This article first appeared in Forum, The Edge Malaysia Weekly on July 4, 2022 - July 10, 2022

In the debate over whether Malaysia chose the right currency regime for itself — which became public when a former two-time prime minister got involved — we saw in Part 1 of this article (The Edge, June 27) how a free-floating regime is simply not applicable to a small, open economy like Malaysia’s. In this concluding part, we look at the country’s experience in pegging a currency (de facto and de jure) and at managed floats.

Pre-1996, it was well known that Malaysia was defending the ringgit at the RM2.50/USD level (this would be akin to “pegging” a currency, that is, a de facto peg). Then, the Asian financial crisis happened, and the ringgit rate went from RM2.52/USD on Jan 2, 1997, to a low of RM4.63/USD on Jan 9, 1998, before the peg of RM3.80/USD was set on Sept 2, 1998, along with strict capital controls.

What did happen in terms of costs to the country’s foreign exchange reserves was instructive: Forex reserves started at US$27.89 billion in 1996, based on World Bank numbers, and dropped to a low of US$21.47 billion in 1997 before the peg was introduced, and recovered to 

US$26.24 billion in 1998. During the peg years, forex reserves further strengthened to reach US$70.46 billion at the end of 2005. In short, defending a fixed exchange rate proved to be expensive, especially during a crisis, but the peg regime and the capital controls that came with it saw forex reserves tripling.

Was having a peg the cure for the currency problems? Not quite — a couple of bad things happened. The first was that Malaysia lost its monetary independence, meaning that Bank Negara Malaysia had to follow everything the US Federal Reserve did or face another financial crisis.

The other problem that emerged was a very interesting one, and totally unanticipated (see Charts 1 and 2).

That’s right. Due to the peg, Malaysia’s economic cycle, which was counter to that of the US, changed to follow it. Even 12 years after the peg was removed in 2005, the same lockstep dance continued.

Do we have monetary independence nowadays?

Did the currency peg save Malaysia? Or was it capital controls? Or a combination? The jury is still out on that one, but for financial crises, capital controls seem to have worked their way into the list of legitimate defences a country can use.

A managed float regime is one where exchange rates are allowed to fluctuate daily but whose movements are influenced by central banks to keep them stable. According to the International Monetary Fund, as at 2014, around 82 countries, or 43% of all countries, use a managed float, making it the most popular in the world.

Bank Negara announced the adoption of a managed float regime for the ringgit in 2005, as a replacement for the peg. This is in sharp contrast to the widespread belief that it has allowed the ringgit to free-float and is only intervening to ensure an orderly market.

How good has Malaysia’s experience been at managing the float? The hyper-volatility of the ringgit against the USD after the peg is worrying, up to 32.7% as calculated by V-Lab.

To make things worse, the ringgit is a non-internationalised currency, meaning that speculative players cannot obtain and play with it offshore. Imagine if they could.

What is the source of all this volatility? It is a non-internationalised currency so this shouldn’t happen. Is it due to the depth of the ringgit market being so thin that a large trade sways the market? If so, market-deepening measures need to be undertaken.

The gold standard for managed float regimes is Singapore. Its currency appreciation is enviable.

How does Singapore do it? According to Paul Yip in his book on the issue, four methods are used:

1.    Singapore chose to manage its currency over managing its interest rates as the prime monetary policy tool, given how much the country must import for its daily needs;

2.    Huge forex reserves. Singapore’s reserves as at end-2021 were 1.05 times its gross domestic product (Malaysia’s were 0.33 times in the same period, the UK’s 0.01 times);

3.    Tight supervision of its banking system. Moral suasion and the licensing of banks and/or approval of their boards of directors/CEOs is done very seriously with national interests at heart; and

4.    Managing the economy’s liquidity levels through the Central Provident Fund (CPF) and the Monetary Authority of Singapore’s (MAS) open market operations. To put it simply, Singapore’s budget surpluses and CPF contributions “take out” around 3% to 5% of its broad money supply, M3. This would ordinarily cause a recession, but MAS replenishes liquidity by selling SGD and buying USD in the forex market. This then is a control method for liquidity, and the scarcer a currency is, the greater its value in general. It also means it can weaken the currency as it wishes.

Why did Singapore choose to target forex rates as its instrument of monetary policy? Based on its own research — and backed up separately by the Mundell-Fleming model for small, open economies — targeting interest rates would cause massive capital flows, impacting exchange rates, output (that is, GDP), exports and inflation. Singapore appears to have chosen well.

Interestingly, research by the US National Bureau of Economic Research shows that the choice of exchange rate regime has no bearing on income distribution. Hence, income equality programmes, for example, should not be affected.

So, end all, how do the three different regimes compare in practice statistically? Gosh, Gulde and Wolf in their 2002 book, Exchange Rate Regimes, noted these results:

1.     Nominal exchange rate volatility is highest for free-floating regimes compared with under pegged or managed-float regimes;

2.     Average inflation is highest under free-floating regimes, followed closely by managed-float regimes and rather far below it, pegged regimes; and

3.    GDP growth-wise, managed-float regimes do best, with pegged and free-float regimes just about equal in the lower ranks.

An interesting finding was that under pegged regimes, monetary growth was tiny and quite stable, leading to GDP growth that was quite stable. The authors named it the “monetary discipline effect”.

The conclusion here is that Malaysia has chosen well to adopt the managed-float regime given that the country is still a developing nation. What matters now is its implementation, as the volatility charts show. It’s time to tighten the nuts and bolts. Most importantly, expectations of and for the domestic economic players need to be managed so that surprises and damaging effects can be minimised.

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

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