Is the ringgit undervalued? That was the question we asked last week, and one which we had pondered for some time. Many analysts believe that it is, cheaper relative to other currencies than it should be fundamentally, based on the fact that Malaysia runs consistent trade surplus and its foreign reserves have been fairly steady. In fact, the reserves recovered from the dip in 2012-2015 and are currently near peak 2011 levels. On the surface, both factors — trade surplus and rising reserves — are positive and should boost the value of the ringgit. To say a currency is undervalued implies that it will appreciate in value over time. We think such a conclusion is an over-simplification.
To quickly recap, exchange rate is the external value of a country’s currency, which is determined by demand and supply for that currency. We have explained some of the key drivers of the value of a currency last week, including current and future expectations of interest rate, inflation, terms of trade, public sector debt, current account surplus/(deficit), underlying economic performance, political stability and global macroeconomic environment. Market participants assess all these factors to form expectations of the future exchange rate, which, in turn, drive demand for a currency. When demand is higher than supply, the currency’s value will appreciate and vice versa.
Let’s start with the easy part. As we noted last week, the ringgit has been in a secular decline against the Singapore dollar, offsetting the effects of positive interest rate differentials (real yields in Malaysia have mostly been higher historically). (See Chart 1) This indicates that demand for the Singapore dollar is much stronger, despite offering investors lower yields. Clearly, there are other larger factors at play.
For one, while Malaysia’s current account surplus has fallen sharply since 2011 after the global commodity price collapse, Singapore’s current account balance has been trending broadly higher. Notably, the latter’s current account surplus is far larger, both in absolute terms and as a percentage of GDP, at 19.3% in 2022, compared with just 2.6% for Malaysia (down from 15.9% in 1999 and 10.9% in 2011). And as we have discussed in previous articles, Singapore accounts for the lion’s share of foreign direct investment (FDI) flows into Asean, even as Malaysia lost ground since the Asian financial crisis (AFC). Malaysia’s share of Asean FDI from 2000-2020 fell to 8%, from 24% in the 20 years prior to the AFC, while Singapore’s share rose to 55% from 39% over the same period.
The huge inflows from trade and investment are reflected in Singapore’s rapidly growing pile of foreign reserves, which stood at US$294 billion as at February 2023. By comparison, Malaysia’s foreign reserves now stand at just over US$114 billion. (See Chart 2)
There was a sharp drop in reserves held by the Monetary Authority of Singapore (MAS) in 2022, by about US$128 billion. This is approximately the sum of S$185 billion that the government had previously indicated it will transfer to GIC Private Ltd. Note that MAS regularly transfers what it deems as “excess foreign reserves” to GIC for longer-term investment. The sovereign wealth fund was established in 1981 to manage and invest Singapore’s foreign reserves, primarily overseas. Global SWF estimates GIC is now the fourth largest sovereign wealth fund in the world, with some US$744 billion in assets under management (AUM) as of March 2021. Reserves held by MAS and AUM under GIC would total well over US$1 trillion.
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In short, rising foreign reserves held by MAS plus the AUM under GIC, which are invested abroad, reflect high demand for the Singapore dollar. (See Chart 3.) When demand is strong, the currency appreciates. No mystery.
Malaysia must continue with liberalisation and free capital market
Conversely, the long-term decline of the ringgit against the US dollar and Singapore dollar indicates relatively weaker demand for the former. This conclusion is fairly obvious from Malaysia’s falling trade surplus, which is a result of structural weakness in the economy and rising imports of consumption goods, as well as weak foreign capital inflows. The value of the ringgit also appears to be closely correlated to commodity cycles. This suggests that unless there are real reforms to address the underlying economic structural weakness — as opposed to just political posturing — the ringgit may well continue its downtrend.
And no, Malaysia absolutely must NOT peg the ringgit or re-impose any form of capital controls. For starters, pegging the ringgit, say to the US dollar, will not work — because our foreign reserves are simply too small to credibly defend a peg and it would mean giving up the interest rate as a policy tool, unless it also comes with capital controls.
Malaysia has imposed capital controls twice, the first time during the height of the AFC — which included a ban on all offshore trading of Malaysian stocks and the ringgit (which was pegged at 3.80 to the US dollar) — and in 2016, albeit in a far looser form. In the latter instance, exporters had to convert at least 75% of their sales into ringgit (retaining only a maximum of 25% in foreign currencies) and all settlement of domestic trades (between exporters and other companies within the global supply chain) had to be in ringgit. This was a setback to Bank Negara Malaysia’s broader liberalisation strategy since the ringgit peg was removed in 2005.
Both times, the restrictions were imposed in reaction to steep depreciations of the ringgit. In effect, the government was treating the symptoms instead of addressing the underlying root causes. And there were severe, long-term consequences, for which we are still paying the price. We have written extensively on how capital controls damaged the country’s attractiveness to investors, both local and foreign.
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Prior to the AFC, the country had been hugely successful in attracting foreign investment, becoming a key regional electrical and electronics (E&E) hub, and Bursa Malaysia (then known as the Kuala Lumpur Stock Exchange) was one of the region’s booming stock markets. Post-AFC, Malaysia’s share of Asean foreign direct investment (FDI) fell precipitously. The country also suffered cumulative net outflows of foreign portfolio investment (both debt and equity combined) in the ensuing 10 years (1998-2008). The FBM KLCI remained the worst-performing benchmark index in the region for the past decade, down 15.7%. Yes, negative 15.7% for the Malaysian stock price index over the last 10 years.
There is no doubt capital controls hurt the development of our capital markets and likely deprived many businesses of a valuable source of funding for investment and growth. Gross capital formation as a percentage of GDP fell sharply, from a high of 43% in 1997 to an average of less than 24% in the following decade — forcing premature de-industrialisation. Slower investment translated into lower growth in potential output and actual GDP, hampering the move up the value chain and capping productivity gains, which, in turn, led to low wage-income growth for the population.
Most of the capital control measures have long since been lifted, including the export conversion rule. But their long-term — and very costly — consequences remain. To reimpose any form of capital controls or another reversal in the financial liberalisation process for the third time would, we fear, surely lead us down the path of no return.
In fact, simply talking about it is damaging. Words also have consequences. The answer to halting the secular slide in the ringgit must be to address the underlying root causes.
Rise in foreign currency holdings in the banking system and Bank Negara’s negative forex swap balances
At the start of this article, we noted that Bank Negara’s foreign reserves have gradually recovered from the dip in 2012-2015 and are currently near peak-2011 levels. The numbers are accurate but the reality is more nuanced. The detailed statistics reveal a rising negative foreign exchange swap balance — effectively Bank Negara borrowing foreign currencies — since mid-2015 and especially since 2022. This was also a period of broad ringgit weakness. (See Chart 4).
A foreign exchange swap is a financial transaction between two parties — a central bank (in our case, Bank Negara) and another central bank or commercial bank — to exchange specific amounts of two different currencies and repay the amount of the exchange (principal plus interest) at a future date. The transaction between central banks are typically used to provide liquidity to each other or to stabilise their respective currencies in foreign exchange markets.
A negative foreign exchange swap balance represents a short-term liability for the central bank, that is, the amount in foreign currency borrowed that has to be repaid. Until then, the balance is counted as part of reserves. In other words, if all of Bank Negara’s swap positions were to be closed today, foreign reserves would be noticeably lower than the reported gross figures. (See Chart 5 below). Malaysia’s gross foreign reserves is about five months of rolling average nominal value of imports. In terms of net foreign reserves, adjusting for foreign exchange swaps and government short-term foreign liabilities, it covers just three months. This creates a perception risk.
As the international financial market is liberalised, central banks have increasingly moved from direct monetary policies to indirect ones. They rely less on fixing of interest rates by administrative means or imposing controls to using more instruments that are in accordance with market mechanism.
Foreign exchange swap is a money market tool, used by central banks to affect domestic liquidity, manage their foreign reserves and stimulate domestic financial markets. It is an alternative tool for market intervention and especially useful in countries with a less developed short-term government securities market. Since the 1980s, Bank Negara has mostly replaced the use of swaps — as a mean to provide liquidity to banks — with open market operations (as government securities market matured) and Bank Negara certificates. That is, until recent years. Part of the appeal of swaps are that they have no direct effect on the spot exchange rate and are flexible, inconspicuous and easily reversible.
Central banks around the world have used foreign exchange swaps for a variety of objectives. They have been used in times of financial crisis, to provide additional liquidity to banks and help prevent failures as well as mitigate the risks of systemic financial instability. And, in less dire situations, to affect domestic liquidity. For example, a foreign exchange swap with a local bank will increase Bank Negara’s foreign reserves and, at the same time, increase domestic money supply by the ringgit equivalent amount. This temporary (for the duration of the swap) increase is high-power money, a liquidity injection that will boost the lending capacity of banks.
Foreign exchange swaps have also been used for the management and acquisition of foreign exchange reserves. For instance, to improve the matching between the composition of reserves currencies and the country’s import basket or to increase the gross foreign exchange holdings when there is scarcity or acute shortage of foreign reserves (especially for countries with persistent balance of payment deficit).
Uncovered positions can, however, lead to massive losses for the central bank, if the local currency depreciates in the interim.
It is difficult to distinguish the real motivations behind central banks’ foreign exchange swap decisions. Like most instruments, they can be used positively or negatively. And we are not here to say which, simply to highlight the fact that they exist and what are the possible consequences.
Chart 6 shows the foreign exchange swap balances for select countries. A positive swap balance (example, Singapore, Thailand, Japan and South Korea) suggests these central banks have surplus foreign currency liquidity and are willing and able to lend to other central banks as needed.
A picture is worth a thousand words
Bank Negara’s rising negative foreign exchange swap balance suggests tightening foreign currency liquidity in the market. Because interventions — to prevent excessive volatility in the foreign exchange market — require instant access to reserves, liquidity is crucial. The swaps provide short-term capital inflows.
Chart 7 provides a good explanation for the tightening foreign currency liquidity. Deposits in foreign currencies (instead of in ringgit) have been rising steadily over the years, totalling over RM242 billion in February 2023. There were particularly steep increases in 2014-2015 and again in 2021-2023.
Here is the hard truth: the willingness of investors to invest (and reinvest their profits) in the country and for the people to hold the ringgit is all about perception of financial openness and, critically, confidence.
The sharp increase in foreign currency deposits in 2014-2015 was due to rapidly deteriorating confidence in the country. It was a particularly fraught period for Malaysia, as the sheer scale of the fraud at 1Malaysia Development Bhd (1MDB) became increasingly clear to all. The fallout — the investigations, arrests, public discontent and protests as well as political uncertainties — created a massive crisis of confidence. Events came to a head in 2016 when foreign authorities, including the US, Switzerland and Singapore, seized assets related to the sovereign fund. It had, by then, racked up more than RM50 billion in debts. The ringgit depreciated sharply. And “panicked” officials slammed in the export conversion rule.
The measure did stem the ringgit’s decline, temporarily, but did little to boost confidence. The ensuing general election in 2018 was historic, marking the first defeat for the coalition that had ruled for six decades. It also heralded more political instability — and uncertainties over policy continuity — as what followed were unstable coalitions and multiple changes in government administrations. We had six prime ministers in the 60 years since independence and four in the last five years.
The ringgit depreciated anew in 2021, after the export conversion rule was removed, and deposits in foreign currencies again jumped sharply higher. We think the hoarding of foreign currencies last year is spurred, at least in part, by higher yields on US dollar deposits, but clearly, confidence is yet to be restored.
The biggest challenge for Malaysia is the lack of confidence
Confidence, expectations and economic outcomes are closely correlated. Confidence is shaped by our expectations for the future, based on what we see, experience and hear — on economic conditions, government policies, political stability, interest rates, exchange rates, inflation as well as social media and news reports, which influence perception and sentiment.
It certainly does not help when politicians deem it fair game to undermine Bank Negara’s independence, for instance in setting interest rates. The credibility of a central bank — underscored by its independence from political interference — is paramount, because it affects the people’s confidence in its monetary policy, ability to anchor inflation expectations and maintain economic and financial stability. This is why countries have laws to ensure central bank independence. For instance, the 1913 Federal Reserve Act explicitly states that the Federal Reserve System is an independent entity within the government. Its decisions on monetary policy are not subject to approval from either the executive or legislative branches of government, though it remains accountable to Congress.
When confidence is low, people hold on to foreign currencies, which leads to ringgit depreciation. We have already written about how the weak ringgit impoverishes the people, translating into diminished purchasing power and rising cost of living.
Lack of confidence also means people are less likely to spend and businesses less likely to invest, leading to slower economic activities and GDP growth, job creation and wage increases, all of which then feeds right back into the expectations-confidence-economic outcomes loop.
To break this vicious cycle, we must tackle the underlying root causes with real, concrete actions. No more quick fixes, please! A floating exchange rate will provide flexibility to monetary policy and liberalisation must continue. And to answer our original question, no, we see no evidence that the ringgit is undervalued — it reflects the prevailing confidence, fundamentals and expectations for the Malaysian economy.
Conclusion
Why is there such a contrast between public articulation, by economists, analysts and the media, and the actions of smart money? Is it like stock/equity analysts where their interests lie in making positive recommendations? Perhaps it is not to offend (intellectual dishonesty), or superficial analysis, or self-serving?
Yet, a depreciating currency makes all residents who earn in ringgit poorer, creating price inflation and raising the cost of living. The ringgit can be strengthened if confidence is improved (since expectations drive actions), which will boost investment and raise the current account surplus sustainably.
And if politicians want to be helpful, the best thing they can do is pass a law that explicitly guarantees Bank Negara’s independence in conducting monetary policy, free from political interference, plus banning the application of any form of capital controls henceforth, unless first approved by Parliament (therefore, it can never be done, if the entire world must be told in advance). What must not happen ever again is another capital control in whatever form. Right before the AFC, the economies of Thailand, Indonesia and South Korea were in far worse shape than Malaysia. They chose to let the market mechanism work while we chose capital controls. Look who is now behind the pack?
The Global Portfolio fell 0.7% for the week ended April 12, led by losses from Tencent Holdings (-7.2%), Meituan (-2.2%) and BYD Co (-2%). We disposed of all our holdings in Oversea-Chinese Banking Corp, DBS Group, ABF Singapore Bond Index Fund and Grab Holdings, for a collective gain of 5.1%. Part of the proceeds were reinvested into the Star Media Group. The other gainers last week were Global X China EV and Battery ETF (+0.5%) and Alibaba Group Holding (+0.4%). Total portfolio returns since inception now stand at 24.3%, trailing the MSCI World Net Return Index’s 45.4% returns over the same period.
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