Friday, October 16, 2009

Why The IMF Thinks MYR Is Undervalued

In keeping with the forex theme this week, in my last post I pointed out that Singapore is accumulating international reserves at a faster pace than Malaysia, but yet is considered to have a "strong" currency. Later I linked to research that suggested that SGD was as undervalued as the MYR, while the IMF suggested SGD was only slightly undervalued. Why the divergence in opinion?

There is of course the difference in methodologies used to determine currency misalignments (which I talked about here, here and here). But what I'd like to point out today are two potential issues that may be affecting MYR currency misalignment analysis.

The first issue lies with differences in calculating the real effective exchange rate index (REER) itself which may be to blame. To illustrate, here are my calculated nominal and real indexes, compared with the published IMF calculated indexes:

Notice that the nominal indexes are more or less equivalent, with any differences attributable to the currencies included in the basket as well as changes in the weighting scheme. I calculate my indexes with weights changing on a quarterly basis, while the IMF changes once every five-ten years or so - but doesn't appear to make a significant difference here.

There is however a substantial divergence in the REER indexes, with the IMF REER much higher in 2008 - and thus indicating that the nominal rate is too low, and the exchange rate is undervalued. The main difference between the real and nominal indexes is the application of price deflators in the real index, which are used to adjust currency values based on inflation. For the IMF index, CPI inflation is generally used for most countries except for OECD members, where unit labour costs are substituted.

Since CPI inflation can more readily go negative than unit labour costs (as we've seen this past year), that puts an upward bias into the IMF's REER index in periods of disinflation or deflation, especially with OECD countries taking more than a third of the total weight in the MYR index.

Another issue is one of export structure. Most analysis, including the one I linked to in the last post, use aggregate exports when running regressions (heck, so do I). The problem here is that when there is a commodity bubble, prices might go up without output necessarily increasing to the same degree. For example, palm oil and rubber (log annual changes, export volumes and values):

If the increase represents a transitory change, then the degree of currency adjustment required to rebalance the current account will be inflated - hence current account approaches to exchange rate determination, such as used in the aforementioned paper and in two of the three methodologies used by the IMF, would tend to overstate the equilibrium level of the exchange rate.

As an aside, I made the point in my last post that positive terms of trade shocks would see the income effect dominate, and would not reduce volumes very much. The behaviour of agricultural commodity exports over the past few years is certainly suggestive that my conjecture is worth considering.


  1. I don't think its possible to pin point an exact value, neither do I think the Ringgit band would change anytime soon. Whilst you look at exports, our import our tremendous as well, and most of the reserves we accumulated over the last 10 years was in 2003,2004 and 2007. At the same time our Balance of Trade for 08 was negative, for 09 is in the black.

    If things remain the way it is (which never happens) then the Ringgit should appreciate as most of the foreign money has left the shores alread ($150 billion over the last 10 years), so the balance of trade would look better.

    But things rarely stay the same. Any new innovation from the Stanfords and the MITs, especially ground breaking new technologies in semiconductors, for example using optical chip technology as opposed to silicon wafer could mean the death knell for the country if the new factories emerge in places like China, India or any of the other countries who have cheaper and smarter labour.

    Thats why the foreign outflow of $150 billion is a double edged sword; it shows what the Rest of the World thinks of the country, and by all means the verdict is an unequivocal thumbs down.

  2. This comment has been removed by the author.

  3. You can't pinpoint an exact value, you're absolutely right - it's something I've been harping on ever since I started this blog.

    And you're also right the level of the Ringgit doesn't vary very much, especially in terms of its trade-weighted value - which to my mind means that the actual market value isn't far off its medium-term equilbrium value.

    In short, MYR isn't "weak" by any means.

    Also exports and imports appear to be cointegrated - which is a technical term meaning that there exists a long term relationship between the two variables. They are not independent, something I've used to good effect for instance here.

    Imports go up when exports go up, for the simple reason that exports contain a high-import content, which is equivalent to saying "low-value added". The trade balance only really shot up in 2007-2008 during the commodities boom, as the import content (especially of electronics) of those exports are lower. Looking at one side of Malaysian trade is almost the same as looking at both.

    And your point about reserve accumulation is only somewhat correct - but I'd say that MYR was undervalued from 2003-2005, and reserves jumped in 2008 from commodities income. Balance of trade in 2008 was net RM142b in the black (or are you referring to the whole BOP?).

    I'm curious where you got the data for "foreign money" from? (Is that USD btw? and for which period?). If you're referring to last year, then most of the outflow was due to the crisis and a flight to quality, which affected all markets and currencies in favour of the USD, not just Malaysia.

    If you're referring to the whole decade up to now, then most of the money is actually Malaysian investment abroad (negative for MYR), which ought to come back to us via an improvement in the income component of the BOP (positive for MYR). On the whole, countries with a positive net foreign asset position (high outward investment) tend to paradoxically have stronger currencies.

    [sorry for editing - changed volatility to levels, which is what I meant to say)

  4. Dear En. Hisham H,
    Warm Regards from The Rembau Times

    I agree with the export and import being cointegrated.

    As to Portfolio investments, net flow was negative right up to the time when Pak Lah became PM, and then it turned positive, until the recent market turmoil.

    As to the flow of Funds out of the country, I am referring to the Financial Account in the Balance of Payments - "Direct investment Abroad". The total sum is a negative USD 143 (RM432) billion over the last 10 years.

    Yes it is certainly possible that this would include Malaysian firms making investment abroad, but it could also include foreigners selling hard assets and moving overseas. Right now without the detail we do not know, but we can get a clue by looking at the Investment Income portion (Flows In). In 1999 it was a 6+billion, in 2008 it was 40 billion RM. So a gain of 34 billion a year; but in the same token a cummlative sum of -RM432 b was recorded in the BOP Direct Invesment abroad account. If that is all foreign invesment abroad by Malaysian firms, then it means on average we are acquring RM 43.2 b more assets overseas per year, we do so for a period of 10 years, and our cash flow after year 10 is still only 34 b more per year than our base year, that means the project has a negative NPV. So it must be that some of this money is foreigners taking the money and leaving.

    The second issue is when we see that most of the funds in the Direct Investment column have their destination as Labuan. It seems strange, I can never can understand why we need Labuan, perhaps I am no where near as smart as the all wise Dr. Mahathir, but it does seem strange.

    That is why I said on a net basis, foreigners took out a lot of money from hard assets in this country.

    Its just my suspicion, but the data seems to support it, no?

  5. Thank you for the clarification. I wasn't necessarily disagreeing with you, just wondering as to the provenance of the data you were working from.

    Let me digest this for a while and I'll get back to you (watch for a post tomorrow - work calls I'm afraid).

  6. I'm not sure how to reconcile this:

    You state that DI abroad reached a cumulative USD143 billion for the last ten years. According to the official figures, it's only RM143b and only if you shorten the period to 2001-2008.

    If the latter figure is correct, and even after stripping out inward income flows from portfolio investment, that gives an average annual return on investment of around 15% at at 2008, which isn't too bad especially since that's not even counting reinvested earnings.

  7. I've just checked with IMF IFS data. DI abroad comes to approx. USD44b from 1999-2008, and about USD41b from 2001-2008, which jives with the official BNM figures.

    Taking the financial account as a whole, the figures are USD61b for 1999-2008, and USD48b for 2001-2008.

  8. Analysis is up: