IN THE last six months, the ringgit has been the second worst-performing currency in Asia, after the yen. Two weeks ago, it breached the 3.400 level against the US dollar and since then, it has been hovering within a hair’s breath of 3.5000. On Dec 5, it touched 3.4757 before closing at 3.4713.
From its year-high of 3.1463 recorded on Aug 27, the ringgit has lost 10.3% of its value against the greenback. Last week alone it declined 2.6%.
While the yen’s fall is a deliberate policy move by the Bank of Japan to devalue its currency, the ringgit is a victim of a convergence of several factors on both the external and domestic fronts.
The question is, does the currency’s weakness reflect Malaysia’s economic fundamentals or is it a cyclical and temporary trend? Market observers and economists think its weakness will continue into next year.
What sparked the sharp depreciation of the local currency was the drop in oil prices. Malaysia is the only economy in the region that will be negatively impacted by low oil prices as it is a net energy exporter while the rest are net importers.
“Currencies of net energy exporters will clearly suffer from lower oil prices ... In the region, the ringgit has the highest correlation to crude oil price movements. Correlation statistics also show that crude oil price is currently the most important driver of ringgit price movements, among others (for example, the US Dollar Index, the FBM KLCI, palm oil prices and ringgit-US yield differentials). The overhang of foreign positioning in local market debt, particularly in short-term BNM bills and government T-bills, further adds to the ringgit’s vulnerability,” notes Barclays Research in a recent report.
During the US Federal Reserve’s quantitative easing era, foreign inflow into ringgit-based debt increased due to the attractiveness of both carry and currency returns. As the broad US dollar turns positive and as prospects for the ringgit deteriorate, the risk of foreign debt outflow from Malaysia has risen, the research house adds.
Nomura’s FX strategist Wee Choon Teo agrees that there are several ongoing themes — apart from the drop in oil prices — in the market that are putting pressure on the ringgit:
Fall in commodity prices. “The bigger story is the drop in commodity prices (including crude palm oil) and its impact on Malaysia’s trade (and current account) and fiscal balance,” Wee opines.
Nomura, in a report, says while fiscal fears are overdone, it sees a more worrying impact on the trade balance. “Our estimate of terms-of-trade shock so far is that the trade balance will be reduced year on year by about RM0.8 billion on average in October and November due to negative price effects.”
However, this is small compared with the average monthly trade surplus of RM6.8 billion so far this year.
A correction in the equity market, especially in the oil and gas sector. BIMB Securities Research notes that Bursa Malaysia is one of the worst performers in the region this year, falling 2.4% year to date. In the last three months, the equity market has seen a total outflow of RM2.3 billion while outflow year to date amounted to RM4 billion.
High foreign ownership of Malaysian bonds and expectations that the US Fed will raise interest rates in the second half of 2015. The widely held view is that foreign investors will begin to divest ringgit-assets when the risk premium spread between Malaysian Government Securities and US treasury bills narrows as US rates rise, making it less attractive for foreign investors to hold Malaysian bonds.
The strengthening of the US dollar. Last Wednesday, the US Dollar Index (US dollar versus a basket of six major currencies) strengthened to a 5½-year high of 89.005. The upward trend is premised on improving economic growth indicators for the US economy.
How low can the ringgit go? Moving forward, visibility of how far south oil prices will go remains poor. Volatility is the new normal, most economists and market players say. Even so, the consensus view is a weakening bias for the ringgit, with projections ranging from an average of 3.50 to 3.60 against the US dollar next year.
“There is a possibility that the ringgit could breach the 3.60 mark during the year but we think on average, 3.60 is a more likely scenario,” says a foreign exchange dealer with a local bank.
The magnitude of the ringgit’s depreciation is dependent on how much lower commodity prices fall and whether the market sees a big outflow of foreign funds from the bond and equity markets.
The rule of thumb is that a 10% drop in oil prices will lead to a 3% depreciation of the ringgit, says Nurhisham Hussein, general manager/head of the economics and capital markets department, investment division, at the Employees Provident Fund (EPF). This is based on the fact that commodities make up about a third of Malaysia’s total exports.
A big concern today is the huge foreign holding of Malaysian bonds. As at Oct 31, foreign investors held RM250 billion of Malaysian debt and 45.9% of total Malaysian government securities.
And when they do decide to get out, the outflow will hit the financial markets hard.
What will Bank Negara Malaysia do?
Certainly, a selldown will cause the ringgit to weaken further, bond prices to fall and yields to rise. The question is, to what level can the ringgit fall before it impacts the economy adversely and how will Bank Negara respond to a continued weakness in the currency?
The central bank has two policy options — use its international foreign exchange reserves to absorb the selldown or raise interest rates to cushion the ringgit’s depreciation.
Malaysia’s foreign exchange reserves stood at US$125.7 billion (around RM411.7 billion) as at Nov 28. While the reserves are adequate to cushion the selldown, economists say Bank Negara may not want to use up all its bullets as this will affect its ability to respond should a financial crisis happen in the future.
Or it could let the market absorb the selldown. Industry observers say the market can do this as financial institutions are always on the lookout for good liquid assets to meet liquidity requirements.
Additionally, a portion of the debt paper held by foreigners comprises BNM bills, which have shorter tenures, and some of which could already be close to maturity.
At this stage, most market observers believe Bank Negara will not want to raise interest rates as the economy is in slowdown mode and macro-prudential measures introduced in the last three years have dampened private consumption.
Raising rates further could affect the ability of both the man in the street and companies to service their loans, causing a deterioration in the asset quality of banks.
“For now, the central bank will be more tolerant of a weaker ringgit and keep rates steady, intervening only to smooth the sharp swings in the currency,” says the foreign exchange dealer.
With inflationary pressures eased by the fall in fuel prices, Bank Negara now has more room to manoeuvre. Most market observers and economists, however, do not expect the worst-case scenario yet, that is a sudden outflow of foreign funds of a magnitude that could cause panic in the financial markets.
The EPF’s Nurhisham, for one, believes that this is unlikely to happen because he thinks the US, contrary to widespread expectations, will not raise rates until 2016. He explains that the threat of rising inflation in the US is dissipating and that the Fed will be in no hurry to raise rates as economic growth sustainability is still not convincing. “Even if the Fed raises rates, it will be slow,” he says.
Another factor that could depress the ringgit next year is how badly Malaysia’s economic fundamentals will be eroded by a continued fall in commodity prices, in particular the trade balance. The current account surplus, which has been shrinking in the last couple of months, will come under further pressure.
The worry is that if the current account sinks into a deficit, which could lead to Malaysia suffering a twin deficit (current account and fiscal deficits), that could cause a sovereign rating downgrade, notes AllianceDBS Research in a recent report.
The implications of a sharp fall in the ringgit’s value for the Malaysian economy are just beginning to unravel and visibility remains poor. The focus is now on how Bank Negara and the government will deal with the situation to prevent a nasty fallout.
This article first appeared in The Edge Malaysia Weekly, on December 8 - 14, 2014.