Thursday, October 15, 2009

Q3 2009 MYR Exchange Rates Review

I realized a couple of days ago that I hadn’t done an update on the Ringgit for quite some time. As I got started I remembered why – out of all the data I’m tracking, forex is by far the hardest and most complex to manage.

First because (unlike most) my approach goes beyond the USD exchange rate, and second is because I calculate the trade-weighted indexes, the data problems can occasion some hair-pulling. The actual forex and trade data are easy to get even across the fifteen currencies I use in the broad nominal index, but getting timely up-to-date information on price deflators for calculating the inflation adjusted index isn’t.

For instance, Australia (of all people) only publishes quarterly series for their CPI, which requires interpolation to the monthly frequencies I’m using. China on the other hand does publish monthly but only for year-on-year index movements, which means actual monthly inflation is really a matter of guesswork.

Both these countries matter because without more granular info on Australian CPI I can only calculate the real effective (inflation adjusted, trade-weighted) index once a quarter and with a lag of up to two months, and because movement in the Yuan accounts for nearly 15% of the real index. Having inaccuracies in either of these currency cross rates would increase the error rate of the calculated indexes, and incidentally my own peace of mind.

Having said that, there’s been quite a bit of change on the forex front especially over the past month, so a review would be useful. I also took the time to work a bit more on exchange rate elasticities as it relates to trade, and the results are fascinating to say the least – assuming of course, I’m doing this at all correctly. But trade elasticities will have to wait, as this post will be long enough already.

First, the overall view (2000=100):

The MYR has lost quite a bit of ground since the end of 2007, but there are signs things are turning around. My view (which by all accounts isn’t very popular) is that MYR was overvalued at the end of 2007, and the retracement was justified, if a bit overdone. That’s fairly common in currency markets – the overshooting I mean. Right now we’re probably a little (2%-3%) under the short term equilibrium, and just a bit more (4%-5%) under the medium term equilibrium level.

I have to digress here to explain the equilibrium terminology:

1. Short term equilibrium is the market-clearing equilibrium, where demand and supply of currency match. It’s also the equilibrium consistent with relative real interest rates.

2. Medium term equilibrium refers to the equilibrium justified by flow fundamentals – like changes in terms of trade, government spending, GDP and the current account.

3. Long term equilibrium is a stock equilibrium, which is the point the exchange rate is consistent with holdings of both (financial and real) assets and liabilities.

It’s hard to put a time period to any of these definitions, as they differ according to the structure of a country’s economy, its external exposure, and the dynamics of its exchange rate, but generally short-term means 1 year or less, medium term is anywhere up to 4-5 years, and long term any period over that. Of course, any change in economic fundamentals means that any given equilibrium is a moving target – again not a very popular view outside of academia.

But to get back to what’s happening with MYR, here’s MYR movements against the major currencies (2000=100):

Note that the MYR is close to its short-term fair value against both USD and especially EUR, but grossly undervalued against the JPY. I’m interpreting it in this fashion based on the differential between the nominal and real indexes here – the general rule of thumb is that the nominal rate should move towards the real rate. I’m also using the year 2000 as an equilibrium reference point, which believe it or not is the consensus among the studies I’ve seen, including the IMF’s.

The reason for the JPY gap can squarely by blamed on the JPY carry trade, which involves borrowing in JPY and investing in higher yielding currencies (e.g. AUD and NZD). In currency trading terms, that means short JPY and long AUD for instance. One interesting thing going on now is that the carry trade business is increasingly moving to USD (hence the general JPY strengthening trend), so we’re likely to see MYR overshoot above its equilibrium level against the USD – that ought to make all the “weak currency policy” conspiracy theorists happy.

The two other major currencies of importance to MYR are CNY and SGD (2000=100):

These five currencies each have a weight exceeding 10% in my indexes, and collectively form about two-thirds of the movements. The CNY rate is fairly close if a little undervalued, but for SGD, MYR does look more than a little overvalued. That appears to be consistent with recent IMF assessment of the SGD, in that the SGD is undervalued relative to its medium term level.

As for the rest of the currencies in the basket, I won’t post detailed charts unless someone asks for them, except to note that there has been a general trend of appreciation in the MYR particularly against the GBP and Indian Rupee (INR), except for against the AUD which went through a roller-coaster ride over the last year (2000=100):

Again, this has been a function of the carry trade, in which the AUD was one of the main targets. The onset of the financial crisis in August last year caused a sharp pullback in risk taking among international investors, including unwinding of currency positions. That helped boost the JPY, and prompted a selldown of target currencies like the AUD. As normalcy returned, so did the carry trade – hence the recovery in AUD.

I should note here that the INR, IDR (Indonesian Rupiah), PHP (Philippines Peso) and VND (Vietnam Dong) all look overvalued relative to the MYR to me, but that’s consistent with their relatively smaller trade exposure and regulated capital accounts. Unless the latter is opened up, these currencies should keep their elevated status. On the other hand, MYR appears overvalued against both HKD and TWD.

Technical Notes:
1. Forex data from the Pacific Exchange Rate Service.
2. CPI data from DOS, International Labour Organization, Eurostat, Australian Bureau of Statistics, and the General Statistics Office of Vietnam.

1 comment:

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