April 2012 Monetary Conditions [Updated]

Well, I’m back from my break, recharged but thoroughly unrested

But on to last week’s monetary data release from BNM. I haven’t done one of these for a while, as (1) little substantive has changed; and (2) while I’ve been updating the data, I’ve lacked the time to publish a review in a timely manner. Old news is stale news as they say.

Nevertheless, things are heating up (metaphorically) in a monetary sense. With Europe back in the news, China showing signs of a slowdown, and US recovery losing steam, it’s back to global risk aversion again. And that means global capital outflows into US treasuries (notice that gold hasn’t budged).

We’re only seeing a few signs of this locally though, as money supply growth is pretty stable (log annual and monthly changes; seasonally adjusted):

International Reserves And The Balance Of Payments

From the comments:

Wenger J Khairy said...

Dear HishamH,

Appreciate your response. Perhaps would like to comment further on the link between reserves and the BOP. The argument was presented in the book the "Dollar Crisis".

The author presented the case for the link between reserve build up and a growth in the money supply. He cited Thailand and Japan and as the example.

The thrust of the story

(a) From strict correlation point of view, reserve and credit growth was correlated for the case of Japan, Malaysia and Thailand. The lag maybe between 1-2 years.

(b) Build up of reserves act as high powered money entering into the domestic banking system.

(c) One can draw a simple flow chart how lets say surplus US dollars earned by Sime Darby gets deposited as Ringgit in Maybank, and at the same time increases Bank Negara reserves.

In the case of Thailand, their reserve build up was due to surplus on the Capital and Financial account

(d) Build up of reserves act as exogenous source of credit creation in the domestic banking system. If there was a build up of credit due to solely endogenous factors, wouldn't it be highly inflationary?

My wife told me that I’m barely comprehensible to readers who aren’t that knowledgeable about the inner workings of economics or finance, so I’m going to answer Wenger’s query in some detail – though this post will feature a little bit of double-entry accounting.

2009 International Investment Position

The Department of Statistics last week issued Malaysia’s IIP report for 2009, which shows the level of Malaysian ownership of foreign assets matched against foreign ownership of Malaysian-domiciled assets. If you want a simpler business-type analogy, the balance of payments is our external cash flow report while the IIP is our external balance sheet report.

I’ve noted before that Malaysia has become a net creditor nation in 2008 – we own more foreign assets than foreigners own our assets – and for the first time since independence. The 2009 data more than confirms this trend (RM millions):

We’re now RM120 billion to the good, compared with around negative RM140 billion in the early part of this decade, and worlds away from the more than RM700 billion in the red in 1986 (source: see note 2).

Now whether this is good or bad depends on your point of view. The rapid increase in foreign asset accumulation in the last 5-6 years has largely been driven by direct investment (and reinvestment of earnings) abroad by Malaysian companies (RM millions):

…compared with relative stability in foreign accumulation of Malaysian assets (RM millions):

…apart from portfolio capital which remains highly volatile (RM millions):

 

The problem here is that Malaysian companies are investing abroad corporate savings that might have been invested domestically – one reason why private investment growth has been so poor since the 1997-98 crisis, and why we have not been able to match the growth rates in GDP that we saw pre-1997. The outflow of funds (we’re talking about half a trillion Ringgit over the last ten years) has also played a role in dampening appreciation of the Ringgit.

The flip side of this is of course, that our income account in the balance of payments is going to improve over time as investments (hopefully) bear fruit – a source of foreign exchange which will be non-trade related, and thus reduce our external vulnerability.

One further side effect of this is that it reduces the incentive for massive accumulation of foreign exchange as an insurance policy against capital outflows, which can be expensive. Luckily, BNM has more or less ceased forex intervention (with some notable exceptions) since the float of the Ringgit in 2005, but there are still structural factors which will inhibit reducing our reserves over the short run – liquidity of foreign portfolio assets for starters, as well as the relatively higher proportion of foreign ownership of Malaysian equities and debt.

But this development does mean that one of the underpinnings of the Ringgit’s valuation is long term positive.

Technical Notes:

1. 2009 International Investment Position from the Department of Statistics
2. Lane, Philip R. & Milesi-Ferretti, Gian Maria, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004”, International Monetary Fund Working Paper 06/69, March 2006

Lies, Damn Lies, and Then There Are Statistics

UBS Securities Asia Ltd has issued a report that has generated a bit of a buzz in the online media titled "Malaysia - Another Bizarre Story" (try here, alternate here). The headlines in the online media however are less timid:

“Money leaving Malaysia in massive amounts and bizarre fashion”

“Malaysia's Disastrous Capital Flight”

Ye Gods.

I’ve covered the issue of capital flight before in this post (read the comments for an interesting discussion). There’s no doubt that capital has been leaving the country in the aftermath of 1997-98, which in my opinion and from anecdotal evidence is largely due to domestic investment abroad. However, this UBS report is highly misleading as it purports to show that large amounts of capital left the country in 2009, which isn’t the case at all - at least, not any worse than it usually has.

Here’s my view (point by point, in blue) of where this report went wrong.

“Question: which Asian country had the biggest FX reserve losses in 2009? The answer is Malaysia, and by a very wide margin; we estimate that official reserves fell by well more than one-quarter on a valuation-adjusted basis.”

This is the main evidence that the report uses to justify its conclusion. But note that the basis of this estimate is from peak 2008 levels against current levels, which is more than a little disingenuous (look at notes for the first chart in the report). The assessment of “more than a quarter” loss suffers from what’s called the “base” effect – if you use a period with a high denominator, you can get negative growth even if the actual levels are increasing (international reserves, RM millions):

I put in a longer sample period so it’s easier to see what’s going on. Using a more conventional year on year calculation, this is what you get (log annual changes):

See what I mean? For most of 2009 growth in reserves was negative, despite the fact that the actual level of reserves was largely flat to increasing. Malaysia suffered technical deflation for much of 2009 for much the same reason, but I don’t hear anyone crowing over consumer prices falling.


Here's what monthly growth looked like (log monthly changes):

Through the whole of 2009, we've had exactly three months where reserve growth was negative, while the rest of the year saw reserves rising. This type of problem is the reason why I've consistently advocated looking at levels rather than growth metrics during times of violent change. You simply miss a lot of what's going on by using a period-to-period percentage change approach.


I’m also a little suspicious of the claim that the estimates were valuation adjusted – BNM already books revaluation losses and gains every quarter. If you revalue again based on published statistics, that would constitute double counting and would exacerbate movements in reserves.

“Other structural surplus neighbors like China, Hong Kong, Singapore, Taiwan and Thailand have all seen sizeable increases in FX reserves over the past 12 months … and yet Malaysian reserves nearly collapsed.”

Sloppy analysis – reserves at end 2008 stood at RM317.5 billion, versus RM331.3 billion at end 2009, including a revaluation loss of over RM10 billion for 2009 as a whole. That means a net increase of RM13.8 billion over a 12 month period – sure doesn’t look like a collapse to me.

More important, the first three countries listed all have an explicit exchange rate target. China has effectively halted Yuan appreciation against the USD in the last year and a half, Hong Kong has a currency board arrangement with the USD which effectively means forex reserves back the money supply, and Singapore explicitly uses the exchange rate as the instrument for implementing monetary policy unlike the more conventional interest rate target as used in Malaysia. I don’t know off-hand how Taiwan manages monetary policy (Taiwan is not an IMF member, and aren’t categorized within the IMF’s exchange regime framework), but Thailand uses a managed float with an inflation target, also implying intervention in foreign exchange markets.

Why this is important is that the countries listed all accumulate or lose reserves due to implicit or explicit exchange rate targets. Malaysia does not fall under that category under either a de facto or de jure basis, and I’ve gone on record to state that I don’t think BNM has an exchange rate target for the Ringgit at all. Hence, if there is no intervention, there should be effectively little to no change in reserves – which is what happened in 2009.

So what’s the story for 2008, because there was a massive loss in reserves back then? Looking at the reserve levels, you see a mild run-up from 2005 to 2006, and then acceleration from end-2006 to about mid-2008. Not coincidentally, reserve accumulation happened simultaneously with the commodity bubble of those years:

That's the main difference between Malaysia and the other countries we were compared to in the report - we are a commodity exporting country, none of the others are. Given that exports of commodities didn’t change much in volume but export receipts did, we had an abnormal influx of income that was more nominal than real. In the aftermath of the collapse in prices post July 2008, we had a drop in income that was also more nominal than real. Hence, from BNM’s perspective, the appreciation of the exchange rate (as well as the money supply impact of the inflow of trade receipts) warranted intervention to mitigate the Ringgit’s (and the money supply's) rise during the boom, and limit the Ringgit’s (sharp) fall (and the potential contraction in the money supply) in its aftermath. In addition, BNM had to meet the sudden demand for USD from the banking system as depositors and investors pulled out:

If you look at newspaper reports at the time (4Q 2008), BNM as good as admitted buying MYR against USD to support the currency:

Now if these factors are taken away – receipts from a commodity bubble boosting forex supply within the banking system and forcing an overshooting appreciation of the exchange rate, we would not have had reserve accumulation in 2007-2008 in the first place, and reserve accumulation would simply be on the same trend as it was from 2005-2006. And we wouldn't be arguing about a loss of reserves we probably shouldn't have had in the first place.

3.       “And this despite a massive, unprecedented decline in high-powered “base” money, as shown in Chart 4. Indeed, over the past 12 months Malaysia recorded one of the biggest base money contractions in the entire EM world, matched only by the Baltic states (Chart 5). This is in part because the Malaysian central bank responded with a sharp drop in reserve requirements to keep banks liquid … but still, we can’t help but note that the domestic financial system seems uniquely unaffected by apparent capital outflows.”

This one’s a bit funny – the writer was obviously not referring to M1 (currency + demand deposits) (RM millions; and log annual changes):

He’s referring to base money which is a bit different – currency + bank reserve deposits. This is a rather funny metric to use, because under a modern regulatory system, bank reserve deposits are barely relevant. As long as the statutory reserve ratio is below the risk-weighted capital ratio (8% under the original Basle requirements, somewhat more nebulous under Basle II), then the money multiplier is effectively limited by the capital ratio and not the reserve ratio.


Hence BNM’s cut in the reserve ratio was a token and not an effective policy change, unlike the situation in China for instance where the reserve ratio is one of the primary instruments for managing the supply of credit (because it's double the capital ratio). BNM hasn’t seriously used the reserve ratio as a policy instrument since before the 1997 crisis.

What’s even funnier is the description of the cut as “sharp” – it was a 50% cut, which sounds big until you realize that it was from 1% to 0.5%. And the banks have more or less ignored the reserve requirement anyway – the banking system has been flush with cash for years, and they haven’t bothered to lend out the excess (banking system deposits with BNM in RM millions; loan-deposit ratio):

Hence there should be no surprise that interest rates have trended lower in 2009 – there hasn’t actually been a large outflow of capital (and hence a contraction in the money supply), there hasn’t been a massive loss of reserves, and...there isn’t really a story here except maybe UBS wanting to sell something.


(H/T Hafiz Noor Shams - free plug for you, mate!)

Direct Investment, the Balance of Payments, and the International Investment Position

It’s no secret that capital has been leaving the country, even as the trade balance generates a continuous surplus. Breaking down the financial account of the balance of payments (BOP), here’s what Malaysia has experienced over the past ten years or so (1999-2008, RM Millions):



While FDI has been increasing, it doesn’t even begin to cover outward investment or the (negative) “other” investment. Portfolio investment has ebbed and flowed depending on the vagaries of the stock market, except for last year with a flight to safety from all emerging markets prompting a sell down of equities and other assets in favour of (paradoxically) USD assets. That spike has partially reversed in 2009.

The cumulative numbers are staggering: negative RM156.6 billion in outward direct investment, RM257.0 billion in other investment, and RM52.8 billion in portfolio investment, for a total outflow as at end of 2008 of RM 466.5 billion.

That’s right, nearly half a trillion Ringgit, or half of current M3.

The question is: is this outward flow occurring because foreigners are abandoning Malaysia as an investment destination, or is this Malaysian companies investing abroad? The former is downright bad for obvious reasons, while the latter is only somewhat good as it can be counterbalanced by subsequent inward income flows. Anecdotal evidence favours the latter, as there’s plenty of news of domestic corporations making big bets on other emerging markets – such as Maybank in Indonesia, and Maxis in India.

However, there is an inherent flaw in using BOP data to figure out where investment is actually going, because it is a flow measurement, not a stock measurement. With BOP data, we’re completely ignoring the possibility of reinvestment of profits and earnings. This doesn’t turn up in financial flows, and it’s difficult to judge private sector investment attitudes towards Malaysia based on BOP data alone.

It is more than possible that the outward flow of investment is due not only to Malaysian firms investing overseas, but also to foreign-owned firms redirecting investment overseas from retained profits generated locally. That in itself is not great news, but it’s certainly more palatable than foreign firms pulling up stakes and leaving. What we need is to get a view of foreign and domestic holdings of investment stock, not just flows as in the BOP, to get a better idea of what’s going on.

Luckily, we do actually have such a report – the International Investment Position. This is a relatively new set of statistical information (as such things go), and data availability is still very patchy for many countries. Malaysia’s for instance, only goes back to 2001 and was first published in 2005. Prior to the IIP, figuring out a country’s investment stock position (more commonly known as the net foreign asset position) was a matter of guesstimation and to be honest it still is, even with the IIP – you’re depending on accurate reporting to compile the statistics and there are many offshore money centers, some with dubious legal enforcement.

Be that as it may, the IIP makes for interesting reading. I’ve posted on Malaysia’s net foreign asset position, and the IIP (with some discrepancies) confirms the notion that Malaysia is now a net creditor nation (RM Millions):



Since we’re at the moment interested in the direct investment position, here’s both the asset and liabilities side (RM millions):

External Direct Investment Assets


External Direct Investment Liabilities


So we are primarily looking at Malaysians investing abroad, with a very small pullback in foreign inward investment in 2008, which is understandable given economic conditions over the past two years. The numbers don’t quite reconcile with the BOP data, mainly due to slightly different categorization as well as the element of reinvested earnings involved.

And of course, the net portfolio position is still sharply negative (RM millions):



But on the whole, we’re in a better than decent position here (assuming the positive IIP holds). Even though investment and capital are leaving the country, this is counterbalanced by an increase in future potential earnings from abroad, as well as less pressure to keep reserves high. This also puts upward pressure on the exchange rate.

Technical Notes
1. BOP data from BNM's Monthly Statistical Bulletin
2. The International Investment Position Reports available from DOS