This article first appeared in The Edge Malaysia Weekly on December 25, 2017 - December 31, 2017

IF it has been said once, it has been said a thousand times in the past three years — “The ringgit is undervalued based on its fundamentals”. But this year, the ringgit’s fundamentals could not be ignored any longer.

The year saw gross domestic product grow  6.2% year on year in the third quarter, shattering all expectations. With the economy expanding at its fastest pace in nearly two years, full-year GDP growth is now expected to hit 5.8% y-o-y, up from 4.2% y-o-y last year.

Couple this with improving crude oil prices, stable inflation, an anticipated interest rate hike, a strong trade surplus and a narrowing budget deficit — and you have a strong case for the recovery of the ringgit.

This year, it gained 9.07% to close at 4.08 against the US dollar last Friday, making it the second best performing currency in the region, losing to the South Korean won by a thin margin.

Of course, it helps that the ringgit is coming off a low base. This time last year, it was one of the worst-performing currencies in the region — falling almost 22% in the preceding two years. It also helps that the US dollar performed poorly this year. Based on the US Dollar Index, which benchmarks the greenback against other major currencies, weighted by trading volume — the dollar weakened by 8.5% this year.

Compared with other currencies in the region, the ringgit managed only marginal gains. For example, it strengthened by only 1.8% against the Singapore dollar, closing at 3.03 last Friday.

While improving fundamentals certainly underpinned the ringgit’s rebound, market interventions should be credited with improving the liquidity and demand for the currency. This, of course, refers to Bank Negara Malaysia’s policy that requires exporters to convert 75% of their proceeds back to ringgit. Prior to this, less than 1% of export proceeds were brought back onshore.

In addition, Bank Negara required all payments between residents to be concluded in ringgit.

While it may have created some friction for exporters, it was a good move by the central bank as it did not put pressure on its relatively low foreign reserves. In fact, foreign currency reserves recovered marginally this year, rising to US$102.2 billion as at Dec 15 (RM431.6 billion), up 8.1% from US$94.52 billion as at Dec 31 last year.

Stronger export numbers have also acted as a multiplier force for Bank Negara’s policy. As at October, export growth averaged 21.32% y-o-y, compared with 1.41% y-o-y last year.

This led to an overall expansion of the trade surplus — averaging RM8.011 billion each month this year (10 months ended October), compared with the monthly average of RM7.27 billion last year.

Against this backdrop, it helps that the government has managed to keep the budget deficit within target — 3% in 2017 and on track to hit 2.8% by 2018.

Structural concerns could hold the ringgit back

With the ringgit teasing to break past the 4.00 level against the US dollar, the question is this — will it hover around this level or can its fundamentals support a return to the sub-3.4 levels seen before it crashed in 2015?

It is important to note that there are still some hurdles for the ringgit to overcome to achieve this.

First, it hinges on the local economy’s ability to deliver strong growth. Expectations for the coming year have been revised in the light of this year’s strength, but the consensus is for growth to decelerate to around 5.2% y-o-y. While this is still an excellent pace, surprising on the upside may be tougher, coming off the high base set in 2017.

The second concern would be inflation, which has picked up this year to average 3.9% y-o-y (as at November), compared with 2.09% y-o-y last year and 2.1% in 2015. High inflation is considered a downside risk to any currency.

The third risk to the ringgit would be crude oil prices. Currently, crude oil is trading at near post-glut highs — around US$65 a barrel. This has largely been the product of the production cut agreement between the Organization of the Petroleum Exporting Countries and some non-Opec members, like Russia.

Currently, the deal is set to last till end-2018. However, history has shown that maintaining such cooperative production cuts is the only thing that is more difficult than agreeing to them in the first place. Factors that could test the agreement include geo-political tension in the Middle East, as well as a resurgence in shale oil production in the US.

While the implementation of the Goods and Services Tax has helped to reduce reliance on oil revenue, a sharp fall in oil prices would certainly put pressure on the government’s fiscal position. In turn, hurting the ringgit.

“At 50.9% of GDP as at June 2017, Malaysia’s general government debt is significantly higher than the A-rated peer median (40.5% of GDP at end-2016). While we expect the debt ratio to remain stable in the next few years, it is also likely to stay above the median for A-rated sovereigns,” notes Moody’s Investors Services in a report earlier this month.

While the ratings agency maintained its stable A3 rating on Malaysia, it flagged concerns with the relatively constrained policy space and debt affordability, compared with other A-rated sovereigns.

“According to the government’s budgeted estimates, revenue will decline as a proportion of GDP, to 16.6% next year from 16.8% in 2017, a continuation of the trend seen since a recent peak in 2012 (when revenue stood at 21.4% of GDP), which was in part due to exposure to oil price trends. As a result, debt affordability is weak relative to peers, with interest payments accounting for 12.5% of revenue in 2016, much higher than the A-rated median of 5.6%,” explains Moody’s.

While this has been mitigated by strong domestic growth and a low proportion of foreign currency-denominated government debt, it underscores the need for the government to improve the quality of the federal balance sheet.

It will certainly take time, but if it can be done, perhaps the ringgit can gradually inch towards 3.00 against the US dollar. 
 

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