Thursday, March 5, 2015

The Facts of Life: Monetary Policy Edition

[Rant Mode On]

Lim Sue Goan on the economy and the Ringgit (excerpt):

Bleak economic outlook for the Year of the Sheep – Lim Sue Goan

...The PM should put more focus on economy instead, in view of the plummeting international oil prices and a significantly weakened ringgit....

...Thirdly, the government should support the ringgit. The continuous fall of ringgit has brought up operating costs for many businesses resulting in import inflation. In the long run, the depreciating ringgit will harm the country's economic fundamentals.

Rafizi Ramli on petrol prices and the Ringgit (excerpt):

Harga RON95 Dan Diesel Bagi Mac 2015: Kejatuhan Ringgit Penyebab Harga Minyak Meningkat

….Jika Dato’ Seri Najib Tun Razak menyalahkan pasaran minyak mentah dunia akibat turun naik harga minyak, beliau bertanggungjawab sepenuhnya kepada turun naik kadar matawang RM. Di bawah pentadbiran beliau sebagai Perdana Menteri dan Menteri Kewangan, kadar matawang RM kini jatuh ke paras terburuk sejak krisis kewangan Asia 1998.

Kenaikan harga petrol dan diesel yang akan dihadapi oleh rakyat Malaysia dalam bulan-bulan mendatang adalah akibat kegagalan beliau sebagai Perdana Menteri dan Menteri Kewangan.

What do these two (very different) commentators have in common? They both think the government, or more correctly Bank Negara, should do “something” about the Ringgit. They’re hardly alone, as I find this to be a common sentiment.

Here’s how I think the PM and the Governor should respond:

To be fair, exchange rates are confusing at the best of times, and I’ve been studying them for twenty years.

But what are the practical consequences of “supporting” the Ringgit? Well, Bank Negara could spend some of that hoard of foreign exchange it has (which for some strange reason some people think is kept in a cash vault in a subterranean basement at BNM) on buying up Ringgit. That would reduce the amount of Ringgit in circulation, which would drive up its value relative to the US Dollar. Simple, right?

Except reducing the Ringgit money supply increases its “price” (money demand will exceed money supply). All things equal, this equates to an increase in domestic interest rates.

But, as some of the more-in-the-know commentators might argue, they can always sterilise, right? Yes they can – by injecting more Ringgit into the market by buying up government securities and bills. But by doing so, they increase the amount of Ringgit in circulation again relative to the USD, and the foreign exchange rate goes back to square one. Sterilisation weakens and nullifies the original currency intervention.

Under the conditions of free capital mobility, you can only control either domestic interest rates OR the foreign exchange rate, but not both simultaneously. Trying to “support” the Ringgit is tantamount to giving up Malaysia’s hard won monetary policy credibility anchored on the OPR. The converse is true: there is no such thing as a currency defence if domestic interest rates do not rise. The interest rate defence and FX intervention approaches to maintaining a currency exchange rate are effectively the same thing; you can’t have one without the other.

A second problem is that if the market thinks the Ringgit’s market value should be weaker, you’ll have to continuously keep buying up Ringgit as long as the market rate is out of line with demand and supply. Eventually you’ll run out of FX reserves, but not before you’ve pumped up domestic interest rates to truly punitive levels.

To take an extreme recent example, Russia started off 2014 with a benchmark interest rate at under 6%. As oil began to crash and selling pressure built up on currencies of oil exporters, the central bank stepped in to buy Roubles against the USD. This is what happened:


Not pretty, and this is hardly the worse case I’ve seen. In Malaysia in 1997, overnight interest rates at one point hit 50% (!). Don't look now, but Brazil is also going down this route (the policy rate has been hiked 1% in just two months, despite a weakening economy).

So don’t worry about the Ringgit. It actually hasn’t dropped very much, and things could be much, much worse. Like, BNM could seriously be listening to Mr Lim, YB Rafizi, or worse, Mr Tong Kooi Ong. Then we’d really be in trouble,

Smile and wave, boys, smile and wave.

[Rant Mode Off]


  1. Thanks Hisham for putting things into the right perspective.

  2. Hi hisham.
    1) Didn't russia embark on an interest rate defense which is the main cause of interest rate hikes as opposed to buying back rouble?
    2) Can you explain the mechanics of how buying back currency causes higher interest rates for my learning? Tq

    1. @J

      1. They actually did both. Foreign exchange reserves fell about 25% in the second half of last year IIRC

      2. Read this first. Exchange intervention is functionally the same, except you're using foreign exchange instead of central bank bills. Either way results in a reduction in domestic money supply, and thus rising market interest rates.

    2. 1) Not trying to find fault. But it was implied in this article that the chief cause for the drastic increase in interest rates was because of the buying of Rouble. Now that it's clear Russia did also do an interest rate defense, the example appears a bit mischievous?

      2) I'm still trying to understand. I know that liquidity is what affects interest rates. When you suck up money from the Forex market, what is the mechanic by which it affects the liquidity in the domestic market? And how long is the delay?

      TQ for being patient.

    3. Another question just to check my understanding. How realistic a scenario is it for KLIBOR rates to:
      1) Go lower than OPR (I'm guessing not realistic, as BNM will issue more bills at OPR yields)
      2) Go higher than OPR (I'm guessing realistic, as in a liquidity crunch, someone on the open market would just offer a higher price)

    4. @J

      1. I wasn't implying you were. But forex intervention is a de facto interest rate defense, though not vice versa. The main difference is in what you're selling.

      2. In a forex intervention to prevent a depreciation of the domestic currency, you buy domestic currency and sell foreign currency. But buying domestic currency is equivalent to reducing domestic liquidity, and the effect is immediate. The impact of orex intervention, if large enough, is thus to directly raise domestic interest rates.

      In a typical financial system, interest rates are not set administratively. The central bank has to adjust domestic liquidity to achieve the stated target. They do this by selling bonds for domestic currency, thus reducing liquidity in the system and causing interest rates to rise.

      Looking at the two types of intervention, the only difference is that in a forex intervention, the central bank is selling foreign exchange, whereas in an interest rate defense, the central bank is selling domestic currency bonds. For all intents and purposes, the two are the same as far as the impact on domestic liquidity is concerned.

    5. @J

      On the KLIBOR question, the OPR is a target with an intervention band (about 25bp up or down).

      It's hard to say if BNM's response is asymmetrical - the daily data over the last couple of years shows a slight bias towards allowing overnight rates to drift below the OPR but there have times when it's traded near the top of the intervention range.

      Capping a rate increase (increasing liquidity) is actually easier than a rate decrease, because its cheaper - BNM creates new money and uses it to buy or redeem bills or deposit the money in the system. Issuing bills to reduce liquidity (raise interest rates) means having to pay interest.

  3. Tq for your explanations. Ever the masterful and willing teacher