Chart of the Week: Valuing the Ringgit

I’ve done this exercise once before (see here), but this way is probably a lot more intuitive for most people. The TL:DR version – the Ringgit is undervalued, but not by much:

The chart above has the USDMYR exchange rate on the right, and the Fed’s USD broad nominal effective exchange rate on the left, from 2005 to the present. The correlation is very close – better than 95%. In other words, almost all the variation in the MYR exchange rate has come from movements in the USD rather than factors idiosyncratic to the MYR.

I won’t say that the gaps between the lines are good measures of the MYR’s over- or under-valuation, but they are indicative. In the MYR’s recent history, there’s been two episodes of obvious misalignment, roughly from mid-2015 to early-2016, and from the end of 2016 to the present.

The first you can probably call the 1MDB effect, and just like in my previous exercise, you can say it was indeed a factor in pushing down the MYR. However, the effect was short-lived, again roughly coinciding with the sale of Edra Energy.So to the idea that 1MDB, and Malaysian governance generally, has any bearing on the Ringgit exchange rate: please go away. You’re not relevant anymore.

The second coincided with the US elections and probably more pertinently, BNM’s reaction to the change in global capital flows it triggered. I’d call this the fear-of-capital-controls effect. It’s still persisting, and I’d call it a roughly 5% deviation from where the MYR should be (around RM4.00 to the USD).

The bottom line is: Yes, the Ringgit is undervalued, but probably not as much as people think.

An Exorbitant Privilege

One of the big themes over the past year has been the strength of the US Dollar, which has appreciated against currencies and commodities since the middle of last year. That pushed many currencies into “undervalued” territory – exchange rate levels that are below what is suggested by their economic fundamentals. That’s certainly the case here in Malaysia, oil price declining notwithstanding.

But given that its been largely a move by the USD, it would be fair to flip the question on its head: If other currencies are “undervalued”, the opposite must also be true. How “overvalued” is the USD?

US Ratings Downgrade: The End Of The World Is Nigh! Again

I hadn’t touched a computer since last Friday, so I only heard the news Monday morning. While S&P’s move was a bit of a surprise, coming as it did on the heels of the agreement last week on the US debt ceiling, it wasn’t an absolute shocker. The magnitude of the US national debt – and more importantly, who’s holding it – suggests that the risk was always there.

Fundamentally though, nothing has really changed since last week or last month. I can’t help feeling that the ratings agencies are bolting the stable door after the horses have fled. They were roundly criticised and partly blamed for the CDO mess that caused the liquidity crunch in 2007-2008 – both in rating structured products at AAA grades as well as for failing to downgrade fast enough when it became clear that most of the stuff was junk. This is perhaps S&P’s way of saying never again, as the downgrade is a bit of a paper tiger.

What makes this all ironical is that because US government borrowing is all denominated in US dollars, the risk of default is effectively zero. Hence, I don’t know if there’s going to be any real impact on US debt issuance or investor appetite for US treasuries. Even as equities worldwide faced a sell-off, when I checked just now – as I suspected would happen – US treasury yields were down, not up as you would expect on a ratings downgrade. The news just provided investors an excuse to act on their fears over global growth, as equities have looked overbought to me and many others since early this year.

But flight to safety leads directly back to US sovereign debt. So you’ll have this paradoxical situation of the debt downgrade leading to higher demand for the very debt that supposed to be less credit worthy (and incidentally, higher demand for the USD). Go figure.

And before anyone starts blaming the Fed for treasury price movements, let’s note that QE2 ended last month and hasn’t been extended (yet). I’ll also note in passing that the ECB took the opportunity today to quietly expand their QE program, adding in Spain and Italy to the existing support they’ve extended towards Greek, Irish and Portuguese debt.

We’re truly living in interesting times.

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.

Monetary Policy Update III: Is The Ringgit Oversold?

There has been a lot of movement on the currency front over the last year or so. Here's the trends against the G3 currencies (index movement relative to Dec 2007, 2000=100, all charts use MYR as the base currency, hence a rise is an appreciation, a fall a depreciation):



Between Dec 2007 and Dec 2008, MYR lost 10.2% against the USD, 1.3% against EUR, and 26.7% against the JPY. The tight trading range against the EUR is pretty remarkable. Against the Yuan and the other "dragon" economies:



Notice the massive appreciation of 37.2% against the KRW to the end of 2008. Against the rest of ASEAN plus Vietnam:



The contrast in different trajectories is striking between this group against the "dragon" group. Finally, the other major trade partners we have a general trend of appreciation:



However, on the whole, MYR has been depreciating through the year even including inflation adjustments. On a trade weighted basis:



...and cumulative gains/losses:



The question is: is this depreciation an equilibrium movement, or a disequilibrium movement? It is well known and documented that movements in currencies over the short term cannot be predicted with any accuracy, and that currency exchange rates tend to stray from the rate predicted by economic fundamentals for long periods of time. The fact that currency markets are perhaps the largest, deepest, and most liquid in history makes the latter phenomenon extremely vexing to economists, particularly free-market fundamentalists.

But back to the question at hand, a believer in Purchasing Power Parity (PPP) would strongly be of the opinion that MYR strengthening has a long ways to go. The IMF estimates the implied PPP conversion rate for MYRUSD is 1.967 in 2008, the World Bank estimate is 2.105 for 2007, while the Penn World Tables suggest 1.28! On the other hand, evidence for strong-form PPP being a determinant of exchange rates is extremely weak, even over very long periods of time. Similarly, interest rate parity does not appear to matter unless you add in a time-varying risk premium and expected inflation, both of which are unobservable variables and thus not amenable to rigorous empirical testing. I’ve covered this and other arguments against PPP in my exchange rate policy posts (here, here and here).

Based on the variables I identified in those posts, what appears to matter (strongly) for the MYR are terms of trade and government consumption. On that basis the long term annual model I have suggests the MYR was overvalued by about 5.5% at the end of 2007. The model hasn’t been updated since I first estimated it in late 2008, mostly because the data requirements are extremely onerous (24 currencies, 14 times series for each). A lot has changed since then, particularly with the relative changes in government spending as well as a sharp fall in commodity prices, which changes the terms of trade. Insofar as individual fiscal stimulus spending plans cancel out, the prime factor behind the MYR depreciation has been a change in the terms of trade.

In summary, what I think we’ve seen in 2008-2009 is a move to equilibrium, as well as a change in fundamentals i.e. the equilibrium rate has been falling as well. What that means is that I suspect the MYR is still overvalued, and may have a bit further to fall. This is weakly supported by the real exchange rate being below the nominal exchange rate.

Where MYR weakness will manifest itself is likely to be against the Yuan and the “dragon” currencies (with the exception of the KRW) and not necessarily against the USD, which has its own reasons for weakness. That’s an opinion and not a prediction by the way – foreign exchange rate determination is complex enough at the best of times. Note that my argument here implies that the MYR is actually not that far off its true equilibrium value, and is very much in contrast with the rest of the domestic investment/academic community who still seem stuck on PPP as the appropriate valuation method for exchange rates.

Interesting sidenote: In general, nominal and real rates for MYR track closely for free float currencies (USD, EUR, GBP), and has tended to diverge with currencies that are either pegged or feature intervention (very, very obvious for JPY, Indian Rupee, and Vietnam Dong). Does this make the MYR a free float currency? It sure looks like it to me.

Technical Notes:
All currency data from Pacific Exchange Rate Service. CPI deflators are from various sources including the IMF, ILO, and national sources.

Unwinding Global Imbalances

As a quick follow-up to my last post, the BEA last night posted Febuary data on US international trade. There's been a marked improvement in the trade balance:



That's the lowest level in the trade deficit since November 1999. The bad news is that it's been driven by a sharp contraction in trade:




Interpreting this in light of my last post, I don't think there's any question that global trade and savings imbalances are being unwound right now and fairly rapidly, without a big adjustment in the USD (although I think that's probably still on the cards). Right now funding the deficit has fallen to an average of $1 billion a day, rather than the $1.9 billion required last year.

As to how sustainable this is, about half the reduction in y-o-y imports comes from a lower oil bill, and another sixth or so from lower imports of cars. If and when growth resumes, both these categories are likely to pick up again, so we're not out of the woods yet.

Links of the Day

Dani Rodrik posts a reply from the ILO on monitoring global stimulus plans:

"We at the International Labour Organization (ILO) have been keeping track of the stimulus efforts of 40 countries (including the G20) for our annual report and other work. While I agree with most of Gallagher's conclusions, there are factual inaccuracies in their work. Here is my quick response (I also posted comments on your blog):"

and Brian Setser shows why the USD is strengthening despite the ongoing US economic malaise:

"Part of it is that other countries are now in worse shape that the US; what started as a US crisis turned into a global crisis. Part of it is that a fall in the price of oil is good for the US (lower oil import bill) and seemingly good for the dollar. And part of it is that — judging from the TIC data — Americans are selling their foreign investments in “risky” assets faster than foreigners are selling their investments in risky US assets...The huge surge in demand for t-bills from central banks and private investors alike hasn’t hurt either."