Balassa-Samuelson effect is an economic theory that says countries with higher productivity growth in the tradable goods sector (for example, manufacturing) will see their currencies appreciate in the long run. Why?

● An increase in productivity in the tradable goods sector leads to lower production costs, making their exports more competitive in the global market;

● Increased productivity in the tradable goods sector leads to higher wages for the sector because workers are producing more value. To attract and retain employees, non-tradable sectors (for example, services) must also increase wages, even if their productivity has not increased by as much (or at all);

● Higher wages in the non-tradable sector leads to higher prices for non-tradable goods and services, since these sectors have not experienced the same productivity gains (and cost savings) to offset the wage increases. This increases the overall price level in the economy, that is, inflation; and

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● As the overall price level increases, the country’s currency appreciates in real terms. This means that, relative to other countries, it becomes more expensive for foreigners to purchase goods and services from the high-productivity country, and the high-productivity country finds foreign goods and services cheaper. This appreciation reflects an adjustment to the increase in purchasing power of the currency due to higher productivity.

This theory, where higher productivity (richer) countries tend to have stronger currencies and higher price levels compared to lower productivity (poorer) countries applies to long-term adjustments. It does not account for short-term fluctuations in the exchange rates.

We present a simple mathematical example to illustrate this theory.

The maths: Lower productivity gains lead to long-term depreciation of the currency

Table 1 sets out the assumptions for our simplistic simulation. Countries A and B each produce the same single product for export. Both are price-takers — that is, the selling price (of US$100 ($134.5) per unit) is set by the market. At the beginning (t=0), both A and B have the same exchange rate of 4LCUs (local currency units) per USD, the same level of productivity (one unit per worker per hour) and the same wages (40LCU, or US$10, per worker per hour). The wage cost per unit as a percentage of the selling price is 10% (US$10/ US$100, or 40LCU/400LCU). Thus, both A and B are equally competitive in the global market.

After a period of time, at t=1, the productivity in B improves (owing to better training, improved technology and process, and so on). B can now produce two units per worker per hour. As a result, the effective wage cost per unit is halved to US$5 (US$10/2 units) or 20LCU (40LCU/2 units) — and the wage cost drops to 5% of selling price (US$5/US$100). Meanwhile, productivity in A remains unchanged, as does its wage cost per unit (US$10, or 40LCU) and wage cost as a percentage of the selling price of 10% (US$10/US$100). Clearly, A is now less competitive than B — because of its lagging productivity gain (see Table 2).

A must reduce its wage cost to match that of B to compete in the global market. It cannot realistically cut wages (in LCU), but depreciating its currency will reduce wage cost in USD terms. In Scenario 1, currency A depreciates to 8 per USD while currency B remains unchanged at 4. In other words, currency A also depreciated against currency B — you now need 2 currency A to buy 1 currency B, from the original 1:1 at t=0. Fol- lowing the depreciation, A’s wage cost drops to US$5 per unit (40LCU/8) even though its wage remains unchanged in local currency (40LCU). It is now once again competitive with B in the global market.

Let us consider Scenario 2 at t=2. B decides to double wages from 40LCU to 80LCU, commensurate with its productivity gains, which has also doubled from one unit per worker per hour to two units per work per hour. A also increases wages for its workers by the same quantum, but its productivity gains are lesser (from one unit to 1.25 units per worker per hour, or 25%). In other words, A’s wage increase is in excess of productivity improvements (see Table 3).

In this scenario, A’s wage cost per unit rises to US$16 (80LCU/1.25/4), or 16% of the selling price (US$16/US$100), if the exchange rate stays at the original 4LCU per USD. Meanwhile, because its productivity gain (doubled from one unit to two per worker per hour) matches the wage increase (doubled to 80LCU, from 40LCU), B’s wage cost per unit remains unchanged at US$10 (80LCU/2/4) or 10% of the selling price (US$10/US$100). Again, A becomes uncompetitive and in the absence of other solutions, its currency depreciates to compensate for lagging productivity so that it is competitive. To match B’s cost, currency A must drop to 6.4 per US$ from 4. Now, the exchange rate for A:B is 1.6:1, weaker than the original 1:1.

What this simplistic simulation says is that: 1) wage increases must be underpinned by matching productivity gains for countries to remain competitive in the global market; and 2) when a country’s productivity gains (even though positive) lag that of its competitors, the equalising factor will be long-term depreciation of its currency. Got it?

The supposition that the value of the ringgit is only a monetary phenomenon — the differentials in interest rate — is a big mistake. A wrong prognosis will lead to bad prescriptions — with damaging consequences.

To repeat: Exchange rates are driven by the differentials — not absolutes — between the two countries (in each pair).

What happened: Malaysia’s lagging productivity gains and secular decline in the ringgit

In the following paragraphs, we will show that Malaysia’s productivity growth has lagged many of our neighbours (remember, everything is relative), how it came to be, and the data evidence (direct and indirect) of a secular decline in the ringgit.

Malaysia’s productivity growth over the past 10 years — as measured by real GDP (output) per employment — was the slowest compared to our closest neighbours. Worse, our real wage growth minus productivity gains is the highest (see Table 4). As we have demonstrated in our simplistic mathematical simulation, when productivity growth lags and wage increases are in excess of productivity gains, the currency depreciates in order for the country to maintain export competi- tiveness. This is what happened — the ringgit exchange rates have fallen against all of these countries (see Chart 2).

Here is collaborating evidence: Malaysia’s real effective exchange rate (REER) has been falling steadily over the years (see Chart 3). The REER calculates the value of a country’s currency, weighted by the trade balance with its major trading partners (that is, the weighted average of bilateral exchange rates) and adjusted for inflation (Consumer Price Index [CPI]).

The REER, therefore, provides a more comprehensive understanding of a country’s relative competitiveness in international trade. A falling REER indicates that the ringgit has become weaker relative to the currencies of our major trading partners. This makes our exports cheaper, that is, we gain competitiveness in the global market — with an “undervalued” currency. But there is a price to pay.

The actual effect on the population is different, depending on whether you are an exporter, what you consume, whether you earn a fixed wage or are in business. But the overall result is the falling purchasing power of the ringgit, which also creates what we call “shrinkflation” — the situation in which you get a smaller product size or quantity or inferior-quality ingredients even though the sticker price remains unchanged. Since the price remains the same, it does not show up in inflation data but there is no doubt that the standard of living is falling.

Our ability to consume falls — with negative implications for domestic businesses (more on this later) — and imported goods and services become more expensive. Maintaining consumption growth comes at the expense of savings. The cost of living rises.

To temper the rising cost of living, the government must maintain ever-growing subsidies — despite the pressing need for greater fiscal discipline to reduce fiscal deficit. Indeed, even as the government begins to roll back subsidies, it is at the same time implementing new handout programmes, many of which target the lower-income groups. This leaves the middle class increasingly squeezed between subsidy rationalisation and rising costs of living.

The need for continued handouts also makes reducing the fiscal deficit harder — especially given the falling share of revenue from extractive industries (such as oil and gas, mining, timber) as a percentage of GDP (see Chart 4). These profits are essentially “free money” that have been used to buffer an increasing subsidy bill for decades.

And we have not even mentioned the “leakages, wastages, corruption” lost through “transfer payments”, which were previously funded by these “extractive free money” but now imposes higher costs on the people’s standard of living, the value of the ringgit and fiscal deficit as these industries constitute a smaller and smaller share of the economy.

How it came to be: Loss of relative competitiveness is the unintended consequence of past policies

The ideal way to stay competitive (and to raise wages and income levels) is through continuous gains in productivity — by creating an environment conducive to innovation and reducing the cost of doing business — at a rate that is at least comparable with your competitors, and for wages not to rise in excess of these productivity gains. Clearly, this requires tackling the underlying structural weakness in the economy. How did we end up here?

The major policies back in the 1980s — Malaysia Inc Policy in 1981 and Look East Policy in 1982 — transformed the economy, away from primary commodities to manufacturing for export. Our economy was designed to be a low-cost manufacturing hub for multinational corporations (MNCs), particularly those from Japan and the US, notably in the electronics and electrical (E&E) industry. We used wide-ranging subsidies — and, later, cheap migrant labour — to suppress costs and inflation. This is a common path taken by emerging economies at the early stage of development.

We then chose, however, to impose capital controls during the Asian financial crisis — to protect inefficient local businesses and elites — instead of undertaking painful reforms (the route taken by South Korea) that included allowing some to fail and for competitive pressures to drive innovation and productivity. Capital controls severely damaged Malaysia’s attractiveness to foreign and domestic investors.

To compensate for sagging investments, the government implemented policies that encouraged domestic consumption to drive growth. This was a short-term fix that led to high household indebtedness. Consumption also came at the expense of savings, and falling savings as a percentage of GDP led to a smaller pool of domestic money for investments.

Investments as a percentage of GDP fell sharply, affecting productivity growth and perpetuating the reliance on low-value, labour-intensive manufacturing. Falling investments as a percentage of GDP also limit the capacity for future economic growth. In short, we consumed instead of investing for the future.

We have written in depth on all the above in previous articles. Owing to space constraints, we are not going to rehash everything here, but you can scan the QR code for a refresher on one of our more recent pieces titled “Economic policies dictated by politics in Malaysia — why they fail” (The Edge, Jan 22, 2024).

Suffice it to say, Malaysia failed to move up the value chain, diverging from the eco- nomic development paths taken by countries such as Taiwan, South Korea and Singapore. Our spending on R&D stayed low, the urgen- cy to innovate muted by protectionist policies and state capture by the elites. Malaysia thus continues to rely heavily on the low-value, low-skill segment of the market, attracting low-quality investments.

Yes, we are still getting FDI (the brown bar in Chart 5), albeit a falling share of total investment flow to Asean — because Malaysia remains a lower cost base (if the goods are exported) with the ringgit depreciation. 

As with the MNCs (since the 1980s), however, a majority of these are low-quality investments with very little knowledge and technology transfer, and limited linkages to the domestic economy. For example, the huge investments for data centres are, by themselves, low-quality investments with low job creation. The value comes later, from expanding the digital ecosystem — that is where the high-paying jobs are.

It was always about the economy

We are glad the World Bank recently articulated this — that the weakness of the ringgit is due to the loss of competitiveness of the Malaysian economy. The drafting of this article started some three weeks ago. At that time, it felt like we would be the only one highlighting this elephant in the room. We no longer feel alone.

The facts are clear. The big picture is that the ringgit has been on a secular downtrend for decades, not only against the USD but also against the currencies of other major competing economies such as Singapore. It is, without doubt, a long-term structural phenomenon.

Yes, the ringgit has also appreciated against a basket of other currencies (see Chart 1), most of which are also “basket-case economies”. (In case you are wondering, the Norwegian krone is weak, owing largely to its huge capital outflows. Its sovereign wealth fund is the largest in the world, investing the country’s oil profits.)

At the risk of sounding like a broken record, exchange rates are relative, just as competitiveness is. Over the last two decades, Malaysia has become more competitive than some economies, and our currency has appreciated against theirs. Similarly, we have become less competitive than others, and we see our ringgit falling against their currencies.

There are clearly short-term instances in which the ringgit strengthened, as a result of the various short-term developments we mentioned earlier. For instance, if US interest rates fall or if sharply higher oil prices boost export surplus and foreign exchange (forex) reserves, they could lead to a short-term appreciation in the ringgit. But the evidence (both direct and indirect) also underscores a secular decline in the ringgit that is consistent with falling global competitiveness.

Evidence of a secular decline in the ringgit

Long-term depreciation of the ringgit is positive for exports and FDI. But it makes investing in ringgit-denominated financial assets such as cash and stocks not worth holding, since returns will be eaten away by currency loss.

Case in point: Stocks on Bursa Malaysia have been chronic underperformers. Portfolio foreign fund flows into Bursa have been negative in eight of the past 10 years — with outflows totalling RM67.4 billion. The total returns for the FBM KLCI over this period was a meagre 10.2%, equivalent to compound annual returns of just 1%. That is worse than leaving your money as fixed deposit in the bank!

This does not apply only to foreigners. Domestic investors would similarly be worse off as the ringgit loses purchasing power. For instance, the Employees Provident Fund reports a big gap between returns on its foreign and domestic investments. There is no question that the foreign returns were boosted by exchange gains on the back of the ringgit depreciation (see Chart 6).

And we have no doubt that the secular ringgit decline is also why foreign currency deposits by businesses and individuals has been rising through the years (see Chart 7). Note that foreign currency deposits were rising even when US interest rates were near zero (for the better part of more than a decade, since the Global Financial Crisis until early 2022), and the interest rate differential between the USD and ringgit was negative.

Therefore, even though Malaysia continues to run a current account surplus, Bank Negara forex reserves are not rising in tandem. In fact, forex reserves have fallen sharply from the peak in 2011 and more or less flatlined since 2014 — owing to capital outflows (see Charts 5 and 8). We suspect this also has to do, at least in part, to the loss of confidence during and in the aftermath of the 1MDB scandal.

We also see evidence of the long-term ringgit weakness in declining trade surplus or net export (export less import) due, in part, to the rising cost of imports. Remember, a depreciating ringgit makes exports cheaper for foreigners (and therefore more competitive), but imports become more expensive. The trend worsened after the government encouraged domestic consumption (in the 2010s) to drive economic growth when investments fell. Trade surplus as a percentage of GDP is now barely positive (see Chart 9).

Rising costs, coupled with slow productivity gains, also mean that businesses, increasingly, have to sacrifice margins and profits. For instance, wage growth has been in excess of productivity gains (see Table 4) in the past 10 years.

The falling purchasing power of the ringgit also eats into the nation’s ability to consume — wages in absolute terms are low, reflecting low productivity levels — that is, it gets harder and harder for businesses to pass on rising costs through higher selling prices.

The biggest companies in the country, those listed on Bursa, have reported anaemic profit growth, falling margins (when profit growth is less than sales growth) as well as returns on investments (see Chart 10).

Poor earnings growth is the biggest reason that the local bourse is a chronic underperformer — in the long term, stock prices are driven by underlying earnings — and why valuations, on average, are low compared to, say, US stocks. They reflect investor expectations of earnings and growth, and confidence in the company. And the outlook for investing in Bursa-listed stocks gets worse if one factors in the likely loss on forex. More than half of all Bursa-listed companies, including high-quality ones, are trading below their net asset values, that is, below the value of the company if it is liquidated. Investors are clearly not confident that the country can resolve persistent structural problems in the economy.

This environment — of falling margins and returns on investments — further makes domestic investments less attractive, and we believe contributed to overall investments decline. It also means less money to be spent on critical R&D, which, in turn, hampers future productivity gains. Malaysia’s spending on R&D is far below that of high-productivity nations such as South Korea and Singapore (see Chart 11).

Conclusion

Exchange rates are expressed in pairs, that is, the value of one currency is always relative to another. The ringgit exchange rates are determined by changes in demand and supply relative to that of other currencies. Remember, prices (for the ringgit or stocks or any other goods and services) are determined by marginal demand and supply, not absolutes. For example, the current account surplus may be positive in absolute terms, but if it drops from, say, RM100 million to RM10 million, then the (marginal) change in demand is negative — and the currency will fall, all else being equal.

There are cyclical factors — for instance, interest rate differentials and commodity cycles — that hurt or boost the value of the ringgit in the short term. But we believe there is an underlying secular decline in the ringgit — driven by long-term macroeconomic factors.

This is why the ringgit has fallen against a basket of currencies of our closest neighbours for the past 10 years — even when there are short-term reasons for it to appreciate, as widely expected by many analysts through the years. These factors should lead to a stronger currency, but they have not.

The secular decline in the ringgit is in fact the inevitable consequence of our domestic policies and actions over the years, albeit one that we think was unintended.

The REER shows a falling ringgit against our major trading partners over the past decade, making our exports more competitive in the global market. So, yes, the ringgit is “undervalued” — and it is used as a tool to gain competitiveness, because productivity gains have lagged those of our competitors. The ringgit depreciation has become the default, in the absence of any decision to address the structural problems in the economy. Raising productivity is a long and arduous process.

The next stage of growth for the global economy will be driven by productivity gains from the Fourth Industrial Revolution. This very likely means that Malaysia’s lagging productivity gains will only worsen as our peers and competitors continue to improve at a faster clip in an increasingly knowledge-driven and digitalised world that is skill-biased. As relative productivity falls behind, it will be harder and harder for Malaysia to catch up.

Of all our past actions — and, critically, inaction — perhaps allowing the continued deterioration in the quality in our public education system is the most damaging and the effects long-lasting. Even today, when the increasingly poor quality of our education is clearly evident and widely acknowledged, there has been no discussion on reform, on policies to arrest and reverse this decline, except in the state of Sarawak. A country with a poorly educated workforce will lag in its ability to adopt, and adapt to, technological advancements, and to reap the full benefits of digitalisation. Even if we act decisively to reform the education system right now, it will still be years before we reap the benefits.

By not addressing structural reforms, Malaysia has effectively “chosen” the path of perpetual depreciation of the ringgit (though there are likely to be short periods of cyclical uptrends) — even if the decision-makers are not fully cognisant of their “choice”. The chronic depreciation of the ringgit will boost the country’s FDI and export competitiveness — but it will lower the Malaysian standard of living. Critically, it creates its own ecosystem — attracting lower and lower value products and capital while talent and wealth creators leave in search of better ecosystems (environments).

Of course, it is not too late to act. The answer lies in supply-side factors, especially in the quality of human capital (scan the QR code to read our summary of Claudia Goldin’s book The Race between Education and Technology published in the article titled “Education was, is and always will be the great equaliser” [The Edge, Jan 29, 2024]). Our Asean neighbours, such as Vietnam, understand the value of good education and are focused on expanding access and teacher training, not just investments in infrastructure. Despite its relatively low per capita income, Vietnam has one of the best schooling systems in the region, and its students score relatively high in international assessments of reading, maths and science (far higher than Malaysian students). To quote Ho Chi Minh, “To reap a return in 10 years, plant trees. To reap a return in 100, cultivate the people.” The solution is a long, hard road. No easy fix.

We do have a second opportunity — in digital transformation. As we have shown in this article, it is all about raising productivity, ahead of competing economies. We had fallen behind since the late 1990s. The Asean Free Trade Area (Afta) agreement, signed in 1992, may have helped further erode our competitiveness. By eliminating tariff barriers, productivity became even more important to gain competitive advantage. Digitalisation is our best chance to catch up. We need to get it right — or be condemned to third world country status. Does the leadership understand this and what needs to be done?

Box Article: The ringgit can rebound in the near term

What we have articulated in the main article are the long-term decline in the value of the ringgit, the reasons behind it and what needs to be done to reverse this secular trend. Within this broad downtrend, however, there will be short periods in which the ringgit will strengthen. The following are some positives that could drive a near-term ringgit rebound.

Better domestic economic growth outlook

Bank Negara Malaysia forecasts gross domestic product growth of 4% to 5% in 2024 (3.7% in 2023) on the back of:

Recovery in exports: Expectations for a stronger global economy and trade are positive for Malaysia’s manufacturing and exports. In January, the International Monetary Fund raised its global economic growth forecast to 3.1%, from 2.9% in October 2023. Global trade is also projected to rebound to 3.3%, from 0.4% last year. Importantly, global semiconductor sales — an important sector for Malaysia — are turning around.

Higher tourist arrivals: Arrival numbers are expected to increase to 27.3 million this year, from 20.1 million in 2023. The tourism sector is planning measures to attract more tourists, and promote longer stays and higher spending.

Higher current account surplus

The recovery in exports and growth in tourism should boost the current account surplus, estimated at 3.2% of gross national income in 2024, up from 1.3% last year.

More investments to drive growth

These include key infrastructure projects such as the East Coast Rail Link, Johor Bahru–Singapore Rapid Transit System Link and MyDIGITAL as well as healthy pipeline projects. The Malaysian Investment Development Authority has approved a record level of planned investments of more than RM300 billion.

Federal Reserve interest rate cuts

US interest rates are expected to fall in the coming months. The resulting narrowing in interest rate differentials should attract capital flows to Asia, including Malaysia.

Greater fiscal discipline

Plans to reduce the fiscal deficit, including through subsidy rationalisation and the enactment of the Public Finance and Fiscal Responsibility Act. The government intends for subsidy rationalisation to release more funds for education and infrastructure, which would bode well for Malaysia’s long-term economic potential and productivity.

— End of Box Article —

Stocks in the Malaysian Portfolio finally succumbed to profit-taking, after racking up a string of weekly gains. Total portfolio value fell 5.5% last week. The top losing stocks were Insas-WC (-27.3%), Insas (-9.9%) and Frasers Logistics & Commercial Trust BUOU

BUOU

FRASERS LOGISTICS & COMMERCIAL TRUST

REAL ESTATE

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(-4.5%). UOA Development (+3.3%) was the sole gainer in our portfolio. Last week’s losses pared total portfolio returns to 194.3% since inception. Nevertheless, this portfolio is still outperforming the benchmark FBM KLCI, which is down 15.5%, by a long, long way.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.