This article first appeared in Forum, The Edge Malaysia Weekly on June 27, 2022 - July 3, 2022

The strengthening of the US dollar against the ringgit earlier this year had all parts of the Malaysian economy up in arms. It wasn’t anything new. The same level was reached in 2020, as Chart 1 shows but for different reasons.

The volatility of the ringgit caused former two-time prime minister Tun Dr Mahathir Mohamad to advocate pegging the ringgit again, presumably against the US dollar, like it was done from 1998 to 2005 during his first tenure. Bank Negara Malaysia responded by saying it was not in the country’s best interests.

How true is this? Given that inflation in the US is unabated at the time of writing and the Federal Reserve is almost certain to combat inflation by raising interest rates, this will likely see the ringgit continually fall unless Bank Negara raises rates in lockstep. It is worth relooking at this issue. Over the next two articles, I will examine whether fixed exchange rates (pegging it to another currency) or free-floating exchange rates (which many believe is what Malaysia is on) are best for the country. But wait! There is a third option: managed float regimes. Would this be the best?

As we begin, it is worth remembering that economics is a game of perspectives and relativity, that an interpretation can often be biased towards the interpreter’s own background knowledge and purpose of writing. Whether the person interpreting the facts for a developed, developing or even a less-developed country’s perspective, for example, is a question that must be answered. This isn’t even going into the different schools of thought like Keynesianism, Neo-Keynesianism, Monetarist, Classical, Neoclassical, Marxian, Austrian School and so on. It would be quite extraordinary to find an economist who knows, never mind understands, the nuances of all these schools of thought.

Yet, much of economics is read as if it is in absolute terms, that is, applicable to all. Clear examples are the writings of Adam Smith and John Maynard Keynes, produced at a time when Britain was already the most developed nation on earth, and hence their writings and advice have had limited use and impact for developing and less-developed nations. It gets very confusing and obfuscating. Many things simply slip through the cracks. In the words of Queen Elizabeth II when asking about the failure to predict the great financial crisis of 2007/08: “Why did nobody notice it?”

The startled silence that followed is legendary. Only recently have theorists given thought to these distinctions and impacts, as to the different levels of development of countries. The Mundell-Fleming model, for example, makes adjustments for how the model works with small, open economies versus large, developed ones.

Malaysia is indeed such an economy, open to trade to a fault and yes, it is small. In financial macroeconomics terms, nonetheless, “small, open economies” means, inter alia, that the economy has no ability to influence world interest rates.

To be blunt, small, open economies like Malaysia are buffeted by capital flows, whether they are caused by trade or portfolio (aka “hot money”) flows. This tends to cause the ringgit to fluctuate, particularly against the world’s highest use currency, the US dollar (see Chart 1). Fluctuations of the ringgit caused by trade flows are easily visible, via its current account balance (see Chart 2).

Not so easy to see are hot money flows as data on it is by and large not collected by governments. Perhaps they should.

Why would any of this be important to the ordinary Malaysian? Two reasons, the first of which is inflation. Chart 3 says it all — as the ringgit falls, the Consumer Price Index (CPI) goes up, and vice versa. Goods, especially imported ones and even domestic final products with substantial imported components just get more expensive (cost-push inflation, as economists call it). Chicken is an example, with its feed — corn — fully imported. Data scientists might note the lag of two years or so between the ringgit’s value and inflation, most probably due to the inventory replacement cycle. Also note that the major outlier event in 2019 to early 2021 is, of course, the lockdowns caused by Covid-19, when Malaysia went through a deflationary period. The 2007/08 CPI spike was during the global financial crisis and the one in 1997/98 was due to the Asian financial crisis.

The other source of concern for Malaysians are interest rates. The key strategy to combat inflation is to raise interest rates, making it more expensive for borrowers. While Malaysian corporates are renowned for having low gearing ratios (a debt-to-equity ratio of 0.22 times based on Bank Negara’s recent numbers), Malaysian households are highly geared, hence rising interest rates would add to their misery.

A free-floating currency regime simply means that the central bank of a country would allow its currency’s exchange rate to be determined by the market without intervention. This essentially would absolve the central bank of any responsibility for the exchange rate at any point. However, in reality, it isn’t an absolute thing; no central bank will stand by and do nothing while its currency collapses and wealth destruction razes the economy to the ground.

One of the key requirements for having a free-floating currency is that the country has a deep enough market for currency exchange such that the open market can absorb any transactions to be done, without substantially skewing the exchange rate in doing so. Otherwise, to maintain currency stability, the central bank has to step in. This is usually the province of developed countries. This explains why the UK, for example, the sixth largest economy in the world, had a measly foreign exchange (forex) reserve of US$31 billion at the end of March, for a country whose GDP was US$3.32 trillion in 2021. It is a forex reserve over GDP ratio of less than 0.01 times.

Without a deep currency market, the currency would fall to high volatility and be subject to predatory attacks, at the country’s expense.

For developing and less-developed countries, seeking to have a free-floating currency regime may be very dangerous wishful thinking indeed. In my next article, I will examine the fixed exchange rate and managed float regimes, as well as the results of statistical studies on which stands out best on volatility, inflation and economic growth.

Huzaime Hamid is chairman and CEO of Ingenium Advisors Sdn Bhd, Malaysia’s financial macroeconomics advisory

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