Last week, we discussed Bank Negara Malaysia’s (Bank Negara) decision for a more tempered path in raising interest rates in the country, breaking from the US Federal Reserve and other major central banks around the world. And there are good reasons, we believe, for this. By limiting mark-to-market losses (due to higher interest rates) for the bond holdings of banks, Bank Negara is preserving the aggregate capital buffer and, more importantly, lending capacity, of the domestic banking system. Keeping domestic interest rates low also helps put a lid on the burden of debt servicing, for leveraged households, businesses as well as the government. Household debt to gross domestic product (GDP) remains relatively high at 67.4%, while government debt and liabilities totalled RM1.5 trillion or 83% of GDP (scan the QR code below for a refresher on last week’s article).
That has spurred more calls, including from local economists, academicians and politicians, for Bank Negara to continue holding interest rates at current levels, regardless of global interest rates — to help leveraged households and businesses, support economic growth and prevent additional pressures on cost of living inflation. In economics, no matter how much one wishes it to be true, there is no such thing as a free lunch. We have said this many times.
Yes, there are valid reasons for keeping interest rates low, but they come at a cost. Every decision in life involves a trade-off. The tradeoff for low interest rates is that it punishes savers and is a major — though not the only — factor behind the recent ringgit depreciation. Of this, we have no doubt.
In case readers are confused by all the contradictory noise in the local media recently, we decided to spend some time this week explaining factors that affect a currency’s value. For some, the subject matter may be a bit dry and theoretical. But we think it is worth some space here, if only to lay the groundwork for our next article, which we believe will be more interesting.
To recap, “interest rate” is the domestic price of money or credit. “Exchange rate”, on the other hand, is the external value of a country’s currency, which is determined by demand for and supply of that currency. Exchange rate is expressed in pairs — for instance, US dollar to ringgit or Singapore dollar to ringgit — as the rate at which one currency can be exchanged for another based, primarily, on relative economic fundamentals between the two countries. When demand is higher than supply, the currency’s value will appreciate and vice versa.
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What drives exchange rates?
The difference in interest rates between two countries is one of the major drivers for cross-border fund flows and in the foreign exchange (forex) market. Higher (lower) interest rates offer lenders in an economy higher (lower) returns relative to another country — and, therefore, would attract more (less) foreign capital, all else being equal.
For example, the interest rate in the US has been rising at a faster clip compared to that in Malaysia (and most of the world) over the past one year. That translates to stronger demand for the US dollar, as investors seek to earn higher returns. In fact, just last weekend, a friend happily mentioned that he was earning a 7% interest rate on short-term, two-week US dollar deposits in a Malaysian bank, well above the returns on ringgit deposits of any duration. As a result, the US dollar strengthened and the ringgit depreciated (see Chart 1). A similar correlation is seen between the Singapore dollar and the ringgit over the same period — as the difference in interest rates between Malaysia and Singapore narrows, the ringgit weakened (see Chart 2).
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Some of the other major determinants of the value of a currency include current and, critically, future expectations — of inflation, terms of trade, public sector debt, current account surplus/(deficit), underlying economic performance, political stability, global macroeconomic environment and, last but not least, investor sentiment and confidence in the country.
Simplistically, when all of the above-mentioned factors are positive — such as improving terms of trade, robust economic growth and growth outlook, falling budget deficit as well as stable inflation and political environment — there will be stronger investor confidence in the country and, accordingly, higher demand for, and appreciation in, its currency.
Clearly, all these factors are inter-related, where one factor feeds into others, compounding or offsetting its independent effect. Plus, some factors will exert greater influence than others at different points in time, under different circumstances. In short, there are many moving parts at any one time. The forex market is complex, in that multiple factors combine and interact, often in unpredictable ways.
Inflation, interest rate and exchange rate are highly correlated
For example, adding domestic inflation into the picture may shift the interest rate differential and exchange rate relationship. A country with consistently low inflation also tends to have lower interest rates — but will likely have a strengthening currency value because its purchasing power increases relative to other currencies over time. On the other hand, countries with high inflation normally have higher interest rates — given that the interest rate is often used to combat inflation — but weaker currencies, as inflation erodes purchasing power and reduces the attractiveness of higher interest rates to foreign capital. Hence, it is the country with a higher real interest rate differential — instead of just higher nominal interest rate differential — that is generally more attractive to foreign capital. In other words, the real interest rate differential is largely positively correlated to the value of the currency.
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Interest rate is one of the most important policy tools for the majority of central banks the world over, frequently used to influence (and manipulate) inflation and/or exchange rates.
For instance, the Bank of Japan has kept its interest rate near zero for more than two decades to combat deflationary pressures. And the Fed is aggressively hiking interest rates to fight the highest inflation since the 1980s. Sharply higher US interest rates and a widening interest rate differential with the rest of the world led to the US dollar appreciation against most currencies through the better part of last year, though it has weakened slightly in recent months on market expectations of a Fed pivot.
Conversely, Singapore’s monetary policy is centred on a managed float exchange rate system, allowing domestic interest rates to largely reflect global interest rates and expectations of future Singapore dollar movements.
Chart 3 shows the long-term relationship between the real interest rate differentials and exchange rates for the US and Malaysia. The relationship was largely positively correlated from 2006 to 2018, which is what one would expect, but then appears to have limited correlation thereafter. The ringgit was in a broad downtrend against the US dollar for the past 10 years, regardless of the real interest rate differentials.
The weakening of the ringgit is even more obvious when we compare the real interest rate differentials and exchange rates for Malaysia and Singapore (see Chart 4). The ringgit has been in a long-term secular decline against the Singapore dollar, lasting multi-decades. This is so even though real yield differentials have mostly been in positive territory — that is, real yields (returns) in Malaysia are higher than that in Singapore.
The interest rate-inflation-exchange rate relationship is one that is very well researched and established. However, as we also noted last week, it is also true that this relationship is by no means linear or perfect, especially when viewed over the longer-term horizon.
For starters, there is the problem with our consumer price index (CPI) computation. We think few would argue that the official figures severely understate the “real” cost of living inflation for the average Malaysian. If so, this would also “overstate” the real interest rate in the country, and accordingly, the real interest rate differential with others. We believe this is a contributory factor, but there are other, larger reasons. We will explore this issue in greater depth next week.
And as we said, the forex market is complex and clearly, there are other more dominant factors in play that would explain this apparent breakdown in the relationship when it comes to the ringgit.
In theoretical discussions, we isolate each factor and its impact independently, with the qualification of “all else being equal” (or as economists like to say, ceteris paribus). Unfortunately, in the real world, there is no such thing as “all else being equal”. This does not mean that the theory is wrong or has no impact — definitely not justification to blithely ignore it altogether, but simply that real life is complicated.
Make no mistake, though. A weak ringgit impoverishes the people by eroding purchasing power and wealth. Imported commodities and raw materials, goods and services as well as capital equipment become costlier — all of which are inflationary. Inflation is a huge problem for everyone, raising the cost of living for ALL Malaysians. This is true even if you do not directly buy or consume any imported products. Locally reared chicken are raised on imported feed. Fertiliser used to grow fruits and vegetables is imported as are many types of machinery and parts in manufacturing locally made goods.
In short, the trade-off for keeping interest rates low is not costless — as some are suggesting — and therefore, the costs and benefits must be carefully considered. It is a balancing act. Populist outbursts on interest rates by some politicians lacking knowledge do more harm than good.
Is the ringgit undervalued, given Malaysia’s trade surplus and rising reserves?
Another dominant driver in exchange rates is trade. Generally speaking, a country with a trade (current account) surplus will experience rising value for its currency. This is because when export proceeds exceed import costs, there will be net inflow of foreign currency — and therefore, greater demand for the country’s currency, all else being equal. A trade surplus is typically reflected in rising foreign reserves, which is the foreign currencies held by its central bank.
Malaysia’s total exports have always exceeded imports — that is, we have a trade surplus with the world — even though the quantum fluctuates from year to year. For example, the trade surplus fell in 2012-2013 and then again in 2015-2016 due to the global commodity price collapse; first for crude palm oil and then for crude oil.
Oil price suffered one of its biggest shocks in history, falling by more than 75% — from a high of US$115 in 2015 to as low as US$28 in 2016 — over the two-year period. The oil price crash was perpetrated mainly by significant efficiency improvements by US shale producers, becoming, effectively, the marginal cost swing producer in the global energy market. The Organization of the Petroleum Exporting Countries’ (Opec) then-policy was to compete with surging US production, compounding the oversupply and leading to a massive supply glut — and low oil prices in the ensuing years.
As a net oil exporter, Malaysia’s revenue was materially affected by the oil price slump, which did not return to 2014 highs until last year, briefly, after Russia invaded Ukraine. Brent crude is now hovering at around US$80 per barrel, still a ways off its peak in 2014.
This partly explains why Malaysia’s trade surplus remains well below pre-2012 levels. Bear in mind that oil exports have an outsized impact on the overall current account surplus — high oil price translates to high profits (surplus), given that costs are mostly fixed (from the ground) — as opposed to Malaysia’s export of manufactured goods, which have relatively high import content (that is, low value added).
Plus, imports of consumption goods too have been rising rapidly — faster than imports of capital and intermediate goods — as consumption became a bigger and bigger driver of GDP growth. Total consumption (private and government) as a percentage of GDP rose from 61.2% in 2011 to 70.6% in 2021 — from a low of 51.3% in 1998.
Nevertheless, Malaysia’s current account remains consistently positive and foreign reserves have been relatively steady, recovering from the dip in 2012-2015 to near-peak 2011 levels. Both factors are positive and should give strength to the ringgit. They are also reasons why many analysts believe that the ringgit is currently undervalued. Is it? We will seek to answer this question in our next article.
The Global Portfolio gained 0.1% for the week ended April 4, on the back of mixed performances from our stock holdings. The big gainers were Grab Holdings (+4.3%), BYD Co (+4.2%) and Oversea-Chinese Banking Corp (+1.3%), while Meituan (-4.4%), Global X China EV and Battery ETF (-1.3%) and DBS Group Holdings (-0.6%) were the losers last week. Total portfolio returns since inception now stand at 25.3%, trailing the MSCI World Net Return Index’s 45.4% returns over the same period.
We disposed of all our holdings in the iShares 20+ Year Treasury Bond ETF for a net gain of 10.1%, and reinvested most of the proceeds in Chinese-based stocks. We think Chinese stocks will outperform in the foreseeable future. In addition to topping up our investments in Alibaba Group Holding, Tencent Holdings and Meituan, we also acquired shares in LONGi Green Energy Technology Co. LONGi is a leading manufacturer of solar modules and developer of solar power projects in the world.
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.
