Ringgit Under Pressure? Markets Are Irrational

I was going to write about this last week, but it got put on the back burner by the suspension of the fuel subsidy (excerpt):

Ringgit down to four-and-half-year low

KUALA LUMPUR: The ringgit has fallen to a fresh multi-year low against the US dollar, as sentiment has been somewhat dented by Malaysia’s shrinking current account surplus and slower economic growth in the third quarter of 2014.

At 5pm yesterday, the ringgit was being traded at 3.3565 against the greenback – the weakest level since May 2010. The ringgit is the second-worst performer in the region after the Singapore dollar so far this year. Over the last two weeks, it had declined 2% against the greenback….

…Analysts said the narrowing current account surplus put Malaysia in a less favourable position compared with the other countries….

…“The dollar is rising broadly against most major currencies in the world in anticipation of the United States tightening its monetary policy stance, involving a rise in its interest rates, next year.”…

…An economist said that the fear amongst currency traders was that Malaysia’s long streak of surplus since late-1998 might be broken, leading the country to a twin-deficit situation.

Malaysia has already been running on fiscal deficits for the past 16 years. Its fiscal-deficit-to-GDP ratio stood at 3.9% last year.

A narrowing of Malaysia’s current account surplus would give rise to concerns about the risk of the country slipping into twin deficits, a situation where an economy is running both fiscal and current deficits.

An economy with twin deficits is particularly vulnerable to capital reversals, which could impact the value of its currency, as was the case with India and Indonesia last year when their financial markets and currencies took a huge battering, as investors withdrew from emerging economies with twin deficits, because these countries were deemed to be structurally weak.

Oh, the irony. Let’s follow this logic shall we?

Investors and currency traders are selling the Ringgit in favour of the US Dollar, because the interest rate differential between the two countries is about to change. The Fed is expected to raise US interest rates in the second half of 2015, while BNM has disappointed the markets by not budging in the last two MPC meetings.

So far so good. The yield in one currency is going up, while the yield on another currency isn’t. All other things equal, there would be a capital flow from the second currency into the first. Never mind that Malaysia’s policy rate (3.25%) is still well above the Fed Funds Rate (still 0.25%). We can take that 3.0% difference as the currency risk premium (which I’ll return to at the end of this post), or differences in inflation expectations, and still take this change in capital flows as perfectly rational.

But this story about current account and twin deficits doesn’t look rational at all.

This is the situation in Malaysia (% GDP):

You can see clearly here what the article was talking about. Malaysia has had a consistent fiscal deficit since 1998, counterbalanced by a strong current account surplus. But that surplus has been in decline since 2008, and is set to contract further over the next few years. So there’s obviously some backing to investor fears over the twin deficit problem (which I don’t disagree with, by the way).

Right, right?

Only thing is, they’re selling Ringgit in favour of US Dollars, and this is the situation facing the US (% GDP):

Not a hint of a surplus anywhere. The US hasn’t run a budget surplus since Clinton was in office; the trade balance has been decidedly negative since Bush Sr. ran the White House – 20 odd years and counting.

So investors are fleeing the Ringgit because the fear that Malaysia is turning “structurally weak”, and buying instead the currency of a country with the precise features they’re trying to avoid.

Um, how does that work, exactly? Tell me again about efficient markets and rational expectations, because it sure doesn’t look like the real world behaves that way.

Now, you could conjure up an explanation that this very obvious papering over of economic fundamentals could be explained by a country’s risk premium. In other words, Malaysia is perceived to be more risky, so requires a higher rate of return before investors will take a chance on its markets.

But economists who’ve tried to model currency risk premiums have tended to find that it’s time-varying, even after controlling for various other fundamental factors. To translate that into simple English: the risk premium is a convenient label for our ignorance of why investors behave the way they do. Or their irrationality.

Technical Notes:

All data from the October 2014 World Economic Outlook database from the International Monetary Fund