Why Bank Negara Malaysia should just let the ringgit do its thing – to float freely (Part 1)

Much has been said over the months from the years of 2014-2015 about the weakness of the ringgit, about how its decline should be controlled by the various governmental institutions (Bank Negara Malaysia), or more extreme, the pegging of the ringgit to a major currency or a basket of currencies. To the layman or rather to many mom and pops, the strength or weakness of the ringgit signifies the strength of the Malaysian economy and the decline of it means that the economy is not doing well and purchasing power has eroded. There is some truth to this assertion but only to a certain degree.

To begin with, the weakening or strengthening of the ringgit ultimately depends on two things in my opinion – the demand and supply of the ringgit.

I think the best way to illustrate this is to simply go back to the basics of demand and supply which I hope my readers have encountered before.

Demand and Supply of Ringgit

Now, I will be explaining briefly what the graphs mean. The price is actually the price of the ringgit (MYR interchangeably) in relation to a major currency which in this case is the USD ( MYR1 = USD 0.33), quantity would be the quantity of MYR. DD1 and SS1 signifies the demand and supply curve respectively of the MYR, and p1 and q1 is the equilibrium price and quantity of the intersection between the demand and supply curve.

If let’s say, the government of Malaysia decides to issue government bonds that seems attractive to investors (let’s not talk about interest rates of the bond or maturity, just that investors want to buy it), foreign investors holding USD would exchange that money for MYR at that exchange rate which in economic terms means that the demand for ringgit has risen in relation to USD. This is signified by an upward (or rightward) shift in the ringgit demand curve which increases prices and quantity. (from DD1 to DD2). As MYR1 carries with it more USD to the bang, the ringgit has appreciated in relation to the USD. Vice versa if demand for the ringgit decreases too. I will not be talking about the supply curve mechanism for now as BNM’s monetary policy has been rather steady up until now at 3.25-3.50%.

Now, in layman’s term, if you want to buy Malaysian assets, you ultimately need RINGGIT to buy them as they are mostly denominated in ringgit and the demand for the ringgit indirectly reflects demand for Malaysian assets. The more you demand of Malaysian assets, the more ringgit you demand, and the more the ringgit will appreciate. And vice versa.

Here is why I say there is some truth to this assertion that the ringgit signifies the strength of the economy or rather demand for Malaysian assets or products. The recent decline of the ringgit is actually not recent, for one reason – it has actually been declining since 2013. At this juncture, an important question to ask is why? Of course this question has many if not infinite explanations as the demand of the ringgit is influenced by any factors imaginable. For example, foreign investors might stop buying Malaysian palm oil because of its labor abuses, or maybe its electrical semiconductors are found to contain a high faulty percentages. Anything can affect the demand for the ringgit.

In my opinion, ultimately, the demand for the ringgit by and large is affected by something foreign, the FED’s monetary policy. Since 2013, the FED under Ben Bernanke had already signaled to the market that there might be a plan for the rewinding of QE (quantitative easing). Before I proceed, I think it is important to explain how the FED’s policy affects Malaysia in a straightforward sense.

The FED and Bank Negara Malaysia essentially influences the economy in the same way, that is its interest rate policies. During the 07/08 crisis, the FED lowered its interest rates (it is not just interest rates they lowered, but something unconventional was done too which is called QE but I will leave that for another day) and this affected the bond prices of US security bonds. The FED essentially “printed money” to purchase these bonds which in turn increased bond prices in an effort  to lower interest rates. ( Bond prices moved in the opposite direction of its interest rates ). Investors faced with such low yields in government bonds moved their money into higher yielding assets like stocks domestically or internationally.

Now, this is where it gets tricky, these “hot money” or carry trade as economists called it, moved into higher yielding asset classes like emerging market bond and stock markets and inflated prices and valuations. Remember I was explaining to you, if you want to buy Malaysian assets, you need ringgit. This was essentially what happened as foreign investors bought large amounts of Malaysian stocks, appreciating the MYR and inflating the KLSE index. Now, this is where I make my point that most of these money into Malaysia was very short term in nature in that you can easily buy and sell stocks in the open market since Malaysia opened up its capital controls.

The recent decline in the Malaysian ringgit is in my opinion largely affected by investors selling off Malaysian assets in the stock market ( decreasing demand for ringgit ) in conjunction of the tightening already happening in the US. Bank Negara Malaysia’s job is actually to ensure full employment of the economy with the constraint of “low” inflation (I have no idea what Bank Negara Malaysia’s inflation target is) and not to control the stock market or the ringgit demand. Even though there is a clause in the Bank Negara Malaysia Banking act that there should be stability for the ringgit, in no way should this mean that BNM attempt to “control” the stock or ringgit market as this will give a signal that it might adjust its monetary policy to changes in these markets (read market bailout). This will create what economists called the moral hazard problem in that investors seeing that the institution will bail them out if anything goes wrong, make one sided bets of heads, I win, tails, you lose.

Attempting to do this also puts the BNM in a collision course with its monetary arrangements called the tri-lemma in the economics field which I would be explaining in the next part and how I think ultimately the ringgit does not fully reflects the Malaysian economy.

(Photo from IB Times)

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One thought on “Why Bank Negara Malaysia should just let the ringgit do its thing – to float freely (Part 1)

  1. Thanks for this blog post regarding why Bank Negara should leave its currency alone; I really enjoyed it and am definitely recommending this blog to my friends and family. I’m a 15 year old with a blog on finance and economics at shreysfinanceblog.com, and would really appreciate it if you could read and comment on some of my articles, and perhaps follow, reblog and share some of my posts on social media. Thanks again for this fantastic post.

    Like

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