This article first appeared in The Edge Malaysia Weekly on September 18, 2017 - September 24, 2017

THE cost of Prime Minister Datuk Seri Najib Razak’s trip to the US would have been slightly cheaper as the ringgit strengthened sharply against the greenback over the past couple of weeks.

At the time of writing, the ringgit had broken past the 4.20 level against the US dollar, touching 4.1908.

This is a 6.8% improvement from the record high rate of 4.4975 that the ringgit hit earlier this year. However, it is a small consolation for a currency that is currently valued at one-third less than it was four years ago.

Certainly, the stellar economic numbers have helped — the 5.8% gross domestic growth reported in the second quarter surpassed all expectations. However, this does not appear to be the main driver for the improved exchange rate.

“The ringgit strengthening has more to do with US dollar weakness than it has to do with the ringgit’s strength,” says Tan Eng Kiang, the head of group financial markets and treasury at Alliance Bank Malaysia Bhd.

This year, the greenback has lost ground against most other major currencies, with the US dollar index falling 9.93%. Meanwhile, the ringgit has barely strengthened against other currencies, marginally weakening against the Singapore dollar, for example (see table).

In turn, does this spell more upside for the ringgit going forward?

“We reiterate our long-standing bias that the ringgit remains fundamentally undervalued, by about 10%,” says Saktiandi Supaat, head of foreign exchange research at Maybank Kim Eng Research Pte Ltd.

“Our fair value model, which takes into account the relative differentials in interest rates, inflation, current account and a relation proxy variable, estimates the US dollar-ringgit exchange rate at 3.80 levels,” he explains.

In fact, he points to the persisting strength of the Singapore dollar and the Chinese renminbi as key indicators that the ringgit still has room to “catch up” with its regional Asia ex-Japan [peers]”.

In the immediate future however, he notes that there is a risk of a rebound (ringgit weakening) in the short term as “stochastics is near oversold conditions.”

One positive indicator for the ringgit is the country’s 10-year credit default swap spreads, which have fallen to near five-year lows. The lower the CDS spreads, the lower the market is pricing the perceived sovereign risk of a country. Last Friday, CDS spreads touched 115 basis points, almost 200 basis points below the over-300 basis point high in September 2015.

However, Saktiandi also notes that globally, 10-year CDS spreads are at low levels.

“This is not specific to Malaysia’s CDS only. Most Asean CDS, including Thailand and Indonesia, are also at their lows,” he explains.

On top of that, he adds that the current level of Malaysia’s CDS spreads has not priced in any political uncertainty in the next six months.

Against this backdrop, it is also interesting to note that there has not been any dramatic fund flows of late. Data from Bursa Malaysia shows foreign institutions have been net sellers in August, but only marginally so.

On the fixed income side, Tan points out that that there have not been drastic flows either. Even the recent maturity of sizable government bonds was largely rolled over, with foreign funds reinvesting instead of repatriating the money.

Meanwhile, Bank Negara Malaysia’s efforts to broaden and deepen on-shore financial markets have also helped to increase demand for the ringgit. Between December 2016 and June 2017, some US$3.6 billion worth of export earnings was repatriated.

In contrast, only US$0.9 billion was repatriated in the preceding five years.

This has had a stabilising effect on the ringgit, which has seen volatility all but evaporate. This of course, is helped by the fact that volatility in oil prices has also fallen to three-year lows (see chart).

“There is always the risk of volatility returning to the ringgit, but my sense is that it is essential that policymakers ensure there is some sense of stability in the ringgit to ensure businesses are not unduly affected from any sharp moves in the currency,” says Saktiandi.

“For the full year, oil price volatility has traded at a range of 25 to 35 levels. Contrast this with 2H2014 when oil prices slumped, oil volatility spiked to 50-60 levels (from below 20-levels). We do expect oil prices to remain stable in the range of US$45 to US$55 for the coming months and oil price volatility should continue to provide an anchor for the ringgit.”

Looking ahead, Alliance Bank’s Tan is looking out for two main factors that could affect the US dollar-ringgit exchange rate.

Firstly, he says the timing of the next US Federal Reserve rate hike will be key.

“The market consensus for a rate hike later this year is waning. The US economy isn’t growing as quickly as expected and simply isn’t achieving the Fed’s inflation target of 2%,” explains Tan, adding that geopolitical tensions in North Korea and balance sheet reduction details by the Fed will provide greater insights on the direction of rate decisions.

If an interest rate hike fails to materialise, it would be negative for the US dollar and conversely positive for the ringgit-US dollar exchange rate.

“Personally, I do not foresee an interest rate hike so soon. Not unless the Fed revises (downwards) its inflation targets,” adds Tan.

The second key indicator Tan is concerned about is the upcoming Budget 2018 that will be tabled on Oct 27. As it is a pre-election budget, many goodies are expected. But a populist budget alone won’t bode ill for the ringgit, as long as the government sticks to its deficit target of 3%, says Tan.

The actual election itself is expected to bring some volatility back to the ringgit.

“For now, there are two schools of thought. An election this year, and an election next year. Thus, the election cannot be priced in yet. Once it is called, we should see some adjustment,” explains Tan.

However, he does not expect politics to sway the ringgit much, as long as the economic fundamentals remain intact and the numbers show it.

Similarly, Saktiandi says “CDS spreads could potentially rise ahead of an election”. While causality is difficult to establish, he notes that sovereign CDS spreads rose by 20% on average from the beginning of 2013 to before the elections in May. However, the situation could be different this time round given different circumstances and better macro fundamentals, he adds.

He is forecasting the ringgit will trade at 4.275 and 3.1667 against the US dollar and the Singapore dollar respectively, barring any unforeseen circumstances.

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