Saturday, June 20, 2009

Weak or Strong MYR policy? I Say Neither

etheorist has an interesting post that I’d like to respond to, but since my points won’t exactly fit into a comment box, this post will have to do. I’d encourage anyone to read through the rest of his posts, as together they form a lucid argument for the kind of changes required to transform the Malaysian economy, as well as some of the challenges that need to be overcome. But on this specific post, I have some counter-points that I think need to be laid out.

etheorist puts forth the following arguments:

1. Malaysia has followed a weak currency policy since the 1997-98 crisis, which impacts incomes;

2. Money supply growth has also been excessive since then, with inflation again devaluing real incomes;

3. Loan growth during the same period has been directed more to the household sector, and less supportive of business expansion;

4. Hence, the solution is to support a policy of strengthening the Ringgit over the medium term, which would help improve productivity and real incomes.

I have problems with all four points. First the weak currency policy meme:

The notion that currency values are weak or strong based on nominal relative movements is meaningless outside of a Purchasing Power Parity (PPP) based framework. Exchange rates respond to a variety of influences, which completely overshadow the goods-based price arbitrage that underlies the logic of PPP. There is in fact little empirical evidence that PPP is a relevant metric at all when applied to currency movements. To have a currency falling x% against another therefore isn’t equivalent to it being x% weaker except in a purely market sense – it certainly does not equate to it being weaker from a fundamental economic standpoint.

Another factor to consider is that misalignment in a given bilateral exchange rate does not imply misalignment on a multilateral level. MYR has indeed nominally lost ground against many of the major currencies if you consider pre-1997 levels; but at the same time it has gained ground against many developing country currencies in the same period. From an income standpoint, since most manufactures and resources come from developing rather than advanced economies I can’t buy the argument that purchasing power has necessarily fallen generally.

Moreover, the 1998-2005 USD peg while initially undervaluing the MYR on a multilateral basis in the double digit range post-1998, very rapidly turned into an overvaluation by 2001 making the 2000-2001 pseudo-recession more severe than it should have been. So I tend to discard the idea that there is a deliberate government policy of MYR weakness, particularly with reference to the USD.

I’ll return to the question of weakness/strength of MYR later in this post.

Second, money supply growth, far from being excessive post-1998, is well below Malaysia’s historical average (log annual changes):

…and third, so is loan growth (log annual changes):

More to the point, etheorist misses one trend that has been crucial in driving banks towards more consumption-based lending – the rise of the PDS market:

To provide some perspective, in 2000-2005 bank lending grew by RM230 billion of which about RM30 billion went to businesses with the rest going to the household sector. Funds raised on the domestic capital markets (debt + equity) during the same period on the other hand was an additional RM133 billion, with a further RM51 billion raised in 2006-2008.

Corporate financing in Malaysia can no longer be characterized as being solely bank-driven – much like more advanced economies, the debt markets have almost completely overtaken that particular role of the banking sector except in supplying credit for smaller companies and to households. Far from being clueless, bankers have responded in a perfectly rational fashion to a secular change in the structure of the economy (and incidentally helped drive the scramble for investment banking licenses). From personal experience, the shift to consumer lending happened as much because of this structural shift as well as the recognition of just how risky business lending was.

Moreover, growth in residential loans, while exceptionally strong in the early part of this decade, hasn’t overtaken incomes or households’ capacity to absorb supply (unlike in the 1990s):

I’m abstracting obviously from changes in income inequality, but the general sense remains true – if lending for housing was truly excessive, price increases should have accelerated faster but they haven’t. So on that score, I’ve little criticism of the changes occurring in bank lending over the past decade.

So where does that leave us? I have no qualms against a stronger nominal MYR – but only where it is strengthening from changes in the economy itself rather than from a deliberate policy shift. Here are my reasons why:

1. The monetary trilemma – you can only control two out of the three monetary policy variables (interest rates, exchange rate, money supply) at any given time. Targeting the currency ala Singapore or Hong Kong means either letting interest rates or the money supply fluctuate freely and with orders of magnitude greater volatility (IIANM Singapore chooses the former while HK chooses the latter). What are the consequences of such a move? Either option means essentially abrogating some control over domestic monetary conditions, which means less influence on credit, growth and inflation. Malaysia has a far bigger and more diverse domestic economy than either HK or Singapore, which implies the negative consequences would be far greater for social welfare – and the negative consequences can be pretty horrible. (Reminder to self: I still owe a blog post on exchange rate regime choices).

2. The causality running between the exchange rate and other economic variables are not necessarily symmetrical or homogeneous. Take for instance productivity – from the Balassa-Samuelson hypothesis, an increase in productivity in the tradable sector (for instance manufacturing) leads to a depreciation of the exchange rate whereas an increase in productivity in the non-tradable sector (for instance wholesale and retail) leads to an appreciation of the exchange rate. On the flip side, I fail to see how an increase in the exchange rate results in any changes to productivity at all.

3. Finally, I believe a deliberate policy of strengthening the MYR is unnecessary and counterproductive – when present policies are leading us there anyway. The shift to a more services-based economy will, like it or not, lead to a general appreciation of the exchange rate without any further action on the part of the central bank. We are no longer in the era of a dirty float regime, with central bank intervention a constant threat over the market. I find little evidence from the data that there has been BNM intervention in the forex market beyond sterilization operations. The movements of the MYR against other true free-float currencies (no, JPY doesn’t count, and USD is really borderline) leads me to believe that we are truly in a managed float regime, as much as that is possible without full convertibility. Intervention will only be contemplated under those circumstances if MYR strays too far from its medium term equilibrium level.

My current view of the MYR is that it is a little overvalued relative to economic fundamentals on a multilateral basis – but not by much. As economic fundamentals dictate (see here for an incomplete list of potential influences), the equilibrium rate will begin rising and we’ll see that stronger exchange rate that everyone seems to clamour for. But that appreciation will be a reflection of the strength of the economy, and not a policy-induced illusion unsupported by real economic factors.


  1. hishamh,

    That's a very long response!

    1. I do argue with data.

    2. We have our differences in opinion.

    3. Is a strong currency desirable?

    4. If indeed the current policy focus on the services sector is the way for a stronger currency, then I am happy.

    5. This response of mine does not do justice to your effort. But this is Saturday! More maybe later on, in snatches.

    But thank you for your attention.

  2. etheorist,

    I just posted a follow-up.

    BTW, happy belated Father's Day!