Saturday, April 25, 2009

There Is Too A Point In Dropping Interest Rates

In today's business editorial in The Star, P. Gunasegaram clearly doesn't understand monetary policy:

"If Bank Negara decides to lower interest rates next week, as many people expect, there is little that it is likely to achieve but it will further erode returns to savers already, very low at around 2%...And the lower interest rates will weaken the already weak ringgit in the short term as those holding ringgit will get lower returns and, therefore, might opt to move into other currencies...Will there be any benefit from such a rate reduction? Not likely. Recent evidence is that interest rate reductions do not do anymore to stimulate the economy beyond a certain point. An example is Japan where interest rates have been around zero for many years with little effect on the economy."

The first point of misunderstanding is that what matters is the real interest rate, not the nominal interest rate. Japan's ZIRP didn't work not because nominal interest rates were low, but because first under conditions of deflation the real interest rate (nominal interest rates less inflation) was still positive. The zero interest rate bound puts a limit on the reduction of the nominal rate, but does not put a limit on the real interest rate. Monetary policy can still be net contractionary under those conditions.

Second, Japan's policy transmission mechanism (i.e. credit creation through the banking system) during the "lost decade" was broken. With zombie banks supporting zombie companies, monetary expansion gets trapped within the banking system, and did not support economic expansion.

Neither point is yet valid for Malaysia. With annual inflation dropping fast and potentially going negative by July, the real interest rate would be rising in the absence of a nominal interest rate cut. Given the current drop in output, higher positive real interest rates are an extremely bad idea. Just to underscore this point, here's average bank lending rates less annual CPI (log annual changes; 2005=100):

Secondly, Malaysia's banking sector is structurally sound, as (ironically) pointed out in this article in the same newspaper. Capital ratios are more than adequate, and non-performing loan ratios are flirting with all time lows. Monetary expansion and lower cost of funds will thus have a positive impact on borrowing and lending.

The second point of misunderstanding is real return to savers. With annual gross national savings well in excess of 30%, I don't think we need to encourage more savings - quite the opposite. With velocity of money already low and falling, reducing velocity further is another bad idea, and just reinforces the downturn in the economy.

The third point about the currency again confuses nominal and real rates, and misses the crucial "flight to safety" narrative of the USD over the last six months. It's true that interest parity conditions would imply, ceterus paribus, that maintaining nominal rates and thus allowing real interest rates to rise would maintain and/or strengthen the value of the MYR.

This is especially true since ceterus paribus doesn't apply - BNM is behind the curve in loosening monetary policy not only against advanced economies, but also regionally i.e. relative interest rates for MYR assets have been rising. On the other hand, demand for USD has been unnaturally high in recent months, as US financials pull back overseas investments as well as from Euro-dollar asset liability mismatches. This trend will reverse as US financial system leverage unwinds.

The billion-dollar question is - with trade suffering and the threat of imported inflation practically non-existent, does a higher MYR make economic sense?

I haven't fully worked out MYR trade/exchange-rate elasticities (something for a future blog post), but a quick regression estimate suggests a 1% rise in the USDMYR rate results in a 0.39% drop in exports and 0.24% drop in imports, both statistically significant. That is, MYR currency appreciation results in a contraction in total trade, which isn't exactly what we need right now.

One point I do agree with is that banks aren't passing on the full marginal cuts in the OPR to borrowers, as I pointed out here. That's something BNM has to work on.

Technical Note:
Source for average lending rates, CPI and external trade from BNM's Monthly Statistical Bulletin. Forex data from Pacific Exchange Rate Service.


  1. Nope, prefer a weaker ringgit at this stage.

    Negara needs to have effective policies to ensure that lending goes to the right sector. Penalties should be applied if target asset growth/composition is not fulfilled, this can be done on a half/quarterly basis.

  2. Agreed, calling for a stronger Ringgit is...insane.

    I don't know if I would go so far as to have explicit sector/growth targets, though. We'd like to have the illusion of a progressive financial system, don't we? I seem to recall BNM trying out that trick in 1999 - didn't work, because nobody could meet the 8% target.

  3. "With annual inflation dropping fast..."

    For me(an ordinary person on the street), I am still paying the same amount of money for food and public transportation before and after financial crisis with lower pay. It is true there is a lot of discounts for non-essential items, e.g. properties, electronic gadgets.

  4. Your suggestion that the Ringgit should remain weak in order to boost exports is based on the case for competitive devaluation vis a vis regional exporters. Isn't a weak RM policy preventing the economy and industry from rising up the value chain?

    Second point is that monthly inflation is likely to go negative in 2H09 as you rightly point out. But this is due to high base effect of fuel prices hikes that came in mid-08. Eventually, when inflation normalises to 2-3% by 2010, BNM will be in a hurry to raise interets rates.

    Lastly, a weak RM is not conducive for consumers although it is good for exporters. Much of what we consume, although some are subsidised, are imported. Why should we continue to pay heftily for imports in favour of exporters who have no incentive to upgrade their product mix?

  5. encikwan,

    The technical definition of inflation is a general rise in the price level. If prices are high, but stay the same, there is no "inflation". That does not mean things are expensive or cheap, just that the price is not moving.


    Thanks for your comments. I've just reread my post, and I'm pretty sure I wasn't calling for a "weak" Ringgit, just not a "strong" one. I understand that it's possible to mistake my position as being mainly for a weak Ringgit, because the trend of my posts on forex is generally against the conventional wisdom that the Ringgit can and should strengthen.

    The crux of my view is that I see the Ringgit as already being close to its true, fundamentals based value. In fact up to the end of 2007, my view was the Ringgit was overvalued and needed to weaken, which it in fact did. Look for a forex update post soon - I'm still collecting 1Q inflation data for our trade partners, but once that's done, I'll have a clearer idea of where the Ringgit stands.

    With respect to inflation, I'm less paying attention to annual/monthly rates of change than the price level itself - it's almost completely flat right now. This isn't a matter of the base effect anymore - as you point out, last year's fule price hikes effectively screwed those measures up.

    2%-3% inflation is what I would call relative price stability, and on that basis a flat CPI level is effectively deflation - which calls for an interest rate cut.

    Neither am I convinced that BNM will move interest rates upwards much if inflation does return to "normal" levels. The historical record suggests they're more than willing to keep interest rates low in the absence of wage pressures. Last year's experience bears that out.

    On your last point, can you substantiate this statement:

    "Much of what we consume, although some are subsidised, are imported."

    I'm not trying to be adversarial, but I can't find any proof of this. Imports of (non-oil) consumption goods totaled RM32.3 billion last year, which is less than 10% of total private consumption.

    Also, consumption imports appears to be completely impervious to changes in the exchange rate (elasticities are not statistically significant from zero), which also suggests that imports really aren't a big part of household consumption.

  6. Thanks for responding. I am not in favour of BNM or any CB keeping interest rates low or high. The market should decide that level.

    "The historical record suggests they're more than willing to keep interest rates low in the absence of wage pressures."

    Precisely, they will want to ensure the RM is competitive rather than have exporters compete on non-price factors.

    As for the import content issue, I estimate imported foodstuffs account for half of our food consumption. Whether they are price elastic is another issue. Psychologically, consumers know that when the RM is weak, pricing power is weak.

  7. That's an interesting take on things - the implication of that idea is an exchange-rate focused monetary policy a'la Singapore or Hong Kong (not for everyone), or a monetary aggregate based approach (which has been proven to be unworkable). The current fashion is to abandon all three policy instruments in favour of inflation targeting instead - the jury is still out on that one.

    Re: interest rates and exchange rates - you should know that the empirical evidence for currency movements based on relative real interest rates is very weak, and limited to short term dynamics i.e. the rate of appreciation/depreciation, not the level. Interest-parity currency models generally have poor forecasting properties. Most fundamental based models drop interest rates as a variable because it has no impact on the medium-long term valuation of a currency.

    A second point is that for most of the early part of this decade, the Ringgit has been overvalued, not undervalued, a side effect of the USD peg. Interest rates during this period were also low and falling.

    On your last point, it's a far cry from saying half of food consumption is imported, and saying most of consumption is imported.

    Also the exchange rate elasticity does matter, even if only in a negative sense. The fact that there's no statistical relationship between the local price and demand suggests that this is not a purchasing power issue, but rather a structural one.

    If imported foodstuffs are relatively expensive, that should prompt a suppply response from more competitive domestic producers which of course hasn't happened because of price controls. A strong Ringgit won't change this dynamic, but on the other hand will have a negative impact on the other 90% of imports that are not consumption goods, and directly contribute to production and exports. That doesnt make economic sense. The optimal policy solution is a lifting of price controls, not a strong Ringgit.