Why Bank Negara Malaysia should just let the ringgit do its thing – to float freely (Part 3)

In part 2, I wrote about how BNM ultimately will hit the trilemma wall if it decides to “control” the ringgit. In part 3, I will write about what the exchange rate means to Malaysia and how it does not reflect fully the state of the economy. This is entirely my opinion and in no way am I asserting that it has to be true.

For readers that have already read my part 1 and 2, they will know that I am of the opinion that the exchange rate is by and large, a product of the demand and supply of the ringgit. This is also indirectly an indicator of the demand for Malaysian assets and products.

An exchange rate is a number used to signal to investors or anyone, how much of foreign currencies can be exchanged for one unit of local currency ( same thing vice versa, depends on how you want to quote it ). For Malaysian ordinary consumers, this usually mean the figures quoted from any money changer if they decide to say, visit another country for vacation. For a company that imports or exports products either for domestic or international consumption, the exchange rate determines what price does imported products fetch in the local market and the price, exported products fetch in the international market.

Now, this is where it gets interesting. Many Malaysians are worried that the depreciating ringgit would mean that the cost of living will inevitably increase, while some only thinks that this will largely affect prices for imported products. Both sides are right in my opinion, but the scale of it is debatable.

Let’s start with a simple thought experiment about the production cycle of products. A company produces a product called X for the domestic and international market, meaning it exports too on top of selling it in the domestic market. X like any products, needs raw materials that are both sourced from the domestic and international markets. Imported materials cost will inevitably be priced with the exchange rate. As the ringgit depreciates, the company needs more ringgit to buy imported materials and this raises the final price of X. This is what economists called imported inflation. (Side Note: imported inflation might seem like a bad idea, but it is actually not. In Japan’s prolonged recession, some economists actually suggested that Japan peg its yen to a major currency to introduce imported inflation into its economy, which had been suffering from deflation)

Now that I have established the notion on how prices might increase because of the exchange rate, let me say that the scale at which prices increase might not be that big as first feared. This is because of a certain class of financial instruments called options. Options enable the holder to purchase (or not) foreign currencies at a specified exchange rate at a specified agreed timeline. For example, if I was holding an option to exchange MYR300 for USD100 in a weeks time, I could exercise that option in a weeks time regardless of how the ringgit performed ( It might be at MYR 400 for USD 100 in the market )

Because of the experiences of the post-Bretton woods era, exchange rates all over the world began to float freely. Hedging this exchange rate risk became a much needed business strategy, for companies dealing on a regular basis with import and exports. In a sense, Malaysian consumers concern for higher prices might be overblown as companies adopt exchange rate hedging as a required business strategy. If anything, prices should fully reflect the exchange rate only after the short term horizon ( assuming the ringgit continues to depreciate )

The last thing I want to address is does the recent ringgit performance reflect fully the Malaysian economy? My answer is no for the simple reason that much of the decline of the ringgit in recent times were caused by foreign investors selling off Malaysian stocks and bonds in an attempt to re position their investments in accordance with the tightening already happening in the US. Does foreign investors who buy and sell Malaysian stocks and bonds in such short term time horizons serve as a good indicator of the Malaysian economy? Maybe, but my money is on the real export performance and GDP growth, and not the stock market index. (indirectly the exchange rate too)

Saying that, the recent oil price slump and dim prospects of the Chinese economy had pummeled the ringgit heavily. Now, these are actually symptoms of a greater problem Malaysia is facing down the road which I would write about in the future.

Hope you have enjoyed reading on this 3 part series on why BNM should not control the exchange rate and thank you for the support.

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