Wednesday, August 12

Impact of the depreciating ringgit

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On one side, Moody’s vice president-senior analyst of Sovereign Risk Group Christian de Guzman was noted saying that, “Currency depreciation has relatively limited impact on Malaysia’s sovereign rating, because of the Malaysian Government debt structure, which is primarily in ringgit.”

He explained that countries such as Indonesia and the Philippines had more exposure to foreign-dominated debt paper, which accounted for about 40 per cent of their Government debt, and would face a higher impact in local currency depreciation.

But contradictory reports from Bloomberg noted that, local banks’ exposure to loans given out to 1MDB, ratings agency Moody’s gave Malaysia a ‘credit negative’ rating, while Fitch Ratings warned that a credit downgrade was likely.

Falling crude prices also contributed to the decline of the ringgit’s value, with the price of Brent crude falling a further 11 per cent in March alone.

Malayan Banking Bhd (Maybank) president and chief executive Abdul Farid Alias claimed that the ringgit’s true value should be at RM3.30 to the US dollar, saying that volatile liquidity movements in the spot and futures market presently stoke the currency markets.

“After taking into account the external variables such as the economies of China, Japan and Europe and domestic variables, the ringgit from an academic fair value should be trading at RM3.30 right now,” he said.

Macquarie Research however expects that it could drop even lower despite the recent rise of the ringgit to go as low as RM3.95 per dollar.

In a media report, the research house’s Asean economist PK Basu said, “Malaysia is indeed a net exporter of oil, but its net exports of oil are small. Sluggishness in palm oil and rubber prices, as well as plunging crude oil prices, clearly hurt sentiment toward Malaysia and had a negative impact on the earnings of listed companies in the oil services and plantation sectors.”

Basu noted that periods of large depreciation of the ringgit have been relatively rare, and when it has, there has typically been a rebound in exports and the trade surplus after about six months.

“The recent episode of ringgit depreciation should similarly boost exports by Q2 2015, and allow a widening of the trade surplus in April-September 2015,” he said.

During Bank Negara Malaysia’s (BNM) briefing on the annual report, the deputy governor emphasised the ‘terms of trade shock’ that Malaysia has experienced in the past half year, which he said justified the depreciation of the ringgit, primarily as a means to temper the decline in farm incomes from the decline in export-commodity prices.

The governor herself, Tan Sri Dr Zeti Akhtar Aziz, reiterated that the ringgit was ‘significantly undervalued’ given the country’s steady growth prospects and strong economic fundamentals.

She sought to provide reassurance the economy is not as bad as it is perceived to be, following the fall in oil prices.

In fact, at an editor’s briefing, Zeti attributed the ringgit’s fall – to RM3.70 to the US dollar – to a perception of economic uncertainty.

“The financial markets really thrive on volatility so they look for opportunities to generate volatility. As an economy, we need these strong fundamentals; so in uncertain times like this, we are able to ride things out,” Zeti said.

“Nonetheless until we see more evidence in the economic data, I think concerns will linger. I totally agree the ringgit is undervalued, if based on economic fundamentals. Even with oil prices where they are, the ringgit has weakened a lot more than fundamentals suggest.

“The reason for this is the negative sentiment of foreign investors. So until we get resolution around these uncertainties, it is very hard for the ringgit to correct to more fundamental values.”

The current uncertainty over the value of the ringgit has not affected foreign investors’ interest and efforts to woo them, said International Trade and Industry Minister Datuk Seri Mustapa Mohamed.

He said the ringgit’s depreciation has instead made Malaysia a more attractive investment destination.

“What is important is currency stability, and our currency is stable. What is happening today is related to the strength of the US economy.

“But we expect a slight reduction in total investment in manufacturing this year. Of course it is because of the global economic situation, America’s economy is recovering, China’s is slowing down, plus 2014 was an exceptional year.

“It’s very difficult to match this record, we have to face this in our economy, sometimes it’s up and sometimes it’s down, it’s very difficult to sustain,” he said.

 

Inflation

Looking at the multiple factors affecting foreign exchange, as a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.

During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the US and Canada achieved low inflation only later.

Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

Malaysia’s government bonds rose this week as inflation below one per cent raised speculation the central bank will cut interest rates for the first time since 2009.

“Inflation has surprised on the downside,” Vishnu Varathan, a Singapore-based economist at Mizuho Bank Ltd, said before the export numbers was issued. “Bank Negara Malaysia now has less of a reason to hike and may be tipping toward a rate cut if the economy runs into headwinds.”

Due to that, the ringgit advanced 0.4 per cent in the past five days to 3.6693 a dollar and was little changed Friday.

The currency lost 2.7 per cent in March, the worst performance in Asia, on concern that lower crude prices will cut revenue for the region’s only major oil exporter.

Add on the current goods and services tax (GST), RHB Research Institute Sdn Bhd (RHB Research) noted that it would likely add about 0.9 per centage point addition to the headline inflation for the remaining nine-month period of the year.

The silver lining in the matter said the research house was that the postponement of the scheduled gas price hike for the industrial sector in 2015 and the 5.8 per cent reduction in electricity tariff for four months from March 1 until June 30 this year could somehow ease price pressure its impact will unlikely be significant.

On a related development, the RHB Research’s economist also highlighted potential downside risks emanating from domestic demand factors, including falling oil and gas (O&G) prices and its impact on O&G investment; slowing investment in the property sector; and risk of businesses and consumers over-reacting to the implementation of GST.

In this respect, he stressed that the strength of economic growth will likely be a more important consideration relative to inflation for monetary policy decision in 2015.

“While there are expectations in the market for the Central Bank to cut interest rates to support economic growth, we are of the view that a cut in interest rates is unlikely unless the economy slows down significantly,” he opined.

On the whole, the Central Bank would need to strike a balance between economic growth, inflation and the potential risk of further significant outflows of short-term capital, Peck added. RHB Research expects the Central Bank to keep the overnight policy rate (OPR) stable at 3.25 per cent in 2015.

INTEREST RATES AND CURRENT ACCOUNT DEFICITS

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries.

Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down.

On that front, Bank Negara Malaysia (BNM) said it will review the global economic conditions but stressed that the country’s interest rates remain accomodative and supportive of the economy.

“Of course we have to take into account of what is developing. We cannot live in our own world because all of us are affected by global developments,” Zeti said.

“Right now, our interest rates are accomodative, and very supportive of the economy. We will review conditions but right now our economy is on a steady growth path and the interest rates support that growth trajectory.”

Zeti stressed that the Asean region would not pursue a single currency as the region is very diverse and does not have the pre-conditions for it.

“We are going for financial integration to achieve the same objectives of greater collective growth,” she added.

Bank of America Merrill Lynch Global Research Asean economist Chua Hak Bin noted that “Despite the risk to the ringgit, we think BNM will cut rates to shore up growth and confidence. Falling foreign exchange reserves, fast approaching the psychological threshold of US$100 billion (RM369 billion), also limits BNM’s flexibility in terms of defending the ringgit,” Chua said.

“The likelihood of Malaysia experiencing a twin deficit is very slim this year but as always, the financial market is fickle and its anxiety over the possibility of such a twin deficit has generally eroded the sentiment on the ringgit,’’ said Malaysian Rating Corp associate director and chief economist Nor Zahidi Alias.

An important psychological level for the ringgit against the US dollar is RM3.80, the level which ringgit was previous pegged against the US dollar.

‘’Beyond this level, the anxiety among businesses and consumers will increase and sentiment in the financial market will likely be dented,’’ said Zahidi.

These involve concerns over the debt-paying capacity of corporations with sizeable foreign denominated debt; shrinking consumer spending power which affects overall private consumption and general increase in business costs.

With Bank Negara indicating that by and large, the ringgit will be left to the market forces, Maybank Investment Bank research division (Maybank Research) is looking at the ringgit to remain soft against the US dollar at around RM3.75 in the second to third quarter before stabilising in the fourth quarter, to end the year at RM3.60 to the US dollar, said its chief economist Suhaimi Ilias.

“The expected slight improvement in the ringgit/US dollar exchange rate later this year hinges on several factors: the resolution of the 1MDB issue via a corporate and Debt-restructuring exercise, with any possible credit rating downgrade by Fitch to be modest and Malaysia remains an investment grade nation.

“Other factors include signs of commodity prices stabilising with a relatively more positive outlook heading into 2016, and the dissipating fear of a twin deficit. Capital outflows are also expected to diminish and stabilise by then,’’ said Ilias.

Although the ringgit has depreciated significantly against the greenback, it has depreciated by a lesser degree against its trading partners; on an inflation-adjusted basis, it has depreciated less than 3.5 per cent since June 2014, according to Bank for International Settlements’ statistics.

PUBLIC DEBT

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors as large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

If a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices.

Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country’s debt rating (as determined by Moody’s or Standard & Poor’s, for example) is a crucial determinant of its exchange rate.

Malaysia’s finance ministry recently issued a statement stressing that the federal government debt position remained manageable with Malaysia categorised as a country with moderate indebtedness.

“At the end of 2014, total federal government debt domestic and offshore, amounted to RM582.8 billion or 54.5 per cent of the gross domestic product (GDP).

“Of these, 97.1 per cent or RM566.1 billion is domestic debt, while the remaining RM16.8 billion or 2.9 per cent is offshore debt.

“The government remains committed to ensuring that the federal government debt levels do not exceed 55 per cent of GDP,” it said.

According to the statement, Malaysia’s external debt position is calculated based on a new definition, encompassing offshore borrowings by the federal government, public enterprises and the private sector; and holdings of debt securities, deposits and loans denominated trading by non-residents (foreign holders).

“External debt based on a new definition reflects the level of holdings of debt securities and deposits denominated in ringgit by non-residents is high, representing more than 40 per cent of the total external debt.

This is due to the depth, transparency and attractiveness of the Malaysian financial market, it said.

Malaysian financial markets have grown rapidly as a result of progress in the liberalisation of the financial sector.

“It is important to note that the offshore debt of the federal government is small, covering only two per cent of the total external debt is. Offshore debt of the federal government remained unchanged and low at RM16.8 billion or 1.6 per cent of GDP,” the statement read.

Malaysia’s external debt has swelled to RM740.7 billion in the third quarter of last year from RM196 billion in the final quarter of 2013.

The external debt, based on the new definition, showed the level of ringgit denominator security debt held by foreigners, comprising two-thirds of the increase of external debt.

“This is because of the depth, openness and attractiveness on Malaysia’s financial market,” Datuk Seri Najib Tun Razak said.

The Finance Ministry also reveals that the Government’s debt as at December last year stood at RM582.8 billion or 54.5 per cent of the country’s GDP.

“From the total, 97.1 per cent or RM566.1 billion was domestic debt, while the remaining RM16.8 billion or 2.9 per cent was external debt.

“The Federal Government’s financial debt remains manageable and can be categorised as at a modest position,” he said.

The Government, he said, remains committed to ensure that the debt level remains under the 55 per cent per cent.

The recent implementation of the GST may help alleviate the public debt but experts have cautioned Putrajaya against putting too much faith in the services sector and private consumption to drive the economy.

Skipping this phase and going too soon into services was unsustainable, said economist Tan Sri Prof Kamal Salih in a media statement because the consumption needed to fuel those services is coming from debt.

“This is why our private, corporate and public debt levels are so high and this makes us vulnerable to external shocks,” said Kamal.

Experts, however, said this focus was pre-mature as high value services could not grow without a highly skilled and innovative workforce, which in turn came when the country had high-tech, high value industries.

Malaysia’s industries, were trapped in its ‘low value’ model which relied on foreign capital and cheap labour.

“So instead of spending on research and development and becoming more high tech, our industries will spend more money to bring in lowly paid foreign workers to keep up production rates and be cost competitive.”

Because cheap foreign labour was so readily available, money and resources were not put into developing a highly-skilled local workforce, he said.

High-value industries nurture skilled workers who are better paid and who will then be able to sustainably drive domestic demand and consumption without relying on too much debt.

“But because we could not develop our industries we are skipping this phase and going straight into services and trying to maintain growth via consumption.

“Because of wage stagnation, all that consumption is sustained by debt,” he said referring to the fact that Malaysia’s household debt is 86.6 per cent of the total value of the entire economy in 2013.

FUTURE OF THE RINGGIT

The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio’s real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.

“There are positive factors that still support the ringgit: decent economic growth expected for 2015, low Government external debt and a credible monetary authority that has led to relatively low inflation over the years,’’ said Zahidi.

From a yield perspective in 2015, the US dollar will continue to sustain its appeal as the Federal Reserve is preparing to normalise the prolonged ultra low interest rates, albeit in baby steps in the months ahead.

“While the ringgit is expected to stabilise once negative sentiment towards it fades, investors will be focusing on Malaysia’s medium-term growth prospects and also assess whether the ringgit will continue to provide attractive returns from both a yield and appreciation standpoint in the face of higher US interest rates, going forward.

In another report, CIMB Investment Bank did a study in March 2004 when the ringgit was still pegged to the US dollar and at that time, found the ringgit to be undervalued by around five per cent.

‘’Since then, Malaysia’s fundamentals have strengthened further. As such, I would think that the ringgit deserves a much higher value from current levels,’’ said CIMB Investment Bank director/regional economist Julia Goh.

Negative perception and sentiment can really damage the value of a currency, which would cause concern among businesses and investors.

While those businesses that receive their payment in US dollars may celebrate, the net effect may not be that great as there could be high import costs of components and raw materials.

The current depreciation of the ringgit should remain for a year. However due to low debt to GDP ratios and high saving rates the immediate effects are on exports and inflation.

For a country with a depreciated currency, exports will increase in relation to imports as exports become cheaper and imports become more expensive.

Fortunately Malaysia’s trade surplus is RM2.86 billion and it is going to increase due to currency depreciation. The depreciation of the ringgit might increase the inflation rate and raise the cost of living somewhat, but the good news is that Malaysia has been maintaining a ‘safe-side inflation level’ of below two per cent for quite some time.

The exchange rate, whether appreciating or depreciating, was not the issue but volatility of the currency which rendered conduct of business extremely difficult and affected the capital market and the banking sector when it came to mortgages and shares.