ON Aug 12, 2013, I wrote an article in the Forum pages entitled “Asian financial crisis — Part 2?” In it, I said: “The similarities between the mid-1990s and today in Asia are eerily close. However, a full-blown financial crisis striking in the next year or so is pretty unlikely since economic stress has yet to develop to a critical state. However, a gradual and competitive devaluation of currencies in Asia is more likely to occur.”
Whilst there is certainly an element of luck involved, that assessment has turned out to be true and with the recent movements in the foreign exchange markets, perhaps it is time to revisit the topic.
The factors behind the volatility in the currency markets can be categorised under roughly three themes.
Firstly, after years of quantitative easing (QE) by the Federal Reserve, the US economy is showing signs of recovery. This, together with the end of the QE programme, has ignited the expectation of US interest rates rising and perhaps reverting to their long-term average over the longer term. Consequently, on a trade-weighted basis, the US dollar has appreciated significantly — 20% since last July. Its strength is, no doubt, helped by the start of the European Central Bank’s (ECB) version of QE.
Secondly, since the start of QE in 2009, US interest rates have fallen, with the three-month treasuries yielding about 0.02%. Consequently, a significant amount of capital has left the US in search of yield and emerging markets have received trillions of it. And with an influx of capital, corporate leverage has increased.
However, corporate non-bank borrowers appear to have learnt from the 1997/98 Asian financial crisis and structured their borrowings to be long term (according to the Bank of International Settlements, the weighted maturity of loans exceeds eight years). A longer maturity will certainly mitigate rollover and short-term repayment risks.
However, debt servicing in local currency will be higher if the loans are US dollar denominated and the dollar appreciates. Lower free cash flow after financing cost might reduce corporate capital expenditure and ultimately lower the country’s growth prospects. This can spiral into a loop, prompting further withdrawal of foreign capital from emerging markets and depressing the local currency.
Therefore, the best hope for emerging markets is for US inflation to remain muted and its recovery to be less uniform or robust enough to warrant interest rates hikes. This will buy them time for reform and readjustments. However, with US QE having ended and other central banks engaging in their version of QE, the US is relatively in a tightening mode and the underlying trend might only be less potent.
In the case of Malaysia, as reported by Bank Negara Malaysia recently, non-residents held RM223.3 billion (30%) of domestic debt securities last year versus RM70.4 billion in 2009. Whilst a sudden withdrawal of foreign capital would cause a financial market disruption, high foreign participation in the local markets need not necessarily be bad.
Since domestic fund managers have also been diversifying overseas, on an ownership basis in local currency, Malaysia need not necessarily be worse off. Therefore, foreign investment in domestic securities should be welcomed and an open policy will increase the maturity and sophistication of local markets. Ultimately, this should lead to lower cost of capital.
Thirdly, the crude oil price has fallen significantly. This is largely due to a mightier US dollar, the Organisation of the Petroleum Exporting Countries defending its market share, a fall in geopolitical risks, the success of shale oil production in the US and a slowing global economy.
Although the number of rigs in the US (the main source of the additional oil supply) has dropped to the lowest since April 2011, according to Baker Hughes, production is expected to rise 7.8% this year because the remaining rigs are highly efficient, says the Energy Information Administration.
With many half-commissioned rigs being weeks away from production, some believe a sustained rise in oil prices is unlikely as this will attract new shale oil supply from producers who are highly leveraged and will need the additional cash for financing.
With oil prices weak and expected to remain so, Malaysia — the only net exporter of oil in Asia — is perceived to be negatively affected. Last year, the country’s net export value of oil was RM8.8 billion compared with liquefied natural gas’ RM60 billion and crude palm oil’s more than RM40 billion. Thus, the impact will be felt when LNG is re-priced, which usually happens after a lag because LNG is sold on long-term contracts but benchmarked against oil prices.
Oil importing countries, however, will likely benefit from the lower prices. The boost to their growth should, in turn, benefit Malaysia’s electrical and electronics exports, which contributed slightly less than RM40 billion last year. Therefore, the combined trade impact is not so clear-cut.
Nevertheless, these three themes will continue to cause the ringgit’s volatility and bring Malaysia’s fiscal deficit into focus. One of the methods to address the deficit is through levying the Goods and Services Tax (GST). Malaysia needs to introduce GST out of necessity as it faces a structural deficit and too much is at stake for not following through with the implementation.
There has been much debate on whether or not GST is a regressive tax (where the poor suffers a higher burden than the rich). We stand by our research that GST on its own is regressive but when GST is combined with cash handouts (BR1M) and income tax cuts, it is the middle-income households that will have less cash because they are not eligible for BR1M and do not benefit much from income tax cuts. These households earn between RM65,000 and RM103,000 per annum.
Many are naturally worried about rising inflation post-GST implementation. Using a mechanical calculation of the CPI basket, we expect inflation to increase 1.3%. The Australian experience shows that prices will increase over the short term after GST is introduced. However, with strong external deflationary forces, falling, or even negative, inflation is the longer-term threat.
After two months of falling inflation, Thailand recently cut interest rates, joining the growing list of countries easing their monetary policy. Therefore, the pressure to cut interest rates in Malaysia will soon rise after the jolt from higher prices post-GST implementation.
If the interest rate is cut, new lending restrictions might need to be implemented because household debt stood at 87% of GDP in 2013 and grew another 9.9% last year with residential property loans rising 13.2% (2013: 12.9%).
Besides, due to the aggressive monetary policy adopted by Japan, the yen has depreciated significantly against the renminbi (up 25%), the won (up 24%) and Taiwanese dollar (up 19%) in the last two years. Malaysia is “fortunate” that the ringgit has appreciated only 5% against the yen.
With the Bank of Japan committed to hitting its 2% inflation goal and Germany’s competitive position boosted by the ECB’s QE equivalent, the yen might continue to fall. Hence, Asian currencies might embark on competitive devaluation in the future as it is highly unlikely that the Chinese, Korean and Taiwanese authorities will tolerate currency appreciation of the same magnitude in the next two years.
The end of the US QE programme need not necessitate a global contraction of liquidity as the Europeans and Japanese have embarked on their own versions of QE. Future crises need not follow the same mechanism as in the past but the transmission mechanism through the financial markets is likely to be more pronounced.
Beyond the shock of GST, falling inflation is likely to be a concern. With strong external forces, a lower ringgit also seems to be the path of lesser resistance.
Dr Lim Kim-Hwa is CEO and head of economics at the Penang Institute. He is also a Fellow in finance and financial reporting at the University of Cambridge and an associate chartered accountant of the Institute of Chartered Accountants in England and Wales.
This article first appeared in The Edge Malaysia Weekly, on March 23-29, 2015.