Monday, November 24, 2014

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


  1. "Um, how does that work, exactly?"

    Because US dollar is the reserve currency. I believe they can print as much as they want and won't suffer any hyper inflation or a crash in the dollar. Reason being that if US dollar goes to the toilet, so does the entire world, even more so for the ringgit. Which I don't think it will happen.

    Put it that way, if you can choose to be paid between US dollar and Ringgit, which currency will you choose? I believe most people around the world will choose to be paid in US dollar.

    1. @Latuk

      Of course the USD is a reserve currency. But you're committing a fallacy here. The Dollar has been a reserve currency for nearly one hundred years. Given that it was a reserve currency six months ago, and a reserve currency today, that's not a significant enough explanation for the changes in capital flows between then and now.

      And Malaysia can print money too - in fact, we do it everyday (and no, it is not BNM's doing). So do all countries with their own sovereign currencies.

  2. Well, Hisham....when you are a country with the premier "reserve currency" and are the biggest player in financial markets, you are allowed to get away with stuff.

    Put it this way, would the world's rich and famous (including those in Asean) prefer to hold a substantial portion of their wealth in Ringgit or US Dollars, or in assets denominated in those currencies.

    Ok, that's a naughty question, but such are the realities of power.

    Which are not susceptible to explanations by rational economists!

    1. @bee farseer

      See my answer to Latuk above. The same statistical test applies.

  3. Where's the question?

    Or did you miss out a question mark?

    Ok, levity aside, you do make a salient point.

    That is, in a world dominated by the USD, EUR, JPY and, sooner or later, the RMB, the rest of the world's currencies have to scramble to keep themselves relevant in the eyes of investors and "the markets".

    It's an unfair world, isn't it?

    But is the solution capital controls and a MYR-USD exchange rate fixed by government fiat?

    As an "open" trade-based economy, I don't think that Malaysia has much choice in the matter.

    Which is why I am very sceptical about the prognostications of economists.

    Because the US Fed can change the rules of the game any time!

    1. @anon 2.41

      Just to be clear, I'm not complaining about the drop in the Ringgit, I'm complaining about the nonsensical rationalisations people are coming up with.

  4. Let's have some more facts. Are there any other currencies with the twin deficits that everyone's talking about? How has their currency performed?

    1. I would argue that it's not so much "twin deficits" per se, but whether a country is deemed to be too big to fail.

      I am not overly worried about Malaysia's budget deficit, nor am I thinking that the trade stats will go into deficit any time soon.

      Commodity-based economies should worry as Chinese demand softens. Western Australia is already facing this with the rapid downturns in coal and iron ore prices.

      Opec is debating whether to cut production to maintain "floor prices" for crude oil and natural gas.

      This will have knock on effects on their currencies.

    2. @rodger dodger

      The worst performing currency this year is the SGD, even worse than the Ringgit. And Singapore has twin surpluses. Go figure, because I can't :D

    3. @anon 4.17

      Only those who allow their currencies to remain tied to the USD, like most Middle Eastern producers. Malaysia's floating rate partially insulates us from changes in commodity prices - not fully, mind, but better than nothing.

    4. So true, Hisham. Despite Russia's reliance on oil exports, the decline in rouble has been in tandem with the decline in oil price, so their budget deficit has been manageable in rouble temrs (read the article in today's The Edge). Only thing they need to do is to limit their imports (which they have been doing due to the sanctions).

  5. Hisham I agree with u that the markets can be irrational but I'd hazard a guess that foreign investors are more spooked by the lack of strong political stewardship ie the real possibility of the incumbent govt losing in the next next general elections and the uncertainty that may follow than by the govt's recent economic reforms which though praiseworthy have failed to address the serious issues such as continuing leakages in govt revenues, lack of transparency in awarding of public contracts and institutionalised corruption ��

    1. @dukuhead,

      You mean like Singapore? Oh wait... J/K :D

      Actually, a lot of currencies have been hit, not just the MYR. Virtually no one has been spared. That's why explanations based on local circumstances sound so silly.

  6. Perhaps what investors are focused on are the relative growth prospects of the two countries. A declining current account surplus suggests that Malaysia's growth is declining, especially if it's due to a decline in exports. The US is not growing like gangbusters, but growth is expected to at least increase. Switching out of Malaysian assets into safer US assets seems reasonable.

    The US' double deficits aren't indicative of a weakening economy. Malaysia's might be.

    1. @whither the lion

      Malaysia's current account surplus is declining due to higher imports of capital goods, mostly from the ETP.

      Deficits aren't a sign of weakening or strengthening of an economy; rather they're indicative of imbalances.

  7. Hisham,

    Based on the latest available info, what will be the impact of the drop of the crude oil prices to USD75-80 on the Malaysian Govt's Budget for 2015. It was reported that RM37 billion has been budgeted for fuel subsidy. Will the savings from the cut of subsidies for the RON 95 and diesel enough to compensate for the lower tax revenue from petroleum products due to the lower world crude oil prices? Any impact on the projected budget deficit for 2015?

    1. @Value Investor,

      Most of the research houses suggest that the impact will be negative, but not unmanageable. The revenue contribution is far bigger than the subsidy outlay (which also includes BR1M). That RM37 billion figure is the total subsidy bill, and the portion for fuel is actually far smaller.