Tuesday, July 19, 2016

5 Thoughts on the OPR Cut

At the risk of getting a phone call from across the road, here’s what I think of last week’s 25bp OPR cut:

1. Surprise!

One of the reasons the move came as a surprise to the markets and everyone else was that it was not telegraphed beforehand. Nobody got a hint of any change in policy, right up to the announcement. On the one hand, this breaks with recent practice around the world, where guidance is given so that markets adjust in a relatively orderly fashion. On the other hand, if you believe in the neutrality of money and rational expectations, surprise changes in monetary policy are the only changes that work. More on this in a bit (see point 5).

2. Market moves

The first reaction to the announcement was a sharp selldown in the Ringgit, followed by an equally sharp buy up of the Ringgit. Meanwhile, the MGS yield curve shifted downward a full 10bps. How to explain this seemingly contradictory market reactions (popular question I got last week)? Point one is that the bond market had mostly priced in a rate cut since March/April already, so the only real surprise was the timing (most expected a move at the September meeting). Hence, the relatively small movement of yields – though if you talk to bond traders, 10bp in a day is a pretty massive shift.

Much of this shift – and the see-saw movement of the Ringgit – was less about the cut itself, but rather speculation over another cut in September/December. A lot of foreign money came in to position for a future OPR cut, and this helped the Ringgit strengthen again. The language of the MPC statement certainly left the door wide open for further moves down the road, though the Governor’s subsequent comments put a wet blanket on market ardour.

3. How effective will the cut be?

My rough guestimate (literally a back of the envelope calculation), is that it will allow corporations and households save something like RM2 billion in interest costs or approximately 0.2% of GDP. I could probably refine that estimate, but won’t bother. Nothing to sneeze at, but not a real game changer and roughly the same impact as the 3% cut in the EPF contribution rate. Datuk MI described it as a preemptive move to support growth i.e. in the context of this year’s forecast of 4.0%-4.5%. I think we can take that comment at face value – I see it as putting a floor underneath potential growth this year.

4. Reading the tea leaves

This is a difficult year to make policy if you’re data driven, given the distortions in the data. Let me count the ways:

  1. We had GST last year along with some hikes in excise duty on select goods, which drove up inflation temporarily. The measured effect on price increases will die off beginning in June this year;
  2. Companies and households also faced cash flow constraints last year, again due to GST, but are in a better position this year. We also have the EPF cut, minimum wage revision, and civil service pay revision, which will start having an impact in the second half of this year. Hence, BNM’s (and my) confidence that domestic demand will hold up;
  3. Oil prices were all over the place in the last 18 months, creating substantial volatility in the overall CPI. Core inflation has been much better behaved (and I wish more people would refer to that instead);
  4. The lagged impact from oil prices to government revenue means that, unlike corporations and households, the maximum impact on the fiscal position will come this year, not last year (see note below), with some spillover into next year. Given the aim of a reduced fiscal deficit and a debt to GDP ratio below 55%, this means as far as demand management this year is concerned, it’s all on BNM as the government’s hands are tied (actually, pretty much hand-cuffed);
  5. The phase-in of Basel III for the banks has played merry hell with monetary aggregates and interbank liquidity measures over the past year. That’s why we have M2 growth signalling recession, despite credit and economic growth still holding up relatively well even if they’ve slowed. Having said that, credit standards have definitely tightened;
  6. On top of all these domestic factors are changes in the international environment: from Brexit, to the expansion of ECB and BOJ QE, to China’s mini-stimulus, and negative interest rates in a few countries. All these shocks are creating distortions in financial prices and capital flows, which complicate policy making. On top of that again, we also appear to be in the midst of a structural change in the global economy as global value chains are compressing, which is causing trade volumes to stagnate.

I don’t think I can recall a year where there have been so many moving parts to try to figure out.

5. Changes at BNM

I always felt that the change in Governor would make BNM communication a lot more “interesting” and a little harder to read – at least I got that part right. This past week has certainly confused the markets and market observers, which is not necessarily a bad thing in itself, but might be detrimental to policy effectiveness. Here’s what I mean – the OPR cut was intended as insurance for growth, and the MPC statement certainly made clear that BNMwas ready to act further if necessary. That had the desired effect of moving borrowing costs down, not just for the banking sector, but for the bond market as well.

The Governor’s comments the next day on no further cuts being planned however, even with the proviso that the MPC would take subsequent events into consideration, basically undermined the drop in yields. This is important, because the development of Malaysia’s bond market over the past two decades means a significant portion of corporate financing is conducted through it and not just the banking system. In other words, some of the impact of the OPR cut (as marginal as that might be) was unfortunately lost. I don’t think this was intentional, but it does show just how much weight the Governor’s comments carry.

Nevertheless, one thing is clear from all this: This is no longer TS Zeti’s central bank. There’s a new sheriff in town.

Technical Notes:

There are five sources of revenue from oil & gas for the government:

  1. Petronas dividend – Forms the bulk of oil & gas revenue, and is neither price nor time sensitive for the government. Of course, for Petronas, it’s a different story entirely. This forms the bulk of the explicit government revenue from oil & gas, especially with the drop in prices;
  2. Petroleum income tax – also called PITA. Levied on upstream operators, this is sensitive to prices and comes with an approximate half year lag (as it’s based on earnings). Another big chunk of government oil & gas revenues;
  3. Royalties – this is levied on volume of production (again upstream) and is sensitive to prices, but with not much lag in payment. Not very significant in terms of tax quantum;
  4. Export duties – price and time sensitive, as this revenue stream also depends on the timing and volume of shipping overseas. Not very significant in terms of tax quantum;
  5. Corporate income tax – price sensitive and very lagged. The reason why I list this here is because LNG is considered as downstream production and therefore does not fall under PITA. The lag here is the worse among the oil & gas revenue sources because there is a lag built into LNG contracts from oil prices to gas prices (about 5 months, judging from the export data), and another lag from LNG revenues to earnings recognition and thus taxation. I think the impact from prices to government taxes could take as long as a year. Considering that LNG exports far outweigh crude oil and distillates, the effect of this lag on government revenue ought to be significant, but since the numbers are subsumed under overall corporate income tax, it’s hard to tell just how big an impact it actually has.


  1. Hi Hisham,

    A not-so-directly-related question: why do banks reduce only 20 bps in their BR? Isn't that their cost of funds now 25 bps lower?

    Or is it up to the banks to decide based on the competition for loans?

    Thx first.

    1. @Fung

      Under the old BLR system, changes in the OPR moved the BLR one for one. Under the new system, it depends on the cost of funds of individual banks. Not all deposits have floating interest rates - banks still have to pay the old rates on FD for example, until they mature and are rolled over.

      Add to that the competition for deposits (not loans), and the net impact is somewhat less than 25bps.