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.
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.
