Bank Negara Malaysia (Bank Negara) kept the overnight policy rate (OPR) unchanged at 3% in its latest Monetary Policy Committee meeting. We agree with the central bank’s decision not to raise the interest rate, even though this will likely contribute to further weakness in the ringgit in the near to medium term.
Interest rate is the price of money, and it would be foolish to think that exchange rates are not driven by interest rate differentials. Like all assets, we hold a currency with the expectation of profiting from it, primarily by earning a return on the savings deposit (the interest rate) and/or through foreign exchange movements (when the currency appreciates). Of course, we also hold a currency for transactional purposes, to pay for goods and services, and there are costs associated with holding different currencies.
Right now, the interest incomes that can be earned on US dollar and Singapore dollar deposits are far higher than that for ringgit deposits (see Table). Hence, it is unsurprising that the ringgit has been depreciating in value against both currencies (see Chart 1). Remember, the exchange rate is the external value of a currency, which is determined by its underlying demand and supply. When demand decreases, the currency depreciates and vice versa.
But the fact is, even if Bank Negara had raised the OPR by 25 basis points — or even 50bps, for that matter — we doubt it would make much difference to those seeking to profit from interest rate differentials. Returns on the ringgit will still be lower than that for the US dollar and Singapore dollar deposits at prevailing interest rates. For it to be meaningful, the OPR hike would have to be substantially larger than 50bps.
Furthermore, interest rate differential is not the only factor driving exchange rates. Some of the other key drivers include expectations of inflation, fiscal deficit and public sector debt, current account surplus/(deficit) and importantly, confidence in the na- tion’s economic performance and competitiveness. Many of these factors are, in turn, influenced by perceived political stability and governance, which affect critical national decision-making and policies.
Over the longer term, some factors will be more important than others in driving the exchange rate at different points in time. Case in point: Looking at the longer-term charts for the ringgit against both the US dollar and Singapore dollar, it is clear that the correlation between exchange rates and interest rate differentials varies at different times (see Chart 2).
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In 2023, thus far, lower current account surplus (meaning lower demand for the ringgit) — down sharply from 2H2022 — is also likely to have contributed to prevailing ringgit weakness (see Chart 3). Exports for both commodities and manufactured goods have fallen in 1H2023, compared with 2H2022. Prices for oil and crude palm oil (CPO) are well off their peaks in 2022 while electrical and electronics and other manufactured goods exports declined on the back of weaker global demand. The saving grace was the lower outflow in terms of repatriation of incomes, which was sharply higher in 2021-2022.
Given the current clouded outlook for the global economy and exports, we doubt that raising the OPR — and narrowing the interest rate differential — will have much effect on the ringgit. Higher interest rates will not change future expectations and confidence.
On the other hand, the negative impact of a higher OPR on highly indebted households and businesses as well as government finances would be significant. For instance, unlike in the US, where most home mortgages are long-term fixed rate, nearly all mortgages in Malaysia are based on variable interest rates. This means that any increase in the OPR will immediately translate into higher monthly mortgage payments for households. And this will have a big impact on consumption, given our comparatively low household incomes and rising cost of living. In other words, the average Malaysian has a low savings buffer against the higher cost of borrowing.
Similarly, government debt and liabilities now total some RM1.45 trillion, equivalent to nearly 81% of the gross domestic product. In recent years, an ever-increasing larger share of government revenue must go towards servicing this mountain of borrowings. Higher interest rates will worsen the already large fiscal deficit.
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Conclusion
In conclusion, raising interest rates by 25bps or 50bps does not materially affect the interest rate differential calculus, between the ringgit and US dollar and Singapore dollar deposits. Thus, it will likely not help strengthen the ringgit, at least not beyond the immediate knee-jerk reaction. But a higher OPR will quite certainly have a material negative impact on the economy, in terms of consumption and public finances. This being the case, we foresee Bank Negara leaving the OPR alone — to protect households, businesses, the government and the economy — and allowing the ringgit to be determined by market forces. Every decision in life must, inevitably, involve a trade-off.
Our outlook: Interest rates and borrowing costs will remain at current levels, but the ringgit will weaken further in the foreseeable future. However, should exports improve — for instance, a sustainable rise in crude oil or CPO prices and/or recovery in global demand for goods — this would help the ringgit.
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