This article first appeared in The Edge Malaysia Weekly on June 25, 2018 - July 1, 2018

THE local currency revisited the 4.00 level against the US dollar last week. But it has not performed any worse than its Asian peers since the beginning of this month and has been among the best performers in the region in the past six months. So, where is the ringgit, which saw its worst depreciation two years ago, getting its strength from? The Edge outlines four factors that have been impacting the local currency and which could determine its direction in the next 6 to 12 months.

1 Crude oil prices

Being an oil-producing country, it is hard for Malaysia to escape the effects of volatile crude oil prices.

What is worth noting is the direct correlation between the movement of crude oil prices and the ringgit. During the oil boom that began in 2009 and ended in late 2014, the local currency gained strength, hitting a high of 2.9390 against the greenback in July 2011.

Likewise, when oil prices started crumbling in June 2014 — Brent crude fell 58.86% from US$115.06 per barrel on June 19, 2014, to US$47.34 on Sept 28, 2015 — the ringgit suffered its sharpest depreciation since the 1997/98 Asian financial crisis. It tumbled 38.4% from 3.22 against the greenback on June 20, 2014, to 4.45 on Sept 29, 2015.

Not surprisingly, when crude oil rebounded from US$45.54 in June 2017 to the US$70 level in March this year, the ringgit hit 3.86 against the US dollar — its highest level since May 2016. Suffice it to say that the ringgit’s movement is determined, to some extent, by how the members of the Organization of the Petroleum Exporting Countries (Opec) control their oil production.

When Opec cuts its production, oil prices will ultimately rise. In fact, after its members reached an agreement to reduce supply in November 2016, after eight long years, crude oil prices recovered some 50%.

Nevertheless, it has been reported that Opec is currently divided between increasing production, given strong demand, and continuing to maintain it at the current level.

According to the International Energy Agency (IEA), one of the issues that will likely dominate the June 22 Opec meeting in Vienna is oil exports from Venezuela and Iran. In Venezuela, which has the world’s largest proven crude reserves, oil production is on the brink of collapse as it battles recession. Iran, meanwhile, is being threatened by another round of sanctions by the US.

IEA believes that by end-2019, output from these two countries could be 1.5 million barrels per day — much lower than current levels. It adds that it estimates the Middle Eastern Opec members to increase production by about 1.1 million barrels per day to make up for the shortfall and expects more output from Russia.

“However, even if the Iran/Venezuela supply gap is plugged, the market will be finely balanced next year, and vulnerable to prices rising higher in the event of further disruption. It is possible that the very small number of countries with spare capacity beyond what can be activated quickly will have to go the extra mile,” the agency comments in a recent Oil Monthly Report.

According to IEA, crude oil demand has been forecast to hit 100 million barrels per day by the middle of next year. Some quarters believe this should help prevent prices from crashing to the lows seen in 2014, even if Opec decides to raise oil production after its latest meeting. 
 

2 Overnight policy rate trend

A rise in interest rates would help lift the ringgit, which had depreciated to 4.0022 against the US dollar last Friday. But any rate hike would have an adverse impact on the domestic economy, not to mention household and national debt. By the same token, keeping the overnight policy rate (OPR) low could result in capital outflows as money goes to where the interest rates are high.

Shortly after Tan Sri Muhammad Ibrahim assumed the post of Bank Negara Malaysia governor on May 1, 2016, he cut the OPR by 0.25% to 3%. In January this year, he raised the rate by 25 basis points to 3.25%.

But with Datuk Nor Shamsiah Mohd Yunus taking over his post from July 1 (to June 30, 2023), will the monetary policy, which is accommodative to growth, remain unchanged, when the US and other countries are raising rates aggressively?

Recently, the US Federal Reserve raised interest rates by 0.25 point, putting the Fed Funds Target Rate in the 1.75% to 2% range. The central bank has said two more rate hikes are appropriate, bringing the total number of hikes to four this year.

Local economists do not see any more rate hikes by Bank Negara this year, regardless of the change of the guard at the central bank. They believe that the OPR will be maintained at 3.25% for the rest of the year.

“We are still keeping our single rate hike for OPR intact for 2018. Inflationary pressures remain moderate while domestic growth is expected to be resilient in the near term. At this juncture, the current level of OPR is sufficient to support growth amid volatility due to external developments,” says MIDF Research head Dr Kamaruddin Mohd Nor.

AmBank Research does not see any urgency to raise rates, given that the economy is sitting on comfortable positive real returns, coupled by the fact that the ringgit is still one of the strongest currencies in the region.

The research house adds that there is no demand-pull inflationary pressure despite an increase in consumer spending from the fuel subsidy and removal of the Goods and Services Tax.

While grappling with the impact of capital outflows due to the narrowing interest rate differentials between Malaysia and the US, Bank Negara is likely to tolerate a soft ringgit along with the weakening of regional currencies against the US dollar, says Socio-Economic Research Centre executive director Lee Heng Guie.

“Nevertheless, should domestic economic conditions improve, the market and investors must prepare for a further easing of monetary accommodation,” he adds. 
 

3 New political landscape

First, they were surprised, then they were concerned. That is probably the reaction of foreign investors when Malaysia changed its government for the first time in 60 years.

The zero-rating of the Goods and Services Tax, removal of road tolls, halting of major infrastructure projects and revealing of the national debt of over RM1 trillion have caused concerns about the country’s growth prospects, the government’s fiscal position and, more importantly, the country’s sovereign rating.

Since the May 9 general election, the ringgit has depreciated 1.67% against the US dollar. Nevertheless, its decline had begun a month earlier, on April 2. Between April 2 and June 21, it had lost 3.98%.

“The selling pressure on the ringgit was evident with the unexpected outcome of the 14th general election ... foreign investors rebalanced their portfolios on concerns about political and policy transitions, including the review of mega projects,” says Socio-Economic Research Centre (SERC) executive director Lee Heng Guie.

Nonetheless, he points out that the ringgit’s decline was aggravated by external factors such as the surging US Treasury yields, expectations of further US interest rate hikes, fears of contagion risk in emerging markets on capital reversals and strengthening of the US dollar.

As the new government works on setting its policy direction, there are bound to be uncertainties, and investors, local and foreign, will stay on the sidelines.

One thing that could be unsettling for foreign investors is to see the combined federal government debt amounting to RM1 trillion. Lee says this warrants close monitoring as a default on the contingent liabilities will ultimately dent the government’s balance sheet.

Rating agency Moody’s Investor Services says the government’s treatment of various debts from other sources will play an important role in determining the risks contingent liabilities pose to the country’s credit profile in the future. “The new administration’s treatment of large infrastructure projects that may be placed under review, but have benefited from government-guaranteed loans in the past, and the outstanding debt of 1Malaysia Development Bhd (unrated) will play an important role in determining the risks contingent liabilities pose to the credit profile,” it says in a statement.

However, it has not changed its assessment of Malaysia’s direct government debt burden as yet, keeping it at 50.8% of gross domestic product for 2017.

Meanwhile, the move to abolish GST and replace it with the Sales and Services Tax is causing concern — whether the government would be able to make up for the revenue lost and narrow the budget deficit.

Moody’s has warned that the removal of GST without an effective compensatory fiscal measure will be viewed as a “credit negative” because it will result in the government being more dependent on oil revenue. Furthermore, the move would mean narrowing the government’s tax base.

MIDF Research economist Dr Kamaruddin Mohd Nor opines that the government’s revenue measures will play an important part in the overall fiscal position in the face of a narrower revenue base.

According to SERC’s Lee, foreign investors and global rating agencies will remain wary of the government’s commitment to fiscal consolidation and debt containment, particularly its capacity to honour its debt obligations promptly.

“A default would cause a downgrade in the country’s sovereign rating and a hike in borrowing cost for corporates and exert downward pressure on the ringgit as investors sell Malaysian bonds,” he says.

Despite this, it should come as a comfort that the government is committed to maintaining its fiscal discipline to reduce the country’s budget deficit to 2.8% this year.

Kamaruddin says greater clarity in policies and taking measures to beef up governance could boost the ringgit.

Lee believes that a continued current account surplus, clarity of policies, fiscal and debt path and the affirmation of Malaysia’s sovereign rating could support the ringgit over the next six months. 

4 US dollar’s renewed strength

The safe haven status of the US dollar, which is highly sought after by investors and central banks around the world, remains intact, although countries like China have been increasingly looking to settle cross-border trades and commodity contracts in other currencies.

So when US President Donald Trump last Monday threatened to slap new tariffs on US$200 billion worth of Chinese imports, investors sold equities across Asia and other emerging markets and flocked to such assets as US Treasuries and other highly rated government bonds. Gold, the yen and Swiss franc are some of the other perceived safe haven assets.

However, the greenback’s renewed strength is not just due to a flight to safety on fears of a trade war.

US dollar assets are also relatively more attractive because of the US Federal Reserve’s hawkish stance on interest rates compared with other major central banks, economists say.

“The dollar is so heavily backed by investors because of how far ahead the US is in terms of economic progress and monetary policy compared with its peers in the developed world. Essentially, the US economy and Fed are offering investors something that other developed economies and central banks are ultimately unable to — consistency. The Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan are all unable to provide this,” says Jameel Ahmad, global head of currency strategy and market research at FXTM, in a June 18 report.

There are “no current indications that the US dollar will experience a reduction in buying demand”, he adds.

Economic data from the US has also not disappointed, at least not yet. The US economy is still adding jobs — its unemployment rate in May was at an 18-year low of 3.8% — supporting wage growth.

Citing robust economic growth and low unemployment, Fed chairman Jerome Powell, on June 20, said the case for further interest rate hikes remains “strong”.

Just a week earlier (on June 13), the Federal Open Market Committee (FOMC) had given a more optimistic view of economic growth and higher inflation expectations after voting to raise US interest rates by another 25 basis points — the sixth hike since the first increase in December 2015 — putting the federal funds rate to a new range of 1.75% to 2%.

The US central bank also signalled two more hikes this year, bringing the total for 2018 to four — one more than what economists and analysts say the market had priced in. At least two more rate hikes are expected in 2019, experts say, which would bring US interest rates closer to the 3% level seen as the longer-term normal.

“The Fed’s hawkish outlook has been the trump card for the US dollar in 2018. Our view for four Fed hikes this year was affirmed at the FOMC meeting on June 13. With other major central banks on hold this year, the US dollar is widening its positive rate and bond yield differentials against the euro, the British pound, the Australian dollar and the yen. With the federal funds rate at its 2% inflation target, the Fed has started communicating that its monetary stance cannot stay loose indefinitely,” DBS Bank’s FX strategist Philip Wee writes in a June 22 note.

Indeed, the Fed’s more hawkish stance on interest rates came just ahead of the ECB’s dovish statement that interest rates would likely remain unchanged “at least through the summer of 2019”. The euro also fell after the ECB outlined the end of its quantitative easing programme, halving bond purchases from €30 billion to €15 billion from September before stopping in December 2018.

There is also uncertainty about the next interest rate hike by BoE, which increased its rate for the first time in a decade to 0.25% in November last year.

The pound sterling rose last Thursday after news broke that the BoE’s chief economist unexpectedly joined two other policymakers in voting for an interest rate hike (although rates were kept unchanged), renewing hopes for an increase by year-end, if not in August.

Experts, however, see fresh concerns about the lack of progress in the Brexit negotiations between the UK and the EU weighing on the British pound. Unlike the US, the UK has seen relatively disappointing economic data this year.

The prospect of a stronger dollar also makes US dollar assets more attractive ahead of a currency appreciation. Little wonder then that the greenback rallied to its highest level in over a year after the likelihood of an interest rate hike increased.

The US Dollar Index — which takes into account the exchange rates of a basket of major currencies, such as the euro, yen, Canadian dollar, British pound, Swedish krona and Swiss franc — on June 20 reached its highest level since mid-July 2017, Bloomberg data shows.

Whether the US dollar will continue to outperform its peers will likely be tightly linked to how well the US economy can continue to deliver growth.

“The upshot is that US rates are not willing to head lower unless US economic indicators start to falter. That has not happened. US macro data appears to be holding relatively better than in the rest of the world,” DBS Bank’s rates strategist Eugene Leow writes in a June 22 note.  

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