(June 26): We are in a world in which monetary policies are being taken to extremes. The biggest central banks in the developed countries — including the US Federal Reserve, the European Central Bank, The Bank of England and the Bank of Japan — are all in sync when it comes to helping their economies recover from the devastating impact of the Covid-19 pandemic.
They are going full steam ahead on quantitative easing (QE) and near-zero or negative interest rate policies. The rationale is basic economics — by cutting the cost of capital, they are pushing businesses to invest and take on more risks and households to spend.
Suffice it to say, this current breed of central bankers have evolved far beyond their traditional role as regulators and ensuring a smooth-operating financial system.
They are actively participating in capital markets and directly influencing financial asset prices to support and promote employment and economic growth.
Negative interest rates would be too aggressive — and experimental, with no historical precedence as guidance — for smaller emerging countries to embrace.
But we think there is room for Bank Negara Malaysia to cut interest rates one more time — by 50 basis points in one go, with the understanding that this will be the final reduction. We believe this way would be better — in providing businesses with greater clarity and therefore confidence — than a slow drip of smaller cuts over time.
There is no question that the Malaysian economy needs as much help as it can get now, to avoid falling into a bankruptcy-unemployment-consumption downward spiral.
Interest rates are the price of money. Cheaper cost would stimulate loan demand and investments that, in turn, create jobs and wage growth. It would also reduce the interest burden on existing debt, which would provide some relief to businesses currently struggling with falling demand and revenue.
Yes, there are longer-term problems associated with prolonged low interest rates. For instance, it would create zombie companies through the persistent misallocation of resources, by providing lifelines to subpar businesses and robbing those with better returns of funding and other resources.
We understand that cutting interest rates will affect bank profitability through the narrowing of net interest margins.
But helping businesses tide themselves over this difficult period will avoid damaging productive capacities and hasten economic recovery. This will, in turn, reduce the odds of loan defaults and a healthy economy will translate into stronger loan demand growth, both of which will be good for banks and the country in the long run.
At the same time, preventing mass bankruptcies would help keep unemployment in check and alleviate pressure on indebted households — Malaysia’s household debtto-GDP is relatively high at 82.7% — especially for those whose incomes are being affected by the pandemic.
One group that will be disadvantaged by the lowering of interest rates would be retirees, who will see their interest income Global Portfolio streams diminished. But this is rectifiable through direct fiscal aid.
The textbooks tell us that foreign capital flows are directed by the differences in yields, the so-called yield spread. That is to say, the country that has higher relative interest rates will enjoy higher capital inflows.
If this is true, then lowering domestic interest rates risks capital outflows, which will then lead to a depreciating currency.
Historical statistics, however, do not quite support this hypothesis.
Chart 1 shows the correlation between Malaysia’s sovereign yield differential and exchange rate against the US Treasury and dollar. Contrary to traditional wisdom, there are periods in which the ringgit strengthens when yield differentials are in decline and weakens when yield differentials are rising.
Taking the longer-term view, since the global financial crisis, yields for 10-year Malaysian Government Securities (MGS) have been rising relative to 10-year Treasury yields. But the ringgit has depreciated against the greenback over the same period.
In other words, the strength of the ringgit is not only driven by yield differentials but is, instead, tied to a confluence of factors, including expectations of risks, growth and outlook for the country. All the more reason that Bank Negara and the government must do everything possible to help the economy reflate and recover as quickly as possible from the pandemic.
As mentioned, the yield differential between the MGS and US Treasury is at the widest in two decades and more or less steady against selected countries in the region (see Chart 2). In short, cutting interest rates will not be out of sync with the rest of the world.
In fact, with the worst of the pandemic fears receding, money is trickling back into corporate and emerging-market bonds, where yields are significantly more attractive than zero and negative interest rates in major developed countries.
Emerging countries have stronger growth prospects and, for most, the default rate — especially for sovereign bonds — is low. The inflow of hot money could cause a strengthening of the ringgit, which will hurt Malaysia’s export competitiveness in this crucial time of economic recovery.
To be sure, lowering interest rates reduces Bank Negara’s ability to tackle the next crisis. But the central bank can revert to a more normal interest rate regime in the months ahead as the economy recovers.
Global interest rates will be kept very low by the biggest economies for the next two years at least. And since the interest rate tool is a relative rather than an absolute measurement, the risk of a muted future response tool is minimal.
The Global Portfolio fell marginally, by 0.2%, for the week ended June 25, but performed better than the MSCI World Net Return Index, which dropped 1.7%. Total portfolio returns now stand at 17.8% since inception. The portfolio is outperforming the benchmark index, which is up by 8.7% over the same period.
Most technology stocks continue to do well, with Adobe, Alibaba Group Holding, Microsoft Corp and Apple ending higher for the week. Vertex Pharmaceuticals was also among the gainers.
Shares in Apple reached fresh all-time-high levels last week. The company recently unveiled plans to use in-house-designed chips in its Macs, replacing the Intel chips it has been using for the past 15 years. The transition will take place over two years, with the first batch of Macs with Apple-designed chips shipping out at year-end. According to Apple, its chips will provide better performance and battery life, which would boost its market share.
We disposed of all our remaining shares in The Boeing Co, netting a loss. The stock remains very volatile in the current uncertain environment, ending sharply lower last week. Other notable losers were Builders FirstSource, BMC Stock Holdings and Starbucks Corp.
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