Ringgit Fallacies: Imported Inflation and International Reserves

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

Be that as it may, two things I’m hearing these past weeks are: domestic inflation is going to accelerate from imported inflation (a mantra that’s been going on now for quite some time), and the sharp drop in international reserves raises risks of a Ringgit collapse.

Both sound plausible; both are wrong.

First, imported inflation. Econ 101 will tell you that, ceteris paribus, a decline in the exchange rate would raise the domestic price of imported goods i.e. imported inflation. The problem is that we’re not in a  ceteris paribus world – the real world is actually pretty messy, and nothing stays the same.

Let’s put this into context. In this particular circumstance, we’re actually looking at two mutually reinforcing forces. First is that the pending tightening of Federal Reserve monetary policy (I’m ignoring the UK for the moment) relative to economic weakness in the rest of the world means a general shift away from other assets into USD assets. This translates into the USD appreciating against all other currencies, or at least those which are either floating or pretending to float. What does this mean for the price of imported goods elsewhere?

Unless you’re importing goods from the US (in which case, ouch), not much. Even if goods are generally invoiced in USD, that’s generally more for convenience than anything else. Real prices should not change if currency cross rates (i.e. anything but the USD) stay the same. The MYR NEER has dropped over the past year, but nowhere near as steeply as against the USD (index numbers; 2000=100):

The MYR has suffered a 20pt drop against the USD, but less than half that against the full basket our trade partners currencies. The impact on prices of imports should therefore be correspondingly less. By the same token, there won’t be a sudden boom in exports due to a “weaker” Ringgit, because the Ringgit hasn’t really dropped that much.

Even more important is the second factor – the drop in commodity prices (IMF All Commodity Index; 2005=100):

Aggregate commodity prices have dropped by a full third in the second half of 2014; a select few, like crude oil and iron ore, have dropped even further. What this means is that energy and raw material input prices for finished goods have dropped substantially. International producers can mostly afford to maintain local pricing for goods, because their profit margins have increased enough to offset the lower revenue (in USD terms). A few have taken advantage of the changes in terms of trade to try and have it both ways (higher retail prices + lower input costs), but most are content to maintain their margins.

Forget imported inflation – we’ve been importing deflation since last year (index numbers and log annual changes; 2005=100):

More formally, I’ve tested the impact of changes in USDMYR on import prices, using a data sample from the start of the float of the Ringgit in July 2005 to the present. There is a very weak correlation, but once you account for serial correlation (from import price persistence), the result is a big fat zero. Movements in the exchange rate are NOT driving changes in imported inflation, much less inflation as a whole.

Moving on to the role of international reserves. I’m continually bemused by the tendency of nearly everyone (local and abroad) to analyse the situation as if we still live in a Bretton Woods world. So let me make it clear – in a floating exchange rate regime, international reserves don’t matter. The choice of whether to utilise international reserves to support the currency is solely a matter of central bank discretion.

In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

The vast majority of the population will not be affected – the ones who are, are mostly in the upper tier of the income distribution and can presumably take their shopping elsewhere (I’m buying stuff off EBay Germany these days). Concerns over imported “inflation” hitting the man on the street (or businesses for that matter) are overdone, as I’ve demonstrated above. Multinationals who dominate Malaysia’s manufacturing sector don’t care – both their outputs and inputs are denominated in USD, and the decline in the exchange rate just improves their domestic profit margins. The capital markets are obviously affected by capital outflows, but then Malaysia’s equity and bond markets were pricey anyway, and amazingly still are relative to the rest of the region. All the doom and gloom on the markets appears to have glossed over the fact that Malaysian market valuations are just coming down to the regional average.

Again, to put all this into context, Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

Also missing in the commentary is the cost of accumulating and maintaining international reserves. Since buying reserves is inflationary and thus needs to be sterilised, and because the interest rate differential is typically positive between domestic and reserve currency rates, international reserves typically involve a net loss to the central bank and the country (unless you’re willing to take some risks). {The opposite is also true – utilising reserves to support the currency is deflationary, and thus undermines the economy through tighter monetary conditions. I really wonder why people think “stabilising” the exchange rate is such a good idea].

Another big issue is the habit of quoting reserves in USD terms. In a world where the USD is appreciating against nearly all other currencies, movements in international reserves are artificially exacerbated, as nobody keeps all their international reserves in a single currency. This habit can cause some embarrassment for the analysts involved, as in this smackdown by Singapore’s MAS earlier this year. BNM really ought to issue a similar statement (log annual changes; 2005-2015):

Note that reserves in USD terms is far more volatile than in MYR terms. People will of course look at the steep drop in reserves since 2014. To which my response would be: so what? I repeat: we’re not living in a Bretton Woods world of fixed exchange rates. BNM can, and in my view should, stop intervening, until and unless the banking system itself is running short of USD.

Speaking of which (RM millions; 2005-2015):

Looks pretty healthy to me. The banking system were under greater stress after the the “taper tantrum” in 2013.

All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

I recently met an Australian trade delegation, who were smugly proud the Aussie dollar has crashed. The only reason why the Ringgit is the worst performing currency in Asia, is because nobody considers Australia as being Asian (which must frustrate the Aussie government no end).

The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.